Financing the Growth of Your Propane Business with Leverage
Introduction to Financial Leverage
Cash flow is the lifeblood of a propane marketer. The difference between cash flowing into the business from customers and cash flowing out to pay suppliers, vendors, employees, lessors, and other parties is net cash flow. If that number is positive over time, the business has generated a profit, and there should be a growing amount of cash in its bank accounts. An owner can either distribute this profit for personal benefit or purchase additional business assets to generate even more cash flow in the future. Successful propane marketers use financial leverage to accelerate this growth in cash flow even more.
Financial leverage is the use of relatively low-cost debt to buy more assets. By borrowing, an owner can fund the purchase of business assets that are otherwise beyond its current financial means. And the interest expense for this borrowing is ordinarily tax-deductible. By adding more fixed assets such as storage, propane tanks & cylinders, vehicles, and real estate, the business can attract and service more customers and more positive cash flow. If appropriately planned, these new assets will help generate enough positive cash flow to pay off the amount borrowed and make even more cash flow available to the owner down the road.
Of course, providers of certain types of debt will want to restrict the owner’s ability to distribute cash flow for personal use and establish specific ongoing financial covenants and reporting requirements to monitor the business’s financial health. Excessive leverage can be a potential hazard should the business experience a downturn and fail to generate enough cash flow to meet its then-current payment obligations.
Financial Leverage for Smaller Marketers
Most smaller propane marketers already use some form of leverage. The most common and least expensive kinds are customer credit balances and trade credit. When budget customers have positive balances, they have essentially have extended an interest-free loan to the business in return for future performance. Suppliers that offer favorable payment terms are helping the business finance its product purchases on a short-term basis. Absent both arrangements, the business would need to use cash on the balance sheet, or absent that borrow in another manner.
A revolving credit facility or revolver is an arrangement under which a lender, typically a commercial bank, agrees to lend cash to the business up to some specified limit on an ongoing business. Any amount the business repays becomes available to be borrowed again. The lender will typically take a security interest in the business’s cash, receivables, inventory, and equipment to be enticed into this arrangement. The lender will also seek a junior collateral position on fixed assets to the extent that the business has already pledged those assets to a different lending party. Properly filed liens, which is how lenders perfect their security interest, can position a lender ahead of other parties in priority for repayment should the business become financially insolvent and declare bankruptcy. The term of a revolver is typically six months to two years.
A commercial real estate loan is another standard leverage tool used by smaller marketers. Such loans are used to acquire commercial property for operating locations, possess terms of five to twenty years, amortize monthly, and are secured by a mortgage on the subject estate property. These loans can present a significant source of leverage for the business because the amount a lender is willing to advance against the market value of the real estate is relatively high (70 to 80 percent). In this case, the lender considers business creditworthiness but emphasizes the collateral as a source of repayment. And since real estate values are likely increasing at the same time the loan balance is decreasing, the cushion that protects the lender rises over time.
Propane marketers often finance the purchase of their vehicles, bulk storage tanks, field tanks, and other equipment using equipment loans or equipment leases. Like the commercial real estate loan, an equipment loan relies on a security interest in the assets being financed as a source of repayment. Since equipment tends to be a wasting asset with much shorter economic life spans than improvements to real estate, these loans are typically structured to have terms in the range of two to five years, with monthly amortization. Banks, captive finance companies, and independent equipment financing companies can all provide equipment loans, but terms and pricing can vary. The latter two sources also typically offer lease arrangements whose benefits can depend mainly on the circumstances of the particular business and asset involved.
Financial Leverage for Larger Marketers
The larger a business, the less risky potential creditors will perceive it, and its access to capital will increase accordingly. One additional alternative for a larger propane marketer to fund its growth is using a secured term loan. Bank and non-bank lenders offer such loans with terms ranging from three to six years in length and pricing moderately higher than shorter-term revolvers – more so for the non-bank lenders. Banks will often offer a loan package that comprises both a revolver and term loan. A shared collateral package secures the combined loan package. Alternatively, lenders could bifurcate the security interests in the business assets. The working capital-related assets might secure the revolver, while the remaining other assets secure the term loan’s interest. Each will likely seek a junior security interest in assets for which they do not have a senior interest. Repayment or amortization of a term loan is subject to some flexibility compared with other loan alternatives.
Large businesses can likely also borrow using subordinated debt and mezzanine debt. These forms of debt fill the gap between senior debt and equity in the capital stack of a business. Both permit a company to stretch its finance when a business opportunity arises such as a strategic acquisition. Both feature terms more extended than a senior term loan (typically six to eight years), have little required amortization, and may or may not have second or third lien security interests in the business’s assets. While both will have interest rates in the range of 10 to 12 percent, the mezzanine might have a provision to defer cash interest payments by rolling them into the existing loan balance. Also, mezzanine debt will typically have some mechanism by which the lender gets some form of equity participation.
Financial leverage can help an owner accelerate cash flow growth for a propane marketer. And the leverage tools available can vary based on the size of the business, assets available to be used as security, and the business’s perception of creditworthiness. A prudent propane marketer owner will balance the potential financial benefits of leverage with the increased solvency risk should the business face a significant downturn and the impact of restrictions put in place to protect the lender’s interest.