Cash flow is the lifeblood of a propane distributor. The difference between the cash flow coming into the business from customers and the cash flow going out to pay suppliers, vendors, employees, lessors and other parties is net cash flow. If this number is positive over time, the business has generated a profit and there should be an increasing amount of cash in its bank accounts. An owner can either distribute this profit for personal use or purchase additional business assets to generate even more cash flow in the future. Successful propane traders use financial leverage to accelerate this cash flow growth even further.
Leverage is the use of relatively inexpensive debt to buy more assets. By borrowing, an owner can finance the purchase of business assets that are otherwise beyond their current financial means. And the interest expense of this loan is generally tax deductible.
By adding more fixed assets, such as storage, propane tanks and cylinders, vehicles, and real estate, the business can attract and serve more customers and more positive cash flow. If planned appropriately, these new assets will help generate enough positive cash flow to repay the amount borrowed and make even more cash flow available to the owner later.
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 financial covenants and reporting requirements to monitor the financial health of the business. Excessive leverage can be a potential hazard if the business experiences a downturn and fails to generate enough cash flow to meet its then-current payment obligations.
Financial leverage for small traders
Most small propane traders already use some form of leverage. The most common and least expensive types are customer credit balances and trade credits. When low-budget customers have positive balances, they have essentially given the business an interest-free loan in exchange for future performance.
Suppliers who offer favorable payment terms help the company finance its short-term product purchases. In the absence of both arrangements, the company would have to use cash from the balance sheet or, in the absence of it, borrow cash in some other way.
A revolving credit facility, or “revolver”, is an agreement under which a lender, usually a commercial bank, agrees to lend the business money up to a certain specified limit on an ongoing basis. Any amount the business repays becomes available to borrow again.
The lender will typically take security over the cash, receivables, inventory, and equipment of the business to be drawn into this arrangement. The lender will also seek a secondary collateral position over fixed assets to the extent that the business has already pledged those assets to another lending party. Properly filed liens—this is how lenders perfect their security—can position a lender ahead of other parties in priority for repayment if the company becomes financially insolvent and declares bankruptcy. The life of a revolver is usually six months to two years.
A commercial real estate loan is another standard leverage tool used by small traders. These loans are used to acquire commercial property for operating locations, have terms of five to 20 years, are amortized monthly and are secured by a mortgage on the property in question.
These loans can represent an important source of leverage for the company because the amount that a lender is willing to advance relative to the market value of the property is relatively high (70% to 80%). In this case, the lender considers the creditworthiness of the business but emphasizes the collateral as the source of repayment. And since real estate values likely increase as the loan balance decreases, the cushion that protects the lender increases over time.
Propane dealers often finance the purchase of their vehicles, bulk storage tanks, field tanks and other equipment using equipment loans or equipment rentals. Like the commercial real estate loan, an equipment loan relies on a security interest in the financed assets as a source of repayment. Since equipment tends to be a wasted asset with a much shorter economic life than real estate improvements, these loans are typically structured to have tenors in the range of two to five years, with monthly amortization.
Banks, captive finance companies, and independent equipment finance companies can all provide equipment loans, but terms and prices may vary. These last two sources also generally offer leases, the benefits of which may depend mainly on the circumstances of the business and the asset concerned.
Financial leverage for large traders
The larger a company is, the less potential creditors will perceive it, and its access to capital will increase accordingly. An additional alternative for a larger propane distributor to fund growth is to use a secured term loan. Bank and non-bank lenders offer such loans with tenors ranging from three to six years and prices moderately higher than shorter-term revolvers – more so for non-bank lenders.
Banks often offer a loan package that includes both a revolving loan and a term loan. A shared collateral package secures the combined loan package. Alternatively, lenders could split security interests in business assets. The working capital assets could secure the revolver, while the other remaining assets secure the term loan interest.
Each will likely seek second-ranking security over assets for which they do not have a higher-ranking security. Repayment or amortization of a term loan is subject to some flexibility compared to other loan alternatives.
Large corporations can also borrow using subordinated debt and mezzanine debt. These forms of debt bridge the gap between senior debt and equity in a company’s capital stack. Both allow a company to stretch its finances when a business opportunity arises, such as a strategic acquisition. Both feature longer terms than a senior term loan (typically six to eight years), have little amortization required, and may or may not have second or third lien security interests in business assets. .
While both will have interest rates in the range of 10% to 12%, the mezzanine could have a provision to defer cash interest payments by transferring them to the existing loan balance. Also, mezzanine debt will usually have a mechanism whereby the lender obtains some form of equity participation.
Financial leverage can help an owner accelerate a propane distributor’s cash flow growth. And the leverage tools available can vary depending on the size of the business, the assets available to use as collateral, and the perceived creditworthiness of the business.
A prudent propane distributor 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 interests of the lender.