For smaller businesses, debt sometimes gets a bad rap. But for many businesses, access to a business line of credit may be not only necessary, but a smart move. Knowing how to select the right line of credit and manage it wisely, rather than managing everything on a cash basis, can help a successful small business become a larger successful business.
Financing options can be complex, however, so it’s worth taking the time to go through one’s cash and financing options with a business banker who can take the time to understand what one is trying to do.
Cash Reserves – “The First Line of Defense”
Most people have heard the personal finance adage that they should have on hand an amount of cash equal to six months of expenses, in case they lose their job or have an emergency expense. But does this hold for businesses? And is it realistic or wise to have that much capital sitting around? The short answers: Yes and yes. How much one needs will depend a lot on one’s business and cash flow, so it is helpful to talk with a banker or business advisor who can draw on experience working with similar types of business.
Smoothing Out Irregular Business Cycles and Protecting Capital with a Line of Credit
Many businesses have expenses and income on different cycles. Buying inventory weeks ahead of a shopping season, or raw materials that take months to turn into finished products the business can sell are classic examples. Managing ebbs and flows by saving cash in rich times to spend later makes it hard for a business to grow since it won’t have enough capital to expand significantly if the market is ripe. Lines of credit enable more flexibility than a credit card and often have better terms, and a business can cover ongoing expenses with less stress. With a line credit, a business is financing the gap between the placement of the order and the delivery of the product or service.
Using Term Loans for Capital Expenses instead of Paying Cash
Buying a large-ticket item is stressful for smaller businesses. Purchases like major machinery or real estate can cost a lot, but they enable a company to make money over a long period of time and have an intrinsic value that improves a business’s balance sheet (and can be used to secure the loan). Saving up cash takes a long time and carries an opportunity cost. More importantly, term financing frees up cash to use for more productive purposes, like hiring people to run the machine or more inventory to sell at a store.
Weighing the Cost of Financing against Gains in Efficiency
Business owners should think of purchases in terms of value to the business, not just price plus interest. Some purchases are more valuable than others. If the monthly payment for one piece of equipment is twice as much as another but triples productivity, that would be a good place to take on more financing — as long as there is a market for the increased output. Seizing such opportunities isn’t as risky as it might seem if the business has a good business plan and a good lender who will help validate these kinds of cost/benefit equations.
Using Financing to Help Manage Changes in Ownership
Succession planning helps businesses — and people. Many businesses delay or avoid talking about succession plans. They shouldn’t. In many companies, talk of succession planning may seem unnecessary or even “bad luck.” But planning what happens to one’s business not only ensures business continuity, it relieves families of the burden of sorting out ownership and is crucial for the well-being of employees and partners, too.
Buying, selling and passing down a business are situations as unique as the people involved. An owner may want to take on a partner or sell to a buyer who doesn’t have the cash available. Or perhaps it’s time to set up an Employee Stock Ownership Plan (ESOP) so the owner can make the employees owners. In both cases, loans and payouts can be structured in lots of ways beyond a simple bank loan to make the opportunity attainable for all the parties involved.
Business owners shouldn’t expect to be experts in finance as well as running their own business. Financing options are more varied and specialized than many people might expect. For those who have generally run their business on cash, credit card and simple charts of accounts and are ready to take the next step, a business advisor can help them learn about the possibilities that are available.
Kevin Fox joined Alerus in January 2018, bringing with him more than 22 years of financial industry and banking experience. As a business advisor, Fox works to understand the needs and goals of his clients, then acts as a trusted advisor to provide solutions that make sense and add value. Often, his role involves bringing in experts from within Alerus, including retirement specialists, treasury specialists, mortgage bankers and wealth advisors, to form a team and craft solutions tailored to the client’s specific needs.