Cash [Flow] is King as Credit Lines Shrink

To a degree, every business plays banker to its client base when extending credit for receivables. However, the nation’s credit crisis has magnified the need for companies to become their banker’s collection department.

The extended period of “loose lending” that contributed to the credit crunch continues to bite businesses nationally, as banks responded by restricting the short-term loans that once helped companies manage cyclic cash flows. Greg Dombrowski, president of Johnson Bank-Madison, said the pendulum has swung away from relaxed underwriting, but not before, “We, as a country, are paying for some of those [lending] decisions.

“Right now, where some borrowers might argue that it is much more conservative than it was, some of us might argue that it’s representing a more rational approach to credit in a more even-keeled environment,” he said.

Madison Impact

Gordon Meicher, a partner in the accounting firm Meicher & Associates, works with CPAs throughout the country. He said the credit crunch is impacting Greater Madison, but not to the same extent as other areas of the country. Meicher estimated that for an average business, local collections had averaged anywhere between 25 to 40 days before July 2008, but that has lengthened to an average of 30 to 50 days, he indicated.

“I would say that in Dane County, although there are very dramatic affects, they are nowhere near what they are in some parts of the country,” Meicher echoed. “I’m not saying we’re insulated, but I am saying that it could be significantly worse than it is.”

Steve Bethke, president and CEO of Madison’s Ideal Manufacturing Sales Corp., agreed that the impact of the credit crunch is less severe in Greater Madison, though area business are still getting hurt. His company builds liquid filling machinery, and most of its customers are located outside of Madison and around the country. “I think a lot of the people I know probably aren’t leveraged as heavily as maybe some of the people you’re reading about in other areas,” he said.

Still, Meicher noted, with cautious banks tightening credit terms and scrutinizing every transaction, a lot of deals that would have gotten done two years ago are not getting done today.

In addition, businesses overall are not extending the usual credit for receivables, either. Some major corporations have unilaterally instituted 60-day or 90-day terms with vendors – who have no choice but to comply to keep the client. (Anheuser-Busch InBev, the fifth-largest consumer products company in the world, is 120 days.)

As a result, cash-flow management is more difficult than it’s been at any time since 1990-91. “I can tell you from my conversations with clients, there is a trickle down effect – that you are seeing companies slow down in the payment of their obligations to their creditors,” Dombrowski said, “and as a result, those businesses are forced to slow down in the payment of their obligations.”

As Dombrowski explained, trouble elsewhere can spell trouble here, too. “We have a client that has relationships in China, and we saw the tightening of credit in China have an impact on our client who runs a company here in the Madison area,” he said. “They came to us needing additional credit to backstop what – in prior years – would have been provided as working capital loans by the Chinese banking system to the Chinese factories that were supplying them.”

Beyond collections, he said, “The extreme of that is we are watching businesses go out of business; not too significantly here in the Madison market, but we obviously are seeing this across the country. When those businesses fail, generally our clients that are providing goods and services are unsecured creditors, and typically get nothing to very little back as an unsecured creditor.”

Relationship Negotiations

These days, cash flow management requires some firm but deft negotiating. Creditors can’t go ballistic with “slow pays” because, in most cases, they want to maintain the relationship for when the economy regains traction. While burning bridges is tempting, our advisers suggested it should be resisted while more diplomatic (and even some suggested methods) are pursued.

“You don’t know who to trust and who not to trust,” Meicher said. “I have one client that had a client that was ‘golden’ – their best client that paid them for 20 years. That client now is becoming a really slow pay, and that’s difficult. The problem is that you’ve got this 20-year relationship, and you’re in a very cumbersome situation because you don’t want to upset the relationship. On the other hand, you need to continue your cash flow.”

Given the unprecedented conditions of the economy, more businesses are working out payment terms on the front end of a contractual agreement. Businesses like Ideal Manufacturing require upfront deposits as a matter of course; Bethke said the company gets 40% down, 40% upon shipment, and then 20% afterward. This minimizes risk.

“We don’t have a lot hanging out there that we’re not going to get paid for,” he said.

Bethke acknowledged that a lot of Ideal Manufacturing’s customers are like a Sherwin Williams or a DuPont in that when they order a piece of equipment, “it’s budgeted, it’s done, and you know the money is there.” He added, “We haven’t had too much of a problem with the bigger companies.”

Ideal Manufacturing also serves many smaller, regional companies, but has been fortunate enough not to cut anybody off, or decline to service equipment or deliver parts until it gets paid. With slower pays, the company typically has worked out modified terms, allowing customers to pay a certain amount per month for a specified period of months to square accounts.

“We do a cash flow every week, and my office manager stays pretty much on top of this,” Bethke said. “When we see something going a little longer than normal, she just calls up the credit department or their payables and talks to them. We haven’t really run into a big problem where somebody has really run into trouble and can’t pay the last part of their bill.”

Bethke said Ideal Manufacturing has tried to be more creative on the sales side than on the accounts receivables side. This entails being more creative with its terms, perhaps lowering down payments or the percentage down, or offering longer terms to pay upfront. “Right now, people have pulled their horns in and are trying to make do with what they’ve got,” he noted. “We’re trying to see if that will stimulate some people, but so far most of the companies just don’t have a need. You could give them the best terms in the world, and they are just not going to buy anything because they don’t need it. Their businesses are down.” Adding more stress.

In managing cash flow, the tried-and-true advice is to bill promptly and aggressively follow up on overdue notices. In a sagging economy, however, aggressiveness has to be tempered with reasoned appeal. Said Meicher: “Usually what you do is call and say, ‘Look, I’ve got to give a [financial] aging to my bank. I have a line of credit.’ Explain that to them. ‘I’ve got to give an [aging] of my receivables to my bank, and your receivable is really putting me in a difficult position, financially. I want to be here to help you in the future, and I need your help with taking care of this account,’ especially anything over 60 days. You try to tell them that it’s not just you; it’s outside of your realm. That’s the first thing.”

“The second thing is you have to explain to them how it’s hampering your business, and how they can help you through this, and the reason you’re doing this is you appreciate the relationship and you need to continue the relationship.”

Dombrowski said the approach to collections should vary by business, but with the understanding that “what this gets back to is something that always happens during an economic downturn – businesses become inwardly focused.” Some might argue that businesses take this to extremes, he said, but organizations take a closer look at managing expenses, looking at business efficiency and business practices.

“Most of our clients, if they haven’t already, we have at some point talked to them about doing that, looking at strategies to employ to get a better collection of receivables,” he said.

In Dombrowski’s view, oftentimes, the better leverage exists at the CEO level or with the owner of the business: “One of the things that can be done to improve accounts receivable collection, that we like to see, is that receivable collections become more than just the responsibility of one person in the accounting department. That the owner of the business is calling the owner of the business that owes them money, that the controller of the business might be calling the controller of the business that owes money, and there is a cascading effect and an understanding within the company that a number of people play a role in helping to improve receivable collections.”

Asked if he had seen anything creative in the receivable collection area, Dombrowski said he hadn’t, but he did offer a quick comment on the use of business credit cards to pay bills, which in some cases is suggested by creditors. “I suppose if you had a large enough credit line,” he said, “that would be an interesting way to add an extra 20 days of float into your payment schedule.”

Managing your payables often involves holding on to cash as long as possible – without incurring late fees or interest charges or hurting vendors. From the standpoint of a “slow pay,” Meicher suggests sending “a little drab of money” to as many creditors as you can. “I always tell my clients, ‘You have to pay your employees. You can’t get rid of that debt. You have to pay the IRS, the taxes and things like that. The penalties can be as much as 10% a month if you don’t pay them. You have to pay the suppliers that are getting you the product you need to sell.” And, he said, tongue in cheek, “you have to pay your accountant.”

The other thing you need to pay mind to, of course, is your company’s reputation. There are repercussions of not paying for services rendered or inventory purchased according to standing terms. More than one Dane County business has had a hard time overcoming rumors of pending demise when suppliers compared notes and started asking questions of other vendors. If you are going to alter payment terms, it should be a change mutually agreed upon by all parties, our experts advised, to avoid earning a “the check is in the mail” reputation. Once that proverbial train builds steam, it’s hard to derail.

When it comes to cash flow, Bethke, who sits on the board of Mid-America Bank in Janesville, recommends keeping your banker very close. With the type of structure that Ideal Manufacturing has on its loan through the Bank of Prairie du Sac, Bethke said it can use deposits to pay down its loan, which keeps loan balances down and “helps us manage our cash flow very well.”


Cutting off [Your] Capital?

While the federal government tries to stimulate credit availability – the effectiveness of Treasury Secretary Timothy Geithner’s plan to help financial institutions shed their risky subprime mortgage assets remains to be seen – regulatory limitations and possible legislative changes could have the opposite affect closer to home.

For example, community banks across Wisconsin have traditionally bought and sold “participation” as a means of diversifying credit risk. Under this concept, if a business needs a large credit facility, the originating bank tries to sell off a piece of that to other banks to limit its credit exposure and do the deal. Lately, however, examiners have been pushing banks to eliminate or reduce their participation purchase position.

When that happens, credit is pushed back to the originating bank, limiting the bank’s ability to provide new funds because the borrower may be bumping up against legal lending limits. In some cases, it’s an over reaction; in other cases, it’s completely justified.

If the bank didn’t understand the credit or is having some capital limitation challenges, it might be the appropriate strategy, Dombrowski said, but there is a clear message being sent that participations are being looked at much more critically, and banks are much less willing to engage in participation activities because of that. “So while the examiners perhaps are providing good guidance relative to that specific bank, the challenge in the system is that you’re constricting the flow of capital by doing it,” he said.

Another hotly contested limitation on capital could soon be enacted by the Wisconsin Legislature. For more than 130 years leading up to 1998, courts had recognized that workers should have “first draw” for unpaid compensation from a financially troubled company.

In 1998, a Republican-controlled Legislature removed that first-draw protection in favor of banks and other secured creditors. However, it was restored in 2003 – along with a protection lien of $3,000.

In Dombrowski’s view, a new bill toincrease the per worker wage-protection lien from $3,000 to $10,950 would add another layer of headaches to credit and cash-flow management because these worker protection liens – part of the state’s Wage Lien Act – still take precedence over the liens of banks and other secured lenders.

For a business with 100 employees, the change would add more than $700,000 million of of additional wage lien rights to workers. The wage-protection lien covers earned but unpaid compensation, including regular pay, unpaid bonuses, and unpaid vacations.

Dombrowski said the new bill, which has passed the State Senate and is before the State Assembly’s Labor Committee, couldn’t come at a worse time. “What’s going to happen is the secured lender is going to find a way to reduce the amount of credit that it’s going to give that business because of the existence of this much larger lien liability that has priority ahead of a secured lender,” he said.

Mike Browne, a spokesman for the bill’s chief sponsor, State Senator John Lehman, D-Racine, said protecting workers first makes more sense because of the potential domino effect on the repayment of mortgages, credit cards, auto loans, and other consumer debt. “There is another side to the bank’s argument – that it’s detrimental to the credit market for consumers to default on the loans that they have,” Browne said.

Less taxing debt?

The recently enacted American Recovery and Reinvestment Act includes provisions to help small businesses meet their debt payments and to defer some of the tax cost of debt restructurings.

Under the Act, the Small Business Administration will receive $255 million for a new loan program to help small businesses meet existing debt payments. The Act creates deferred payment loans of up to $35,000 to viable small businesses that need funds to make payments on an existing, qualifying loan. According to the SBA, repayment would not have to begin until 12 months after the loan is fully dispersed.

In addition to business stabilization loans through the SBA, the Act allows any business taxpayer that realizes “cancellation of debt” income from the acquisition of its debt in 2009 or 2010 to have the option to defer the taxation of that income, improving liquidity.

John Emanuel, an attorney for Whyte Hirschboeck Dudek, said Congress moved on this issue because public officials realized that a business that has some of its debtreduced, forgiven, or restructured could have ended up with a fairly dramatic tax burden – one that can largely supplant the cash-flow benefit of reducing debt. Sometimes the tax cost can undermine the value of the debt reduction, he said, depending upon what debt was reduced and when it would have been paid.

The tax cost is incurred in the year in which the debt is reduced, canceled, or forgiven, not when the debt otherwise would have been payable. As Emanuel explained, under the old law, the tax cost could trump the value of the debt reduction.

“If you take $1 million in debt off my balance sheet, great,” he said. “That’s $1 million less that I owe to my creditors. Oh, but now I owe $400,000 to the government. Well, I’ve benefited by $600,000 now, but in fact it’s possible that the $1 million of debt that I would have had to pay 10 years from now gets replaced by a $400,000 tax bill that I have to pay next month.”

The Reinvestment and Recovery Act did not reduce or eliminate the tax cost of a debt forgiveness or debt restructuring; it simply allows taxpayers who have debt restructured, forgiven, or canceled in 2009 or 2010 to spread out the tax cost of over five years – 2014 to 2018. According to Emanuel, the law doesn’t apply to consumer debt, only business debt. “There is no [business] size limitation,” he said, “and I suspect that a lot of small- and medium-sized businesses will find this advantageous.”