Beware of this financing trap

As business owners, we would all like to fund company growth organically with revenue and profits. There are a number of things, however, that eat at our margins, including payroll, vendors, suppliers, insurance, etc.

Despite all these things, you never want to use short-term borrowings to cover long-term debt or long-term growth. To illustrate this, let’s use the real example of Company X, which made the Inc. 5,000 list four years in a row but ended up in a “fire sale.”

Unexpected challenges

Company X had a $500,000 line of credit, which it used to make small acquisitions. Leadership was managing payables and payroll as they expanded because revenue was growing and remaining consistent.

Life was good until the company lost its two largest clients, causing revenue to tank. Company X had been right on the verge of acquiring another company, too.

The current ratio, which gives an idea of the company’s ability to pay back its short-term liabilities, fell below its bank’s covenant for the line of credit.

You know the next chapter of the story: The bank called in its line of credit, and the company struggled to meet payroll and pay vendors and suppliers.

Matching loans with assets

A line of credit is meant for rising and falling working capital needs. Companies get into trouble by imaginatively using the easy availability of these short-term lines of credit. Some purchase equipment with money from a short-term line of credit, which is just as dangerous as making acquisitions.

Growth and equipment purchases require unique forms of capital cash planning. The mere act of rapid growth typically is not enough to create capital to fund growth or purchase large equipment.

Matching the term of the loan with the life of the asset is an important business principle. When purchasing equipment, consider asset-based lending. When expanding your company by acquisitions, consider equity financing.

Planning is essential

If Company X had properly planned for equity financing instead of just hoping for the best based upon the use of its line of credit, the company would still be in business today.

Yes, the founder would have had to give up some ownership, but he would have attained the required capital, while maintaining a healthy balance sheet and current ratio. The bank would not have called in its line of credit.

Proper capital planning is essential at every point in a business. As a business owner, do not assume that revenue growth will continue indefinitely. There is always something unexpected lurking around the corner.

Don’t be lulled into a trap because you have had four years of growth. Instead, stick to the principles of financing — fund long-term growth with long-term financing vehicles.