In my last posting I discussed one reason why a business owner might be sitting across the desk from you. The focus was the challenges of balancing a business owner’s desire to leverage his/her business to enhance his/her rate of return with a banker’s desire to manage risk in a loan relationship. There are other reasons why a business owner may be asking you for a loan. One of the most common reasons is one that is not always so obvious. Uncovering this particular reason lies at the heart of what commercial loan officers do.
Let me start by providing a definition for WORKING CAPITAL. Next I want to explain one of the business cycles that take place in almost all businesses.
Most people in business are familiar with the common definition, which is described in a mathematical way. Current Assets minus Current Liabilities equals Working Capital. Let me share another definition. Working Capital is the amount of Long-Term Debt and/or Equity that is invested in Current Assets. In the graphic below you can see what I am referring to.
Why is Working Capital important? That is a good question. To answer that, another set of graphics illustrates how Working Capital fits into the Short Term or Trading Asset Cycle of most businesses. In the first graphic below the Short Term Cycle moves as follows:
1. The business owner buys $50 of inventory on credit from a supplier and isrequired to pay it back in 75 days.
2. The business owner takes 45 days to find a buyer, then sells theinventory for $75.
3. The business owner has to grant the buyer 30 days to pay to provide an incentivefor the buyer to complete the purchase.
4. At the end of 30 days the buyer pays the business owner $75 and the business owner pays the supplier $50 making a nice $25 profit.
So, why does this work? The 75 days that the supplier grants the business owner to pay for the inventory is enough time to hold the inventory, sell it on credit terms, and collect the cash. However, that is not typically what happens. Let me change one assumption and let’s see what happens. In the second graphic the business owner needs to grant 60-day term to the buyer to incent the buyer, not the 30 days in the first scenario.
The solution to avoid the $50 Working Capital shortfall and the possible need to borrow would have been a $50 investment by the business owner. This investment creates Working Capital. Even $25 of investment on the part of the business owner would have reduced the need to borrow.
Inadequate working capital creates a need for bank loans because it limits a business owner’s ability to fund its day-to-day operations and meet short-term obligations. Here's how this situation typically develops:
1. Cash Flow Gaps
This is the situation we illustrated above and is the most common reason.
2. Seasonal Fluctuations
Businesses with seasonal revenue patterns may face periods when cash inflow is low, but expenses remain steady or even increase. In such cases, loans provide liquidity to sustain operations during lean periods.
3. Inventory Requirements
To meet demand, businesses often need to purchase inventory upfront. Insufficient working capital may prevent these purchases, leading to missed sales opportunities. A loan can enable the business to stock up on inventory ahead of anticipated sales.
4. Delayed Receivables
When customers delay payments, businesses may struggle to cover their short-term obligations. This creates a liquidity crunch, making short-term loans necessary to maintain operations. In the illustration above, if the term granted to the buyer didn’t change, but the buyer delayed payment we have a shortfall.
5. Unexpected Expenses
Emergencies or unforeseen costs, such as equipment breakdowns or sudden cost increases, can strain limited working capital. Loans provide a buffer to handle such unexpected needs.
6. Growth Opportunities
Inadequate working capital can hinder a company’s ability to take advantage of growth opportunities, such as large orders or expansion. Loans can provide the necessary funding to capitalize on these opportunities without disrupting day-to-day operations.
Adequate Working Capital is one of the critical elements to successfully managing the Short-Term Cycle in a business. Inadequate Working Capital can significantly hinder that success. There are so many variables that can change for a business, thereby driving changes in the Short-Term Cycle. Determining the real reason behind a business owner’s need to borrower is critical to a commercial loan officer. That will explain why the business owner is sitting across from you.
“Keep asking the question; Why?”