Managing Net Debts

Net debt is a financial liquidity metric used to measure a company’s ability to pay its obligations by
comparing its total debt with its liquid assets. In other words, this calculation shows how much debt a
company has relative to its liquid assets. Thus, demonstrating its ability to pay off the debt immediately if
it were called.

Definition: What is Net Debt?

This leverage ratio measures the net amount of liabilities that exceed cash and cash equivalents. This
metric is important for both management and investor analysts because it shows how well a company can
handle its current obligations and if it has the ability to take on more debt in the future.
Management uses this leverage ratio when they need to find out the whether they can feasibly borrow
more money to expand operations or purchase new assets. Analysts and investors, on the other hand,
mostly use this ratio to determine whether the company is highly leveraged or has the ability to pay its
obligations easily. Analysts and investors can also use this metric to predict whether the company can
withstand adverse economic conditions because it allows them to forecast a company’s ability to take on
new debt in times of need.

A ratio higher than one means that the company has more debt than current assets. If all of the
company’s creditors called their debts immediately, the company would not be able to pay them without
selling long-term assets. If the ratio is less than one, on the other, the company has more than enough
liquid assets to pay off its obligations.

Let’s take a look at how to calculate net debt.

Formula:
The net debt formula is calculated by subtracting all cash and cash equivalents from short-term and long-
term liabilities.

Net Debt = Short-Term Debt + Long-Term Debt – Cash and Cash Equivalents.

Calculation of the Equation

The First step in calculating the net debt equation is to identify the short term debts, these are those debts
which are payable in 12 month period. After this, add all the short term debts of the company.

The second step is to identify the long term debts, obviously these will be those debts which would be
payable in more than one year period. After this, add all the long term debts of the company.

Then add all the cash and cash equivalents of the company, cash equivalents means the liquid assets of
the company (meaning those assets that are readily or easily converted into cash).

Now the final step is to add up total short-term debt and the total long-term debt and then subtract the
total cash and cash equivalents from.

Now let’s take a look at an example.

Example:
Company ABC has following items listed in the balance sheet:
  Bank Overdraft: 100,000
 Trade Payables: 80,000
 Trade Receivables: 150,000
 Bank Loan: 500,000
 Cash on hand: 300,000
 Cash in bank: 450,000

First, let’s identify the short-term debts. In this example, bank overdraft and trade payables are both short-
term obligations since these are payable in one year period. Trade payables are the purchases that the
company ABC made on credit and are repayable within a 12 month financial year. Bank overdraft is
however the limit allowed by bank over the balance in the bank account. It means that if the company’s
bank balance reaches zero there is a certain limit allowed by the bank that the company can still make
transactions.

Total Short Term Debt = 100,000 + 80,000 = 180,000

Then comes long term debts which in this case is only Bank loan, as this is payable in more than one
year period. It is understandable that the bank loan is always repayable after more than one year.

Long Term Debt = 500,000

Now it is time to identify and add up the cash and cash equivalents, which in this case are Cash in hand,
trade receivables and cash at bank. Trade Receivables are the sales made on credit over the year.

Cash and Cash Equivalents = 150,000 + 300,000 + 450,000 = 900,000

Finally the last step is to compute the Net Debt of company ABC

Net Debt = 180,000 + 500,000 – 900,000 = -120,000

If the figure of Net Debt is negative then it is a good sign because it means that the company ABC has
enough cash to pay off its debts.

Analysis and Interpretation

As already explained in the example above, the calculation of the net debt ratio is pretty simple. The main
issue arises in locating the figures from the financial statements. It is easy to remember that the short-
term debt will always be listed under the current liabilities (liabilities or debts due in a year) and the long-
term debt would be listed under the non-current liabilities (liabilities or debts due in more than one year).
Finally the cash and equivalents would be listed under current assets excluding the inventory figure.
This ratio holds importance mostly to the investor’s point of view because the company stock price
fluctuates based on the company’s financial health. A highly leveraged company is not only riskier than a
debt free company, it is also less able to expand and grow into new markets.

The Company ABC is financially healthy as the net debt ratio is negative $120 million. This means that
the company has $120 million more cash and liquid assets than total debts. This means that the company
could pay off its entire liabilities section on the balance sheet without selling off a single long-term or
operating asset. Thus, operations could continue even if the debt was called today.
Creditors also use this metric to analyze a company’s ability to take on new loans to finance operations or
invest in new equipment. ABC company has a strong ratio, shouldn’t have a problem convincing a bank to
extend more debt.

Practical Usage Explanation: Cautions and Limitations

As with all financial ratios, the net debt calculation should not be analyzed in a vacuum. It’s important to
use this metric with other liquidity and leverage ratios like the net liquidity ratio,  cash conversion cycle,
and the debt to equity ratio in order to get a full picture of the company’s financial position and amount of
leverage.
It’s also important to compare this metric to other companies in the industry. Since industries are financed
differently, it’s important to have a benchmark. For example, it’s not uncommon for industries with heavy
equipment requirements like mining, drilling, and construction to have large amounts of debt. Whereas,
service based industries like public accounting typically have small amounts of liabilities on their balance
sheets.

If the net debt comes higher than the industry average, it means the company may not be able to pay off
its debts in the future and the market price of the company’s share might fall. It’s always important to look
at industry trends in order to get some relevance in terms of decision making.

BREAKING DOWN 'Net Debt'

The net debt figure is used as an indication of a business's ability to pay off all its debts if they became
due simultaneously on the date of calculation, using only its available cash and highly liquid assets.

Net Debt and Total Debt 

Net debt is calculated by determining the company's total debt. This includes long-term liabilities, such as
mortgages and other loans that do not mature for several years, as well as short-term obligations,
including rent, utilities, loan payments and interest due within the next year, credit card and accounts
payable balances, and taxes.

Net Debt and Total Cash

The net debt calculation also requires figuring out a company's total cash. Unlike the debt figure, the total
cash includes cash and highly liquid assets. Cash and cash equivalents would include items such as
checking and savings account balances, stocks, and other marketable securities.

Comprehensive Debt Analysis

The concept of net debt is particularly important in investing and is one of the most commonly used
metrics in fundamental analysis. Stocks that perform well over time tend to be issued by companies that
are financially healthy and able to meet their obligations with relative ease. While the net debt figure is a
great place to start, a prudent investor must also investigate the company's debt level in more detail.
Important factors to consider are the actual debt figures – both short term and long term – and what
percentage of the total debt needs to be paid off within the coming year.

The reason behind the debt is also important. A business can take on new debt financing to fund an
expansion project, or it can use those funds to repay or refinance an older loan that it has not yet paid off,
which may be a signal of deeper troubles. If the majority of the company's debts are short term – meaning
they must be repaid within 12 months – consider whether the business could afford to cover those
obligations if its sales took a dive. If the company's current revenue stream is the only thing keeping it
afloat, its long-term prospects could be questionable.

Because different types of businesses use debt differently, it is also important to compare a company's
net debt with that of other companies within the same industry and of a comparable size.

Managing cash flow

Your cash flow is the money you have coming in from revenue and going out for expenses. Good cash
flow management will ensure you always have money available for paying your expenses when they are
due.

Even profitable businesses can fail if cash flow is not managed properly. If you don't have enough money
available to pay your lenders or suppliers, banks may foreclose and suppliers could cut supplies.

There are many areas in your business that can impact on your cash flow. It is important to understand
how customer payment terms, supplier payment terms, loan payments, future spending decisions and
other items can affect your cash flow.

This guide will help you to manage your cash flow and understand how to use cash flow analysis to
inform business decisions.

Plan and monitor cash flow

Planning and monitoring your cash flow is one of the most important things you can do when running your
business. This should also include how you will address cash shortfalls or surpluses if they occur.

Forecast cash inflows against cash outflows

A cash flow statement will help you forecast your money coming in and going out. Forecasting your cash
flow is usually done annually and broken down into monthly amounts. Always record the amount in the
month it is expected to be spent or received. For example, electricity is usually paid quarterly so should
be recorded in the month it is due.

You can use a cash flow template to forecast your annual cash flow. You will need to estimate and record
the following amounts for each month:

 total monthly cash inflow - includes sales, sales of assets, capital injections from borrowings or
owners funds, interest revenue and any other sources
 total monthly cash outflow - includes items such as purchases, loan payments, supplies,
telephone, electricity, wages and any other bills
 net cash flow - take the total outflows from the total inflows to see if there is more money in or
out
 opening balance - record your cash available at the beginning of the month
  closing balance - calculate your funds available at the end of the month by adding the net cash
flow to the opening balance. This will become your opening balance for the next month. Note: If
your net cash flow is negative, this amount will be reduced.

Include GST when inserting amounts for some cash inflows (particularly sales) and many cash outflows
(particularly purchases). Calculate the difference between total GST inflows and total GST outflows and
insert this as GST payments.

Different businesses are subject to differing GST requirements, so you should seek specific advice from
your tax adviser. Learn more about working with business advisers.

Monitor actual inflows against outflows

As each month passes it is important to record your actual cash flow. This can be compared against your
forecast to see if you are tracking as planned. You may find you need to review and adjust your forecast
as amounts change over the year.

Always make sure your payments received match invoices issued, and receipts and payments match.

Invest surplus cash or arrange loans

If you forecast excess cash for some months, it can be worth putting it in short-term investments to
maximise your income. If you anticipate any shortfalls in cash, you may want to plan for an appropriate
loan to temporarily cover your costs. Don't forget to include these extra payments or receipts in your cash
flow forecast.

Monitoring your financial performance

There are a number of ways you can monitor the financial performance of your business using available
data.

By using financial ratios you can assess where your business is underperforming, and judge the effects
changes in one area will have elsewhere.

Monitoring figures closely will allow you to maximise efficiency and minimise waste, which will help your
business in the long run.

This guide will help you understand how to assess the performance of your business by using common
financial ratios. It will also help you to monitor profitability, cash flow and non-financial factors such as
staff turnover and customer satisfaction.
Types of financial ratios

A ratio that contains 1 or more financial figures is a 'financial ratio'.

You can use ratios to simplify financial and non-financial data to monitor and improve your business
performance.

Key financial ratios

The following table provides a quick summary of key financial ratios, what they indicate and how to
calculate them.

Ratio Indicator of Method

Gross profit margin % of gross profit on sales (Gross profit x 100) ÷ sales

Net profit margin % of net profit on sales (Net profit before tax x 100) ÷
sales

Material to sales % of sales dollars spent on (Direct materials x 100) ÷ sales

materials

Labour to sales % of sales dollars spent on (Direct labour x 100) ÷ sales

labour

Overhead expenses to % of sales dollars spent on (Overhead expense x 100) ÷

sales overhead expenses sales

Stock turnover Number of times stock Cost of goods sold ÷ (0.5 x

turns over opening + closing    stock)

Debtors turnover Average time to collect (Debtors x days in period) ÷

 Ratio Indicator of Method

debts credit sales

Working capital Liquidity of business Current assets ÷ current liabilities

Liquidity (also known as Solvency of business Current assets (minus stock) ÷

quick assets ratio) current liabilities

Using ratios in your business

A ratio is a means of relating one number to another. In financial analysis, ratios may be expressed as the
ratio, rate or percentage, depending on your own preference.

To provide useful meaning, financial ratios need to be compared with, for example:

 the trend of your results over the past year or so (i.e. trend analysis)
 the results by other competitors (if these are available)
 industry benchmarks or general business standards
 budgeted results
 the effect of economic conditions.

Commonly used financial ratios

Your first decision will be which financial ratios to use. The most common categories of ratios are:

 profitability - use gross profit margin and net profit margin ratios as 2 key indicators of business
performance and likelihood of success
 cash flow and liquidity - use these ratios to assess the amount of working capital you have in your
business, and work out how solvent the business is in the short to medium term
 risk and return - use these ratios to judge how successful investment in your business is, and
what effect further investment may have in specific parts of the business
 stock turnover and sales - use these ratios to identify overstocking or deficiencies in your
production or marketing strategies.

Non-financial ratios
Non-financial ratios can also be important to your business, as they can highlight issues that may not
show up on the balance sheet. Staff turnover and client satisfaction are examples of non-financial factors
you may want to examine.

Learn more about non-financial ratios.

Getting help with financial ratios

Financial advisers can recommend the most suitable ratios for your business and show you how to
produce reports to calculate and monitor them.

When you have started to analyse the figures produced by your financial ratios, you can use them
to benchmark your business. This will help you assess productivity by comparing your performance to
other businesses in your industry.

Tips for improving cash flow

Many areas of your business can have an effect on how much cash you have available. By controlling
your expenses and increasing your profits, you can improve your cash flow.

Monitor stock levels

Holding too much stock will tie up cash and increase storage and insurance costs. Practising good stock
control will keep stock at efficient levels.

Manage accounts

Follow up on overdue accounts. Managing debtors and having good credit policies will keep your cash
coming in.

You may also be able to negotiate longer payment terms with your suppliers. If you can get payment from
your customers before you pay your suppliers, you will have zero out of pocket.

Review banking products

Using the right banking transaction products can have the money in your pocket sooner. Consider a
mobile eftpos device, or investigate services to take payments over the phone or online.

Increase income

Review your pricing, use an advertising campaign or improve your customer service to see if you can
increase profits. You may also want to consider growing your business.

Reduce overheads
Think about reducing staff overtime and controlling overheads. Make your business more environmentally
friendly and you may reduce costs such as power and water bills and minimise wastage. Remember to
clearly communicate your policies on these items to your staff.

Improve your financial skills or get expert advice

Improving your management and financial skills can help you improve your cash flow. Attend
a workshop to improve your business knowledge.

You can also seek advice from a professional accountant or financial adviser, who can assess your
individual situation.

Analysing your cash flow statement

When you have a good understanding of your cash flow, you can use that information to measure your
performance and make decisions.

Assess your business performance

 You can compare your cash flow to similar businesses. This can help you to identify where you
are under spending or over spending compared to your competitors. Learn more
about benchmarking your business.
 Cash flow can be used to calculate your financial performance. Financial ratiosoften use cash
flow to measure your business and see if you are progressing towards your goals. These ratios
are also used by lenders and investors to determine your businesses financial condition.
 Compare your forecast amounts against your actual amounts to see if you are performing as
expected.
 If you are trying to recover from a setback, you may want to review your cash flow to see where
you can free up cash. Learn more about surviving an economic downturn.

Consider cash flow in decision making

When making decisions on specific objectives or purchases, you should consider any impact on cash
flow. The cost of an advertising campaign may lower your cash flow initially, but the resulting increased
sales may raise your cash flow later. You may need a strategy to cover the cash shortage to gain the
long-term benefit later.

Your finance plan is a key part of your business plan. Your cash flow forecast can help you to identify
financial opportunities or risks and ensure your business is heading in the direction you want.

To get finance, you may need a cash flow projection. Some lenders will require this to ensure you can
make repayments. If you are considering taking on debt finance, you will need to consider how
repayments will affect your future cash flows.

Financial statements and forecasts

Financial statements and forecasts show how your business has been performing and how you think it
will perform over time.
Financial statements are historical. They show you how your business has been operating (i.e. in terms of
profitability, cash flow, assets and liabilities etc.). Financial forecasts, on the other hand, look to the future.
They project a financial situation you should be aiming for.

Financial statements and forecasts are valuable reference tools to help guide your business planning.
They are also key documents for attracting funding. Investors and creditors will use them to assess the
health of your business's finances.

This guide explains how to use financial statements and forecasts to monitor and manage your business
performance.

Understanding cash flow statements

A cash flow statement shows how much cash is moving in and out of your business over a certain period
of time (i.e. it reflects your 'liquidity').

Having enough cash available to pay your debts and to buy materials and assets is an important part of
business planning. A cash flow statement will quickly tell you if you are likely to have any issues in this
area.

What's in a cash flow statement?

There are normally 3 sections in a cash flow statement, each relating to a different area of your business:

 cash flow from operations

 cash flow from financing
 cash flow from investment.

Cash flow from operations

This section contains the main cash-generating activities of your business. Generally speaking, any
money earned or spent in the normal day-to-day running of your business will appear in the operations
section of your cash flow statement.

The largest figure in this section should be the net income generated by sales of the goods or services
you produce.

Accounts receivable (money owed to you) and accounts payable (money you owe) will also appear in this
section. If accounts receivable are increasing at a faster rate than income from sales, you may have a
problem managing your debtors.

Cash flow from financing

This section measures the flow of cash between your business and its owners and creditors.

Cash income in this section can include:

 any funds borrowed

  public issues of shares or bonds.

Cash expenditure in this section can include:

 loan repayments
 dividends paid out
 re-purchased shares or bonds.

Cash flow from investment

Investing activities listed in this section generally include purchases or sales of long-term assets, such as
property, plant and equipment. The sale or purchase of investment securities would also be included
here.

How to read a cash flow statement

Depending on the size and complexity of your business, your cash flow statement may include a few or
many items. The crucial figure, found at the bottom of the statement, is your net cash flow.

You can compare this figure with the net cash flow from your previous statement. An increase in cash
reserves indicates your business is healthy and heading in the right direction. If cash reserves stay
roughly the same, there may only be problems if the figure is low. If your cash reserves are decreasing
you may find it increasingly difficult to pay your debts, and find yourself relying more heavily on credit.
You should take immediate action to resolve whatever issue is causing your cash shortfalls.

Financial forecasting

Financial forecasting is a vital part of business planning. Although many events affecting your business
are unpredictable, it is still possible to use forecasts to guide your decision making, exploit trends and
give your business a competitive edge.

In order for forecasts to work for your business, they need to be realistic. You can use existing financial
statements as a guide. If you are a new business, you may want to work with a business adviser to
develop your financial forecasts.

Profit and loss forecast

A profit and loss forecast shows the expected revenue and expenses for your business over a period of
time. It shows how much profit is likely from a predicted level of trading.

Producing a profit and loss forecast involves listing your planned expenses and calculating the sales
targets needed to reach your profit goals. You can then check your forecast regularly to ensure your
business is running according to plan.

You can compile your profit and loss forecast in the same format as your profit and loss statement. This
will allow you to compare them later and refine your projections for the future.
It's important to note that a profit and loss forecast does not reflect your liquidity. It contains non-cash
items such as depreciation, creditors you have not paid, and invoices raised but for which no cash has
been received. It also excludes any payment of loans.

To get an idea of your business's likely cash position, you will need to create a cash flow forecast.

Cash flow forecast

A cash flow forecast is an estimate of your business's cash inflows and cash outflows over a period of
time (but usually covers 12 months).

Cash flow forecasting is a management tool that predicts cash surpluses or shortages. You can use a
cash flow forecast to find out if you will struggle to pay your debts or taxes when they become due, or if
you can afford to make a major equipment purchase or take on more staff.

By setting up your forecast in the same way as your cash flow statement, you can compare your
predictions with your actual performance. This will alert you to any variances, which you can then
investigate and find out why you business is under (or over) performing.

Examples of Cash Flow Management Problems in Business

Real estate development has always been a highly cyclical industry and developers are often prone to
cash flow problems. Property development requires significant initial capital investment as well as
ongoing cash outflows for operations, and unless some or all of the development can be sold before
construction, developers often run into cash flow problems before the development begins to sell off,
particularly if the property market happens to soften during construction. Many property developers have
been forced into bankruptcy due to negative cash flow for extended periods of time.

Any business that is undergoing rapid expansion can run into cash flow problems. Business expansion
generally involves increasing labor costs as new employees are hired, increased rent for additional space,
higher advertising costs, and more capital investment for new facilities, equipment, etc. Having to
maintain increased levels of inventory can also quickly eat into excess cash.

Extending credit to other businesses is another common way for businesses to run into cash flow
problems. Invoicing is normally done on 30 or 60-day terms and it is not uncommon for customers to
delay payment, which can leave your business in a cash flow crunch.

Here's an example of a business with cash flow management problems in which the cash balance is
negative for the year:

Acme, Inc. - Cash Flow Statement for the Year Ended Dec. 31, 2016

Cash Flow From Operations $

     Receipts  

        Customer Invoices $80,000

        Other $1,500

     Disbursements  
        Employee Salaries -$45,000

        Suppliers -$25,500

        Other -$5,000

Net Cash Flow from Operations $6500

Cash Flow From Investments  

     Equipment and Software Purchases -$5,500

Net Cash Flow From Investments -$5,500

Cash Flow From Financing  

     Loan Payments -$3,300

     Shareholder Dividends -$5,000

Net Cash Flow From Financing -$8,300

Net Change in Cash Balance -$7,300

Solving Cash Flow Problems

As a business owner, you need to perform a cash flow analysis on a regular basis and use cash flow
forecasting so you can take the steps necessary to head off cash flow problems. Many
software accounting programs have built-in reporting features that make cash flow analysis easy.

This is the first step in cash flow management.

The second step of cash flow management is to develop and use strategies that will maintain an
adequate cash flow for your business. One of the most useful strategies for small businesses is to shorten
your cash flow conversion period so that your business can bring in money faster. 

If your business is expanding, you may need one or more injections of cash during the growth phase. This
can take the form of a business loan from a financial institution known as debt financing, or equity
financing from investors.

Debt financing is common for assets such as equipment, buildings, land, or machinery where the assets
to be purchased are used as security or collateral for the loan. The main advantage to debt financing over
equity financing is the business owner(s) do not have to give up partial ownership of the business and so
retain full control.

For short-term cash flow shortages, many small business owners make use of credit cards or  lines of
credit.

Equity financing involves raising money from angel investors or venture capitalists. Equity financing is
much less risky in that money invested do not have to be repaid if the business does not succeed;
however, in exchange for financing the investor(s) become part owners and as such take a share of the
profits and have a say in how the business is run.
Whatever form of financing is required it is vital to have an updated business plan in place to present to
financial institutions or investors. The business plan should demonstrate the need (and effect) of financing
for the future of the business.

What is Cash Management?

Cash management is the efficient collection, disbursement, and investment of cash in an organization
while maintaining the company’s liquidity. In other words, it is the way in which a particular organization
manages its financial operations such as investing cash in different short-term projects, collection
of revenues, payment of expenses, and liabilities while ensuring it has sufficient cash available for future
use.
What is the definition of cash management? 
In the real world, organizations have strict cash management controls to monitor its inflows and outflows
while retaining a sufficient amount in order to take advantage of attractive investments or handle
unforeseen liabilities. Efficient management of cash prevents loss of money due to theft or error in
processing transactions. Numerous best practices are adopted to enhance management of company’s
funds.
This involves shortening of cash collection periods, regular follow ups for collections, negotiation of
favorable terms with suppliers allowing delay in payment periods, and preparation of cash flow forecasts.
Businesses also use of technology to speed up cash collection process. They must do all of this while
maintaining adequate amount of funds to meet daily operations.

The objective of cash management is to have adequate control over the cash position, so as to avoid the
risk of insolvency and use the excessive cash in some profitable way. The cash is the most significant
and highly liquid asset the firm holds. It is significant as it is used to pay the firm’s obligations and helps in
the expansion of business operations.

The concept of cash management can be further understood in terms of the cash management cycle. The
sales generate cash, and this has to be disbursed out. The firm invests the surplus cash or borrows cash
in case of deficit. Thus, it tries to achieve this cycle at a minimum cost along with the liquidity and control.
An optimum cash management system is one that not only prevents the insolvency but also reduces the
days in account receivables, increases the collection rates, chooses the suitable investment vehicles that
improves the overall financial position of the firm.

The importance of the cash management can be understood in terms of the uncertainty involved in the
cash flows. Sometimes the cash inflows are more than the outflows, or sometimes the cash outflows are
more. Thus, a firm has to manage cash affairs in a way, such that the cash balance is maintained at its
minimum level while the surplus cash is invested in the profitable opportunities.

Example
A computer manufacturing company, Techno Ltd., uses supplier Beta & Co. to purchase its core
materials. Beta & Co. has the policy of allowing its customers who buy on credit to pay within 30-days
period.

At the moment Techno Ltd. has $20 million cash resources available and has to pay $5 million to Beta &
Co. after 30-day period for the purchases. However, after 30-day period Techno Ltd. has an investment
opportunity requiring use of the full $20 million cash resources.

If the company is able to renegotiate its terms with suppliers allowing 60-day period, the delay in payment
will allow the company to benefit by using current funds for the investment and paying suppliers with cash
generated next month from other projects. Thus, by properly managing its funds, Techno can take
advantage of investment opportunities while maintaining its operations.

The term cash management refers to the collection, concentration, and disbursement of cash. In many
ways, managing cash flow is the most important job for business managers. If a company happens to
miss paying an obligation due to lack of cash, the company becomes insolvent, which is the primary
cause of bankruptcy. Not only this, but having a poorly managed cash flow leads to having no margin of
safety in case of unanticipated expenses, trouble finding funds for expansion, or difficulties in hiring and
retaining employees.

Typically, cash flow problems are the leading cause of business failures — so it is important to make sure
you understand every technique available to keep your business afloat. To have a successful business,
you need to be able to manage your cash flow well. Here are some useful cash management techniques
to help you as you grow your business.

Monitor Your Cash Flow Regularly

Staying on top of your cash flow is the first and foremost important aspect of cash management. To help
with this, create a cash flow budget that charts finances for shorter and longer terms. This will assist in
understanding where your money will be going and how much is necessary, as well as keeping track of
what finances you currently have and should be spending.

Bill Promptly and Accurately

The faster you mail an invoice, the sooner you will be paid. If your company's deliveries or services do not
automatically trigger an invoice, then establish a weekly billing schedule to stay on top of things. Along
with this, always include a payment due date to encourage customers to pay quickly.

Encourage Faster Payments

If payments are coming in at a rate that isn't beneficial to your company, it's time to begin encouraging
faster payments. There are options such as offering discounts for early payment that can be used or other
incentives that your company can offer. Be sure to ensure that getting paid early is worth the loss, though.
Too much of a discount could only be more of a financial burden.

Designate a Cash Flow Monitor

Choosing a trustworthy employee to monitor cash flow provides your business with someone to watch
and inform you when your company reaches a certain threshold. This is an excellent way to stay on top of
things efficiently without taking up too much of the company's time and resources.

Cut Costs Where You Can

To manage your cash well, it's important to make sure your company isn't spending more than it can
handle. Cutting costs such as subscriptions or services you no longer need, cutting back on utilities, rent,
or payroll, or renegotiating terms of outstanding loans or leases are different ways to save your company
money.

Get a Business Line of Credit

Lines of credit are good insurance policies against cash flow problems, but it's important to get a business
line of credit before you find your company needing one. If you use either your accounts receivable or
inventory as collateral, you may even be able to get a line of credit for a percentage of them.

Delay Payments to Vendors

To keep the cash in your account for as long as possible, wait to pay your vendors as long as you can
(without risking late fees). The only time that it is a better option to pay early is if there is a worthwhile
incentive available, otherwise, stick with waiting.

Use Available Technology

There are different professional accounting software solutions available that will assist you in your
finances, as well as cash flow spreadsheets in the cloud at sites such as Dropbox or OneDrive. The
benefits of these include being able to access your financials from anywhere and at any time.

Use Banks Wisely

Banks can offer incredibly useful services such as overdrafts or credit that are great for businesses,
especially those that are just starting out. The First State Bank provides services such as Business Online
Banking, Merchant Card Services, Remote Deposit Capture, and many others that are perfect cash
management tools that will assist in recognizing your cash flow and keeping track of it.
These are just a handful of the many different cash management techniques available. Remember, cash
management is one of the most important aspects for businesses to keep themselves successful and
running smoothly. Recognizing your cash flow and understanding where there is room for improvement is
crucial for all businesses, and these cash management techniques are the first steps to helping you
become more fiscally responsible.
What are cash investments?

Although cash offers the lowest potential return of all the investment types, it is also the lowest
risk and can help you meet short term goals as well as complementing higher risk assets in your
portfolio.
Cash investments include money in bank accounts, savings accounts and term deposits and can provide
stable, low-risk income in the form of regular interest payments.
As a result, they are considered as a ‘defensive’ asset that can play an important role in helping you
reduce the volatility of your portfolio.
 
Term deposits
If you put your money in a term deposit, for example, you will receive a fixed interest rate in exchange for
depositing it with the issuer for an agreed period of time.
Term deposits allow you to choose how long you want to invest for and the interest rate is generally
higher for longer terms than for shorter terms.
 

What are the benefits of term deposits?

 High interest. You can often earn a higher interest rate on term deposits than you can on high-
interest savings accounts.
 Guaranteed income. The interest you will earn is fixed at the start of the term and does not
fluctuate if official interest rates change.
 Optional terms. You can choose how long you want to invest in a term deposit, with options
typically available from three months to 60 months.

 
What other cash investments are there?
There are also some investment funds that focus on cash, including exchange traded funds, which are
listed on the Australian Securities Exchange (ASX). These funds pool together the money of investors
and invest in cash related assets.
 
What are the risks of cash?
The major issue to consider with term deposits is the lack of access to your cash during the fixed term. If
you decide to withdraw mid-term, you will usually forego interest payments and may be required to pay a
fee.
If the rate of interest you receive is lower than the rate of inflation, then the value of your money would not
actually be growing in terms of your spending power. But it’s important to consider the returns you get
from your portfolio as a whole, not just from one asset.
Asset Based Financing
Asset based financing is based upon collateralizing a loan with a certain asset or the cash flows from
an asset like a receivable. Additionally, asset financing is used quite often to try and receive cash in the
form of a loan. The investors in asset backed financing often have first claim over the assets.

Asset Based Financing Explained

Often times, companies have accounts receivable payments that they believe they will see in the future. If
they believe that they will need financing soon they will use these future receivables and sell them off
to investors. This allows the company to become more liquid by receiving a loan of cash up front rather
than having to wait on the future receivables so that the company is able to meet its short
term obligations. If the company were to default on this loan then the asset based lender could assume
the future receivable payments to pay the loan. Another form of asset based lending is for a company to
simply use an asset like equipment or land as collateral in order to obtain a loan. This occurs if a bank or
other financial institution decides not to extend credit unless they have some sort of collateral.

Asset Based Financing Example

Tiny Tots Inc. specializes in the manufacture of toys. Currently, the company wants to obtain financing so
that it can expand its operations into South America. After visiting with the bank, the bank decides that it
will provide financing. But the company must use asset backed financing and put its
current production facility up as collateral. Tiny Tots agrees with this proposition and a contract is signed.
After 5 years of production Tiny Tots has become very successful in South America. Tiny Tots pays off
the loan, thereby freeing the production facility from the asset backed security. It should be noted that if
the company had failed to make the interest and principal payments that the bank has the ability to take
possession of the production facility. Then the bank will sell it to pay off the loan.

Asset-Based Financing Basics

Once considered financing of last resort, asset-based lending and factoring have become popular choices
for companies that do not have the credit rating or track record to qualify for more traditional types of
financing.
 
In general terms, asset-based lending is any kind of borrowing secured by an asset of the company. This
article will consider asset-based lending to mean loans to businesses that are secured by trade accounts
receivable or inventory.
 
Asset-based lenders focus on the quality of collateral rather than on credit ratings. Borrowers pledge
receivables, inventory and equipment as collateral. Traditional bank lenders may have significant
problems with asset-based loans. Banks are constrained by both internal credit granting philosophies as
well as federal regulations. Banks typically do not accept transactions with debt-to-worth ratios higher
than four or five to one. Asset-based lenders that are either nonbanks or separate subsidiaries of banks
are not subject to such constraints. This gives asset-based lenders the freedom to finance thinly
capitalized companies.
 
 
REVOLVING LINES OF CREDIT (REVOLVERS)

A revolver  is a line of credit established by the lender for a maximum amount. Revolvers are used by
retailers, wholesalers, distributors and manufacturers. The line of credit typically is secured by the
company’s receivables and inventory. It is designed to maximize the availability of working capital from
the company’s current asset base. A typical term for a revolver is one to three years or longer. The
borrower grants a security interest in its receivables and inventory to the lender as collateral to secure the
loan. In most cases, lenders require personal guarantees from the company’s owners.
 
The security interest creates a borrowing base for the loan. As receivables are collected, the money is
used to pay down the loan balance. When the borrower needs additional financing, another advance is
requested.
 
The borrowing base consists of the assets that are available to collateralize a revolver. It generally
consists of eligible receivables (defined below) and eligible inventory. The size of the borrowing base
varies with changes in the amounts of the borrower’s current assets limited to the overall revolving line of
credit. As the borrower manufactures or acquires new inventory, and as it generates receivables from
sales, these new assets become available for inclusion in the borrowing base.
 
The borrowing base certificate is a form prepared by the borrower and submitted to the lender periodically
(usually monthly). It reflects the current status of the lender’s collateral. This certificate should be
compared to the balance sheet for consistency.
 
Within the overall line of credit, there can be a sublimit for letters of credit. For example, an asset-based
lender may grant a company an overall line of $16 million, which includes $2 million for letters of credit
and $14 million for loans collateralized by the receivables and inventory. Letters of credit are usually
necessary when a company is making purchases from a foreign vendor who requires a guarantee of
payment.
 

USE OF A LOCKBOX

A typical agreement gives the asset-based lender control of the company’s incoming cash receipts from
customers. A “lockbox” or a “blocked account” is established by the lender for the receipt of collections of
the accounts receivable. The lockbox account usually is created at the bank where the borrower does
business. The company’s customers are instructed to pay their accounts by mailing remittances to the
lockbox. These payments are deposited in a special account set up by the lender. The lender credits
these funds against the loan balance. The lender then makes new advances against the “revolver” as
requested.
 
A revolver differs significantly from a term loan. As discussed, the loan balance in a revolver typically is
secured by receivables and inventory, which can fluctuate daily. With a term loan, the outstanding
balance is fixed for a period ranging from a month to several years. A term loan has an agreed-upon
repayment schedule. Generally, once an amount has been repaid in a term loan, it cannot be reborrowed.
In a revolver, however, the company can borrow, repay and reborrow as needed over the life of the loan
facility.
 
ELIGIBLE ASSETS

Not all receivables qualify for inclusion in the borrowing base. Examples of receivables that would be
ineligible are receivables that are more than 90 days old and related-party receivables.
 
Borrowing against or factoring U.S. Federal Government receivables is subject to the requirements of the
Assignment of Claims Act of 1940 (see “Other Resources”). There may also be restrictions on receivables
generated from foreign sales and receivables to companies that both buy from and sell to the borrower.
 
In general, eligible inventory includes finished goods and marketable raw materials and excludes work-in-
process and slow-moving goods. There also could be limits on the advance rate for specially
manufactured goods that can only be sold to a specific customer.
 
Advance rate.  The amount that can be borrowed is based on the advance rate set by the lender. The
advance rate is the maximum percentage of the current borrowing base that the lender can make
available to the borrower as a loan.

Example: Computation of the Advance Rate

A company has a revolving line of credit with an asset-based lender for a maximum amount of $10
million. The agreement provides for an advance rate of 85% of eligible receivables and 60% of eligible
inventory. The agreement provides that eligible receivables consist of balances that are not over 90 days
old and that eligible inventory consists only of finished goods. The accounts receivable at the end of the
period is $5.5 million with $500,000 over 90 days old. Inventory is $10 million of which $6 million is
finished goods. The borrowing base would be computed as follows:
 
a. Accounts receivable [($5,500,000 ‒ $500,000) x 85%] $   4,250,000
b. Inventory ($6,000,000 x 60%) 3,600,000
c. Total available $   7,850,000
 
Because the total available, $7,850,000, is less than the maximum line, $10 million, and assuming that
the company has borrowed the total amount available, the loan is considered to be “in formula.”
 
If in the above example eligible receivables were $8 million, the loan would be “out of formula” as follows:
 
a. Accounts receivable ($8,000,000 x 85%) $   6,800,000
b. Inventory (same as above) 3,600,000
c. Total (and amount borrowed) 10,400,000
d. Maximum line 10,000,000
e. Excess capacity above line limit $   400,000
 
A typical agreement would require that the amount overborrowed be immediately repaid to the lender.
That amount would generally be subject to a higher interest rate.
 

 
Dilution of receivables. Dilution of receivables represents the difference between the gross amount of
invoices and the cash actually collected for such invoices. Factors such as bad debt write-offs, warranty
returns, invoicing errors, trade discounts and returned goods all are involved in computing dilution.
Dilution is expressed as a percentage. Dilution is important because, as mentioned, the lender uses it to
establish the advance rate.
Example: Dilution
A company bills $1 million to its customers for invoices. Of that, $930,000 is eventually collected. The
difference is $70,000 ($20,000 represents returned goods; $5,000 is subtracted for prompt payment
discounts; and $45,000 is written off as bad debts). The rate of dilution would be 7%
($70,000 ÷ $1,000,000).

 
Credit insurance. An insurance company provides an asset-based borrower with an insurance policy
covering the receivables. It is common for asset-based lenders who are financing companies in certain
industries, for example, the retail industry, to require credit insurance. The cost of credit insurance is
relatively modest. Credit insurers may decline to insure certain customers.
 
PURCHASE ORDER FINANCING

Purchase order financing can be used by companies with limited working capital availability who receive
an unusually large order from a customer and, as a result, need additional funds to provide materials and
labor to manufacture or supply its product.
 
In this type of financing, the lender accepts the purchase order from the company’s customer as collateral
for the loan. These lenders are willing to accept the added risk that the order will be completed, delivered
and accepted by the company’s customer. While the cost is also higher than traditional asset-based
borrowing, in some circumstances—based on the profit margin for the company and maintaining or
establishing its relationship with the customer—purchase order financing may be cost-effective.
 
FACTORING
Factoring is a financial transaction whereby a company sells its accounts receivable to a third party,
the factor, at a discount to obtain cash. Factoring differs from a bank loan in three ways:
 

 The emphasis is on the value of the receivables, not the company’s creditworthiness.
 Factoring is not a loan—it is a sale of receivables.
 A bank loan involves two parties; factoring involves three parties. The three parties are the
company, the factor and the company’s customer (debtor).

 
The sale of the receivables transfers ownership of the receivables to the factor. This means that the factor
obtains all of the rights and risks associated with owning the receivables. The factor also obtains the right
to receive the payments made by the company’s customer for the invoice amount. As previously
discussed, this also occurs in asset-based borrowing. In nonrecourse factoring, the factor bears the risk of
loss if the debtor does not pay the invoice.
 
There are three principal components to the factoring transaction: the advance, the reserve and the fee.
The advance is a percentage of the invoice face value that the factor pays to the selling company upon
submission. This is similar to the advance in asset-based borrowing. The reserve is the remainder of the
total invoice amount held by the factor until the payment by the selling company’s customer (debtor) is
made. The fee is the cost associated with the transaction that is deducted from the reserve prior to its
being paid back to the seller (credit guarantee). The interest charge fee is calculated based on the
advanced amount outstanding, multiplied by the agreed-upon interest rate. The factor will often add a
surcharge for debtors who are not considered creditworthy. The factor’s overall profit is the factoring fees
and interest charges less bad debts (if the factoring is nonrecourse).
 
It is a fairly common belief that factoring is too expensive, but this is not necessarily true. It is well known
that factoring is more expensive than a bank loan. Factoring is a method used by a company to obtain
cash when the company’s cash liquidity is insufficient to meet its obligations and accommodate its other
cash needs. A company sells its invoices at a discount when it calculates that it would be better off using
the proceeds to bolster its own growth than it would be by effectively functioning as its “customer’s bank.”
Therefore, the trade-off between the return the firm earns on its investment in production and the cost of
utilizing a factor is crucial in determining the extent that factoring is used and the amount of cash the
company has on hand. In other words, whether to use factoring or traditional lending is an important
business decision. Sometimes in cases where a bank will not extend credit, a factoring company will.
 
When initially contacted by the company, the factor first establishes whether a basic condition exists: Do
the company’s customers have a history of paying their bills on time? That is, are they creditworthy? Note
that a factor may obtain credit insurance against the debtor’s becoming bankrupt and therefore not being
paid, similar to credit insurance in asset-based borrowing. In a full-service factoring arrangement, the
debtor is notified to pay the factor, who also takes responsibility for collecting payments from the debtor
and assumes the risk of the debtor’s not paying in the event the debtor becomes insolvent. This is called
nonrecourse factoring. Recourse factoring is typically less costly for the company because the company
retains the bad debt risk.
 
ACCOUNTING FOR FACTORING AGREEMENTS

When a receivable is sold to the factor without recourse, the balance sheet presentation is straightforward
—account for the receivable as a sale. When the receivable is sold with recourse  to the factor, whether or
not the receivable is accounted for as a sale or as a secured borrowing will be determined by following
the provisions of FASB Accounting Standards Codification (ASC) Section 860-10-40.
 
Typically, factors that are familiar with the provisions of U.S. GAAP will purposely structure the agreement
so that the transaction is treated as a sale rather than a secured borrowing. This is crucial if a company is
mandated by loan covenants or otherwise to meet certain ratios such as debt to equity and working
capital.
 
For a step-by-step example that applies ASC Section 860-10-40 to factoring agreements with
recourse, click here.
 
ACCOUNTING FOR LONG-TERM DEBT REVOLVERS

The classification of long-term debt revolvers is an important consideration when a classified balance
sheet is presented because asset-based lenders generally attach great importance to working capital.
Under certain circumstances, all the debt will be classified as short term or long term. Under certain
conditions, a portion of the debt will be classified as short term with the balance classified as long term.
The proper accounting presentation under U.S. GAAP depends on whether the agreement provides for a
subjective acceleration clause or a lockbox arrangement.
 
A subjective acceleration clause is a provision in a debt agreement that states that the lender has the
right to accelerate the payments of the obligation under conditions that are not objectively determinable.
For example, the agreement may provide for acceleration if the debtor fails to maintain “satisfactory
operations” or if a material “adverse change” occurs.
 
In effect, if the lender feels uncomfortable, the line can be pulled and repayment demanded. A lockbox
arrangement can exist either in an asset-based loan or in factoring. It provides that the company’s
customers must remit payments directly to the lender or factor and such amounts received are applied to
reduce the outstanding debt or the amount advanced.
 
Where there is a subjective acceleration clause and the likelihood of the acceleration of the due date is
remote (such as when the lender historically has not accelerated due dates of loans containing similar
clauses and the financial condition of the borrower is strong and its prospects are bright), neither current
classification nor disclosure is required. However, when an entity is in poor financial condition, has had
recurring losses, or has liquidity problems, debt otherwise classifiable as long term that is subject to such
covenants shall be classified as a current liability, unless the lender has formally waived accelerated
payment beyond one year. In other situations, disclosure of the existence of such clauses is sufficient
(see ASC Subtopic 470-10, Debt—Overall).
 
Borrowings under a revolving credit agreement may be classified as noncurrent if the agreement extends
for at least one year beyond the date of the financial statements, even when the borrower intends to
reduce the amount outstanding. However, under certain circumstances, debt issued under revolving
credit agreements shall be classified as current, even though the agreement runs for more than 12
months. This would be the case where there is a maximum borrowing base.
 
MAXIMUM BORROWING BASE

If the maximum borrowing is tied to a borrowing base, the entity shall make a reasonable estimate of the
lowest borrowing base during the next year. Any borrowings in excess of the amount permitted at the
estimated low point of the borrowing base shall be classified as current.

Consider the following example:

A company has $10 million of debt under a revolving line of credit that matures more than one year from
the balance sheet date. The company estimates that during the upcoming year, it will repay $2 million of
the debt. Then $2 million of the debt will be classified as current on the company’s balance sheet, and $8
million will be classified as long term. If, however, the company does not intend to repay the loan during
the 12 months after the balance sheet date because it needs to reinvest in its business, for example, if the
company’s business is growing, the company could estimate that there will be no repayments during the
current year. In that case, all of the $10 million of outstanding debt would be classified as long term.
If the agreement requires that the outstanding balance be reduced to zero at least once each year
(cleanup requirement), all of the borrowing shall be classified as current.
 
Borrowings under a revolving credit agreement that contain a subjective acceleration clause and also
require a borrower to maintain a lockbox with the lender (whereby lockbox receipts may be applied to
reduce the amount outstanding under the revolving credit agreement) are considered short-term
obligations. As a result, the debt shall be classified as a current liability.

Note that some lockbox arrangements do not go into effect unless the lender exercises a subjective
acceleration clause (a springing lockbox). Long-term borrowings under such arrangements should be
classified as noncurrent, because the customers’ remittances do not automatically reduce the debt
outstanding. This would be rare. The authors have never encountered a springing lockbox in practice.

Asset Based Financing: Advantages & Limitations

Asset based financing is a funding option that enables businesses to access either a loan or a revolving
line of credit that is secured by assets (i.e. collateral), such as inventory, equipment, receivables and so
on.

Asset Based Financing Advantages

There are several advantages of asset based financing that make it an intelligent funding solution for
many businesses. These include:

 Since funding is based on assets vs. profile (i.e. history of profitability, credit scores, etc.), it is
much faster and easier to obtain than a conventional bank loan.
 The total cost of borrowing is typically lower than other types of funding options, such as
factoring.
 Additional inventory that is acquired or generated during the life of the loan can be added to the
borrowing base, which in turn can increase the loan (or line of credit if applicable).

Asset Based Financing Limitations

As with all business funding products, there are some limitations to asset based financing that are
important to keep in mind as well. All of these pertain to loans where receivables are used as collateral
(instead of equipment, inventory, real estate, etc.):

 Lenders may periodically want to verify a sample of invoices.

 Lenders may want to scrutinize larger transactions to ensure that a borrower’s customer has the
capacity to pay in full and on time.
 Payment is often handled through a “lock box” arrangement, in which the borrower’s customers
remit payments to a designated bank account. Lenders then credit the received funds against the
loan balance.

The Real Reason Why Banks Do Not Offer Asset Based Financing
The fact is, most banks would be delighted to offer asset based funding, because it is indeed a smart and
safe option for certain businesses that have sufficient collateral, and do not qualify for conventional bank
loans (e.g. impaired or bad credit scores, less than two years of history, not cash flow positive, risky
industries or marketplaces, etc.).
However, banks must follow strict federal regulations that, among other constraints, do not allow for loans
where borrowers have relatively high debt-to-worth ratios. Since this typically characterizes most
businesses that would be interested in asset based financing, banks are on the outside looking in —
hence, their anti-asset based financing stance.

National Business Capital: Proudly Offering Asset Based Financing

At National Business Capital, we do not face these federal funding constraints, and as such we proudly
offer asset based financing to businesses across the country.
To learn more and help determine if this is the optimal funding solution for your business,  contact
our team today or fill out our 1-minute application. You’ll receive a funding decision within 24 hours!
If you’re looking for asset based financing and banks keep turning you down, you’re not alone! Check out
our eBook “How to Get Business Funding When Banks Say ‘No’” to see the reasons why banks deny
loans and the next steps to take towards securing business funding!

Chapter iv: financial management

4.5 managing debts and financial risks

 Prepared by:
Ian ceasar angeles kasilag, mba
Syrill s. cayetano, mba, lpt