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Posted: July 13, 2010

Financing expansion in a down economy

Try these tips

Joe Schmidt

With today's economic challenges, many may think this is a bad time to expand their business. However, this could actually be an ideal time to do so if an individual has a plan, stays flexible and has a good banking partner.

Make a Plan

Before heading to the bank or exploring nontraditional financing options, individuals need to have a clear picture of what their dreams are and what reaching them will take. Although the climate may be right to diversify a business, realize that one might need more time or equity to fully reach desired goals.

Before meeting with a financial partner, individuals should take time to translate their dreams into a business plan, including:

• An overview of the business' history and plans for expansion
• Marketing strategy
• Biographies for key management
• Historical and projected cash flow
• Sources and uses of funds
• Assessment of the company's competitive advantages and weaknesses

Individuals shouldn't feel obligated to "wow" the banker with volumes of paper. Executive summaries and bullet points can be more effective. If the person is not a financial expert, their accountant can help with forecasting, and industry associations or non-competing peers can help ground the plan in reality and best practices. Regardless, individuals should ensure their plan makes sense on paper and that execution can be tracked.

Examine Cash Flow, Not Just Credit Score

Creditworthiness is measured by factors aside from the credit score. The company's historical cash flow is the best indicator of a person's ability to pay bills and manage future debt.

Evaluating cash flow gives the lender an accurate portrait of the person's ability to manage the company and its debt. While total revenue is important, bankers focus attention on gross profits and the balance between fixed and variable operating expenses. Fixed expenses are those bills one must pay, such as mortgage and utilities, while variable expenses are those that can be managed or even reduced to help fund an expansion. Armed with this information, a banking partner can better assess a company's debt tolerance.

Maximize Ability to Adapt

From the banking perspective, there is more a polarization than a dramatic deterioration in the overall financial condition of the small business community. Strong small businesses are getting stronger, and the ones that were marginal are becoming weaker. The difference lies in the financial health of the company's balance sheet and management's skill and ability to adapt to change.

Being flexible allows a person to be proactive in dealing with opportunities and threats. As a small business owner, one should constantly evaluate business practices. A great best practice is to review in detail total expenses incurred over a one-year period. Look at each line item and determine if the cost is essential or nonessential, variable or fixed. Determine whether each expense is incurred in conjunction with a sale or if it's a bill that must be paid regardless of the amount of revenue the company generates.

Loan payments are a fixed expense, while inventory purchases and commissions are variable, because they are tied to sales. Essential expenses are those critical to conducting business (e.g., wages), while nonessential costs are generally discretionary, such as bonuses. Quickly adapting to change requires the ability to place more of the overhead and expenses in variable versus fixed categories. Business owners can view nonessential expenses as a method to minimize tax consequences.

Once an owner has landed in a variable environment, they are much better positioned to take on expansion or rapid growth. It can open the business to newfound cash flow that can help launch a new product line or grow a market share, because the owner is no longer dedicating 50 to 90 percent of his or her cash flow to fixed expenses independent of sales.

Play the Market to the Business' Advantage

In this economic climate, banks are eager to help established small businesses expand. In fact, this could be an opportunity to re-evaluate a business to see where one can diversify, and even grow, services or market.

As one looks toward expansion and finding the capital to fund it, the key is keeping an eye on the balance of debt versus equity. While debt allows a person to leverage a company's balance sheet, it has to be repaid. A good tool for measuring the amount of debt one wishes to take on is to determine how long they want the return on that asset to be working for the bank versus themselves. Equity, on the other hand, isn't repaid, leaving all excess cash flow to either strengthen the balance sheet for additional growth or to be distributed to shareholders.

When considering financing options that include outside investors, remember that while sharing the risk, one also will be sharing the profits. A good small business bank will want to be a partner. That partnership includes a level of risk to both parties. Recognize that the bank is receiving a finite return on its investment through the interest paid. Therefore, unlike investors, a bank is not in a position to take on significant risk to gain significant returns.

Ideally, one wants a mix between debt and equity that encourages growth and maximizes long-term profits. Startups are typically funded mostly by equity because they don't have historical financial performance to evaluate cash flow, and because they have limited collateral to leverage. On the other hand, existing small businesses can draw on steady cash flow to fund their expansion off the strength of their current financial condition. Of course, a banking partner can help find the right recipe for each situation.

Choose a Banking Partner Carefully

Consider that banks travel along the same economic road as individuals. Some are better able than others to handle challenges in a struggling economy. Those that are not diversified or who have overly-focused on short-term gains are finding it necessary to make adjustments to their practices that may not be favorable to some people's goals.

But there are others who can serve as models for how to weather the economic uncertainty. And, finding the right banking partner is the critical path to expansion. A banker should be a key adviser and a model for one's business-helping the owner diversify, evaluating opportunities, devising a strategy to find the right mix between debt and equity and exploring ways to be proactive.
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Joe Schmidt is a senior vice president for UMB's Investment and Wealth Management division in Denver. Joe may be contacted via email at joseph.schmidt@umb.com.

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