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Buttressing the balance sheet.

For Sudbury area business owners, the sudden and unexpected downturn in the mining sector brought on by recent labour disputes underscores the importance of maintaining strong working captital positions in good times. These disputes have left several Sudbury mining contractors over-extended and unable to borrow sufficient working capital to weather the drop in demand for their services.

The good news is that these companies are typically well-managed and competitive and will emerge stronger than ever, once demand strengthens.

The lesson from this unfortunate situation is clear: a principal financial management objective today should be to improve liquidity to protect against unforeseen demand shifts, which in today's changing economy can happen overnight. That means building cash reserves, maintaining strong operating lines and reducing liabilities on balance sheets.

Owners with healthy businesses can protect their firms against unexpected drops in revenues and position themselves to take full advantage when opportunities, such as the right strategic acquisition, comes along.

The classic methods of enhancing working capital are, of course, paring back inventories, shortening terms on receivables and delaying or moderating plans for expansion or new equipment purchases.

Less well known, perhaps, is that companies with strong cash flows can also improve liquidity by structuring debt on a long-term, non-demand basis, in the form of term loans or subordinated debt.

Unlike short-term "demand" loans, these instruments strengthen working capital because only the current portion (the amount owing during the current fiscal year) shows up on the balance sheet as a current liability.

One of the key advantages of subordinated debt is that, in most cases, bankers will treat the remaining portion of sub-debt as equity when calculating debt/equity ratios.

A company with strong cash flow can improve liquidity by: Arranging term or subordinated loans for any fixed assest originally purchased using an operating line of credi, maximizing long-term debt by borrowing against other existing fixed assets and adding to cash reserves and replacing short-term, "on-demand" loans with long-term, not-on-demand loans.

The benefits of a strong working capital position are numerous. Banks look favourably on companies with good liquidity and, in some cases, may even offer lower interest rates. Also, if a business that structures long-term debt to improve working capital does get hit with a drop in revenues, it is in a much better position to negotiate new demand loans or arrange alternative forms of short-term financing.

Term and sub-debt loans are business loans, not asset loans. Cash flow, market position and quality of management are the key criteria. As a result, a decline in cash flow makes it more difficult to qualify.

The experience of an Ottawa-area printing company illustrates the point. This company almost went out of business in the 1990-91 recession because it had just completed a large expansion when its market collapsed. Fortunately, the company's owner was able to pare back his organization, negotiate deferred principle payments with its term lender and ride out the recession.

In 1995, at the height of the recovery, the company acquired two multi-minion dollar presses using lease financing. This time, however, the owner also opted to use long-term financing to protect his working capital position and arranged a $2 million equity investment to maintain his cash reserves. A down-turn did not occur, the company hit its growth targets, and the owner paid off his investor over five years.

Another option this owner could have explored was the use of subordinated debt to strengthen his working capital. The important point here is that this owner used the strength of his firm's cash flow to attract long term financing as a hedge against an unforeseen decline.

Some companies may question the wisdom of taking on more long-term debt to build cash reserves. After all, long-term debt puts additional pressure on cash flow.. The important things to bear in mind are that no one ever went out of business because they had too much liquidity, and the winners in the changing economy will be businesses with the cash to capitalize on opportunities and weather demand shifts.

Norman Meunier is assistant vice president of RoyNat Capital at Sudbury's, a specialist lender to SMEs.
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Publication:Northern Ontario Business
Geographic Code:1CANA
Date:Apr 1, 2001
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