Small Business Management in st the 21 Century
Small Business Management in st the 21 Century David T. Cadden and Sandra L. Lueder © 2012, published by Flat World Knowledge 1
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Chapter 10 Financial Management © 2012, published by Flat World Knowledge 3
Learning Objectives 1. Understand the difference between accounting and finance for small business. 2. Understand the major activities of finance. 3. Understand how finance can affect the selection of a business form. 4. Understand the various sources that can be used to finance the startup operations of the business. 5. Understand what factors might affect the extent to which the firm is financed by either debt or by equity. © 2012, published by Flat World Knowledge 4
Learning Objectives 6. Learn about the importance of cultivating a relationship with your banker. 7. Understand the elements of CAMPARI approach to evaluating a loan. © 2012, published by Flat World Knowledge 5
Learning Objectives 8. Learn the importance of a breakeven analysis. 9. Understand how to conduct a breakeven analysis. 10. Understand the potential power and danger of financial leverage. 11. Learn how changing financial leverage can affect measures of profitability such as ROA and ROE. 12. Learn how to use scenarios to evaluate the impact of various levels of financial leverage. © 2012, published by Flat World Knowledge 6
Learning Objectives 13. Understanding that the effective and efficient financial management can enhance value provided to customers. 14. Appreciate that effective financial management can improve the firm’s cash flow position. 15. Understand that the use of technologies can significantly reduce cost of operations and improve profitability. © 2012, published by Flat World Knowledge 7
Finance • Finance can be seen as "the science of money management". • It can be seen as consisting of three major activities: – Financial planning – Financial control – Financial decision-making © 2012, published by Flat World Knowledge 8
Finance • Financial planning deals with the acquisition of adequate funds in order to maintain the operations of the business and to make sure that the funds are "available at the right time". • Control seeks to assure that assets are being "utilized efficiently". • Decision-making is associated with determining how to acquire funds, where to acquire funds and how those funds should be used and within the context of the risk assessment of the aforementioned decisions. © 2012, published by Flat World Knowledge 9
Finance and Organizational Type • The federal government recognizes six forms of business organizations for tax purposes: – – – Sole Proprietorship Partnership Corporation S-corporation Trust Nonprofit • The last two are unlikely to be used by a small business. • Each of the remaining four formats have implications for financial management and tax issues. © 2012, published by Flat World Knowledge 10
Finance and Organizational Type • Sole Proprietorship – Many small businesses operated by a single individual adopt sole proprietorship format of business organization. – It is the most basic type of business organization. – It is also the least expensive to create easiest to operate and to dissolve. – Sole proprietorships disappear upon the death of the owner. – This type of business is taxed as personal income. – The owner can extract all profits from the business for their personal use or the owner can decide to reinvest any portion of the profits back into the business. – 70 percent of all businesses in the United States are sole proprietorship's yet they only produce 20 percent of all the nation’s profits. © 2012, published by Flat World Knowledge 11
Finance and Organizational Type • Partnerships – Partnerships generally are unincorporated businesses. – By having more than one owner (investor) it is often easier to raise additional capital. – General partnership is comparable to sole proprietorship in that neither are a taxable entity; therefore, the partners’ profits are taxed as personal income. © 2012, published by Flat World Knowledge 12
Finance and Organizational Type • Limited Partnership is a business that may have several general partners and several more limited partners. – The major difference with general partnership is that the limited partners do not have unlimited liability. – Their losses are limited to the original investment in the business. © 2012, published by Flat World Knowledge 13
Finance and Organizational Type • C-corporation – This form of business entails more effort and expense in creating this format. – Corporations must be chartered by the state in which it is headquartered. – Corporations are viewed as legal entities meaning they can enter into legal agreements with individuals and other corporations. © 2012, published by Flat World Knowledge 14
Finance and Organizational Type • C-corporation – Corporations are owned by their shareholders. • The shareholders are liable only for the original investment in the business. – It sometimes much easier to raise capital either through debt or through the issuance of stock. – Profits derived from this type of business are taxed at the corporate. © 2012, published by Flat World Knowledge 15
Finance and Organizational Type • S-corporation – This is a special format designed to eliminate the problem of double taxation. – It first differs from a C-corporation format in that it is limited to 100 shareholders. – If a shareholder is an employee of the business and contributes any service to the business then the Corporation is required to pay that individual a salary. © 2012, published by Flat World Knowledge 16
Acquisition of Funds • Capital is the life’s blood of all businesses. • It is needed to start a business, to operate a business and to expand a business. • Capital comes from several sources: – – Equity Debt Internally Generated Funds Trade Credits © 2012, published by Flat World Knowledge 17
Sources of Capital © 2012, published by Flat World Knowledge 18
Sources of Equity: Equity Financing • Equity financing raises money by selling a certain share of the ownership of the business. • A major source of equity financing for most small, startup businesses comes from personal savings or investments from family and friends. • A corporation may issue stock. • There are two major types of stock – common and preferred stock. © 2012, published by Flat World Knowledge 19
Sources of Equity: Equity Financing • Common stock holders have voting rights. – They have a proportional vote for members of the board of directors. • Preferred stock does not carry with it voting rights, but has a form of guaranteed dividend. • Requirements for issuing stock involves: – determining the price and number of shares to be issued – creation of stock certificates – the development of a record to record all stock transactions – meeting all federal and state securities requirements. © 2012, published by Flat World Knowledge 20
Sources of Equity: Equity Financing • Another source of financing comes from venture capitalist. – They look for substantial returns on their initial investment – 5, 10, sometimes even 25 times their original investment. – They look for firms that can rapidly generate significant profits or significant growth in sales. • Still another source comes from angel investors. – They may be more attracted to their interest in the small business concept that in reaping significant returns. – It is much more likely that Angel investors will play a much more active role in the decision-making process of the small business then venture capitalists. © 2012, published by Flat World Knowledge 21
Debt Financing • Debt financing represents a legal obligation to repay the original debt plus interest. • Most debt financing involves the fixed payment schedule to repay both principal and interest. • Failure to meet the schedule has serious consequences which might include the bankruptcy of the business. • Those that provide debt financing have the expectation that the principle will be repaid with interest, but they are not formal investors in the business. © 2012, published by Flat World Knowledge 22
Sources of Debt Financing • The largest source of debt financing for small businesses in the United States comes from commercial banks. • These loans can either be secured or unsecured. – Secured loans involve the pledging of some assets – such as a home, real estate, machinery and plant as collateral. – Unsecured loans provide no such collateral, and as such because they are riskier for the bank they generally have higher interest rates. © 2012, published by Flat World Knowledge 23
Sources of Debt Financing • The Small Business Administration has a large number of programs designed to assist small businesses with loans. • These include the SBA's business loan programs, investment programs and bonding programs. • It should be understood that the SBA does not make the loan itself to a small business, but rather guarantees a portion of the loan to its partners. © 2012, published by Flat World Knowledge 24
Capital Structure – Debt vs. Equity • A critical component of financial planning for any business is the determination of the extent to which the firm will be financed by debt and by equity. • This decision determines the financial leverage of the business. Many factors enter into this decision particularly for the small business. • From the classic economic and finance perspective one should evaluate the cost of both debt and equity. © 2012, published by Flat World Knowledge 25
Capital Structure – Debt vs. Equity • Debt’s cost centers largely on the interest rate associated with the specific debt. • Equity cost includes ceding control to other equity partners, the cost of issuing stock and dividends payments. • One should remember that the interest payment on debt is deductible and therefore will lower the business’ tax bill. • Neither the cost of issuing stock or dividend payments is tax-deductible. © 2012, published by Flat World Knowledge 26
Capital Structure – Debt vs. Equity • Financial leverage is the ratio of the total debt of the firm to its total equity. • The can be several reasons to use financial leverage – You’re using someone else’s money to grow the business. – There is the deductible nature of interest on debt. – Increasing one's financial leverage can have a positive impact on the business’s return on equity. © 2012, published by Flat World Knowledge 27
Capital Structure – Debt vs. Equity • Beyond a certain point the debt may be out of reach and therefore the entire "lifting" power of financial leverage may be lost. • The assumption of too much debt may lead to an inability to pay the interest on the debt. • This situation becomes the classic case of filing for Chapter 11 bankruptcy. © 2012, published by Flat World Knowledge 28
Relationships with Bankers • • • A standard complaint of small businesses - bankers only lend money to those businesses that don't need the money. The inverse of the complaint from the bank standpoint might be that small businesses only request money when they are least likely to be able to repay it. The conflict between small businesses and bankers may stem from a misunderstanding of the respective roles of both groups. © 2012, published by Flat World Knowledge 29
Relationships with Bankers • Bankers lend money with the clear expectation that they will be repaid both principal and interest. • It's in the interest of both parties to transcend these two conflicting perceptions of the role of bankers in the life of a small business. • The key way is for the small business owner to try to foster improved communications with their banker. © 2012, published by Flat World Knowledge 30
Relationships with Bankers • It should be the responsibility of the small business owner to maintain frequent contact with whoever is representing the bank. • This should involve more than just providing quarterly statements. It should include face-to-face discussions and even asking them to tour the facilities. • The point is to personalize the working relationship between the two parties. © 2012, published by Flat World Knowledge 31
Relationships with Bankers • Bankers and loan officers will rely heavily upon data related to the creditworthiness of the small business. • They will also consider the trustworthiness and integrity of the business owner. • This notion of integrity has to be built over time. • It's predicated upon projecting an image that you can be counted upon to honor what you say, to know the right thing to do to make the business a success, and to be able to execute the correct decisions. © 2012, published by Flat World Knowledge 32
CAMPARI • It is said that bankers when reviewing a perspective loan applicant think of the acronym “CAMPARI”. • This actually term stands for: – – – – Character Ability Means Purpose Amount Repayment Insurance © 2012, published by Flat World Knowledge 33
CAMPARI • Character – Part of that definition of integrity will include a sense of professionalism which can be reflected in one's attitude and dress. Bankers will also review one's history as a business leader. This notion of character may also be extended to the upper echelon of the management team of the small business. © 2012, published by Flat World Knowledge 34
CAMPARI • Ability – The bank is concerned with repayment of the loan and interest. The application of the loan should be able to demonstrate clearly the business's ability to repay the loan. Everything should be brought to bear to prove that the loan will not be defaulted upon and that it will be paid in a timely fashion. © 2012, published by Flat World Knowledge 35
CAMPARI • Means – This refers to the business's ability to be able to function so that the loan will be repaid. To show that your business plan should clearly indicate the business's ability to repay the loan. It should also be able to cover any issue that would convince the banker of the validity of the overall plan. © 2012, published by Flat World Knowledge 36
CAMPARI • Purpose – Bankers want to know to what purpose the borrowed money will be put. One should clearly identify where the money is going, such as purchasing a piece of capital equipment. • Amount – It is very important that you are able to specify the exact amount of the loan and also to justify how you determined this amount of money. © 2012, published by Flat World Knowledge 37
CAMPARI • Repayment – This refers to demonstrating your ability to repay both the interest and principal. Again, detailed documentation such as sales projections, projections and profit margins and projected cash flows are essential if you wish to secure the loan. © 2012, published by Flat World Knowledge 38
CAMPARI • Insurance – The best of plans may not pan out. One should show contingencies plans to the bank that would indicate how you would be able to repay the loan in the event that the scenarios that you've identified do not come to fruition. © 2012, published by Flat World Knowledge 39
Breakeven Analysis • Breakeven analysis is a remarkably useful to someone considering starting up a business. • It examines potential costs – both fixed and variable – and then determines the sales volume will be necessary in order to produce a profit for given selling. • Breakeven analysis begins with several simplifying assumptions. – It assumes that you're selling only one product at a particular price – Variable production cost per unit is constant over a wide range of values. © 2012, published by Flat World Knowledge 40
Breakeven Analysis • The purpose of a breakeven analysis is to determine the sales volume that would be required so that you neither lose money nor make a profit. • This translates into a situation in which the profit level is equal to zero. • Put in equation form this simply means: Total Revenue - Total Costs = $0 © 2012, published by Flat World Knowledge 41
Breakeven Analysis • By moving terms, we can see that the breakeven point occurs when Total Revenues = Total Costs. • We can define Total Revenue as the selling price of the product times the number of units sold. This can be represented as follows: Total Revenue (TR) = Selling Price (SP) * Sales Volume (Q) or TR = [SP * Q] © 2012, published by Flat World Knowledge 42
Breakeven Analysis • Total Costs is seen as being composed of two parts Fixed Costs and Total Variable Costs. • Fixed Costs (FC) exists whether the firm produces any product or has any sales. • They consist of rent, insurance, property taxes, administrative salaries and depreciation. • Total Variable Costs (TVC) are those that change across the volume of production. © 2012, published by Flat World Knowledge 43
Breakeven Analysis • As production rises the Total Variable Cost will likewise rise. This can be represented as follows: Total Variable Cost (TVC) = Variable Cost per unit (VC) * Sales Quantity (Q) or TVC = [VC * Q] • Total Costs (TC) is simply the summation of the fixed cost plus the total variable cost: Total Costs (TC) = [Fixed Cost (FC) + Total Variable Cost (TVC)] or TC = [FC + TVC] © 2012, published by Flat World Knowledge 44
Breakeven Analysis • At the breakeven point Revenues equals Total Costs, so the above equation can be rewritten as: Selling Price (SP) * Sales Volume (Q) = [Fixed Cost (FC) + Total Variable Cost (TVC)] or (SP * Q) = [FC + TVC] © 2012, published by Flat World Knowledge 45
Breakeven Analysis • This equation can be rewritten so as to solve for the value of Q - the sales value: [SP * Q] - [VC * Q] = FC • The term Q (Sales Volume) is present in both terms on the left hand side of the equation so it can be factored at producing: Q * [SP – VC] = FC • The sales value to produce the breakeven point can now be solved for in the following equation: Q = FC / [SP – VC] © 2012, published by Flat World Knowledge 46
Breakeven Analysis • To illustrate, a stall at a local mall sells cell phone cases for $15. 00. the cost of each case is $7. 50 per case. The monthly rent charged by the mall is $1500 per month. How many cases must this stall sell each month to breakeven? SP = $15. 00; FC = $1500. 00; VC = $7. 50 Q = FC / (SP – VC) Q = $1500. 00 / ($15. 00 - $7. 50) Q = $1500. 00 / ($7. 50) Q = 200 cases © 2012, published by Flat World Knowledge 47
Capital Structure • A critical financial decision for any business owner is determining the extent of financial leverage the firm should acquire. • Building a firm using debt amplifies the return of equity to the owners; however, the acquisition of too much debt, which cannot be repaid, may lead to bankruptcy. © 2012, published by Flat World Knowledge 48
Customer Value • • Previously there has been extensive discussion of the notion of market segmentation. The financial equivalent of customer segmentation examines the profitability of different groups of customers. Some customer groups may be extremely profitable to the firm while others produce nothing but losses. To be able to identify these different groups requires a commitment to accounting and financial analysis of each customer base. © 2012, published by Flat World Knowledge 49
Customer Value • The determination of the margin provided by different customer groups is a bit of a challenge. • One approach is to utilize activity based costing systems. • Activity based costing systems were developed in the late 1970 s and the early 1980 s. • This approach to accounting “is a process where costs are assigned due to the cause and effect relationship between costs and the activity that drives the cost. ” © 2012, published by Flat World Knowledge 50
Customer Value • Done properly, activity-based accounting can help a business identify the true costs to serving particular customer groups and therefore identify their real profit margins. • A business may discover that some customer groups are actually a source of losses to the firm. • Activity-based accounting is complex, difficult to implement and, in some instances, does not conform to GAAP (Generally Accepted Accounting Principles) requirements. © 2012, published by Flat World Knowledge 51
Cash Flow Implications • Two areas where good financial management can help cash flow are: – E–procurement – Factoring • E-procurement involves managing the timing of invoices to customers and from suppliers so as to improve the cash flow of the firms. – The electronic handling of orders and their associated invoices assures that customers will receive their orders in a more timely fashion. – E-procurement means that fewer personnel are required to take and handle orders. © 2012, published by Flat World Knowledge 52
Cash Flow Implications • Factoring is associated with the businesses accounts receivable. – Firms may offer discounts to customers who pay early; however, they may also know that customers are unlikely to take advantage of the early payment discount. © 2012, published by Flat World Knowledge 53
Influence of Technology, E-commerce and E-business • Firms can strengthen their financial position by moving their software programs and databases to an outsourced site. This is often referred to as cloud computing. • Advantages of cloud computing include: – Reduction in the number of computers, servers and network connections that a small business firm requires. – Scalability: Cloud applications can grow with the business. Some charge on the basis of the number of users. © 2012, published by Flat World Knowledge 54
Influence of Technology, E-commerce and E-business • Advantages of cloud computing (continued) – Updates: The latest version of software is done automatically by the vendor. – Access: Cloud programs can be accessed wherever one is a connection to the Internet. – Integration: Having programs and databases on the cloud facilitates multiple members of the organization to be able to successfully work together. © 2012, published by Flat World Knowledge 55
Influence of Technology, E-commerce and E-business • Advantages of cloud computing (continued) – Security: Cloud providers recognize the securing their clients data is a core issue for their survival. The vendor has a much greater capability of assuring security. – Customization: Businesses can acquire the software that they need. – Extensions into the World of Social Media: Cloud providers can assist businesses who wish to utilize various forms of social media (Facebook, Twitter, Linked. In, etc. ) yet lack the technological savvy to do so. © 2012, published by Flat World Knowledge 56
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