Business Financing, Credit, and Cash Flow

Pay as you go, or borrow to grow? This thread looks at both sides, and supplies some sage advice. December 2, 2006

I am looking for some help on obtaining business credit. I am almost ready to take off and so far, I have paid all startup costs out of pocket. I would like to borrow some capital to speed up the process, but I also do not want to take on too much personal debt at startup. I have been looking at these companies that say they can show you how to build business credit without a personal guarantee. Does anyone have experience with this?

Forum Responses
(Business and Management Forum)
From contributor L:
Pay as you go, if you can, as long as you can. Then you have nothing but equity/assets to fall back on if you really do need that line of credit or loan.

From contributor D:
I would go on the assumption that there will always be a personal guaranty required for a small startup business. This holds true for leasing equipment, line of credit or credit cards - at least in my experience. I agree with contributor L - pay as you go. Buy tools as you can afford them, buy material for a job with the deposit money and structure your business so that you have a dependable cash flow.

From the original questioner:
Thanks for the input. What is the standard on how much money to get up front from a client? Should I be getting enough to cover material or more?

From contributor D:
For small jobs (say under $5,000), I ask for 50% down. As the jobs get larger, 5000 to maybe 30000, I will ask for 1/3 down, 1/3 upon substantial completion and balance due on installation. For larger jobs, I will ask for a draw schedule so that I can get money as I need it, but I always like to have enough to purchase at least most of the material with the first down payment.

From contributor S:
As far as business goes, it's prudent to have as much credit as you can get, but to use it as little as possible. Pay as you go is, of course, the best way for a small business, but it's not always realistically possible when managing day-to-day cash flow. And my accountant insists on leasing large equipment because the tax benefits far outweigh any interest penalties. It has to do with the difference of writing off the whole lease payment for the entire year or depreciating the asset(s) little by little over a period of years. Ask your accountant what he/she thinks.

Also, if you own your own home, a home-equity loan is about the cheapest money you can borrow. It also has some wonderful tax benefits. A lot of people wouldn't be comfortable with this and I fully support that point of view. But for me, we had a lot of equity built up that was just sitting there doing nothing. It worked for us to put it to profitable use. Again, talk to your accountant.

We use a company credit card for almost all purchasing... materials, outsourced doors/drawers, hardware, and we even auto-pay some of our recurring bills on the card (leases, garbage, etc.) This is very risky if you're not absolutely disciplined about paying the card down to zero every month. The last thing you want is to have your profit margins eaten up by credit card interest. It bears repeating... you must pay down to zero every month.

But if you're confident you can get those cards down on time every time, there are some real benefits to this method:

1) Your vendors still list you as COD because they get paid right away. Mine give me a 2-5% discount for COD, and my door vendor puts my orders right into production as soon as I fax them in because they've already been paid (no 30-60 day net, which helps their cash flow).

2) You get to decide when to pay off the bill (within that 30-day window). We have it set to pay off the card on either the 10th or the 20th of the month. The dates will largely depend on your accounting and billing cycles, but the flexibility is there whatever date you choose. Small business is all about cash flow, and a little flexibility goes a long, long way.

3) You get whatever rewards your card is set up with... free flying miles, hotel discounts, points/cash back... whatever. These pile up very quickly when you're spending $30-$40k every month. Be careful on which card you pick, though, and read the fine print. Some don't accrue rewards unless you hold an outstanding balance.

4) If there's a problem with a vendor, you can dispute the payment through the credit card company and get credited back the money... at least temporarily until the dispute is settled. If you can demonstrate that the payment went toward a product that was not delivered as promised (dinged up doors, out of square drawers, etc.) you stand a very good chance of winning the dispute. And since the vendor isn't holding the money because it's been credited back to you until settlement, they'll be a lot more cooperative at fixing the issue. You can avoid the whole "we've already been paid, what do we care" syndrome.

Again, I am not necessarily recommending this because of the interest risk, but it's an option that's worked well for us.

From contributor N:
I run my business as most people here suggest - cash only! I ask for a 50% deposit on almost all work. For large jobs (over 10K), I'll take less. We usually work on a draw schedule on those. When I first got started, I found nothing is a greater motivator than the monthly rent, and you have to get this job finished and paid to make rent. Very quickly you get so you have enough cash put back (2K or so) so you can cover rent or electric or whatever.

Buy tools as you see a need and can afford them. Don't buy tools just because they are neat and cool. Don't under buy or over buy tools. Say you need a new table saw - just a good basic saw. Don't go to HD and buy a cheap contractors saw that works today, but won't in 3 years. You also don't need a monster 10hp sliding saw as your basic shop saw. Anticipate growth. Make investments in equipment wisely.

The real cool thing about running a cash based business is the money at the end of the job is mostly yours. You don't have to turn an extra 5K a month for equipment payments.

The most important thing about a cash business is the amount of pressure you don't have to take on. For instance, your sales hit a slump. A year ago you were going like a bat out of hell. 15-20K a month. People were throwing money at you to do work. Life was good. Today you are busting your hump and the market has cooled off a bit. You are averaging 8-10K a month. If you run a cash based business, that only means you take off a few hours early a few days a week. Or you spend a little more time working new business. Or you fish a little more.

Right now, if I didn't get another job for 6 months, I would still make rent, electric, etc. with what I have in the business savings. I would not go out of business. That is the real reason, and the most important one, that I use only cash. I sleep better at night not worrying about payments.

From contributor B:
Only thing to add is, I believe you can depreciate capital assets 100% in the first year, provided they total no more than $100K. My understanding is that this makes lease payments not such a slam-dunk. Best way to get good credit is to make money! Do that and you'll have to beat creditors off with a stick.

From the original questioner:
Thanks for the great advice. I know every situation is different, however, I have clients that want me to make trim now at the prices I want. The problem is I need a new molder to produce the quality I want and to be more efficient. My machine is rather old and is good for short runs, but it's far more time consuming than a newer one will be. My business has no debt right now, but it's like I'm losing money every day because these guys are buying elsewhere. I am struggling to see whether I should make small packages on my machine until I can pay cash for a new machine. I am just getting started and my business already seems to be outgrowing me, which can be frustrating. I have figured what I can make with the clients I have now that want molding, and figure I could pay off what I would have to borrow in a couple months or less. I am, however, not 100% sure that all these guys will purchase what they have said they will. If I get the 50 percent up front, is it a safe bet to finance the new equipment? I really appreciate the advice from you seasoned business pros and wish you all great success.

From contributor A:
You have gotten some very good advice from the previous posters. At most of the shop auctions around here, you see a lot of nice new equipment selling for way less than it cost. Rarely do you see an auction with old mismatched machinery. It's always the guys throwing money around. Think about it - could you last six months with the lease payment? The year after 9-11, we went four months without any decent jobs. We survived and bounced back quickly on the fifth month.

Lastly, are these customers willing to pay a good price for the new work, or do they just want a second source to beat down prices on their present supplier? If they are serious about it, have them sign a long term contract and buy the machinery you need. Also, make them pay on delivery. If you ramp up and then have to wait to be paid...

From contributor Y:
Good advice from the others. Be conservative and safe. There are always risks in business - you just need to minimize them. It took me a long time to get a decent business built up. I saw quite a few competitors go down the tubes during that time. Some with great new equipment, some with junk. I have looked at leasing several times, but it has never made sense to me. It always costs more, and is a debt that must be paid every month, work or no. There is a lot of BS about leasing out there, but like someone else said, you can fully depreciate a quite large investment the first year (assuming you made that much profit). Most startups don't buy $100K+ equipment every year!

We've made short-run moldings for years along with curved moldings. The curved moldings are more profitable. We produce them for several lumberyards that retail them. I can't compete with the commodity moldings sold by the lumber yards, but if you want 6" cherry base and 4" casing, they don't handle that as a commodity item. But we will grind any pattern you want to draw on a cocktail napkin and deliver in a week. We sort of fell into our molding niche by accident, but it has been good.

As for the places selling advice on getting something for nothing, "business credit" without a personal guarantee - look out. I used to use a line of credit through the local bank. It cost nothing if not used and was available when needed, a little bit or a lot at a time. I had to sign personally for it. I think you will need at least 3 times your monthly sales available as working capital and figure on some losses and slow pays. Don't have one or a few customers that represent much of your business. It's almost impossible to replace a customer that was 50% of your income in a relatively short time. I've done that, not fun!

From contributor G:
I disagree totally with the "pay as you go" mentality. If I did that, my business would have taken forever to grow. Sounds like you are already paying for the new moulder in inefficient production. A wise tool loan will easily increase production enough to pay for itself, including interest and then some. I never would have been able to build my shop, buy my first widebelt, moulder, profile grinder, slider, etc. without borrowing. Money is a tool. Interest is the cost of that tool. Use it wisely and it will pay for itself many times over. Your business growth will probably leave the "don't ever borrow" guys in the dust.

From contributor D:
Looking back at my initial response to this question, I may have been too brief. I am going on the assumption that the person asking the question has a new or relatively new business and therefore may not have a strong or predictable cash flow with which to make monthly payments on loans or leases. Credit is a good thing if used carefully. I have leased equipment and credit for my business and look at these tools as a way to grow a business, as has been stated, but I have also had my share of grief when a payment was late and I found myself talking to the creditors' lawyers about them attaching my personal assets if I could not get caught up immediately. Having said that, I still pay cash for 99% of all material I buy and most of my tools, but will use credit when I know that I can make the payments on time.

From contributor Y:
Like contributor D, I may have come off sounding like you should never borrow. Not true - just be very careful. I have used a line of credit for operating capital and a couple of times to acquire a major tool before I had the entire amount saved. Every time I get another auction flier, I'm reminded about why I'm a conservative borrower! I've got a long wish list of tools and shop improvements arranged by payback probabilities. I know the ones at the bottom of the list will likely never happen. Sure does make for an impressive list, though.

From contributor S:
I'm somewhat surprised by the responses that adamantly claim it must be done one way or the other. I think if you read through all of the posts, including my original post, it becomes clear that the point of financing vs. leasing vs. cash is the importance of keeping your options open. I stand firmly behind my opening sentence: "... have as much credit as you can get, but use it as little as possible."

If you're running cash only and the machinery you have is adequate for your production, then there's no reason to go into the hole just for some new tools. You can afford to wait and build up slowly over time. Contributor A asked "could you last six months with the lease payment?" But the real question is "would the right machinery increase production and profitability enough to offset the lease payment?" If the answer is "no", then there you go. But if slow production caused by inadequate machinery is eating into your profit margins, then you're not doing yourself any favors by avoiding a monthly bill.

It's not the "cash" part that bothers me, it's the "only" part. Why paint yourself into a corner if you don't have to? There's also been some question regarding leasing write-offs versus 1st year depreciation. Someone said that not many 1st year start-ups purchase over $100k in machinery. My response is that of those that spend less than $100k, how many make that that much profit in the first year to depreciate it against? I'm sure there are at least some, and that's the point... keep the options open for your business. If that tax structure works for you, great! If not, like it didn't for us, you have other options. I don't think there's anything BS about it, except the claim that it's BS in the first place.

One final note I'm surprised hasn't been mentioned more: we're cabinetmakers/woodworkers... experts to one degree or another in what we do. Anyone seeking serious answers to questions like these must consult a financial professional. Get an accountant and pay them for what they do best. What you read here are just guidelines of thought, options to investigate... nothing more.

From contributor E:
Some really good advice here... and some questionable. Get some professional help. Finances are as much of your overall business plan as the product you are going to produce. Spending money to be more efficient does no good if you can't tap into more work to fill the increased available production time. Remember the payments/lease/interest on that new efficient machine go on even when it's idle.

Personally, 38 years self employed has taught me to pay cash for everything I can. A small shop is only an injury on or off the job away from financial disaster. Your family will sleep a lot better at night knowing that whatever they see really belongs to them, not the bank. Price swings are another motivation for having things paid up.

I should be clear that I am talking about capital investments here... vehicles, equipment, building. Materials I have always had on 30 day credit, and paid every month or during the discount period if offered.

Talk to a good accountant about the income tax issues. I don't believe what has been mentioned about the deductibility of up to $100K and 100% for durable manufacturing equipment. I found computers on a 3 year schedule, durable equipment on a 7 year plan to be the norm. With a lease, you can deduct more (higher percentage) each year, but you are paying basically loan interest plus a profit to the lease company. It's not free. It's like buying an income tax deduction.

Never borrow on your home. Yes, the rate is lower, but it's the only thing you have to have. Don't ever take a chance on losing your home because business went south.

From contributor J:
I too run my business with as much cash as possible, using a rewards credit card like cash, paying it off every month, same as I do for my personal finances.

Regarding capital equipment purchases, you need to do a little business math to determine whether a lease or cash purchase is the most advantageous to your business. This depends on the financial strength of your business, the ROI (Return on Investment) time, market projections, cost of money (includes the cost of not having the money spent on the machine in your interest bearing account), etc.

The first thing I would look at is how much potential business I'm missing and the value of this lost business. If I can buy a machine that will allow me to capture this business, can I earn enough to pay for the machine in about a year (plus or minus)? If so, is it more advantageous to buy with cash or finance (ask your CPA/accountant this). How does it fit my business plan? Sometimes it makes business sense, sometimes it don't.

From contributor R:
1) Yes, get financial advice, but keep your eyes and ears open. They make mistakes, too. And they are not as interested in your business as you are.

2) For write-offs, I believe what some of the posters are referring to is Section 179. At one time during the Bush administration tax cuts, the number was somewhere around or over $100K. Sorry, I never made enough profit to have to concern myself with the top number. However, I'm pretty sure that number is now much lower, perhaps $20K/year. If you're a smaller shop like mine, that much equipment written off against my income does a lot. The time or two I did look into leasing, the interest rate was higher than the banks and I had the section 179 write-off to eliminate the advantage of leasing.

Do what works for your situation; just look at all the options thoroughly.

From contributor G:
The deductibility has indeed been $100,000 for I believe three years now. Many equipment manufacturers have been using this fact to their advantage in advertising. I do not know if that will be the case for this year.

From contributor A:
Let's look at the original question. They guy is starting up and is smart enough not to bet the farm on this new business.

For years I have wanted a high price edge bander, griping and begrudging all the while banding with the cheap one. On the advice of a few posters on this site, I bought the true 32 book and read the thing. One of the book's points is to look at the total time needed in a job for each machine before deciding what to upgrade. Turns out three hours will edgeband a set with a cheapy edgebander, versus one hour for a really nice machine. Of course, quality is better and the range of edgebanding is wider, but a new bander went way down on the list.

Look at the statistics for new business startups, look in an old phone book and check out how many competitors are still around after a few years. For a startup business, and I am assuming that this guy may not have a lot of experience in running a business, it would be extremely foolish to borrow for major purchases. One of the banes of our profession is workers making the jump to working on their own without having a clue as to the real costs involved in producing quality work under the restraints imposed by local, state and federal government. For years we kept track of what people worked on all day, down to quarter hour increments. After six months, we compiled the data and found out that 35% of all work was nonproductive, and trust me, we keep them at the machines and producing product. I was shocked at the numbers, but they have remained constant over the years.

Until this guy makes the jump from being a good craftsman to being a good businessman, odds are that it would be suicide to borrow more than he could pay off with current cash on hand.

Professional help is indeed needed, but accountants know very well how to add numbers or tax law and not a darn thing about how to actually run a profitable business. Start small, keep your mistakes small, keep the risks small. Add risk of bigger jobs, bigger payroll, bigger shop and tools on down the road, and I would bet there will be a road. And think of it this way - would you spend weeks and thousands of dollars on building a set of cabinets and then try to finish them with a radically different finish? No sample panels, just jump in with both feet?

The comments below were added after this Forum discussion was archived as a Knowledge Base article (add your comment).

Comment from contributor M:
I work for a Community Development Center and there are similar non-profits all over the US to help small businesses make wise decisions that fit their circumstances. We have both a business training department and a loan team. Our particular organization also has a smallwood division that works with both of the other teams to support small businesses in the timber industry.

I would suggest that, besides contacting the typical financing and accounting companies, see if your area has a Small Business Development Center. You may find that they offer a more complete/innovative look at your ideas and situation.