When asked, I nearly always recommend financing short-term assets to handle short-term cash needs and long-term assets for long-term needs. In general, it is not advisable to use long-term assets to provide short-term cash, especially working capital. However, there are times when this rule needs to be set aside.
Working capital is always considered a short-term asset. It is used to pay current liabilities such as payroll, accounts payable, make long term note payments and buy inventory. Long-term assets such as real estate and equipment are ordinarily financed for a period greater than 12 months. In the case of real estate 15 – 30 years is common. For certain types of long life equipment or machinery, a financing period of 15 years is not uncommon.
It makes sense to consider leveraging equity in real estate or equipment when there is simply no other way to obtain working capital. The positive aspect of doing this is the working capital is repaid over a long period which keeps payments low, but the downside is you only get a one time injection of cash to become working capital verses a line of credit or factoring which allows a company to draw and repay cash as sales rise and fall.
Sometimes a combination of refinancing real estate and using a factoring or bank line of credit to restructure other long term debt and provide working capital makes the best sense.
Here is an example:
XYZ Manufacturing is a precision metal fabrication company serving the oil, gas, and petrochemical industries in the
XYZ has an opportunity to double their business if they start doing fabrication for a large petrochemical company. XYZ is excited about the opportunity but nervous that if there is a downturn in their industry, some or all of this addditonal work could go away. They don’t want to take on large amounts of long-term debt to handle the new work. XYZ’s margins will be good and they have existing plant capacity to handle the new work, but will have to hire 55 new employees and begin a second shift.
XYZ considered an SBA loan but felt the up front origination and loan guarantee fees were too high for them and the SBA loan would be have to be much larger than they wanted to borrow. They found a bank that was willing to refinance the existing land and facilities at 7.75% for 30 years with no up front fees or closing costs other than an appraisal and environmental report which the SBA also wanted. XYZ decided to be conservative and only borrow $600,000 against the land which appraised at nearly $2.0 million. This money would be used to hire and train new workers as well as to mobilize the new work that would double revenues. XYZ believed their accounts receivable would grow to a little more than $1.5 million because the new customer would be paying less quickly than their existing customers. Their bank was willing to give them a $500,000 traditional line of credit but the owners wanted more cushion, so they elected to use a bank factoring program and set up a $1.6 million factoring line of credit. This line of credit would be partially drawn upon to handle the growing accounts receivable and raw materials that would also grow substantially. Their steel supplier offered them a cash discount of 1.5% if they paid upon delivery.
In summary, the equity in the real estate was used to finance the mobilization costs and provide a much larger cash safety margin then XYZ was used to having. The factoring line of credit would be used to insure that all payables would be paid in such a way as to insure prompt payment discount. Steel was to be purchased COD in order to get a discount of 1.5%. The net result of this financing structure provided a large self liquidating line of credit that paid for itself with steel discounts, and the equity in the real estate provided enough cash so the owners could attract, hire and train fabrication personnel in a market where such personnel are in short supply.