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.

Description:

The company in question is just a few years old and produces a highly reliable and sophisticated  information service that it sells to select industries who stand to reap significant rewards for having timely and accurate access to the information being provided.  The addressable market for the new product is large and the company’s product uniquely addresses a largely unmet need in the market.  The company has gained considerable experience in the technology and know-how necessary to produce the high quality information it provides to its clients.  The company also has developed a strong stable of clients and is currently growing its revenues rapidly.

The company has historically been funded through a combination of owner’s equity, third party equity and some debt financing.  It recently completed a small additional third party equity raise and restructured in remaining bank debt with the aim of amortizing fully within the next year.  The company maintains approximately $750,000 in accounts receivable (its primary financial asset) and expects to grow its A/R balance commensurate with its sales going forward.  The company is profitable, but continues to have large cash flow requirements associated with investing further in its technology and expanding its distribution capabilities.

Financing Question:

How best should the business owners optimize their cost of capital while at the same time gaining access to the cash flow to make the investments necessary to accelerate its growth?

Assessment:

To find the optimal solution to this problem, it is probably best to ask (and answer) the following two questions:

1. Is the target balance sheet optimal?  If no, why?
2. Are there any important economic or financial caveats that might change the answers the questions above?

First let’s take a look the company’s “Target” balance sheet and compare it to an “Improved” balance sheet.  (Btw – we’ll answer the question of why the “Improved” balance sheet is better in the next section):

The important thing to note is the two balance sheet structures above is simply that the “Target” is 100% equity financed and the “Improved” is financed with a combination of debt and equity.

We make the assertion above that the “Target” balance sheet is not optimal and offer an “Improved” balance sheet to show one we believe is better (i.e. maintains a lower cost of capital).  Let’s take a look at the following analysis to understand why the “Improved” balance sheet is materially less expensive for the company as compared to the “Target”:

As evidenced in the income statements above, the company with the “Improved” balance sheet produces a Return on Equity that is nearly half again greater that with the “Target” balance sheet.  So at this point we know the answer to question 1, above:

1)       The “Target” balance sheet is not optimal from a cost of capital point of view and we can see this by noting the significant Return on Equity differential.

What about the answer to question 2?  We offer the following analysis and commentary to look at potential answers to this second question:

First an analysis – how much more expensive would the cost of debt financing (i.e. the interest rate) have to be for it to be an inferior solution for the company?  See the table below (please note that for example purposes, the only variable change in the table below is that of the interest rate):

As demonstrated above, the interest rate on the debt would have to be greater than 26.3% per annum for the company’s cost of capital to be equal based on the two balance sheet options evaluated in this example.   Hopefully it goes without saying that that costs of debt in excess of 26.3% would result in an inferior solution for the company.  Certainly this seems a powerful demonstration of the real costs of financing decisions.

There are clearly a number of other considerations that could affect the analyses presented in this article – but any such impact would – from a financial point of view – most likely be at the margins.  In the end, the cost rationale for making certain capital raising decisions is frequently a compelling one.  Our counsel to this prospective client – of course solely from a financial point of view – is simply this:  To raise additional capital – not necessarily only as needed – but more so as can be productively deployed – through the issuance of either debt or equity – in whichever combination produces the lowest cost of capital.  And do not delay making high return investments unless you are simply not able to access the capital necessary to make investments at a price that will generate a positive marginal return.

Description:

The company in question is a new company with an exciting new consumer product.  The addressable market for the new product is large and the company’s product addresses a largely unmet need in the market.  The business owner is highly experienced in the product segment, but for the first time is launching a branded consumer product venture.  To date, the company has been financed entirely with owner’s equity – primarily from savings and mortgaging owned commercial real estate.  The company has secured purchase orders with several large national and regional retailers and is on the cusp of significantly ramping sales and in doing so, expects to expend considerable resources on the marketing and advertising necessary to drive the product launch.

Financing Alternatives:

The business owner is currently evaluating how best to finance the next – and first considerable – growth phase of the company.  The realistic options are twofold as follows:

1. Take out an additional mortgage on his owned commercial real estate property, or,
2. Enter into a accounts receivable financing relationship

Assessment:

The mortgage option will provide the business owner a lower nominal cost of financing – probably 5-6% – since the creditworthiness and interest rate is based primarily on the considerable equity in the property.  But this type of financing should be properly understood for what it truly is – an additional equity investment in the business – not different in substance than writing a personal check.  The accounts receivable financing facility would likely have a notional cost of 8-10% plus a small per invoice service fee.  Comparing these two options on a nominal cost basis will, however, yield an answer that from a corporate finance point of view, fails to properly consider the entire cost of the equity.

The proper corporate finance analysis of this situation is perhaps further complicated by the fact that the business owner does have the resources to make an additional considerable equity investment in the company – thereby being able to directly avoid the real cost of diluting his equity and the intangible cost of having to wrestle with governance and other complications associated with having a third party equity partner.

Yet as the Nobel Economist Milton Friedman famously said “there is no free lunch” – and while properly assessing of the entire cost of this equity investment may be somewhat clouded by certain of the facts – the costs do nonetheless continue to exist – even if seemingly (although not in fact) indirectly.

The following comparison will help make this clear:

As evidenced above – and assuming there is no cost of dilution or intangible governance costs – you can see that two companies that are identical in every way – except that one is 100% equity financed and the other is financed with 50% equity and 50% debt – produce very different returns on equity – again solely due to the way they are capitalized.  The difference in the returns profile is significant – with Company B generating equity returns that are 50% better than those of Company A.  By any measure this is a marked difference.

There may be other considerations (i.e. not yet generating sufficient A/R that can be financed) for our prospective client that could tilt the equation towards the additional equity investment, but like Milton Friedman said – “there is no free lunch”!

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.

A.  The Baseline – The Implied Value of 2% – 10, Net 30

There is perhaps no better endorsement of the inherent value of the speed of cash flow than this common billing convention.  And because it is so commonplace, we’ll use it as the basis for making our case.  Offering a full 2% discount on the price if payment is made in 10 days or less is a pretty large concession.  How large?  Believe it or not the annualized value is 36%.  (e.g. 2% discount for accelerating payment by 20 days – the difference between 30 days and 10 days; and 18 x 20 day periods in a year – 360 divided by 20; so 2 x 18 = 36%).  So fairly large indeed from our lens.

B.  The Rationale – How Can 36% Make Sense?

Actually it does make sense – in fact it often makes tremendous sense.  The following little example should make this point quite clear.  Suppose you sell a product for a margin of 10%.  If you sell that product once per month then you have earned a 10% margin 12 times during the year – or 120% annualized.  So you can think about it one of two ways 1) you offer a 2% discount on a 10% margin product and still earn a net margin of 8% on each sale, or 2) you could think about it in annual terms – which in the example above would imply 36% discount on a total annualized margin of 120% – or a net annualized margin of 84%.  As illustrated in part by the example, either way you think about, you always come out ahead so long as your margin on each sale is at least 2%.

C.  The Clarity – This Part Can Sometimes Be Counter Intuitive – But It’s True

When you offer 2% – 10, Net 30, you are doing 2 things very clearly.  Let’s take a look at both:

First – You are attempting to self finance your working capital needs (as opposed to borrowing from a third party) by offering a financial incentive for customers to pay early.

Second – You are placing an annualized value on the speed of your cash flow of 36%.

At first blush this may feel outlandish – who after all would pay 36% annually to finance anything?  Uncomfortable as it may feel to acknowledge, you can rest assured of at least two things: 1) the implied value of the speed of cash flow is – when offering 2% – 10, net 30 – in fact 36% annually – no matter how you slice it, and 2) it makes all the sense in the world to do in many, if not most, circumstances – as our example in B (above) helps to illustrate.   Which probably explains why it is so commonly offered.

D.  The Comparison – How To Use This Knowledge In Practice?

So are we suggesting that businesses stop offering 2% – 10, net 30 payment terms to their customers?  Hopefully it’s clear that our answer is “No”.  Unless, however, the business can borrow for less than 36% annually (or earns a margin of 2% or less).  Many business are able to borrow from traditional banks for interest rates (in this environment at least) meaningfully less than 36%.  This is terrific and we endorse it without qualification provided the business is otherwise a good candidate for borrowing.

Many small and medium businesses are not, however, able to borrow the money they need to grow from traditional bank sources.  For these companies the cost of borrowing will be higher.  So our counsel to them is simply this:  If you are (or would consider) offering 2% -10, net 30 payments terms, borrowing your working capital needs from a third party is in your financial best interest so long as you can 1) do so for less than 36% annually (hopefully much less) and 2) are otherwise a good candidate for borrowing.

1.  Absolute cost matters, but relative cost matters more

When faced with a higher than expected cost proposition business owners instinctively recoil.  And while there is no question that less (as it relates to costs) is always better, it is important to consider the cost of capital relative to the return potential of the project.   Consider an example where a business owner has identified an excellent investment project (e.g. potential for 30% ROI), but is faced with an unusually high cost financing proposition – at least compared to his historical borrowing costs (e.g. 15%).  Faced with this set of facts, many business owners will simply refuse to accept the “high” borrowing costs and will not proceed with the investment.  In this example (and taken in isolation), however, passing on the opportunity would not be the rational value maximizing decision – when an opportunity to 15% net is presented.  Some might now say 15% is not enough!  To which we say OK – but that’s not the point we are trying to make.  Our point is simply that it is not optimal to forgo an attractive investment project that meets your risk adjusted return criteria (whatever it may be and after considering your cost to finance it) solely because the cost to finance it is deemed too “high”.

2.  Make sure the math makes sense

We frequently run across companies in narrow margin businesses.  When we discuss whether or not some level of borrowing could make sense, we often hear something like “I only earn a 5% margin, so borrowing for more than 5% doesn’t make sense – as it will simply consume the margin.”  This is an apples and oranges comparison.  If a business earns a 5% margin and turns over its sales in 45 days (for example), then the 5% margin is earned 8 times during the year (360 days divided by 45 days) which is 40%.  In this example it is the 40% annual figure that should be properly compared to any annual borrowing costs.  Although it may seem reasonably obvious when presented in this manner, it is discussion we encounter frequently in our day to day conversations.

3.  Remember that invested capital includes both debt and equity

The optimal level of borrowing (if any) is different for each business.  And every business maintains a level of invested capital (equity and/or debt) all of the time.  So the question becomes can some level of borrowing reduce the cost of capital (i.e. contribute to greater profitability) – since debt is generally a less expensive form of capital than equity?  The answer is “yes” – in the right circumstances.  Since there is no A+B=C formula for determining the “right” circumstances, some general guidelines are offered below:

Some business characteristics that support greater borrowing include – sales not highly sensitive to the economy, reasonably stable profit margins, consistent profitability, ability to adjust costs to meet higher or lower demand levels, low to modest ongoing capital investment required, etc.

Those business characteristics that support less borrowing are generally the inverse of the above.  If your business can support borrowing, doing so will reduce your cost of capital.  In fact, borrowing at the proper levels is likely to be a necessity for such businesses as competitors will almost certainly be doing so.

Of course we welcome your participation.  Whether you wish to comment on a post, share an experience, pose a question or even challenge the advice offered in a post – all constructive contributions are not only welcome, but encouraged.  In short, we want to hear from you – the dynamic companies that drive economic growth – about your business challenges, experienced and needs.  You can comment on various posts, submit questions via our contact form, or call us for a private discussion.

We expect to frequently write on topics that we encounter through our work with our clients, but in all such instances will be careful to protect their privacy by refraining from the use of specific names.  We want our clients and prospective clients to rest assured that their stories and challenges are safe with us – always and without exception.

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