Start Up Financial Plan:
Focus On Funding
At some point, no matter how carefully you monitor your cash flow, you will have to borrow money from a bank. There are two main reasons to borrow: to cover a temporary cash flow gap and to provide working capital for the growth of your business.
Plan ahead. A written financial plan-whether for a bank or internal use-is a major step in the right direction. A financing plan helps you avoid the causes of cash flow problems, anticipate financing needs (for growth or for survival), and helps keep your total borrowing under control.
A financing plan spells out responses to such questions as: What are the business's needs? Why can't they be met from retained earnings? Are operating profits going to be available to meet long-term debt? How much is needed, when, and under what terms? Most important, the plan should provide an answer to the banker's biggest question: How will this loan be repaid?
You must be able to show that you can afford to service the loan. One of the classic ways small businesses trip themselves up is to use this year's financing to pay off last year's debt. This pyramiding is doubly defeating. It creates a larger debt load than is wise, and it is very discouraging to be always struggling with debt even while profitability is increasing. Be wary of using financing to conceal operating losses.
Start by identifying your business's different needs for funds. Most of these will be covered by operating profits. Those that cannot be (or cannot without making the liquidity vanish) should be carefully analyzed to see whether more debt should be sought. It's important to remember that if debt financing is needed to cover a cash flow gap ordinarily caused by insufficient operating profits, the underlying cause of the shortfall must be identified and dealt with before financing will do any good. Borrowing to paper over an operating problem always leads to a worsened situation, tempting though it may be at the time.
Suppose, for example, that your sales have fallen off and costs have risen, making it clear that soon you'll have a severe liquidity or working capital problem. If the lag in sales can be cured without borrowing, fine. (You can almost always take costs down a few notches.) If you will still have a cash flow problem, then make sure that the borrowing won't make it worse. If the sales problem can't be resolved, sooner or later you'll be back to the bank to borrow more, thus driving costs even higher.
Make sure you know your needs before going to the bank-both in dollar terms and in what benefits that cash inflow will have. Any banker you'd want to work with will ask what you need the money for and whether you could raise it from operations. To admit that you haven't looked for operating economies and profits as a way to generate money is a sure way to lose credibility. Enter the bank well prepared.
Legitimate financing needs fall into five related categories. At any one time your needs may overlap several of these categories. A start-up, for example, may face radical expansion, perhaps requiring an acquisition or the launch of a new division.
Start-ups. A new business needs a combination of investment capital and long-term debt. One error that cripples a lot of small businesses is the use of short-term debt to finance long-term needs. The basic rule in financing is to match the term of the loan to both the term of the need and to the source of repayment. Using a 90-day note for permanent financing needs is very risky. Not only is there the ever-present danger that the loan will not be renewed, but there is the added disadvantage of never being able to plan more than 90 days ahead.
Working capital shortages. After initial capitalization, working capital should be generated from operating profits over a long period. If you suffer from chronic working capital shortages due to under-capitalization but are making some operating profits, then the answer may be a term loan if you can demonstrate that the loan will more than repay itself in additional operating profits. Sometimes a modest working capital loan will put a business over the hump, affording enough breathing room to make much higher operating profits. But remember, a working capital loan, which is paid back monthly over a period of up to three to seven years, for example, adds to any existing financial strain. If your business won't generate sufficient operating profits to cover the payments comfortably, then added equity is needed, not another loan.
- Using Credit Wisely
- Managing cash and securing capital are the two biggest challenges small-business owners face, particularly in the startup phase. To keep personal expenses separate from business expenses, use business credit cards as money management tools. Here are three ways they will help you:
- Business credit card: Use it to make and manage purchases, as well as cover travel and entertainment expenses. Like a reserve of credit, a business card gives you the flexibility to pay bills in full or revolve your balance.
- Business check card: An ideal replacement for cash and checks with the convenience of a debit card, check cards allow you to draw on funds from a business checking account. They are excellent for startups, since they allow your company to establish a business relationship with your bank.
- Business credit line: Providing an unsecured line of credit up to $50,000, the credit line gives businesses a source of working capital for emergencies or growth opportunities.
Equipment and other fixed assets. Equipment and other fixed-asset loans are about the clearest examples of matching a loan to the need and payment base. Since these loans are ordinarily secured by the equipment, the anticipated useful life of the equipment becomes a major factor in the credit decision. A rough guideline is that you can finance equipment with a projected useful life of 10 years for up to 70% of its life and up to 90% of its value. Don't buy fixed assets on 90-day notes. The timing is wrong. If You're trying to make your business work on sweat equity, you may want to go ahead and pay off a piece of equipment more rapidly than we'd recommend. That's an option, but a hard one to live with. While equipment loans rarely go beyond 7 years, commercial real estate may be financed over 10 or more years, depending on the situation. Since you are building equity in equipment and real estate from profits over a number of years, you should finance it the same way.
Inventory, seasonal progress. These loans are short-term and usually are tied to a clearly defined source of repayment, such as one inventory turn, fulfillment of a contract, or sale of a specific asset. Short-term notes are repaid from short-term sources, clearly identified before the credit is granted. Medium- and long-term debts, on the other hand, are repaid from more indirect sources. A banker looks to proven management ability (usually evidenced by a profitable history and clearly understood plans) for repayment. Since there is no single fast source of repayment, the risk is greater and the decision more difficult. This is a crucial distinction. A poorly run company may be a good short-term credit risk, but for long-term credit, a business must show ability to consistently generate profits. Remember, term loans come due every month, adding to the drain on resources and, in turn, increasing the risk and need for more careful financial management.
Sustained growth. The final major need for financing is growth, which can outstrip working capital. As sales go up, for example, liquidity goes down. A combination of investment, lines of credit tied to receivable and inventory, and long-term working capital loans is the common answer. Notice what this implies. If you plan to grow, you must plan to generate profits consistently, at the same time keeping your business liquid to meet current obligations. To make sure that you maintain liquidity, you have to be certain of your financing strategy. The answer? A solid financing plan.
Work with your banker. If you aren't comfortable preparing a financing proposal complete with financial statements, or if you feel that your banking relationships could be improved, get your banker involved in your long-term planning efforts. Like all business professionals, bankers like to use their skills. Since most businesses suffer from a lack of financial management skills, and since most bankers have these skills, it is to your advantage to make the first move. Invite your banker to help you. Level with him or her. If you can't keep communications open, then you won't get help-and it's quite possible that you won't get the financing you need. By being open, you'll enhance your credibility; better yet, you'll more likely find that you can turn the banker's skills into a positive resource rather than a roadblock.
