Funding Working Capital Challenges Amidst a Changed Banking System
Robert L. Turner, III’s thirty years experience across the entire building materials industry supply chain as a lender, distributor, manufacturer, and construction services executive forms the basis of his unique perspective on the industry’s challenge to fund working capital required for the inevitable market recovery.
This article begins by recognizing realities of the “new economy,” outlines a comprehensive program of steps to help fund growth working capital. This back-to-the basic focus on internal cash generation solutions to better position any firm as a funding candidate is followed by an in-depth look at new funding options in the market.
Florida’s building materials businesses enjoyed robust growth during a decade of economic expansion, which peaked in the first quarter of 2006. Quarterly national GDP growth, housing starts, and the US banking system decelerated faster than a roller coaster in 2007 and 2009, and Florida was no exception. Managers who engineered survival strategies should be given MVP awards. Instead, their reward is a new challenge to fund growth working capital to finance the long awaited industry recovery.
A glance in the economic rear view mirror provides a shocking recognition of the realities of the “New Normal” economy. Businesses may be in the hot seat, rather than the driver’s seat, in financing growth needs. Success starts with focus on what you can control, with a mindset shift toward internally generated cash to reduce outside funding needs, thereby positioning a firm as a candidate for funding, and seeking innovative new funding to align needs to solutions. In this case, adversity breeds innovation.
Economy of the Future: “New Normal”
Some 437 banks have failed since 2007, including 61 in Florida. Total failures include 306 in 2009-2010, 92 in 2011, and 11 in the first quarter of 2012. The FDIC placed 844 of the remaining 7,436 banks on a watch list near the end of 2011. Trepp LLC’s 2012 Banking Sector Outlook categorizes 218 banks as representing a high risk of failure. Reuter’s March 14, 2012 article, “Credit Crunch an Unusual Ally in U.S. Lumber Rally”, indicated distributors are having trouble buying lumber in the tight stocks environment, and they can’t get capital from banks so they are buying futures. This is continued evidence of the lingering bank credit crunch of recent years.
ProSales Magazine’s August 2011 “Accounts Receivable & Banking Survey” included responses from 191 building materials industry firms, with 63% of these having sales less than $25,000,000 annually. A high percentage of these firms use a single local bank for financing. Small local banks were among the hardest hit with failure rates. This presents issues for future funding.
The Chicago Tribune June 12, 2010 article, “Sluggish Economy Feels Like New Normal”, suggests economic sickness beginning in the financial system lingers in the economy a long time. This creates a long sluggish period with high government debt, slow economic growth of 2 to 2.5%, and sticky unemployment. This lasts so long it begins to feel “normal.”
These factors, and unemployment, drive housing starts, which create demand for building materials. Starts peaked at seasonally adjusted 2,273,000 in January 2006, and hit the trough of 478,000 in April 2009. This is a peak to trough decline of 79% and the worst activity level since 1959. Starts were around 610,000 in 2011 and are projected to be 678,000 in 2012. Putting this in perspective, starts did not drop below 1,000,000 any year between 1960 and 2007!
The US recession technically lasted eighteen months, from December 2007 through June 2009. However, housing and building products lagged throughout the economic recovery. Building products faces the “Great Hangover.” What comes next? The welcome but painful need to finance working capital for growth. Given the lingering pain within the banking industry, fresh funding approaches are mandatory.
Building Products: Preparing for the Roller Coaster’s “Third Turn”
The industry’s wild roller coaster decelerated at “Turn 1” in the third quarter of 2008 with financial market turmoil, GDP growth plummeting from to -6% from 5.1% in first quarter 2006, and a business failure epidemic; “Turn 2” began in 2009 as housing starts plummeted 79% from the January 2006 peak, and it continues as firms hold on for survival pending economic recovery
The long awaited “Turn 3” is showing recovery signs of the market turning upward. “Turn 3” presents a new challenge, one of funding growth driven by long-term housing demographics. Banking’s loss driven aversion to housing driven businesses is a challenge. If housing starts double from around 610,000 in 2011 to 1,220,000 within a few years, which is possible, the industry’s working capital needs will also double.
Executives face daily sales, operations, employee, and financial challenges. Cash is the “fuel” required to operate a business. Without it, the business stops.
Six Steps Approach to Funding Working Capital and Taking Control of Your Destiny
Step One: Shift Mindset to Prioritize Financial Concepts
There are no silver bullets. There is no substitute for a disciplined effort to execute a few basic concepts.
How, and where, should companies focus on financial priorities? The simple “I.D.&A.” approach. What is this? Inside the company; Down the financial statements; and Across the order-to-cash cycle. This results in both operational and financial discipline, production, and profitability.
Focusing “inside the company” generates cash before relying on loans. Concentrate on what you control. This is a no regret approach. Companies will either generate more cash, or become a better candidate for subsequent financing alternatives.
Step Two: Look Down the Balance Sheet for the Greatest Cash Opportunities.
Think of the 80/20 rules. Which 20% of balance sheet items provide 80% of the cash generation opportunity? Receivables, inventory, and payables are obvious liquidity targets.
Step Three: Look Down the Income Statement for Profit Margin or Cost Improvements.
Opportunities to improve profit margins and/or reduce operating expenses, albeit even by small percentages, produce significant benefits.
Step Four: Use the Statement of Cash Flows to Understand Working Capital Requirements.
Cash, not net income, is king! This important, grossly underutilized, tool reconciles net income to net cash.
Step Five: Look Across the Order-to-Cash Cycle to Tighten Costly Process Gaps.
CFO Magazine’s “Working Capital Scorecard” (June 2011) benchmarks working capital across many industries by using a “Days Working Capital,” or “DWC” measure. DWC is comprised of days sales outstanding in accounts receivable (DSO), plus days of inventory on hand (DIO), less outstanding accounts payable (DPO). (Note: Many firms use cost of goods sold in lieu of sales for both inventory and payables calculations).
Figure 1 below illustrates the working capital intensive nature of building products businesses, and distributors:
What does fifty-three Days of Working Capital Outstanding, or “DWC” mean? Example: A “building materials” business with $60,000,000 annual sales, divided by 360 days, generates $167,000 in sales daily. A 1-day improvement in DWC is worth $167,000 in working capital. The fifty-three DWC days multiplied by $167,000 equals $7,651,000 in net working capital funding.
Most businesses suffer from process linkages and inefficiencies across the order-to-cash cycle, such as billing delays, which add working capital needs in addition to the DWC calculation above.
Accounts receivable is a large, critical working capital improvement lever. Why? Receivables are the “closest to cash” asset, and they can account for up to 40% of assets and half of the net working capital investment. Waiting thirty-five to forty-five days for payment is problematic enough, but there is also the risk of non-payment loss.
Inventories are equally important. Both receivables and inventory must serve as a solid collateral base for working capital loans. Poorly managed receivables and inventories are not attractive to funding sources.
Step Six: Seek New Funding Options Available in the Market.
Success with steps one through five positions any business as a stronger candidate for the traditional, or new funding solutions. Why? Internally generated cash results in a “cleaner house” with more efficiently managed working capital assets and quality lender collateral.
Financing sources prefer to fund growth of a well-run company, rather than funding the clean up of old problems. In a market with more aversion to risk, tight underwriting standards, and limited funding, firms with well-managed working capital assets will have more success with financing.
Working Capital Funding Alternatives:
Business owners have many options. Each alternative is designed to meet different needs, and each has both pro and con tradeoffs. Below is an overview.
Types of Traditional Working Capital Funding:
oBank Line of Credit (“LOC”)
This has been common for established businesses with strong credit, quality assets, and solid cash flow. Small businesses are challenged to secure this type of funding in today’s banking environment.
oAsset Based Loan (“ABL”)
ABL loans may be a fit for highly seasonal businesses with detailed historical financials, and significant assets, which may be tightly monitored. Lenders today are concerned about valuation of collateral.
This works if the owner is willing and able to invest significant personal assets in the business, and/or take on new partners. However, it is often the most expensive type of financing.
oFactoring of Receivables or Purchase Orders
Factoring can be an expensive funding option, albeit with advantages for early stage or high growth businesses with quality accounts receivables or purchase orders.
oEquity Investors and/or Sale of Your Business:
Many private equity investors are warming up to investing in building materials related firms. “Building Products Manufacturers—A Mitigated Strategy to Invest in the Distressed Real Estate Market”, a March 15, 2012 article by Don Walker of John Burns Real Estate Consulting, is encouraging. He indicates an investment in building materials manufacturing allows one to bet on the recovery without the complexity of investing directly in distressed real estate.
“M&A: 2011 Review & Look Ahead”, by BMO Harris Bank’s Engineering & Construction Group, sees a large buy side demand in the market. FMI’s Porter Wiley, Managing Director of the Building Products Practice, reports seeing lots of demand on the buy and sell side. Both sources, along with others indicate the challenge is multiples not being in line with historical averages due to depressed EBITDA. An improving housing market should alleviate this to enable more M&A activity in 2012-2013.
Emerging, New Types of Funding—Economic Adversity Breeds’ Innovation:
“Entrepreneurs Turn to Alternative Finance,” BusinessWeek.com’s September 1, 2009 article, indicated asset-based lenders, factors and others are filling the void created by banks tightening lending standards. Below are a few examples in the market today.
Focus on accounts receivable first is paramount. Why? Business trade credit in the US is 1.5 times larger than the commercial bank loan market—Credit Research Foundation, 2009. For building products firms, accounts receivable is one of the largest, controllable, and the closest to cash asset.
oProfessional Collection/Receivables Management
Firms like Chicago based Brown & Joseph, Ltd. combine the latest credit intelligence technology with professional resources typically unavailable to smaller firms. Businesses are utilizing outsourcing type solutions to more effectively manage accounts receivable collections and reduce overhead expense.
oSale of Old or Written Off Receivables
All firms have sustained uncollectible accounts receivable accounts resulting in charge-offs to bad debts. Brown & Joseph, Ltd. offers a program to evaluate these old receivables free of charge, and pursue collection of same based on pure contingency fees. This can be “found cash.”
oBusiness Line of Credit (“Business LOC”)
Atlanta based AdvancedAR offers a business line of credit alternative to direct bank financing, by combining professional accounts receivable management with fast access to financing at very attractive rates. By improving your receivables processes to reduce DSO and bad debt, accounts receivable serves as collateral for the line of credit.
oM&A Liquidity Options
Many business owners have survived the recession and desire exit options. Atlanta based M&A Marketplace by CHC is an innovative concept to connect owner/sellers with pre-screened buyers via a seller friendly auction without the cost and complexity of the investment banking/broker process.
ExpoCredit Corporation, based in Miami, is partnering with Banco Sabadell to provide a program which helps business cost effectively extend trade payables to suppliers. This is an opportunity for a business to extend trade credit financing, while enabling the supplier to obtain faster payment.
oTrade Finance, Purchase Order Financing, and SBA Backed Loans
Hana Financial, based in Los Angeles, provides an array of working capital financing alternatives. This firm handles financing for all sizes of clients with options ranging from factoring of receivables, to complex purchase order financing, and SBA loans.
oSupply Chain Financing
Konnecta, Inc., based in Atlanta, has developed a very innovative program with HSBC Bank. This approach combines a rich technology platform, trade credit expertise, and financing pre-qualification to cost effectively facilitate trade credit financing for both suppliers and customers. With pre-arranged banking support and electronic visibility across the supply chain, trade payables or receivables may be extended or accelerated.
Summary—Funding Working Capital in the New Economy—Six Clear Steps
Florida’s businesses suffered mightily during the longest and deepest recession since World War II. No industries have been hammered than homebuilding, building materials, and banking. All are related.
The “new normal” business recovery will include an economy with slower growth and a forever changed banking climate. This warrants new approaches, and now is the time to start. As summarized below in Figure 2, this article combines a back to the basics approach by focusing first on internally generated cash. This better positions a company as a stronger candidate for financing.
Many new types of non-banking funding and cash generation solutions have evolved to meet today’s conditions. Private equity and merger and acquisition activity is improving. Savvy investors understand housing cycles. This will generate positive interest in, and options for building materials firms.
Preparing for the Rebound of Florida’s Building Materials Industry – Funding Working Capital by Robert Turner III, Management Services & Associates, LLC www.msallcsite.com