The Commandments of Borrowing

1.  Asking “How?” and “What are the proceeds used for?” is just as important as asking “How much?”  In the majority of borrowing situations, the business owner focuses only on how much money they need as their primary concern.  But understanding what the proceeds will be used for and how the loan will be repaid is equally important, because ignoring these issues could lead to borrowing wrong.

“Is borrowing wrong even possible?” you may ask.  It is not only possible, but it is probably likely, unless both the debtor and the lender approach each borrowing situation armed with a firm understanding of the basic financing patterns and the lending requirements for the correct structuring of liabilities.  Improper financing can be the death to a business. 

2.  Growing businesses and farms will often require an increased investment in both current and fixed assets.  It is incorrect to assume that growth in revenues will occur without any required growth in assets.  The only case where this is not true is if there is gap of unused capacity within the growing company and an increase in efficiency where the result is an increase in sales. But in most cases, if your borrower expects to double his sales, it will require an increase in resources to accomplish that.

3.  Fluctuating current assets should be financed by cash or short-term debt and paid off by cash flow.  Recently, I saw a financial statement from a company that had a large debt to a supplier that was over six years old!  This is a situation where the borrowing was improper.  If you borrow money from a lender or a vendor to get supplies that you need to manufacture your product, that debt should be paid off when you sell the product and are paid.  It should not be paid off from net profits after all other operating expenses are taken care of. 

Lenders can help manage this structure with using borrowing bases and other controls to force the business to pay back the operating lines in a timely manner.  This also requires understanding how and when cash flows through the business for proper structuring.  Lines should be reviewed at least annually and should be monitored at least monthly.

4.  Permanent current assets are financed by equity, permanent current liabilities or intermediate term debt and are paid off by net profits.  Any seasoned lender has been in a place where a line of credit becomes “evergreen,” in that it does not get paid off or reduced in outstanding balance.  This is a clue that the line is improperly structured.  These debts should be placed on an amortized payment and paid off by the net profits of the business over a reasonable period of time, perhaps up to 5-7 years.  The struggle here for the lender is how to properly collateralize this loan, since assets such as real estate, buildings and equipment may already be pledged.  Use of a government guarantee like the SBA may be a nice alternative to mitigate the risk. 

Permanent current assets are the base levels of cash, accounts receivable and inventory that these items never drop below.  If a company has an accounts receivable level of $50,000 and inventory of $50,000 with sales of $1MM, then it is expected that the company would need to have receivables of $100,000 and inventory of $100,000 to reach sales of $2MM.  This is assuming the accounts and inventory receivable turnover ratios remain constant. 

Of all the needs for lending, the most difficult may be the permanent current asset financing.  When a company has real growth, as opposed to a seasonal fluctuation, that represents a permanent increase in current assets, these will behave like a fixed asset.  This should be financed with equity, permanent current liabilities, expanded terms from suppliers, or intermediate term debt. 

5. Fixed assets are financed by equity and long-term debt and are paid by net profits of the business.  Most of these assets are capitalized and depreciated.  Fixed assets usually relate to fixed costs, those that do not change relative to sales over a reasonable range.  Increases in fixed assets should lead to greater capacity for the business to increase revenues. 

These are generally the easiest to finance.  The amortization term should not exceed the useful life of the asset.  Proper LTV, LTC, and terms are usually spelled out in your loan policy. 

6.  Ignoring these principles will lead to friction between the borrower and the lender.  It could lead to a business that fails and a lack of sleep as the loan officer worries about the customer.   Proper adherence to these ideas will give the business or farmer the best chances for success and also grant adequate cash flow to sustain the business.

A Company Gone Under

The last stage of company growth after Wonder, Blunder, and Thunder, is the Under stage.  This is the time when the company’s effectiveness wanes and many firms just go out of business completely.  A company can fail for many reasons.  It can fail to recognize new trends that make their product irrelevant.  It can fail due to poor financial management.  Its leadership can also fail to plan for the future.  Consequently, many companies die and are buried each year.

When dealing with this stage, it is important to realize that sometimes it is healthy for a company to be allowed to die; in some cases it is planned.  A case may be a small one-accountant CPA firm with no future succession plan.  In that case, it would be wise to sell the business and close shop when possible.  Some companies may exist to complete a particular task, and when the job is done, the company needs to end.  In each of these cases, it is important to make adequate plans to close the business.

Some companies do not adapt to changes in the world around them.  Just think of the changes in how music is delivered.  When I was born, records were the rage.  Then came the 8-track tape.  This was improved with the cassette tape.  The first stereo I bought could play records, 8-tracks, and cassettes.  I thought that I would never need another system as long as I lived. 

But then came the CD.  The sound quality was so much better and I thought that this was where all music was going.  Now we have iPods and downloadable music that is more convenient and sounds better than any other in the past.  Music can be downloaded any time from multiple sources on the Internet, and trips to the record store are obsolete.  My kids have more music on their devices today than I ever dreamed could be possible. 

If you had a company that just made records or just made cassette tapes and never adapted to new ways to deliver music, you would already have closed your doors by now.  Avoiding the “under” stage requires vision and foresight to keep the company out of the graveyard. 

Avoiding this stage also requires the company to have some of the characteristics of the other three stages.  The firm needs the excitement of the wonder stage and the desire to understand the world around it.   They also need to be willing to take the chances and overcome the failures evident in the blunder stage.  The company must also capitalize on the victories and make a real difference in their market area. 

With proper planning and work, a company can maintain its status as live and vibrant instead of being six feet under and pushing up daisies.

The Thunder Stage - Making Real Noise in the World

If a business is able to grow beyond the Wonder and Blunder stages in its life-cycle, it will next come to the Thunder stage.  The impact companies have in this stage is similar to a Midwestern thunderstorm, with its flashes, crashes, wind, and rain.  The impact may be felt worldwide or may be on a local basis.  No matter what the scope of the market area is, the company does make a difference, and cannot be ignored.

Many of these companies are ones that are studied, benchmarked, and copied by others.  Larger ones may become household names like Apple, Microsoft, Toyota, Lowes, or Exxon. Large or small, the businesses make a lasting impact in the world around them.  They may even change how people live and the products they demand.  The explosion of personal computers, tablets, and smartphones are good examples of this. 

Companies in this stage are defined with a strong culture.  They have strong demand for their product and can command a good price for it.  They may be able to determine what customers they want to work with.  They also may be able to make a difference for the long-term and become a wonderful place to work for their employees.

The challenge to a company in this stage is how do they remain a “Thunder” force?  Just like a thunderstorm will dissipate when the conditions are not conducive, companies or products can also fade away.  In the past three years consider some of the large companies that have gone out of business:  Hollywood Video, Circuit City, Borders Book Stores, Ultimate Electronics, Fashion Bug, and Hostess.  These are all companies that we all assumed would always be there. 

Navigation in the Thunder stage is just as important as it is in any other business growth stage.  There is a tendency to become complacent in this stage since the company has “arrived;” however, that is just the recipe for failure.  The best companies that stay a Thunder force will spend a lot of resources improving existing products or delivery service methods, or expanding into new ones that fit their business model.  A good example is the constant improvement Apple makes with its products.  We have watched a company once irrelevant, and noted for its school computers; expand its reach into a high quality product that competes with personal computers in many homes.  They have begun the use of Apps instead of programs and have established the tablet and smartphone benchmarks with their iPad and iPhone.  Now, Apple is setting its sights on TV and changing the way you receive your cable or satellite channels. 

Succession planning of key personnel and products is also important.  A law firm may be one of the best in its area, but if they have key attorneys who leave or pass away, it can devastate a firm who has not properly planned.  If a manufacturer like Hostess does not place its company on firm financial footing, it may not have the resources to continue in the future.  If a company, who may be at the top of their class, fails to recognize a trend that is moving away from the industry, they will not remain a force for long.  Note how many blacksmiths and buggy whip manufacturers are around today.  Long-term vision is important to remaining in this stage.

It takes proper navigation, succession planning, and continual development for a company to continue to make a lot of thunder for the long-term.

The Blunder Stage—Going from Mistake to Mistake with Great Enthusiasm

The second stage of a four-stage business life-cycle is the blunder stage.  This stage is marked with flashes of brilliance among a sea of blunders, much like one will find in adolescence.  In this stage, the wonder of the early stages of the business has worn off and actual executable plans find mixed results of successes and failures. 

The challenge here is to not make mistakes serious enough to kill the business and also, to not get so discouraged that the business owner gives up.  Endurance and persistence are keys for a business to get through this stage. 

Winston Churchill said, “Success consists of going from failure to failure without loss of enthusiasm.”  Clearly these words must have rung in the ears of Englishmen while they endured some of the darkest days of WWII.  Churchill also realized that the journey is more important than success or failure when he said, “Success is not final, failure is not fatal; it is the courage to continue that counts.” 

The business leaders in this stage should remember the early wonder years of the company.  Why did you get into business to begin with?  What opportunities were you hoping to capture?  What was your business plan?  When you are in the thick of long work days, unending deadlines and a string of mistakes, it is easy to call it quits.   That is why it is important to review the vision and mission of the firm and relive why you started.

Not only is it helpful to remember the wonder years, it is helpful to look forward to the future to the next business stage, the thunder years.  These are the times when the company really becomes profitable and effective in its mission.  The mistaken laden times the business owner is in now will eventually pass.  Failure is not fatal, it is important to learn to fail forward. 

Some of the most successful businesses came from failing forward.  Henry Ford went bankrupt seven times before he landed on the Model T.  Dave Anderson bounced from job to job and city to city as a travelling salesman.  When he failed at that business, he opened up Famous Dave’s BBQ, his real love and passion, and became a millionaire.  Fred Astaire had his first rejection letter hung above his fireplace.  The director who turned him down for a part said he could not act, was a bad singer and was even worse as a dancer.  Astaire went on to become a household name with his dancing and acting with Ginger Rogers.

Flexibility and wisdom are important in this stage.  Leaders need to be flexible enough to change direction, abandon a product, or revise a strategy when necessary.  But they also need the wisdom and insight necessary to know when to stay the course and push through the failures, knowing they are on the right path.

Unfortunately, some businesses never move out of this stage, just like some people never seem to grow up.   But for the ones that push through, the glory years are just ahead.

The Life Cycle of a Business-Wonder

I once worked for a boss who believed that any business goes through four distinct phases in its existence, from its beginning to when the doors close down.  The overall success of the business will be determined on how well the leadership navigates through these stages and continues to remain relevant to its revenue source.  The ultimate challenge is for a business to avoid the last stage and to continue into stage three.  The four stages are: wonder, blunder, thunder and under.

Wonder:  Have you ever watched a young baby or toddler explore the world around them?  Have you ever gone on a trip to a new place that you always wanted to go?  In either case, you can see the wonder that surrounds the person as they explore their world.  The explorer’s eyes are big, and they tackle assessing every detail possible about their environment with inexhaustible zeal.  It has always fascinated me to watch people passionately exploring the world around them. 

This stage applies to businesses as well.  In many ways, MBS is in the wonder stage.  There are so many opportunities for a well-run business and agriculture CUSO.  We are located in the strongest economic growth area of the country that is being driven by multiple industries, a business friendly state and local government (compare that to much of the rest of the nation), a desirable place to live, and wonderful, hospitable people.  The demand for our services is off-the-chart as we are swamped with new deals, even when we have not actively solicited new business.  We are also gaining new, experienced people, who are excited about the possibility of building a company and making their mark on it.  Every day when I come to work, I am excited and amazed with the possibilities set before MBS.  We are truly blessed.

All start-up businesses go through this stage.  But not only start-ups, this stage can also apply to an existing business introducing a new product or service as well.  This stage is marked by characteristics that are necessary for a business in any stage to have, if it is to grow.  Any firm who wants to be better cannot just be satisfied by the status quo.  They must desire to achieve greatness.  The leadership must be willing to explore the world around them and discover ways they can become relevant with a new product, service, or a new way to make something existing better.  This is why large companies have strong research and development departments. 

My oldest son is interested in pursuing a major in game design in college.  We recently visited with a professor at an institution that offers a degree in this area.  As he spoke, you could see the wonder that he had for his field.  And as he spoke, his passion also transformed his wonder into actual wonder owned by my wife, son and myself.  You see, wonder is transferrable, and the passion of an executive can be shared among an entire team.  Someone once said that you can gain an audience if you set yourself ablaze first. 

 In that meeting, I learned that game design is not just about a nerd in his parent’s basement building some shoot-em-up game to be stocked at the local Game Stop.  Design involves an intricate team of professionals working together as one.  You have a story-teller who writes and designs the script of the game.  Graphic designers turn the written idea into pictures.  Three dimensional graphic artists make the game appear to be in the real world.  Scientists help keep the game grounded, using natural laws of physics or creating the game to defy those laws.  Computer programmers turn all this work into an actual game on some sort of platform.  Marketing professionals take the game and figure out how to distribute and sell the game.  They also get feedback from the market for improvements or for the next game.  It also takes leadership to make sure all these areas work together at once for one goal.

As the professor’s eyes sparkled while he described the process, I realized that successful companies in this industry are built upon a collaborative company model.  In many ways, these companies are textbook examples of how a business can run and work as a team.  Communication between the different players is important to achieve the final goal.

The industry is not just about what you buy your kid at the game store for his X-Box.  Games are being used for medicine, in rehabilitation of patients with brain injuries and training students.  Companies are beginning to use games to train their employees as the employee will retain more knowledge in an interactive environment that involves more senses rather than just reading or listening to a lecture.  Even large financial companies like Wells Fargo are looking to gaming as a way to train staff. 

The degree is challenging, with students taking classes such as physics and calculus.  Graduates compete for jobs with students from MIT.  Starting salaries are often above $80K annually.  But the possibilities are endless.  This is an industry in a wonder stage.

Some companies never leave this stage.  Now it is great for companies to always have some wonder in them, for that keeps them growing.  But to never leave the wonder stage is like always remaining a toddler.  A problem in this stage is focus and long-term planning.  It is easy to become so enamored with your surroundings that you go nowhere and are constantly running from one opportunity to another.  Strategic planning is essential. 

Coverage Ratios: Is Your Company a Little Exposed?

Coverage ratios are designed to measure how well a company is able to meet the demands of its operational expenses and debt requirements. They are similar yet different from leverage ratios. In leverage ratios, we measure the lender’s margin of comfort in the event of liquidation. Coverage ratios indicate the cash flow margin of the company as a going concern. Highly leveraged companies or businesses with high debt requirements are vulnerable to an economic downturn or a drop in top line sales, because the fixed payments from the debts may conflict with the reduced cash flow from the falling sales. The company will have to do whatever they can to provide cash to satisfy their obligations. Ultimately, an answer will be to find a way to de-lever the company and reduce its obligations.

Times Interest Earned Ratio (Interest Coverage) is used to show the ability of the company to meet its interest obligations. It is used a lot by public bond rating agencies and banks monitoring revolving lines of credit, revealing the amount of company earnings needed to pay interest on its debt. The reason for the focus on just the interest rate exposure is that many bonds and lines of credit do not require any amortization.

Since it does not take into account the principal portion of payments, the ratio will have its shortcomings. But it is a valuable picture of what impact an increase in borrowing rates will have on the company’s cash flow and the extent which earnings pay the financing requirements of the firm. The ratio must be at least greater than one, since a ratio below one will indicate the company does not make enough net cash flow to pay its interest requirements. This is the case in several European countries now.

The ratio is as follows:  (Net Income Before Taxes + Interest Expense) / Interest Expense

Debt Service Coverage Ratio is the granddaddy of the coverage ratios in the eyes of the lender. This measures the ability of the company to perform on its debt obligations. In simple terms, it is defined as:  Earnings Before Interest, Taxes, Depreciation and Amortization (EBIDTA) / (Interest Expense + Current Portion of Long Term Debt (CPLTD))

This is designed to show, after paying all the operational expenses of the business, how does the debt requirements compare with the EBIDTA. A ratio of 1:1 would indicate that the company is able to pay all its obligations but has no money for anything else. Lenders will often use this as a loan covenant or measuring tool to assess the health of the business. They will also have different thresholds for different industries, ages of collateral and types of collateral.

There are some concerns with this ratio. If a company makes large capital improvements and then expenses them, this could lower their EBIDTA to a point where they may be in violation of their loan covenant. A prudent solution is to keep separate financials according to GAAP while having another set that complies with the tax law. An example here would be a manufacturer who is able to fully expense $200K in capital improvements to their plant under repair and maintenance in the year the work was completed. This reduction in EBIDTA may put the company in violation of the DSCR requirement.

A shortcoming with using the DSCR is that the expenses for taxes are real cash expenses. Using the DSCR they are not regarded at all. Another problem with using EBIDTA is if a business has regular ongoing capital expenses each year, necessary to continue operations. Ignoring those expenses may show an adequate DSCR, but miss the overall shortfalls of cash needs the company may have in order to keep operations intact.

Another issue with DSCR is how to treat large salaries or personal expenses of the owners. These would be treated as ongoing operational expenses, but if excessive, may show the company in a worse light than what it is. If the excessive salaries are added back, then a look at the global picture of the owners, the subject company and their other businesses may be appropriate in judging the financial ability of the company.

Funded Debt/EBIDTA Ratio and the Debt Yield are used by some banks to see a comparison of the balance of all funded debts to EBIDTA. The ratio for Funded Debt/EBIDTA is:  Balance of all Funded Debt / EBIDTA = Funded Debt to EBIDTA ratio.

If you have a company with a ratio of 2, this would mean that the entire balance of all funded debt is only twice the amount of EBIDTA. The reciprocal of this is the Debt Yield which is figured by:

EBIDTA / Funded Debt = Debt Yield and is usually expressed as a percentage. So if we have a ratio of 2:1 in the above ratio, this one would be 50%. These ratios are used by some lenders to judge the amount of leverage compared to the net operating income of the company.

The Power of Persistence

In college, most fraternities and sororities tend to headline some of their most successful members:  CEOs, athletes, celebrities, great scientists and presidents.  It was during my freshman year that I became acquainted with Calvin Coolidge, the only US President who came out of my fraternity.  Coolidge is not as well-known as many other Presidents.  He was known as a man of few words.  One time, at a party, a lady guest bet the President that she could make him say more than three words.  Coolidge calmly replied, “You lose!” and walked away.

When Coolidge spoke, his words were very pithy.  It is his comment on persistence that has made an impact on my life.

“Nothing in the world can take the place of Persistence.  Talent will not; nothing is more common than unsuccessful men with talent.  Genius will not; unrewarded genius is almost a proverb.  Education will not; the world is full of educated derelicts.  Persistence and determination alone are omnipotent.  The slogan ‘Press On’ has solved and will always solve all the problems of the human race.”

The wise commercial or agricultural lender knows that persistence is very important in the sales process.  True, it is good to have some easy deals that can be done quickly, but the real “golden members” often take months and years to cultivate.  These are not transactions, but long-term relationships with people who own and run the businesses.  These people are the same as you and I, in that we all have hopes, dreams, ideas and things that will keep us up at night.  We all aspire to do great things beyond ourselves, for that is how we are made.

After being on both sides of the credit union/banking fence, I think that the relationship building aspect comes easier to the credit union folks.  I may be wrong on this, but I feel the credit union culture is more focused on people and relationships than profits and bottom lines.  Relationships take time to build, sometimes years, but the outcome can be rewarding.

When I was banking in Missouri, one of the clients I was handed had a $500K loan with our bank and was a large developer.  The client had a small group of financial savvy individuals he would work with on large condominium projects.  My first strategy was not to ask for more business, but to learn more about them and their company.  I grew to know all the players and their families over several years of meetings, lunches and site visits.  When I left that bank, we had over $12MM of various projects and term notes that we financed for them.

My longest persistence story came when I was in Colorado.  About a year after I began banking there, I was introduced to a small company that was growing rapidly.  They were in a segment of the construction industry that did not experience the economic slowdown and was the recipient of large sums of Federal, State and bond funding.  I met and began to get to know the CFO and one of the owners. 

I spent time with them and learned about their industry, their company and developed a relationship with them personally.  After a couple of years, we closed a large construction crane lease of over $1MM.  We still had no deposit accounts nor did we have their main lending relationship.  My strategy was to continue to get to know them.  I made office visits, had lunch and breakfast appointments and took them to sporting events.  Around 4 ½ years into the relationship building, the main partner completed a large job in Missouri and Australia and moved back to Colorado.  We opened personal accounts and closed on a mortgage and equity line for his new house.  We also began to discuss moving the main source of financing to my bank. 

Eventually, after 5 years of developing a relationship, we established a relationship with over $15MM of loans and another $20MM of deposits.  It was one of the largest new deals our bank did that year.  This was done with a combination of genuine interest in the people and the company, willingness to invest time with them (even sometimes investing your time for the long haul instead of the quick easy deal that comes in the door), and persistence.  The commercial and agricultural sales cycle is sometimes quite long.  But if you are persistent, it is rewarding.

Small Business Survival Tips for Tax Time

Well tax season is here again!  While many of us struggle just to keep our records straight, we need to take a moment and look at tax strategies available for the small business.   Many of your members are small business owners, and it is important for them to understand how taxes affect their business, how to properly file their returns, how to avoid audits and how to claim the right tax deductions. After all, one of the first steps to achieving wealth is to lower your tax liability to the lowest legal possible amount.  Here are some tips to ease the burden of the upcoming tax season and to help your members prepare for the April 15, 2013 deadline.

1. Keep Good Records and Understand Available Deductions - Your accountant may be able to advise you on the various tax credits and deductions that are applicable for the 2012 tax year, since their tax software programs are usually updated to ensure they don’t miss a single deduction. However, many accountants are overwhelmed this time of year and become focused on tax preparation and not tax planning.  It is important to form tax strategies to help lower your liability.  Your records should be kept as if you expected to be audited.

2. Utilize the Small Business Jobs Act Tax Provisions - The Small Business Jobs Act of 2010, signed into law by President Obama, has over 17 tax provisions to decrease tax burdens for small businesses. Several of these provisions may be taken advantage of during this year’s tax season.

3. Remember the Tax Credits within the Affordable Care Act – These tax credits will allow small businesses to recover up to 35 percent of the health care premiums a small business pays to cover its workers. In 2014, the tax credit will increase to 50 percent.  There are also some tax benefits for small employers who reimburse employees for out-of-pocket medical expenses.

4. Avoid Common Audit Traps - Your accountant can assist you in ensuring you are not placing ‘red flags’ in your return. An example is classifying employees as Independent Contractors. Independent contractors and employees are not the same, and it is important to understand the difference. Here is the ‘test’ provided by the IRS.

5.  Home Office Deduction - Know how to determine if you are eligible to claim this deduction, and if you are, be certain you do it properly using this IRS guide:

6.  Charitable Donations - Be specific and label every deduction on the check or receipt for non-cash donations. This link is the IRS Guide for non-cash charitable giving:

In fact, here is an online mini-course covering all IRS regulations with regard to charitable giving:

7. Keep Business and Personal Expenses Separate - Maintain separate bank and credit card accounts for your business and personal use. This provides easier record keeping and makes your business expenses more defensible in the eyes of the IRS.

8.  Learn the Laws that Govern Estate and Gift Taxing.  Many small businesses and farms are controlled by families.  It is important to learn tax law as it applies to transferring all or parts of the business to heirs.  Without proper planning, large tax liabilities could be incurred.  Here is the link to the IRS publications for estate and gift taxes.

As you see many members preparing for tax time, it is a good time to review the financing structure of the business or farm.  Perhaps there is an opportunity to plan for future expansion or a need to refinance existing debt with better terms or structure.  Feel free to contact us to help you serve your members.