For companies to grow and thrive in today's business environment, access to capital is critical, particularly in the manufacturing and distribution (M&D) industry. Whether you are in the equipment, component parts, food and beverage, aerospace, building materials, technology, or pharmaceuticals sector, access to capital is an essential component to manage your business. M&D companies, in particular, need access to working capital to finance daily operations and to maintain equipment with little or no down time.
There are several types of financing options available for M&D companies. Two of the most significant are traditional financing with banks and non-traditional specialty financing with non-banker lenders.
Traditional financing, or bank financing, generally requires a high criteria for the banks to fund. Funding is based on the strength of the company's balance sheet and income statement. Banks extend credit based on the historical strengths of the company such as positive equity, net income, strong debt-to- equity ratios, and positive cash flows.
Often, financial and non-financial covenants are required. Ongoing financial covenants require companies to maintain these strengths in future years. Non-financial covenants are typically required and can be restrictive by limiting the amount of distributions the owners can withdraw, limiting the amount of additional financing obtained, and requiring approval prior to any material acquisition. Despite these restrictions, companies that qualify for bank financing usually obtain the most beneficial rates and terms.
Typical bank financing includes revolving lines of credit to manage fluctuations in cash flow and term loans to help fund expansion for the purchase of property and equipment, acquisitions, or general cash flow needs.
Revolving lines of credit have borrowing base formulas which are typically calculated on the company's receivables and inventory. Banks will lend a percentage of eligible receivables and inventory. Eligible receivables are typically less than 90 days old and would not include customers that the lender considers too risky (foreign receivables, for example). Eligible inventory would not include slow moving inventory or may not include specialty inventory manufactured for a specific customer. Typical terms for these types of arrangements are one to three years. Payment terms for lines of credits with banks can be interest only through the maturity dates, but can also have annual clean up periods in which the line of credit must be paid down.
Non-Traditional Specialty Financing
Non-traditional financing -- asset-based lending, factoring, or purchase order financing -- remains a viable option for companies that may not qualify for traditional financing.
Asset-based loans are tied directly to the value of assets of the borrower - typically accounts receivable and inventory. The asset-based lender puts less emphasis on the historical and current financial situation or credit rating of the company as a whole and more emphasis on the quality of the accounts receivable and inventory used as collateral. Borrowing base formulas are generally more restrictive when determining eligible accounts receivable and inventory compared to a traditional line of credit with a bank. Asset based lenders generally require the collection of receivables to be used to pay down the loan. When the company needs additional funds, an advance is requested based on the then-current collateral.
Factoring is a transaction in which the company sells its accounts receivable to the lender at a discount. The factor purchases ownership of the receivable and obtains the risk related to collection of that receivable. The lender in this type of financing will have a good understanding of the credit worthiness of the customers since the lender will bear the risk of loss. The costs include lender's fee, interest charge, and certain surcharges. Factoring is more expensive than a bank loan but it is a viable alternative when the company does not have sufficient liquidity to manufacture or supply its product.
A third option is purchase order financing which is generally utilized when a company does not have working capital available to fulfill a large order from a customer. This option is very common with new, fast growing companies that have a working capital need to manufacture or supply product. The lender accepts the purchase order from the company's customer as collateral and accepts the risk that the order will be delivered. Similar to factoring, the cost of purchase order financing is more expensive than a bank loan but, in many situations, is the only way for the company to supply product.
Generally, personal guarantees of the business owners are required by lenders in both traditional and non-traditional lending transactions, but in certain situations this requirement could be waived. Making the right decisions concerning financing options could save your business money and avoid unnecessary compliance cost. Seek out your financial advisors to assist with introductions to lenders as well as guidance in navigating your company through the financing process.
Questions: Contact Matthew Jahrsdoerfer, CPA, Berdon LLP New York Accountants
This article first appeared in the July 6, 2016 Client Alert.