How to Finance a Small Business

As businesses are created and grown, they typically need to obtain credit to operate if they sell their product or service on terms, or until they begin to retain sufficient earnings.  I’ve been fortunate enough over the past 22 years to assist numerous small businesses in many different industries with their credit needs and can share some observations that might be helpful to you if you own, or are considering starting, a small business.

Small businesses get credit from one or more of three basic sources: Lenders, Vendors, and Owners. That’s a very simplified answer to a complex question, but I like it because it breaks business credit down to its simplest form and it rhymes. Let’s examine each one in a little more detail:

Lenders:

This category is exactly what it says. Businesses can borrow money from traditional lenders such as banks, credit unions, savings and loans/savings banks, and yes, even credit cards. As much as lenders try to differentiate themselves, borrowing money from any of these sources generally comes down to the same basic qualifications (old timers like me refer to these as the “C’s” of credit):

1.       Capacity/Cash Flow – Can the business afford to pay back its loans and still provide a reasonable salary to the owner/return to the shareholder with some margin/cushion?

2.       Character – Does the company/owner/principal have good character?

3.       Collateral – Is there sufficient collateral to secure the loan, or does the borrower qualify for the loan on an unsecured basis?

4.       Credit – Does the company/owner/principal have good credit, e.g. have they performed as agreed upon with previous loans?

Another source of credit that has become more prevalent is “factoring”. Factoring is a process where you sell your accounts receivable to a factoring company, they pay you a discounted percentage of the total up front, and the factoring company collects the receivable from the customer over time. The discounts are typically high, thus making this type of financing very expensive, especially when you convert the discount percentage to an annual percentage rate (APR). For a brand new business with very good receivables, this may be their only financing option other than an owner injection.  

Vendors:

Some people refer to this type of financing as “trade payable” financing. You essentially “borrow” money from your vendors/suppliers who offer payment terms by delaying payment, which in turn creates cash flow for your business. Utilizing this type of credit is typically on a short-term or gap basis. In the past, the old rule was “2/10 net 30” which meant that if you pay an invoice within 10 days the vendor offers a two percent price discount, but the entire balance is due within 30 days.   These days, most companies, especially larger ones, have discovered the cash flow that is created by delaying payments, so few take advantage of the discount offered.  In all likelihood, this has reduced the number of vendors offering discounts. 

Owners:

A business can receive capital (cash) injections from an owner to provide the credit it needs.  If the business is a partnership or corporation, this entails giving a portion of the business ownership to the person/persons making the injection, and providing them with a rate of return that is greater than what a traditional lender will require. That is because there is greater perceived risk for the investor. Borrowing with this method is done through the issuance of equity (stock) or debt (bonds). You may or may not be willing to give up a portion of your business to provide capital with this method.

Which brings us to the final point; how much capital does a business need? That’s a very complex equation, but here’s a quick formula that can “get you in the ballpark:”

1.       Annual credit sales of the business / 365 (days)  = average daily credit sales

2.       Multiply the average daily sales X the average collection period of your accounts receivable in days.

3.       This is about how much capital a business needs to support that level of sales.

Example: XYZ Corporation sells $1,000,000 worth of widgets per year. About 80% ($800,000) is sold on credit. Most of XYZ’s customers pay in 30 days, although a few pay early and a few pay late, but 30 is a reasonable average collection period. How much capital does XYZ need to support their credit sales?

1.       $800,000/365 days = $2,191.78 is their average daily credit sales

2.       $2,191.78 X 30 days =

3.       $65,753.42 is about how much capital XYZ needs to support $800,000 in credit sales.

You can also deduct that as XYZ’s sales increase, so will the capital need unless the company has been in business long enough to retain earnings (profit) to support sales with cash.

I hope you’ve found this information useful, and if Texas Bank and Trust can ever be of service to you or your business, we would certainly appreciate the opportunity. 

Stay tuned, my next blog post will be “How to Start a Small Business.”  Wishing you continued success,

James Sheridan

Senior Vice President/Commercial Lender

Tyler Grande Branch

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This information is provided with the understanding that neither Texas Bank and Trust Company nor James Sheridan is engaged in rendering specific legal or accounting services. If specific expert assistance in these areas is required, please contact a competent professional offering those services.