Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. PowerPoint Presentation by Thomas M c Kaig, Ryerson University Financing Requirements and Sources of Financing 8

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 8-2 Looking Ahead After studying this chapter, you should be able to: 1.Estimate the amount of financing a new or existing business will need. 2.Describe the types and sources of financing available. 3.Describe the appropriateness of types of financing at various stages of a venture’s life. 4.Evaluate the choice between debt financing and equity financing. 5.Discuss the most important factors in the process of obtaining start-up financing.

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 8-3 Businesses Need … Businesses need cash for three core reasons: 1. T o purchase assets such as equipment and inventory 2. To pay for other costs incurred such as payroll, advertising, taxes, etc. 3. Pre-start-up costs which include R&D and expert advice  Businesses also need space and equipment to operate.

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 8-4 Types of Assets Current assets (working capital) Assets that can be converted to cash within the firm’s operating cycle—cash, accounts receivable, and inventories. Fixed Assets Relatively permanent resources intended for the use of the firm. Net fixed assets = gross fixed assets – accumulated depreciation Other Assets Intangible assets (patents, copyrights, goodwill)

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 8-5 Business Decisions The business owner must make two additional decisions which are:  Buy or lease the equipment?  Acquire new or used equipment?

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 8-6 Advantages and Disadvantages of Leasing Advantages: It 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.

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 8-7 Working-Capital and Cash Budgets Working Capital Management  The management of current assets and current liabilities Cash budget or cash flow forecast  A planning document strictly concerned with the receipt and payment of dollars

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 8-8 Accounts Receivable Accounts Payable Accounts Receivable is the amount of credit extended to customers that is currently outstanding Accounts Payable (trade credit) is outstanding credit payable to suppliers.

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 8-9 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 Flow of Cash Through A Business

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Cash Flow Forecast The difference between total cash available (beginning cash = cash incoming from operations = cash outflow from non-operating activities) is the ending cash balance, which becomes the cash balance for the next month.

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Forecasting Assets and Financing Requirements Estimating Asset Requirements  Use industry ratios for assets-to-sales  Use breakeven analysis and empirical data Percentage-of-Sales Technique  Forecasting asset investment and financing requirements 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.

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Types of Financing Debt Capital  Financing provided by a creditor Current (short-term) Debt Accounts payable Accrued expenses Short-term notes Long-Term Debt  Loans and mortgages from banks and other lenders with maturities greater than one year …continued

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Types of Financing Spontaneous financing  Short term debt External equity  Funds that derive initially from the owner’s investment in a firm Profit retention  The re-investment of profit in a firm Internal equity  Funds that come from retaining profits within a firm.

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Ratio 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  Debt as a fraction of assets; total debt divided by total assets. Spontaneous financing—debts such as accounts payable that increase as the firm grows.

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Sources of Funds Figure 8-1

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Other Forms of Capital Informal capital  Funds provided by wealthy private individuals to high risk ventures such as startups Business angels  Private investor who finances new, risky, small ventures

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Business Suppliers and Asset-Based Lenders Trade Credit (Accounts Payable)  Financing provided by a supplier of inventory to a company, which sets up an account payable for the amount. Short-duration financing (30 days) Amount of credit available is dependent on type of firm and supplier’s willingness to extend credit …continued

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Business Suppliers and Asset-Based Lenders Asset-based Loan  A line of credit secured by working-capital assets Factoring  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 …continued

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Business Suppliers and Asset-Based Lenders Chartered Banks  Primary providers of debt capital to small companies.  Banks limit lending to providing for the working-capital needs of established firms, but some initial capital does come from this source. Line of credit Maximum amount that bank will permit firm to borrow. …continued

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Business Suppliers and Asset-Based Lenders Commercial Banks  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

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited The 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 Cs 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

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Selecting a Banker Many reasons for selecting a banker exist 1.Chequing account facilities 2.Flexibility of loan arrangements 3.Management advice 4.Bank’s location

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Questions Lenders Ask Lender’s Questions  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 lawyer?

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Financial Information Required for a Bank Loan 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

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Negotiating a Loan Terms of Loans  Interest rate Fixed or floating rates  Loan maturity date  Repayment schedule Equal monthly or annual payments Decreasing monthly or annual payments  Loan covenants Bank-imposed restrictions on a borrower that enhance the chances of timely repayment Filing financial statements, restricting salaries and personal loans, requiring personal loan guarantees

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Repayment Schedule Term loan  Schedule for re-payment is generally arranged in one of two ways: The loan can be repaid in one equal monthly or annual payments covering both interest on the remaining balance and payment on the principal Decreasing monthly or annual payments that cover equal payments on the principal and interest on the remaining balance. …continued

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Repayment Schedule Assume a firm is negotiating a $250,000 term loan, at an interest rate of 10%, to be repaid in five equal annual payments.  PV = -250,000 (present value)  N = 5 (number of payments)  I/YR= 10 (interest rate per year)  FV = 0 (future value in 5 years)

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Government-Sponsored Programs and Agencies Small Business Loans Act (SBLA)  Federal program that provides financing to small businesses through private lenders  Federal government guarantees repayment Business Development Bank of Canada (BDC) Industrial Research Assistance Programme (IRAP) Program for Export Market Development (PEMD)

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Other Sources of Financing Large corporations Venture capital firms Stock sales Private placement Initial public offerings (IPO) Public sale

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Appropriate Sources of Financing Figure 8-2

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited 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.

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Using the Cost of Debt as an Investment Criterion Favourable Financial Leverage  A benefit gained by investing at a rate of return that is greater than the interest rate on a loan. Debt Capacity  The limit at which a firm cannot assume more debt without additional equity investment by its owners.

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Equity financing Debt financing HIGH LOW HIGH Equity Financing Debt Financing Potential Profitability Financial Risk/Control Tradeoffs Among Potential Profitability, Financial Risk, and Voting

Chapter 8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited Keeping the Right Perspective Amar Bhide at Harvard University offers the following advice to aspiring entrepreneurs wanting to start their own businesses  Get operational. Stop planning.  Go for quick break even.  Fit growth goals to available personal resources.  Have a preference for high-ticket, high profit margin items that can sustain personal selling.  Start with only a single product or service.  Forget about having a crack management team.  Focus on cash.  Cultivate the banker.