Last week, we learned about what the working capital gap means, why it's important, how it's calculated, and ways to optimize it.

This week, we will embark on a journey to uncover a foolproof method that empower businesses to navigate the complex world of financing, ensuring a clear understanding of how much capital their company can access.

In this issue, you will learn:

1. Why businesses should care about maximizing financing potential
2. Maximizing the value of assets
3. Navigating the limitations of financial covenants
4. How to calculate the maximum lending value

Why should you care?

For businesses looking to scale or simply planning weekly cash flow to stay afloat, understanding this financing method is pivotal. This knowledge empowers strategic planning, enabling owners and management to make informed decisions about the company's growth and maintain liquidity during challenging times.

Whether expanding operations, launching new products, or entering new markets, extracting the maximum value from assets supports sustainable business growth. It ensures that the business has the necessary financial backing to execute growth strategies without compromising liquidity.

So how can businesses unlock their maximum financing potential?

Let's find out.

Maximizing the value of assets

To get the most bang for your buck, maximizing the value of your assets is the most efficient way to do borrow. Each tangible asset becomes a crucial element in securing the capital your business needs. But how did we arrive at this approach, and why is it integral to your financing strategy?

It is customary practice for banks to lend against tangible assets. Simple example: when you get a mortgage to buy a house, the house becomes the asset pledged to the bank to secure the loan. But businesses are a bit more complex. There are other assets that have material value: accounts receivable, inventory, equipment, and etc.

Banks assign a standard loan to value ("LTV") for each asset class. Typical LTVs are outlined below. Keep in mind the LTVs are subject to change +/- 5-10% based on the specific details within the asset.

• Accounts receivable: 75%
• Inventory: 50%
• Equipment: 65%-100%
• Real Estate: 65%-75%

Limitations of Financial Covenants

As we delve deeper, we encounter another crucial factor - financial covenants.

Financial covenants exist to ensure the company is operating within the risk parameters of the lender. Just because a company has assets doesn't mean it can lever it up to the sky. Financial covenants constraints imposed by lenders can significantly impact the total eligible financing for your company, thereby restricting further indebtedness. In other words, the company may not have full access to the loan when covenants are offside.

Here are a few common financial covenants to test against the limits:

• Current Ratio > 1.25x
• Debt to Tangible Net Worth < 3.00x
• Debt Service Coverage Ratio > 1.25x

Financing example:

Now, the moment you've been waiting for. Let's take these 2 factors and apply them to a real scenario for a company using a line of credit ("LOC"). Key aspects to consider:

• Line of credits are used to finance the company's working capital needs.
• The primary working capital assets used to finance the LOC are accounts receivable and inventory.
• The standard covenants for this facility would be the current ratio and Debt to Tangible Net Worth.

Here's the balance sheet for our example company, Newsletter Inc.

Step 1: Determine the maximum lending value based on assets

1. Multiply the asset's book value with its LTVs.
2. Add up the lending values

Based on the calculation above, Newsletter Inc.'s maximum lending value is $26,459k. Notice the company's current outstanding balance is $17,006k. This means the maximum lending value can support an additional $9,453k in financing against the assets.

Step 2: Calculate the financial covenants based on the existing loan

1. Calculate the Current Ratio and Debt to Tangible Net Worth ratio

You will find that Newsletter Inc. currently operates within it's financial covenants.

Step 3: Reverse engineering covenants to test limits of lending value

Start with the current ratio.

For simplicity, let's assume any incremental loan is drawn and held as cash.

1. Using excel, copy the table below and program the cells using the formulas on the right.
2. Using the "Goal Seek" function, set the "Current Ratio" cell to the covenant's minimum threshold of 1.25x by changing the "Incremental Amount" cell.
3. Run the function.

By stretching the current ratio covenant to its lowest threshold, Newsletter Inc. has the ability to reach a maximum LOC of $46,926k.

What this means: It is impossible to borrow $46,926k because the maximum value that the assets can support was $26,459k. In this case, the maximum lending value is $26,459k.

[For the nerds: You can also find the incremental amount by solving for X based on this formula --> Covenant Threshold = (Current Assets + X) / (Current Assets + X)]

Moving onto the Debt to Tangible Net Worth covenant.

1. Using excel, copy the table below and program the formulas.
2. Set the maximum Debt to Tangible Net Worth covenant to 3.00x.

By stretching the Debt to Tangible Net Worth covenant to its maximum threshold, Newsletter Inc. has capacity for a maximum LOC of $24,392k.

What this means: Notice the Debt to Tangible Net Worth covenant produces a lending value of $24,392k, which is lower than the maximum lending value based on assets at $26,459k.

To remain onside of the financial covenants, Newsletter Inc.'s ultimate borrowing capacity is limited to $24,392k.

[Side note: You can arrive at the same result using the Goal Seek function on the D/TNW covenant within Step 2 above]

Conclusion

You've journeyed through the intricacies of determining your company's financing potential. Here are the key takeaways:

• Empowerment: Gain the knowledge to make informed decisions about your company's financing.
• Strategic Planning: Plan ahead for growth and navigate challenges with confidence.
• Financial Resilience: Ensure your business has the liquidity it needs during both prosperous and challenging times.

Now armed with these insights, you're equipped to unlock your financing potential and pave the way for the success of your business. Remember, knowledge is power, especially in the world of finance. Lastly, borrow only what you need knowing you have the capacity to repay.

That's it for this week. See you next Saturday.

Thank you for reading Financing Journey. I hope you've enjoyed this issue. If you think this would be helpful to anyone you know, please share this newsletter and connect with me on X and LinkedIn for daily financing tips.

Have a topic you'd like me to cover? Email me at hello@lawrencefan.com.