Marketing Insight #003 Credit Is Available. But What Is Your Line of Credit Really Financing?
A line of credit can solve a timing problem. It shouldn't be expected to solve an operating problem.
Recent banking data presents an interesting picture for small businesses.
The Federal Reserve Bank of Kansas City's latest national Small Business Lending Survey reported that new small-business lending increased in the second quarter compared with the same period a year earlier.
More recent banking data from the Federal Reserve Bank of Dallas provides another piece of the picture.
In its September survey of banks and credit unions headquartered in the Eleventh Federal Reserve District, loan volume and demand continued to grow—but at a slower pace. Respondents also reported tighter credit standards and terms and higher loan pricing.
Credit hasn't disappeared.
But the environment reinforces an important question for every owner-led business that depends on bank financing:
What Is Your Line of Credit Actually Financing?
For a product-based business, a line of credit can be an extremely valuable financial tool.
There is often a natural timing gap between when cash must be spent and when customers ultimately pay.
Inventory may need to be purchased.
Products may need to be manufactured.
Suppliers and employees need to be paid.
Goods are shipped.
Customers are invoiced.
Receivables are eventually collected.
A line of credit can bridge that timing difference.
That's exactly what working-capital financing is designed to do.
But problems begin when temporary borrowing quietly becomes permanent borrowing.
Timing Problem—or Operating Problem?
There is an important difference between borrowing to finance the normal working-capital cycle and borrowing because the underlying business isn't generating enough cash.
Consider two businesses using the same $500,000 line of credit.
The first draws on the line to purchase inventory for confirmed seasonal demand. Inventory ships, customers pay, and the company substantially pays down the borrowing.
The second continually carries approximately the same balance because inventory isn't turning, receivables are aging, margins are inadequate, capital expenditures are consuming cash, or the business simply isn't producing enough internally generated cash.
Both businesses have debt.
But the debt is telling two completely different stories.
In the first company, borrowing supports the operating cycle.
In the second, borrowing may be masking a cash-flow problem.
The Bank Will Eventually Ask the Same Questions Management Should Already Be Asking
When credit becomes more expensive or lending standards tighten, financial visibility becomes increasingly important.
Management should be able to explain:
How much are we borrowing?
Why do we need it?
What specifically is the borrowing financing?
When should the cash come back into the business?
What will allow us to repay the borrowing?
If those questions are difficult to answer, the problem isn't simply banking.
It's visibility.
A business shouldn't have to wait for its banker to ask why the line of credit keeps increasing.
Management should already know.
Working Capital Deserves Particular Attention
For product businesses, borrowing requirements are frequently connected to three major working-capital accounts:
Accounts Receivable. Inventory. Accounts Payable.
If receivable days increase, cash is collected more slowly.
If inventory days increase, cash remains committed longer.
If supplier terms shorten, cash leaves the business sooner.
Any one of those changes can increase borrowing requirements even if sales and profits appear healthy.
Growth can magnify the effect.
A company growing rapidly while simultaneously carrying more inventory and waiting longer for customer payments can create substantial financing requirements.
The line of credit may make that growth possible.
But management still needs to know whether the underlying growth economics make sense.
Cash Flow Reality Check
If your business uses a line of credit, consider asking:
What specifically is our current borrowing financing?
Does the line regularly pay down as working capital converts back into cash?
Are receivable days or inventory days increasing our borrowing requirements?
How much of our borrowing supports profitable growth—and how much may be compensating for operating inefficiency or weak cash generation?
If our lender tightened terms or reduced availability, what would we change first?
Those aren't questions to ask only when a loan renewal approaches.
They are ongoing management questions.
Borrowing Creates Capacity. Cash Flow Creates Financial Strength.
There is nothing inherently wrong with using debt to finance a productive business.
For many product-based companies, access to working-capital financing is essential.
The objective isn't to eliminate borrowing.
It's to understand it.
Know what the money is financing.
Know why the requirement is increasing or decreasing.
Know how the borrowing converts back into cash.
And know whether the underlying business is becoming financially stronger—or simply becoming more dependent on outside capital.
A line of credit can provide flexibility.
But the strongest flexibility comes from understanding and improving the cash flow underneath it.
Cash Flow Creates Options™
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