How understanding the business life cycle helps in credit assessment. from businessbankingcoach.com in association with

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1 How understanding the business life cycle helps in credit assessment from businessbankingcoach.com in association with

2 Understanding the business life cycle and the position of a business in its cycle helps us in assessing the business and its financial needs.

3 So, first off, let s take a look at the business life cycle and its various phases.

4 So, first off, let s take a look at the business life cycle and its various phases. It s the position of the business in one of those phases that determines its financial needs and what type of facilities can be offered by the bank.

5 The concept behind the business life cycle is that every business goes through different phases during its lifetime. That lifetime might last a few months or it could last 100 or so years.

6 .but all businesses have to come into existence, experience growth (fast or slow), then reach a point where the growth tails off and, eventually, they will fall into decline if nothing changes within the business to send it back into another growth phase.

7 The key thing to remember, then, is that it s the business sales figure that indicates in which phase of the life cycle it s in.

8 The key thing to remember, then, is that it s the business sales figure that indicates in which phase of the life cycle it s in. So look at the trend in sales on the income statement for the past 3 or 4 years to get a sense of where the business is now..and where it s heading.

9 So, what s happening to a business as it moves through each phase? Sales Growth Decline Maturity Start - up Time

10 In the start-up phase, the business is just getting going, trying to make some sales but incurring expenses as it establishes itself and acquires assets and capacity.

11 In the growth phase, the business has established itself in the market and starts to generate significant sales that take it into a profitable situation.

12 In the growth phase, the business has established itself in the market and starts to generate significant sales that take it into a profitable situation. The problem is that sales growth often has to be supported by additional inventories and/or accounts receivable (depending on the type of business) so more cash is tied-up in working capital (current assets).

13 In the maturity phase, the business is well established in the market and sales are at a relatively high level which generates significant profit.

14 In the decline phase, the business is losing ground in its market which could be due to a variety of reasons. Sales fall and the business becomes unprofitable.

15 There are two ways it will go either it will disappear entirely or it could revert to a new growth phase if the cause of its decline can be reversed often achieved with a change of management.

16 Once you have an idea of which phase of the life cycle the business is in, it s useful to think about the characteristics of a typical business in the phase that will help you to focus on what the business might now be looking like and what to expect.

17 We ll use four characteristics for this purpose. For each phase we ll think about a typical business ; Cash position Profit Capital base Management experience

18 In the start-up phase, we d typically expect to see; A weak cash position due to the need to invest in assets and working capital to pay operating expenses while sales (and, therefore, income) are still low.

19 In the start-up phase, we d typically expect to see; A weak cash position due to the need to invest in assets and working capital to pay operating expenses while sales (and, therefore, income) are still low. Weak profits because sales are still low and are insufficient to cover operating expenses.

20 A weak capital base because start-up businesses are usually under-capitalised from the start and the capital base is not being strengthened from profit retention because there would usually be no profits at this time.

21 A weak capital base because start-up businesses are usually under-capitalised from the start and the capital base is not being strengthened from profit retention because there would usually be no profits at this time. Weak management experience because the managers are new to the role and need time to gain experience.

22 Given all these weak characteristics, it s no surprise that banks are often reluctant to lend to a business in the startup phase of its business life cycle.

23 In the growth phase, we d typically expect to see; A weak cash position due to the need to continue to invest in additional assets and working capital to support the growth and to pay ever-increasing operating expenses while sales (and, therefore, income) are still growing.

24 In the growth phase, we d typically expect to see; A weak cash position due to the need to continue to invest in additional assets and working capital to support the growth and to pay ever-increasing operating expenses while sales (and, therefore, income) are still growing. Improving profits because sales are growing and are covering operating expenses.

25 An improving capital base because it s usual for growing businesses to retain any profits made and these are added to the capital base in order to finance the growing asset side of the balance sheet.

26 An improving capital base because it s usual for growing businesses to retain any profits made and these are added to the capital base in order to finance the growing asset side of the balance sheet. Improving management experience because the managers are learning more about the market as the business grows and they learn more about their role.

27 Given these mostly improving characteristics, these businesses are attractive targets for banks.

28 Given these mostly improving characteristics, these businesses are attractive targets for banks. The only problem is that they are really only just established in their markets so the future could go either way.

29 In the maturity phase, we d typically expect to see; A good cash position as there is no longer a need to continue to invest in additional assets and working capital as the business is in a maintenance phase where sales are at a reasonably high level but are not growing.

30 In the maturity phase, we d typically expect to see; A good cash position as there is no longer a need to continue to invest in additional assets and working capital as the business is in a maintenance phase where sales are at a reasonably high level but are not growing. Good profits because sales are high and are generating sufficient profits to cover operating expenses which are well under control.

31 A good capital base because at least some of the profits have been retained (after any dividends were paid to shareholders) and the profits have been added to the capital base.

32 A good capital base because at least some of the profits have been retained (after any dividends were paid to shareholders) and the profits have been added to the capital base. Good management experience because the managers are fully conversant with the needs of the market and their roles.

33 Given these strong characteristics, these businesses are highly attractive targets for banks.

34 Given these strong characteristics, these businesses are highly attractive targets for banks. The only problem is that the businesses don t really need banks any longer as they have sufficient cash to pay their expenses and often finance their own asset replacement policy.

35 In the decline phase, we d typically expect to see; A weakening cash position as sales are falling and businesses are usually slow and/or reluctant to reduce operating expenses significantly very often management believes the decline to be temporary.

36 In the decline phase, we d typically expect to see; A weakening cash position as sales are falling and businesses are usually slow and/or reluctant to reduce operating expenses significantly very often management believes the decline to be temporary. Reducing profits because sales are falling and are failing to generate sufficient profit to cover operating expenses.

37 A weakening capital base because profits are reducing and shareholders are often reluctant to give up their dividends leading to little profit retention. Often, dividends are paid from previous year profits, directly reducing the capital base.

38 A weakening capital base because profits are reducing and shareholders are often reluctant to give up their dividends leading to little profit retention. Often, dividends are paid from previous year profits, directly reducing the capital base. Good management experience (assuming the same management is in place) but often they become distracted because the business does not offer them the same stimulation as when it was successful.

39 Given these weakening characteristics, these businesses are not targets for banks.

40 Given these weakening characteristics, these businesses are not targets for banks. The only problem is that the businesses already hold accounts at banks so banks cannot easily get rid of them but they should try before its too late.

41 If we think about the types of borrowing facilities that businesses in each phase might need, we would have the following;

42 If we think about the types of borrowing facilities that businesses in each phase might need, we would have the following; In the start-up phase, businesses need shortterm facilities to finance working capital such as inventory, accounts receivable etc. and term loans to finance fixed assets such as vehicles, plant and equipment, buildings etc.

43 In the growth phase, businesses need shortterm facilities to finance increasing working capital such as inventory, accounts receivable etc. and term loans to finance fixed assets such as vehicles, plant and equipment, buildings etc.

44 In the maturity phase, businesses no longer need short-term facilities to finance working capital but they might require term loans to finance the replacement of fixed assets such as vehicles, plant and equipment, buildings etc.

45 In the maturity phase, businesses no longer need short-term facilities to finance working capital but they might require term loans to finance the replacement of fixed assets such as vehicles, plant and equipment, buildings etc.

46 Keep in mind that the business may have sufficient funds to avoid having to borrow so interest rates charged would have to be highly competitive.

47 In the decline phase, businesses may need to borrow but this could be so Business in that they can decline please lend me money continue to pay operating expenses caused by their reluctance to cut costs or to pay dividends to shareholders as the business current cash flow is inadequate to do so.

48 In the decline phase, businesses may need to borrow but this could be so Business in that they can decline please lend me money continue to pay operating expenses caused by their reluctance to cut costs or to pay dividends to shareholders as the business current cash flow is inadequate to do so.

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