No business can operate without a ready supply of liquidity. A business requires capital to generate sales, buy inventory, pay employees and purchase assets. Whether to stay in business or expand, the business owner needs to consider all the options with regard to financing. These commonly include:
- Capital that can be generated internally.
- Financing from trade creditors.
- Borrowed funds from banks and other lending institutions.
- Sales of equity ownership interests.
Each source of funds has different characteristics that should be considered depending on the needs of the business.
As a business grows, so does the need for additional financing. It is important to anticipate those situations in advance so the business owner is not left unprepared and scrambling for funds at the last minute. In fact, one of the leading causes of business failures is inadequate financing. The following examples illustrate typical situations in a growing business that require increased financing:
- Sales growth typically requires an increase in inventory levels to support the higher volume.
- Higher sales result in higher levels of customer accounts receivable.
- Growth may require the business to carry larger cash balances to meet current obligations.
- Growth may lead to expansion opportunities to open new locations or add product lines.
- In the short term, it may be necessary to spend cash in order to take advantage of cost saving opportunities offered by newer equipment that presumably will lower long-term costs.
- Higher liquidity allows the business to take advantage of savings through vendor discounts.
- When sales fluctuate due to seasonal factors. If inventory is purchased in advance but receivables won’t be collected until 30 or 60 days after the sale, a long sales cycle exists. Sufficient funding to maintain cash flow during that period is critical.
- To maintain timely payments on debt obligations to preserve credit rating.
- A slow down in economic conditions which cause temporary sales and profit declines as well as existing customers to pay more slowly.
Short-Term versus Long-Term Capital
Short-term needs are generally classified as those of less than one year while long-term needs are defined as those in excess of one year.
Is best suited for assets that turn over quickly such as accounts receivable or inventories. A seasonal business that builds inventories in anticipation of sales but will not collect receivables until after the selling season often needs short-term financing during this interim period. Other businesses such as contractors or manufacturers with substantial work-in-process inventories often need short-term financing until the work is completed and payment is received.
Is generally associated with the purchase of property, plant and equipment with useful lives of several years. It may also be a practical alternative in situations where short-term financing recurs on a regular and frequent basis. This is because a series of short-term demands can realistically be viewed as a long-term need. Long-term financing may prevent a crisis from occurring should capital not be available to meet a short-term cycle. A company with steady sales and profit growth may find long-term financing to be more appropriate.
Improve internal finance sources
This refers to funds generated within the business as opposed to by suppliers, lenders, and investors. For example, accelerating receivable collections, liquidating excess inventory, selling off non-productive capital assets, retaining profits versus paying shareholder distributions and cutting costs can all be thought of as sources of internal financing.
A business can minimize its external capital needs by establishing procedures that help to reduce the possibility of cash shortages caused by ineffective asset management. Preparing a cash flow projection will identify the months posing a cash shortage problem. Typically, these cash flow projections can be created as an Excel spreadsheet to consider various “what if” assumptions.
Before seeking capital from external sources, the business should thoroughly explore all reasonable means to generate as much financing from internal sources as possible. This will reduce interest expense, lower the repayment obligations and result in less sacrifice of control in the business. The ability to generate capital internally will also provide greater confidence to outside investors and lenders making it easier and less expensive to acquire the necessary external funds