Chapter 11


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Chapter 11

  1. 1. The Essentials of Finance and Accounting for Nonfinancial Managers By Edward Fields Chapter 11 Financing the Business
  2. 2. Financing the Business <ul><li>Borrowing money is a positive corporate strategy </li></ul><ul><ul><li>Increases growth </li></ul></ul><ul><ul><li>Finance seasonal slowdowns </li></ul></ul><ul><ul><li>Invest in opportunities </li></ul></ul><ul><li>Financing strategies must be dynamic </li></ul><ul><ul><li>What was beneficial six months ago may no longer be valid </li></ul></ul><ul><li>Financing decisions affect virtually every department </li></ul>
  3. 3. Financing the Business <ul><li>Budgets grow and people are hired because of new financing </li></ul><ul><li>Or, layoffs occur when finances are in short supply </li></ul><ul><li>The main issues affecting financing are: </li></ul><ul><ul><li>Maturity </li></ul></ul><ul><ul><li>Cost </li></ul></ul><ul><ul><li>Conditions and restrictions </li></ul></ul><ul><ul><li>Payment schedule </li></ul></ul><ul><ul><li>Collateral </li></ul></ul>
  4. 4. Financing the Business <ul><li>IMPORTANT: </li></ul><ul><li>There are two classes of financing: </li></ul><ul><ul><li>Debt </li></ul></ul><ul><ul><li>Equity </li></ul></ul><ul><li>Debt financing will be explored first </li></ul>
  5. 5. Debt Financing <ul><li>Debt financing can take one or two forms: </li></ul><ul><ul><li>Short term borrowing </li></ul></ul><ul><ul><li>Long term borrowing </li></ul></ul><ul><li>Short Term involves loans with a maturity of one year or less </li></ul><ul><ul><li>Used to cover current needs </li></ul></ul><ul><ul><ul><li>Seasonal cash flow needs </li></ul></ul></ul><ul><ul><ul><li>Major customer orders </li></ul></ul></ul><ul><ul><li>These loans are sometimes called working capital loans </li></ul></ul>
  6. 6. Debt Financing <ul><li>Long term loans have maturities longer than one year </li></ul><ul><li>Long term loans intended to finance: </li></ul><ul><ul><li>Major capital expansions </li></ul></ul><ul><ul><li>R & D </li></ul></ul><ul><ul><li>Real estate </li></ul></ul>
  7. 7. Short Term Debt <ul><li>There are a number of different short term debt financing options such as: </li></ul><ul><ul><li>Accounts receivable </li></ul></ul><ul><ul><li>Factoring </li></ul></ul><ul><ul><li>Inventory financing </li></ul></ul><ul><ul><li>Floor planning </li></ul></ul><ul><ul><li>Revolving credit </li></ul></ul><ul><ul><li>Zero balance accounts </li></ul></ul><ul><ul><li>Lines of credit </li></ul></ul><ul><ul><li>Credit cards </li></ul></ul><ul><ul><li>Compensating balances </li></ul></ul><ul><li>Each will be discussed in the following slides </li></ul>
  8. 8. Short Term Debt <ul><li>Accounts receivable financing </li></ul><ul><ul><li>Excellent short term financing </li></ul></ul><ul><ul><li>Assists in cash flow </li></ul></ul><ul><ul><li>Uses all or part of accounts receivable as collateral </li></ul></ul><ul><ul><li>Certain invoices (late more than 90 days) might not be used for collateral </li></ul></ul><ul><ul><li>The company retains the risk if customers do not pay </li></ul></ul><ul><ul><li>Banks typically create a line of credit between 70%-90% of accounts receivable </li></ul></ul>
  9. 9. Short Term Debt <ul><li>Factoring </li></ul><ul><ul><li>Company sells accounts receivable to bank or factoring company </li></ul></ul><ul><ul><li>Sold at a discount from face value </li></ul></ul><ul><ul><li>Company receives immediate cash </li></ul></ul><ul><ul><li>Customers will now pay bank or factoring company </li></ul></ul><ul><ul><li>Expensive form of financing </li></ul></ul><ul><ul><li>May lead customers to misjudge the companies financial condition </li></ul></ul>
  10. 10. Short Term Debt <ul><li>Factoring - con’t </li></ul><ul><ul><li>The factor may call overdue accounts directly </li></ul></ul><ul><ul><li>Factoring can cost between 2% and 5% per month </li></ul></ul><ul><ul><ul><li>What is the annual cost expressed as a percent </li></ul></ul></ul><ul><ul><li>Accounts receivable can be sold as “with recourse” or “without recourse” </li></ul></ul><ul><ul><li>Selling “without recourse” is more expensive </li></ul></ul>
  11. 11. Short Term Debt <ul><li>Inventory Financing </li></ul><ul><ul><li>Typically only finished goods and raw material qualify </li></ul></ul><ul><ul><ul><li>What about WIP? </li></ul></ul></ul><ul><ul><li>Lenders typically finance ½ of the qualifying collateral </li></ul></ul><ul><ul><li>Good form of financing to cover cost of large orders </li></ul></ul><ul><ul><li>Good to use in seasonal business </li></ul></ul><ul><ul><ul><li>Financing inventory which is then immediately followed by a period of high cash flows </li></ul></ul></ul>
  12. 12. Short Term Debt <ul><li>Floor Planning </li></ul><ul><ul><li>Common in retail and high priced products </li></ul></ul><ul><ul><ul><li>Boats, cars, motorcycles </li></ul></ul></ul><ul><ul><li>The vendor and its products must be credit qualified </li></ul></ul><ul><ul><li>The lender buys the products and then places them in retailers store </li></ul></ul><ul><ul><li>Lender retains title </li></ul></ul><ul><ul><li>When sold, the retailer MUST pay the lender to obtain title to transfer to purchaser </li></ul></ul>
  13. 13. Short Term Debt <ul><li>Floor Planning – Con’t </li></ul><ul><ul><li>Flooring is often provided by a manufacturer through a credit company </li></ul></ul><ul><ul><li>Manufacturer will offer bargains and deals to smooth out manufacturing increases </li></ul></ul><ul><ul><li>Slow moving product is often provided to retailer with little to no interest </li></ul></ul>
  14. 14. Short Term Debt <ul><li>Revolving credit </li></ul><ul><ul><li>A working capital loan using accounts receivable and inventory </li></ul></ul><ul><ul><li>Loan amount tied to a formula based on inventory and accounts receivable quality </li></ul></ul><ul><ul><li>Not suitable for long term projects </li></ul></ul><ul><ul><li>A lender may require an annual “cleanup” period. (Zero out the loan) </li></ul></ul>
  15. 15. Short Term Debt <ul><li>Zero Balance accounts </li></ul><ul><ul><li>A type that may be required by the loan agreement </li></ul></ul><ul><ul><li>The loan and checking account are tied together </li></ul></ul><ul><ul><li>When a deposit is made the interest and principle are automatically deducted </li></ul></ul><ul><ul><li>When a check is written the loan balance increases </li></ul></ul><ul><ul><li>The account balance is typically zero </li></ul></ul>
  16. 16. Short Term Debt <ul><li>Line of Credit </li></ul><ul><ul><li>Not a loan </li></ul></ul><ul><ul><li>An advance arrangement with lender </li></ul></ul><ul><ul><li>Used if needed and if not needed there is no loan </li></ul></ul><ul><ul><li>Very favorable method of securing financing </li></ul></ul><ul><ul><li>Interest only accrues when funds are used </li></ul></ul><ul><ul><li>A small fee is typically assessed such as 1% of the total line </li></ul></ul>
  17. 17. Short Term Debt <ul><li>Credit Cards </li></ul><ul><ul><li>Increasingly popular </li></ul></ul><ul><ul><ul><li>Eliminates accounts receivable </li></ul></ul></ul><ul><ul><ul><li>No overdue receivables </li></ul></ul></ul><ul><ul><ul><li>Customers credit worthiness need not be evaluated </li></ul></ul></ul><ul><ul><ul><li>Customers can take as long as they want to pay </li></ul></ul></ul><ul><ul><li>Merchant must pay a fee ranging from 2% or more </li></ul></ul><ul><ul><li>Excellent choice or small orders (merchant and customer) </li></ul></ul>
  18. 18. Short Term Debt <ul><li>Compensating Balances </li></ul><ul><ul><li>A bank strategy that increases the effective cost of borrowing </li></ul></ul><ul><ul><li>The borrower is required to keep a specified amount in their checking account at all times </li></ul></ul><ul><ul><li>Example: </li></ul></ul><ul><ul><ul><li>A company borrows $1M or 1-year at 10%. Bank requires a 10% compensating balance or $100k. This results in an effective interest rate of 11% </li></ul></ul></ul>
  19. 19. Short Term Debt Review <ul><li>Accounts receivable financing </li></ul><ul><li>Factoring </li></ul><ul><li>Inventory financing </li></ul><ul><li>Floor planning </li></ul><ul><li>Revolving credit </li></ul><ul><li>Zero balance accounts </li></ul><ul><li>Lines of credit </li></ul><ul><li>Credit cards </li></ul><ul><li>Compensating balances </li></ul>
  20. 20. Long Term Debt <ul><li>A variety of long term financing options are available </li></ul><ul><li>Each will be discussed in the following slides: </li></ul><ul><ul><li>Term loans </li></ul></ul><ul><ul><li>Bonds </li></ul></ul><ul><ul><li>Debentures </li></ul></ul><ul><ul><li>Mortgage bonds </li></ul></ul><ul><ul><li>Convertible bonds </li></ul></ul><ul><ul><li>Senior debt </li></ul></ul><ul><ul><li>Subordinated debt </li></ul></ul><ul><ul><li>Junk bonds </li></ul></ul>
  21. 21. Long Term Debt <ul><li>Term Loans </li></ul><ul><ul><li>Most frequently long term debt option </li></ul></ul><ul><ul><li>A loan from a bank to a company. Typical use is to finance expansion efforts </li></ul></ul><ul><ul><ul><li>Fixed maturity </li></ul></ul></ul><ul><ul><ul><li>Five to seven years </li></ul></ul></ul><ul><ul><li>Will be repaid in monthly installments </li></ul></ul><ul><ul><li>Spreading payments (interest & principal) over time is called amortization </li></ul></ul><ul><ul><li>The amortization of the principal can take place over a period longer than the loan period </li></ul></ul><ul><ul><ul><li>The ending balance is called a balloon payment </li></ul></ul></ul>
  22. 22. Long Term Debt <ul><li>Bonds </li></ul><ul><ul><li>A bond has many characteristics similar to a term loan </li></ul></ul><ul><ul><ul><li>A Negotiable instrument that can be bought and sold </li></ul></ul></ul><ul><ul><ul><li>Usually sold to the public through offerings registered with the SEC </li></ul></ul></ul><ul><ul><li>Typically sold in units of $1,000 </li></ul></ul><ul><ul><li>A bond selling a face value is selling at par </li></ul></ul><ul><ul><li>The interest rate is called the coupon </li></ul></ul><ul><ul><li>When issued their prices fluctuate with economic conditions </li></ul></ul><ul><ul><li>Bonds are usually interest payments only with principal repaid at maturity </li></ul></ul>
  23. 23. Long Term Debt <ul><li>Debenture bonds </li></ul><ul><ul><li>A bond with only “the full faith and credit” of the company as collateral </li></ul></ul><ul><ul><li>There is no specific collateral </li></ul></ul><ul><ul><li>Bond owners are classified as unsecured creditors </li></ul></ul><ul><li>Mortgage bonds </li></ul><ul><ul><li>Only difference form a debenture is the existence of collateral </li></ul></ul><ul><ul><li>Bond owners are classified as secured lenders because of the collateral </li></ul></ul><ul><ul><li>Because of the collateral, the interest rate is lower than debenture bonds </li></ul></ul>
  24. 24. Long Term Debt <ul><li>Convertible bonds </li></ul><ul><ul><li>Used by companies with poor credit ratings </li></ul></ul><ul><ul><ul><li>Poor credit risk companies bonds would be forced to offer extremely high interest rates to attract financing </li></ul></ul></ul><ul><ul><li>Bond sold at a low rate (7%) rather than a potentially high (12%) rate </li></ul></ul><ul><ul><li>Bond owner has the right to convert the bond into common stock at a later date </li></ul></ul><ul><ul><li>Bond/common stock holders can share in the reward if the company does well </li></ul></ul>
  25. 25. Long Term Debt <ul><li>Senior debt </li></ul><ul><ul><li>A debenture that gives holders priority over all other debentures in the receipt of interest and assets in the event of bankruptcy </li></ul></ul><ul><li>Subordinated debt </li></ul><ul><ul><li>Holders of this debt have a priority below holders or senior debt </li></ul></ul><ul><ul><li>Holders of this debt will receive an interest rate higher than holders of senior debt </li></ul></ul>
  26. 26. Long Term Debt <ul><li>Junk Bonds </li></ul><ul><ul><li>The creditworthiness of most companies and their securities is rated (Standard & Poor’s, Moody’s) </li></ul></ul><ul><ul><li>Bonds with the three or four highest ratings are investment grade </li></ul></ul><ul><ul><li>Investment grade bonds recommended for pension funds and very conservative investors </li></ul></ul>
  27. 27. Long Term Debt <ul><li>Junk Bonds – con’t </li></ul><ul><ul><li>Bonds that do not receive the high ratings have a much smaller pool of investors and must pay higher rates </li></ul></ul><ul><ul><li>Known as “high yield bonds” </li></ul></ul><ul><ul><li>Bonds with very low ratings must pay very high rates (risk vs. reward) </li></ul></ul><ul><ul><li>Bonds with a very high yield and low quality status and knows as “junk bonds” </li></ul></ul>
  28. 28. Long Term Debt Review <ul><li>Term loans </li></ul><ul><li>Bonds </li></ul><ul><li>Debentures </li></ul><ul><li>Mortgage bonds </li></ul><ul><li>Convertible bonds </li></ul><ul><li>Senior debt </li></ul><ul><li>Subordinated debt </li></ul><ul><li>Junk bonds </li></ul>
  29. 29. Equity <ul><li>Selling common and preferred shares is essentially a permanent form of financing </li></ul><ul><li>Requires no repayment </li></ul><ul><li>Equity financing may also be issued for the purpose of: </li></ul><ul><ul><li>Expanding stock ownership </li></ul></ul><ul><ul><li>Reducing concentration of voting power </li></ul></ul>
  30. 30. Equity <ul><li>There are three important categories under the heading of stockholders equity: </li></ul><ul><ul><li>Venture capital </li></ul></ul><ul><ul><li>Preferred stock </li></ul></ul><ul><ul><li>Common stock </li></ul></ul>
  31. 31. Equity <ul><li>Venture capital </li></ul><ul><ul><li>Suppliers of venture capital are usually financing an idea not yet implemented </li></ul></ul><ul><ul><li>Company founders must have solid credentials </li></ul></ul><ul><ul><li>Companies are usually not candidates for bank loans </li></ul></ul><ul><ul><li>Venture capital investors want some ownership in the company </li></ul></ul><ul><ul><li>Venture capital investors will be intimately involved in how their money is spent </li></ul></ul>
  32. 32. Equity <ul><li>Preferred stock </li></ul><ul><ul><li>A hybrid class of equity usually associated the mature businesses </li></ul></ul><ul><ul><li>Shareholders receive an indicated, not guaranteed, dividend </li></ul></ul><ul><ul><li>When cash is tight, preferred receive dividends before common stockholders </li></ul></ul><ul><ul><li>Generally not entitled to vote </li></ul></ul><ul><ul><li>May have the option to convert their preferred shares into common shares </li></ul></ul>
  33. 33. Equity <ul><li>Common stock </li></ul><ul><ul><li>When a company is going public for the first time they will have an IPO </li></ul></ul><ul><ul><li>A means to raise cash </li></ul></ul><ul><ul><li>Going public is expensive </li></ul></ul><ul><ul><ul><li>SEC filings </li></ul></ul></ul><ul><ul><ul><li>Legal expenses </li></ul></ul></ul><ul><ul><li>Common holders vote </li></ul></ul>