Tips for Loan Causes, Part 2
The following is the final part of this article. In Part 1, I discussed the need for borrowing caused by accounts receivable and inventory slowdown, short and long-term growth, and increased operating investment. In this final part, I analyze the remaining causes of the loans.
• Renewals and expansion of fixed assets
Fixed assets wear out with use or become obsolete and require replacement. The cost of the new fixed asset is expected to be recovered or converted to cash during its useful life. This is known as the capital investment cycle. Fixed assets are necessary to support a series of operating cycles. It is logical, therefore, to spread the cost over several cycles, but certainly not beyond their useful lives. A business that chooses to purchase an expensive fixed asset from its cash flow will likely run out of cash later. Fixed assets require long-term financing. As a general rule of thumb, a company whose fixed asset usage rate is increasing and at least 60% should start planning equipment replacement. It is prudent to make a comparison to the industry average of the sales / net fixed assets ratio, which is a useful indicator of the financing needs for the expansion of production capacity.
• Disbursements for fixed assets
Excessive growth of other assets such as investments, prepaid expenses, deferred charges, intangibles, and goodwill can be causes of indebtedness. However, these expenses must constitute a significant proportion of total assets over time to cause concern. Funding for these assets can be short or long depending on the intended use of the assets.
• Low profitability or losses
The companies are financed internally with the profits. If profits drop significantly or a business operates without profitability for an extended period, a cash shortage is likely to occur. Cash shortages can cause other causes of indebtedness, such as lower sales growth. Lenders will not typically finance losses or decreased profitability. A prudent lender will endeavor to investigate the cause of losses or decreased profitability by analyzing sales and expense trends. Temporary losses and decreased profitability can be financed with short-term loans, long-term losses or decreased profitability can be financed with long-term funds.
• Dividend distributions or payments
If dividend payments or distributions exceed earnings, a need for borrowing may arise. The payment ratio can help identify distributions or the trend of dividend payments. A high or rising ratio to earnings is an indicator of impending cash shortage danger. The borrowing need arising therefrom can be short-term or long-term and can be financed as such. However, many lenders tend to avoid financing dividend payments.
• Debt restructuring
Debt restructuring is a borrowing necessity, but it does not result in new funds for the borrower. It is simply a replacement for another creditor, often to improve debt service ability. The most common reasons for debt restructuring are to replace commercial creditors’ debts to the maximum, loan mismatches, expensive and poorly structured debt. Financing of restructured debt will depend on need. For example, commercial creditors will be financed with short-term debt for the duration of the operating cycle and liabilities will be financed with long-term debt to provide better debt service. Low profitability over a prolonged period can also create a need for borrowing. Temporary losses may require short-term borrowing, but persistently low profitability or losses may require long-term financing.
• Unexpected expenses
These are typically one-time expenses incurred to cover litigation, facilities, and uninsured losses, to name just a few. Large unexpected expenses can cause a business to miss out on regular expenses. In such circumstances, therefore, these expenses can be financed with bank debt. The primary source of repayment will determine the term of the loan.