If you are a business owner or CFO, you already know that the company credit line is the life blood of the business. This provides availability to additional cash when the company's own cash flow (accounts receivable) don't line up with expenses. Nothing quite alarms a CEO like not having cash in the bank to cover payroll or critical purchases. Without an ample credit line, businesses can get in trouble fast. The recent credit crunch has made getting and keeping credit lines a real challenge since many banks just aren't lending.
With so much emphasis being placed on credit these days, it seemed appropriate to make lending the subject of this month's Measure of the Month. As you begin to craft measures for your 2009 management incentive plans, you may want to consider this one for your CFO and/or Controller. It brings several measures of a business' financial health together into a single measure that will help ensure the people responsible for making sure your business has ample cash keep their eye firmly on the ball.
Normally established by the bank, Borrowing Base is the portion of the maximum allowable monthly lending limit that the company is able to borrow in a particular month based on the financial condition of the company at the time.
([Accounts Receivable Control Base] + [Gross Sales for the Period] - [Net Collections for the Period] - [Past Due Accounts]) x [Lending Factor]
Accounts Receivable Control Base = Total accounts receivable at the end of the prior month
Gross Sales for the Period = Total gross revenues generated from operations during the prior month
Net Collections for the Period = Total dollars collected on outstanding invoices during the prior month
Past Due Accounts = Total dollars on accounts that are delinquent beyond a certain date, normally 60 or 90 days
Lending Factor = the portion of the available funds that the bank is willing to loan. For example, most banks are willing to lend up to 80% of receivables (the idea being that if the company defaults the bank would not be able to recover 100% of what is outstanding -- this is akin to the 20% down payment you need to have to buy a house).
HOW TO USE THIS MEASURE
When banks set up a line of credit, they analyze the business' finances and arrive at the maximum figure that they are willing to lend each month. But this is actually a theoretical maximum. Just because the bank says they will lend, let's say, $1 million per month doesn't mean you actually have access to all the money. The million is the maximum amount they will lend, but the actual amount is the result of the above calculation. Another way to say it is that the bank will lend $1 million or the result of the calculation, WHICH EVER IS LOWER.
In order ensure that your company has access to as much money as possible, you need to maximize the elements of the above calculation. This means that sales must generate as much revenue as possible, accounting must minimize bad debt and keep Days Sales Outstanding (DSO) within acceptable limits, and credit line usage must be controlled since money already lent reduces the amount that remains available.
WHEN TO USE THIS MEASURE
Because cash management is so critical to every business, someone in your company should have this measure (or something similar) on their incentive plan at all times. Of course, this measure does not apply to companies that do not have or use credit lines. For such businesses, other cash flow measures should be used instead.
WHO SHOULD USE THIS MEASURE?
This measure can be a mainstay on incentive plans for Controllers and other finance managers and executives. When modified to include available loan balance (i.e., the difference between the Borrowing Base and credit line usage) it becomes a very powerful measure of the overall effectiveness of cash management.