Trapped in an Inflexible Working Capital Line - II?

We often offer articles that are based on experiences we have encountered with actual clients or prospective clients – and since the facts and circumstances are frequently nuanced we take some pains to describe the details of the situation and explain our point of view in some depth. The result is often articles that are somewhat lengthy and described by some as a bit difficult to absorb.

So for a change of pace, below is the result of an analysis we recently completed expressed in a single chart with a reasonably simple conclusion as follows:

If you are a business with a working capital line that is fully drawn – and your financing provider is unable or unwilling to offer you more financing capacity – you will be better off with a new working capital line that does offer you greater capacity – even if you have to pay more for it – so long as the new working capital line offers you sufficient availability to finance incremental new sales equal to the difference you have to pay for the new facility compared to the old – and, of course, you are able to win this amount of new business.

As the analysis in chart demonstrates the relationship is nearly 1 to 1 based on the variables used. This means that you can pay 5% more in annual financing costs so long as you can win incremental new sales (just one time – so not each year) of 5+% and you will be better off – or 10% more in financing costs so long as you can win incremental new sales of 10+% – and so on.

We’ll discuss some of the variables to the analysis in greater detail below for those that are interested, but the message is largely similar even if the variables differ slightly depending on the circumstance. With this analysis, we reinforce an age old adage instinctively known to all successful business owners: New sales are the life blood of any great business and they are very often worth pursuing even if some of the costs associated with securing them are incremental higher.

So without further adieu, the chart:

Discussion of analysis variables:

We assumed a company with a 10% after tax net margin. If you have a smaller net margin, you will need marginally greater incremental sales for each higher increment of financing costs to break even. If you have a higher net margin the reverse is true. It is important to note here that the relationship is non-linear on either side of a 10% net margin so it will be important to understand the specifics if your business net margin is different than 10%. We can help you with this if interested.

We assume a 35% tax rate and all financing costs being fully tax deductible.

We assume an annual base cost of financing of 8% – so if you have to pay 13% per annum for new financing that would correspond to the 5% figure on the y-axis in the chart since the cost is 5% higher than the old financing costs. We would point out, however, that the analysis results hold regardless of your annual base cost of financing – whether it is 3% or 23% – it’s only the increment between new and old that matters.

It is important to note that the x-axis represents incremental new sales. This is important to the analysis because a business that generates a 10% net margin can use that profit to finance new sales with that earned equity. For a business owner to realize the break-even outlined in the chart, it must generate new sales in addition to the amount it would be able to finance with new earned equity.

As mentioned in the opening, the incremental new sales must only be one-time for the analysis to hold. This means that a business could pay 5% more in financing costs each year, but need only generate 5+% new sales one-time and then retain those new sales in future years for the analysis to hold. Importantly, it expressly does not mean that the business would have to win 5+% incremental new sales each year – just one-time and then retain them.

The size of your business (i.e. annual revenues) also does not matter for the analysis to hold. This analysis applies whether you business generates $100K or $100MM in annual revenues.

The analysis also assumes that there would be no other changes to the commercial profile of the business – so such things are Days Outstanding for A/R and A/P, marginal costs of fulfillment, etc. would all remain the same.