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Chapter 14 Copyright © 2010 by Nelson Education Ltd.

Financing

Requirements,

Pro Forma Financial

Statements, and

Sources of Financing

14

PowerPoint Presentation by

Ian Anderson, Algonquin College


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. Create pro forma (forecast) cash flows, income statements, and

balance sheets.

3. Describe the types and sources of financing available.

4. Describe the appropriateness of types of financing at various stages

of a venture’s life.

5. Evaluate the choice between debt financing and equity financing.

6. Discuss the most important factors in the process of obtaining start-

up financing.

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Businesses Needs

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

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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)

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Business Decisions

The business owner must make two additional

decisions which are:

–Buy or lease the equipment?

–Acquire new or used equipment?

• Bootstrapping

– See In The Trenches, p. 419

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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.

• May be significant cost or tax implications.

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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

–Inflow and outflow of cash

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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.

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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

14-9


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.

– Beginning cash + Cash coming from operations +

Cash coming from financing and other activities

- Cash outflow from operations – Cash outflow from

non-operating activities

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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.

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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

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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.

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Cash Flow Forecast

• Most critical financial projection for new or

growing business

• Without cash the business dies

• Brings together elements of Balance sheet

and Income statement

• Concerned with the timing of inflows and

outflows of cash

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Pro Forma Income Statements &

Balance Sheets

• First – identify which items belong on the

income statement and balance sheet

• Balance sheet items include

– Cash, accounts receivable, inventory, prepaid

expenses, accounts payable, start-up capital,

financing, and capital expenditures

• All other items are income statement items

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Sources of Financing

Exhibit 14-2

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Other Forms of Capital

• Personal Savings

• Friends and Relatives

• 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

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Sources of Funds

Exhibit 14-3

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Venture Capitalists (VCs)

• VCs look for:

– People: strong management team

– Products: high value-added features and

competitive advantage

– Markets: large and growing

– Margins: gross margins of 40-50%

– Return: short ROI cycles

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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

14-20



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

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Asset-Based Lenders

• Chartered Banks and Credit Unions –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.

–Credit Unions are growing in popularity

with SMEs

• Line of credit • Maximum amount that lender

will permit firm to borrow.

…continued

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Asset-Based Lenders

• 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

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The Lender’s Perspective

• Lenders’ 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

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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?

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Selecting a Lender

Many reasons for selecting a lender exist

1. Chequing account facilities

2. Flexibility of loan arrangements

3. Management advice

4. Location

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Financial Information Required

for a 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

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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 • Lender-imposed restrictions on a borrower that enhance the chances of

timely repayment

• Filing financial statements, restricting salaries and personal loans, requiring personal loan guarantees

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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

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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)

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Government-Sponsored Programs

and Agencies

• Canada Small Business Financing Program (CSBFP)

– 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)

14-31


Other Sources of Financing

• Large corporations

• Stock sales

• Private placement

• Public sale

– Initial public offerings (IPO)

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Finding Sources of Financing

• Three basic types of financing:

1. Spontaneous financing

2. Profit retention

3. External financing

• Comes from outside investors

• First ask, ―Should I use debt or equity financing?‖

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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.

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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.

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Equity

financing

Debt

financing

HIGH

LOW

LOW HIGH

Equity

Financing

Debt

Financing

Potential

Profitability

Financial Risk/Control

Tradeoffs Among Potential Profitability,

Financial Risk, and Voting

14-36


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.

14-37

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PowerPoint Presentation · PDF filePowerPoint Presentation by Ian Anderson, ... accounts receivable, ... –What are the strengths and qualities of the management