11.437 Financing Community Economic Development
Class 5: Working Capital Financing
I. Three different meanings of term “working capital”
1.
2.
3.
Excess of current assets over current liabilities
Firm's investment in short term assets that it needs to
operate over its operating cycle (production, sales and
collection)
Investments in non-fixed assets need to operate its business
II. Different business needs and uses of working capital
1.
Critical to meeting short-term cash needs and liquidity for
the firm to survive.
2.
A permanent working capital investment to be able to
operate a business with a comfort margin to meeting shortterm liabilities
3.
Seasonal or cyclical working capital to finance the
temporary cash shortfalls due to the nature of the firm’s
normal business cycle.
4.
Working capital needed for fund growth. As a firm grows,
it needs to maker greater investments in inventory,
accounts receivable, personnel, etc. to realize increased
sales.
5.
"Working capital" to support new market or product
development, undertake R&D to improve existing products
& operations
1
Relationship between permanent and short-term working capital
Firms usually need a permanent investment that increases as
they grow. Above this permanent working capital investment is
the needs for seasonal short-term working capital financing.
Since small businesses have less access to long-term sources of
capital to fund permanent working capital, they have to rely
more on short term working capital financing. This leaves them
with poorer liquidity and smaller net working capital positions,
which makes it harder to secure short-term loans.
III. Sources of working capital for small businesses
`
Largest sources:
Commercial banks
Vendor trade credit
Commercial finance companies
Other sources:
SBA programs
Business Development Companies & higher risk loan pools
Public and non-profit loan funds
Venture capitalists\SBICs (for long term permanent
working capital)
Informal sources:
Credit cards
Second mortgages on homes
2
IV. Working capital debt financing tools
1.
Line of credit: can be unsecured or secured.
Terms
¾ Annual clean-up (full repayment of line before renewal)
¾ Compensating balance requirements
¾ Financial covenants (debt\equity; working capital)
¾ Fees (points) on full line whether used or not
¾ Interest payment based on amount borrowed
Advantages: easier to set up, fewer transaction and legal
costs, may not have to pledge collateral
Disadvantages: full cost may be high, esp. w/compensating
balance; can only serve seasonal or cyclical needs since it
must be fully repaid each year
2.
Accounts receivable financing:
Terms and conditions
¾ Security interest in accounts receivables
¾ Lending limit based on % of accounts receivable,
ranging from 60-80%, depending on credit quality of
customers
¾ May require bank controlled collection (lock box)
Advantages: may not require compensating balances,
option for firms where financial position doesn't permit line
of credit
Disadvantages: requires pledge of collateral, higher
transaction costs
3
3.
Factoring:
Terms and conditions
¾ Sale of accounts receivables at a discount
¾ Factoring firm assume risks and costs of collection
¾ May be recourse provisions for deficiency
Advantages: quick and efficient source of cash, not really a
loan if non-recourse; reduces collection costs for firm
Disadvantages: may be expensive (require a steep
discount); may effect customer relations; perceptions of
financial distress
4.
Inventory financing:
Terms and conditions:
¾ Pledge of inventory as security
¾ Control of inventory by warehousing agent or direct
assignment by serial numbers
¾ Financing based on percent of inventory (varies with
type); may be only 50-60% depending on quality of
inventory
Advantages: can help finance large inventory requirements;
may be a cost effective source of financing for high quality
inventory; may be the only source if AR are weak or firm’s
overall financial position doesn't allow a Line of Credit
Disadvantages: Pledge of collateral; higher transaction and
administrative costs
4
5.
Term working capital loan:
Terms and conditions:
¾ Pledge of assets (senior or subordinate)
¾ Financial covenants
¾ Fixed repayment terms
Advantages: can finance long-term working capital needs,
lower monthly\annual payments
Disadvantages: may tie up much of the firm’s collateral;
restrictive covenants are a burden; higher cost
Sample term sheets from Fleet Bank
V.
Underwriting Issues with working capital:
1.
Track record of firm principals/owner in running the
business and personnel credit history
Track record of the firm: financial and competitive
performance of business
Financial position of the business (net working capital,
current and quick ratios, net worth, debt/equity ratio, etc.)
Sources of repayment of the loan: (1) cash flow analysis of
the business over term of the loan; (2) collateral securing
loan; (3) guarantees securing loan
2.
3.
3.
5
Cash study: Crystal Clear Window Company
1. What is Crystal Clear Company’s situation? Why are they
seeking financing? What are their financing needs?
a.
b.
Repay $40,000 loan from Mr. Mulder, one principal's
Additional working capital to finance sales growth
What do these needs suggest about appropriate types of
financing?
2.
What is firm's financial condition? How well is it
performing? What does its condition suggest about the
firm’s credit worthiness or risks of making the loan?
Liquidity position and trends
Financial structure and leverage
Profitability
3.
What about the firm's capacity to repay the loan?
Cash flow
Strength of collateral
Strength of guarantees
4.
What is your view of the firm's market and business plan?
Strengths of business' market & operations
(growing market, quality product, competent principals,
good employee morale, history of solid growth
Weaknesses
(sells to only one type of customer, limited financial
expertise in firm management, may be outgrowing
facilities)
6
Don't know much about competition and competitive
factors in their market.
5.
What do these conditions imply about firm's future sales
and earnings? What more would you want to know?
6.
What is your opinion of proposed $75,000 Accounts
Receivable loan to Crystal Clear Window? Do you
recommend it? Why or why not?
What problems do you see with the proposed financing?
What benefits or advantages does it have for the firm?
7.
From an economic development perspective, is this the
type of firm you would want to finance? What economic
development benefits does it offer?
8.
What are alternatives for how the lender might structure the
loan? What financing might better match the firm’s needs?
9.
What are Crystal Clear Window's options to address its
working capital needs and reduce its required loan amount?
10. As a CED lender, what might you do to help make the loan
stronger and/or improve the Crystal Clear's situation?
Draw out 3 issues:
Different type of WC needs: cyclical vs. permanent; structuring
loan to address which ones apply
Working capital finance options: considerations of different
tools and their benefits
Underwriting issues
7