The following is the final part of this article. In Part 1, I discussed the need for borrowing caused by slowing accounts receivable and inventory, short-term and long-term growth, and rising active investment. In this final part, I discuss the remaining causes of indebtedness.

• Renewals and extensions of fixed assets

Fixed assets wear out with use or become obsolete and require replacement. The cost of the new fixed asset is expected to be recovered or converted into cash over its useful life. This is known as the capital investment cycle. Fixed assets are necessary to support a series of operating cycles. It is logical, therefore, to spread the cost over several cycles, but certainly not beyond their useful lives. A business that chooses to buy an expensive fixed asset with its cash flow will likely run out of cash later. Fixed assets require long-term financing. As a general rule of thumb, a company whose fixed asset utilization rate is increasing and at least 60% should start planning for equipment replacement. It is prudent to compare the industry average sales/net fixed assets ratio, which is a useful indicator of financing needs for production capacity expansion.

• Expenses for fixed assets

The excessive growth of other assets such as investments, prepaid expenses, deferred charges, intangibles and goodwill can be causes of indebtedness. However, these expenses must constitute a significant proportion of total assets over time to cause concern. The financing of these assets can be short-term or long-term depending on the intended use of the assets.

• Low profitability or losses

Companies finance themselves internally from profits. If profits drop significantly or a business operates unprofitably for an extended period, a cash shortage is likely to occur. Cash shortages can cause other causes of indebtedness, such as slowing sales growth. Typically, lenders will not finance losses or decreased profitability. A prudent lender will endeavor to investigate the cause of losses or declining profitability by analyzing sales and expense trends. Temporary losses and decreased profitability can be financed with short-term loans, while long-term losses or decreased profitability can be financed with long-term funds.

• Distributions or payments of dividends

If dividend payments or distributions exceed earnings, a need for borrowing may arise. The payout ratio can help identify distributions or dividend payout trends. A high or rising ratio relative to earnings is an indicator of imminent danger of a cash shortage. The need for indebtedness that derives from it may be short or long term and may be financed as such. However, many lenders tend to avoid financing dividend payments.

• Debt restructuring

Debt restructuring is a borrowing necessity, but it does not generate new funds for the borrower. It is simply a replacement for another creditor, often to improve debt service capacity. The most common reasons for debt restructuring are to replace commercial creditor debts to the max, loan mismatches, expensive and poorly structured debt. The financing of the restructured debt will depend on the need. For example, commercial creditors will be financed with short-term debt for the duration of the operating cycle and liabilities will be financed with long-term debt to provide better debt service. Low profitability over a long period can also cause a need for a loan. Temporary losses may require short-term borrowing, but persistently low profitability or losses may require long-term financing.

• Unexpected expenses

These are typically one-time expenses incurred to cover litigation, settlements, and uninsured losses, to name just a few. Large unexpected expenses can cause a business to default on regular expenses. In such circumstances, therefore, these expenses may be financed with bank debt. The primary source of payment will determine the term of the loan.