Capital and Financing Requirements For Small Businesses
Initial Capital Requirements The fundamental building blocks for an entrepreneur are
knowing what assets are required to open the business and how those assets will be financed. The balance sheet lists the investment decisions of the business owner in the asset column and the financing decisions in the liabilities and owners’ equity column. The financing necessary to acquire each asset required for the business must come from either) owner-provided funds (equity or borrowed funds. The process of determining initial capital requirements begins with identifying the short-term and long-term assets necessary to get the business started. After that you can then decide how to pay for them.
Defining The Required Assets Every business needs a set of long term and short
term assets in place before the business ever opens its doors. Short term assets are assets that will be converted into cash within one year. Typical short term assets include: Cash and inventory (stocks) Prepaid expenses such as rent & insurance Working capital reserve
Because many businesses are not profitable in the first
year or so of operation, having a cash reserve with which to pay bills can help you avoid insolvency
Long term assets are those assets that will not be converted into cash within one year The most common long-term assets are: Buildings and equipment Land Leasehold improvements
Patents
These assets must be in the business before the enterprise earns its first dollar of sales . You must carefully evaluate your situation to determine exactly what needs to be in place
in order for the business to effectively operate. A useful exercise is to prepare a list of the assets the business if money were not a problem. Then review the list and determine the essential assets that are needed to operate the business on a ‘bare-bones’ basis. Try to determine the cost of these assets under each scenario. With the final list of required assets and corresponding dollar costs in hand, you can determine your financing requirements.
Remember each dollar of assets must be supported by a dollar of
equity or liability funds How much equity can you contribute personally to the enterprise? This contribution does not necessarily have to be cash. The total market value of the owners' assets used in the business plus all cash contributions from the owner to purchase assets or set up cash reserves is the owners’ equity The final step is to subtract the owners’ equity from the total required assets. This should result in the dollar amount that must come from other sources Although some entrepreneurs are well versed in determining their need for capital and knowing where to find it, the failure of many businesses can be traced to undercapitalisation The ability to be a proactive manger of the financing aspects of a business is paramount in a dynamic economy.
The Five Cs of Credit When an entrepreneur decides to seek external financing,
he/she must be able to prove credit worthiness to potential providers of funds. A traditional guideline used by many lenders is the five Cs of credit. These elements include: 1. Capacity- refers to the applicant’s ability to repay the loan Capacity is usually estimated by examining the amount of cash and marketable securities available and both historical & projected cash flows of the business
2. 3. 4. 5.
Capital- is a function of the applicant’s personal financial strength. The net worth of the business- the value of its assets minus the value liabilities determines its capital Collateral- assets owned by the applicant that can be pledged as security for the repayment of the loan. If the loan is not repaid, the lender can confiscate the pledged assets. Character- the applicant’s character is considered important in that it indicates his or her apparent willingness to repay the loan. Character is based on primarily on the basis of the applicant’s past repayment patterns, but lenders may consider other factors such as marital status, home ownership, and military service. The lender’s prior experience with the applicant’s repayment payments affects his choice of factors in evaluating the character of a new applicant. Conditions- the general economic climate at the time of the loan application may affect the applicant’s ability to repay the loan. Lenders will usually not extend credit in times of economic recession or business downturns.
Additional Considerations In addition to the 5 Cs, potential investors will want to
know more about you and your business. For start-ups, simply having a good idea will not be enough evidence to convince many investors to risk their capital in your business. You will need to show that you are a competent manger with a track record of prior business success. If possible, you should show an informal board of directors made up of people whom you may contact for assistance. Potential members of such a board include bankers, attorneys, CAs and successful business owners.
Basic Financial Vocabulary Two potential forms of finance are available to entrepreneur: Debt Equity Debt funds (also known as liabilities) are borrowed from a
creditor and of course must be repaid . Using debt to finance a business creates leverage, which is money you can borrow against the money you already have. Leverage can enable you to magnify the potential returns expected due to investing your equity in the business. Debt funding can also constrain future the future cash flow generated by the business and can magnify the loses. Debt creates the risk of becoming technically insolvent if the entrepreneur is unable to make payments on time.
Equity funds, are supplied by investors in exchange
for ownership position in the business and need not be repaid. Providers of equity funds forgo the opportunity of receiving periodic payments in order to share in the profits of the business. As a result , equity financing does not create a constraint on the cash flows of the business However equity owners demand a voice in the management thus reducing your autonomy to run the business as you like .
Debt Financing Three important parameters associated with debt
financing are:
the amount of principal to be borrowed, the loan’s interest rate and the loan’s length of maturity
Together they determine the size and extent of your
obligation to the creditor. Until the debt is repaid, the creditor has a legal claim on a portion of business’s cash flows. Creditors ca