Essentials of Business Financing

This chapter looks at the sources of capital that is available to a business.

Types and Sources of Capital

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.

Borrowing Working Capital

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.

ToWhether you manage a factory, wholesale outlet, retail store, Service shop, or are a builder, you'll have to sell. No matter how
good your product is, regardless of what consumers think of it, you must sell to endure.

Direct selling methods are through personal sales efforts, Advertising and, for many companies, display - like the packaging and
styling of this product - in windows, in the establishment, or both. Establishing a fantastic reputation with the general public
through courtesy and special services is an indirect method of selling. While the latter should never be disregarded, this short
discussion will be restricted to direct marketing methods.

To establish Your Company on a business footing requires a Whole Lot Of aggressive personal selling. You may have established
competition to conquer. Or, if your idea is fresh with little if any competition, you have the extra difficulty of convincing
people of the value of this new idea. Private selling work is nearly always necessary to achieve this. If you are not a fantastic
salesperson, seek an employee or asociate who's.

Another way to create sales is by marketing. This may be achieved Through papers, shopping papers, the yellow pages section of the
telephone directory, and other published periodicals; radio and tv; handbills, and direct mail. The media you select, in addition
to the message and kind of presentation, depends upon the particular customers you would like to attain. Plan and prepare
advertising carefully, or it will be unsuccessful. Most media will be able to describe the features of their viewers (readers,
listeners, etc.). Ever since your first planning described the qualities of your potential customers, you want to match these
characteristics with the media crowd. If you're selling expensive jewelry, then don't market in high school papers. Should you
repair bicycles, you probably need to.

Advertising can be quite expensive. It Is a Good Idea to put a limit upon An amount to spend, then remain within that limit. To
help you in determining how much to spend, study the working ratios of similar businesses. Media advertising salespeople can allow
you to plan and even prepare advertisements for you. Make sure you tell them your budget limitations.

A third method of stimulating sales is successful displays both in Your place of company and outside it. If you've had no previous
expertise in display work, you are going to want to examine the topic or turn the job over to somebody else. Observe screens of
different businesses and read books, trade magazines, as well as the literature provided by equipment manufacturers. It may be
smart to hire a display expert for your opening screen and special events, or you could get the services of one on a part time
foundation. Much is dependent upon your kind of business and what it requires.

The appropriate number and types of selling effort to utilize vary from business to business and from owner to owner. Some
businesses prosper with low-key revenue attempts. Others, such as the used-car lots, thrive on aggressive, hoop-la promotions. In
any event, the importance of effective selling cannot be over-emphasized.

On the other hand, don't lose sight of your major goal - to Earn a profit. Everyone can generate a large sales volume selling
dollar bills for ninety cents. But that will not last long. Keep control of your own costs, and price your product carefully.

Record Keeping. 1 essential element of business management is the keeping of adequate records. Study after study indicates that
many manager failures can result from inadequate records or the owner's failure to use what information was available . Without
records, the businessperson can't see in advance that way the business is going. Up-to-date records may forecast impending
disaster, forewarning you to take steps to prevent it. While extra work must maintain an adequate set of documents, you'll be more
than repaid for the effort and expense.

If you are not prepared to maintain adequate records - or have someone Keep them - you shouldn't attempt and run a small business.
At a minimum, records are Required to substantiate:

1. Your yields under taxation legislation, such as income tax and social Safety legislation;

2. Your request for credit from equipment manufacturers or a loan From a bank;

3. Your claims about the company, should you wish to market it.

However, most important, you need them to run your business successfully And to raise your profits. With an adequate. Yet simple,
accounting system you may answer these queries as:

How much business am I doing? What are my expenses? Which seem to be too large? What is my gross Profit margin? My net gain? How
much am I piling in my charge enterprise? What's the condition of my operating capital? How much money do I have on hand? How much
in your bank? How much do I owe my Suppliers? What is my net worth? That is, what is the worth of my ownership of The enterprise?
What are the trends in my Receipts, costs, gains, and net value? Is my financial situation improving Or growing worse? How can my
assets compare with what I owe? What's the Percentage of return on my investment? How many cents from every dollar of Sales are
net profit? Answer these and other questions by planning and studying balance sheets and profit-and-loss statements. To do this,
it's Important to record information about trades as they happen. Keep This data in a detailed and orderly manner and you'll have
the ability to answer the above questions. You'll Also have the answers to these other vital questions About your company as: What
products or services do my clients enjoy best? Next best? Not at all? Can I carry the merchandise most often asked? Am I Qualified
to render the professional services they need most? How a Lot of my charge Clients are slow payers? Shall I switch to cash only,
or use a charge card Bill plan?

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