Finance inventory with retained earnings, or credit line

Mark,

Yes...but. The "but" is that, as an S-corp, you tend to operate a little differently. Your retained earnings are retained by the S-corp owners. When times are tough, it is incumbent upon them to mortgage their houses, etc and loan the company money. That's a little bit simplistic and harsh, but generally it is the way it works as you don't retain earnings. So long as the owners are clear on the issues, you've done your fiduciary job of ensuring that they *can* prepare for the risks.

Note, I see this quite a bit; a working capital line becoming the effective capitalization tool for S-corps. You are quite right that it is risky. The other sane alternative, having the owners dump in a bunch of cash (paid-in-capital), can be functional and less expensive/risky than the bank option, but it can require a lot of capital. That creates additional personal risk *and* means they can't put their personal wealth into boats and such. It seems in this case that the owners either can't do enough APIC or want the personal flexibility. Again, not uncommon.

Downside risk management is also an option. What does the bank line say? Is it secured by the inventory? The company? Personal guarantees? What happens if they pull the line? Do you just flush out the inventory, pay it off, and start asking for prepayment, or will it kill the company?

So, yes. Fear it, as it is a risk (a very real one). Come up with alternatives. Get the owners on the same page, then cross your fingers.

Cheers,

Keith

Would the bank, or other investors, consider a fixed-term loan, secured by the inventory? Or a guaranteed line? This would eliminate the fear of the bank pulling the line. And of course the interest payments are tax deductible. Or maybe have the customers pay a deposit, especially if the products are customized.

A quick note from the lender side - having a bank lend on inventory is golden. If you realized how difficult it is to borrow on inventory you would treasure the relationship. Having said that, conventional banking is on a full court press to lend to creditworthy small businesses. Knowing that someone like yourself is involved in the operations only makes the small business more valuable to the bank - that risk mitigation is even on the business owner's radar.

Unless there are wild fluctuations in their revenue and a significant negative drop off in their borrowing base, it's unlikely the line would get pulled.

But all small businesses should regularly reach out to business bankers and establish a rapport with different institutions, while keeping a keen eye on the health of their existing lender.

Gary is point-on.

After a couple of decades in the service sector, I moved to the manufacturing side. In a down economy, I've been surprised to see how eager and willing banks are to lend against inventory and AR. Of course, good margins, managed collections, and net profits help. But we have banks soliciting without knowing much about our business.

It also pays to research, review, prepare a RFP, and be willing to switch banks. The results can be very worthwhile.

You have received some good advice from the commenters so far.

Simply - do not be afraid of debt. Be aware of its terms and the profitability of the business. Using debt wisely is a great way to grow and manage a business.

Other than the income tax shareholders must pay on their share of S-corporation earnings, whether distributed or not, I’m not familiar with a tax on retained earnings. In fact, earnings that are not distributed to shareholders increase the basis of their stock, which reduces the amount of taxable gain upon sale of the stock. The decision to finance working capital with debt or equity is not simple and will be dependent upon various factors, such as the company’s ability to obtain debt at reasonable costs/terms, the shareholders’ appetite for debt, the shareholders’ desire or need for cash for personal use or outside investments, etc.

Don't be afraid of debt. With rates as low as they are right now, managing a line of credit to fund inventory purchases and receivables is somewhat easier.

Some factors that seem obvious to me, but may not feel obvious, include your inventory turns, vendor terms and actual time required to collect on your receivables. Funding of these sources and uses of cash should be part of an overall strategy focused on matching your collections with your outgoing payments as closely as possible. That is sometimes easier said than done, but there are steps that can be taken to bring those two points closer together (the point of deposit from a customer and the point of payment to a vendor).

With regard to servicing debt, devoting payments from customers to debt first would be a strong first priority and you, as the CFO need to make sure the owners of the company understand and agree to your strategy for managing a line of credit. I keep our cash balances as low as possible whenever we are actually using our line of credit. Those balances do me no good when they are sitting in a bank account.

As recommended above, you need to carefully read the covenants in the debt agreements. Typically they will require financial statements, including your current A/R aging, rest periods on the line and that you keep your primary accounts with the bank. These should be easy issues to manage, but are also easy to let lapse.

Once you decide to go with a debt option, your relationship with the bank is just as important as your relationship with your largest customers. Your business banker can smooth the path for renewals and fee waivers, but you have to do what you can to make his job easier as well. He/she wants a profitable account that follows the rules and doesn't create drama. Communication is critical and can not be understated as a factor.

In my experience, numerous manufacturing companies in different countries, a few non-profits as well, long-term loans have expiry dates, and payment schedules, short-term loans (lines of credit) are forever. I have never been with a company that is offside in its covenants and that, indeed, is the risk. But if the relationship with the bank is a good one and it is clear that the bank is there to support the business by funding the working capital, and they are kept informed in a timely fashion, there is little need to fear on a micro level. Pressure sometimes comes when the credit climate is such that the bank needs to pinch at certain points.

Even if one gets comfort from a stable bank relationship, there is still risk. If the bank should 'go under', or sell itself to another to shore things up, there may still be a situation where the loan is called. To mitigate this, it might be prudent to establish relationships with 3 or 4 institutions, in the event the current bank pulls out you'll be in a better position to secure a new source of funds without too much delay.

Diversification is still one of the best risk mitigation strategies.