Is Your Business Growing—but You Never Have Cash?

The Debt-Free Mindset

Many entrepreneurs are understandably proud of building a company without debt. They have heard the warnings throughout their careers: debt is risky, interest is wasted money, banks become intrusive, and a business should never borrow money it does not need. There is considerable wisdom embedded in those principles. Excessive leverage has destroyed plenty of otherwise good businesses, and debt should never be used casually simply because a lender is willing to provide it.

There is, however, an important distinction between avoiding excessive debt and concluding that all debt is inherently undesirable. Debt is simply a form of capital. Whether it is helpful or dangerous depends on its amount, cost, structure, duration and, perhaps most importantly, what it is being used to finance. Borrowing money to perpetually fund operating losses is one thing. Borrowing against high-quality accounts receivable to bridge the ordinary period between delivering a product or service and collecting the customer's invoice is something entirely different. The first may be financing an economic problem; the second may simply be financing time.

That distinction is especially important for founder-owned businesses because the alternative to bank financing is not necessarily “no financing.” The capital still has to come from somewhere. If a business requires $3 million, $5 million or $10 million to finance the timing difference between paying its expenses and collecting from its customers, someone is supplying that capital. If there is no lender doing it, the company—and ultimately its owners—probably are.

The Working-Capital Problem Hiding in Plain Sight

Consider what happens during the normal operating cycle of a business. A company may have to pay employees today, suppliers next week and subcontractors shortly thereafter. It may incur freight, materials, production or other expenses throughout the process. The customer, meanwhile, may not pay the invoice for 30, 45 or 60 days. Nothing is necessarily wrong. The customer is not delinquent, the company is not losing money and the transaction itself may be quite profitable. There is simply a timing difference between when the business spends cash and when it receives cash.

That timing difference creates a working-capital requirement, and someone has to finance it. For many growing businesses, that requirement can become surprisingly large. A company with $30 million of annual revenue does not necessarily have to finance only a few days of expenses. Depending on its billing cycle and customer payment terms, millions of dollars can be tied up in accounts receivable at any given time.

If a bank is not financing a reasonable portion of those receivables, the business is generally financing them with its own cash. That means money generated from profitable operations is continually being redeployed into the operating cycle rather than accumulating as available liquidity. The owner sees strong earnings on the income statement but relatively little cash accumulating in the bank account.

A Very Simple Example

Suppose a company generates $1 million of cash from its operations during a particular period. At the same time, it needs $750,000 to fund payroll, suppliers and other costs associated with customer work for which the corresponding receivables have not yet been collected. Assume those are high-quality receivables and the customers are expected to pay in the ordinary course. There is simply a delay between performing the work and receiving the money.

Now consider two versions of exactly the same company. In the first, the company has an appropriately structured working-capital revolving credit facility. It can borrow $750,000 against eligible receivables to bridge the timing difference, which allows substantially more of the $1 million of internally generated cash to remain available to the business. When the customers ultimately pay their invoices, those collections repay the revolving borrowings and restore the borrowing capacity for the next operating cycle.

In the second version, the company has no working-capital facility. It generates exactly the same $1 million, has exactly the same customers and earns exactly the same profit. The difference is that the company must take $750,000 of the cash it just generated and put it straight back into the operating cycle while it waits for its customers to pay. The business generated $1 million of cash, but only $250,000 remains available as liquidity during that period.

Nothing mysteriously disappeared. The economics of the business did not suddenly deteriorate. The cash has simply been absorbed by the working-capital cycle, and the business financed that cycle itself. That distinction is at the heart of why some successful business owners perpetually feel as though their companies never have enough cash.

Your Business May Be Acting as Its Own Bank

There is another useful way to think about this. Imagine that your company has $5 million of accounts receivable and that your average customer pays in approximately 45 days. Those receivables represent $5 million that your customers owe the company, but during those 45 days your business must continue operating. Employees are paid, vendors are paid, rent and insurance are paid, and the next customer order must be fulfilled.

Who is financing those 45 days? If the company does not have a working-capital facility, the answer may be that the company is financing them itself. In economic terms, the operating business is extending financing to its customers using its own capital. The customer gets the benefit of 30-, 45- or 60-day payment terms, while the company provides the capital necessary to bridge the gap.

That should prompt an important capital-allocation question. Why is the operating company using its most flexible form of capital—cash—to finance high-quality, short-duration receivables if a commercial bank may be willing to finance a substantial portion of those assets at a reasonable cost? There may be perfectly good reasons to do so, particularly for a company with abundant excess cash and few attractive uses for it. But it should be a deliberate decision rather than an accidental consequence of having always believed that operating without debt is inherently better.

Why Growth Can Make the Problem Worse

This phenomenon becomes particularly important when a business is growing rapidly. Suppose a $20 million revenue company carries approximately $3 million of accounts receivable. The owners have historically funded the business themselves, liquidity is adequate and they see little reason to establish a revolving facility. Then the business succeeds. Revenue grows from $20 million to $30 million and eventually to $40 million. Accounts receivable may grow from $3 million to $5 million or $6 million. Payroll increases, vendor purchases increase and the absolute dollars required to support the operating cycle increase with them.

The company is objectively more successful than it was before. Revenue is higher, EBITDA may be higher, enterprise value may be substantially higher, and the customer base may be larger and more diversified. Yet substantially more cash is now tied up financing the operating cycle. Unless the company's working-capital financing grows along with the business, the owners may find that the larger and more profitable the company becomes, the more liquidity it seems to consume.

This creates a counterintuitive outcome that is worth understanding: a company can become larger, more profitable and more valuable while simultaneously becoming less liquid. Management experiences this as a cash-generation problem, but the underlying issue may be at least partly a capital-structure problem.

EBITDA Is Not Cash

This is also where business owners need to distinguish between profitability, cash generation and liquidity. EBITDA is a useful measure of operating performance, particularly when comparing companies or evaluating enterprise value, but EBITDA is not cash sitting in a bank account. A company can report excellent EBITDA while experiencing significant demands on cash from working capital, capital expenditures, interest, taxes, debt repayment and other uses of capital.

Accounts receivable are particularly important. A company may recognize revenue and the associated earnings today but not collect the customer for another 45 days. The income statement therefore reflects the economic activity before the corresponding cash reaches the bank account. If the business is growing, the amount tied up in that timing difference can increase from period to period. A CEO can therefore truthfully say that EBITDA has increased substantially while the CFO simultaneously reports that liquidity remains tight. Both statements can be correct.

That does not mean working capital explains every instance of weak cash conversion. It does not. A business with poor margins, uncontrolled expenses, excessive capital expenditures or genuinely uncollectible receivables has an economic problem that financing alone will not solve. But before concluding that a profitable company's apparent lack of cash demonstrates weak underlying economics, management should understand precisely where the cash is going and how much is being absorbed by growth in working capital.

A Revolver Does Not “Create” Cash

This distinction is essential because a revolving credit facility does not magically make a business more profitable. It does not increase EBITDA, turn a bad customer into a good customer, fix poor margins or solve a fundamentally broken business model. What it can do is change what the company is required to do with the cash it generates.

Return to the earlier example. The business generated $1 million and had a $750,000 temporary working-capital requirement. Without a revolver, the company funded the $750,000 itself. With an appropriately structured revolver, the bank temporarily financed eligible working-capital assets, allowing more of the company's internally generated cash to remain available elsewhere in the business. When the customer pays, the revolver is repaid and the borrowing capacity becomes available again.

This is why a properly functioning working-capital facility revolves. It expands and contracts with the operating cycle. The facility is not intended to permanently finance losses; it is intended to bridge predictable timing differences between cash outflows and cash inflows. Used properly, it allows short-duration assets to be financed with short-duration capital rather than requiring the company to permanently commit its most flexible capital—cash—to that purpose.

Match the Capital to What It Finances

The working-capital discussion illustrates a broader principle of corporate finance: the duration and structure of capital should generally correspond to the asset or investment it is financing. Short-duration working-capital assets are generally best financed with short-duration revolving capital. Equipment with a multi-year useful life may appropriately be financed with equipment financing or term debt. An acquisition expected to generate value over many years generally should not be financed with a working-capital revolver that may need to be repaid in the near term. Permanent capital requirements may appropriately require equity.

The objective is not to borrow as much money as possible. In fact, maximizing debt is usually the wrong objective. The objective is to construct a capital structure in which the type and duration of capital are appropriately matched to what the company is financing, while maintaining sufficient liquidity and a prudent margin for error.

The Cost of Debt Versus the Cost of Using Your Own Cash

Owners frequently focus on the visible cost of debt. Suppose a bank offers a working-capital facility carrying an 8% interest rate. The owner immediately sees the expense and reasons that using the company's own cash costs nothing. From an accounting standpoint, there is no explicit interest expense associated with self-financing, but economically the company's cash is not free.

Cash has an opportunity cost. Every dollar tied up financing receivables is a dollar that cannot simultaneously be used to make an acquisition, purchase equipment, hire a key employee, open a new location, invest in technology, reduce more expensive debt, withstand an economic downturn, make a distribution to shareholders or simply remain available as a liquidity reserve.

The relevant comparison is therefore not always “interest expense versus zero.” The better question is what the borrowing costs and what the company gains by preserving its cash for other uses. A business that can borrow at 8% to finance a high-quality, short-duration receivable may rationally choose to do so if preserving that cash enables the company to pursue investments with substantially greater returns or simply provides valuable protection against uncertainty.

This does not mean the answer is always to borrow. It means the decision should be evaluated as a capital-allocation decision rather than through the simplistic assumption that debt costs money while cash does not.

Not Every Receivable Can Be Borrowed Against

A business with $10 million of accounts receivable should not assume that a commercial bank will provide a $10 million revolving facility. Asset-based and working-capital lenders generally establish a borrowing base by determining which receivables qualify as eligible collateral and then applying an advance rate to that amount.

A lender may exclude or reserve against receivables that are too old, disputed, foreign, concentrated among a small number of customers, subject to unusual contractual rights or otherwise considered difficult to collect. The bank may then advance only a specified percentage of the remaining eligible receivables. Consequently, a company with $10 million of gross A/R may have materially less than $10 million of actual borrowing availability.

The important question is therefore not simply how much accounts receivable appears on the balance sheet. Management should understand how much of that A/R is eligible, what advance rate a lender will apply, what concentration limits exist and what other reserves may reduce availability. A sophisticated company should be able to bridge clearly from gross receivables to eligible receivables and ultimately to actual borrowing capacity.

Deferred Revenue Can Complicate the Analysis

Deferred revenue is another area that can become important when establishing a working-capital facility. A company may receive money from customers in advance and record that amount as deferred revenue until it performs the corresponding obligation. Some lenders may reserve against deferred revenue when calculating borrowing availability, particularly where the customer could have a legitimate right of setoff, refund or recoupment against an outstanding receivable.

However, the accounting balance and the lender's actual economic exposure are not necessarily identical. If one customer owes the company money while an entirely different customer has prepaid for future services, a blanket dollar-for-dollar netting of the two balances may not accurately reflect the collection risk associated with the first customer's receivable. Similarly, an obligation to provide future products or services is not necessarily economically identical to an obligation to refund cash.

A sophisticated borrower should therefore understand how its lender intends to treat deferred revenue and, where appropriate, be prepared to explain those balances at the customer and contract level. The broader lesson is that borrowing capacity depends on the quality and legal characteristics of the assets, not merely the accounting balances appearing on the company's financial statements.

When Debt Becomes Dangerous

There is an important boundary to everything discussed here. A revolving facility should not become a permanent substitute for profitability. If a company continually draws more money because it is losing cash, has structurally inadequate margins or cannot collect its customers, the facility is no longer simply financing a temporary working-capital cycle. It may be financing an underlying economic problem.

A healthy working-capital facility should generally revolve. The company borrows as receivables and other working-capital needs increase, customers pay, the facility pays down, new receivables arise and the company borrows again. If the outstanding balance only moves in one direction—up—management should understand why. Likewise, a company needs adequate cushion beneath its borrowing limit. A revolver that is theoretically large enough but remains nearly fully drawn at all times may provide little protection when something unexpected occurs.

The appropriate lesson is therefore not that debt is good. Nor is it that debt is bad. Debt is a financial tool whose value depends on how intelligently it is structured and used. A poorly designed revolving facility can create significant risk; an appropriately structured facility can materially strengthen liquidity and financial flexibility.

A Larger Revolver Is Not Necessarily a Better Revolver

Facility size alone is also a poor measure of quality. Owners and executives should understand the borrowing base, advance rates, customer-concentration limits, eligible and ineligible receivables, financial covenants, minimum availability requirements, cash-dominion provisions, reporting requirements, interest rates, fees, maturity and security interests. They should also understand the circumstances under which a lender can reduce availability or exercise greater control over cash.

A $10 million commitment that routinely produces only $4 million of actual borrowing availability may be considerably less useful than the headline commitment suggests. Similarly, the lowest-priced facility is not automatically the best facility. Flexibility, covenant headroom, actual availability, ease of administration and the lender's willingness and capacity to support future growth can be every bit as important as the interest-rate spread.

This becomes particularly important for acquisitive or rapidly growing companies. A facility designed precisely for the company's current size may become obsolete surprisingly quickly. Management should therefore consider not only what the business requires today but how the financing can expand as revenue, receivables and working-capital requirements grow.

The Real Objective Is Liquidity

Ultimately, this discussion is less about debt than it is about liquidity. A well-capitalized business needs sufficient liquidity to operate confidently through ordinary fluctuations and unexpected events. That liquidity can come from cash, committed borrowing capacity or, most commonly, an appropriate combination of both.

There is tremendous strategic value in having cash available when the company needs it because opportunities and problems rarely arrive according to a budget. A customer can fail, a supplier can change payment terms, a competitor can unexpectedly become available for acquisition, a key employee may need to be hired, a technology investment may become urgent or an economic downturn may arrive faster than anticipated. The company with adequate liquidity has choices; the company without liquidity frequently has choices made for it.

That is why an appropriate working-capital facility can be valuable even to a business that could technically operate without one. The relevant question is not simply whether the company can self-finance its receivables. The more important question is whether doing so represents the best use of the company's capital.

The Question Owners Should Ask

For many entrepreneurs, operating with little or no debt will remain an entirely appropriate choice. Some businesses require very little working capital. Some collect cash before incurring significant costs. Some owners deliberately maintain substantial cash balances and have few attractive alternative uses for that capital. Other companies operate in industries where receivables are difficult to finance or where the economics simply do not justify the cost and complexity of a borrowing facility. There is nothing inherently wrong with any of those approaches.

But “we don't use debt” should be a deliberate capital-allocation decision, not an inherited rule that nobody has examined. If a company is profitable and growing but perpetually seems short of cash, management should not immediately conclude that the business is failing to generate enough of it. The first step should be to understand the balance sheet: how much is tied up in accounts receivable, how long customers take to pay, how quickly employees and suppliers must be paid, and how much additional working capital each incremental dollar of growth requires.

Then the owner should ask a very simple question: Who is financing our working capital? If the answer is “we are,” there is one more question worth asking: Is that really the highest and best use of our cash?

The answer may still be yes. But for many successful and growing businesses, it will not be. Recognizing that distinction can fundamentally change how an owner thinks about debt, liquidity, growth and the capital structure required to support the business they are building.