Lee Rust, Owner, Florida Corporate Finance
There are few companies which can operate without some source of external financing, and among those, most should use such financing to support additional growth. Knowing the sources, costs, and possibility of arranging financing for a company can be an important element in its growth plans and, on occasion, its survival. Of course, the best known and most widely available source of such operating capital is a local bank. For debt financing, bank loans are also the least expensive. Banks, however, are generally “cash flow” lenders. That is, they lend to companies that are operating profitably and have a relatively high debt service coverage (principal plus interest) provided by operating cash flow.
The two primary forms of bank debt are credit lines and term loans. In general, credit lines are short term borrowings for working capital purposes and are used to support growth and fluctuations in the principal components of that working capital, that is, accounts receivable and inventories. The credit line borrowing base and outstanding amount changes as the levels of those two current assets change. The interest rate for credit lines are also usually variable and change with market rates from the prime rate as a low up to three percent or more over prime depending upon the financial strength of the borrower.
Bank term loans are fixed dollar amounts most often used to fund longer term asset purchases such as equipment, vehicles, or acquisitions. Those loans are payable monthly, usually over three to seven years, and can have either fixed or variable interest rates. Those rates are usually equivalent to credit line interest for any given borrower but may be higher for longer term loans. Although banks talk about asset-based lending and will certainly want a first lien security interest in all company assets to secure their loans, they are primarily interested in the profit and cash flow levels needed to assure that their loans will be repaid on a timely basis.
True asset-based lenders are often referred to as commercial lenders. Those non-bank sources for debt financing will often provide funds to a weaker credit than a bank. Although commercial lenders may provide a loan to a company that is marginally profitable or, on occasion, even unprofitable, they will want to have their loan fully secured by assets that can be liquidated in their loan. Because those assets are most often “near cash” items such as accounts receivable and inventory, most loans from commercial lenders have characteristics similar to bank credit lines.
The total cost of funds charged by commercial lenders, however, is usually significantly higher than the interest for bank loans. In addition to interest on the borrowed funds in the range of prime plus two to six percent, commercial lenders also charge a number of fees that can increase the effective interest rate or total cost of funds to a range of 15 percent to as much as 22 percent. These fees include quarterly field audits during which an auditor for the lender spends several days at the borrower’s facility confirming the accounts receivable, inventory levels, and other assets in relation to the borrowing base calculations used to establish the amount of allowable funding. Those audit fees can be
$800 to $1,000 per day plus travel expenses.
In addition, commercial lenders often charge an annual facility fee of 1 percent or so of the total funds available whether used or not, plus monthly servicing costs of 0.1 to 0.2 percent or more of the average outstanding balance during the month, and early termination fees of 1 to 3 percent of the total credit facility. All of those fees become part of the effective interest or cost of funds for the borrower.
The least attractive form of debt financing is factoring. That is generally the sale of accounts receivable to a factor for some discounted amount. Although the account receivable is paid by the factor within days of the related sale, if your company averages a collection period of 45 days and you sell your receivables to a factor for a 3 percent discount, that is equivalent to an annual interest rate of 24 percent. The effective interest rate for factored receivables can often be as high as 36 percent per year.
Factoring was originally designed for use by garment manufacturers which sold goods to department stores that demanded 120-day payment terms. Because the manufacturers enjoyed relatively high gross profits and had long collection periods, they could afford to discount their receivables to a factor. For other manufacturers or distributors with lower gross profits and shorter collection periods, receivable sales to a factor are not usually an attractive source
of funds. I often tell my clients that when factoring their receivables, they’re working for the factor and not for themselves.
Beyond these forms of debt financing, there are also several sources of equity financing for small companies. These include venture capital firms, “angels,” corporate investors, and individuals, among others. For now, you might only consider that any form of equity financing, such as the sale of a common stock interest in your the event of a default. In addition, that liquidation must be sufficient to fully retire the outstanding balance for company, is usually much more difficult to arrange than debt. It is used when the growth capital needed by a company is significantly larger than any amount it might borrow from conventional sources. However, if the sale of equity is being considered because a company’s financial condition is too poor to support debt financing, it’s usually best to cure the financial results problem prior to raising any new funds.
On occasion, I’ve had clients point with pride at a balance sheet devoid of any credit line or long-term debt. My usual response is that such a balance sheet shows a deficiency in the use of the company’s assets to support additional or accelerated growth. If a company has excessive financial strength, its owners and managers should determine how to use that strength to increase the revenues, profits, and enterprise value of their company. Excessive financial strength is, to me, as much an indicator of management weakness as excessively poor performance.
Lee Rust, owner of Florida Corporate Finance, specializes in Mergers & Acquisitions, Corporate Sales, Strategic Planning, Financing and Operations Audits. He can be reached by phone at 407-841-5676 or by email at hleerust@att.net. Lee will present a business practice seminar at FRSA’s Annual Convention, June 27-29 at the
Gaylord Palms Resort and Convention Center in Kissimmee.
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