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How and When to Use Financing

Tips and tools for the complex and uncertain business environment

We find ourselves in a complex and uncertain business environment that seems to be heading toward a recession. Inflation and interest rates have increased. Consequently, the cost of financing and the general risk to businesses have also increased. This situation makes it harder to get financing at a time when businesses may need it the most.

How to make the wrong decision

Many bad financial decisions happen because of an error in judgment by a person or team. These errors usually fall into three general categories:

Not doing due diligence. Many small business owners don’t spend enough time and resources doing due diligence. I can understand it; due diligence is tedious work. As a general manager, you have better things to do than focus on all the details. Unfortunately, not performing thorough due diligence increases your likelihood of making an avoidable mistake.

Allowing emotions to play a role in the decision. I have seen business owners who attach a lot of emotion to financial decisions. The type and intensity of emotion vary by situation. Unfortunately, letting your emotion interfere with these decisions is usually detrimental to your business. Examples include situations in which owners make a “prestige purchase” or avoid reviewing their financial statements because of negative emotions. 

Not getting objective advice when needed. Small-business owners, especially in competitive industries like construction, are very self-reliant. They got to where they are by doing everything themselves. Self-reliance may be an advantage sometimes. However, it backfires when you become overconfident in your abilities. Overconfidence always leads to bad decisions.

The strategies discussed in the following sections are designed to help you avoid making these common errors.

Solving cash flow problems

One of the most common reasons construction companies get financing is to manage cash flow problems. These problems can lead to companies delaying vendor payments or not having the funds to pay for necessities. This situation creates a sense of urgency which can prompt business owners to get financing quickly. However, rash decisions without adequate due diligence can cost your business dearly. As a rule, never get financing until you can answer the following four questions confidently:

Why do you have a problem? Finding out why you have a cash flow problem takes some diligence. The only way to do this effectively is to scrutinize your financial reports. These reports help determine the source of the problem and point to a possible solution. For example, companies often have cash flow problems because clients pay too slowly or because excess funds are tied to slow-moving inventory. Companies may also have issues because the business is unprofitable or has expensive debt. These scenarios create cash flow problems that lead to a dangerously low bank account. However, they have different causes and require specific solutions.

Keep in mind that companies often have more than one problem. Consequently, don’t stop examining the company’s statements and operations until you have done a thorough evaluation.

Will financing fix the problem? You must determine whether financing will help improve the situation. Financing won’t fix every cash flow problem. In fact, it could worsen some problems. For example, financing could solve problems due to slow-turning accounts receivable or slow-moving inventory. However, financing can also enable an unprofitable business to operate longer and get into more problems. For this reason, it is dangerous to get financing without first understanding your situation.

What products should you consider? In most cases, the best solutions for these challenges are revolving lines of financing. These solutions include options such as lines of credit and receivables-based financing. You can use these products when you need funds, and repay the line as your situation improves. The main exceptions to this are problems caused by expensive debt or unprofitable businesses. These problems require you to restructure the debt or company accordingly.

What is your exit strategy? Getting financing may bring peace of mind, but it comes at a cost. Unless the funding is explicitly used to grow the business, it will hurt profits. It’s to your advantage to use the least amount of financing for the shortest time frame that allows you to solve the problem.

Develop an exit strategy to move your company off the financing line. Ultimately, this goal requires that you solve the problem that prompted the need for financing in the first place. For example, companies with slow-paying clients or collections problems should improve those areas and build a cash reserve. Each situation is unique, though, and requires a specific solution.

Replacing or adding new assets

Business owners also get financing when they need to replace existing assets or add new assets. This situation differs from cash flow problems and requires a modified approach. In this section, the term “asset” refers to machinery and equipment. However, the process remains the same for any type of asset.

Do you need the asset? The answer to this question may seem obvious, but many business owners replace machinery with more expensive models or add new equipment without a solid financial justification. This mistake can affect your company’s financial health for a long time.

Ask yourself if the company needs the asset you are getting. Develop a business case and financial justification for the acquisition. Compare the costs of getting the asset against the revenues the asset will generate.

Can the company afford the asset? The next step is to determine if your company can afford the asset. It’s a matter of examining your financial statements and ensuring your company can make the payment without getting into trouble. Buying assets in anticipation of future demand is more complex. Ideally, you want to secure assets incrementally as demand grows. This strategy helps ensure you never acquire assets you won’t use or can’t afford.

How are asset acquisitions financed? Assets are usually purchased using a term loan. The lender pays for the asset while you make fixed payments to the lender for a period of time. Another option is to lease the machinery or equipment. Leases are similar to rentals, though most leases allow buying the asset at the end of the term for a nominal cost.

Handling large purchases

The analytical process of determining whether to make a large purchase, such as buying a new facility or acquiring a competitor, is similar to the process in the previous section. You determine three things: if you need it, if you can afford it and how you will finance it.

There is one crucial caveat. Making a mistake in a large purchase could put you out of business. This point leads me to one additional question you should always ask when you make a large purchase.

What is the worst that could happen? Consider the worst-case scenario if you make the acquisition and things don’t go as expected. Will your business be able to handle the purchase and manage a downturn or a significant customer loss? If it can’t, reconsider your strategy.


Real-World Worst-Case Scenario

Some years ago, I worked on a transaction involving a very successful company. The business was a proverbial cash cow that made lots of money for the owners. The managers ran a “lean” company, as reflected in their financial reports. Their operations were so lean that their current offices and facilities looked spartan, to put it kindly. The CEO decided it was time to upgrade to a better facility that matched their exalted level of success.

The company bought a new building and equipped it accordingly. The facilities were spectacular by every measure, and the CEO was proud of the acquisition. I was impressed, though it looked like the CEO had purchased the building to increase the company’s perceived prestige. There was one catch with the transaction: its financing cost was just as spectacular as the new facility.

Things didn’t take long to unravel. The market turned, and the company became distressed. They no longer had a strong financial position thanks to their recent acquisition. Consequently, they had to take drastic actions. The company began cutting expenses and soon realized they had to unload the new facility.

Because the market had turned, the building was sold at a heavily discounted price. Predictably, the company’s finances had to be restructured. Restructuring only postponed the inevitable. Ultimately, the company went into an unrecoverable financial tailspin.

A word of advice

Financial decisions can have long-standing consequences for your business, for better or worse. Consult a CPA or similar professional before making any major financial decision. Ideally, work with a CPA who is seasoned in business management.

This is a no-lose proposition. There are two possible outcomes: the CPA may find problems with your strategy and prevent you from making a costly mistake. Alternatively, the CPA may agree with your strategy, reinforcing the course of action. Either way, you are better off for having had the consultation.

The process doesn’t need to be complicated. Generate financial reports and prepare a simple justification for your plan. Discuss the project with your CPA and describe your reasoning. Ask them specifically if they see any problems you have overlooked.

Depending on the project’s complexity, the meeting with the CPA could cost a few hundred to a few thousand dollars. This expense is money well-spent.


Marco Terry

Marco Terry

Marco Terry is managing director of Commercial Capital LLC, a factoring company and provider of invoice financing to companies in the glass industry. He can be reached at 877/300-3258.