1.2 Understanding the Business

Module Objectives

I. Identify the steps of a business’s operating cycle

II. Identify the relationship between a business’s financing needs and its operating cycle

III. Identify the relationship between a business’s financing needs and its capital investment cycle

IV. Identify the impact of supplier terms on a borrower’s financing need

V. Identify the differences between manufacturers, wholesalers, retailers, and service companies

VI. Recognize the likely length of a business’s operating cycle based on the type of business it is

VII. Identify the growth stage of a business

VIII. Identify the level of risk inherent in the different growth stages of a business

Overview/Key Points

• The Decision Strategy approach balances risk and opportunities

• A business’s growth state is likely to influence the amount of credit risk a business presents

• Businesses in the concept creation, development, young operating, and declining stages are likely to present more risk than businesses in the middle-aged operating and mature operating stages

Preliminary Analysis

1. Preliminary assessment

• What is the specific opportunity?

• Is the opportunity legal and within your institution’s policy?

• Are the terms logically related?

• Do the risk appear to be acceptable?

2. Identify borrowing cause

• What caused the need to borrow?

• How long will the borrowed funds be needed?

Activities in the business cycle

• Making sales

• Purchasing equipment

• Paying workers

• Buying supplies

• Buying and storing raw materials

• Adding value in the manufacturing process

• Collecting cash from custom,mers

• Developing new products

• Earning a profit

The Asset Conversion Cycle

• Lenders must understand the cycles of a business to identify loan opportunities and reach conclusions about borrowing cause, repayment sources, the degree of risk, and opportunities for noncredit services

• The business cycle is also known as the asset conversion cycle, which includes the activities that make up the business

• The business cycle activities are divided into those that are part of the operating cycle, and then those that are part of the capital investment cycle

• Every business has an asset conversion cycle, which is when cash is converted to assets and then back to cash

The Operating Cycle

• This cycle begins and ends with cash

• Compromised of the collection period and the holding period (when goods are being prepared for sell, and then the collection period begins)

• Once cash is collected, one operating cycle is complete

• IF the company generated more cash at the need of the operating cycle than it used to complete the cycle, it has made a profit

  

The Capital Investment Cycle

• The capital investment cycle supports the operating cycle

• This includes purchasing production equipment to support the operating cycle and recovering the cost of that equipment over several operating cycle from the profits used to make that asset

The Holding Period

• The time between buying goods/raw materials and selling those goods for a finished product

The Collection Period

• The time between selling a product and collecting cash from customers

The Payment Period (Not part of the operating cycle)

• This is the time between the purchase of goods or raw materials for sale, and paying suppliers for those good or raw materials

• Knowing the length of the payment period is essential for determining financing need(s)

• The payment period is usually shorter than the operating cycle (which is what creates a payment financing issue)

• Cash flow timing differences occur when cash goes out before it comes in-like when a company must pay suppliers for inventory before it collects cash from the sale of that inventory to its customer

• The funding gap due to the cash flow timing difference creates a financing need

  

Operating Cycle Financing Needs

• The cash flow timing difference is the gap between its operating cycle (holding period - collection period) and payment period (the financing provided by suppliers)

• Unless a company has significant cash resource, it will need to borrow to help cover the cash flow timing different

• The repayment source for these loans is usually the future cash collected from the sale of goods

How can companies reduce their cash flow timing differences?

Reducing the holding period

• Purchase raw materials later int eh year as needed

• Produce inventory over a short period

• Add a product line that would be popular in what is their off-season

Reducing the collection period

• Offer a discount for early payment

• Reduce the payment terms offered to customers to collect cash more quickly

• Increase collection activities to encourage payment

Increasing the payment period

• Negotiate more favorable payment terms with suppliers

• Finding new suppliers that offer extended terms

Capital Investment Cycle Financing needs

• The capital investment cycle also creates financing needs for most companies

• It is unlikely that a growing company would be able to finance the purchase of large, fixed asset from the profits of a single operation cycle

• Companies often finance such large purchases using long-term loans

• The loans are repaid with cash flow from profitable operations over multiple operating cycles

Overview of Business Types

• Businesses are grouped by their operating cycles, capital investment cycles, and borrowing needs

Business types from longest operating cycles to shortest (and length of capital investment cycle in parenthesis)

• Manufacturers (Long; continuing need for fixed assets)

• Wholesalers/Distributors (Varies depending on type)

• Retailers (Periodic need for fixed assets)

• Hybrids of manufacturing, retail, and service (Periodic need for fixed assets)

• Capital-intensive service (Large amount of fixed assets needed)

• Labor-intensive service (few fixed assets needed)

Product Distribution Chain

• As a lender, it’s important to understand how your borrower fits into the distribution chain

• Product businesses are linked together in a chain that begins with raw materials and ends with the sale of the product to the end user

• The finished product of one manufacturer may become the raw materials for another

• The manufacturer may sell directly to the retailer without the need for a distributors

Manufacturing

• These businesses tend to have a longer operating cycle than most other businesses, as well as longer cash flow timing differences

• More likely to need periodic long-term loans to fund the acquisition of fixed assets to replace, upgrade, or expand production capacity

• They purchase raw materials (on credit), produce their products, and hold the products in inventory until they are sold

• Most sales are on credit, creating a longer collection period

• The capital investment cycle is a large part of a manufacturer’s business

• They must purchase the equipment (fixed-assets) needed to process the raw materials and recoup their investment over a period of years

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Wholesales/Distribution

• Wholesalers and distributors need loans to finance seasonal increases in inventory and receivables

• They also need capital investment cycle loans for items such as trucks, warehouses, and inventory systems and related equipment

• Their inventory consists of finished goods

• Sell to other business rather than an end users

• Nearly all sales are on credit

• Use warehouses, trucks, forklifts, shelving, and conveyor systems

Retail

• Sell directly to the public

• Likely to borrow for seasonal buildups of inventory, but have fewer or no accounts receivable

• Mush make sufficient sales in time to repay suppliers

• Long-term financing is generally is not needed, unless expanding or buying real estate

Service-Capital-intensive

• Rely heavily on fixed assets to operate, like an air-charter service

• These businesses need long-term financing, but also short-term financing if the business sells on credit terms

Service-Labor-Intensive

• Businesses that rely heavily on labor-whether skilled or unskilled, such as a nail salon

• They have short operating cycles and have few credit needs

• May be seasonal in nature and need to borrow to cover operating expenses during the collection period

Professionals

• Highly-educated service-providers who have received specialized education, training, and a degree, such as medicine, law, accounting, architecture, or engineering

Hybrids

• Restaurants are a hybrid of manufacturing and service

• The operating cycle of these business may be very short

• A warehouse that sells to both individuals and manufactures is a hybrid

Business Growth Stages

• As a business gets older, it has different issues and needs

• Some business life cycle stages simply aren’t bankable (concept and declining)

Concept Creation

• High-risk as this is just an idea in the drawing board stage

Development

• High-risk as this business has no income, no saleable product, and few assets

• Venture capital firms or small business programs can help at this stage

Young Operating

• This is the period between when the business begins to generate sales and the point when the business has established a consistent record of profitability

• It is difficult to raise capital for a new venture

• Risk and failure rates are very high due to less that adequate financial backing

• If recent sales increased and have generated accounts receivable and inventory, specialty lenders may help finance a business at greater cost than traditional financing

• Risks include undercapitalization, low margins, powerful suppliers that set terms, strong customers that may delay payment, rapid sales growth

Middle-Aged Operating

• Sales growth continues to be rapid, but more consistent

• Profit margins are usually higher than in earlier years

• The business often stats to diversify by introducing new products

• Less administrative overhead is required as products are added

• Moderate to low-risk

Mature Operating

• A mature operating business is well-established and often it has grown with its market

• Sales are stable

• Profit margins are strong buy may begin to decline as competition increases

• Most major cash needs can be met with the profit generated by the business

• A mature business generally manages its working capital fairly well

Declining

• Some businesses grow to maturity and remain at the state indefinitely

• They introduce new products or enter new markets, thus regenerating their own life cycles

• No longer has the capital to invest in new products or new markets

• Has to sell assets or liquidate

• High risk borrower

Campisi Brothers Case Study

• Their line of credit is up for renewal in May

• They got their insurance settlement from the plant fire

• They want to expand both their facilities and their product line