In my many years as a credit analyst and loan underwriter I came across many small business owners who had no clue as to the underlying causes for needing a loan. For example, a borrower requests for a loan to pay piling bills but cannot identify what is specifically draining cash. This is a common request that lenders deal with everyday. For this type of borrowing need, a lender is likely to approve a short-term loan. Without analyzing the borrower's financial statements to identify reasons why there was insufficient cash, a lender may hastily conclude that the loan will be paid from debt collections.
As the lender analyzes the financial statements, he or she realizes that the borrower had just bought equipment in cash. This is what caused the borrower to experience cash shortages. This problem will persist for a long time unless the borrower restructured the debt. What the borrower, in this example, needs is a long term loan to finance the new equipment. The lender will determine the loan amount and maturity based on cost, type and the useful life of the equipment.
The following are some of the borrowing causes:
• Account Receivable slowdown
This occurs when the period from invoicing to receiving payment increases. For example, if a company offers 30 days credit and the collection period is 40 days, the customer has taken 10 days longer to pay than the company is willing to permit. As the collection period grows, a company will require more funds temporarily to finance operations until receivables convert to cash, hence the need to borrow. Increase in the collection period may be caused by poor collection systems, bad payers or management decision to increase terms to customers. Account Receivable slowdown should be financed with short term funds. However, if the slowdown is long term, funding should last several months or years as well.
• Inventory slowdown
Slowdown of inventory occurs when a company takes longer to sell inventory. It is either voluntary or involuntary. Inventory buildup often to take advantage of the prevailing low prices is voluntary. Inventory buildup due to slow sales is involuntary. Both causes result in increased holding period. The formula for determining inventory turn is; cost of goods sold divided by inventory while that for determining days on hand is inventory divided by cost of goods sold times 365 (number of days in a year). The later formula is an estimate as it does not take seasonal fluctuations into account. Voluntary inventory buildup is usually temporary and should be financed with short term funds. Involuntary buildup should be financed with longer term loans.
• Short-term sales growth
This occurs when a company experiences rapid sales growth during certain months of the year. It is common with clothing retailers, liquor stores and toy stores during festive seasons when sales rise rapidly and then drop sharply after the festive season. The source of repayment for this type of a loan is the conversion of inventory and receivables to cash. Match the loan repayment schedule with the timing of the conversion of accounts receivable to cash
• Long-term sales growth
Sales change measured over a full year rather than monthly is known as long-term sales growth. As sales grow, trading assets grow as well. If sales growth is long term, then inventory and receivables arising from sales growth are considered permanent. The repayment sources of such a loan are profits, spontaneous financing and bank debt. Note that sales growth generally requires more cash than it generates. Therefore, rapid sales growth will inevitably require long-term debt financing.
• Increase in working investment
While working investment is an estimate of the amount needed to finance trading assets, working capital represents the long term portion of that need. Trading assets are composed of seasonal and permanent assets. Seasonal assets are financed with "seasonal" or short term loans while permanent assets are financed with long term finance, also known as working capital. The formula for Working Investment is; Accounts Receivable + Inventory – Accounts Payable – Accrued Expenses. To calculate working capital or the long term financing portion, simply subtract current liabilities from current assets. A company is said to be financed properly if, at the lowest point in the operating cycle, working capital is equal to the amount of working investment.