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Do Your Sources & Use of Funds Match?

I have a confession to make. During COVID, I did my share of stress eating. Pizza, potato chips and dip, fast food with fries. They don’t call it comfort food for nothing. Of course, it wasn’t one single meal or circumstance that led to my weight gain over the last year. It was probably 100 or so small decisions that created it. 

Managing cash flow in your business is the same. One isolated circumstance or decision won’t create a lack of cash flow. But, 100 or so small decisions over time will definitely do it. Let’s talk about one of those small decisions that is often overlooked.  

You don’t buy a piece of equipment or your office building on a line of credit. You also don’t finance your payroll for the month on a term loan payable over 3 years. Why? Because your building should be on a mortgage loan and your payroll should be funded through your line of credit. You want your source of funds (where the money is coming from) to match your use of funds (what the money is being used for).   

It’s important for these sources and uses to match. By that, I mean long-term uses (purchase of long-term assets) like a business, a piece of equipment, or a building should be financed with long-term sources of funds, such as a mortgage or term loan. Short-term uses like operating expenses or funding payroll should be funded with a bank line of credit, a short-term source of funds. The reason for this is most lines of credit are repaid from short-term assets like accounts receivable or inventory. 

Your line of credit will typically have a use of proceeds section that stipulates that the line is to be used for temporary working capital, or short-term uses. It will also have a 30-day annual payout which means that the line must be at $0 for 30 consecutive days out of the 365 days in a year.

If you’ve used the line for a long-term use like purchasing equipment for example, you may have unintentionally violated the use of proceeds agreement, and you won’t have the cash flow to repay the line in full for 30 days. You run the risk of the bank declaring a default because you have violated the commitment from the bank’s point of view. On long-term sources of funds, you typically try to match the amortization of the loan to the book depreciation schedule of the asset, 3-7 years for equipment and 15-25 years for real estate. 

Also, you wouldn’t take out a 3-year term loan to fund payroll for last month, which would be a short-term use with a long-term source. You end up paying interest over three years for one month’s worth of payroll, so you’re paying more interest than is necessary. 

Sometimes as business owners we get busy. We’re juggling multiple priorities and we don’t pay attention to things like this. Sometimes, the path of least resistance is the one we take to get it done. Therefore, we may have a situation where we have unintentionally shot ourselves in the foot if we funded a long-term use with a short-term source or vice versa. Take time to review your balance sheet and cash flow statement to be sure that your sources and uses of funds for the last 12 months match. If they don’t, consider taking steps to correct the situation and talk to a financial partner you trust. 

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