Business Planning and Seeking Financing

When to Seek Financing

The old adage that it takes money to make money is especially true for small businesses. The list of expenses for operating a small business seems endless: payroll, taxes, insurance, rent, office supplies, inventory, telephone bills, etc. Sooner or later, most businesses find themselves with inadequate cash flow to cover these and other expenses. A decision must be made: At what point is outside financing needed?

For small business start-ups, the problem is especially acute. Starting out, revenue is low or nonexistent. This, coupled with the many one-time expenses for establishing the business - legal fees, security deposits, initial investments in equipment, stationary and business cards, and initial inventory - means that money must come from somewhere other than the business itself.

Businesses beyond the start-up stage (about one year for most businesses) might need money for expansion, upgrading equipment, or getting through seasonal downturns in the industry. Other reasons to borrow money include:

A general rule of thumb is that a business should borrow only to increase sales or decrease costs.

Whatever the purpose of borrowing, the need for it usually arises from a single source: insufficient cash flow both to pay for necessary business expenses and to maintain working capital. Simply defined, cash flow is equal to cash inflow minus cash outflow. In the long run, a company must have positive cash flow to be viable, but temporary imbalances occur when there is more cash flowing out of the company than in to the company. Companies can manage this on a very short-term basis by tapping into cash reserves or negotiating more lenient payment terms from venders. In cases where the cash flow problem is large or lasts for a predictable, extended period (such as in a seasonal business), it makes sense for the business to borrow. This is especially true if the lack of cash flow is delaying needed improvements in facilities and equipment or is hampering growth.

Businesses use cash flow statements to determine when and how much they need to borrow. The cash flow statement is simply a one-year projection of monthly cash inflows and outflows of a business. The ending cash balance from one month is carried over as the beginning cash balance of the next month. All expected cash inflows for the month are added and all projected cash outlays subtracted to yield the new ending cash balance. Proceeding month-by-month, businesses can estimate when they will need to borrow and how much.

As with other business decisions, the decision to borrow money requires careful consideration: Is borrowing absolutely necessary? Can a purchase be delayed long enough to be paid for through cash flow? Will the cost of borrowing (interest) outweigh the benefits of the item being financed? Will future cash flow be sufficient to repay the debt and still yield a profit? How will debt incurred now affect the company's ability to borrow in the future if the need arises? What will be pledged as collateral and is it worth risking its loss if the debt cannot be paid? Are there other options (vender credit, buying increments, a cheaper substitute)?

Of course, the decision to borrow depends not only on the need for the financing, but also on whether someone will lend the business money, and if so, who?