Financing Requirements and Sources of Financing February 26, 2004
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