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Financial needs of small business

Published:2017-01-12

Irrespective of the nature of the proposed venture, a number of common factors need to be considered when raising finance.

 

At a minimum, the financial requirements of the venture and the financial structure of the enterprise through which the venture is operated need to be analysed to ensure that the finance selected meets the anticipated needs, including the desired level of debt to equity.

 

There are four major factors which must be addressed by any manager or entrepreneur seeking to raise business finance regardless of the nature of the proposed business venture.

 

These four essential factors are:

 

1.    Determining and understanding the financial requirements of the venture.

2.    Understanding the financial structure of the business enterprise (the vehicle for the venture).

3.    Understanding the types of finance that may be utilised.

4.    Identifying relevant sources of finance.

 

Although the above procedures appear to be (and are) a matter of common sense, many organisations fail to observe them in practice. Even the larger listed companies are, on occasions, guilty of ignoring the principles of sound fundraising.

 

Failure to apply the procedures can, and usually does, result in higher borrowing costs, delays in obtaining funds, poor financial structures and a bad image among potential lenders and investors.

 

Financial requirements

 

The viability of a venture is generally determined in financial terms, ie whether the expected rate of return compensates the business for the additional risks it has assumed. The financial requirements of a proposed venture are determined by:

 

·      the required levels of inventory

·      the terms of payment to creditors

·      the ability to recover debts

·      the level of investment required for fixed assets, and

·      sales quantities and value compared with the cost of generating those sales.

 

Together these aspects of activity hold the keys to the business’ financial requirements.

 

Accordingly, an understanding of the nature (ie the financial consequences) of any proposed business venture is a vital prerequisite to undertaking that business venture.

 

The need to understand financial structure

 

All businesses are essentially financial entities. Unless they produce a form of financial activity, they have obviously failed. There should be no justification for a venture other than to produce a positive financial return, either directly or indirectly, on the original funds invested.

 

An analysis of the factors identified above can provide simple answers to funding issues. For example, some businesses may discover that accepting credit cards allows them to convert debtors into cash sales (at a price of course); special terms may be negotiated with suppliers under certain circumstances; stock may be available on an agency or sale-or-return basis; fixed assets may be funded through finance arrangements (again carrying a cost).

 

Preparing forecasts

 

Based on the above considerations a business plan and cash flow projections should be prepared — specifically cash flow projections arising from market studies and business plans.

 

It is important to consider possible ways to lengthen the time available for cash outflows and to shorten the timing of cash inflows (although one should be careful of over-optimism about debtors’ recoveries, creditors’ terms and stock turnover).

 

Ideally, generous terms should be negotiated with creditors and incentives provided to debtors for early payment.

 

Preparation of these projections and budgets should be the raison d’être for giving consideration to the factors forming the core of the financial requirements of the business. As a summary of the venture’s financial requirements, they have the advantage (if they are accurate) of illustrating the potential success or otherwise of the venture. As such, they are essential business practice for all business organisations and for all ventures regardless of size.

 

Financial structure

 

Managers and, more particularly, entrepreneurs often give detailed consideration to financial and other aspects of proposed ventures whilst ignoring the importance of the vehicle for the venture.

 

In considering financial structures, it is useful to ask the question “why are large companies successful?”. Their success is not due simply to their size. Bad investment decisions eventually destroy any chance of success regardless of the initial size of the organisation. Rather, it is because large companies employ certain techniques and structures which are well-proven and which:

 

a)    work for them, and

b)    are acceptable to lenders and investors.

 

If one examines the financial structures, the accounting and reporting techniques and the business planning procedures used by some of the successful companies in Australia, and indeed in the rest of the world, the usefulness of such techniques and structures becomes obvious. What is often not understood is the applicability of these to so-called “small businesses”. It is essential for each organisation to “think like a large company” and in so doing assist potential lenders and investors to view the organisation in a somewhat less speculative and more respectful light than may have otherwise been the case.

 

Highlight

 

Regardless of the initial size of an organisation, bad investment decisions will destroy its chances of success. The preparation of budgets and cash flow projections will assist in the day-to-day activities of a small business as well as providing potential lenders and investors with a less speculative proposal.

The financial structure of the borrowing vehicle is generally the key factor in any presentation to a lender.

 

The financial structure presented to a potential lender must demonstrate its ability to service the debt and expand. It should not be limited to its immediate needs.

Just as an office should be structured to allow expansion of staff, a business should be structured to handle more finance — debt and equity.

 

Irrespective of the vehicle through which the venture is to operate, its structure of equity, debt and assets will depend on the nature of the business and its financial requirements (both short and long terms) as discussed in. The two most important structural factors are the major prudential ratios:

 

·      Gearing (or debt to equity, see). The ratio of debt to equity (net worth). Ideally, this ratio should be 1:1 or less or, in the early stages of a venture, or at least capable of achieving 1:1 in the short term.An acceptable level may be determined with reference to other firms in the same industry or a particular entity’s tradition. An acceptable level of debt to equity may also be imposed by lenders

 

·      Current ratio (or quick ratio, see)— which measures the entity’s ability to meet short-term commitments. The ratio of current assets to current liabilities (receivables and payables due within 12 months). This should be 1:1 or higher.

 

These ratios, together with other relevant factors such as the relative cost of debt and equity, should be used when determining the proportions of debt and equity finance to be raised.

 

Types of finance

 

Equity finance

 

“Equity finance” consists of funds contributed by the venture’s owners (equity capital) plus surpluses generated and retained by the venture which are the property of the owners (reserves and retained earnings). Equity finance (shareholders’ funds) represents a company’s wealth and is also the owner’s investment in the company at any point of time.

 

The four major sources of equity finance are:

 

      i.         private and personal funds

     ii.         retained earnings

   iii.         venture capital and investment companies, and

   iv.         the public.

 

The activities of venture capital and investment companies and the raising of equity from the public are specialist areas and tend to be very specific to an organisation.

 

Private equity capital can often be derived through the capitalisation of shareholders’ loans to the company. Since it is necessary to ensure that every venture has adequate “start-up” capital, lenders like to be satisfied that it is not the intention of owners to extract their funds at the earliest possible opportunity. The capitalisation of shareholders’ loans is one method which helps to reassure them in this regard.

 

There may be many sources of private funds for equity, but these generally depend on the circumstances of the company and its owners.

 

Retained earnings and reserves are the residue of corporate profit after deducting income tax and dividends to shareholders. It is important to maintain a balance between dividends (cash returns to shareholders) and an increase in corporate wealth by retention of earnings (growth in shareholders’ investment). The balance will depend on a company’s financial requirements within its chosen growth rate.

 

Reserves derived from revaluations may also be helpful in increasing equity although they are not usually a source of funds. However, adjustment of the equity structure very often allows the company to increase its debt funds.

 

Debt finance

 

The major forms of debt finance are:

 

·      working capital funding/factoring

·      trade finance, and

·      fixed asset finance.

 

Each of which is discussed further below.

 

Working capital

 

Working capital includes the funding of debtors, stock and work-in-progress and its main sources are:

 

·      bank overdraft (should only be used for cyclical requirements and/or for emergencies)

·      extended credit from suppliers (with or without their agreement)

·      inventory and other stock financing loans

·      factoring and accounts receivable funding, and

·      trade finance.

 

These sources are available in the following ways:

 

·      overdrafts and fully drawn advances from trading banks

·      bills of accommodation, from banks, finance companies and merchant banks

·      promissory notes and short/medium term loans from finance companies and merchant banks

·      floor plan finance and factoring from finance companies, and

·      internal funds.

·       

Working capital is discussed in more detail at in CCH’s Business Advisors Guide) and following.

 

Trade finance

 

Trade finance (a form of working capital finance) specifically relates to the buying and selling of goods — domestically and internationally. It tends to be specific to individual transactions and the main sources are trading banks, confirming houses, merchant banks, finance companies and government authorities.

 

The major types of trade finance are:

 

·      the establishment of letters of credit for importers

·      guaranteeing letters of credit for importers

·      reimbursing or guaranteeing payment of local suppliers

·      pre-shipment finance for exporters

·      post-shipment finance (short, medium and long term) for exporters

·      acceptance and discounting of local and export trade bills of exchange, and

·      finance of shipping costs for importers.

 

Trade finance is discussed in more detail at in CCH’s Business Advisors Guide) and following.

 

Fixed asset financing

 

Fixed asset financing generally involves loans over specific assets for periods up to the life of the relevant asset. This may include:

 

·      term loans

·      debentures and other securities

·      property mortgages

·      leasing and secured loans

·      leveraged leasing and other forms of consortium finance, and

·      sale and leaseback arrangements.

 

Traditionally, many people wishing to purchase a business went to see their bank. Bank policy for such loans has always required nothing less than dollar-for-dollar real estate security. This is due to their perception that business acquisition loans fall in the high risk area. The consequent security mortgages over the purchaser’s home or other property can often severely inhibit growth and expansion in future years when extra capital is needed. Even finance companies, who are traditionally higher risk lenders, often shy away from business acquisition loans. However, in more recent years, a number of finance companies have changed their attitudes in this respect. They have come to realise that with careful evaluation of a proposal the risk factor can be drastically reduced.

 

Should the finance company approve of the business and the prospective borrower, it will lend up to 50% of its fair value. This fair value figure usually does not include any items of stock. The security taken is a charge (equitable mortgage) over the business, its stock and the lease. Certain businesses are considered more favourably for the purposes of security than others. For example, newsagencies and liquor shops fall into this preferred bracket. Providing good figures can be shown, it is not unusual to obtain a loan geared as high as 70% of a fair valuation for these types of businesses. However, in every case, a lender will be guided by information that will prove that the profitability of the business can adequately service the loan while at the same time produce sufficient living income for the purchaser. In some instances, a loan equal to the full purchase price can be obtained with extra collateral security. In these cases, proof in respect to the ease of servicing the loan is by far the dominant feature.

 

Sources of finance

 

Banks

 

Banks are the most common source of debt finance for small business. They provide a wide range of finance products ranging from the traditional bank overdraft to more innovative products to suit the needs of different businesses. Depending on the amount involved, finance can be approved immediately. In any case, an answer can usually be given within a week from the request.

 

Some banks have a commercial division for borrowers seeking loans of larger amounts (greater than $250,000). In the first instance, an approach to a bank for finance should be made through a local branch, which can determine the appropriate department to handle the request.

 

Merchant banks and finance companies

 

Merchant banks and finance companies generally do not offer the same range of services provided by banks. As merchant banks and finance companies tend to operate in niche markets, they are often more competent in particular areas than major banks.

 

Many of the major banks are associated with finance companies and therefore a reference by a bank to a particular finance company may represent a vested interest. Independent advice should be sought in this regard.

 

Suppliers

 

A common form of short-term finance is the use of supplier credit. All businesses use supplier credit to some degree, although it is most successfully used by large organisations operating in a competitive environment. They are able to negotiate longer payment terms with suppliers who do not want to jeopardise potential future sales.

 

Small businesses need to be aware that some suppliers charge a credit fee. When interest rates are low, it can be better to utilise a bank overdraft than pay a fee based on a percentage of credit purchases.

 

Approaching sources of finance

 

It is very important to approach potential lenders (and investors) with clear indications of the venture’s financial requirements. There are three basic rules as follows:

 

1.    Know your financial requirements (How much? What areas of activity? How long are funds required?).

2.    Pick the correct source or sources of finance to meet these requirements.

3.    Prepare and present a suitable application or submission.


(Information source: Wolters Kluwer)