Financing

Requirements and
Sources of
Financing
 Businesses Need …

Businesses need cash for three core

reasons:
1. To 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.
 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)
 Business Decisions

The business owner must make two additional

decisions which are:
 Buy or lease the equipment?
 Acquire new or used equipment?
 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.
 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
 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.
 Flow of Cash Through A Business

Owner's Borrowed Sale of

Investment Borrowed
Funds Fixed Assets
Funds

Collection
Collection of
of
Cash Accounts
Sales Accounts
Receivable
Receivable

Purchase of Payment of
Fixed Assets Expenses

Payment of Payment for

Dividends Inventory
 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.
 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.
 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
 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.
 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.
Sources of Funds

Figure 8-1
 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
 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
 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
 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
 Business Suppliers and
Asset-Based Lenders
• Commercial Banks
Term loans
• Loans for 5 to 10 years to finance
equipment
Real estate mortgage
• Long-term loan with real property
held as collateral
 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
 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
 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?
 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
 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
 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
 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
• SME Bank
• First Women Bank
• Microfinance Bank
 Other Sources of Financing

• Large corporations
• Venture capital firms
• Stock sales
• Private placement
• Initial public offerings (IPO)
• Public sale
 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.
 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.
 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.