It is a fact that many business owners have struggled to operate their businesses during the last two years. Although there are some that have thrived because of their industry or advantage in the market, the mindset of the average business owner right now is one of conservation of resources at all costs. Once the recession has bottomed out for your business and your recovery has begun, it will be time to begin thinking about new sales and new opportunities. Since financing is likely to be a scarce resource for many months after the recession has begun its recovery, some business owners will have to make decisions about either 1) forgoing growth and replenishing cash or 2) paying a higher cost for financing.
The definition of opportunity costs according to NetMBA is:
Scarcity of resources is one of the more basic concepts of economics. Scarcity necessitates trade-offs, and trade-offs result in an opportunity cost. While the cost of a good or service often is thought of in monetary terms, the opportunity cost of a decision is based on what must be given up (the next best alternative) as a result of the decision. Any decision that involves a choice between two or more options has an opportunity cost.
Businesses that have had a rough time over the last two years will have to establish at least two years of profitability before they are likely to acquire much low cost bank credit. They will however have access to alternatives for working capital through factoring companies and asset based lenders (ABL). Typically factors and ABL lenders charge a higher rate for the use of their funds, so the trade-off will be having access to enough working capital to grow and recover in exchange for some of their profits.
When I think about opportunity costs I think of lost sales and lost profits. Many companies right now have low inventories, low accounts receivable, and low safety cash in the bank. When the economy recovers and sales increase, the need to buy more inventory or hire more workers will generate the need for more working capital. The increased sales that will be generated will mean more accounts receivable (A/R). Each of these positive events will generate the need for many companies to find external financing, typically to finance the short-term assets of A/R, inventory, and the cost of added payroll.
If bank lines of credit are scarce for most companies which I predict they will be for several more years, then businesses will have to turn to more expensive forms of financing.
The key to managing the increased cost of financing is to use a number of mitigating techniques:
- Don’t measure the cost of alternative financing in an annual percentage rate (APR); instead measure it in estimated real dollars. By estimating the cost of financing in dollars it is easier to compare to the profit being gained by the use of the financing.
- Pass on as much of the additional cost of financing to your customer as possible. When setting prices and making proposals, if you can add 2 percent or more to the cost of the sale, you will cover most if not all of your financing costs.
- Make a plan how you are going to use the higher priced capital. I recommend using such capital in the following order: 1) income producing costs like inventory payroll or cost of goods sold; 2) reducing trade payables if they are outside of terms and to a level that are lower than your A/R; and 3) putting aside safety cash.
- Once you have enough safety cash (how much will vary depending on increasing sales or seasonality), then only use the alternative financing when your cash balance falls below your safety cash level. Borrow only enough cash to bring the safety cash back within your comfort zone.
- Keep a weekly cash flow forecast! I have written about this process numerous times during the last year and I have been flooded with e-mails from companies who are now doing this with great results. You may download a free Excel-based cash flow forecast template for your use and modify to meet your specific circumstances. Using a cash flow forecast will help keep financing costs to their lowest possible level.
- If possible, pick an alternative working capital lender that does not have minimum monthly fees and that has a stellar reputation for treating their customers well. Use our comparison checklist to see how different factors and ABL lenders match up side by side.
By using these mitigating techniques you will keep your financing costs to the bare minimum while having access to the cash necessary to grow profitably.