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Berkonomics

Here’s a rule for companies with outstanding loans

 

Here is one that is so important to the continued health of a growing company that it cannot be overstated. It’s a bit complex for novices. But hang in there as I explain a bit about accounting classification of assets and liabilities.

Differences between types of assets and liabilities

First, let’s be sure we know what is short in term and what is long in term.  Long term debt is taken on for the acquisition of fixed assets such as equipment, cars, facilities and acquisitions of companies or their assets.   Short term debt is often composed of accounts payable to the trade or employees for expenses, payroll liabilities, accrued but unpaid vacations, customer deposits, and the portions of any loans due to be repaid within one year.

How much can you borrow against company assets?

Asset-based financing is common for companies with accounts receivable and / or inventories.  There are numerous lenders engaged in this practice, including most business banks.  Typically, companies may arrange to borrow between 70% and 80% of those non-government receivables that have not aged past 60 days from invoice, up to a maximum amount, or “credit line”.

[Email readers, continue here… ]  Other companies have both the creditworthiness and relative size to be able to borrow from private and banking sources without collateral, with unsecured loans.  Many of these lines of credit require that the borrower “clean up the line” for one month out of every year, that is to be out of debt with the lender for that period to prove to the lender that the need for the cash is not permanent, used like a long-term loan.

How to get in trouble mixing cash use and loan classes:

Numerous companies have gotten into trouble by using the easy availability of these short-term lines of credit, meant for rising and falling working capital needs, to make payments upon long term obligations such as asset loan payments when due.  And worse, some even purchase assets such as equipment with money from short term loans.  Matching the term of a loan with the life of the asset is an important business principle.

The “coffin corner” to avoid in cash management

Receivables are assets for only 60 days for the purpose of these lines of credit, and the available line can be reduced automatically as receivables reduce with payments by customers or aging beyond 60 days.  We all expect new receivables to be added to replace these, but a cyclic business; a disruption in the general economy; a reduction in the company’s revenues would each contribute to a reduction in the amount available for such borrowing.

To avoid the coffin corner of an over-borrowed asset-based line with no cash for working capital, remember that short term borrowings such as these should never be used to pay any long-term obligations or to purchase fixed assets.

  • Michael O'Daniel

    I worked for a company that went out of business because of asset-based borrowing, in this case financing its receivables (at 22%!!!). The company was healthy and marginally profitable on an ongoing cash basis, but the lender demanded changes in management that the company resisted, so the lender pulled the plug. I found that private lenders who do asset-based financing often impose even more stringent conditions than conventional banks.

    • Michael,
      Unfortunately, I have several stories just like yours. Lenders taking control, exercising rights hidden in contracts to confiscate the mail to take checks before company receipt, moving against company assets, moving to marginalize management, and more. These contracts that desperate or unknowing entrepreneurs sign without understanding are deadly; and the lenders are not afraid to destroy a business to harvest cash to repay the loans. Thanks for your insight.

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