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Chapter 14Copyright © 2010 by Nelson Education Ltd. Financing Requirements, Pro Forma Financial Statements, and Sources of Financing 14 PowerPoint Presentation by Ian Anderson, Algonquin College
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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. 14-2
Chapter 14Copyright © 2010 by Nelson Education Ltd. Businesses Needs 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 14-3
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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) 14-4
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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. 14-6
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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 14-7
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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. 14-8
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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 14-10
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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 14Copyright © 2010 by Nelson Education Ltd. 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 14-12
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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 14Copyright © 2010 by Nelson Education Ltd. 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 14-14
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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 14-15
Chapter 14Copyright © 2010 by Nelson Education Ltd. Sources of Financing Exhibit
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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 14-17
Chapter 14Copyright © 2010 by Nelson Education Ltd. Sources of Funds Exhibit
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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 14-19
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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 14-21
Chapter 14Copyright © 2010 by Nelson Education Ltd. Business Suppliers and 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 14-22
Chapter 14Copyright © 2010 by Nelson Education Ltd. Business Suppliers and 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 14-23
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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 14-24
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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? 14-25
Chapter 14Copyright © 2010 by Nelson Education Ltd. Selecting a Lender Many reasons for selecting a lender exist 1. Chequing account facilities 2. Flexibility of loan arrangements 3. Management advice 4. Location 14-26
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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 14-27
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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 14-28
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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 14-29
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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) 14-30
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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
Chapter 14Copyright © 2010 by Nelson Education Ltd. Other Sources of Financing Large corporations Stock sales Private placement Public sale –Initial public offerings (IPO) 14-32
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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?” 14-33
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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 14Copyright © 2010 by Nelson Education Ltd. 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 14Copyright © 2010 by Nelson Education Ltd. Equity financing Debt financing HIGH LOW HIGH Equity Financing Debt Financing Potential Profitability Financial Risk/Control Tradeoffs Among Potential Profitability, Financial Risk, and Voting 14-36
Chapter 14Copyright © 2010 by Nelson Education Ltd. 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
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