Short-term loans are used by small businesses to finance working capital expenditures. This strategy is risky. Operational risks are enough for small businesses; they don’t need additional financial risk.
How can small firms borrow more money quickly? How do they determine if the risk associated with short-term debt financing is severe enough to forgo profitable opportunities?
Small businesses often are unable to adhere to the matching principle because of their difficulties obtaining long-term capital. Like many small businesses, Anderson has given up on exact matching. Working capital is financed by revolving credit lines, which lenders accept (including permanent components).
Matching is not necessary.
When does risk go too far? The remedies depend on the degree of mismatch, the structure and management of financings, and the operational risks faced by the company. In my judgment, Anderson wasn’t overworked. I’ll start by talking about the risks associated with ignoring the matching principle.
Three Dangers
The following three associated dangers occur when a company (or a charity organization) breaches the matching principle:
1. Interest rate uncertainty.
Interest rates may be raised when it comes time to renew the loan. The problem could seem academic given that working-capital agreements like the one previously discussed often have a fluctuating interest rate. But for businesses that can’t afford the risk, it’s certainly not academic. Consider how your organization would be affected if the prime rate increased to 15% or 20%. If the results of pushing the numbers are not what you want to see, you must take action.
According to a government assessment of the condition of small businesses, this problem: “Long-term borrowing rose but still remained less than short-term borrowing in terms of a total quantity. Small enterprises’ susceptibility to high and erratic loan rates has a significant impact on their success or demise.
2. Risk of refinancing
Businesses that depend significantly on annual renewals of working capital loans should think about the refinancing risk question: What will we do if the lender calls off the arrangement? Action is required if you are unable to come up with a viable response. You do not have a solid answer if you say, “Our lender would never do that.”
3. The dangers of losing operational independence.
Lenders often don’t abruptly cease borrowing agreements; in fact, they’re frequently extremely helpful. However, when issues develop, they demand solutions and may offer “suggestions” that you might find offensive. They could even demand amendments to the agreements, such as more security, personal guarantees, or fees. The worsening of the relationship with the lender, indicated by the change in conditions, could not have happened at a worse moment for the disgruntled company owner.
Identify the period during which you genuinely need the finance, said two partners of a Big Eight accounting company while speaking about the financing of a new business. If you do, acknowledge the requirement and contact lenders on that premise. If you do, in fact, have a permanent capital need to sustain working capital expansion.
Too many business owners attempt to get started with loans that have set payback terms, whether they be short-term or otherwise, rather than realizing that as they expand, their volume will rise, increasing the need for finance. As a consequence, instead of focusing on the core issues facing the company, the entrepreneur spends too much time thinking about financial issues, notably attempting to arrange additional finance. The maxim, “Do not fund long-term requirements with short-term money,” is an excellent one to live by.
It’s a good idea to discuss the matching notion openly with your lender and, if relevant, non-operational business owners. Better terminology may emerge from conversations. They encourage a clear understanding of each party’s position, minimizing unwelcome surprises.
If a company violates the matching principle, it has to have enough flexibility to pay down short-term expenses without disrupting operations. Flexibility may be provided via flexible financial sources and/or a plan to release working capital. To maintain flexibility, contingency planning is essential.
The new loan officer who took over the company’s account didn’t win the owner over. The owner received warnings and suggestions, but the bank did not call in the notes. To pay off the credit line, he obtained a second mortgage. He pledged not to let the tragedy happen again.
Lenders, owners, and managers must all agree on the guidelines for working capital. Anderson’s work was successful. It previously ran into trouble since it relied on direct shipments from suppliers rather than maintaining a complete inventory.
Late in the year, a large competitor stocked a key product line in order to gain a delivery time advantage. If Anderson didn’t follow suit, sales would be lost. For the endeavor, Anderson needed $100,000 in long-term operational capital. Anderson decided to swiftly purchase goods using its credit line before negotiating long-term finance.
Due to its sound financial management, Anderson is able to handle problems that would be insurmountable for other small enterprises. It can compete with larger businesses because of its financial flexibility.
Examining the Alternatives
Some small business owners are unable to make investments and are unable to acquire long-term financing (on reasonable terms) at CitrusNorth. Some business owners think their only option for long-term working capital is short-term borrowing. Failure to secure financing indicates inadequate flexibility. Thus the company should adhere to the matching principle.
Take the Nelson Company as an example. John Nelson started his retail business using debt financing, including short-term loans. The company generated a profit and cleared its obligations swiftly. Numerous loan installments were made on time.
Nelson constructed a second shop, which was almost as prosperous as the first. Permanent operational capital was financed by short-term loans, which were promptly repaid. Based on a one-year working capital loan (with no cleaning provision) that the lender routinely extended, the company had six units within five years and plans for more. Many banks were also willing to collaborate with the company.
Growing problems affect the company. Operational advantages on a monthly basis become monthly losses. The economy had a severe downturn at the same time, notably in Nelson’s area. The company overextended its payables, yet it eventually turned out to be untrustworthy. John Nelson was unable to make investments or raise money. Despite being patient, the bank ultimately made a demand. Nelson sold several of his company’s divisions to rescue it.
Although breaking the matching principle wasn’t the only reason for Nelson’s problems, it did make matters worse.
Trust Your Own Decisions
Bankers who read this article may believe I’m being too severe. They can claim that a small business owner can depend on the maturity of the loan officer and the reliability of the bank. They may claim that the tiny business shouldn’t be concerned about the loan being canceled or additional, onerous restrictions being put in place.
Some bankers aid consumers with more than are necessary. I believe it is a mistake to rely too much on lenders since they have different ideas about what constitutes an acceptable risk level and what should be done in the event of a crisis.
The owners of Anderson gave him a loan. Despite the fact that it isn’t always possible or desirable, small businesses should include the owners in making financial policy decisions.
Three partners discussed buying a business. The majority of the financing would come from long-term debt and equity, while inventory would need quick borrowing. The company wouldn’t be able to pay back the short-term bonds on schedule if forecasts fell more than 5 to 10 percent short of the desired outcome. If the owners could agree on the problem and the solution, they could afford to invest more.
The proprietors were at a loss as to whether to take on further debt or increase their investment when the company was unable to repay its short-term borrowing. The company met its duties, but at a great emotional cost.
Too often, financial issues are resolved at the worst possible time—during a crisis. When corporate resources are swept away, people cannot reason.
Capital Problems
Risk and profit are balanced by investors. Two unfavorable standards for the risk-return trade-off of a small business are:
Operational hazards are greater for small businesses than for large ones. Lenders and investors often want more comprehensive management.
As transaction sizes grow, administrative costs for capital providers decrease, which might have an impact on small loans and investments.
Smaller businesses often misjudge their ability to raise long-term finance. Banks are targeting tiny, growing companies as the market for financial services becomes more competitive. Small businesses with excessive short-term debt may want to talk to their current lenders and alternative banks that pose as small-business finance authorities about refinancing certain debts. It’s OK to shop around and inform lenders.
There is equity as well. Small company owners worry that if they sell shares to outsiders, they may lose ownership and control. Smart investors are more interested in making money than in having influence over the firm they support. If the business of the firm falls, outsiders could enter. A stock sale might generate much-needed funds that are not reliant on cash flow and could persuade banks to provide long-term financing.
Rich individuals and established venture capital firms now have easier access to funding thanks to capital gains and tax reductions. Business owners looking for such funding should have a plan that prioritizes marketing and ROI. 4
The SEC has loosened the guidelines for selling publicly traded stocks in recent years. Now, businesses looking to raise up to $7.5 million may sell shares using the simplified form S-18. 5 Investors are more willing to buy shares in a small, emerging company now that there is greater interest in entrepreneurship and small business.
By engaging creative financial experts to organize transactions, business owners may save administrative costs. Investors and financial institutions are aware of the earning potential of small businesses.
Investigate long-term financing sources even if your group doesn’t rely substantially on short-term borrowing. Money availability is necessary for financial flexibility. Having backup resources and connectivity may help you deal with unforeseen problems.
Don’t make operational risks worse by adding bad financing. To maintain flexibility, include working capital finance into your company’s strategies.
Author bio
Krystel Shaylee Hudson, Loans Writer at Citrus North
Krystel is a Citrus North personal finance writer. She is a freelance personal finance writer located in Dallas. She is interested in writing about all kinds of personal finance issues such as mortgages, debt or student loans, auto financing, and personal loans. In the past, Krystel worked in search engine optimization (SEO) and affiliate marketing for a major home improvement business. When she’s not working on her computer, Krystel can be found working as a volunteer or trying out new coffee places.
