Understanding how banks think and behave – and what they look at in a business – is essential for pharmacy owners, says Paul O’Sullivan, Sigma Healthcare’s Group Manager Sigma Financial Services.
Proper financing, and an understanding of how banks think and behave, is essential to the survival of your pharmacy business. It is during the good times that you build your reputation with a bank, so that in times of distress your business is less buffeted relative to others and your business is more resilient.
Most pharmacists look at their profit and loss statement at the end of each year and simply assume that profit = cash in and a loss = cash out. This is way too simplistic and one reason why I have seen many profitable pharmacies run out of cash. Why?
In its basic form, a profit and loss statement represents the financial ‘score’ a business achieves over a year. The balance sheet, however, represents the financial score of a business over its lifetime. Too often, pharmacists ignore the balance sheet – as an accountant, that’s where I start looking for sources of cash.
Your balance sheet is also an important source of truth for your banker in terms of financing your business. Essentially the strength of your balance sheet will determine what a lender will allow you to borrow.
So, what does your balance sheet reveal to a potential lender?
Sources of cash in your balance sheet
The most obvious sources to free up cash from your balance sheet are:
- Term deposits, liquid assets such as shares and other investments – this can be achieved by reducing terms for trade debtors, increasing stock turns or reducing stock (without impacting sales) and resisting the temptation to prepay for expenses
- Fixed assets, including offering security over assets, purchasing equipment on lease and selling surplus assets
Related party loans or receivables
When reviewing financial statements of pharmacy customers, this is the very first item I look for in a pharmacy balance sheet. Any related party receivable represents cash the owner has taken out of the business – and my immediate response is to advise the recipient to repay it. This can be more difficult than it seems, because some business owners treat the business as a ‘part’ of themselves – whereas good business operators treat the two separately.
Liabilities and equity
If your debt levels are already low, you can free up cash by seeking additional payment terms for isolated debt arrangements from suppliers, temporarily change your loan obligations to interest only payments and review your interest rate. If you have a low Loan-to-Value Ratio (LVR) you could redraw against the security, and consider extending the term of your debt to reduce monthly payment amounts, reduce drawings out of the business, and declare dividends but don’t pay out the cash. It should be noted that most of these solutions related to liabilities and equity are temporary and cannot be sustained long term.
Once your balance sheet is ‘efficient’, then you can leverage the best financing arrangement for your business.
Next, the four Cs
In addition to your balance sheet, finance providers look at four aspects of your business: Character, Capacity, Capital and Collateral.
Character
Character is represented by you as the business owner. Can you demonstrate good business management, leadership within your pharmacy, documented systems and processes, and a well thought out and articulated written business plan? Have you surrounded yourself with good advisors (accountants, legal advisors and a strong peer network)?
Bank lending is influenced by the people, so being of good character improves your chances of getting a loan.
Capacity
This represents the depth and breadth of your income streams and the strength of your business’s profitability. Does your pharmacy have multiple income streams – aged care, dispensary, front of shop, professional services? Do the location rules protect you, or are you vulnerable to those rules, or reliant on a particular customer demographic?
Often, the strength of the pharmacy is also its weakness – and the more concentrated one of these income streams, the greater the financial risk of disruption. One of my previous articles provides many of the capacity questions you should ask yourself.
The true definition of goodwill is the ability to generate consistent cash flow earnings over time, and the ‘capacity’ to do that is what the bank is asking the owner to demonstrate.
Capital
The most common mistake I see most prospective pharmacy owners make is not arranging enough finance to buy the pharmacy on an LVR of 75%, all because they haven’t sufficiently funded the start-up working capital of the business – the basic and essential investment required to stock the pharmacy.
Greenfield sites are very cash hungry. New business owners may not ‘pay’ for the pharmacy when they acquire it, but they will indeed ‘pay’ for it by funding the losses the pharmacy will likely make in its formative months and years. Have you got the cashflow to sustain the losses for a longer period than your business plan indicates?
Apart from stock, the other key capital question is investment in equipment and programs, such as automated dispensing equipment, Professional Services programs, Sigma’s LEAPP program , IT systems, security, websites and plant. These are important drivers of business success and financial returns but require cash up-front and takes time to recoup, so you need to consider how it will be funded.
Collateral
As a last resort, a lender will use security to recover any debts. Be very careful about what guarantees and security you provide, because you are putting at risk assets other than just your pharmacy. Sometimes this is necessary to obtain finance, but only do it if you absolutely have to, and make sure the security is released as soon as you have met the lender’s underwriting criteria.
Don’t set and forget! Too often, I visit pharmacy owners doing the hard yards: the LVR is 45% and the bank has both the pharmacy and their home tied up as security. These customers give all sorts of explanations why the bank can’t or won’t release security. My response is always the same: “Change banks!”
If you have any questions we can help with please contact your Sigma Account Manager or Sigma Financial Services via pharmacy.finance@sigmahealthcare.com.au or call 03 9215 9780. Your privacy is of paramount importance and any discussion is highly confidential.
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