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Week 7


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Week 7

  1. 1. Financing Requirements and Sources of Financing February 26, 2004
  2. 2. “ 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
  3. 3. “ In G-D we trust, everyone else pays cash” <ul><ul><li>1. To purchase assets such as equipment and inventory </li></ul></ul><ul><ul><li>2. To finance expenses such as payroll, advertising, taxes, receivables etc. </li></ul></ul><ul><ul><li>3. To pay for other pre-start-up costs which can include R&D and expert advice </li></ul></ul>
  4. 4. Types of Assets <ul><li>Current assets (working capital) </li></ul><ul><ul><li>Assets that can be converted to cash within the firm’s operating cycle (cash, accounts receivable, inventories, prepaid expenses) </li></ul></ul><ul><li>Fixed Assets </li></ul><ul><ul><li>Relatively permanent resources intended for the use of the firm (machinery, land, buildings…) </li></ul></ul><ul><ul><li>Net fixed assets = Gross fixed assets – accumulated depreciation </li></ul></ul><ul><li>Other Assets </li></ul><ul><ul><li>Intangible assets (patents, copyrights, goodwill) </li></ul></ul>
  5. 5. Buy or Lease? <ul><li>Advantages: </li></ul><ul><li>Leasing requires no up-front cash, freeing up the firm’s cash for other purposes. </li></ul><ul><li>Leasing provides a hedge against equipment obsolescence. </li></ul><ul><li>Disadvantages: </li></ul><ul><li>Leasing requires the business to make regular payments. </li></ul><ul><li>Penalties to get out of contract </li></ul>
  6. 6. 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
  7. 7. Cash is King!!! <ul><li>Working capital management </li></ul><ul><ul><li>Cash budgets and forecasting </li></ul></ul><ul><ul><li>Cash flow statements </li></ul></ul><ul><ul><li>Accrual vs. cash-based accounting </li></ul></ul><ul><ul><li>Managing receivables, payables and inventory </li></ul></ul><ul><li>The growth trap </li></ul><ul><ul><li>A cash shortage resulting from rapid growth </li></ul></ul>
  8. 8. Assets-to-Sales-Financing Relationships Increase in Sales Increase in Asset Requirements Increase in Financing Requirements Results in Results in
  9. 9. Estimating financial requirements <ul><li>Estimating Asset Requirements </li></ul><ul><ul><li>Use industry ratios for assets-to-sales </li></ul></ul><ul><ul><li>Use breakeven analysis and empirical data </li></ul></ul><ul><li>Percentage-of-Sales Technique </li></ul><ul><ul><li>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 </li></ul></ul>
  10. 10. Types of financing(debt + equity) <ul><li>Debt Capital (f inancing provided by creditors) </li></ul><ul><ul><li>Short-term (current) liabilities </li></ul></ul><ul><ul><ul><li>Accounts payable; Accrued expenses; Short-term notes </li></ul></ul></ul><ul><ul><li>Long-Term liabilities </li></ul></ul><ul><ul><ul><li>Loans and mortgages from banks and other lenders with maturities greater than one year </li></ul></ul></ul><ul><li>Owners’ Equity = Owners’ Investment + earnings retained within the firm </li></ul><ul><ul><li>Owners are “residual owners” of the firm </li></ul></ul><ul><ul><ul><li>Creditors have first claim on the assets of the firm </li></ul></ul></ul>
  11. 11. Sources of Financing <ul><li>External Equity </li></ul><ul><ul><li>Owners’ original investment </li></ul></ul><ul><li>Internal Equity </li></ul><ul><ul><li>Profit retention (retained profits) </li></ul></ul><ul><li>Spontaneous financing </li></ul><ul><ul><li>Debts such as accounts payable that increase as the firm grows </li></ul></ul><ul><li>Forecasting financial requirements (in total): </li></ul>Total sources of financing Spontaneous financing Profits retained within the business Total asset requirements = + = External sources of financing +
  12. 12. Ratio Analysis <ul><li>Liquidity </li></ul><ul><ul><li>The degree to which a firm has working capital available to meet maturing debt obligations. </li></ul></ul><ul><li>Current Ratio </li></ul><ul><ul><li>The firm’s relative liquidity, determined by dividing current assets by current liabilities </li></ul></ul><ul><li>Debt Ratio = total debt / total assets </li></ul><ul><ul><li>Its purpose is to show the proportion of a company's assets which are financed through debt. </li></ul></ul><ul><li>Debt to Equity = long-term debt / equity </li></ul><ul><ul><li>Indicator of financial leverage. Compares assets provided by creditors to assets provided by shareholders. </li></ul></ul>
  13. 13. Debt or equity financing? <ul><li>Potential Profitability </li></ul><ul><ul><li>Borrowing increases potential for higher rates of return on owners’ equity; exposes firm to more financial risk. </li></ul></ul><ul><li>Financial Risk </li></ul><ul><ul><li>Investing more owner equity limits potential return on equity; lowers financial risk for firm. </li></ul></ul><ul><li>Voting Control </li></ul><ul><ul><li>Increasing equity through borrowing requires owners to share control with external investors. </li></ul></ul>
  14. 14. Tradeoffs between Debt & Equity Financial Risk Potential Profitability LOW Equity financing Debt financing HIGH LOW HIGH Equity Financing Debt Financing Control /
  15. 15. 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
  16. 16. 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
  17. 17. Angel Investors (informal capital) <ul><li>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. </li></ul><ul><ul><li>The &quot;average&quot; 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 </li></ul></ul>
  18. 18. Business Suppliers <ul><li>Trade Credit (Accounts Payable) </li></ul><ul><ul><li>Financing provided by a supplier of inventory to a company </li></ul></ul><ul><ul><ul><li>Short-duration financing (30-120 days) </li></ul></ul></ul><ul><ul><ul><li>Amount of credit available is dependent on the type of firm and the supplier’s willingness to extend credit </li></ul></ul></ul><ul><li>Equipment Loan and Leases </li></ul><ul><ul><li>Installment loan (mortgage on equipment) from the seller of machinery purchased by a business. </li></ul></ul>
  19. 19. Asset-based Lenders <ul><li>Asset-based Loan </li></ul><ul><ul><li>A line of credit secured by working-capital assets </li></ul></ul><ul><li>Factoring </li></ul><ul><ul><li>Obtaining cash by selling accounts receivable to another firm. </li></ul></ul><ul><ul><ul><li>Accounts are sold to factor at a discount to invoice value </li></ul></ul></ul><ul><ul><ul><li>Factor can refuse questionable accounts </li></ul></ul></ul><ul><ul><ul><li>Factor charges fees for servicing accounts and for amount advanced to firm prior to collection </li></ul></ul></ul>
  20. 20. Commercial Banks <ul><li>Line of credit </li></ul><ul><ul><li>Maximum amount that bank will permit firm to borrow </li></ul></ul><ul><li>Revolving credit agreement </li></ul><ul><ul><li>Maximum amount bank is committed to lend a firm on an ongoing basis </li></ul></ul><ul><li>Term loans </li></ul><ul><ul><li>Loans for 5 to 10 years to finance equipment </li></ul></ul><ul><li>Chattel mortgage </li></ul><ul><ul><li>Loan collateralized by inventory or moveable property </li></ul></ul><ul><li>Real estate mortgage </li></ul><ul><ul><li>Long-term loan with real property held as collateral </li></ul></ul>
  21. 21. The Banker’s Perspective <ul><li>Bankers’ Concerns </li></ul><ul><ul><li>How much the bank will earn on the loan? </li></ul></ul><ul><ul><li>What is the likelihood that the lender will be able to repay the loan? </li></ul></ul><ul><li>The Five C’s of Credit </li></ul><ul><ul><li>Character of the borrower </li></ul></ul><ul><ul><li>Capacity of the borrower to repay the loan </li></ul></ul><ul><ul><li>Capital invested in the venture by the borrower </li></ul></ul><ul><ul><li>Conditions of the industry and economy </li></ul></ul><ul><ul><li>Collateral available to secure the loan </li></ul></ul>
  22. 22. Questions Lenders Ask <ul><ul><li>What are the strengths and qualities of the management team? </li></ul></ul><ul><ul><li>How has the firm performed financially? </li></ul></ul><ul><ul><li>How much money is needed? </li></ul></ul><ul><ul><li>What is the venture going to do with the money? </li></ul></ul><ul><ul><li>When is the money needed? </li></ul></ul><ul><ul><li>When and how will the money be paid back? </li></ul></ul><ul><ul><li>Does the borrower have qualified support people, such as a good public accountant and attorney? </li></ul></ul>
  23. 23. Information required by banks <ul><li>Three years of the firm’s historical statements </li></ul><ul><ul><li>Balance sheets, income statements, and statements of cash flow </li></ul></ul><ul><li>The firm’s pro forma financial statements </li></ul><ul><ul><li>The timing and amounts of the debt repayment included as part of the forecasts </li></ul></ul><ul><li>Personal financial statements </li></ul><ul><ul><li>The borrower’s personal net worth (assets – debts) and estimated annual income </li></ul></ul>
  24. 24. Negotiating the loan <ul><li>Terms of Loans </li></ul><ul><ul><li>Interest rate </li></ul></ul><ul><ul><ul><li>Fixed or floating rates </li></ul></ul></ul><ul><ul><li>Loan maturity date </li></ul></ul><ul><ul><li>Repayment schedule </li></ul></ul><ul><ul><ul><li>Equal monthly or annual payments </li></ul></ul></ul><ul><ul><ul><li>Decreasing monthly or annual payments </li></ul></ul></ul><ul><ul><li>Loan covenants </li></ul></ul><ul><ul><ul><li>Filing financial statements </li></ul></ul></ul><ul><ul><ul><li>Restricting salaries and personal loans </li></ul></ul></ul><ul><ul><li>Personal guarantees </li></ul></ul>
  25. 25. Government-sponsored programs and agencies <ul><li>Federal assistance to small businesses </li></ul><ul><ul><li>Small Business Loans Act (SBLA) </li></ul></ul><ul><ul><li>Business Development Bank of Canada (BDC) </li></ul></ul><ul><ul><li>Industrial Research Assistance Program (IRAP) </li></ul></ul><ul><ul><li>Program for Export Market Development (PEMD) </li></ul></ul><ul><ul><li>Tax Incentives </li></ul></ul><ul><li>Provincial government assistance </li></ul>
  26. 26. Other Sources of Funds <ul><li>Venture Capital Firms </li></ul><ul><ul><li>An investor or investment group that commits money to new business ventures </li></ul></ul><ul><li>Community-based financial institutions </li></ul><ul><ul><li>Lenders that provide financing to small businesses in low-income communities for the purpose of encouraging economic development </li></ul></ul><ul><li>Large corporations </li></ul><ul><ul><li>Financing and technical assistance to critical suppliers and technology developers </li></ul></ul><ul><li>Stock Sales </li></ul><ul><ul><li>Private placement </li></ul></ul><ul><ul><li>Initial public offering (IPO) </li></ul></ul>
  27. 27. Funding Stages and Sources
  28. 28. Summary— Financing and Financial Requirements <ul><li>Estimated the assets needed and the financing for a new venture </li></ul><ul><li>Evaluated the choice between debt and equity financing </li></ul><ul><li>Described various sources of financing available to small firms </li></ul>
  29. 29. Next steps <ul><li>Read textbook chapters 9 and 10 </li></ul><ul><li>Research for marketing plans </li></ul>