The primary responsibility of a business owner or company manager is to make sure that employees are always paid on time. Nothing erodes company morale and employee goodwill more than missing payroll.
In my experience financing distressed businesses, few companies ever recover from missing payroll. By the time they reach that point, the situation is already so dire that little can be done. The only effective solution is to prevent it from ever happening.
The first step toward this solution is always knowing a company’s financial standing. I am always surprised when business owners cannot provide me with accurate financial reports. This occurrence is common for small business owners, especially in the construction industry. But without financial reports, how can an owner know where the company stands financially?
Cash in the bank is not always a good indicator of how well a company is doing, since it does not give an idea of payables or receivables. The best way to get a good financial picture of a business is to update the accounting system regularly and review the following reports:
- Cash flow statement
- Accounts receivable aging
- Accounts payable aging
- Profit and loss statement
- Balance sheet.
Once an owner knows where the business stands financially, he or she can better understand where it is headed. An owner should spend time developing a sales forecast, then determine the cost to deliver those sales and evaluate if the company has the resources to do so. This last point is crucial. Businesses often hit a cash crunch because they did not have the resources to handle their sales book, but made the sales anyway. It’s not unusual for these types of problems to put the business into an unrecoverable tailspin. Therefore, an owner must plan finances so they can manage the business effectively and capitalize on opportunities.
Several solutions exist that can help a company finance payroll. Some solutions are better than others—and some can actually do more harm than good. Remember that payroll is an ongoing expense. Consequently, it’s best to have a financial solution that provides revolving financing.
Recommended solutions
1 - A company’s financial reserves
The absolute best way to “finance payroll” is for a company to do it itself by building financial reserves. When the time comes, an owner can use reserves to cover payroll expenses. (For details on how to build a financial reserve, see the article “How to Build a Cash Reserve” on page 18 of the April 2016 issue.) The first step is to size the reserve correctly. An owner should partner with the finance department or a CPA to determine what number works for the business. Once the size of the reserve is determined, the company needs to start saving money. The company should build its reserve over time by contributing a little every month.
2 - Revolving lines of credit
If a company’s reserves are not sufficient, an owner can consider a line of credit. Lines of credit provide the most flexibility. They allow a company to borrow money when needed and repay it once finances improve. Lines of credit are excellent solutions that allow a company to complement existing reserves. Unfortunately, they can be difficult to get due to their qualification requirements.
3 - Invoice factoring
Invoice factoring is an alternative to commercial lines of credit. Many companies experience financial problems because they can’t afford to wait 30 to 90 days to get their invoices paid. Factoring, in which a third party takes over collection of an invoice while advancing the company a portion of the balance owed, accelerates these payments and improves cash flow. This helps a company meet payroll. While factoring is easier to get than a line of credit, the solution is more expensive and less flexible.
Options to avoid
And now, a few options that don’t work well to finance payroll. While there is nothing wrong with these financing solutions per se, they are not ideal for solving payroll problems.
1 - Business loans
Business loans can be a great solution to finance the purchase of equipment or property. They can also be used to finance certain projects. However, they are not an effective way to finance payroll because payroll is an ongoing expense.
2 - Merchant cash advances/ACH loans
Merchant cash advances, also known as ACH loans, can provide a quick cash-flow infusion to a business. They have a structure that is like a loan, where a company gets a lump sum and then makes fixed payments over time. However, they are very expensive and are not well-suited to finance payroll.
3 - Home equity lines of credit
Home equity lines of credit provide the flexibility of a business line of credit, at a very affordable cost. However, because they use the owner’s home as collateral, the owner is risking their home for the business. If things go wrong, the owner could lose all equity—and the house.
The decision to get business financing is very important and should be made only after weighing the pros and cons. I suggest that owners consult their finance team or a CPA before seeking financing. Their advice will likely save money in the long run.
