A Firm’s Sources of Financing

Dr. Nazatul Shima Abdul Rani (PhD)

 Learning Outcomes
• After reading this chapter, you should be able to:
1. Describe how the nature of a firm affects its financing sources
2. Evaluate the choice between debt financing and equity financing
3. Identify the typical sources of financing used at the outset of a new
venture
4. Discuss the basic process for acquiring and structuring a bank loan
5. Explain how business relationships can be used to finance a small firm
6. Describe the two types of private equity investors who offer financing
to small firms
7. Distinguish among the different government loan programs available
to small companies
8. Explain when large companies and public stock offerings can be
sources of financing.
 Introduction
• Basic types of financing include:
1. Spontaneous debt financing – such as accounts payable
and accruals, which increase in response to increase in
sales.
2. External financing – which comes from outside lenders
and investors. Lender provide debt capital, and
investors (common stockholders, partners, or sole
proprietors) provide equity financing.
3. Profit retention – which is provided by the cash flows
generated by the business, or what we call cash flows
from operations.
 The Nature of a Firm and its Financing Sources

• Four basic factors determine how a firm is financed:

Factors Descriptions
1. A firm’s economic 1. Firm with potential for high growth and large profits has more possible sources of
potential financing than does a firm that provides a good lifestyle for the owner but little in the
way of returns to investors.
2. Most investors in startup companies limit their investment to firms that offer
potentially high returns within a 5 to 10 year period. Company that provides a
comfortable lifestyle for its owner but insufficient profits to attract outside investors
will find its options for alternative sources of financing limited.
2. Company size and 1. The size and maturity of a company have a direct bearing on the types of financing
maturity available.
2. Larger and older firms have access to bank credit that may not be available to younger
and smaller companies.
3. Types of assets 1. Banker considers 2 types of assets when evaluating a loan: tangible assets (can be seen
and touched – inventory, equipment, buildings) and intangible assets (goodwill or past
investments).
4. Owner preferences for 1. Owner of a company faces the question “ Should I finance with debt or equity, or some
debt or equity mix of the two?”
2. The answer depend on his or her personal preferences.
3. The ultimate choice between debt and equity involves certain trade-offs.
 Debt or Equity Financing?
• To make an informed decision, a small business owner needs to recognize
and understand the trade-offs between debt and equity with regard to
potentially profitability, financial risk, and voting control.
• Potential profitability:
– Return on owners’ investment, or return on equity, is a better measure of
performance than the absolute dollar amount of net profits.
– Return on equity= net profits/ownership equity; return on assets: net
profits/ownership equity; return on equity= net profits/owner’s equity
investment
– A general rule: as long as a firm’s rate of return on its assets (operating profits
/total assets) is greater than the cost of the debt (interest rate), the owners’ rate
of return on equity will increase as the firm uses more debt
• Financial risk:
– If debt is so beneficial in terms of producing a higher rate of return for the
owners, the bad news is that debt is risky.
– If the firm fails to earn profits, creditors will still insist on having their money
repaid, regardless of the firm’s actual performance.
– Equity is less demanding, if a firm is not profitable, an equity investor must
accept the disappointing results and hope for better result next year.
– Debt is double edged swords- it cuts both ways.
– If debt financing is used and things go well, it will go very well for the owners, but
if things go badly they will go very badly for the owners.
• Voting control:
– The third issue in choosing between debt and equity is the degree of control
retained by owners.
– Raising new capital through equity financing mean giving up a part of the firm’s
ownership, and most owners of small firms resist giving up control to outsiders.
– Many small business owners choose to finance with debt rather than with equity.
 Tradeoffs Between Debt and Equity
High Equity and Low Debt Financing

EQUITY

DEBT

Results:
Voting control: Owners must share control with other equity investors who buy the stock or make a large investment.
Financial risk: Lower
Potential Profitability: Lower potential return on investment for the owners

High Debt and Low Equity Financing

DEBT

EQUITY
Results:
Voting control: Owners maintain control without having to make a large investment.
Financial risk: Higher
Potential profitability: Higher potential return on investment for the owners
 Sourcing of Financing
Sources of Funds

Personal Savings
Friends and Family
Other Individual Investors
Commercial Banks
Business Suppliers
Asset-based Lenders
Equity Government Sponsored Programs Debt
Venture Capital Firms
Community Based Financial
Institutions
Large Corporations
Public Sale of Stock
 Sources Close to Home

Personal savings is by far the most Personal savings serve as the Using credit cards to help finance a
Personal Savings

Friends and Family

Credit Cards
common source of equity primary source of financing for small business became
financing used to start a new most small business startups, increasingly common among
business, which needs equity to friends and family are a distant entrepreneurs.
allow for margin of error. second. Approximately half of all
In its few years, a firm can ill afford They provide almost 80 percent of entrepreneurs have used credit
large fixed outlays for debt startup capital beyond the cards at one time or another to
repayment. entrepreneur’s personal savings. finance a startup or business
A problem for many people who Entrepreneurs who acquire expansion.
want to start a business is that financing from friends and family It is essential for an entrepreneur
they lack sufficient personal are putting more than just their using credit card financing be
savings for this purpose. financial futures on the line, they extremely self disciplined to avoid
Many individuals who lack are putting important personal becoming overextended.
personal savings for a startup find relationships at risk, too. Credit cards are a significant
ways to own their own companies Friends and relatives who provide source of financing for a number
without spending large amounts of business loans sometimes feel that of entrepreneurs, the eventual
money. they have the right to offer goal is to use credit cards as a
suggestions concerning the method of payment and as a
management of the business. source of credit.
 Bank Financing

• Bankers make business loans in one of the 3

forms:
– Lines of credit: an informal agreement between a
borrower and a bank as to the maximum amount of
funds the bank will provide at any one time.
– Term loans: money loaned for a 5 to 10 year term,
corresponding to the length of time the investment
will bring in profits.
– Mortgages: a loan for which items of inventory or
other movable property serve as collateral.
– Real estate mortgage: a long term loan with real
property held as collateral.
 Understanding a Banker’s Perspective

5 Cs
●
● 3 years of the firm’s historical financial
statements
●
● The firm’s pro forma financial
●
● Recouping the principal of the loan
statements, in which timing and
●
● Determining the amount of income
●
● The borrower’s character amounts of the debt repayment are
the loan will provide the bank ●
● The borrower’s capacity to repay the included as part of the forecasts
●
● Helping the borrower be successful ●
Personal financial statements showing
loan ●
and then become a larger customer the borrower’s net worth (net
●
● The capital being invested in the
venture by the borrower worth=assets-debt) and estimated
●
● The conditions of the industry and annual income
economy
●
● The collateral available to secure the
loan
3 priorities of a
Written loan
banker from
request
entrepreneur
 Selecting a Banker
• Wide variety of services provided by banks makes
choosing a bank an important decision.
• Loans are negotiated with the same bank in which the firm
maintains its checking account.
• The firm may use the bank’s safe deposit vault or its
services in collecting notes or securing credit information.
• Experienced banker can also provide management advice
in financial matters to a new entrepreneur.
• the location factor limits the range of possible choices of
banks.
 Negotiating the Loan
Key term Details
Interest rate The interest rate charged by banks is usually stated in terms of either the prime rate or the
LIBOR.
Prime rate – is the rate of interest charged by banks on loans to their most creditworthy
customers.
LIBOR – London Interbank Offered Rates
Loan Maturity Date A loan’s term should coincide with the use of long-term financing, while long-term needs
demand long-term financing.
Some banks require that a firm “clean up” a line of credit one month each year.
Repayment schedule Loan is set to be repaid over 5 to 10 years, depending on the type of assets used for collateral.
Bankers may have the option of imposing a balloon repayment before the loan is fully repaid.
Balloon payment: a very large payment required halfway through the term over which
payments were calculated, repaying the loan balance in full.
Loan covenants Loan covenants: bank-imposed restrictions on a borrower that enhance the chance of timely
repayment.
Sample loan covenants:
1. The company must provide financial statements to the bank on a monthly basis or, at the
very least, quarterly (positive covenants)
2. As a way to restrict a firm’s management from siphoning cash out of the business, the bank
may limit managers’ salaries. It also may prohibit any personal loans from the business to
the owners (negative covenant)
3. A bank may put limits on various financial ratios to make certain that a firm can handle its
loan payments.
4. The borrower will normally be required to personally guarantee the firm’s loan. Banker
wants the right to use both the firm’s assets and the owner’s personal assets as collateral.
 Business Suppliers and Asset-Based Lenders
• Companies that have business dealings with a new firm are possible sources of funds for financing
inventory and equipment.
• Wholesalers and equipment manufacturers/suppliers may provide accounts payable (trade credit) or
equipment loans and leases.

Sources of funding Details

Accounts Payable 1. Trade (or mercantile) credit is the source of short-term funds most widely used by small firms.
(Trade Credit) 2. Accounts payable (trade credit) is of short duration – 30 days is the customary credit period.
3. This type of credit involves an unsecured, open-book account.
4. Supplier (seller) sends merchandise to the purchasing firm; the buyer then sets up an account
payable for the amount of the purchase.
Equipment Loans 1. An installment loan from a seller of machinery used by a business.
and Leases 2. A down payment of 25 to 35 percent is usually required, and the contract period normally runs
from 3 to 5 years.
3. Lease equipment for 36 to 60 months and cover 100 percent of the cost of the asset being
leased with a fixed rate of interest.
4. 80 percent of all firms lease some or all of their business equipment.
5. 3 reasons for leasing:
1. The firm’s cash remains free for other purposes
2. Available lines of credit can be used for other purposes
3. Leasing provides a hedge against equipment obsolescence
Asset-based 1. Asset-based loan: a line of credit secured by working capital assets.
lending 2. Factoring- obtaining cash by selling accounts receivable to another firm.
3. Purchase-order financing – obtaining cash from a lender who, for a fee, advances the amount of
the borrower’s cost of goods sold for a specific customer order.
 Private Equity Investors
• Business angels
– Private individuals who invest in others’ entrepreneurial venture.
• Informal venture capital
– Funds provided by wealthy private individuals to high-risk ventures
• The art of the start:
1. Make sure the investors are accredited.
2. Make sure they’re sophisticated.
3. Don’t underestimate them.
4. Understand their motivation.
5. Enable them to live vicariously.
6. Make your story comprehensible to the angel’s spouse.
7. Sign up people the angel has heard of.
8. Be nice.
• Venture capital firms
– Individuals who form limited partnerships for the purpose of raising venture
capital from large institutional investors
 The Government
• In the USA, these are some loans provided by the government for small
business owners.
Government Loan Description
The Small Business Federal government has a long history of helping new businesses get started,
Administration primarily through the programs and agencies of the Small Business Administration
(SBA).
7(A) Loan Guaranty A loan program that helps small companies obtain financing through a guaranty
Program provided by the SBA.
Certified Development An SBA loan program that provides long-term financing for small businesses to
(cdc) 504 Loan Program acquire real estate or machinery and equipment.
7(M) Microloan An SBA loan program that provides short term loans up to $35,000 to small
Program businesses and not-for-profit child care centers.
Small Business Privately owned banks, regulated by the SBA, that provide long-term loans and
Investment Companies /or equity capital to small businesses.
Small Business An SBA program that helps to finance companies that plan to transform
Innovative Research laboratory research into marketable products.
(SBIR) Program
 Where Else to Look
Other sources of Descriptions
financing
Large Corporations Large corporations at times make funds available for investment
in smaller firms when it is in their self-interest to maintain a close
relationship with such a firm.
Stock Sales Selling stock to outside individual investors through either
private placement or public sales.
Private Placement The sale of a firm’s capital stock to select individuals.
Public Sale Make their stock available to the general public, going public or
making an initial public offering,
 Class Discussion
• Describe the different types of loans made by
a commercial bank.
• What does a banker need to know in order to
decide whether to make a loan?
• Explain the three trade-offs that guide the
choice between debt financing and equity
financing.
 Case Study
• John Dalton is well on his way to starting a new venture-Max, Inc. He
has projected a need for $350,000 in initial capital. He plans to invest
$150,000 himself and either borrow the additional $200,000 or find a
partner who will buy stock in the company.
• If Dalton borrows the money, the interest rate will be 6 percent. If, on the
other hand, another equity investor is found, he expects to have to give
up 60 percent of the company’s tock. Dalton has forecasted earnings of
about 16 percent in operating profits on the firm’s total assets.
1. Compare the two financing options in terms of projected return on the owner’s
equity investment. Ignore any effect from income taxes.
2. What if Dalton is wrong and the company earns only 4 percent in operating
profits on total assets?
3. What should Dalton consider in choosing a source of financing?
 References
• Petty, J.W., Palich, L.E., Hoy, F., and
Longenecker, J.G. (2012). Managing Small
Business: An Entrepreneurial Emphasis, 16th
edition, South Western-Cengage Learning.