The Importance of Keeping Capital in Your Business

Lenders such as VCF often use the 5 C’s of Credit as a framework to gauge the creditworthiness of borrowers. When looking at a potential borrower, Lenders want to evaluate the risk of default. Using the 5 C’s, a Lender can effectively measure the quality of the potential borrower and the loan. Through the 5 C’s of Credit, a Lender examines a variety of factors before reaching a decision. As a business owner, you can increase your chances for loan approval by understanding the 5 C’s of Credit.

At a glance, the 5 C’s of Credit Represent:

  1. Character– broadly speaking, what type of person you are.
  2. Cash Flow– the cycle surrounding the amount of cash coming into and out of a business.
  3. Collateral– something you can pledge to back and secure a loan.
  4. Capital- refers to the amount of your own money you have embedded in your business.
  5. Conditions- the market conditions of your industry.

What is Capital?

Capital refers to the amount of your own money you have embedded in your business. It is synonymous with Owner’s Equity: A culmination of the amount of funds the owners invested to start the business and the business’ profits that the owners reinvested and kept in the business since its inception.

What Is Capital Structure, and Why Is This Significant to Lenders?

Capital Structure refers to the amount of debt a business carries relative to its level of equity. It is measured by the Debt to Equity Ratio, also known as the Leverage Ratio. This is calculated from dividing Total Liabilities by Equity (Capital). The Leverage Ratio tells us the worth of a company compared to their total obligations.

Lenders like to see a business owners who have some “skin in the game.” The more aggressively a business owner capitalizes a business, the more stake they have in their own company. If a business owner has nothing personal to lose, then their obligation to run their business well and repay all of their debtors may not be as strong.

Equity is an indication of a company’s ability to weather a downturn in the business. Traditional lenders prefer to see all of your Capital and profits staying in the business. Most traditional lenders favor Leverage Ratios no more than 3:1. Some will even argue it has to be stronger than that- the lower this ratio is, the better (2:1, or 1:1 meaning equal amounts of debt and equity). Let’s say, for example, a business begins to experience a sudden decrease in sales volume leading to losses. If equity is a combination of the initial investments made by the owners as well as the reinvested profits of their business, equity begins decreasing as losses are incurred. If (and oftentimes, when) things start going poorly, lenders need to feel confident you are going to be able to repay all of your debt. If a business has taken on or continues to take on substantially more debt than the business itself is worth, this can be a cause of concern for lenders. Debt is a wonderful tool, when it is used appropriately. A good lender will never accommodate more debt than a business’ Capital Structure can reasonably support. There is no single “right or wrong” Capital Structure; this is also dependent upon a company’s unique position within their respective industry.

What is the Difference Between Subordinated and Senior Debt, and How Does This Effect My Leverage? Generally, Asset-Based Lenders such as VCF are willing to accept a higher leverage ratio, because we have a deeper understanding of all the 5 C’s of Credit. We gain a thorough knowledge of the business’ Collateral, the challenges they are facing internally or externally, the conditions of the business’ industry, and of the character of the people running the business. We also feel more comfortable accepting businesses with a higher leverage ratio because of our position as a Senior Lender in all of our client’s Capital Structures.

A Senior Lender is said to have the “first lien” position, meaning they are the priority to be repaid. Any other lenders are said to be subordinate, and are not to be repaid until the Senior Lender is paid out, even if the subordinated debt was established before the Senior Debt.

Oftentimes, there are situations where the owners, family members, or outside investors have made loans to a business that they are willing to subordinate to a Senior Lender. These loans are not paid until the business returns to profitable operations and is generating sufficient excess cash flow. In some cases, there are other lenders involved who are willing to subordinate the debt owed to them and re-negotiate the terms of their debt repayment.

The concept of subordinated debt causes Senior Lenders to evaluate your Leverage Ratio differently. Here’s where it can become a little tricky: Senior Lenders calculate your Leverage Ratio with subordinated debt added to equity.

For example: Say you have a company that has $100,000 in equity, and $200,000 in loans from family friends, a debt that they are willing to subordinate to a Senior Lender. The business also has other Liabilities of $800,000.

Normally, you would calculate your Leverage Ratio as follows: $1,000,000 Total Liabilities / $100,000 Equity = a 10:1 Leverage Ratio.

However, our methodology is to take that $200,000 of subordinated debt out of Total Liabilities, and add it to equity instead.

The new leverage calculation is as follows: $800,000 liabilities / $300,000 equity, with a new Leverage Ratio of 2.5: 1. In the eyes of a lender, there is a huge difference between having a 10:1 Leverage Ratio and having a 2.5: 1 Leverage Ratio.

The reasoning behind treating subordinated debt as equity is because subordinated debt does not have to be repaid as long as a facility with a Senior Lender is in place. In this case, “Equity” is viewed as anything that could possibly be used to repay the Senior Lender, in the unfortunate but possible event a business becomes insolvent.

Why would a Business with Plenty of Capital Require a Working Capital Lender?

A business owner who has a lot of Capital invested in their business is much more likely to have positive cash flow and display other promising signs of prosperity. However, in many situations a business does have the appropriate Capital Structure, but is suddenly overwhelmed with many large orders. Getting new business is wonderful, but you may not have the assets or resources available to fulfill a product or service order larger than what your company has typically dealt with in the past. During this time, it makes sense to work with an Asset-Based Lender that can operate with more leverage, and is comfortable doing so because they have a mechanism in place to value the collateral against the loan outstanding at all times. The higher cash availability the Asset-Based Lender can provide against your collateral provides your business the appropriate type of financing and drives enterprise values when your cash flows are just temporarily stretched.

If you feel confident about the Capital invested in your business, consider asset based lending as a viable option for you. Take advantage of the opportunities you may miss by not securing the financing you need- contact VCF today at 804-897-1200.