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How to prepare a commercial loan request.

It is quite common for owners of small to medium-sized businesses to borrow money to purchase fixed assets. Many times these asset acquisitions are necessary because of physical or technological obsolescence. In other instances the fixed assets are purchased for expansionary purposes. If as a result of fixed asset acquisitions the business anticipates significant sales growth, borrowing for the cost of the fixed assets themselves will not be sufficient. With significant sales growth, increased cash will be "invested in" or "tied up" in accounts receivable and inventory. In addition, many times to achieve the targeted sales growth further monies will need to be spent for marketing and advertising purposes. Thus if the business owner simply borrows for the cost of the fixed assets needed, a cash shortage will arise. This cash shortage, which will occur during the sales growth period, could be very damaging to the business.

This article will attempt to provide a method, and the underlying reasoning behind the method, to quantify the total cash need associated with fixed asset acquisitions. In addition, correctly structuring a loan request, once the total cash need is determined, will be discussed.

However, prior to discussing the method to determine the total cash need associated with fixed asset acquisitions and the related loan structure, basic cash flow terminology and principles will be examined. These cash flow topics include gross funds flow (GFF), the operating cycle, permanent working capital (PWC), the matching of cash sources and uses, and standard credit terminology.

Gross Funds Flow (GFF)

Gross funds flow is the maximum cash available in any given period from normal operating activities or from "working the business", i.e. selling products and incurring all necessary cash expenses such as: cost of goods sold, selling expenses, administrative expenses, interest, taxes, etc. It is a function of two major variables: sales and the cash expenses associated with sales. The common formula given for gross funds flow is GFF= Profit After Taxes (PAT) + Depreciation (DEP)

At first glance, this formula gives the impression GFF is a function of depreciation, which it is not. Computing GFF by adding DEP to PAT is a short cut method of determining GFF, as can be seen from the following example:
 Sales 100,000
 -Cost of Goods Sold 50,000
 ___________________ _______
 -Gross Profit 50,000
 -Utility Expense 15,000
 -Salary Expense 5,000
 -Depreciation Expense 10,000
 -Interest Expense 3,000
 -Rent Expense 7,000
 _____________ ______
 -Earnings before taxes 10,000
 -Income Tax Expense 3,000
 ___________________ _____
 Profit after taxes (PAT) $7,000

1 . GFF= Sales - cash expenses associated with sales = $100,000 - $50,000 + $15,000 + $5,000 + $3,000 + $7,000 + $3,000) = $17,000

Note: Depreciation was not included in this computation

2 . GFF= PAT + DEP = $7,000 + 10,000 = $17,000. This is a shortcut method of determining GFF.

During any period through successive iterations of the operating cycle, which is discussed below, GFF is generated.

The Operating Cycle

The operating cycle, known as the cash to cash cycle in a business, is the length of time measured in days that cash is "invested in" or "tied up" in normal operating activities. These activities consist of buying, paying for and selling inventory; paying salaries; and incurring and collecting accounts receivable. Computationally, the operating cycle equals: Days Accounts Receivable (AR) + Days Inventory (INV) -Days Accounts Payable (AP) -Days Accruals (ACC) where:
 +Days AR = (AR)(360)
 +Days INV= (INV)(360)
 Cost of Goods Sold
 -Days AP (AP)(360)
 -Days ACC = (ACC)(360)
 Salaries + Payroll taxes

Each business has a unique operating cycle which will vary with sales credit terms offered, type of production processes, credit terms received when purchasing and length of payroll period. Manufacturing businesses as a group tend to have the longest operating cycles, with wholesaling businesses second, retail businesses third and service businesses fourth.

Understanding the operating cycle is a critical element in cash flow management and financing sales growth. Holding everything else constant, businesses with longer operating cycles will have more cash "tied up" or "invested in" accounts receivable and inventory on a regular basis then businesses with shorter operating cycles. Therefore, longer operating cycle businesses will have more difficulty internally funding sales growth than businesses with shorter operating cycles. The following are examples of businesses with long, medium and short operating cycles:
 1. Long Operating Cycle:
 Steel Plant
 +Days AR 60 DAYS
 +Days INV 100 DAYS
 -Days AP 30 DAYS
 -Days ACC 7 DAYS
 123 DAYS
 2. Medium Operating Cycle:
 Medical Supply House
 +Days AR 45 DAYS
 +Days INV 32 DAYS
 -Days AP 30 DAYS
 -Days ACC 7 DAYS
 40 DAYS
 3. Short (Negative) Operating Cycle:
 +Days AR 0 DAYS
 +Days INV 3 DAYS
 -Days AP 30 DAYS
 -Days ACC 14 DAYS
 41 DAYS

Permanent Working Capital (PWC)

Working capital is defined as current assets minus current liabilities and is used as a measure of liquidity. PWC is a completely different concept than working capital. PWC at any point in time equals AR + INV - AP - ACC. It represents the amount of cash invested in normal operating assets, AR and INV, minus the amount of this cash investment financed by trade creditors and employees as reflected in AP and ACC. It is called permanent because although individual accounts receivable are collected, individual items of inventory are sold and individual trade creditors and employees are paid, new accounts receivable are incurred, new inventory is purchased, and new trade and employee credit is received. Thus, as sales growth occurs there is a permanent investment in accounts receivable and inventory with partial funding from trade creditors and employees. This investment occurs "automatically" as inventory orders are processed, inventory is sold and -accounts receivable are incurred.

This investment in PWC is a first use of cash occurring before investment in net fixed assets (NFA) or payment of debt service (DS) obligations.

The particular operating cycle of a business and the business' sales volume in any given period will dictate the amount of cash that will be invested in normal operating activities of the business or the amount of PWC. As either of these two variables change, so will the amount of cash invested in PWC. A useful analogy is to compare PWC to the volume of water in a pipe where the length of the pipe is determined by the operating cycle and the width of the pipe is determined by the sales volume. If either the length or width of the pipe changes, so does the volume of water in the pipe. To complete the analogy, if either the operating cycle or the sales volume changes so does the cash invested in PWC.

The Matching of Cash Sources and Uses Principle

The essence of correctly financing assets is to match the life of the asset financed to the term of the financing. By matching in this manner, the cash flow generated by the asset purchased becomes available for debt service payments associated with the financing. This concept is known as the matching of cash sources and uses. To the extent long-term financing is not available for long-term assets purchased, including PWC, a long-term financing gap exists. As discussed later in this article, many public sector loan programs exist to plug" this gap.

Based upon this principle, short term asset needs like seasonal inventory build-ups should be financed with a short-term credit source such as a short-term installment note or a short-term line of credit. Long-term assets such as PWC or fixed assets should be financed with a long-term credit source such as long-term debt or equity. The greatest confusion in relation to this principle relates to PWC. When fixed assets are purchased and sales volume increases are expected, PWC needs will increase.

Long-term financing is necessary not only for the fixed asset increase, but also for the PWC increase. In reality, many times long-term financing for PWC is difficult to obtain. In this case, part or all of the PWC increase will need to be financed with short-term funding, particularly if no public sector loan program is available to fill the long-term financing gap. This financing of a long-term need with a short-term financing source will cause significant cash flow problems.

Basic Lending Criteria

All lenders, both in the private and public sectors, evaluate loan requests against five basic lending criteria. Lenders affiliated with different loan programs apply the criteria in varying degrees and manners. However, the criteria themselves are used as an evaluation tool for all loan programs. The five criteria are as follows: equity requirements, collateral requirements, management ability, repayment ability, and personal guarantees. In addition, certain public sector loan programs have additional criteria such as job creation, minority participation, low to moderate income requirements for borrowers, etc. Each of these five basic lending criteria will be discussed briefly.

Equity means the percentage of the business financed by the owner versus creditors. It is typically measured by the debt to equity ratio. Acceptable debt/ equity ratios vary but as a rule of thumb for private sector lenders debt to equity ratios should not exceed the following:

1 . Service businesses: 1.5.-2.0 to 1.0

2. Distribution businesses: 3.0 to 1.0

3. Manufacturing businesses: 4.0 to 1.0

Public sector loan program equity requirements are slightly more lenient. The purpose of the equity requirement is to test owner commitment to the business. A very high debt-to-equity ratio means the business is financed primarily with borrowed funds and the owners have little commitment.

Collateral is the term used for "hard" assets which "back up" the loan. Collateral is the second method of payment available to a lender. The first method of payment being cash flow generated by successive iterations of the businesses operating cycle. If the first payment method is inadequate, lenders can utilize the second method.

There are a number of different methods employed to measure the adequacy of collateral. A frequently used method is the loan-to-value ratio. Generally private sector lenders like to see the loan-to-value ratio less than or equal to 75% for real estate, less than a equal to 509o' for inventory, and less than or equal to 60% for accounts receivable depending upon the quality and concentration of the accounts receivable. A loan-to-value ratio of 75% means for each dollar of loan there is $1.33 worth of asset value, and a collateral cushion is available for the lender.

When determining the value of collateral for the loan-to-value ratio, asset values are usually their balance sheet values or depreciated purchase cost values, although appraisals, particularly for real estate, are frequently utilized. Public sector loan programs have similar but slightly more liberal collateral requirements than private sector loan programs.

Management ability is subjectively assessed by lenders based upon applicant experience, quality of the loan papers, the business owner's educational background, past business history, etc. It is easier for a lender to assess management ability in an existing business than in a start up business. For an existing business, management ability is probably the. most significant credit variable followed in order by repayment ability, collateral and equity. In a start-up business this order is usually reversed, with collateral and equity position being the most significant variables, with repayment ability next and finally management ability.

The reasoning for the reversal of these credit variables between a start-up and existing business is that in a start-up business there is no history. Without a historical record, management ability and probability of repayment are highly questionable. For these reasons start-up businesses are difficult to finance and result in lenders requiring significant equity contributions and collateral levels.

Requirement ability is typically demonstrated by cash flow projections. Most loan applications, relating to both public and private sector loan programs, require two years of monthly cash flow projections and related proforma financial statements. A critical issue with lenders when evaluating these projections is the reasonableness of the underlying assumptions. Personal guarantees are usually required of all business owners having a significant business interest regardless of the type of loan program. In most cases, a significant business interest is deemed to occur when an ownership interest is greater than or equal to 20%. In addition, many times the chief executive officer will be required to sign personal guarantees.

One additional point bears mentioning about public sector loan programs. Most of these programs are not meant to compete with private sector programs, but rather they are gap" programs. If a particular business does not completely meet the five criteria discussed above to a private sector lender's expectations, a "gap" will arise. This could be an equity gap, collateral gap, or repayment ability gap. Public sector loan programs requiring slightly less equity contribution, or level of collateral, and/or by offering longer terms or lower interest rates, allow these gaps to be plugged." If the gaps are very large, the public sector loan programs typically won't work. Most of these loan programs are used in cooperation with private sector programs and offer either loan guaranties or subordinated mortgages on existing collateral. In recent years a plethora of these types of programs have arisen at local, state and national levels. They are most easily accessed through a private sector lender and/or an economic development professional.

Procedure to Determine the Correct Project Cost and to Structure the Loan Request

The following steps are necessary to determine the correct project cost:

1. Project the operating cycle, sales volume, cost of goods sold expense, purchases and salary expense and related payroll tax expense for the next period assuming the fixed assets have been purchased. These projections need to be realistic and based upon historical trends modified for anticipated changes.

2. Determine additional cash that will be invested in PWC. To determine this amount, utilize the operating cycle formula:
+Days AR = (AR)(360)
+Days INV= (INV)(360)
 Cost of Goods Sold
-Days AP = (AP)(360)
-Days ACC= (ACC)(360)
 Salaries + Payroll taxes

With the projected operating cycle and revenue and expense estimates from step one, solve the above formula for AR, INV, AP and ACC. From these solved amounts, which represent balances in these accounts at the end of the projected period, subtract the beginning balances in AR, INV, AP and ACC. The difference represents the additional cash that will need to be invested in PWC as a result of the fixed asset acquisition and resultant projected sales increase.

3. Project any new marketing expenditures and or advertising expenditures necessary to reach the target sales volume. These amounts can be "costed out" based upon the market strategy to be utilized.

4 . Determine new fixed asset costs. This amount can be determined from vendor inquiries.

5 . Sum the amounts from steps two, three and four. This sum is the actual project cost. It takes into account not only fixed asset costs but also "seed" monies needed for marketing and advertising as well the incremental investment in PWC resulting from the projected sales growth.

Once the actual project cost is determined, the loan can be structured. To accomplish this, any new equity monies available should be subtracted from the project cost, determined in step five above. The remaining amount will be the debt financing required. Based upon the five lending criteria discussed previously and conversations with the businesses bank of account and/or public sector economic development professionals, determine the amount of debt that can be attracted to the project and the terms associated with this debt. Strong projects will attract sufficient private sector debt. The debt in more marginal projects might consist of both private and public sector components.

Once the actual project cost is determined and related financing structured with new equity and debt monies, the financing structure must be tested to see if it will "cash flow" or, in other words, if there is repayment ability. To determine this, the following steps are necessary:

1. Project the income statement for the next period through profit after taxes. The projected income statement should be based upon the projected sales level and projected operating expenses, including interest expense on the new project debt and depreciation expense associated with the acquired fixed assets.

2 Project the balance sheet for the next period from the "bottom up." In other words, first project new worth, then liabilities and finally assets, with cash being the last asset projected. The profit after taxes projected in step one should be added to the beginning net worth to determine the ending net worth. All liabilities should be projected based upon their beginning balances which should be adjusted for new debt incurred as well as principal payments which will be made during the period. AP and ACC balances were previously determined, based upon the projected operating cycle, purchases, salary expense and related payroll tax expense when the correct project cost was determined. The total amount of projected net worth and projected liabilities by definition equals the total amount of projected assets. Next, individually project the ending balance for each asset other than cash, and subtract the sum of these individual asset projections from the total amount of projected assets. Each individual asset should be projected based upon reasonable assumptions. Net fixed assets should be increased for assets purchased and reduced for depreciation occurring during the year as well as asset disposals. AR and INV were previously determined, based upon the projected operating cycle and projected sales volume and cost of goods sold expense, when the correct project cost was determined.

3. When the sum of the individual asset projections is subtracted from the total amount of projected assets, which was the result of adding projected net worth to projected liabilities, a positive or negative balance will result. This balance is a plugged" cash balance at the end of the period. If the balance is negative, the proposed financing structure does not cash flow and there is insufficient repayment ability. If the balance is slightly positive, the proposed financing structure is "thin." Even though the projected cash flow or repayment ability appears sufficient, a margin for error is necessary due to the fact that projections are at best only good estimates. A useful approximation technique to see if the deal is too "thin" is to solve for how many days of sales are represented by the cash plug. For instance, if the annual sales projection is for 500,000, then one day of sales would be the $500,000 divided by 360 or $1,389. If the cash plug amounts to $9,732, then the cash plug represents seven days of sales ($9,732 divided by $1,389). As a generalization, most structures will work if the balance in the cash plug account is greater than three to five days of sales. Anything less than this is a very thin" deal that won't cash flow even with a modest negative change in the projection assumptions.

In summary, if the proposed financing structure won't cash flow because the cash account plug" is negative or thin, i.e., the plug" in the cash account is less than three to five days of sales, the structure won't work. If the proposed financing structure doesn't work but is not too negative or thin," an

alternative is to work with the banker and/or public sector economic development professional and attempt to restructure the debt. Other possibilities involve reducing the scope of the project or increasing the equity injection or some combination of the two. If the proposed financing structure does cash flow, the business can proceed with the project because fixed asset costs, additional marketing and advertising monies as well as the required investment in PWC have been considered.

One additional point bears mentioning. Adjustment to the above testing procedure for the proposed financing structure in cases where businesses have highly seasonal sales patterns may be necessary. It is possible for the proposed financing structure to cash flow according to the above procedure and for a business to have cash flow problems for a given month or two during its peak seasonal sales period.

To prevent this problem from occurring, if a business has a highly seasonal sales pattern, then in addition to the above testing procedure for the proposed financing structure, monthly cash flow projections need to be compiled. If these monthly cash flow projections indicate that cash flow problems will develop prior to or during the peak sales season, a short-term credit line, possibly collateralized by accounts receivable and inventory, will need to be secured. Once the peak sales season is completed and the resultant cash collected, the short-term credit line can be extinguished.


When financing fixed asset acquisitions, "seed" monies for sales expansion as well as increased investments in PWC must be considered. Once consideration is given to all three financing needs and a total project cost is determined, financing needs to be structured and secured. To the extent possible the term of the financing should match the useful life of the asset purchased.

Structuring the financing can be a complicated procedure, particularly for projects where private and public sector monies are blended. After investigation of available loan options, a financing structure needs to be developed. Once developed the structure has to be tested to see if it will cash flow. If the proposed financing structure does not cash flow or has "thin" cash flow, based upon the projected income statement, projected balance sheet and related "cash plug", then debt restructuring might be a possibility. Other possibilities include reducing the project cost or increasing the equity contributed.

The procedure discussed and delineated in this article allows for a comprehensive approach to determining the actual financing needed for fixed asset acquisitions. The procedure also allows the related financing structure to be tested to determine if sufficient repayment ability exists.

Leonard Sliwoski is currently an associate professor of accounting and the director of the Small Business Development Center at Moorhead State University.

He has a PhD from the University of North Dakota, is a certified public accountant, certified managerial accountant and a certified economic development finance specialist. He also provides litigation support in the areas of loss income determination and business valuation. He was formerly a senior tax accountant with Arthur Andersen.
COPYRIGHT 1991 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Author:Sliwoski, Leonard J.
Publication:The National Public Accountant
Date:Jan 1, 1991
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