Financing Requirements and Sources of Financing February 26, 2004
“ A bank is a place where they lend you an umbrella in fair weather and ask for it back when it begins to rain.” --Robert Frost
“ In G-D we trust, everyone else pays cash”
1. To purchase assets such as equipment and inventory
2. To finance expenses such as payroll, advertising, taxes, receivables etc.
3. To pay for other pre-start-up costs which can include R&D and expert advice
Types of Assets
Current assets (working capital)
Assets that can be converted to cash within the firm’s operating cycle (cash, accounts receivable, inventories, prepaid expenses)
Relatively permanent resources intended for the use of the firm (machinery, land, buildings…)
Net fixed assets = Gross fixed assets – accumulated depreciation
Intangible assets (patents, copyrights, goodwill)
Buy or Lease?
Leasing requires no up-front cash, freeing up the firm’s cash for other purposes.
Leasing provides a hedge against equipment obsolescence.
Leasing requires the business to make regular payments.
Penalties to get out of contract
Flow of Cash through a Business Borrowed Funds Collection of Accounts Receivable Owner's Investment Borrowed Funds Sale of Fixed Assets Collection of Accounts Receivable Payment of Expenses Payment for Inventory Payment of Dividends Cash Sales Purchase of Fixed Assets
Cash is King!!!
Working capital management
Cash budgets and forecasting
Cash flow statements
Accrual vs. cash-based accounting
Managing receivables, payables and inventory
The growth trap
A cash shortage resulting from rapid growth
Assets-to-Sales-Financing Relationships Increase in Sales Increase in Asset Requirements Increase in Financing Requirements Results in Results in
Estimating financial requirements
Estimating Asset Requirements
Use industry ratios for assets-to-sales
Use breakeven analysis and empirical data
Method using a percentage of the total sales for a firm as the basis for forecasting the level of assets to be held by a firm and financial requirements
Loans and mortgages from banks and other lenders with maturities greater than one year
Owners’ Equity = Owners’ Investment + earnings retained within the firm
Owners are “residual owners” of the firm
Creditors have first claim on the assets of the firm
Sources of Financing
Owners’ original investment
Profit retention (retained profits)
Debts such as accounts payable that increase as the firm grows
Forecasting financial requirements (in total):
Total sources of financing Spontaneous financing Profits retained within the business Total asset requirements = + = External sources of financing +
The degree to which a firm has working capital available to meet maturing debt obligations.
The firm’s relative liquidity, determined by dividing current assets by current liabilities
Debt Ratio = total debt / total assets
Its purpose is to show the proportion of a company's assets which are financed through debt.
Debt to Equity = long-term debt / equity
Indicator of financial leverage. Compares assets provided by creditors to assets provided by shareholders.
Debt or equity financing?
Borrowing increases potential for higher rates of return on owners’ equity; exposes firm to more financial risk.
Investing more owner equity limits potential return on equity; lowers financial risk for firm.
Increasing equity through borrowing requires owners to share control with external investors.
Tradeoffs between Debt & Equity Financial Risk Potential Profitability LOW Equity financing Debt financing HIGH LOW HIGH Equity Financing Debt Financing Control /
Sources of Start-up Financing 0 10 20 30 40 50 60 70 80 Personal Savings Family Members Partners Personal Charge Cards Friends Bank Loans Private Investors Mortgaged Property Venture Capital Other Percentage of Entrepreneurs Using Source of Financing Sources of Financing
Sources of Financing Debt Equity Personal Savings Other Individual Investors Business Suppliers Asset-Based Lenders Commercial Banks Government-Sponsored Programs Community-Based Financial Institutions Large Corporations Venture Capital Firms Sale of Stock Friends and Relatives
Angel Investors (informal capital)
Wealthy individuals who invest in new (often risky) ventures expecting high returns. They often are highly involved in the business and are usually the bridge from the self-funded to the VC stage of the business.
The "average" angel investor is 47 years old with an annual income of $140k and a net worth of $1.2M. She invests $60k, in 3 out of 10 proposals, within 100 km of her home and expects a 26% annual return, and to lose money on 1 out 3 deals
Trade Credit (Accounts Payable)
Financing provided by a supplier of inventory to a company
Short-duration financing (30-120 days)
Amount of credit available is dependent on the type of firm and the supplier’s willingness to extend credit
Equipment Loan and Leases
Installment loan (mortgage on equipment) from the seller of machinery purchased by a business.
A line of credit secured by working-capital assets
Obtaining cash by selling accounts receivable to another firm.
Accounts are sold to factor at a discount to invoice value
Factor can refuse questionable accounts
Factor charges fees for servicing accounts and for amount advanced to firm prior to collection
Line of credit
Maximum amount that bank will permit firm to borrow
Revolving credit agreement
Maximum amount bank is committed to lend a firm on an ongoing basis
Loans for 5 to 10 years to finance equipment
Loan collateralized by inventory or moveable property
Real estate mortgage
Long-term loan with real property held as collateral
The Banker’s Perspective
How much the bank will earn on the loan?
What is the likelihood that the lender will be able to repay the loan?
The Five C’s of Credit
Character of the borrower
Capacity of the borrower to repay the loan
Capital invested in the venture by the borrower
Conditions of the industry and economy
Collateral available to secure the loan
Questions Lenders Ask
What are the strengths and qualities of the management team?
How has the firm performed financially?
How much money is needed?
What is the venture going to do with the money?
When is the money needed?
When and how will the money be paid back?
Does the borrower have qualified support people, such as a good public accountant and attorney?
Information required by banks
Three years of the firm’s historical statements
Balance sheets, income statements, and statements of cash flow
The firm’s pro forma financial statements
The timing and amounts of the debt repayment included as part of the forecasts
Personal financial statements
The borrower’s personal net worth (assets – debts) and estimated annual income
Negotiating the loan
Terms of Loans
Fixed or floating rates
Loan maturity date
Equal monthly or annual payments
Decreasing monthly or annual payments
Filing financial statements
Restricting salaries and personal loans
Government-sponsored programs and agencies
Federal assistance to small businesses
Small Business Loans Act (SBLA)
Business Development Bank of Canada (BDC)
Industrial Research Assistance Program (IRAP)
Program for Export Market Development (PEMD)
Provincial government assistance
Other Sources of Funds
Venture Capital Firms
An investor or investment group that commits money to new business ventures
Community-based financial institutions
Lenders that provide financing to small businesses in low-income communities for the purpose of encouraging economic development
Financing and technical assistance to critical suppliers and technology developers
Initial public offering (IPO)
Funding Stages and Sources
Summary— Financing and Financial Requirements
Estimated the assets needed and the financing for a new venture
Evaluated the choice between debt and equity financing
Described various sources of financing available to small firms