During my corporate banking career, I have been asked by many different business owners and CFO’s of small and large companies, what is the correct debt structure for my business and how much should my company borrow?  This is an interesting question with several variables for consideration; a banking partner can be one great source to discuss this question with, along with a CPA professional.

A business asset conversion cycle, the cycle by which cash is used to prepare a product or service, sell it to a customer and convert the sale back to cash, is a great place to start.  I like to begin with questions to understand the business better and develop a deeper understanding of the asset conversion cycle.  These questions include: strategy, product mix and services, current and alternative suppliers, competitors, geographic market, payment terms with customers and suppliers, customer concentrations, sales growth potential, and capital expenditure needs.  These are just some discussion points that illuminate how the business operates.  In other words, you must understand the business well enough to understand its asset conversion cycle and its capital needs.  The asset conversion cycle will assist in building the road map for debt structure and the amount of debt the company can carry on its balance sheet.

Each business, of every size and shape, has an asset conversion cycle and that cycle has two primary components: The operating cycle and the capital investment cycle.  The operating cycle includes the normal operations of a company such as the production and sale of goods or services and the collection of cash from those sales.  The capital investment cycle includes the purchase and use of the fixed assets needed to support day-to-day operations.  By studying the business asset conversion cycle, you can understand why and when the business needs more cash to operate and when and how it will be able to repay that cash.  The asset conversion cycle is a critical determinant of how much total capital a company may require and the excess cash flow to support loan repayment.  This can then be considered in context when reviewing a company’s historical financial statements and projections to determine loan structure(s) and how much debt a company needs to borrow.

To further illustrate, let’s take a look at a toy manufacturing company, fitting coming off the holiday season.  CV Toys makes toys for small children with a highly seasonal customer base.  CV Toys makes toys between January and October and ships them to their retail customers between August and November each year.  The retail customers pay CV Toys between December and January.  During this operating cycle, CV Toys expect to generate $7,000,000 per year in annual sales and they have to purchase raw materials, manufacture the toys, warehouse the toys until shipment, ship the toys, send a bill to their customers and collect cash from their customers.  This operating cycle starts with cash however doesn’t end with cash collection from customers until 9-10 months later.  Capital will be required to finance 8-10 months of the operating cycle before CV Toys collects from their customers.  A thorough discussion of this companies operating cycle used in context when reviewing the company’s historical and projected income statement and balance sheet will assist in understanding cash flow.  Debt structure and amount of debt needed to support the operating cycle will be determined.

CV Toys also needs equipment to manufacture the toys, which is a part of the capital investment cycle. The company needs a certain amount of equipment to produce enough toys to generate the $7,000,000 in sales management projects.  CV Toys may need to borrow to buy the equipment and a loan will be repaid from excess cash flow, also known as profits from several years of successful operating cycles.  Management projections over a few operating cycles will provide insight into how much annual excess cash flow can support annual equipment loan payments and a separate loan structure can be determined.  The seasonality of the business and understanding the operating cycle as outlined above will assist in determining when the excess cash flow is available for payments.

The operating cycle and capital investment cycle make up the asset conversion cycle and by understanding the cycle, you can determine the best loan structure and amount of debt a business can safely support.