In the first section of this course I'll explain the times when you want to consider getting a business
loan.
I'll show you some quick tests that you can estimate whether your company has a large enough cash cushion
or might run low over the next year.
The most accurate way to assess whether you need a loan is to do a cash flow projection.
I'll provide a template for this and talk you through how to use it.
Now that you can find out your cash position I'll explain how lending fits into business cash flows
and the categories of the sources and uses those cash flows.
This information is useful both for you and show lenders your ability to pay back any loan.
Lenders will analyze your balance sheet may do some of the metric calculations I'll be showing you.
They'll want to see your cash flow projections.
Knowing your fluctuations in cash helps you and your lender determine the appropriate size for a line
of credit one of the most obvious times is when you are buying buildings or equipment.
These require huge amounts of cash that few businesses have sitting in their bank accounts getting loans
for these is easier than getting some other types of business loans because the building or equipment
can be pledged as collateral to the lender closely related to buying property is constructing or improving
a building during the construction phase.
The structure of the short term construction loan you will receive is very different than the long term
loan once the construction is completed.
I'll talk about the types of loans later in this course a very common use is for short term lending
needs for companies with healthy cash flows.
It's more profitable to borrow money during times of net cash outflows and pay the short term loan off
during times of cash inflows.
For example many companies have regular patterns of large cash inflows from sales followed by big cash
net outflows for payroll or to pay vendors.
This is similar to the previous bullet but the cash inflow and outflow cycles are much longer.
Examples include seasonal businesses like landscapers ski resorts and hotels.
I used to work at a bank that provided seasonal loans to farmers.
Finally some loans are used more for operating efficiency and ease than for cash flow reasons.
Corporate credit cards are a very expensive way to borrow money if you don't pay them off each month.
They're very useful though to allow employees to buy items especially when they're buying things online
in the next few slides.
I'll talk through four ways to estimate whether you need loans.
The current ratio and quick ratio or two ratios to quickly compare your cash to future needs for that
cash.
If you're low on these ratios getting longer term funding like real estate loans or funds from the owners
may be good sources of cash reviewing past bank statements can show you how much your cash goes up and
down within a month or across multiple months.
Business lines of credit which I'll explain later in this course are good solutions for these cash fluctuations.
Knowing the sizes of these fluctuations allows you to determine how big of a line you'll need the current
ratio is also known as the working capital ratio.
It's calculated as current assets divided by current liabilities.
It's a simple definition but immediately leads to the question What's a current asset and a current
liability assets are things you own or have right to.
Examples include cash or inventory and accounts receivable.
Liabilities are things you owe like payments to your vendors or lenders.
These items are listed on your balance sheet.
The word current means the asset will be converted into cash within a year or the liability will be
paid within a year non-current assets and liabilities are all other assets and liabilities.
Many accounts and accounting software create balance sheets grouped into current and non-current sections
Here's a sample balance sheet that shows how to calculate the current ratio.
This is a classified balance sheet meaning current assets and non-current assets are subtotal within
the asset section.
Current assets are six hundred thousand dollars current liabilities are three hundred and fifty thousand
dollars so the formula is six hundred thousand dollars divided by three hundred and fifty thousand dollars
for a current ratio of one point seven one is one point seventy one good or bad.
I'll explain that in the next slide.
A higher current ratio is better.
Here's a quick way to assess your financial health with the current ratio a working capital of one needs
your current assets are as big as your current liabilities a working capital of less than 1 means your
current assets are less than your liabilities whereas a current working capital of more than 1 means
your current assets are more than your current liabilities.
If your current ratio is 1 meaning your cash inflows will cover your cash outflows.
That's good right.
Well it's good but it may not be good enough.
This formula is an estimate of future cash flows and has weaknesses that I'll soon explain.
That's why many people recommend having a ratio between one point two and 2.0 to give yourself a cash
cushion for unexpected cash needs.
If you have consistently strong profits with good access to debt and equity then you can have a lower
working capital ratio.
Some companies like Amazon have negative working capital ratios because of their financial strength
and sophisticated cash management.
Small businesses are an amazon so it's better for you to keep working capital above one a ratio above
2 may mean you can invest cash in your business pay down debt or distribute it to owners run on cash
flow projection to confirm this and decide whether you want to keep the cash for safety or invest it
for higher profits the current ratio is one of the easiest ways to estimate if you have enough cash
for the next year.
But it has some weaknesses it doesn't include cash received from profits or cash will pay for losses
that are reflected on your income statement.
You won't receive and keep the cash from some assets that are traditionally classified as current.
For example your accounts receivable are constantly replaced with new ones so they don't provide as
much cash as you may think your inventory sold will be replaced with new purchases of inventory items
like these are called permanent working capital and must be financed with long term debt the quick ratio
is known as the acid test ratio.
Frankly that's a pretty extreme title for an accounting metric but it sounds cool.
It's calculated as current assets less Inventory Prepaid Expenses and supplies divided by current liabilities.
This ratio removes some assets and is a tougher test for your cash flow than the current ratio.
Like the current ratio higher is better from a cash flow perspective.
A common recommendation is for this to be equal to one or higher here's the same balance sheet we looked
at earlier but now we'll calculate the quick ratio current assets are six hundred thousand dollars but
we reduced that by the inventory balance of three hundred thousand dollars.
Current Liabilities are three hundred and fifty thousand dollars so the formula is three hundred thousand
dollars divided by three hundred and fifty thousand dollars for a quick ratio of point eighty six.
That's a little under 1 and may mean the company will be tight on cash in the future reviewing your
daily cash balances from recent months can tell you if you have large cash fluctuations within a month.
I know the head of a small company that received monthly financial statements that always showed decent
cash balances.
He went to write a check in the middle of a month and there was no cash.
The bulk of his revenues were received near the end of the month his month and cash balances were fine.
But he didn't realize how tight cash was mid-month.
He got a line of credit to fix that.
There are few ways to get this info and I go from low tech to high tech.
One way is to review your paper bank statements.
Another is to review the banking transactions either in your accounting system or your bank's online
banking site.
A third way is to download transaction histories from your accounting software or bank your first looking
for patterns of when you have high points in cash and low points in cash.
See if you can find any consistent times of the month when cash is high or low.
These patterns will be useful for you when you make cash projections.
Also calculate the differences between the high and low balances.
This can give you an estimate for future months of how much cash will drop or rise.
For example if you know the difference is one hundred thousand dollars and you have eighty thousand
dollars in cash at a high cash point.
There's a chance that you may need to borrow twenty thousand dollars by the time cash drops back to
its low one hundred thousand dollars lower I worked at a financial institution where a cash balances
would pop up ten to twenty five million dollars on the last day of every month.
The day of the week the month ended on also greatly influence whether the pop was closer to 10 million
or twenty five million.
This knowledge helped me manage cash a month in reviewing monthly cash balances helps you identify seasonal
trends and the size of those trends.
You can look at bank statements your accounting system or an online banking site you can use end of
month balances or monthly average balances.
Many business bank statements show an average balance for the month which is a little better to use
for this exercise.
One year of data can show a potential trend.
But looking at 24 to 36 months will tell you if the pattern is consistent year after year when I worked
at banks I would submit a worksheet to the Federal Reserve monthly average balances over the past 36
months.
They use this information to set the line of credit we had with them.