In honor of SBDC day we wanted to share some information on an important topic that is critical the success and financial health of a company. It is something that is often overlooked until it is too late and silently sucks the cash out of a business. The name of this deadly business killer – mis-financing.
What is mis-financing? Mis-financing refers to the way that a company’s debt is structured. A company that has used short-term money (e.g. line of credit) to pay for a long-term use (e.g. equipment) is considered mis-financed. Proper debt structure matches the length of the loan with the purchased assets ability to repay.
Why is it important for owners to understand if they are mis-financed?
For a company, cash is king. Having proper fixed asset financing is an important component of how cash flows through a business. Many business owners view debt as debt and do not understand the nuances between long-term and short-term. They use their line of credit to make large equipment purchases, and then use their cash to pay down the line of credit. Owners see the favorable interest rates on a line of credit as benefit of using their short-term financing to pay for their fixed asset purchases. This structure is the equivalent of buying a house using a credit card and can create a number of cash flow problems for a company.
For example, a mis-financed company is more likely to max out their line of credit, and lack the cash to rest the line, creating an evergreen loan scenario. In the past several years, we have all heard stories of companies who have had their lines reduced or called because they were not able to provide a resting period. These owners were mis-financed and never had the benefit of having someone explain the proper financing structure for their assets.
Another common problem that arises with mis-financing, is that the cash that should be allocated for growing the business is sucked out to pay off the line of credit. Instead of utilizing cash to invest in additional personnel, resources, etc. to grow sales, a company is unable to accept new jobs or clients because they do not have any cash to grow.
Can a business recover?
Once a company has been mis-financed it can be hard to recover. Companies in this situation have typically pushed their accounts payable out so far that they are unable to take advantage of vendor discounts or worse, their vendors no longer want to do business with the company. The business typically is struggling from a cash flow perspective and may not have enough left on their line of credit to cover their seasonal financing needs. These issues compound and can be a recipe for disaster for any business.
How can a business owner identify mis-financing?
There are three places that a trained eye goes to on a company’s balance sheet to identify mis- financing; gross fixed assets, long-term debt and retained earnings. If the company has been properly financed, it would have enough cash between retained earnings and long-term debt to finance fixed assets. If retained earnings and long-term debt equal fixed assets, then the balance sheet balances and the company is properly financed. If fixed assets are greater than the sum of retained earnings and long-term debt, then the company has been mis-financed. In order to diagnose mis-financing, you will need to look at the variations in these three categories over a multi-year period.
Business owners can also turn to their local SBDC Advisors to help. Local SBDC offices provide business owners with free face-to-face business consulting and at cost training to help make sure every business owner understands the structure and benefits of proper fixed asset financing.
SBDC and Finagraph have also teamed up to provide businesses with on-line cash flow training, certification and in-person training in your state. Our goals are to help every small business understand and manage their cash flow to ultimately eradicate cash flow as a reason businesses fail.
Visit www.CashFlowTool.com/SBDC for more information.