I received this question the other day during a blog discussion;
“I’ve heard that a line of credit should only be used to cover cash shortages to pay for normal operating expenses in the months when we need it…that we should NOT use it to buy equipment (fixed assets). Is this true?”
Here are my thoughts: Match the life of the loan to the life of the asset. All assets require some source of funds to acquire them in the first place. When the source is borrowed funds, it is absolutely critical that you match the length of the debt with the asset’s ability to generate cash flow or net profits and thus repay the debt.
A short-term loan such as a credit line should be used for short-term assets (also known as current assets) with the logic being that you’ll get the cash from the collection of your receivable to pay off the loan within the year. In most cases, inventory is also a short-term asset that’s used up within the year.
Ignoring these principles – and incorrectly financing the business – is the most frequent cause of trouble between owners and lenders. It is essential that you do not use short-term debt for permanent-type assets. When this is done, the consequence is often termed “restructuring.” This is the bank telling you that the financing was done wrong the first time and now needs to be fixed. These can be very unpleasant discussions. And generally the solutions can be disastrous.
Growing businesses often require an increased investment in both current and fixed assets. If improperly managed, growth can cause a shortage of cash; therefore, the business owner must carefully assess future asset investments and plan for their financing.
There’s no need to turn yourself into a CPA, but you must be able to read financial statements, talk with your financial people and assess your company’s performance.
Know your key drivers and manage them. Banks use a number of ratios to analysis your current health. Get a Free Excel Ratio Spreadsheet that allows you to enter your company information into that will give you the following ratios;
Liquidity – 6 Ratios
Leverage – 7 Ratios
Efficiency – 6 Ratios
Profitability – 7 Ratios
The template also contains lender comfort zones for each. Using these key performance indicators will keep your company financially in tune and ready to handle growth comfortably.
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