Trapped in an Inflexible Working Capital Line?

As economic activity begins to pick up on several fronts, we are increasingly running into situations where prospective clients are unable to finance new business opportunities due to an existing working capital line of credit – and their bank being either unwilling to increase the line or in some cases insisting that it be reduced. So what to do if your company finds itself in this uncomfortable situation?

 

We advise a couple of straightforward next steps as follows:

 

1. Develop a simple, yet clinical, analysis of the entire cost picture

 

Here’s an example:

 

Gross Margin on new sales:                15%

 

Accounts Receivable balance:             $500K (amounts less than 90 days)

 

Working Capital Line Limit:                  $400K (fully drawn – implied advance rate of 80%)

 

Interest rate on bank W/C Line:           8%

 

Average Days Outstanding:                 45

 

Trade terms – days:                             7 (common for service companies with weekly payroll)

 

In the example above, the company must invest $8,500 in payroll for every $10,000 in sales – and must do so for nearly 40 days – until it is paid by its customer.

 

So what is the Gross Profit – after financing costs – on a sale?

 

Gross Profit (before financing):          $1,500

 

Financing costs:                                  $72 (8% annual rate to borrow $8,500 for 38 days)

 

Net Gross Profit:                                 $1,428

 

This example makes clear that a company could double or even triple it’s financing costs and still earn a large Net Gross Profit – so long as it can make and finance the new sale. If the company is not able to invest in the payroll to produce the sale due to financing constraints, however, it forgoes a Net Gross Opportunity of ~$1,400. By any measure, this is a bad outcome for the company.

 

2. Review this analysis with your existing working capital line provider

 

A clinical assessment of the forgone sales opportunity should resonate with your current financing provider. And because it is so commercially compelling, will hopefully lay the foundation for an increase in your Working Capital Line limit.

 

If the logic does not resonate with your existing financing provider and does not result in an increase in your line limit, we advise companies to reconsider their financing relationship. Sales opportunities are the life blood of any company and an inability to finance bona fide and profitable new sales that will pay on acceptable commercial terms is an unacceptable result for a business owner.

 

We encourage business owners faced with cash flow constraints to develop an analysis like the one above for their business. Doing so will make evident that there are few scenarios where the cost of financing is economically unattractive when faced with a potential missed sale due to an inability to flexibly finance it. This type of analysis even demonstrates the economic power of flexible financing for businesses with very low margins – even ones with Gross Margins as low as 3% in the example above.

 

Mostly we encourage our clients and prospective clients to foremost stay focused on being clinical when assessing the commercial needs of their businesses and on topics that might not be entirely analytically straightforward, to consult with a trusted advisor who can help.