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Filling Cash Flow Shortages
Most businesses, especially new businesses, have cash peaks and valleys. As your business matures and you learn the ropes of operating your business, hopefully the peaks will greatly outnumber the valleys! However, in the first few months and years, that's unlikely to be the case.
Some cash flow gaps are created intentionally. That is, a business will sometimes purposefully spend more cash to achieve a particular financial result. For example, a business may purchase extra inventory to take advantage of quantity discounts, accelerate cash outflows to take advantage of significant trade discounts, or spend extra cash to expand its line of business. For other businesses, cash flow shortages are unavoidable. Take, for example, a business that experiences seasonal fluctuations in its line of business. This business may normally have cash flow gaps during its slow season and then later fills the shortages with cash surpluses from the peak part of its season.
Cash flow shortages are often filled by external financing sources. Revolving lines of credit, bank loans, and trade credit are just a few of the external financing options available to help you through the rough times.
- Revolving lines of credit — a revolving line of credit is usually obtained from your bank. This type of financing is when the bank will allow you a specific amount and you are continually allowed to draw down and pay off that amount of debt. As an example, you have a line of credit of $5,000. You borrow $4,000 and then pay off $2,000 and then borrow another $3,000, this process can be continually repeated when you have the revolving line of $5,000. The revolving line of credit must be backed by easily liquidated assets, such as inventory and receivables, along with personal guarantees to the bank. Typically, the bank will value the line at 50 percent of inventory book value, and 60-80 percent of receivables, depending upon the industry and quality of companies involved.
- Bank loans — the cost of taking out a small business loan will vary from lending institution to lending institution. Call around for the best rates. And ask your friends and acquaintances for their recommendations. You'll need the same type of documentation no matter whom you apply to. For a complete discussion of what documentation you'll need, see debt financing.
- Trade credit — your major suppliers and vendors will normally provide you with trade credit. The supplier will allow you an extended amount of time to pay your bill, which may be a significant source of financing if inventory will be large in your new business. However, small businesses should even plan on C.O.D. or prepayment terms with some or all vendors until credit is established (especially retail businesses), unless the new business owner is able to negotiate credit terms or personally guarantee payment. The length of trade credit may be as short as 10 days or may be as long as 90. Payment terms beyond 30 days net are unusual from suppliers for most small businesses and retailers in the USA. However it is possible to negotiate longer terms, often with the payment of additional interest points for each 15-day period over 30 days, with a cap at 60 or 90 days. Overseas suppliers who are anxious to establish and grow their business in the USA may provide 90-day or occasionally even 180-day terms without interest penalties.
For more information on filling a cash flow shortage with financing, see our discussion of improving your cash flow.
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