Why Businesses Borrow

Why Businesses Borrow

When considering the financing needs of any business, start-up or mature, there is always the underlying question of whether borrowing is a good idea. There are two critical aspects to consider before answering that question. First, why does the firm need money, and second, why is the firm borrowing money? The answers to these questions are critical when evaluating the health and stability of a firm such as Dawson Lumber Company and making the credit decision.

Although it was always within the beliefs of J.H. Dawson, former Dawson Lumber president, that growth that should only be financed by internally generated funds, it is very rare for a firm to be financed strictly out of one's savings. It is also important for businesses to borrow money in order to fund their working capital, or operating cycle. Businesses need to invest in inventories and receivables before they can generate and collect revenues from their customers. A working capital loan is used to fund a firm's inventory and is paid off when these assets are converted into sales or cash. This is much like what was experienced by Dawson in 1996 when they were granted an operating line of credit of $3 million followed by another line of credit of $3.8 million and a term loan of $4.2 million in 1998.

While one would think that rapid growth within a firm would be a good thing, a firm can actually grow too much, or at an unsustainable rate. Return on equity and retention ratios determine the rate at which a business can grow without resorting to external financing. When businesses grow faster than their sustainable growth rate, they need external sources to fund the excess growth. This was exemplified in 1999 when Dawson's sales were $2.68 million greater than projected; however, their capital expenditures were $3.6 million over budget.

There are two types of sales growth, seasonal and long-term. Seasonal sales growth occurs within companies that have specialized products which have a peak selling seasons. This causes the business' financing needs to be completely correlated with the level of sales from the firm. Because sales and financing needs have a direct relationship, inventory and receivables also increase seasonally in order to account for the increase in sales. Firms financing needs are generated from the build-up of inventory and accounts receivable during the high selling season. The most logical form of financing for a firm with seasonal sales is a line of credit. Dawson saw trends of seasonal growth. Between the months of April and November, 77% of sales occurred while only 23% took occurred in the remaining months, thus, Dawson was only initially granted a seasonal loan to finance inventory.

Long-term sales growth simply demonstrates the growth of a firm over a longer period of time. A firm's growth percentage can be calculated by ; Dawson demonstrated sales growth in the amounts of 21% from 1996 to 1997 and 38% from the years 1997 to 1998. Like seasonal sales growth, inventory