The Bottom Line
We are in a unique time where there is uncertainty but also access to relatively cheap financing.
This environment allows companies to improve their safety net, and potentially profits, by leveraging financing. It also allows them to improve cash flow by leveraging vendor payment terms.
This opportunity puts companies in a better position to grow, which should be done conservatively. Furthermore, it also puts companies in a better position to handle a potential downturn.
It is early August as I write this. So far, we have had a very volatile year. It started with a strong fear of a recession. These fears proved unfounded, at least for a few months, as the economy showed resiliency and growth continued. Now we are slightly past midyear and concerns of a softening economy have returned. The concerns are strong enough that the Federal Reserve cut its rates for the first time in a decade.
It’s hard to manage a company in this type of environment. This article presents three trends in the current market in addition to suggestions regarding how to navigate this environment while improving cash flow, decreasing general risk, or both.
1. Trend: Lenders are providing (relatively) cheap loans
The business lending market has become increasingly competitive in the past few years. Lenders are losing the conservative attitudes they had in 2008. Instead, they have become more aggressive trying to grow their business. In some instances, they have become too aggressive.
Many loosened their lending criteria, allowing more companies than before to qualify for financing. In my opinion, many lenders are providing loans at low prices that don't justify their risk.
This practice could become a problem for some lenders, but it is an opportunity for businesses. Owners can use this trend to their advantage in two ways. They can enhance their safety net and free up cash, and they can boost profits by leveraging early payment discounts.
STRATEGY: Use financing to boost emergency reserves, free up cash and leverage early payment discounts
This strategy is two-pronged, as an owner would be pursuing two different objectives. The first part of this strategy is to build cash reserves. Every company should have a cash reserve for emergencies. However, cash reserves have a drawback. The company can't use reserve funds for anything other than emergencies. The cash must sit in a bank account. Consequently, it limits access to cash, which affects growth.
An owner can use financing, through a line of credit, to complement emergency cash reserve. This strategy allows the company to keep less cash since it can tap the line in an emergency.
It is much easier to get a line of credit when things are going well than when things are going badly. If a company is doing well, now may be the time to get financing.
The second part of this strategy involves using newfound liquidity to boost profits. A company can boost profits using common strategies such as pursuing new clients or diversifying products. These strategies can be risky, though. One low-risk option for building profits, however, is taking advantage of early payment discounts provided by vendors.
Most vendors expect their clients to pay invoices in 30 to 45 days. However, vendors are often willing to provide a 2 percent discount if the customer pays quickly (usually in 10 days).
With a line of credit to enhance cash reserve, a company can deploy some previously unused funds to pay vendors early. The early payment provides a 2 percent discount, which drops straight to the company’s bottom line. Depending on cost structure, the effects on profit could be attractive.
There are some costs to getting a line of credit that owners need to keep in mind. The best and cheapest product to put this strategy in place is a bank line of credit. Alternatively, a company can use an A/R asset-based line. Other solutions are too expensive.
A word of caution: owners should implement this strategy carefully and with the help of the company’s finance department. Using it incorrectly could lead to financial problems.
This strategy has some inherent risks. The company must manage the cash flow and financing line carefully. The last thing an owner wants is to run into financial problems because they paid suppliers early. Keep this scenario in mind when determining the risk-reward of this strategy.
2. Trend: Some vendors have more access to cash
Some suppliers are financially better than they were 5 or 6 years ago. This improvement is great for them. But it can also benefit their customers. Companies that are doing well are more likely to provide payment terms. And if a company already has terms, it may be able to negotiate longer terms or a higher credit line.
Payment terms can be considered a short-term, interest-free loan from vendors. Getting better payment terms allows companies to hold onto their own cash for a longer time. Consequently, it reduces the need for external financing.
STRATEGY: Free up cash and reduce reliance on bank financing by extending payment terms
If a company doesn’t get terms from vendors right now, the first step is to start getting terms from them. The only way to get terms is to earn their trust as a payer. Companies earn this trust by always paying on time, or a little early.
Here is one trick. If a company can, work with vendors that report data to commercial credit bureaus. This approach helps the company build a public credit file. The company can then leverage this credit file to get credit from other vendors in the future. Pay all vendors on time, but give preference to those that report information. As a company develops a solid profile, ask for longer payment terms and higher lines.
Always follow this order: first build trust and then ask for credit. Repeat the process and keep asking for improvements.
3. Trend: Economic data and experts are both confusing and contradictory
The economy is volatile and confusing. No one seems to have a clear idea of its direction. Some experts claim the economy is still doing well and has plenty of steam left. Other experts say a recession is around the corner. To further cloud matters, the U.S. is involved in a protracted tariff war.
In this environment, the future is anybody’s guess, and economic confusion always calls for caution.
STRATEGY: Grow carefully but avoid unnecessary risks
One of the things learned from the last recession is that sometimes the economy turns quickly and unpredictably. And when that happens, things turn ugly in a hurry.
I saw this firsthand a decade ago in Miami. Many companies in the construction industry were growing too aggressively, thanks to an apparently never-ending boom. They threw caution to the wind and got involved in questionable projects. They also offered very generous terms to meet the aggressive demands from builders and developers. Consequently, they got overextended.
When the market turned, many projects failed. Developers and builders went bankrupt. Unfortunately, in a project/developer bankruptcy, the suppliers are usually left holding the bag. Of course, suppliers could not afford the losses and they folded as well. It was a domino effect.
Remember that a sale is only a sale after payment; beforehand, a sale is a loan. Research prospective clients carefully before signing them on.
Related reading | Your Profits: The Right Way to Build Credit with Your Vendors