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Quantifying the Need for a Business Line of Credit

October 16, 2019

S Rossi 2014

Quantifying the Need for a Business Line of Credit
By Stephen A. Rossi, SVP, Senior Equity Strategist – CNB Wealth Management

Published on October 7, 2019 in the Rochester Business Journal

Whether in good economic times or in bad, most businesses have the need for a short-term source of capital, particularly if they’re extending credit to their customers (i.e. giving them time to pay) or manufacturing a tangible product. This capital often comes in the form of a business line of credit, whereby a business can borrow money to purchase raw material inventory and carry other expenses associated with the production and sale of a finished good, only to pay it back a short time later, once a sale is made and the proceeds of the sale are actually collected. In the business vernacular, this is referred to as a business’s cash conversion cycle or, simply, how long it takes to convert one dollar invested in the business today into one dollar of cash revenue collected at some point in the future.

A business’s cash conversion cycle depends on three critical factors – how fast it can collect the money it’s owed once a sale is made, how fast it can convert raw material inventory into a sale, and how fast (or how slowly, as the case may be) the business pays its vendors for selling them the raw material in the first place. A business’s cash conversion cycle, quantified in days, can help explain a business’s short-term funding need and it can help to quantify the appropriate size of a line of credit facility that a business might need and choose to apply for.

In terms of bridging the funding gap between the time a sale is made and the time that payments are collected, we can study a business’s accounts receivable. For a steady business with little to no seasonality, we divide the business’s total annual sales (i.e. the driver of accounts receivable) by its average accounts receivable (i.e. beginning receivables plus ending receivables divided by two) to arrive at its accounts receivable turnover. This explains how many times each year $1 in accounts receivable is actually converted to cash. Taking the number of days in a year (i.e. 365) and dividing it by the business’s accounts receivable turnover rate then gives us the average number of days that a receivable is outstanding. This is one of the main inputs to a business’s cash conversion cycle.

As we look to bridge the funding gap between the time that inventory is purchased and the time that a sale is actually made, the business’s cost of production is more relevant, not its sales, as was the case with accounts receivables turnover. Accordingly, to compute the number of times a business actually turns its inventory over in any given year, we divide its annual cost of goods sold by its average annual inventory to arrive at its inventory turnover rate. This explains how many times each year $1 in raw material purchases is actually converted into a sale. Taking the same 365-day year and dividing it by the business’s inventory turnover rate provides us with the average number of days that $1 in inventory is outstanding. This is the second major input to a business’s cash conversion cycle.

To the extent that carrying accounts receivable and inventory exacerbate a business’s short-term funding need, how it pays its vendors – or how slowly it pays its vendors in this case – can actually reduce a business’s short-term funding need. In essence, a business can slow down payments to its vendors (to the extent possible) and use the vendor’s capital, instead of its own, to help offset the burden of carrying receivables and inventory. Just as was the case with inventory turnover, accounts payable are more directly related to a business’s cost of production, not its sales. To determine how many times $1 in accounts payable results in $1 actually being paid, we divide annual cost of goods sold by average accounts payable to arrive at accounts payable turnover. Taking the same 365 day year and dividing it by a business’s accounts payable turnover rate then gives us the average number of days that $1 in accounts payable is actually outstanding. This is the third and final input to a business’s cash conversion cycle.

Now that all of the aforementioned components have been calculated, a business’s cash conversion cycle is simply the average number of days that receivables are outstanding, plus the average number of days that inventory is outstanding, minus the average number of days that payables are outstanding. The result is an indication of the average amount of time that a short-term funding gap will exist in the ordinary course of business. We can then look at a business’s average daily cash need - expressed by dividing its total annual sales by 365 days in a year – and multiply this average daily cash need by the number of days identified in our cash conversion cycle (i.e. its funding gap) to quantify the magnitude of a business’s short-term funding need and provide guidance, in terms of the size of an appropriate line of credit.

This is a rather simple depiction of a business’s cash conversion cycle and the magnitude of its short-term funding needs. It will likely require adjustment for any seasonality associated with the business, and all calculations should be based on a projected, rather than historical, basis. Your financial advisor can assist you with the process and can help you better understand whatever other cash flow and collateral constraints might be relevant to your situation. It’s always better, and usually easier, to apply for and obtain a line of credit, even if you don’t have an immediate need for one. When good times turn bad, you’ll be glad you did.

To see his column in the RBJ, click here.