Credit Lines--How Much Is Enough?
How to calculate a number you can sell your banker on
Your business is taking off, but cash is getting tight. Is that a sign that something is wrong? Probably not. All businesses need more capital as they grow. The question is, Where do you go for money?
Unless you have a wealthy uncle, the cheapest way to borrow money is to get a revolving line of credit from your bank. The first thing you have to figure out, though, is the appropriate amount to ask for. If you make a wild guess, you may ask for too much, and your bank may turn you down. If you ask for too little, you'll be back asking for more, and your credibility could suffer. Better to spend a few minutes and come up with the right answer.
To do that, you'll first want to calculate your "cash conversion cycle"--the number of days from the time you pay out cash for raw materials until you receive cash for the finished goods sold. To come up with the number of days in your cash conversion cycle, you'll have to answer the following questions: How many days does it take for your customers to pay you? How many days does it take to make your product, and how long does it sit in inventory before it's sold? How many days do you have to pay your vendors? (See "The Numbers You'll Need," below.)
Let's assume that the answer to each of those questions is 30 days. To figure out the cash conversion cycle, you add the accounts-receivable days to the production and inventory days, and then subtract the accounts-payable days. Or, in our example, 30 + 30 - 30 = 30 days.
To figure out what an adequate credit line would be, you multiply your average daily sales by the number of days in your cash conversion cycle. For example, if a business projects revenues of $1 million this year and its cash conversion cycle is 30 days, it probably needs a line of credit of at least $85,000 ($1 million divided by 365 to get the daily sales average, multiplied by the cash conversion cycle of 30 days, then rounded up). Of course, if your company's sales are seasonal, you'll need more financing during the busy times and less during the slower times.
Clearly, it's important to monitor and control your receivables, payables, and inventory. In the above example, if the receivable days and inventory days each increase to, say, 90, the cycle grows from 30 to 150. When you run the numbers, you'll see that the financing need has ballooned to more than $400,000 and the business is headed for disaster.
Each time you prepare a set of financial statements--or at a minimum, once a quarter--take a few minutes to calculate your cash conversion cycle. If you see that it's steadily lengthening, it may well be time to reevaluate how you manage your working capital. The exception is when your business is seasonal. You may not need to worry about a sudden lengthening of the cash conversion cycle when sales increase rapidly, but you'll want to be sure the cycle readjusts when sales begin to decline.
When you meet with your banker, it will be important to show not only that your receivables and inventory are turning over at a rate that's reasonable in your industry but also that you handle your obligations to vendors in a timely manner. If it takes you 90 days to collect your receivables when your peers can do it in 30 to 45, you will have to explain that to your banker. (Perhaps, for example, you have offered extended payment terms to a large customer.) Similarly, if you pay your vendors in 90 days when standard terms are "2/10, net 30" (2% discount for full payment in 10 days, balance due in 30 days), you'll need to justify that.
It's never too soon to talk to a bank about setting up a line of credit, although realistically, you'd apply for one after your first profitable year. (It's no surprise that the worst time to approach a bank is when you've already run out of cash.) And it can only stand in your favor to be able to show your banker the serious consideration you've given to calculating the amount your business will need.
Paul A. Broni is a managing director of Mercury Partners, a finance and business-consulting firm in Rockville, Md.
The numbers you'll need
To determine your company's cash conversion cycle, you'll need to answer these questions: 1) How many days does it take for your customers to pay you? 2) How many days does it take to make your product and how long does it sit in inventory before it's sold? 3) How many days do you have to pay your vendors? Below are the formulas for arriving at those answers.
Accounts-receivable days: your receivables balance, divided by the last 12 months' sales, multiplied by 365.
Inventory days: your inventory balance, divided by the last 12 months' cost of goods sold, multiplied by 365.
Accounts-payable days: your payables balance, divided by the last 12 months' cost of goods sold, multiplied by 365.
To figure out the cash conversion cycle, add the receivables days to the production and inventory days, then subtract the payables days. That will tell you the number of days your cash is tied up and is the first step in calculating how much money you'll want in your revolving line of credit.
If you run a service business and are looking for a line of credit, your banker will be looking at one thing: your receivables management. Because a bank will generally give you a credit line of up to 70% or 80% of the value of your current receivables, the balance of your financing needs will probably have to come from equity.