This is the third post in the series about bank financing. In Part I and Part II, we entertained various aspects of profitability, cash flow, and industry factors. We move now to the importance a strong balance sheet has in shaping favorable outcomes to credit requests from manufacturing and wholesale distribution companies.

Past and upcoming chapters:

1. Cash flow, historical revenue and earnings trends, diversification of revenue
2. Industry outlook, product demand
3. Balance sheet and liquidity (you are reading this now)
4. Collateral and personal guaranties
5. Management experience, strategic planning

Balance Sheet and Liquidity

Did you know that balance sheet accounts, rather than profitability and cash flow, are the primary sources of repayment for certain types of loans?

Most short term loans (maturities of 12 months or less) are made for the purpose of funding temporary fluctuations in cash balances. Those cash fluctuations are often caused by timing differences between cash expended to manufacture or purchase your inventory and cash received. A simple example of this effect occurs if your company has seasonality in revenues, although there are many other examples.

The key concept here is that if the cash fluctuations are temporary, the loans supporting them are known as “self liquidating” through the natural completion of the selling cycle. In other words, you experience a cash crunch during inventory buildup prior to the heavy selling season, while cash balances grow quickly after the end of the selling season when you receive payment. It is not necessary for your company to make a profit on these sales in order to repay the loans since the conversion of trading assets (reduction in inventory and accounts receivable) will generate sufficient liquidity to repay your loan.

While the last statement is true in a perfect world, in reality, your lender will always want to see a built in cushion. Hence the need for a strong balance sheet. Also, for loans that are long term (maturities greater than 12 months), balance sheet strength is equally important. As an aside, long term loans typically accompany cash needs that are not temporary, such as for the purchase of equipment, buildings, or for permanent working capital.

So what does a strong balance sheet look like to a lender? Three categories come to the fore:  working capital, leverage, and liquidity.

1. Working capital – is the excess of current assets over current liabilities. Expressed as a ratio, anything approaching 2.0 would be considered good in most instances, and reflects the capacity to retire short term liabilities quickly.
2. Leverage – is a comparison of debt (total liabilities) to net worth. Lenders want to see that shareholders have a significant stake in funding the business, and will generally be comfortable if there is near parity between these two sections. A balance sheet with debts that are triple the size of owner’s equity will usually be viewed as highly leveraged, and loan approval becomes more problematic.
3. Liquidity – consisting of cash and equivalents, is the ointment that soothes other sore spots in the loan application, if it is consistently maintained at a meaningful level. Meaningful might be 15-20% or more of total assets, or an amount that would cover 6-12 months of required loan payments.

A weak balance sheet is almost always caused by one of the two following events: (1) operating losses from the business, or (2) the distribution (or advance) of most or all of the profits earned by the business. In the latter case, the business may be very profitable, but the excessive distribution of profits can deprive the company of the liquidity, working capital, and capitalization necessary to fund future growth or to meet its obligations timely.

I have often advised clients to consider reinvesting more of the profits in their businesses, particularly when growth prospects are favorable. By doing so, the businesses are better positioned to achieve the owners’ strategic goals, debt and equity are easier to attract, and ultimately, the shareholders will have gained more personal wealth if the businesses can reach their potential for sales and profitability.

If you own a manufacturing or wholesale distribution company with annual revenues of $5 to $50 million and want to improve your results in any of the areas discussed in this series of articles, please call 704-575-5809 or email jchristian@trinitas-consulting.com for a complimentary Profitability Optimization Session.