How to Make Any Business Financeable (Part 2 of 4)
In our last blog post, we talked about the most important factor in a lenders decision to lend money: cash flow. The company must demonstrate that it can service the new debt and still pay existing expenses.
In this post, we’ll explain the second most important factor – Profitability.
- Cash Flow
- Profitability/Financial Trends
- Leverage/Overall Debt
- Collateral
In assessing the risk of repayment, a potential lender is going to want to know that the company has staying power. That is, will the company be around in the future? A key indicator of this is profitability, both current and historical. A company that has a history of losses and negative equity on its balance sheet will probably not be perceived favorably. A lender may feel that they would be throwing good money after bad. This can be the case even if the company is having a great year and is finally profitable. A lender needs to have a comfort level that the good year is not just a fluke, but is a standard for the future.
One measure of profitability that lenders also look at as an indicator of cash flow is EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation and Amortization. In some cases, the need for financing is for immediate expansion. For example, the company may need new equipment in order to accommodate additional customers. The company may not have sufficient cash flow today to service the additional debt, but if it can demonstrate how the new business will provide the additional cash flow needed, it can go a long way towards convincing a lender that the loan is worth the risk. Ultimately, any lender wants to assess the likelihood they will be repaid, and whether the repayment would happen on schedule. All too often, entrepreneurs attempt to do this by talking to the banker and attempting to “make” them understand. The fact is, this needs to be done with numbers that can be substantiated taking everything into account, including the increase in taxes created by the new business. If I just lost you and this seems impractical for your business, don’t despair. If you start with your Net Profit, add back the named items which are not considered to necessarily affect cash flow (Interest, Tax, Depreciation, and Amortization), and it will provide a good guide for servicing new debt. EBITDA is by no means a perfect measure of cash flow, but it is a common shortcut used by many lenders. A company should therefore evaluate its EBITDA when trying to obtain financing.
Most small businesses make the mistake of employing accounting practices that are geared solely toward tax compliance, and they don’t wind up presenting the company’s finances in the best light. A company that is suffering from negative equity should review its historical accounting to see if there are opportunities to recast the financial statements in a more realistic light, which could also improve its equity position. In some cases, adjustments can be made to bring the financial statements into line with proper accounting practices, and these adjustments can actually affect the equity enough to turn it from a negative to a positive. Such a recasting can have a huge impact on the company’s ability to attract financing.
If you didn’t see the right solution this week, watch for next weeks blog or contact us for an immediate solution.
