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5 Working
Capital Finance

W ith a good foundation in how businesses are financed and how to

interpret their financial statements, we are prepared to address
specialized financing issues for enterprises. This chapter focuses on financing
a firm’s working capital needs while Chapter 6 discusses the financing of
longer term fixed assets. To address working capital finance, the chapter
begins by discussing the different definitions of working capital, and explain-
ing its importance to a business, both for long-term operations and for man-
aging the short-term cash flow cycle. In the next section, the different debt
instruments used to finance working capital are described. Following the
discussion of debt instruments, the most common working capital finance
sources are reviewed. Firms face many working capital finance options, both
in the debt instrument used and institutional sources. The development
finance professional’s job is to first understand the firm’s financing needs
and capacity and then to help it locate and structure appropriate working
capital debt. To help develop these skills, the underwriting issues involved in
structuring working capital debt are reviewed and a case study assignment,
Crystal Clear Window Company, is provided to apply this knowledge to a
specific and realistic working capital financing situation.

____________ The Importance of Working Capital Finance

Three Meanings of Working Capital

The term working capital has several meanings in business and economic
development finance. In accounting and financial statement analysis, work-
ing capital is defined as the firm’s short-term or current assets and current
liabilities. Net working capital represents the excess of current assets over
current liabilities and is an indicator of the firm’s ability to meet its short-
term financial obligations (Brealey & Myers, 2002). From a financing

91
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92 THE BASICS OF BUSINESS FINANCE

perspective, working capital refers to the firm’s investment in two types of

assets. In one instance, working capital means a business’s investment in
short-term assets needed to operate over a normal business cycle. This mean-
ing corresponds to the required investment in cash, accounts receivable,
inventory, and other items listed as current assets on the firm’s balance sheet.
In this context, working capital financing concerns how a firm finances
its current assets. A second broader meaning of working capital is the com-
pany’s overall nonfixed asset investments. Businesses often need to finance
activities that do not involve assets measured on the balance sheet. For
example, a firm may need funds to redesign its products or formulate a new
marketing strategy, activities that require funds to hire personnel rather than
acquiring accounting assets. When the returns for these “soft costs” invest-
ments are not immediate but rather are reaped over time through increased
sales or profits, then the company needs to finance them. Thus, working cap-
ital can represent a broader view of a firm’s capital needs that includes both
current assets and other nonfixed asset investments related to its operations.
In this chapter, we use this last meaning of working capital and focus on the
tools and issues involved in financing these business investments.

Business Uses of Working Capital

Just as working capital has several meanings, firms use it in many
ways. Most fundamentally, working capital investment is the lifeblood of
a company. Without it, a firm cannot stay in business. Thus, the first, and
most critical, use of working capital is providing the ongoing investment
in short-term assets that a company needs to operate. A business requires
a minimum cash balance to meet basic day-to-day expenses and to provide
a reserve for unexpected costs. It also needs working capital for prepaid
business costs, such as licenses, insurance policies, or security deposits.
Furthermore, all businesses invest in some amount of inventory, from a law
firm’s stock of office supplies to the large inventories needed by retail and
wholesale enterprises. Without some amount of working capital finance,
businesses could not open and operate. A second purpose of working capi-
tal is addressing seasonal or cyclical financing needs. Here, working capital
finance supports the buildup of short-term assets needed to generate rev-
enue, but which come before the receipt of cash. For example, a toy manu-
facturer must produce and ship its products for the holiday shopping season
several months before it receives cash payment from stores. Since most busi-
nesses do not receive prepayment for goods and services, they need to
finance these purchase, production, sales, and collection costs prior to
receiving payment from customers. Figure 5.1 illustrates this short-term
cash flow and financing cycle. Another way to view this function of work-
ing capital is providing liquidity. Adequate and appropriate working capi-
tal financing ensures that a firm has sufficient cash flow to pay its bills as it
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Working Capital Finance 93

AR
converted CASH
to cash

COLLECT
SALES
ACCOUNTS
ORDER
RECEIVABLE

Cash
converted to
prepaid
expenses and
DELIVER PRODUCE
inventory
GOODS OR GOODS OR
SERVICES SERVICES

Goods or Services
converted to
Accounts Receivable

Figure 5.1 Cash Flow and the Working Capital Cycle

awaits the full collection of revenue. When working capital is not suffi-
ciently or appropriately financed, a firm can run out of cash and face bank-
ruptcy. A profitable firm with competitive goods or services can still be
forced into bankruptcy if it has not adequately financed its working capital
needs and runs out of cash. Working capital is also needed to sustain a
firm’s growth. As a business grows, it needs larger investments in inventory,
accounts receivable, personnel, and other items to realize increased sales.
New facilities and equipment are not the only assets required for growth;
firms also must finance the working capital needed to support sales growth.
A final use of working capital is to undertake activities to improve business
operations and remain competitive, such as product development, ongoing
product and process improvements, and cultivating new markets. With
firms facing heightened competition, these improvements often need to be
integrated into operations on a continuous basis. Consequently, they are
more likely to be incurred as small repeated costs than as large infrequent
investments. This is especially true for small firms that cannot afford the
cost and risks of large fixed investments in research and development
projects or new facilities. Ongoing investments in product and process
improvement and market expansion, therefore, often must be addressed
through working capital financing.
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94 THE BASICS OF BUSINESS FINANCE

Permanent and Cyclical Working Capital

Firms need both a long-term (or permanent) investment in working
capital and a short-term or cyclical one. The permanent working capital
investment provides an ongoing positive net working capital position, that is,
a level of current assets that exceeds current liabilities. This allows the firm to
operate with a comfortable financial margin since short-term assets exceed
short-term obligations and minimizes the risk of being unable to pay its
employees, vendors, lenders, or the government (for taxes). To have positive
net working capital, a company must finance part of its working capital on a
long-term basis. Since total assets equal total liabilities and owner’s equity,
when current assets exceed current liabilities, this excess is financed by the
long-term debt or equities (Brealey & Myers, 2002). Figure 5.2 demonstrates
this point graphically. For current assets (area CA) to be greater than current
liability (area CL), long-term debt and equity must finance part of area CA.
Beyond this permanent working capital investment, firms need seasonal or
cyclical working capital. Few firms have steady sales and production through-
out the year. Since the demand for goods and services varies over the course
of a year, firms need to finance both inventories and other costs to prepare
for their peak sales period and accounts receivable until cash is collected.
Cyclical working capital is best financed by short-term debt since the seasonal
buildup of assets to address seasonal demand will be reduced and converted
to cash to repay borrowed funds within a short predictable period. By match-
ing the term of liabilities to the term of the underlying assets, short-term
financing helps a firm manage inflation and other financial risks. Short-term
financing is also preferable since it is usually easier to obtain and priced lower
than long-term debt.
Working capital financing is a key financing need and challenge for small
firms. As discussed in Chapter 2, small businesses have less access to long-
term sources of capital than large businesses, including limited access to
equity capital markets and fewer sources of long-term debt. Thus, many
small firms are heavily dependent on short-term debt, much of which is tied
to working capital.1 However, limited equity and reliance on short-term debt
increases the demand on a firm’s cash flow, reduces liquidity, and increases
financial leverage—all of which heighten the financial risks of extending
credit. Consequently, small firms may have trouble raising short-term debt
while at the same time facing obstacles to securing the longer-term debt
necessary to improve their financial position and liquidity, and lessen their
credit risk. Development finance has an important role in addressing this
problem, either by offering working capital loans when private loans are
not available or by providing debt terms that reduce a firm’s financial risk
and help it access private working capital financing. In particular, practi-
tioners can help businesses finance permanent working capital to reduce
their short-term financial pressures.
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Working Capital Finance 95

Assets Liabilities and Owners’ Equity

Current Assets Current

(CA) Liabilities
(CL)

Long-term
Liabilities
Long-term and Owners’
Assets Equity

Share of
current assets
financed with
long-term
capital

Figure 5.2 Positive Net Working Capital Requires Long-Term Financing

___________________ Forms of Working Capital Financing

Working capital financing comes in many forms, each of which has unique
terms and offers certain advantages and disadvantages to the borrower. This
section introduces the five major forms of debt used to finance working cap-
ital and discusses the relative advantages of each one.2 The purpose of this
information is to provide insight into the different ways in which debt can
be structured and prepare practitioners to choose and structure a debt tool
best suited to a firm’s financial situation and needs. Table 5.1 summarizes
the major features of the five working debt tools described below.

Line of Credit
A line of credit is an open-ended loan with a borrowing limit that the
business can draw against or repay at any time during the loan period. This
arrangement allows a company flexibility to borrow funds when the need
arises for the exact amount required. Interest is paid only on the amount
borrowed, typically on a monthly basis. A line of credit can be either
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96 THE BASICS OF BUSINESS FINANCE

Table 5.1 Summary of Working Capital Finance Instruments

Finance Instrument Description Key Terms

Line of Credit Maximum loan limit established. Can be unsecured or secured. Annual
Firm draws on loan as needed up repayment.
to limit. Compensating balance may be
required.
Accounts Loan secured by accounts Loan amount based on a percentage
Receivable (AR) receivable. of accounts receivable. Accounts
Loan receivable assigned to lender as
sales occur. Loan balance paid
down with AR collection.
Factoring Sale of accounts receivable to a third Company paid based on average
party collector (factor). Factor collection period less a collection
bears collection risk. fee. Collection amount can be
advanced with an interest charge.
Inventory Loan Loan secured by inventory. Loan amount based on a percentage
of inventory value. Lender receives
security interest in inventory and
may take physical control. Release
of inventory with loan repayment.
Term Loan Medium-term loan. Principal repaid Loan amount tied to collateral value.
over several years based on a fixed Can be fully amortized or a
schedule. balloon loan. Typical term is three
to seven years.

unsecured, if no specific collateral is pledged for repayment, or secured by

specific assets such as accounts receivable or inventory. The standard term
for a line of credit is 1 year with renewal subject to the lender’s annual
review and approval. Since a line of credit is designed to address cyclical
working capital needs and not to finance long-term assets, lenders usually
require full repayment of the line of credit during the annual loan period
and prior to its renewal. This repayment is sometimes referred to as the
annual cleanup.
Two other costs, beyond interest payments, are associated with borrow-
ing through a line of credit. Lenders require a fee for providing the line of
credit, based on the line’s credit limit, which is paid whether or not the firm
uses the line. This fee, usually in the range of 25 to 100 basis points, covers
the bank’s costs for underwriting and setting up the loan account in the
event that a firm does not use the line and the bank earns no interest income.
A second cost is the requirement for a borrower to maintain a compensating
balance account with the bank. Under this arrangement, a borrower must
have a deposit account with a minimum balance equal to a percentage of
the line of credit, perhaps 10% to 20%. If a firm normally maintains this
balance in its cash accounts, then no additional costs are imposed by this
requirement. However, when a firm must increase its bank deposits to meet
the compensating balance requirement, then it is incurring an additional
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Working Capital Finance 97

cost. In effect, the compensating balance reduces the business’s net loan
proceeds and increases its effective interest rate. Consider a line of credit for
$1 million at a 10% interest rate with a 20% compensating balance require-
ment. When the company fully draws on the line of credit, it will have
borrowed $1 million but must leave $200,000 on deposit with the lender,
resulting in net loan proceeds of $800,000. However, it pays interest on the
full $1 million drawn. Thus, the effective annual interest rate is 12.5% rather
than 10% (one year’s interest is $100,000 or 12.5% of the $800,000 in net
proceeds). Like most loans, the lending terms for a line of credit include
financial covenants or minimal financial standards that the borrower must
meet. Typical financial covenants include a minimum current ratio, a mini-
mum net worth, and a maximum debt-to-equity ratio.
The advantages of a line of credit are twofold. First, it allows a company
to minimize the principal borrowed and the resulting interest payments.
Second, it is simpler to establish and entails fewer transaction and legal costs,
particularly when it is unsecured. The disadvantages of a line of credit
include the potential for higher borrowing costs when a large compensating
balance is required and its limitation to financing cyclical working capital
needs. With full repayment required each year and annual extensions subject
to lender approval, a line of credit cannot finance medium-term or long-term
working capital investments.

Accounts Receivable Financing

Some businesses lack the credit quality to borrow on an unsecured basis
and must instead pledge collateral to obtain a loan. Loans secured by
accounts receivable are a common form of debt used to finance working cap-
ital. Under accounts receivable debt, the maximum loan amount is tied to a
percentage of the borrower’s accounts receivable. When accounts receivable
increase, the allowable loan principal also rises. However, the firm must use
customer payments on these receivables to reduce the loan balance. The
borrowing ratio depends on the credit quality of the firm’s customers and the
age of the accounts receivable. A firm with financially strong customers
should be able to obtain a loan equal to 80% of its accounts receivable. With
weaker credit customers, the loan may be limited to 50% to 60% of accounts
receivable. Additionally, a lender may exclude receivables beyond a certain
age (e.g., 60 or 90 days) in the base used to calculate the loan limit. Older
receivables are considered indicative of a customer with financial problems
and less likely to pay.3 Since accounts receivable are pledged as collateral,
when a firm does not repay the loan, the lender will collect the receivables
directly from the customer and apply it to loan payments. The bank receives
a copy of all invoices along with an assignment that gives it the legal right to
collect payment and apply it to the loan. In some accounts receivable loans,
customers make payments directly to a bank-controlled account (a lock box).
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98 THE BASICS OF BUSINESS FINANCE

Firms gain several benefits with accounts receivable financing. With the
loan limit tied to total accounts receivable, borrowing capacity grows auto-
matically as sales grow. This automatic matching of credit increases to sales
growth provides a ready means to finance expanded sales, which is espe-
cially valuable to fast-growing firms. It also provides a good borrowing
alternative for businesses without the financial strength to obtain an unse-
cured line of credit. Accounts receivable financing allows small businesses
with creditworthy customers to use the stronger credit of their customers to
help borrow funds. One disadvantage of accounts receivable financing is the
higher costs associated with managing the collateral, for which lenders may
charge a higher interest rate or fees. Since accounts receivable financing
requires pledging collateral, it limits a firm’s ability to use this collateral for
any other borrowing. This may be a concern if accounts receivable are the
firm’s primary asset.

Factoring
Factoring entails the sale of accounts receivable to another firm, called the
factor, who then collects payment from the customer. Through factoring, a
business can shift the costs of collection and the risk of nonpayment to a
third party. In a factoring arrangement, a company and the factor work out
a credit limit and average collection period for each customer. As the com-
pany makes new sales to a customer, it provides an invoice to the factor. The
customer pays the factor directly, and the factor then pays the company
based on the agreed upon average collection period, less a slight discount
that covers the factor’s collection costs and credit risk (Brealey & Myers,
2002). In addition to absorbing collection risk, a factor may advance pay-
ment for a large share of the invoice, typically 70% to 80%, providing the
company with immediate cash flow from sales. In this case, the factor
charges an interest rate on this advance and then deducts the advance
amount from its final payment to the firm when an invoice is collected
(Owen et al., 1986; Brealey & Myers, 2002).
Factoring has several advantages for a firm over straight accounts receiv-
able financing. First, it saves the cost of establishing and administering its
own collection system. Second, a factor can often collect accounts receivable
at a lower cost than a small business, due to economies of scale, and trans-
fer some of these savings to the company. Third, factoring is a form of col-
lection insurance that provides an enterprise with more predictable cash flow
from sales. On the other hand, factoring costs may be higher than a direct
loan, especially when the firm’s customers have poor credit that lead the
factor to charge a high fee. Furthermore, once the collection function shifts
to a third party, the business loses control over this part of the customer
relationship, which may affect overall customer relations, especially when
the factor’s collection practices differ from those of the company.
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Working Capital Finance 99

Inventory Financing
As with accounts receivable loans, inventory financing is a secured loan,
in this case with inventory as collateral. However, inventory financing is
more difficult to secure since inventory is riskier collateral than accounts
receivable. Some inventory becomes obsolete and loses value quickly, and
other types of inventory, like partially manufactured goods, have little or no
resale value. Firms with an inventory of standardized goods with predictable
prices, such as automobiles or appliances, will be more successful at secur-
ing inventory financing than businesses with a large amount of work in
process or highly seasonal or perishable goods. Loan amounts also vary with
the quality of the inventory pledged as collateral, usually ranging from 50%
to 80%. For most businesses, inventory loans yield loan proceeds at a lower
share of pledged assets than accounts receivable financing. When inventory
is a large share of a firm’s current assets, however, inventory financing is a
critical option to finance working capital.
Lenders need to control the inventory pledged as collateral to ensure that
it is not sold before their loan is repaid. Two primary methods are used
to obtain this control: (1) warehouse storage; and (2) direct assignment by
product serial or identification numbers.4 Under one warehouse arrange-
ment, pledged inventory is stored in a public warehouse and controlled
by an independent party (the warehouse operator). A warehouse receipt is
issued when the inventory is stored, and the goods are released only upon
the instructions of the receipt-holder. When the inventory is pledged, the
lender has control of the receipt and can prevent release of the goods until
the loan is repaid. Since public warehouse storage is inconvenient for firms
that need on-site access to their inventory, an alternative arrangement,
known as a field warehouse, can be established. Here, an independent pub-
lic warehouse company assumes control over the pledged inventory at the
firm’s site. In effect, the firm leases space to the warehouse operator rather
than transferring goods to an off-site location. As with a public warehouse,
the lender controls the warehouse receipt and will not release the inventory
until the loan is repaid. Direct assignment by serial number is a simpler
method to control inventory used for manufactured goods that are tagged
with a unique serial number. The lender receives an assignment or trust
receipt for the pledged inventory that lists all serial numbers for the collat-
eral. The company houses and controls its inventory and can arrange for
product sales. However, a release of the assignment or return of the trust
receipt is required before the collateral is delivered and ownership trans-
ferred to the buyer. This release occurs with partial or full loan repayment.
While inventory financing involves higher transaction and administrative
costs than other loan instruments, it is an important financing tool for com-
panies with large inventory assets. When a company has limited accounts
receivable and lacks the financial position to obtain a line of credit, inven-
tory financing may be the only available type of working capital debt.
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100 THE BASICS OF BUSINESS FINANCE

Moreover, this form of financing can be cost effective when inventory

quality is high and yields a good loan-to-value ratio and interest rate.

Term Loan
While the four prior debt instruments address cyclical working capital
needs, term loans can finance medium-term noncyclical working capital. A
term loan is a form of medium-term debt in which principal is repaid over
several years, typically in 3 to 7 years. Since lenders prefer not to bear inter-
est rate risk, term loans usually have a floating interest rate set between the
prime rate and prime plus 300 basis points, depending on the borrower’s
credit risk. Sometimes, a bank will agree to an interest rate cap or fixed rate
loan, but it usually charges a fee or higher interest rate for these features.
Term loans have a fixed repayment schedule that can take several forms.
Level principal payments over the loan term are most common. In this case,
the company pays the same principal amount each month plus interest on
the outstanding loan balance. A second option is a level loan payment in
which the total payment amount is the same every month but the share allo-
cated to interest and principle varies with each payment. Finally, some term
loans are partially amortizing and have a balloon payment at maturity. Term
loans can be either unsecured or secured; a business with a strong balance
sheet and a good profit and cash flow history might obtain an unsecured
term loan, but many small firms will be required to pledge assets. Moreover,
since loan repayment extends over several years, lenders include financial
covenants in their loan agreements to guard against deterioration in the
firm’s financial position over the loan term. Typical financial covenants
include minimum net worth, minimum net working capital (or current ratio),
and maximum debt-to-equity ratios. Finally, lenders often require the bor-
rower to maintain a compensating balance account equal to 10% to 20% of
the loan amount. (Brealey & Myers, 2002; Owen et al., 1986)
The major advantage of term loans is their ability to fund long-term
working capital needs. As discussed at the beginning of the chapter, busi-
nesses benefit from having a comfortable positive net working capital mar-
gin, which lowers the pressure to meet all short-term obligations and reduces
bankruptcy risk. Term loans provide the medium-term financing to invest in
the cash, accounts receivable, and inventory balances needed to create excess
working capital. They also are well suited to finance the expanded working
capital needed for sales growth. Furthermore, a term loan is repaid over sev-
eral years, which reduces the cash flow needed to service the debt. However,
the benefits of longer term financing do not come without costs, most
notably higher interest rates and less financial flexibility. Since a longer
repayment period poses more risk to lenders, term loans carry a higher inter-
est rate than short-term loans.5 When provided with a floating interest rate,
term loans expose firms to greater interest rate risk since the chances of a
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Working Capital Finance 101

spike in interest rates increase for a longer repayment period. Due to

restrictive covenants and collateral requirements, a term loan imposes
considerable financial constraints on a business. Moreover, these financial
constraints are in place for several years and cannot be quickly reversed, as
with a 1-year line of credit. Despite these costs, term loans can be of great
value to small firms, providing a way to supplement their limited supply of
equity and long-term debt with medium-term capital.

________ Sources of Working Capital for Small Businesses

Commercial banks are the largest financing source for external business
debt (Berger & Udell, 1998), including working capital loans, and they
offer a large range of debt products. With banking consolidation, commer-
cial banks are multistate institutions that increasingly focus on lending
to small business with large borrowing needs that pose limited risks.
Consequently, alternate sources of working capital debt become more
important. Savings banks and thrift lenders are increasingly providing small
business loans, and, in some regions, they are important small business and
commercial real estate lenders.6 Although savings banks offer fewer prod-
ucts and may be less familiar with unconventional economic development
loans, they are more likely to provide smaller loans and more personalized
service. Commercial finance companies are important working capital
lenders since, as nonregulated financial institutions, they can make higher-
risk loans. Some finance companies specialize in serving specific industries,
which allows them to better assess risk and creditworthiness, and extend
loans that more general lenders would not make. Another approach used
by finance companies is asset-based lending in which a lender carefully eval-
uates and lends against asset collateral value, placing less emphasis on the
firm’s overall balance sheet and financial ratios. An asset-based lending
approach can improve loan availability and terms for small firms with good
quality assets but weaker overall credit. Commercial finance companies
also are more likely to offer factoring than banks. Trade credit extended by
vendors is a fourth alternative for small firms. While trade credit does not
finance permanent or long-term working capital, it helps address short-term
borrowing needs. Extending payment periods and increasing credit limits
with major suppliers is a fast and cost-effective way to finance some work-
ing capital needs that can be part of a firm’s overall plan to manage seasonal
borrowing needs.
Other working capital finance options exist beyond these three conven-
tional credit sources. First, loan guarantees provided through the U.S. Small
Business Administration (SBA) 7(a) program can help early-stage small
firms, and those with weaker credit and collateral, secure loans. Under its
7(a) authority, the SBA offers the Green Line Program, a specialized loan
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102 THE BASICS OF BUSINESS FINANCE

guarantee for line-of-credit financing. The SBA 7(a) program is discussed in

greater detail in Chapter 8. Business development corporations (BDCs) are
a second alternative source for working capital loans. BDCs are high-risk
lending arms of the banking industry that exist in almost every state. They
borrow funds from a large base of member banks and specialize in providing
subordinate debt and lending to higher-risk businesses. While BDCs rely
heavily on bank loan officers for referrals, economic development prac-
titioners need to understand their debt products and build good working
relationships with their staffs. Venture capital firms also finance working
capital, especially permanent working capital to support rapid growth.
While venture capitalists typically provide equity financing, some also
provide debt capital. A growing set of mezzanine funds,7 often managed by
venture capitalists, supply medium-term subordinate debt and take warrants
that increase their potential returns. This type of financing is appropriate to
finance long-term working capital needs and is a lower-cost alternative to
raising equity. However, the availability of venture capital and mezzanine
debt is limited to fast-growing firms, often in industries and markets viewed
as offering the potential for high returns. Government and nonprofit revolv-
ing loan funds also supply working capital loans. While small in total capi-
tal, these funds help firms access conventional bank debt by providing
subordinate loans, offering smaller loans, and serving firms that do not
qualify for conventional working capital credit.
Many entrepreneurs and small firms also rely on personal credit sources
to finance working capital, especially credit cards and second mortgage
loans on the business owner’s home. These sources are easy to come by and
involve few transaction costs, but they have certain limits. First, they provide
only modest amounts of capital. Second, credit card debt is expensive with
interest rates of 18% or higher, which reduces cash flow for other business
purposes. Third, personal credit links the business owner’s personal assets to
the firm’s success, putting important household assets, such as the owner’s
home, at risk. Finally, credit cards and second mortgage loans are not viable
for entrepreneurs who do not own a home or lack a formal credit history.
Immigrant or low-income business owners, in particular, are least able to use
personal credit to finance a business. Given these many limitations, it is
desirable to move entrepreneurs from informal and personal credit sources
into formal business working capital loans that are structured to address the
credit needs of their firms.

Underwriting Issues in
Working Capital Financing __________________________
While underwriting working capital loans follows the broad framework
presented in Chapter 4, several unique issues warrant discussion. Since repay-
ment is closely linked to short-term cash flow, especially for cyclical working
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Working Capital Finance 103

capital loans, finance practitioners need to scrutinize these projections in detail.

Borrowers will need to provide monthly or quarterly cash flow projections
for the next 1 to 2 years to facilitate this analysis. Moreover, this requirement
helps assess how carefully the firm plans and monitors cash flow and helps
identify weaknesses in this key management area. Detailed monthly projec-
tions can also uncover ways to improve cash flow that may reduce borrow-
ing needs and improve the firm’s capacity to repay and qualify for a loan. For
example, a firm may be able to reduce its inventory, offer incentives for more
rapid payment of invoices, or improve supplier credit terms. For working cap-
ital loans, lenders will pay special attention to liquidity ratios and the quality
of current assets since these factors are most critical to loan repayment.
Finally, the underwriting analysis needs to evaluate the applicant’s need for
permanent versus cyclical working capital debt. Small businesses with limited
long-term capital are under heavy pressure to meet short-term cash flow
needs. Adding short-term working capital loans does not address this prob-
lem and may make matters worse. Thus, it is important to analyze why the
firm is seeking debt, what purpose the loan will serve, and how these relate
to short-term cyclical needs versus long-term permanent working capital
needs. In some cases, practitioners need to revise the borrower’s loan request
and structure debt that better reflects the firm’s needs. This might entail
proposing a term loan in place of a line of credit when the business needs
permanent working capital or combining short-term and medium-term debt
instruments to create a good balance between cyclical and permanent work-
ing capital debt. These alternatives can improve a firm’s cash flow and
liquidity to partially offset the greater repayment risk that results from
extending loan repayment. Loan guarantees and subordinate debt can reduce
this additional risk and help convince conventional lenders to both supply
credit and provide it on terms that fit a borrower’s financial needs.

__________ Case Study: Crystal Clear Window Company8

Introduction
Mr. Robb, assistant vice president at Commercial National Bank, will
present a loan request from Crystal Clear Window Company to the loan com-
mittee today. Mr. Robb has spent considerable time on the credit request. He
made a thorough investigation of the principals involved, studied the business
and evaluated its potentials, and made several plant visits to become familiar
with the firm’s operations. He also checked with both suppliers and purchasers
of the finished product. Finally, he secured the necessary financial data (See
Exhibits 5.1 and 5.2), evaluated the firm’s sales projections, and secured an
appraisal of the machinery and equipment. This and other pertinent informa-
tion was passed on to the loan committee members so that each member could
evaluate the request prior to today’s meeting.
 Exhibit 5.1 Crystal Clear Window Company Comparative Income Statements
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104
12/31/67 12/31/68 12/31/69 5/31/70
12 months % of Sales 12 months % of Sales 5 months % of Sales 12 months % of Sales

Sales $390,273 $473,920 $597,441 $206,778

5/19/04

Returns and Allowances 1,764 1,132 3,667 1,022

Net Sales 388,509 100.0% 472,788 100.0% 593,774 100.0% 205,756 100.0%
Cost of Goods Sold
Labor 72,560 118.7% 90,046 19.0% 108,505 18.3% 41,566 20.2%
6:20 PM

Materials 211,983 554.6% 258,155 54.6% 330,966 55.7% 111,772 54.3%

Freight in 6,366 11.6% 7,844 1.7% 9,873 1.7% 3,490 1.7%
Maintenance 1,577 0.4% 864 0.2% 2,816 0.5% 1,233 0.6%
Rent 6,712 1.7% 7,400 1.6% 9,300 1.6% 4,100 2.0%
Depreciation 2,994 0.8% 1,542 0.3% 1,970 0.3% 368 0.2%
Page 104

Total $302,192 77.8% $365,851 77.4% $463,430 78.0% $162,529 79.0%

Gross Profit $86,317 22.2% $106,937 22.6% $130,344 22.0% $43,227 21.0%
Selling and shipping
Salaries 17,056 4.4% 18,920 4.0% 23,447 3.9% 12,500 6.1%
Freight out 6,417 1.7% 7,862 1.7% 10,867 1.8% 3,714 1.8%
Travel 6,775 1.7% 9,637 2.0% 12,033 2.0% 5,150 2.5%
Advertising 6,682 1.7% 6,947 1.5% 9,441 1.6% 2,037 1.0%
Total $36,930 9.5% $43,366 9.2% $55,788 9.4% $23,401 11.4%
Administrative expense
Salaries $33,973 8.7% $38,667 8.2% $38,960 6.6% $16,218 7.9%
Utilities 3,580 0.9% 4,464 0.9% 4,896 0.8% 2,663 1.3%
Rent 960 0.2% 1,000 0.2% 1,000 0.2% 420 0.2%
Insurance 922 0.2% 1,123 0.2% 1,490 0.3% 580 0.3%
Depreciation 167 0.0% 180 0.0% 180 0.0% 90 0.0%
Taxes and license 916 0.2% 1,130 0.2% 1,442 0.2% 600 0.3%
Interest 1,188 0.3% 1,444 0.3% 1,668 0.3% 680 0.3%
Bad debts 1,166 0.3% 1,317 0.3% 1,580 0.3% 325 0.2%
Miscellaneous 1,445 0.4% 1,697 0.4% 2,227 0.4% 814 0.4%
Total $44,317 11.4% 51,022 10.8% $53,443 9.0% $22,390 10.9%
Profit from operations $5,070 1.3% $12,549 2.7% $21,113 3.6% ($2,564) −1.2%
Discounts earned 766 0.2% 518 0.1% 220 00.0% 0 0.0%
Net profit before taxes 5,836 1.5% 13,067 2.8% 21,333 3.6% (2,564) −1.2%
Provision for taxes 1,473 4,422 7,880 0
Net profit $4,363 $8,645 $13,453 ($2,564)
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Working Capital Finance 105

Exhibit 5.2 Crystal Clear Window Company Comparative Balance Sheet

12/31/67 12/31/68 12/31/69 5/31/70

ASSETS
Cash $0 $2,780 $1,244 $0
Accounts receivable 34,706 42,326 52,814 93,237
Allowance for doubtful −1,500 −1,500 −1,500 −1,500
Inventory 45,185 52,433 74,479 79,109
Prepaid expenses 861 1,323 1,218 1,533

Total current assets $79,252 $97,362 $128,255 $172,379

Machinery and equipment $36,345 $38,471 $41,770 $44,298
Leasehold improvements 7,964 8,218 8,426 8,426
Accumulated depreciation −7,118 −8,840 −10,990 −11,448
Total fixed assets 37,191 37,849 39,206 41,276
Total assets $116,443 $135,211 $167,461 $213,655

LIABILITIES AND SHAREHOLDERS’ EQUITY

Bank overdraft $3,773 $0 $0 $0
Accounts payable 37,773 44,287 51,848 77,220
Accrued expenses 9,440 14,322 18,058 13,410
Notes payable 20,000 22,500 30,000 40,000
Other liabilities 0 0 0 18,034
Total current liabilities $70,986 $81,109 $99,906 $148,664
Capital $27,000 $27,000 $27,000 $27,000
Retained earnings 18,457 27,102 40,555 37,991
Total equity $45,457 $54,102 $67,555 $64,991
Total liabilities and equity $116,443 $135,211 $167,461 $213,655

Firm History
Henry Rapp and Alan Keith organized Crystal Clear Window Company in
1960. Mr. Rapp is 42 years of age and had considerable experience with a
large speculative builder of houses in an adjoining state. He is knowledgeable
in the areas of construction, building materials, and real estate credit.
Mr. Keith, 32, is a machinist who learned his trade from his father and was
employed for several years in the production area of a national aluminum fab-
ricating firm. Both men left their respective employers on good terms and were
told that should they ever want to return the welcome mat would be out.
Neither Mr. Rapp nor Mr. Keith is a man of means. Mr. Rapp put all of his
savings, $16,000, in the business when it was formed, and Mr. Keith invested
$11,000—$7,000 from his savings and $4,000 from the sale of his house. Both
men live frugally, and there is no evidence that they are affected by “keeping
up with the Joneses.” Both Mr. Rapp and Mr. Keith are stockholders, and the
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106 THE BASICS OF BUSINESS FINANCE

latter serves as treasurer of the corporation. From a practical standpoint, the

business operates as a partnership.

Operations
Crystal Clear Window Company operates in leased quarters and produces
aluminum windows and sliding glass doors of standard sizes. The operation
is primarily one of assembly. The firm purchases extruded window frames
from a national aluminum manufacturer. These frames are then sawed and
punched to size for assembly, and the prepared frames are assembled along
with the necessary glass and screens, which are also purchased to size. Screens
are purchased from the same firm that provides the aluminum frames. Glass,
imported in sizable lots from concerns in Belgium and Australia on a letter of
credit basis with draft terms at sight, comprises approximately 25% of the
cost of materials. The cutting and punching machines are relatively simple
and inexpensive. The firm maintains duplicate machines that can be substi-
tuted in the event of a breakdown. In the assembly process, a large amount
of labor is used, although approximately 55% of the firm’s total outlay is for
materials. The workforce is relatively young and not unionized, and there
appears to be a high degree of esprit de corps among the 20 employees.
Two salesmen are employed who call on building materials suppliers within
a 300-mile radius of Jonesboro. The windows produced have consistently
exceeded the specifications established by the American Aluminum Manu-
facturers Association, whose standards are acceptable to the Federal Housing
Authority. The high quality increases the marketability of the windows, for
few building supply dealers will handle a product that does not meet the stan-
dards required by the FHA in its appraisal program. This firm has emphasized
an economical operation. Extruded frames, for example, are purchased in such
lengths that the loss from sawing and cutting is kept to a minimum. The
firm follows a policy of keeping its inventory of raw materials, supplies, and
finished products as low as efficient operations will permit. They have restricted
their sales to reputable building suppliers who are financially strong. The firm’s
returns and allowances for uncollected receivables have been very low.

The Use of Aluminum Windows

There has been fabulous growth in the use of aluminum windows in recent
years. Although aluminum windows have been produced for quite some time,
the aluminum window industry per se has been in existence only about
20 years. The use of aluminum windows varies throughout the country;
nationally, however, about 80% of the single-family dwelling units and about
90% of the multiple units constructed at the present time use aluminum win-
dows. Aluminum windows have several advantages over wooden windows.
Aluminum windows are less expensive and their maintenance is considerably
less. They can be manufactured in a shorter period of time. The time required
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Working Capital Finance 107

to produce a wooden window varies depending on the type of wood used, but
in general the manufacturing process requires about triple the time required
for aluminum windows. Another significant advantage of aluminum win-
dows is the on-site cost. Wooden windows are installed by carpenters whose
hourly wage is much higher than that of workers who install aluminum win-
dows. The installation time of a wooden window is much more than that of
an aluminum window, since weights must be installed and slides must be
manufactured on the site. Since holes for nails that support the aluminum
windows are drilled at the factory, the aluminum window can be installed
within a few minutes. For these reasons, the demand for aluminum windows
appears likely to continue.

Financial Status
Sales of Crystal Clear Window Company have mushroomed since the
firm began in 1960—from $2,050 for the first month of operations to
$597,441 for all of 1969. The original capital and retained earnings of the
company have not been sufficient to support this volume of business activ-
ity. A large part of the financing has come from (1) funds that have been
made available due to the fact that the firm’s accounts payable are due on a
net 60-day basis and accounts receivable are due on a net 30-day basis;9 and
(2) loans from Mr. Mulder, who is Mr. Keith’s father-in-law, that now total
$40,000. Mr. Mulder would like these loans repaid because he retired a few
months ago and needs the funds to purchase property in Florida where he
and his wife plan to retire. Mr. Mulder has loaned the funds to the firm at
the same rate of interest that he could have earned on a certificate of deposit
at a local bank, which has varied from 3% to 5.5%. Both Mr. Rapp and
Mr. Keith have been quite appreciative of this loan.
The firm had some difficult initial years, which resulted in meager prof-
itability. However, through trial and error, costs were stabilized, the break-even
point was established, and with greater market penetration greater profitability
was achieved—as shown by the increasing profits and the percentage of prof-
its to sales. As volume continued to expand, the working capital requirement
expanded faster than the accumulated earnings. Consequently, the firm faced
increasing demand for additional working capital support as disclosed by the
increasing reliance on debt, the bank overdraft, and decreasing discounts
earned on early invoice payments. The anticipated rate of sales expansion, the
possibility of outgrowing the present quarters, and the need for additional
equipment all suggest continued absorption of funds for the foreseeable future.
For example, sales have practically doubled during the last 3 years, while
equipment has shown only a modest increase.
Management’s record for honesty and fair dealing is excellent as judged by
the comments of employees, suppliers, and customers. Their ability to pro-
duce and market a product is attested to by increasing sales, nominal bad debt
losses, and a relatively low level of returns and allowances. The economic
outlook for this business is favorable. However, financial understanding on
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108 THE BASICS OF BUSINESS FINANCE

the part of management is an unknown factor since they have been shielded
from financial reality by the availability of friendly debt.

Recommendation
Mr. Robb recommended to the loan committee that the bank finance Crystal
Clear Window Company with a line of credit secured by accounts receivable. He
proposed a $75,000 maximum line with an advance rate equal to 80% of out-
standing accounts receivable and an 8.5% interest rate. The line of credit would
have an annual cleanup, require an increase in deposit balances, and the princi-
pals would have to guarantee the loan. All three members of the loan commit-
tee had different ideas about the loan application. Mr. Edwards thought that the
bank should not finance the firm under any conditions and pointed out the poor
debt-to-worth and current ratios. He suggested that the bank advise the com-
pany owners to sell additional stock. Mr. Robb pointed out that it was difficult
and very expensive for a firm of this size and financial strength to sell stock.
Mr. Davis said that the firm needed a term loan of about $40,000 to replace the
loan from Mr. Mulder that must be repaid. Mr. Robb felt that a term loan would
not give the firm much financial relief since it would require monthly principal
payments, and that the company would need more funds in the future. He felt
Crystal Clear Window Company needed an open-ended amount of credit and
that a term loan would be too restrictive. Mr. Edwards then interjected that
the firm should attempt to reduce its need for funds by (1) offering selling terms
of 1% 10 days net 30 in order to reduce the financial burden of carrying receiv-
ables,10 and (2) purchasing glass locally rather than from abroad. Purchasing
glass abroad has forced the firm to carry large inventories in order to have an
adequate supply of glass on hand. Local purchases would reduce the required
inventory, freeing up funds for other working capital needs. Mr. Conrad was
concerned about the firm’s financial ratios and suggested a short-term seasonal
loan that the bank could review every 90 days and call should the firm be in
financial trouble. Mr. Conrad pointed out that the bank was lending other
people’s money and needed to be cautious. He asked Mr. Robb how the bank
could control lending against accounts receivable given the risk that the firm
might offer false invoices as collateral.
Mr. Robb held his ground and argued that the firm’s management had
proven itself to be honest and successful in building the business from
scratch. He also was confident that an adequate verification program could
be established to reduce the risk of false invoices to a minimum.

Assignment
Commercial National Bank’s vice president has asked you to resolve the
differences between the views of Mr. Robb and the loan committee. Your
assignment is to analyze the firm’s financial condition, credit needs, and cash
flow and recommend how the bank should proceed. As part of your financial
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Working Capital Finance 109

analysis of Crystal Clear Window Company, complete the following

calculations using the financial reports provided in Exhibits 5.1 to 5.3:

(1) net working capital, current ratio, quick ratio, and days receivable
for year-end 1967, 1968, 1969, and 5/31/70
(2) net cash flow for 1969 after investment and financing activities
(3) projected net cash flow for 1970 before any payments on the proposed
loan. This cash flow projection should assume 1970 sales of $750,000
and 1970 expenses at the same expense ratios as listed in the 1969
income statement. To project 1970 annual cash flow, estimate 1970 cash
receipts by adding 1969 year-end accounts receivable (i.e., cash collected
in 1970 from prior year sales) to 1970 sales and then subtracting 1970
year-end accounts receivable (i.e., uncollected cash from sales made in
1970). Assume that 1970 year-end accounts receivables equal 30 days’
worth of 1970 annual sales. Next, estimate 1970 cash expenditures for
both materials and nonmaterial expenses. For materials expenditures,
adjust the 1970 materials expense by adding payment of 1969 year-end
accounts payable and subtracting unpaid accounts payable at 1970 year-
end. Assume that accounts payables at 1970 year-end equal 60 days’
worth of annual material expenses. For nonmaterial expenses, assume all
expenses are paid on a current cash basis within the year so that the cash
expenditure and expense amounts are the same. Use the 1969 expense
ratios to estimate the nonmaterial expenditures. Be sure to include a
provision for taxes but omit depreciation since it is a noncash expense.

Prepare a recommendation to the vice president on what action the bank

should take on the proposed $75,000 loan secured by accounts receivables.

Exhibit 5.3 Crystal Clear Window Company Sales Projection, 1970

Month Projected Sales

January $40,000
February 30,000
March 30,000
April 40,000
May 70,000
June 80,000
July 90,000
August 90,000
September 90,000
October 80,000
November 70,000
December 40,000
Total $750,000
Estimated net profit $19,000
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110 THE BASICS OF BUSINESS FINANCE

Support your recommendation with the results of your financial analysis.

Your recommendations can include approving the $75,000 line of credit as
currently proposed, declining the loan, or proposing alternative loan terms.
In preparing your recommendations, consider the following questions:

• What is the market outlook for the company’s products?

• What is the experience and capacity of the management team?
• Will the company generate sufficient cash flow to repay the loan?
• What are the proposed uses of the loan proceeds and their role in
financing Crystal Clear Window Company’s working capital needs?
Are the proposed financing terms consistent with these needs?

Endnotes __________________________________________
1. The evidence from small businesses financial data on this point is mixed.
Berger and Udell (1998) found that equity accounted for 50% of small firm’s capital—
a fairly high share of long-term financing. U.S. Census Bureau aggregate balance
sheets for manufacturers in 2001 show that small manufacturers had a level of short-
term debt (11.7%), twice that of all manufacturers (5.9%). Small manufacturers also
had a lower proportion of equity capital but a slightly larger share of long-term debt.
See U. S. Census Bureau (2002). Quarterly Financial Report for Manufacturing,
Mining and Trade Corporations 2001, Table 1.1
2. This section draws on discussions of short-term and working capital finance
from Brealey and Myers (2002), pp. 622–626 and Owen et al. (1986), pp. 92–98.
3. Some older receivables reflect slow payment processes or policies by a strong
credit customer, such as government agencies or large corporations.
4. The discussion of inventory control methods is based on Brealey and Myers
(2002), pp. 624–626 and Owen et al. (1986), pp. 95–96.
5. Interest rates in capital markets usually increase as the term of debt increases.
Thus, a lender’s cost of funds for a longer term loan is higher, which adds to the
interest rate charged to a borrower.
6. New England federally regulated thrift institutions, for example, held 9.1%
of the outstanding small business loans among financial institutions in 1999 com-
pared to 5% for the entire nation. Similarly, these New England thrifts had a far
larger share of their assets in commercial real estate and small business loans, 25.3%,
than all U.S. federally regulated thrift institutions, at 11.9%. See Gilligan (2000).
7. According to Venture Economics (2001), $6.2 billion in new capital was
committed to mezzanine funds in 2000, and over $3.3 billion in new mezzanine fund
investments were made that year. Private Equity Market Update 2001 from www.
ventureeconomics.com
8. This case study is adapted from Reed & Woodland (1970), Cases in
Commercial Banking, and is used by permission of Don Woodland.
9. Net 60-day basis means payment is due in full within 60 days, and net 30–day
basis means payment is due in 30 days.
10. This would provide customers a 1% discount if they paid within 10 days.