We are now a year into the credit crisis. Many lending institutions that were good partners in the past are now more focused on preserving and building their capital. Maintaining and building capital is what banks are all about. They loan liquidity, and some of the liquidity they might have loaned you in the past is being held to meet reserve requirements to support loan losses. This explains why the bank bailout didn’t free up lending for those banks accepting the funds. In the past, when cash got tight, your bank probably quickly stepped up to help you. It might not be quite so quick and easy next time. Don’t get me wrong: Banks are still lending money, but it has to be for the right purpose and at the right price. It’s time to take matters into your own hands and understand and plan for your company’s cash requirements. Having adequate access to cash at all times is the most important requirement for the continued viability of your business.
Although cash is a concept we can all understand, bankers tend to communicate in ratios. For this reason, many growers erroneously equate financial health to meeting their bank’s loan covenants, which often include financial ratios. While ratios are beneficial in providing benchmarks to see how we compare to the industry as a whole, they are not necessarily instructive in directing an owner toward the true financial requirements of his business. In fact, managing a business to meet ratios can often tend to direct that operation toward mediocrity.
Calculate Your Minimum Requirement
Every business has its own specific working capital and cash earnings levels or requirements it needs to attain. Working capital is the difference between your current assets and current liabilities. You have a minimum working capital requirement to pay your bills on a timely basis: the sum of your accounts receivable and inventory at the lowest point of the year (usually August, December or January). We measure at the low point because, theoretically, the purpose of your line of credit is to meet your peak needs before and during the shipping season. Take this sum and subtract the estimated account-payable float if you were taking advantage of all trade discounts, and you have your minimum working capital requirement. This would be calculated as follows for a fictional greenhouse operation:
This company needs $7 million to pay its bills on a timely basis, take advantage of trade discounts, reduce its line of credit to a zero balance for a reasonable period and keep interest expense on the line to a minimum. This is a conservative approach, and it is not necessarily time to panic if working capital isn’t currently at this level. This is because most banks have become asset-based lenders and advance a certain percentage on accounts receivable (usually about 80 percent) and inventory (usually about 50 percent) year round.
Therefore, the above company — even at its low point — could probably expect to draw up to $5,300,000 on its line of credit, far from the zero balance mentioned as a goal at the low point. However, it is a big mistake to draw up to the maximum allowed on a borrowing base. That raises red flags for your lender and leaves no cash cushion or room for error. Banks also don’t like to extend “seasonal overlines,” which are outside a borrowing base. These lines are neon signs, flashing “Working capital shortage.” It is also inefficient to pay more interest than you have to. It is far preferable to build toward, if not to, the calculated working capital requirement than to live dangerously on the edge of the maximum allowed on your borrowing base.
Correcting a Working Capital Shortage
Correcting a working capital shortage requires changes that impact the long-term sections of your company’s balance sheet. You have several available options, but all but one have a downside.
Sell obsolete or underutilized fixed assets for cash. The drawbacks: First, few operations I have ever seen have excess fixed assets lying around. There also is the danger of cannibalizing your operation to the point that you lose a needed fixed asset.
Get a term loan and take the cash to pay your short-term creditors. But this supposes the banker will go along and that you have both the ability to generate the cash flow to service the term debt and the collateral to support it.
Sell down your excess inventory and collect your accounts receivable more quickly. But it’s tough for growers of short-cycle plant material to liquidate overproduced inventory, and it is rarely done profitably. The same holds true for shrub and tree growers. During negotiations with buyers, it is sometimes prudent to sacrifice price for better payment terms, but you don’t always get this option.
Generate cash operating profits. This is the best and most reliable way to build working capital. Finding an investor to inject capital also would increase your company’s net worth, but you probably don’t want to give up control of your business.
Now that we have established that the best option to build and maintain working capital is by generating profits, you need to determine what a reasonable level of profits is and how much needs to be allocated to build working capital. My colleagues and old customers will tell you that one of my worn-out expressions is, “It’s one thing to budget a loss, but it’s another thing to budget a loss and show it to your banker.” Though I may have worn it out, it seems to be working because I don’t see too many budgeted losses anymore. However, I do still see inadequate earnings projections. So the question is, “How do I target an adequate level of earnings?” Once again, it all comes back to your cash needs. Begin by determining the cash needed for the following:
- Replacement of worn-out fixed assets that won’t be financed with a term loan
- Servicing the principal of both the current and anticipated levels of term debt
- Building working capital to meet current requirement
- Building working capital to support anticipated sales growth
There is an old saying that if you don’t know where you’re going, any road will get you there. When preparing a budget, the first step is to establish the earnings required to meet your cash needs in the coming year — the destination. Imagine the following scenario for a greenhouse grower trying to determine his cash needs for fiscal 2010.
Management has determined their actual working capital is $1.2 million short of their working capital requirement. Although there’s room in their asset-based line of credit, they want to build working capital by this amount to ensure an adequate cash cushion, take advantage of future prepay discounts and minimize interest expense on the line of credit. Management thinks a three-year plan is reasonable to build working capital to the current requirement. Current term debt principal payments are $500,000 annually.
Their best customer has just awarded them with a new region, resulting in 10 new stores with expected sales of $3 million. To support this higher level of sales, management estimates an increase to the working capital requirement of about $600,000 — $200,000 for accounts receivable and $400,000 for inventory — will be needed.
The grower has the growing capacity, but to meet this new demand they will need a new transplanter and related equipment ($200,000) and new delivery carts ($75,000). Management has determined that a reasonable payback for the new equipment is four years for the transplanter and related equipment, and three years for the carts.
We will assume that the net worth position and debt-to-worth ratios are satisfactory and that the owner is not expecting a dividend payment. (We will address solvency and the long-term sections of the balance sheet in a future article.)
Based upon the above criteria and expectations, management would need to target a net profit in the coming year as follows:
Now that the destination has been identified, the next step is to project sales, costs and expenses to get to that point.
Don’t be lulled into complacency by merely meeting the ratios and loan covenants required by your banker. They are there to help alert a banker when something is going wrong, not to direct you toward financial viability. Generating adequate cash and maintaining an adequate level of working capital are essential in ensuring the financial health of your company. It’s easy to determine your cash requirements. Once you know them, you will have an earnings goal, and your budget becomes a true management tool that will help direct price negotiations, cost allocations and fixed-asset expenditures.