Business working capital requires long-term financing.
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EmailLenders expect their customers to not only understand the necessity of having good, producible records, but also to conduct regular analysis of their financial conditions.
Stemming from my prior lending experience in banking and having administered a revolving loan fund, I understand a great deal about the limited knowledge business owners have regarding how the balance sheet and income statement interact to facilitate proper financial management. After some discussion on the purpose of the loan with a client, I would ask, “Can you give me a financial statement?” One common response, after some thought by the borrower, was “Yeah, I need some money.” While this told me a great deal regarding the applicants financial acumen, it did provide an opportunity to explain the necessity to have good records to make proper business decisions.
Every new business starts with a very simple balance sheet: no assets and no liabilities. Once the owner make an initial investment (generally cash), the balance sheet springs to life. Assets begin with cash, which is quickly converted to other assets like inventory and fixed type assets (equipment, fixtures and real property). Commonly, debt is incurred to finance both the fixed and current assets needed to begin the venture.
Once sales begin, the cash-to-cash cycle ensues. Inventory is sold, sometimes for cash, but commonly terms are given to purchasers, thus slowing the cash-to-cash cycle. To make this investment in accounts receivable, many companies borrow to offset their own lending to customers. This vicious cycle is quickly evident to lenders, who should encourage borrowers to perform proper cash flow planning to avoid having to seek short term financing for the long term investment in working capital.
Working capital is the difference between current assets and current liabilities. As noted above, current assets include; cash, inventory and accounts receivable. Current liabilities are; accounts payable (for inventory and operations) and current maturities on long term debt. To determine how sufficient the amount of working capital is, look at how many times it turns over in a year’s time. This is determined by dividing the total year sales by the working capital. The higher the ratio, the more likely the business will experience cash shortages throughout the year.
Comparing the working capital turnover rate from year to year will indicate either an increased efficiency of the operation in managing its cash to cash cycle or the need for additional investment in working capital. Working capital is financed, by definition, with long-term debt or new owner investment.
Balance sheet changes from one year to the next will indicate how the company is being financed, who really owns the operation and how efficiently it is being operated. Moreover, this year to year comparison of assets, liabilities and equity and the changes therein will add greatly to the understanding, and comfort, lenders have in advancing additional funding.
Michigan State University Extension educators working with the MSU Product Center assist clients with financial planning, analysis and business planning.
