How can you make today's financial management tomorrow's good history? As a history of good management of financial resources is essential for a successful loan application, the owner/manager needs to closely monitor debt management throughout the year, rather than just before financing is sought.

The Line of Credit

Manage the company's line of credit; don't let it manage the company. The key to success is ensuring the line of credit fluctuates in keeping with the business cycles. Use it to meet your peak requirements but at all costs, get it back to zero once or twice a year. Ideally, a business should maintain one month's reserve in liquid investments, such as cash, and use the operating line of credit for financing as needed. This strategy prevents the line of credit becoming a negative operating fund.

Businesses that use their maximum line of credit on a permanent basis will face a severe cash shortage when circumstances suddenly change. These businesses are unprepared to respond when capital assets are essential for growth, an economic slowdown decimates sales, or a large customer goes bankrupt. Borrowing in a panic may solve the immediate problem but could damage the relationship with your lender.

Company Debt

Eliminate your most expensive debt first. Most expensive could be identified by high interest rates, excessive penalties for late payment, or those debts for which the interest is not deductible for income tax purposes. Whenever possible, increase your debt repayment. Beyond a profound impact on the total interest paid, paying debts off more quickly indicates your ability to manage a future lender's funds prudently.

Debt to Equity Ratio

The debt to equity ratio assists a lender in determining the amount of equity that has been accumulated within a business. If the debt to equity ratio is higher than 50%, the business is obviously borrowing heavily against its assets and the lender may take a second look at the risk involved in lending funds. Financial institutions are not keen on investing additional capital to leverage a marginal performer. However, since ratios do not always indicate the entire story, lenders will also look at business' cash flow, risk tolerance and time horizons for the new venture to be financed.

Cash Flow

For the owner/manager, profit is a vital measure of how well the business has performed compared to prior years and where it is going in the future. However, when a lender determines debt service ability, profit is important but not as important as cash flow.

To analyze debt service ability, the lender looks for sufficient cash flow to cover the principal and interest repayments over the term of the loan. For example, if a company's annual cash flow shows $100,000 cash in, and $80,000 cash out, the balance of $20,000 is key to determining the loan amount. Based on this ratio of 1:1.25, the lender would likely be willing to lend $16,000. However, if the same business had a debt service ratio approaching 1:1, the risk may be evaluated as too high. Anything above a 1.25 ratio will make the loan easier to acquire; but below 1:1, a loan is unlikely.

Institutions have various guidelines to establish whether an individual or a company can service a debt. Regardless of the ratio used, a loan officer will undoubtedly take into consideration the amount of the loan required plus the funds required to service other debt and divide it by the gross income.

Stability and Commitment

A lender knows that using the line of credit to finance operations or borrowing funds to increase capital assets does not create an immediate return on investment that will ensure the debt is repaid. Thus, in evaluating risk, lenders will look at management stability and commitment, product or service quality and marketability, and operating efficiencies. Of course, they will want to see the company's prior year's financial data, combined with projected profit and loss statements, and projected cash flows.

A Business Plan

In addition to the financial aspects, lenders will also need a marketing strategy and a viable business plan that clearly support the numbers. As the basis of a sound business plan, well-designed internal reporting systems are the key to generating results-oriented information such as the length of time that lapses from the outlay of cash to purchase raw material to the subsequent sale and collection of accounts receivable.

Tomorrow's Financing

When the business needs financing, the owner/manager needs to establish not only where the business is today, but how effectively and efficiently it has moved from the outset to its present situation. Sound financial management and good internal reporting will help a future lender gain confidence in the business' management team, the product or service being offered and its ability to sustain the business into the future.

The above provides general information only. It should not be regarded or relied upon as accounting or taxation advice or opinions. Logan Katz LLP Chartered Accountants would be pleased to provide more information or specific advice on matters of interest to you.

All contents are Copyright © 2003, Logan Katz LLP Consulting Inc. All Rights Reserved.