Companies looking to grow and needing an infusion of capital have several options, which come with various costs and requirements.
“We look at capital on a sort of continuum, with equity perhaps being the most expensive form primarily because of its diluting impact on ownership of the company. At the other end, there’s self-generated working capital derived from profitable operations,” says Paul Gibson, senior vice president and Eastern Region market manager at Bridge Bank. “In between there are a variety of financing options to assist a growing company.”
Smart Business spoke with Gibson about where small businesses fit along the continuum and options they have available to secure working capital.
What is the least expensive option to get working capital?
There is no cheaper form of capital than self-generated profits. Apple, Inc. is an example of a company that continues to be profitable and has a huge war chest of cash available for any need. But most small and growing businesses are not capitalized like Apple and look to banks to assist in the form of senior debt. This financing is usually based on a bank’s prime lending rate as its index and has a modest margin over, or under, this index. These loans are structured, including a senior secured lien on all assets through a Uniform Commercial Code filing and frequently have financial and/or performance loan covenants. There may be a borrowing formula and an advance rate against receivables as well. There is a direct relationship between pricing and structure, as all pricing is ultimately dictated by risk. When a business can’t adhere to a traditional covenant structure, the looser structure usually translates to increased pricing.
It’s best to determine working capital and growth capital needs first when exploring financing solutions. Next, identify the various capital sources starting at the least expensive and work down until sufficient working capital is obtained. Many times it’s possible to meet all needs with senior debt, but there is a limit to how much is available and that is largely determined by the profile and complexion of the company — overall assets, liabilities, cash flow, liquidity. All of these factors help identify risk.
Many growing businesses find it difficult to obtain traditional senior debt financing because they’re focused on growth at the expense of profitability. Some banks specialize in assisting companies in this dilemma, forging strong relationships long before the mega-banks will.
What’s next if companies can’t obtain sufficient senior debt?
Another potential source of working capital is subordinated debt, also known as mezzanine debt or venture debt. Subordinated lenders do not recover their first dollar in a liquidation scenario until the senior lender has collected its last dollar. This type of financing can take many forms.
With subordinated debt there is generally less structure than with senior debt. The reduced or even lack of covenants and junior lien position contribute to increased risk. Because there’s greater risk, subordinated debt also has a higher price.
Some banks offer these instruments, but more often commercial finance companies, hedge funds and other non-bank lenders offer them. The higher rates they charge are reflective of the higher cost of their capital, usually in investor funds or a bank line.
Why is cheaper not always better?
The true cost of capital shouldn’t only be measured in simple dollars or as the spread of basis points in an interest rate. The least expensive capital isn’t always the best capital because there are more factors than just price, such as opportunity costs, ease of use, flexibility of structure and other intangible benefits. For example, a low-interest loan with a covenant package that’s too restrictive can potentially result in a business disruption when a covenant violation occurs. Balancing pricing and structure relative to individual needs is critical when evaluating multiple loan options.
Most people assume that competition is the primary driver of pricing, but it’s not. Risk determines pricing — whether it’s equity or debt — and competition further refines it. Companies should understand their risk profile. It’s a powerful tool in helping to achieve the best outcome for a business’s financing needs.
Paul Gibson is a senior vice president, Eastern Region market manager, at Bridge Bank. Reach him at (703) 481-1705 or email@example.com.
Insights Banking & Finance is brought to you by Bridge Bank
Many businesses, at one time or another, have cash flow deficiencies. These can stem from a large account falling behind in payments to a seasonal increase/decrease in sales, among other reasons.
Even if a company manages its cash flow appropriately today, no one can predict the circumstances the company may find itself in a few months from now. The best thing to do is to conserve capital for these unexpected events, but the second best thing is to obtain working capital line of credit.
“A company does not need to anticipate cash flow issues to apply for a line of credit,” says Al DeFlaviis, chief lending officer at First State Bank. “Instead, think of it as an insurance policy that doesn’t need to be paid until you need it. But the time to talk to your bank about a line of credit is before you experience a working capital deficiency.”
A line of credit gives a company the opportunity to borrow on a short-term basis for payroll, to take advantage of inventory discounts and to pay other fixed overhead expenses that are due prior to accounts receivable collections.
Smart Business spoke with DeFlaviis about how to use a line of credit to meet your company’s needs for working capital.
How does a line of credit work?
Interest is charged on the outstanding balance, not on the unused portion of the line. Interest rates are almost always variable and are tied to an index such as the prime rate or LIBOR indices. Once you have established a line of credit, your company can usually advance and repay the line as often as necessary. Lines of credit are usually renewed annually at a time when the your company’s annual financial statements have been completed.
How can a business determine what its line of credit should be?
To begin the process, you should first meet with your financial adviser or CPA before arranging a meeting with your banker. Preparing beforehand and gathering your information will allow the banker to better understand your business and determine your capital needs. If those needs are short term, a line of credit may be the appropriate solution, as a line of credit should not be any more than an amount that can be repaid through revenue production within 30 to 90 days.
However, if those needs are longer term, another type of loan may provide a better solution. Term loans are used primarily for long-term capital expenditures such as purchasing equipment, buildings, building improvements, etc., and are made for periods of three to 10 years.
How do banks determine what credit line they’re willing to extend?
With a line of credit, the way funds are used is left to the discretion of the borrower, so the bank carries more risk. As a result, a company must have a good business credit rating and a solid company financial history; it is unlikely a lender will approve lines of credit for start-ups or businesses without a track record of financial success.
Lenders generally also require collateral to secure a line of credit, which is nearly always asset-based, with equipment and facilities backing the line. However, credit lines can also be secured by receivables, inventory and by the owner’s personal assets, and it is not unusual for the bank to require a business owner to personally guarantee repayment of the line of credit.
When entering credit discussions with your bank, be as open as possible about the financial picture of your company. Be prepared to provide financial documentation including profit and loss statements, balance sheets and company tax returns.
Having an inside look at the business not only provides your banker with the confidence to recommend the loan package, but he or she is more likely to lobby on your behalf when the line comes up for approval.
How can a business identify a suitable bank to partner with?
Ultimately, you want to be able to lean on your banking relationship to help your business in good times and in bad, so begin by examining your existing relationship. Has your bank been responsive to your needs, acting not just as a lender but as a partner? If not, it may be time to find another bank.
Look for a banking partner that is the right size and complexity for your needs. For example, a national bank may use an automated scoring system to determine credit. Regional banks are often compartmentalized by market share and industry, and when a business changes or evolves, a different banker is assigned.
Community banks, on the other hand, usually have one person, a commercial relationship manager, who coordinates products and services. That person will understand the needs of your business and create a package of products and services that meets those needs.
Select a banker who understands your industry, as well as your marketplace. You will not only benefit from a line of credit but from your banker’s experience, industry insight and solutions to your company’s financing needs.
Alfred DeFlaviis is chief lending officer and senior vice president of First State Bank. Reach him at (586) 445-6615 or firstname.lastname@example.org.
Insights Banking & Finance is brought to you by First State Bank
Managing working capital can be vastly complex, but your bank’s treasury management professionals understand those complexities and can work to help you and your business implement effective solutions.
Treasury management solutions may help manage corporate cash resources, reduce administrative burdens, speed collections, manage payments, facilitate cash flow, mitigate risks of fraud and make corporate capital work harder, says Jennifer Hall, treasury management specialist at Associated Bank.
“Treasury management solutions run the gamut from picking the right deposit products, moving to electronic payments to investing idle balances,” says Hall. “And some of the most crucial tools are those that help protect businesses from the negative impacts of fraud.”
Smart Business spoke with Hall about how treasury management solutions can help protect your business and how reducing the risk that your business faces can directly affect your net bottom line.
How can businesses reduce their risk of fraud?
Some of the most crucial tools are those that help protect businesses from the negative impacts of fraud. That is critical, as a 2011 Association of Financial Professionals Payments Fraud and Control survey indicated that 71 percent of organizations surveyed had experienced attempted or actual payments fraud in 2010, with an average loss of $18,400.
Paper-based check fraud is far more common than electronic payments fraud is, striking 93 percent of those businesses in the survey that experienced attempted or actual fraud. Check loss prevention tools can help mitigate the risk of check fraud loss by identifying potentially fraudulent checks before a loss is incurred. That entails a daily reconcilement of a company’s issued checks against checks presented for payment to the bank. When a check reaches the bank for payment, it is compared against the file of checks issued from the business, and any discrepancies trigger an alert. The business then verifies the details of the checks on the discrepancy report and decides to either pay the check or stop/return the checks.
How can a business optimize its cash?
Information services, or online banking, provides a detailed transaction history and balance summary information to assist in making decisions about optimizing cash on a daily basis. A quick glance at cash on hand can support decisions to advance or pay down a line of credit, or to move funds into an investment account. Online banking can save time by taking advantage of the ability to move money between accounts or by originating external payments electronically.
Online banking can also be the first line of defense for mitigating the risks of fraud. Encourage dual control for peace of mind; monitoring activities delegated and performed by other members of the staff and daily monitoring of transactions can lessen the risks of both internal and external fraud.
A type of daily reporting service called controlled disbursement may help maximize working capital. Typically, you’re notified by 11 a.m. each day of all checks that will clear against the account on that day. This allows you to precisely calculate how much money to transfer to pay down a line of credit or to invest, removing the check clearing uncertainty from your daily cash flow forecasting.
How can a business speed the collection of money it is owed?
Remote deposit capture service can improve a company’s workflow productivity by streamlining collections and cash flow.
Employees no longer have to drive to a branch to make a deposit into your business account. Instead, you can scan and deposit checks electronically from the convenience of your office. Virtual deposit tickets and endorsements allow remote deposits to be more efficient than manual deposits.
Making deposits this way can speed the availability of funds by extending your deposit cutoff times for same-day ledger credit. In addition, the image technology provides quality control by reducing the risk of errors, and the data may be exported directly to other accounting systems.
Outsourcing receivables collections to your bank can also reduce the costs associated with the processing of accounts receivable. Automated receivables posting can identify who made the payment, the invoice number and the dollar amount, and then integrate the information directly into the company’s account receivable system. In some cases, reducing the processing time of receivables results in information and/or funds being available days sooner.
How can electronic payments increase efficiency?
Electronic payments, or ACH, can save time and may reduce errors by avoiding manual processing of payments. There is an industry trend in which more and more business-to-business payments use ACH. It is primarily used for direct deposit of payroll, but increasingly, business that may be focused on going green, or that are possibly looking to trim administrative costs and reduce the cost of printing and mailing paper checks are using it for other payments, too. Doing so can improve efficiency in receivables and payables processing.
In addition, corporate credit card services, such as the ‘one card’ solution, can combine the benefits of a purchasing card and a travel/expense card into one flexible card. This solution may reduce time and cost in tracking, reconciling and managing travel/expense and purchasing costs. One cards have a built-in general ledger system that can simplify the accounts payable process. And some one card solutions also offer rewards.
A bank’s treasury management professional can help you implement the services that will be most helpful to your organization and its bottom line.
Deposit and loan products are offered by Associated Bank, N.A. (“AB”), Member FDIC and Associated Banc-Corp (“AB-C”). Loans subject to credit approval. Equal Opportunity Lender.
Jennifer Hall is a treasury management specialist at Associated Bank. Reach her at (312) 565-5275 or Jennifer.Hall@associatedbank.com.