small business management mgmt5601 topic 8: financing the ... · –usually secured against...

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Small Business Management MGMT5601

Topic 8: Financing the Small Firm (1) – Debt & EquityProfessor Tim Mazzarol – UWA Business School

UWA Business School MBA Program [email protected] MGMT5601



• Identify the main sources of entrepreneurial capital.

• Understand the nature of bootstrap finance.

• Know the difference between cash flow and profit.

• Understand the nature of bank financing.

• Understand the nature of equity financing.

• Explain the funding equity gap for small firms.

Learning outcomes


In this topic you should learn how to:


Financing the Small Business



Sources of funding for small firms

Three sources of capital:1. “Bootstrap”

- personal savings- family & friends- working capital

2. Debt- bank loans

3. Equity- private and public


Bootstrap Financing

• Benefits of ‘bootstrap’ financing– zero cost– total control over the money– no ‘application’ required– no ‘minimum’ lending requirement

• Bootstrap ‘checklist’– implement proven market ideas– look for quick break-even – look for high ‘gross profit’– Sell directly– Keep the team ‘lean’– Control growth– Focus on cash flow only– Cultivate the banks early


Fixed and Variable Costs

Fixed Costs• Expenses that remain

constant, regardless of operations (i.e. insurance, rates, salaries)

Variable Costs• Expenses that vary in

relation to output (i.e. cost of materials, cost of sales, casual labour)


Causes of Cash Flow Problems

Lack of sales• Seasonal business trends or

inadequate sales and marketing efforts

Not collecting the money owed• Poor debtor control or slow

to pay customers

Not negotiating adequate creditor terms• Poor creditor control in

relation to timing of debtor payment cycle

Holding too much stock• Poor inventory management

Taking too much out of the business• Funding lifestyle and failing

to reinvest in the business for future growth

Buying too many fixed assets• Money tied up in plant,

equipment or property that might be better leased

Overtrading• Trying to do too much too

soon

Lack of Credit• Upsetting the bank manager

Bad Management• Not keeping cash flow

forecast up to date

Source: DUBS (1995)


Cash and Profit Problems

Cash Problems Checklist

Under capitalised?

Excess withdrawals? Excess stock?

Inadequate debtor

control?

Inadequate creditor terms

& control?Excess fixed

assets?Bank

problems?

Profit Problems Checklist

Turnover too low?

Profit margin (Prices) too

low?

Product costs &

contributions?

Departmental costs &

contributions?Labour costs

to high?Material costs

too high?

Overhead costs (e.g.

rent, salaries) too high?


Sources of funding for EU-based SMEs

12%

2%

2%

4%

11%

7%

24%

79%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

DK/NA

other

venture capital firms

private financing firms

public institutions

private investors

leasing companies

banks

Source: EOS Gallup Europe (2005)


Nature and role of debt financing


• Debt financing involves legally enforceable agreement between lender and borrower for:– Repayment of principal and interest– Usually secured against business or

other assets• Legal risk of debt financing is higher

than equity• BUT:

– Cost of debt capital is usually less than outside equity

– Total capital raised is frequently greater with equity

– Debt capital does not erode the overall equity of the owner-manager and any profits remain theirs


Types of debt financing


• Short Term– Trade credit – (suppliers credit terms) – Overdrafts – (flexible line of credit from bank)– Factoring – (debtor financing) – Floor plan loans – (cash advances for high value

stock e.g. retailers, car dealers)– Bridging finance – (short term loan during sale of

major assets e.g. property)– Commercial bills – (written promise to pay by due

date usually within 14 to 180 days)• Intermediate Term Loans

– Personal loans – (usually for equipment, vehicles)– Hire purchase – (results in ownership but may have

high charges)– Leasing – (frees up cash, tax deductible)

• Long Term Loans– Mortgages – (long term assets e.g. property)


Types of financing used by EU-based SMEs

Source: EOS Gallup Europe (2005)

6%

9%

19%

31%

45%

50%

51%

0 0.1 0.2 0.3 0.4 0.5 0.6

Venture capital

Private individuals

Factoring

Short term loans

Long term loans

Overdraft

Leasing


Average bank interest rates for loans to SMEs 2007-2014 selected countries

Source: OECD (2016)

Australia’s SME bank interest rates have been running at an average of 7.5%


Bank financing


• Fast growing firms will soon need additional capital

• Banks supply most financing but need– cash flow forecasts for

business– collateral in case of ‘failure’

• Entrepreneurs and Bankers– have different viewpoints

• Entrepreneur ‘glass half full’

• Banker ‘glass half empty’• A good business plan can

assist bank financing


What are bankers seeking?


• Banks want long-term stable clients• They look for:

– Good cash flow– Adequate shareholder funds (working

capital)– Good reputation & standing– Specific application of the funds

• The 5 C’s of bank lending:– Character – good business track record– Credit score – credit risk assessment– Capacity – ability to repay the debt– Capital – retain earnings/owner’s equity– Collateral – assets that can secure loan


Financing the small business


How to deal with the bank


• The bank should be cultivated over time

• Keep the bank fully informed of the firm’s overall financial position particularly cash flow

• Accept advice from the banker• Negotiate carefully over bank

fees and charges• Be prepared to shop around


What to include in an application for finance


• Personal Profile of Owner-Manager

• Information on the company– Product brochures– Board Members– Customer list

• Evidence of good credit rating

– Bank references– Accountants & Lawyers

• Proof of company ownership or registration

– Audited accounts

• Financial Statements:– Balance Sheet– Profit and Loss Account– Cash flow Statement

• Future Earnings:– Budget for next year– Order book

• Future Plans:– Business Plan– Feasibility Assessments

• Security or Collateral


Assessing funding requirements

Net Fixed Assets• Capital items• Land• Less: Depreciation

Net Working Assets• Debtors• Stock• Work in progress• Cash• Less creditors

Equity• Share capital• Retained profits• Goodwill• IP Assets

Borrowings• Loans• Creditor strain

• Key elements for assessing the funding requirements for a small firm are:– Net Fixed Assets (NFA)

• Fixed Assets less depreciation– True Working Assets (TWA)

• Stock + Debtors – Creditors + Creditor Strain (days payable)

– Equity (EQ)• Share Capital + Retained

Profits– External Funding Calculation:

• NFA + TWA – EQ – Example:

TWA $70,000NFA + $275,000Less EQ ($120,000)External funding need $225,000


Financing the small business


Equity financing

Source: Naylor & Greco (2002)

• Private Investors– Business “Angels”

• wealthy individuals• difficult to find• require careful management

• Venture Capital– Professional Funds Managers

• focus on certain sectors• demand good returns• demand good management

• Public Float– Listing on the Stock Market

• largest source of capital• highly regulated• risk of loss of control


The equity financing cycle



Funding equity gap


• Financing Gap for SMEs– No agreement on this but suggests SMEs

cannot easily obtain funding from banks or VCs.

• OECD research suggests:– There is a lack of reliable data on the funding

of SMEs in OECD countries.– In developing economies the lack of data is

worse.– Financing gaps are more common in

emerging markets.– No single “gap” but many kinds, usually with

start-ups and high-tech firms.– Financing gap is not “insurmountable”.– Requires legal and regulatory support.– SMEs generally lack good information on

financing options.– Need for banking & finance sector to provide

appropriate financing instruments.

Source: OECD (2006)


Case study: Accent Learning Pty Ltd


• What should Julie consider before making an application to a bank for funding?

• How do you think the bank will view Julie’s loan application and would there be any concerns for them in considering her case?

End of Presentation

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