Capital Alternatives

Understanding Money Sources

HOW THE NEED FOR CAPITAL ARISES

There are many factors that can create a need for additional capital. Some of the more common are as follows:

Sales growth requires inventories to be built to support the higher sales level.

Sales growth creates a larger volume of accounts receivable.

Growth requires the business to carry larger cash balances in order to meet its current obligations to employees, trade creditors, and others.

Expansion opportunities such as a decision to open a new branch, add a new product, or increase capacity.

Cost savings opportunities such as equipment purchases that will lower production costs or reduce operating expenses.

Opportunities to realize substantial savings by taking advantage of quantity discounts on purchases that will lower production costs or reduce operating expenses.

Opportunities to realize substantial savings by taking advantage of quantity discounts on purchases for inventory, or building inventories prior to a supplier's price increase.

Seasonal factors, where inventories must be built before the selling season begins and receivables may not be collected until 30 to 60 days after the selling season ends.

Current repayment of obligations or debts may require more cash than is immediately available.

Local or national economic conditions which cause sales and profit to decline temporarily.

Economic difficulties of customers that can cause them to pay more slowly than expected.

Failure to retain sufficient earnings in the business.

Inattention to asset management may have allowed inventories or accounts receivable to get out of hand.

Combination 

Frequently, the cause cannot be entirely attributed to any one of these factors, but results from a combination. For example, a growing, apparently successful business may find that it does not have sufficient cash on hand to meet a current debt installment or to expand to a new location because customers have been slow in paying.

Short- and Long-Term Capital  

Capital needs can be classified as either short- or long-term. Short-term needs are generally those of less than one year. Long-term needs are those of more than one year.

Short-Term Financing  

Short-term financing is most common for assets that turn over quickly such as accounts receivable or inventories. Seasonal businesses that must build inventories in anticipation of selling requirements and will not collect receivables until after the selling season often need short-term financing for the interim. Contractors with substantial work-in-process inventories often need short-term financing until payment is received. Wholesalers and manufacturers with a major portion of their assets tied up in inventories and/or receivables also require short-term financing in anticipation of payments from customers.

Long-Term financing

Long-term financing is more often associated with the need for fixed assets such as property, manufacturing plants, and equipment where the assets will be used in the business for several years. It is also a practical alternative in many situations where short-term financing requirements recur on a regular basis.

Recurring Needs  

A series of short-term needs could often be more realistically viewed as a long-term need. The addition of long-term capital should eliminate the short-term needs and the crises that could occur if capital were not available to meet a short-term need.

Steady Growth 

Whenever the need for additional capital grows continually without any significant pattern, as in the case of a company with steady sales and profit from year to year, long-term financing is probably more appropriate

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MANAGING INTERNAL CAPITAL

Capital can be generated externally by borrowing or locating investors who might be interested in buying a portion of the business.

Before seeking external sources of capital from investors or lenders, a business should thoroughly explore all reasonable sources for meeting its capital needs internally. Even if this effort fails to generate all of the needed capital, it can sharply reduce the external financing requirements, resulting in less interest expense, lower repayment obligations, and less sacrifice of control. With a lower requirement, the business's ability to secure external financing will be improved. Further, the ability to generate maximum capital internally and to control operations will enhance the confidence of outside investors and lenders. With more confidence in the business and its management, lenders and investors will be more willing to commit their capital.

Internal Sources of Capital  

There are three principal sources of internal capital:

Increasing the amount of earnings kept in the business.

Prudent asset management.

Cost control.

Increased Earnings Retention  

Many businesses are able to meet all of their capital needs through earnings retention. Each year, shareholders' dividends or partners' draws are restricted so that the largest reasonable share of earnings is retained in the business to finance its growth.

As with other internal capital sources, earnings retention not only reduces any external capital requirement, but also affects the business' ability to secure external capital. Lenders are particularly concerned with the rate of earnings retention. The ability to repay debt obligations normally depends upon the amount of cash generated through operations. If this cash is used excessively to pay dividends or to permit withdrawals by investors, the company's ability to meet its debt obligations will be threatened.

Asset Management 

Many businesses have non-productive assets that can be liquidated (sold or collected) to provide capital for short-term needs. A vigorous campaign of collecting outstanding receivables, with particular emphasis on amounts long outstanding, can often produce significant amounts of capital. Similarly, inventories can be analyzed and those goods with relatively slow sales activity or with little hope for future fast movement can be liquidated. The liquidation can occur through sales to customers or through sales to wholesale outlets, as required.

Fixed assets can be sold to free cash immediately. For example, a company automobile might be sold and provide cash of $2,000 or $3,000. Owners and employees can be compensated on an actual mileage basis for use of their personal cars on company business. Or if an automobile is needed on a full-time basis, a lease can be arranged so that a vehicle will be available.

Other assets such as loans made by the business to officers or employees, investments in non-related businesses, or prepaid expenses should be analyzed closely. If they are non-productive, they can often be liquidated so that cash is available to meet the immediate needs of the business.

Any of the above steps can be taken to alleviate short-term cash shortages. On a long-term basis, the business can minimize its external capital needs by establishing policies and procedures that will reduce the possibility of cash shortages caused by ineffective asset management. These policies could include the establishment of more rigorous credit standards, systematic review of outstanding receivables, periodic analysis of slow-moving inventories, and establishment of profitability criteria so that fixed asset investments are most closely controlled.

Cost Reduction  

Careful analysis of costs, both before and after the fact, can improve profitability and therefore the amount of earnings available for retention. At the same time, cost control minimizes the need for cash to meet obligations to trade creditors and others.

Before the fact, a business can establish buying controls that require a written purchase order and competitive bids on all purchases above a specified amount. Decisions to hire extra personnel, lease additional space, or incur other additional costs can be reviewed closely before commitments are made.

After the fact, management should review all actual costs carefully. Expenses can be compared with objectives, experience in previous periods, or with other companies in the industry. Whenever an apparent excess is identified, the cause of the excess should be closely explored and corrective action taken to prevent its recurrence.

TRADE CREDIT

Informal Extensions  

Frequently, this is done with no formal planning by the business. Suppliers' invoices are simply allowed to "ride" for another 30 to 60 days. Unfortunately, this can lead to a number of problems. Suppliers may promptly terminate credit and refuse to deliver until the account is settled, thus denying the business access to sorely needed supplies, materials, or inventory. Or, suppliers might put the business on a C.O.D. basis, requiring that all shipments be fully paid in cash immediately upon receipt. At a time when a business is obviously strapped for cash, this requirement could have the same effect as cutting off deliveries all together.

Planning Advantages  

A planned program of trade credit extensions can often help the business secure extra capital that it needs without recourse to lenders or equity investors. This is particularly true whenever the capital need is relatively small or short in duration.

A planned approach should involve the following:

Take full advantage of available payment terms. If no cash discount is offered and payment is due on the 30th day, do not make any payments before the 30th day.

Whenever possible, negotiate extended payment terms with suppliers. For example, if a supplier's normal payment terms are net 30 days from the receipt of goods, these could be extended to net 30 days from the end of the month. This effectively "buys" an average of 15 extra days.

If the business feels that it needs a substantial increase in time, say 60 to 90 days, it should advise suppliers of this need. They will often be willing to accept it, provided that the business is faithful in its adherence to payment at the later date.

Consider the effect of cash discounts and delinquency penalties for late payment. Frequently, the added cost of trade credit may be far more expensive than the cost of alternate financing such as a short-term bank loan.

Consider the possibility of signing a note for each shipment, promising payment at a specific later date. Such a note, which may or may not be interest-bearing, would give the supplier evidence of your intent to pay and increase the supplier's confidence in your business.

Ready Availability  

Trade credit is often available to businesses on a relatively informal basis without the requirements for application, negotiation, auditing, and legal assistance often necessary with other capital sources.

Usage  

Trade credit must be used judiciously. Its easy availability is particularly welcome in brief periods of limited needs. Used imprudently, however, it can lead to curtailment of relations with key suppliers and jeopardize your ability to locate other, competitive suppliers who are willing to extend credit to your business. Remember, that on the other side of the transaction there is another business that is trying to manage its sources of capital, too!