Financing Requirements and Sources of Financing

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

“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”

“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 AssetsTypes 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)

Fixed Assets Relatively permanent resources intended for the

use of the firm (machinery, land, buildings…) Net fixed assets = Gross fixed assets –

accumulated depreciation Other Assets

Intangible assets (patents, copyrights, goodwill)

Buy or Lease?Buy or Lease?Advantages: Leasing requires no up-front cash, freeing up

the firm’s cash for other purposes. Leasing provides a hedge against equipment

obsolescence.

Disadvantages: Leasing requires the business to make

regular payments. Penalties to get out of contract

Flow of Cash through a Business

Flow of Cash through a Business

BorrowedFunds

Collection ofAccounts

Receivable

Owner'sInvestment

BorrowedFunds

Sale ofFixed Assets

Collection ofAccounts

Receivable

Payment ofExpenses

Payment forInventory

Payment ofDividends

CashSales

Purchase ofFixed Assets

Cash is King!!!Cash is King!!!

Working capital managementCash budgets and forecastingCash flow statementsAccrual vs. cash-based accountingManaging receivables, payables and

inventory The growth trap

A cash shortage resulting from rapid growth

Assets-to-Sales-Financing Relationships

Assets-to-Sales-Financing Relationships

Increase in Sales

Increase in

Asset Requirements

Increase in

Financing Requirements

Results in

Results in

Estimating financial requirementsEstimating financial requirements

Estimating Asset RequirementsUse industry ratios for assets-to-salesUse breakeven analysis and empirical

data Percentage-of-Sales Technique

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

Types of financing(debt + equity)

Types of financing(debt + equity)

Debt Capital (financing provided by creditors)Short-term (current) liabilities

Accounts payable; Accrued expenses; Short-term notes

Long-Term liabilities 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 FinancingSources of Financing External Equity

Owners’ original investment Internal Equity

Profit retention (retained profits) Spontaneous financing

Debts such as accounts payable that increase as the firm grows

Forecasting financial requirements (in total):

Totalsources offinancing

Spontaneous financing

Profitsretained

within the business

Total asset requirements= ++=

Externalsources offinancing

++

Ratio AnalysisRatio Analysis Liquidity

The degree to which a firm has working capital available to meet maturing debt obligations.

Current Ratio 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?Debt or equity financing? Potential Profitability

Borrowing increases potential for higher rates of return on owners’ equity; exposes firm to more financial risk.

Financial Risk Investing more owner equity limits

potential return on equity; lowers financial risk for firm.

Voting Control Increasing equity through borrowing

requires owners to share control with external investors.

Tradeoffs between Debt & Equity

Tradeoffs between Debt & Equity

Equityfinancing

Debtfinancing

HIGH

LOW HIGH

EquityFinancing

DebtFinancing

Control /

Financial Risk

Potential Profitability

LOW

Sources of Start-up Financing

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 FinancingSources of Financing

DebtEquity

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)

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

Business SuppliersBusiness Suppliers 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.

Asset-based LendersAsset-based Lenders Asset-based Loan

A line of credit secured by working-capital assets

FactoringObtaining 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

Commercial BanksCommercial Banks 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 Term loans

Loans for 5 to 10 years to finance equipment Chattel mortgage

Loan collateralized by inventory or moveable property

Real estate mortgage Long-term loan with real property held as collateral

The Banker’s PerspectiveThe Banker’s Perspective Bankers’ Concerns

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 borrowerCapacity of the borrower to repay the loanCapital invested in the venture by the

borrowerConditions of the industry and economyCollateral available to secure the loan

Questions Lenders AskQuestions Lenders AskWhat 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

Information required by banks

Three years of the firm’s historical statementsBalance sheets, income statements, and

statements of cash flow The firm’s pro forma financial

statementsThe timing and amounts of the debt

repayment included as part of the forecasts

Personal financial statementsThe borrower’s personal net worth (assets

– debts) and estimated annual income

Negotiating the loanNegotiating the loan Terms of Loans

Interest rate Fixed or floating rates

Loan maturity dateRepayment schedule

Equal monthly or annual payments Decreasing monthly or annual payments

Loan covenants Filing financial statements Restricting salaries and personal loans

Personal guarantees

Government-sponsored programs and agencies Government-sponsored programs and agencies

Federal assistance to small businessesSmall Business Loans Act (SBLA)Business Development Bank of Canada (BDC) Industrial Research Assistance Program (IRAP)Program for Export Market Development

(PEMD)Tax Incentives

Provincial government assistance

Other Sources of FundsOther 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

Large corporations Financing and technical assistance to critical

suppliers and technology developers Stock Sales

Private placement Initial public offering (IPO)

Funding Stages and Sources

Funding Stages and Sources

Summary— Financing and Financial Requirements

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

Next stepsNext steps

Read textbook chapters 9 and 10 Research for marketing plans