I’ve sort of been in the dark about this for a few months, since the major financial freakout hit the front pages. Why is so much industry dependent on credit? I keep hearing that with credit frozen, many businesses won’t be able to function, but I have a hard time understanding why so many businesses would need to be constantly borrowing or financing outside of the financial or lending sector.
That big story in the news right now is about a factory that had to shut down because its line of credit was cut off.
Since I’m economically ignorant, can someone explain why a factory of all things would be dependent on borrowing and financing?
Well first of all you have to meet payroll. If you don’t the government can close you down. So if you’re order is to be delivered on January 1st and you have to pay your workers on Dec 15th, that money HAS to be paid. You can’t say “you’ll get it later.”
Second a lot of business live via bridge loans. They don’t have steady income but streams where it comes in. Let’s say you make a million a year, it may come in three big streams. Which if you plan is fine, but say lightning hits and 4 of your 5 computers zonk out. It can even happen if you have them properly grounded. Now you have a capital expense.
You can plan for things but it’s hard like when you have a steady business and I do a budget and the owners see a HUGE pile of cash not being used. I tell them it’s reserved in the budget and the line is “But why? We’ve not used a capital expense in 3 years and don’t plan to?” Well this part owner want to reassign it to his bonus.
So we do it, something happens and a bonus is in the payroll and boom you have to meet payroll.
Business don’t like to have money sitting in a bank getting 2% interest when they can be using it to expand their business and making profit at 15%. So even if they have to borrow to meet payroll it’s usually less to borrow than to save that money and get only 2% on it.
In otherwords you can make more profit by borrowing that money and investing wisely.
The vast majority of businesses have credit terms with their suppliers; orders are filled with nothing but a purchase order number, followed by an invoice with 30 days to pay. If credit dries up, the suppliers can’t afford to extend credit, buyers can’t afford to extend credit to their customers, bank balances start getting low, and one bounced check can send ripples all the way down the line.
You also have to consider that any change in “business as usual” will be painful. It’s not necessarily the lack of credit that is a problem – that can be handled by sufficient cash reserves – it’s the change from easy credit to non-existent credit that causes havoc.
It’s frankly ridiculous to suppose that business could operate with anything resembling efficiency by means of cash reserves rather than credit. Even a very small business might easily have a couple hundred grand in product ordered but not yet installed and billed for, or installed and billed for but payment not yet received. Having to have cash reserves to order all that stuff would pose an absolutely immense barrier to entry in a vast array of fields.
I have to credit Nametag with the main reason a business has to have credit. It’s not uncommon for balances in the hundreds of thousands or more to be on the books as you wait for product you are shipping to be paid for. Once you’re down to a cash only model your hamstrung. The next important thing is maintaining necessary expenditures when you’re flush with cash. The first time they have a slump and need to pay the workers or pay for repairs their out of business without credit. Businesses use what they make for profit to expand and upgrade and can’t afford to hoard it all away into a savings account.
While the explanations given are true on a small scale basis in a larger scale the view is somewhat different. Say a company A has the capability of making a profit which returns 20% on investment but does not have the funds and Bank B has the funds and can lend them at 5%. The bank lends the money and they both come out ahead. If the bank keeps the money they both lose. In other words it allows capital and industry to come together and profit together. Otherwise the only way to have a successful business would be to have everything you need: idea, capability, capital, etc.