As businesses approach the fourth quarter, there has been a sharp, partial economic recovery from the pandemic, the future has become a bit clearer (but still very uncertain), and various stabilization programs have run their course. So, now is a good time to assess where your business is from a financial perspective, particularly with respect to your balance sheet and capital structure.
At first blush, you may think that if your business has survived, there is little to worry about: “I took out a PPP loan that will be forgiven, I have paid everything else and I have cash in the bank.”
All good news — for now.
Remember, there is no more coming from the PPP and when sales decline, typically, at the start, cash generation increases as purchases decline but receivables from higher, prior sales levels are collected. But now, collections are at the new, lower level. Or sales are going back up, which requires cash for higher payroll and vendor purchases, coupled with the additional time it will now take before cash from this added sales volume is collected.
The point is, while things may look good at this point in time (and especially if they don’t), it’s important to consider the potential impact on your business as the ground continues to shift over the next several months.
First, take a look at your customers, suppliers and employees.
What financial shape are your customers in? Has your customer concentration increased, both as a percentage of revenue and of accounts receivable? What indications do you have of future demand? Are some paying slower or not at all? Consider customer-specific credit insurance if your accounts receivable have become dominated by a handful of customers or for particular customers with their own financial issues.
What is happening with suppliers? Can you get what you need when needed? Are supply problems constraining your ability to sell or has your business increased inventory levels to compensate for the greater uncertainty? Take a look at where they are located. For example, a client of mine imports a commodity from Africa. Pandemic disruptions are likely to continue there longer than here. So, my client has increased inventory levels.
What is the status of your staff? Many industries — particularly manufacturing — are having problems getting enough employees. The reasons vary, but common ones include individual and family health, the need for one parent to stay home, fear of the virus and, until recently, high unemployment compensation. What has all of that done to your costs and your ability to sell?
Next, put all of this together and develop a set of projections.
Develop different scenarios. These should take into account flat or decreased sales, as well as sales recovery along the lines I suggested, here. Sales can increase because customer demand picks up, or because capacity constraints from supply or employee shortages dissipate. Make sure to schedule the time, stay out of the weeds, look externally, and apply common sense with these projections.
Evaluate the income statement for reasonability. Do profit margins make sense? Look at gross margins and EBITDA margins. It is easy to be too optimistic. For example, in the infamous buy-out of Nabisco in the ‘80s, KKR assumed gross margins would increase… forever! Still, is there an opportunity to raise prices (maybe temporarily) to pass on any added costs? If the industry capacity is reduced and prices increase, do customers really have an option?
Review the balance sheet and cash flow. Will the business need to carry higher inventory levels? Do you expect customers to take longer to pay and so forth? If you have deferred payments on loans, payroll taxes, leases and payables, factor in repaying those advances. Look at DSO and inventory turns and check if they make sense. Spend time thinking through assumptions on inventory levels, DSO, and costs.
Now, consider your capital structure. Is it workable?
Make sure the fixed charge ratio is 1.25 or better. If not, the fixed charges will have to be reduced. The usual levers to do that are extending the terms of term loans and also leases, and increasing the amount borrowed on an interest only basis, typically done with a credit line or asset-based revolver.
Interest only credit lines are not a cure all, however. Typically, lenders tie that to a percentage of accounts receivable and inventory. If you have a loan agreement that does just that, will your lender want to decrease your credit line, or perhaps increase it?
Project all ratios that are covenants in existing loan agreements. Will there be future defaults? This can be a tip-off as to whether your lender will want your company to remain as a customer. For now, that lender may make modifications, but sooner rather than later, if continued losses are projected, many lenders will either be unwilling to do the length of term your company needs or force your business to borrow elsewhere.
Another way to lower the fixed charge ratio is to replace loans and their required payments with equity or what is called “mezzanine debt.” Equity doesn’t come with a monthly payment and mezzanine debt often has a low, periodic payment, but comes with interest that is payable on the sale or refinancing of the company and/or with some form of equity rights upon the sale. New funding sources can be brought in or existing lenders (rarely banks) can convert some or all of their loan to equity in the business.
Overall, remember that this exercise is about preparing for an unknown future. Some scenarios may call for debt converting to equity, while others may call for a bigger credit line to cover revenue increases.
Start preparing now. The pandemic has provided a pause with lenders and other creditors.
In short, be prepared for when the problem is you.