Balance Sheet May Hide True Value of Assets
Do you borrow against inventory or receivables for working capital? Could you use more money than this financing technique gets you?
Lenders call this kind of financing asset-based borrowing, and if your answer to the first question is “yes,” your answer to the second is probably the same--and you may want to think about recapitalizing your debt.
In essence, it’s a simple idea: You take a hard look at your debt structure, analyzing what it gets you and at what cost, and you find a way to improve on it.
In practice it’s not always easy, in part because, as outlined in this space last week, the marketplace for business capital is more complex than ever before, and in part because the analysis takes you into areas easily taken for granted. But if you go through it, the payoff can be handsome.
A productive debt structure balances three elements--the assets against which you borrow, the capital you raise by borrowing against those assets and the use to which you put the capital--so that they work together, producing enough working capital to meet your need and grow your company. In the real world these elements sometimes work against one another, with the result that many a business struggles under a debt structure too costly and unproductive.
Wholesalers and distributors commonly borrow against receivables and inventory, as do many manufacturers and even such service businesses as temp agencies. Wholesalers and distributors, of course, often have no other assets against which to borrow, and in any case, since they usually operate on slim margins, their best bet to fatten the bottom line is to turn inventory over as rapidly as possible, speeding cash flow. Similarly, receivables are the only asset against which many service businesses can borrow. Even then many such firms struggle to find a lender with working capital available at a reasonable price.
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A close study of the balance sheet of many manufacturers, on the other hand, can turn up some surprises, as Michael Levi, owner of a small Gardena company, Well Built Radiator Manufacturing of California, discovered late last year. Well Built employs 65 people making replacement radiators for autos and trucks. Levi founded it 34 years ago and remains its sole owner.
When the economy of Southern California contracted earlier in this decade, Levi realized that his line of credit, secured by accounts receivable, inventory and equipment, cost too much and didn’t produce the working capital he needed. The interest ranged from three to six points over prime, plus a monthly fee that brought the total cost to between 14% and 16%, sometimes more--expensive money by any calculation.
Worse, the line generated only about $235,000 in working capital--not enough to cover Levi’s need, much less give him room to grow. And his balance sheet showed the manufacturing equipment, which included stamping machines and metal presses, at fully depreciated values.
Things did not look good. Levi’s lender, a commercial bank, refused to boost his line of credit. He assumed that the depreciated book value of his manufacturing equipment precluded him from borrowing more against that asset, too.
In that, however, he was wrong. The equipment produced income, and that gave it a real-world value that Levi had overlooked. Once Levi opened his eyes to that value, he recapitalized his entire debt structure, raising $400,000 in long-term debt secured by the equipment and replacing his original lender with another willing to lend him $1 million in working capital against receivables and inventory at an interest rate of about 11%.
In all of this, the competition among lenders worked in Levi’s favor. You can imagine the result. Levi estimates that he cut his financing costs by about $15,000 a month. That savings, plus the additional working capital, enabled him to begin growing sales by about 15% a year.
Key to the transaction was a sophisticated financial instrument used by Stanford Rollins, regional manager of the emerging-business capital assistance group of Providence Capital Resources, a national equipment financial services firm, to provide the long-term debt capital against Levi’s manufacturing equipment.
The instrument, which Rollins calls an equipment finance agreement, allowed Levi to capitalize on the operational, or revenue-generating, value of his equipment, in much the same way as a sale-leaseback--with one difference: It did not trigger the sales tax due with true sale-leaseback arrangements.
“Well Built’s original line of credit had interest of 12% to 14%, and the lender also charged a monthly fee that brought the company’s effective interest rate to between 14% and 16%,” he says.
“It was a very expensive line of credit, and because it was secured by accounts receivable, inventory and equipment, it did not give Well Built credit for the real value of the equipment.”
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The lesson, Rollins says, is that your balance sheet may hide the true value of your productive assets, and if you uncover that value, you can make your debt structure rational, with short-term assets generating working capital for short-term needs and long-term assets generating capital for long-term needs.
Levi himself expects his new debt structure to push growth in the coming years.
“We had to do some serious rethinking of the way we did business, and the key element was the cost of our working capital,” he says. “We addressed that element, and every dollar went directly to the bottom line. Now I think I can see growth at 15% for the next several years to come.”
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Juan Hovey may be reached at (805) 492-7909 or at jhovey@gte.net.
