A Step by Step Guide to Financing a Small Business
This is a practical guide that will walk you step by step through all the essentials of financing a business. The book is packed with guides, worksheets and checklists. These strategies are absolutely crucial to your business' success yet are simple and easy to apply.
Table of Contents
1. Essentials of Business Financing
2. How the Need For Capital Arises
3. Internal Financing Sources
4. Trade Credit As a Viable Financing Source
5. Fundamentals of Borrowing
6. How to Obtain Equity Capital
7. How to Obtain Loans the Easy Way
8. How to Effectively Manage Your Borrowings
9. How to Raise Venture Capital Money
10. How to Plan Your cash Flow
11. How to Forecast Your Profits
Essentials of Business Financing
This chapter looks at the sources of capital that is available to a business.
Capital management and capital budgeting to finance a business has two major forms: debt and equity. Creditor money (debt) comes from trade credit, loans made by financial institutions, leasing companies, and customers who have made prepayments on larger-frequently manufactured orders. Equity is money received by the company in exchange for some portion of ownership. Sources include the entrepreneur's own money; money from family, friends, or other non-professional investors; or money from venture capitalists.
Debt capital, depending upon its sources (e.g., trade, bank, leasing company, mortgage company) comes into the business for short or intermediate periods. Owner or equity capital remains in the company for the life of the business (unless replaced by other equity) and is repaid only when and if there is a surplus at liquidation of the business - after all creditors are repaid.
Acquiring such funds depends entirely on the business's ability to repay with interest (debt) or appreciation (equity). Financial performance (reflected in the Financial Statements) and realistic, thorough management planning and control (shown by Pro Formas and Cash Flow Budgets), are the determining factors in whether or not a business can attract the debt and equity funding it needs to operate and expand.
Business capital can be further classified as equity capital, working capital, and growth capital. Equity capital is the cornerstone of the financial structure of any company.
Equity is technically the part of the Balance Sheet reflecting the ownership of the company. It represents the total value of the business, all other financing being debt that must be repaid. Usually, you cannot get equity capital at least not during the early stages of business growth.
Working capital is required to meet the continuing operational needs of the business, such as "carrying" accounts receivable, purchasing inventory, and meeting the payroll. In most businesses, these needs vary during the year, depending on activities (inventory build-up, seasonal hiring or layoffs, etc.) during the business cycle.
Growth capital is not directly related to cyclical aspects of the business. Growth capital is required when the business is expanding or being altered in some significant and costly way that is expected to result in higher and increased cash flow. Lenders of growth capital frequently depend on anticipated increased profit for repayment over an extended period of time, rather than expecting to be repaid from seasonal increases in liquidity as is the case of working capital lenders.
Every growing business needs all three types: equity, working, and growth capital. You should not expect a single financing program maintained for a short period of time to eliminate future needs for additional capital.
As lenders and investors analyze the requirements of your business, they will distinguish between the three types of capital in the following way:
1) fluctuating needs (working capital);
2) needs to be repaid with profits over a period of a few years (growth capital); and
3) permanent needs (equity capital).
If you are asking for a working capital loan, you will be expected to show how the loan can be repaid through cash (liquidity) during the business's next full operating cycle, generally a one year cycle. If you seek growth capital, you will be expected to show how the capital will be used to increase your business enough to be able to repay the loan within several years (usually not more than seven). If you seek equity capital, it must be raised from investors who will take the risk for dividend returns or capital gains, or a specific share of the business.
Working capital is defined as the difference between current assets and current liabilities. To the extent that a business does not generate enough money to pay trade debt as it comes due, this cash must be borrowed.
Commercial banks obviously are the largest source of such loans, which have the following characteristics:
The loans are short-term but renewable;
they may fluctuate according to seasonal needs or follow a fixed schedule of repayment (amortization);
they require periodic full repayment ("clean up");
they are granted primarily only when the ratio of net current assets comfortably exceeds net current liabilities; and
they are sometimes unsecured but more often secured by current assets (e.g., accounts receivable and inventory).
Advances can usually be obtained for as much as 70 to 80 percent of quality (likely to be paid) receivables and to 40 to 50 percent of inventory. Banks grant unsecured credit only when they feel the general liquidity and overall financial strength of a business provide assurance for repayment of the loan.
You may be able to predict a specific interval, say three to five months, for which you need financing. A bank may then agree to issue credit for a specific term. Most likely, you will need working capital to finance outflow peaks in your business cycle. Working capital then supplements equity. Most working capital credits are established on a one-year basis.
Although most unsecured loans fall into the one-year line of credit category, another frequently used type, the amortizing loan, calls for a fixed program of reduction, usually on a monthly or quarterly basis. For such loans your bank is likely to agree to terms longer than a year, as long as you continue to meet the principal reduction schedule.
It is important to note that while a loan from a bank for working capital can be negotiated only for a relatively short term, satisfactory performance can allow the arrangement to be continued indefinitely.
Most banks will expect you to pay off your loans once a year (particularly if they are unsecured) in perhaps 30 or 60 days. This is known as "the annual clean up," and it should occur when the business has the greatest liquidity. This debt reduction normally follows a seasonal sales peak when inventories have been reduced and most receivables have been collected.
You may discover that it becomes progressively more difficult to repay debt or "clean up" within the specified time. This difficulty usually occurs because:
Your business is growing and its current activity represents a considerable increase over the corresponding period of the previous year;
you have increased your short-term capital requirement because of new promotional programs or additional operations; or
you are experiencing a temporary reduction in profitability and cash flow.
Frequently, such a condition justifies obtaining both working capital and amortizing loans. For example, you might try to arrange a combination of a $ 15,000 open line of credit to handle peak financial requirements during the business cycle and $20,000 in amortizing loans to be repaid at, say $4,000 per quarter. In appraising such a request, a commercial bank will insist on justification based on past experience and future projections. The bank will want to know: How the $15,000 line of credit will be self-liquidating during the year (with ample room for the annual clean up); and how your business will produce increased profits and resulting cash flow to meet the schedule of amortization on the $20,000 portion in spite of increasing your business's interest expense.
Other books in this category that may interest you:
Effective Cost Reduction Strategies in a Small Business
A Step by Step Guide to Extending Credit and Collection in a Small Business
A Step by Step Guide to Financing a Small Business
A Step by Step Guide to Revenue and Sales Forecasting in a Small Business
Proven Strategies to Increase Revenue and Profits in a Small Business
A Step by Step Guide
A Step by Step Guide
A Step by Step Guide to Budgeting in a Small Business
A Step by Step Guide to Cash Flow Management in a Small Business
A Step by Step Guide to Balance Sheet and Profit and Loss Statement Analysis
Guide to Self Audit the Bookkeeping and Accounting in a Small Business
Guide to Self Audit of Financial Planning and Loan Proposals in a Small Business
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