The CFO and Working Capital Management: How to Manage Your Debt Strategy

The CFO and Working Capital Management: How to Manage Your Debt Strategy

STEPS TO INITIATE THE BORROWING PROCESS

Stay on top of market activity. This should be a regular, ongoing activity so that when borrowing needs arise, you have a good understanding of the economic factors that may impact the lender’s decision making process.

Be proactive in communicating with peer groups, as well as observing how the competition is financing their business. You may gain some valuable insight from these relationships. Speak to multiple banks and financing companies to get a gauge on how they see your business and the likelihood of them extending credit to you.

Borrow based upon need. The long-term view should be to avoid over-borrowing to keep costs down. However, create a back-up plan in case the need to increase borrowing occurs.

Formulate a formal process to ensure comparable information is obtained from the banks and financing companies to facilitate the best decision. Document your request for proposal, and submit it to all parties to ensure you obtain comparative data. Be flexible, if someone has a better idea to solve your financing need, keep an open mind and review it objectively.

STRATEGIES FOR MANAGING WORKING CAPITAL

A company’s balance sheet is significant in terms of managing working capital. You can easily see how financially sound a company is by looking at the below calculation:

A positive position means that a company is able to support its day-to-day operations.

Businesses that cannot raise cash quickly need more working capital. For example, when inventory sits longer, the working capital position can become poor, and there is financial strain. Companies then need to take on debt to address expansion needs or to maintain current operations during downturns.

One way to maintain good cash flow is to take a strong approach to accounts receivable collection policies and procedures. This is achieved through active and consistent accounts receivable collection efforts. Watch for negative trends, and adjust collection efforts accordingly. In addition, make sure you are aging accounts payable appropriately and managing payments to maximize cash flow, as well as maximizing payment plan opportunities that have no cost to the Company. A best practice for cash flow management is to maintain a minimum cash balance that covers one month of operating expenses, including one month of payroll.

LOAN STRUCTURE BALANCES WITH RISK PREMIUM

The basics for choosing a loan structure involve matching loans with the assets they are supporting. Therefore, loan strategies should be consistent with the length of the borrowing. You would take on long-term strategies with long-term debt. Conversely, you should finance fixed assets acquisitions with a three- to five-year term debt.

For longer-term borrowing, or loans to borrowers with poor credit ratings, the bank is taking on higher risk, and you will pay a higher risk premium. You need to keep the risk premium low so that interest costs are controlled as closely as can be to maintain positive working capital.

NEGOTIATING COVENANTS

The best way to manage negotiating covenants is to keep current on the financial market and obtain competing bids. Prepare projected covenant compliance calculations so that forecasts can be evaluated against the required covenants. Don’t commit to covenant levels that your projections show you cannot meet.

Since the bank will look at the Company’s budget and longer term projections, these need to be realistic and achievable. The bank will generally set covenants within a certain range of projections; therefore, the borrower may typically have 20% latitude on leverage for instance. A company may forecast leverage at 2.0, and the bank may set the covenant at 2.5. It is extremely important to factor in your businesses operating cycle when negotiating covenants, especially if you have a highly seasonal business. This can be accomplished by monitoring company performance ratios used for covenants on a regular monthly basis to understand the changes and impact on covenant compliance. This will ensure that the lender is aware of cyclical issues that could affect the setting of covenants.

MONITORING COMPLIANCE

If covenant compliance is set quarterly, tripping of a covenant and working toward curing is a closely-monitored process. The bank should be brought in early on when a covenant issue arises so that the relationship is not jeopardized. For a lender, the best surprise is no surprise.

INTEREST COSTS

The cost of borrowing can become expensive and can also become in and of itself an item to manage. Competitive bidding will help assess various interest arrangements offered. Ensure that additional interest charges are in-line with the market, and there is flexibility to cure loan defaults without incurring additional interest charges too prematurely.

While it is best to avoid having interest added on to loan principal, this paid-in-kind interest (PIK) could, however, free up working capital, and depending on the loan structure, could benefit a short-term need. This structure would be very unusual, and bringing in an equity investor may be a better strategy.

Author: Maureen DeCicco | [email protected]

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