Dr Jeff Cornwall

My column for the Tennessean this week is the third in a series on managing cash flow:

My previous two columns have examined why the phrase “cash is king” is so true and what steps entrepreneurs can take to improve their cash flow.

So what is the purpose of building up cash reserves? Think of your cash reserves as four pools of funding with four distinct purposes.

The first pool of cash is to plan for those large expenses that are not part of regular monthly expenses, but are critical nonetheless. Examples are quarterly tax payments, annual equipment replacement purchases, or large seasonal marketing campaigns.

Create a calendar of these payments and put cash aside to build up enough to cover them.

The second pool of cash is used to better manage the natural “lumpiness” of cash flow. The reality is that the rate that cash flows into a business is never smooth and predictable. Some businesses have to pay for products to be made or for services to be provided well before they actually get paid. Other businesses may have seasonal sales swings, such as many retail businesses that have most of their sales in November and December.

This second pool of cash should be used to create your own internal line of credit to help navigate the natural “lumpiness” of cash flow.

Be ready for the unexpected

Think of the third pool of cash as your emergency fund. This pool should be large enough to cover at least a month of day-to-day expenses. This will help cushion you from events such as an unexpected loss of a major customer or a major disruption of your business.

I remember one year in our health-care company when we lost about two weeks of sales in the aftermath of a hurricane in September, followed by the loss of about 10 days of sales due to a major ice storm in January. Cash reserves are what got us through those tough times.

The final pool of cash is for an “opportunity war chest.”

Recessions create many opportunities for financially strong companies. There may be opportunities to acquire a competitor’s business that’s been weakened by the economy or to expand and fill the void left by a competitor’s failure.

It may actually prove to be a good time to expand the business — real estate prices, the cost to rent space, equipment expenses and labor costs will all be lower.

Develop an annual plan to forecast all of the needs for a cash reserve.

Create a separate bank account to keep these funds segregated from the cash needed for day-to-day operations.

And make regular and frequent transfers into this account whenever possible to ensure that the funds will be available when you need them.

In a follow-up to the post I wrote yesterday, the Nashville Post has a story today that confirms my outlook for bank lending to entrepreneurial ventures in 2009.

From Geert De Lombaerde’s story:

The credit crisis taking its toll on parts of Nashville’s banking sector could be setting the stage for a clear 2009 division of the haves and the have-nots.

A NashvillePost.com analysis of Federal Deposit Insurance Corp. third-quarter filings shows that four of the top nine banks based in Middle Tennessee or doing most of their business here trimmed their loan portfolios from July to September.  

Such is the case with community banks all across the country, although in some markets small business lending has come to a complete stop.

Geert used my analysis from yesterday as support for his assessment that this “tight lending environment will be with us for a while.” 

However, the surveys of business owners are all beginning to tell us the same story — most entrepreneurs are not really looking for new credit right now, anyway. 

I just received a copy of a new study from the NFIB Research Foundation looking at the current state of small business credit.

First of all, the recession is clearly on the minds of many small business owners.  One-third (34%) of small business owners, defined as small employers having 250 or fewer employees, think the nation’s financial problems have “significantly” affected their business and one-quarter (26%) think it threatens their survival.

So what is their short term worry?  Is it access to credit or the real estate crisis as those in Washington seem to be fixated on right now?  Nope.  Here are their immediate worries in order of importance:

• 45% responded that slow or lost sales
• 23% the unpredictability of business conditions
•  9% falling real estate values
•  9% an inability to obtain credit.

Since the beginning of early September, 30% of small employers applied for credit in one form or another, at least half of which applied more than one time (after all, persistence is one of our virtues).  Of those 70% who did not apply, 12% of them (8% of the population) did not apply because they thought they could not get credit they wanted.

Of those who went after credit since September, 41% obtained all the credit they wanted, while 8 percent obtained most of it. We are consistently told that nobody can get credit, but half of small business owners who tried got all or most of what they asked for!  In addition, 14% got some of what they asked for.  That makes it two-thirds of those who tried got at least some credit.

As one would expect, the ability to obtain credit appears statistically related to financial strength, as measured by greater sales growth in the last two years, fewer mortgages taken out to finance other business activity, fewer upside-down properties, as well as the owner’s positive evaluation of firm performance against the competition, and firm maturity, more specifically, years of operation.

Discouraged borrowers, that is, owners who do not attempt to borrow for fear of rejection, are statistically related to what appears to be weak balance sheets.  Specifically, falling real sales over the last two years, ownership of more upside-down properties, lesser use of real estate for collateral, more mortgages taken out to finance other business activity, and the owner’s negative evaluation of firm performance against the competition.

Financial institutions have changed the terms or conditions of a line of credit loan, line or credit card for 18 percent of small employers. The changes include a lower limit on a credit card or higher interest on a line of credit, though not all changes, particularly with respect to lines, were adverse.

Trade credit (borrowing from suppliers) is growing more difficult to procure. Of the 80 percent who use trade credit, 30% think it has been getting tighter since early September, 14% a lot tighter, while 46% see no change.

Small business owners are heavily invested in real estate. A whopping 96% own their personal residence, 49% own all or part of the building and/or land on which their business sits (excluding the one-quarter who operate primarily from the home), and 41% own investment real estate, excluding their residence and business.

Real estate, particularly home mortgages, is frequently used to finance or collateralize other business assets. 76% percent have at least one mortgage on the real estate they own with 13% having three or more mortgages.  22% have taken out at least one mortgage to finance business activities. 16% use real estate to collateralize other business assets, including 10 percent who use their homes as collateral. 9% own at least one currently upside-down property.