Oiling Your Money Machine

Oiling the
Money Machine

by
CECIL J. MCFADDEN
Vice President
Bank of America N. T. Sc S. A.

This presentation may provide a fresh perspective on some aspects of a business operation. There are no panaceas for financial problems and every business is unique with its own problems and requirements. Happily, a great number of sources and types of financial assistance are available and it is possible to tailor solutions to a rather high degree. Follow- ing is a review of some of the broad functions of finance.
The Money Machine
First let me suggest that, as business managers, the fact that you make springs is really almost incidental. Isn’t your basic purpose to make money? You control a given set of resources and utilize them in a fashion to generate cash inflow in excess of cash outflow — you operate a money machine. If you don’t make money you won’t be around very long even if you make the best steel springs in the world!

This concept of your company as a money machine is largely borne out by the price-earnings method of valuing a company. If a company earns $100,000 after tax, it probably has a value of approximately $1 million regardless of whether its book value is $500,000 or $1,500,000. A company that can earn $100,000 on a $500,000 investment is an efficient “money machine” and commands a premium. On the other hand, there is something wrong with a money machine that earns only $100,000 on a $1,500,000 investment and it will be discounted. Although this is a bit of an oversimplification as it is possible to distort actual earnings capacity — minimizing it for tax reasons
somewhat more subjectively it says something about management. It shows that management is really “managing” and also gives the bank something to measure performance against. When the deviations are small then the ability of management to look ahead and the plan is obviously pretty good. If there are larger deviations, then it triggers discussions between the customer and the bank. The bank is kept well informed and surprises don’t develop as might otherwise happen. Companies that develop this kind of relationship with their banks can expect that their bankers will want to be helpful and will be better able to be helpful. It is my opinion — and I am obviously a bit biased — that those few who approach their banking relationship with an attitude of “what the banker doesn’t know won’t hurt him” in fact hurt themselves. The banker must clearly “play his cards closer to his vest” when he doesn’t have full confidence that he really knows what’s going on in a customer’s operation.

One more comment on “when and how much”. In these rather confused times in the money markets, there is an understandable temptation to try to second guess the market, i.e., to get money before it is really needed or to postpone indicated financing because “the rate is too high”. We feel that it is usually a mistake to distort indicated financing for such reasons. The after-tax cost of interest even at today’s rates is usually not that critical to otherwise viable economic projects.

What Kind and Where?
What kind of financing and where to obtain it tends to run together, being rather interdependent.

The first consideration should be whether the requirement can be met internally. Can receivables be collected faster by closer follow-up and/ or by offering discounts or larger discounts? Can need funds be re-leased by better control of inventory?
A closely related, but external source is of course the firm’s suppliers. Some companies actually or maximizing it in the short run through, curtailment of research and development, etc. — but, the basic concept is valid.

If we may consider your company a money machine, what is the lubricant for this machine? Doesn’t proper financing help it run at maximum efficiency, and conversely doesn’t it overheat and even break down altogether in the absence of such financing? But how much oil is really needed (too much can create its own problems)? When should it be obtained? What kind? Where does one obtain it?
How Much and When?
How much and when can appropriately be tackled together? In my opinion, the best ways to anticipate how much will be needed, and when, is through financial forecasting and budgeting, that is, projecting sales, level of accounts receivable and inventory in relation to the projected sales and necessary capital expenditure to provide the facilities for that level of production. Then as one plots this out on projected P 8c L statements and balance sheets the adequacy of cash and time of maximum cash requirement is rather apparent. I’m sure most spring makers do quite sophisticated financial forecasting but it’s important enough to take a few minutes to review the benefits of this technique. Occasionally I run into managers of surprisingly good-sized companies who disparage this as something akin to reading palms.
Perhaps the most important bene-
fit for management is the discipline required in the preparation. It’s necessary to think through the cycle rather carefully. Will sales continue to grow at a faster or slower pace? If growth is anticipated will the necessary resources — and cash to make them possible — be available on a timely basis? Success creates its own problems through requirements for carrying higher inventories and receivables.
A second benefit of forecasting is that it gives management something to measure actual performance against. If goals are not set it is too easy to just drift — accept whatever comes rather complacently. If on the other hand, goals are not met, the alarm is sounded.

This leads to the third benefit. With good forecasting, it is possible for management to take steps to see that goals are reached. Once the alarm is sounded action should follow. If sales are less than forecast a look at sales effort, the products and competition, etc. is in order and action on a timely basis is indicated.
Another benefit of forecasting lies in your negotiations for credit. It demonstrates that homework has been carefully done and that numbers which may be excessive or in- adequate have not been “just pulled out of the air”. If done on a monthly basis, the forecast will show peak seasonal requirements and whether repayment can be made at the low point in the cycle. It also shows what the relation of debt will be to equity at the high borrowing point. Also, make payment faster than the terms willingly provided by suppliers. As interest rates move higher and dis- counts offered are not adjusted, it may even make economic sense to forego discounts as opposed to borrowing to make payments to suppliers. There, of course, maybe considerations other than economic in foregoing discounts, i.e., forfeit of a reputation for “always taking dis- counts” and the stir you may create by departure from that practice.
These are the least expensive sources but the quantity of funds available is limited. For larger amounts, it becomes necessary to
turn to the conventional money market. A first consideration here is whether equity or credit (or a combination of the two) is the indicated course. We have all been so well inoculated by the “leverage needle” and the impact on return on investment that there is a temptation automatically to conclude that debt financing is always better than equity as long as one can find someone to
provide it. I suggest that this is put- ting the company’s fate in someone else’s hands and that the decision should, in fact, be carefully thought out. Like everything else, there is a price to be paid for leverage. One is that its magnifying power is almost equally effective in reverse. Perhaps of more immediate concern in prosperous times is that continually in- creasing leverage decreases flexibility. Management should give some consideration to saving some borrowing capacity for emergencies — the unexpected. Remember that timing is extremely critical when going to the equity market’ and being forced into
the equity market, at the wrong time can be very costly.
Equity

If a decision is made that funds are needed on a permanent basis then the financing should be done by the equity routes. What are the
Alternative sources and types?


Sources — the present owners may
be in a position to enlarge their investment preferring not to let out- siders ‘in. Or they may wish to be
selective and permit relatives, friends, suppliers, or customers to participate in equity. There may be benefits to tying in suppliers and customers in this fashion but there are also hazards to evaluate. A firm will not want to be obligated to buy from a given supplier because of its ownership interest nor to have customers think there is too close a relationship with one of their competitors.
SBIC
Another possible source of equity is from a small business investment company. These are privately owned and privately operated investment companies which have been licensed by the Small Business Investment Act, passed by Congress in 1958, to help provide a source of venture capital to fill what has been de- scribed as “the equity gap”. It was recognized that many successful and growing firms outstripped their avail- ability for equity type financing on an acceptable basis considerably be- fore they were eligible for a public offering. The SBIC program was de- veloped to fill this “gap”.
Although the SBA administers this program, I want to emphasize that it is privately managed and operated to the largest extent with private money. Our bank, for in- stance, has a wholly-owned SBIC, which we operate as a subsidiary. We have used our own money entirely and do not propose to take advan- tage of any of the borrowing avail- able on a defined basis from SBA. There are several reasons why banks participate in this program. We can- not participate in equity financing except under this program. We feel
that it is desirable to be able to offer this additional financial service to our customers and prospects. We frankly wish to take advantage of the profit potential offered through as- sisting small business at a risk higher than a normal bank risk with the potential higher return through ap- preciation. An SBIC can make straight loans, but usually wants to participate in the growth in value through appreciation of equity. The
SBIC may buy common stock directly, but more frequently it pur- chases debentures with warrants at- tached which would enable the SBIC to purchase common stock in the company at sometime in the future at an agreed upon price. Let me em- phasize that this is not a “govern- ment trough” — investments must measure up economically.
The small business nomenclature can also be misleading, since within the definition of this program, “small” can be rather large. The SBA generally considers a business small and, therefore, eligible for SBIC financing if:
1) Its assets do not exceed $5,000,000;
2) Its net worth does not exceed $21/2MM and,
3) Its average net income after taxes for each of the preceding two years was not more than $250,000.
An SBIC normally cannot own more than — or hold warrants of more than — 50% of the equity of a company. A realistic SBIC will want management to have a sufficient ownership stake to be highly moti- vated.
There are also a number of other private organizations in the United States that buy stock of certain se- lected small corporations as a matter of investment policy. These closed- end investment companies generally confine their interests to very well managed firms with better than average growth and profits. Invest- ment bankers are, of course, the classic source of assistance in equity financing. Most of these companies maintain corporate finance depart- ments anxious to establish a rela-
tionship with a growing company at an early stage to assure that their service will be called upon later as the volume and complexity of the growing company’s financing devel- ops. A small stock issue of up to $300,000 may be made under Regu- lation A with a short form filing with SEC. Above that point, full registra- tion is required but $1 million is normally about the lowest amount
16 Sii/titifii. April 1968
economical to seek in this fashion. Here again we see the “equity gap” mentioned before,
Types of Equity
Careful thought should be given to the type of instrument to be util- ized. More tailoring is possible than may immediately come to mind. Of course, there is the “garden variety” common stock but preferred stock with a fixed dividend and restricted voting power may be a better fit. You can tailor it still further and make the preferred stock convertible and enjoy a lower fixed dividend rate. One may also have a sinking fund arrangement to program retire- ment of the preferred stock at a later date if this appears feasible and de- sirable. Or another step can be taken up the equity ladder to psuedo equity, such as convertible deben-
tures. By this mechanism, one may be able to sell stock today at “tomor- row’s” higher prices and in the in- terim enjoy the benefit of paying interest with before tax dollars com- pared with paying dividends with after tax dollars. A previous attrac- tion of convertibles was exemption from margin requirements but this is no longer true. This does not ex- haust the list of potential types of equity instruments, but it does give some indication of the tailoring
possibilities.
Credit
If the decision is made that there is adequate equity and that financing requirements are of a temporary nature, then management will want to borrow the money.
Sources of Borrowing: Many of those mentioned previously as sources of equity are also sources of credit, i.e., owners, friends, relatives and suppliers. We are seeing an in- creasing use of ledger balance finan- cing by which a few suppliers pro- vide, in effect, term credit out to 3, 4, 5 years. Other sources include leasing companies and commercial finance companies. Life insurance companies and pension funds, are sources of long-term money — usually not less than 10 years. But the commercial bank is still the department
store of credit with a broad variety on its shelves.
The most common type, of course, is the short-term commercial note. This is usually for periods up to 90 days and for so-called self-liquidating purposes. An example is the merchant who borrows in October to buy Christmas merchandise and then repays from proceeds from Christmas sales. If the need is recurring, then a line of credit is established under which the borrower can borrow and repay as he sees fit with no need to negotiate for each borrowing. Such a line is usually subject to an under- standing that the line will be cleared
for a given period each year—usually 60-90 days to demonstrate that it is not “locked in”, i.e., required on a permanent basis.
Frequently, requirements for capital equipment, plant expansion, and similar activities require funds on terms that do not fit the “clean up” criteria of the commercial line, but which more logically should be paid out of cash generation over a period of 3-5 years. The term loan obviously fits this set of circumstances. The banker’s primary concern here is to be assured that there will be adequate cash flow generated so that repayment can be made. He will be looking back at historical cash flow but he will also allow for contributions from new assets acquired or other anticipated change in operation or the market that make it reasonable to expect better than historical performance. Balance sheet analysis is also important. It may be considered the second line of defense. The lender must consider what kind of position he will be in if for any reason the anticipated cash flow does not work out. Bank term loans usually are unsecured and subject to a loan agreement. The loan agreement sets out the details of the arrangement under which the borrower and lender can operate over an extended period of time. There usually would be a requirement of minimum working capital and a minimum worth to debt ratio. Clearly the lender’s posi-tion could be seriously affected if
assets were pledged to others and a non hypothecation covenant is in-cluded. There are, of course, a number of other important covenants to consider in any given case. However, it is important that the credit agree- ment be a bilateral arrangement. It gives the lender a right of acceleration if there is financial deterioration beyond a specified magnitude or if the borrower in some other signifi- cant manner fails to behave as he agreed to. On the other hand, the borrower is assured that he will have use of the funds over the terms without interference from the lender if he can maintain the defined degree of financial health and if he otherwise complies with the covenants in the agreement. Each side knows the rules of the game going in.
Accounts receivable financing is one of the most frequently used types of secured financing. There are a number of varieties, but the most common and most simplified is the “streamline plan” where all receivables are pledged and the borrower can borrow any amount he requires at any given time up to a given per- centage — frequently 80% — of eligible receivables and can repay and reborrow with complete flexibility within that percentage constraint. The advantages of this type of financing include: the flexibility mentioned, no requirement for annual cleanup of borrowing, and no periodic payment as would be required on a term loan.
A similar type of financing is factoring, but there the “borrow: ” not a borrower at all. He sells receivables to the bank without re-course. The advantages here, once the bank agrees to buy a receivable, include: bank assumes all task of collection, bookkeeping, and correspondence regarding collection of the receivable. There is no borrowing to show on your balance sheet.
Inventory lien financing is another secured method which has increased in popularity since the advent of the Uniform Commercial Code. It supplements very nicely accounts receivable financing carrying the financing
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April 1968

one step further back in the manufacturing cycle of the company. We file a financing statement on the inventory, gear our rate of advance — usually 55% to 65% — to the degree of marketability of the inventory. The advantages are similar to those attributed to accounts receivable financing.
Warehouse receipts financing is another type of financing secured by inventory except that the bank has control of the security that it normally does not have under inventory lien financing.
Equipment lease financing is something relatively new to banks. We have had such a department for about five years. A bank-operated leasing activity can own only personal property — it cannot own and lease real estate, but personal property covers a board spectrum. Our leasing division has leased everything from computers to airliners. The advantages include: the possible favorable appearance of the balance sheet,
SWEDISH
lessor may be better able to utilize the tax benefits of depreciation and investment tax credit and therefore provide a more attractive “effective rate” than would otherwise be available.
Real estate loans, of course, pro- vide a method of secured term financing. When a bank’s portfolio of this type loan is relatively filled up, as is the case with many banks right now, it is still usually possible to arrange interim financing for construction, but only if an insurance company or other institutional lender has agreed to take over the long-term mortgage financing once the structure is completed.

SBA loans are a possibility in some instances where other sources of financing are not available. There are three basic types: (I) the entire loan proceeds are provided by a bank and SBA guarantees up to 90% of the loan. (2) the SBA actually participates in the credit — that is pro- vides a portion of the funds — up to
90% of the loan or (3) the SBA can make the entire loan itself if no bank is willing to provide any of the funds. The maximum risk that SBA can accept in any of the three methods is $350M. One ‘advantage is that longer than normal bank terms can sometimes be arranged. There are a relatively limited number of cases where this support will convert other unacceptable bank risks to acceptable bank loans but it does provide a real service in that limited area.
Conclusion:
We have reviewed here the range of financial possibilities available to the businessman. By working out combinations one can get an almost infinite variety. Tailor your finances- ing carefully to your situation keep- ing in mind always the next step as well as the immediate requirement. The more perfectly selected and blended and the more timely applied, the better your money machine will operate.
The End