A recent engagement galvanized for me, how many organizations fail to understand the valuable role that banks play in the success of their organization. As many would contend, I am a strong believer that managing financial resources is the key to business success and growth. Success in business can be boiled down to: selling a product or service for more than producing it, and the product or service must be desired in the marketplace. Within this realm there are a few defining rules; keep inventory to a minimum by regular timely/accurate billing, timely collection of outstanding debts and keep expenses in check. However in the course of business there are times when more funds are needed than those available, hence the importance of banks. Banks can play many roles in the life of a business: short term funds, long term funds even an equity interest. Regardless of the role, like any investor, the bank needs to see value.
Many years ago I had the opportunity to work with a person who inherited a company through familial succession, yet had no concept of running the business; beyond making coffee. Through our time together I impressed upon Daniel some of the foundations to maintaining and growing the business; one of which was the importance of a good relationship with the bank. It wasn’t until recently that I saw Daniel’s frantic frustrations with the bank manifest itself in others. The frustrations boiled down to these people wanting more money from the bank, while the bank wanted to see more value in the companies. With these companies, the banks provided an operating line of credit which was secured with assets, current assets.
As I continue to advise firms on financial management, I feel it is more important to present this topic on managing operating lines. In a subsequent contribution I will present techniques to unlock hidden value in current assets to gain enhance one’s operating line.
As a foundation, banks and investors provide funds to organizations based on known risk and expected return. The level of risk assumed by these funding bodies determines their desired rate of return. Essentially, how much must they be compensated to assume this level of risk? To mitigate some risk, depending on the investment, these bodies will seek some collateral. In the case of an operating line of credit, the collateral is made up those current assets which can be quickly liquidated. In the case of stock or angel investment, the collateral is the vision of management.
An operating line of credit is short term money; it is intended to bridge the gap in converting inventory to cash. I have written extensively on using the ‘right’ type of funding for the ‘right’ type of activity. With this said, the institution is providing access to funds as a means of bridging this gap. In an earlier contribution I explained that the rule of thumb on the amount of ‘bridging’ required is determined on how long it takes to be completely repaid. The rule is, one year.
In determining the amount of the operating line, the institution looks at the economic viability of the organization, its history, its management team and their vision. As a means of mitigating some of their risk, they seek collateral. The most common sources of collateral for an operating line are: accounts receivable, inventory (WIP), and cash. Institutions will extend funds based on the value of these assets. As a caveat to the agreement, the institutions will clarify the value they place on the assets presented. This is clearly outlined in the agreement at the inception of the relationship and emphasized throughout the relationship by way of timely reporting.
It is by way of this disconnect between the institution and the business that frustrations arise. By way of a simple example, it becomes clear how frustrations can arise. ABC Ltd is a local supplier of consumer products; they do not manufacture the goods for sale. They simply add value through combining products to produce a convenience offering. ABC is in a fixed demand niche with very little cyclical behavior and they are one of several suppliers in the area. Their profit margin on inventory is 30% and requires a significant amount of human intervention to get the product offering to market.
In negotiating an operating line of credit, ABC Ltd is made aware that there will be certain limitations on the amount the institution will advance. Some of the most common limitations are:
- Inventory: Inventory is valued at 50% using FIFO (First in First Out). All inventories older than 120 days are excluded from valuation.
- Receivables: Receivables are valued at 70% for all those who are not more than 90 days past normal due date. For ABC, whose terms are N30, the limit is 120 days.
i. Excess Delinquency: Where a single client has an amount of receivable in excess of 120 days which is at least 25% of the total due – the entire account has no value.
ii. Credits: All credits over 120 days are excluded from valuation
iii. Concentrations over 10%: Where a single client represents more than 10% of the total receivable their entire receivable has no value.
Depending on the industry some other limitations on valuation are: accounts with Government bodies, affiliates, foreign receivables and third party relationships. These limitations are set to mitigate the risk of not getting paid should the company fail to be a going concern. Should this occur the institution would enact immediate measure to recoup most of their advanced funding.
The ABC demographics:
Sales: $10M per year
Inventory: $500K average, $75K excess of 120 days
A/R: $750K, $100K beyond 120 days, excess delinquency $65K, $150K in client concentrations.
To the organization, they see $1,250K in value to which they are expecting an operating line equal that amount. However, to the institution the true liquidity of the assets is $647,500, about 52% of expectation! Therefore ABC Ltd is only eligible for $647,500 in operating line. On top of this the institution may further penalize ABC for its inherent risks by imposing a less than sterling interest rate for borrow.
Clearly there is a disconnect between what ABC sees as value and what the lending institution sees as value. Hence the opposing duality, ABC stifled needing more cash and the institution demanding more value.
In my next contribution I will explore actions which ABC Ltd can undertake reduce the suffocating hold which they are under and have a better working relationship with their lender.