When I started my CFO and controllership practice in 2001, I was in for a rude awakening in the world of small business finance. In larger-sized businesses, we have the capital structure nailed down, which includes debt financing.
But in the small business world, here’s what I quickly learned when I started working with CEOs:
- Small business owners view their bankers as investors
- Small business owners expect their bankers to be investors
- Small business owners expect their bankers to take care of their cash flow deficiencies regardless of the circumstances
- Small business owners expect unconditional love from their bankers at all times
And what I found more surprising years ago was that these same bankers only did a so-so job in educating CEOs on debt management.
Accordingly, I will reveal the four biggest banking mistakes I have observed my clients making during my CFO consulting career.
Banking Mistake #1 – Improper Use of the Line of Credit
This has to be the biggest problem I see with small business owners. When I take on a new client, I review the balance sheets over a trailing 48- to 60-month period. The typical pattern I see is a flatline LOC over the course of any year.
I do not know who coined the term yo-yo notes for LOCs, but the metaphor is appropriate. As cash is positive, the line should be paid down. And vice versa as cash starts to go negative. Ideally, your bank should have this process automated, but this automated treasury management feature is sometimes lacking in smaller community banks.
Looking back on my Free Agent CFO™ career, there are two primary reasons the LOC stays flat over an extended period of time. Ignorance. And that’s not meant to be critical. Many bookkeepers and the CEOs they serve are not aware they should be paying down the line when cash is positive.
Laziness is another reason LOCs are not managed daily or weekly. “It’s too much of a hassle.” I’ve heard this from far too many small business accountants and bookkeepers.
Case in point. Several years ago, I was working with a small specialty contractor. They generally maintained a flatline LOC. In my first month on the job, I noticed one week they were sitting on $400,000 in cash. I asked the bookkeeper to pay down the LOC immediately. Her boss agreed.
Do you think it happened? No. A week later, she had a large payroll deposit due. She said it was too much trouble to pay down the line and draw it back a few business days later.
Let’s do some simple math. Let’s assume an average LOC balance of $1 million over the course of the year at 3.25%. And let us assume the LOC is never touched (a little unrealistic, but bear with me). That’s $32,500 in rent paid to your banker for short-term financing. Let’s say we pay down the LOC regularly; the average LOC balance is only $500,000. The interest paid now is only $16,250 over the course of the year. Needless to say, this difference is significant.
But some business owners might say their balances are not that high and the constant movement is not worth it. There’s another reason we want to manage our line regularly–enhanced credibility with the banker.
When the banker reviews your line periodically and sees the movement in regular intervals, trust me, he or she will be impressed. In the banker’s mind, this shows you are a financially intelligent CEO, at least in banking matters.
When it comes time to renew your LOC and request new debt for capital purchases, they will remember your attention to managing an LOC.
Your LOC is a short-term tool for financing short-term cash flow gaps. Your LOC is not term debt. Nail down a process for paying or drawing on your LOC. I’ve created such a system, and if executed properly, the daily treasury management process can be performed in less than 15 minutes per day.
Banking Mistake #2 – Mismatching Debt with the Assets to be Funded
This is somewhat related to the first mistake. Many times in the past, I’ve heard a CEO say he can use the excess capacity to acquire a new piece of equipment. Please don’t do that. Lines of credit are for financing short-term working capital requirements like receivables and inventory. Use term debt for capital assets.
By matching debt with assets, cash is less likely to be squeezed. For example, inventory is converted to receivables, and receivables are ultimately paid. Reductions in working capital allow the credit line to be paid down. Conversely, cash generated from business profits is used for term debt payments (which should have already been planned beforehand).
Small businesses typically misuse their LOC when collateral is tight and the debt-to-equity ratio is already alarmingly high. In these cases, the banker may not desire to extend additional funds. Using the line to fund these longer-term assets is a symptom of a bigger problem. Poor cash flow management, weak executive leadership, and declining sales are contributing factors.
Banking Mistake #3 – Lack of Transparency with the Banker
My top clients allow me to do something extremely important– share our detailed financial reporting package with the banker and meet with them monthly to review the numbers. This exercise is something I look forward to doing every single month. I never skip a month if we have a bad month, quarter, or even year.
In every case, I have not ever encountered problems renewing existing lines or asking for more money for capital expenditures. Why is that? Because this approach leads to more trust between the banker and my clients, even if we have off years. I cannot begin to tell you how much bankers appreciate these monthly meetings. When I ask them how often they do this with other client CFOs, they always answer, “Rarely ever.”
Several years ago, I worked with a large vineyard and winery owner on the west coast. The debt level was high. Cash was tight about nine months out of the year. The internal financial reporting was a train wreck. Even though the company was audited, the banker received little in the way of assurances throughout the year because the reporting he received was hard to read.
Well, that didn’t last for long once I jumped on board. I visited with him within three months to review our lengthy but meaningful reporting package. The numbers were not pretty, but the banker was thrilled because I provided him peace of mind about our current condition each month. He was so happy that he wanted to introduce me to his other ag-related customer base.
As I have described it, the opposite of bank transparency is fear and insecurity. If that’s the case, you have to get over it. Sure, easier said than done. But in the long term, this is a great strategy and one that will bridge the bond between the banker and CEO.
Banking Mistake #4 – Getting Frustrated with the Lender Because They Do Not Like You
Peculiar? I see this periodically and recently had to walk away from a business because they were too frustrated with the banker’s opinion instead of listening to their constructive criticism.
If a banker does not like you, it’s typically not personal. It’s because the business is probably mismanaged. Or there is not much to manage (in terms of sales). Sales could be declining. Margins could be shrinking. AR could be going down the tube. Owner distributions are out of line. You get the idea.
If the banker is uncomfortable with you and your numbers, there is a reason. Don’t criticize the banker. Instead, criticize the strategies that got you into your mess and start finding a way to turn the business around. And you will need help. Seek it out.
I’m Throwing in a Bonus Banking Mistake – Too Much Start-Up Debt
As a rule, I do not work with start-ups. I’m really expensive because I’m extremely effective in what I do. Start-ups are unproven and have little to no cash, and the founders have to play the role of CFO themselves.
Yet, these same start-ups will go out and borrow to the max to launch their start-ups. Their bankers allow it because personal collateral may look decent, and the marketing plan looks somewhat doable (I’ve yet to see a great marketing plan from any start-up, the first document I study hard when mentoring start-up owners).
Just because you can doesn’t mean you should. That’s the message from Carol Roth in her book The Entrepreneur Equation, which could easily be the forward to The E-Myth Revisited.
Borrowing to fund a start-up is seductive and alluring and even reaps a little with an obsession once the decision has been made to borrow. The honeymoon starts once the money is in the bank. It ends when the first bank payment is made. A divorce is in the making when the perfect marketing plan on paper is not so perfect after all.
In no way am I saying start-up debt is bad. I am just against poor decision-making. Many start-up owners I have mentored (mentored usually means free in this context) have not one iota of financial intelligence in their brains. Harsh? Not really, because these same start-up owners typically have emotional intelligence that’s off the charts, along with great social skills. The lack of financial intelligence knocks them off track, and sometimes disastrously.
I’ve Never Had a Bank Loan Go Bad on My Watch
And there’s a good reason. I never fall into the traps listed above. And that’s why the bankers I meet with monthly or quarterly enjoy working with me. They trust me because I share everything. The good. The bad. The ugly. Yes, the ugly. You see, my clients are generally confident and do not lack self-esteem in their numbers. No insecurities.
We get it right on using the LOC correctly. We manage it. We are not a slave to the LOC. The LOC obeys us.
We match our debt with our assets. Yes, that’s fundamental, but the LOC is for working capital, and that’s how we use it. We use term debt as it’s meant to be used.
Transparency? That’s why most of my client base allows me to meet with their bankers monthly. Do you think we ever have issues when it’s time to renew the LOC? Not at all, and chalk up one less headache for the owner/CEO.
Where are you with your relationship with your banker? And bankers, what percentage of your customers are getting it right? Or are they committing these blunders?
Two Other Potential Banking Mistakes
Do you email financials to your banks? Do you pay bank fees on new business loans? If yes to one or two of these questions, you will enjoy reading these brief essays: