THE REALITY TODAY is that a major percentage of new businesses fail in the first three years of operation. Most of them fail, not because of a poor concept, but because of poor financial planning. A creditor's decision is influenced largely by the perceived risk. Most creditors will assess the capital investment or owner's equity position in proportion to the debt financing. This is generally stated in a ratio known as debt-to-worth or debt-to-equity, and is referred to as leverage. 

There is no standard ratio, but too little leverage can limit growth and return on investment. Too much debt can put a strain on cash flow, limit future debt availability and reduce profitability. Funding can be categorized as short-term debt, long-term debt and owner's equity. Each has an important role. 

The first form of funding is owner's equity, or capital provided by the owner(s). At first, most small businesses are forced to finance their start-up with personal savings and credit secured by personal assets. The availability of this form of capital can be extremely prohibitive to a manufacturing business that must buy raw material, carry inventory and accounts receivable, meet payrolls and utilize expensive equipment. As the operation matures the owners must assess the return that that they receive on their investment. 

Often, that return can be increased by taking advantage of various forms of debt. While leveraging to improve your ROI is a topic unto itself, some debt can be advantageous. Short-term debt is debt that must be repaid within the current, 12-month period. One source of short-term debt is your suppliers. This can be either the least expensive or the most costly form of financing you get. If you automatically receive terms from your suppliers, you have a revolving source of funds at no cost. On the other hand, if you don't take advantage of early payment discounts, your cost escalates dramatically. By forgoing that 2% discount offered for payment within 30 days, you have effectively borrowed money at an annual rate of 24%. 

To take advantage of such short-term savings and to hedge against short-term cash fluctuations, maintain an operating line of credit. This is generally hedged against accounts receivable and inventory, which tend to be the normal source of cash fluctuations. Remember that this form of debt is granted on a demand basis and can be revoked or reduced at any time. 

One common mistake is to depend on short-term debt to fund long-term expenditures. Typically, production equipment can take three to five years to pay for itself. It makes sense to plan funding that mirrors that time frame 

Long-term debt is debt that will be repaid over a period in excess of 12 months. This type of funding is essential for major capital acquisitions such as production equipment, real estate and capital investments that generate long-term paybacks. This type of debt must be planned carefully. Before structuring the optimum funding solution for new equipment, you must determine the options available as well as the variables that can affect the decision. 

The normal alternatives would be to pay cash, term finance or lease. Paying cash is usually only cost-effective if there is an excess of cash available, limited investment opportunities or the cost of debt financing is excessive. These are seldom factors for growing businesses. Let's look at the last two options. The decision to borrow or lease can be split into two categories: policy-sensitive and cost-effective. 

Policy-sensitive factors are the issues that are not directly driven by cost. Most such issues result from restrictions on either debt or ownership. For example, a key creditor often will negotiate a limit on the amount of debt that can be taken on. Or perhaps a board of directors has put a freeze on capital expenditures. In both cases, the acquisition of equipment would require a lease that avoids ownership and eliminates the debt from your balance sheet. Some companies set a policy that all capital assets are to be leased. In other firms, a policy may be to disallow ownership of equipment that has a high probability of obsolescence, such as computers. 

A common practice for large organizations is to rent or lease equipment for the duration of current contracts or projects. This also provides a hedge against obsolete or unnecessary assets. Another common practice is to use leasing to provide lower monthly installments, as in car leasing. By assuming a higher resale value on a vehicle at the end of the lease term, lower payments are required for the duration of the lease. This logic can be applied to other types of equipment if the anticipated level of depreciation is low. 

Buckley Owens Machinery Corp. 6416 Fly Road | East Syracuse, New York 13057 Telephone 315.432.0708 Fax 315.432.0736 Email: info@buckleyowens.com