What is capital?
To operate any type of business activity, you need things. These things are different from business to business, but usually include equipment, tools, office equipment, vehicles, computers, etc. These assets are purchased with money. This money is usually referred to as capital.Capital initially comes from two places: the owner and others. Capital that comes from the owner is termed equity. Capital that is gotten from banks or other lenders is called debt. The total equity and debt of a business makes up its total capital at the start of a business. As the business operates and makes profits, the portion of these profits that is kept in the business adds to the capital. This addition of retained profits is called “retained earnings.”
Should I borrow?
Yes, provided you can handle the debt and provided the borrowing will benefit your business.Handling the debt means that you will be able to repay the principal and interest without undue hardship on you or your business. Benefiting your business means the benefits of the debt are greater than the costs.
In considering the benefits to the business, think about the money that can be earned with the borrowed funds. If the earnings attributable to the debt exceed the interest on the debt, this argues for debt. Also think about ownership control. By using debt, the owner’s control is not diluted as it is when money is raised by selling equity.
Finally, in considering debt, remember that there is a relationship between debt and equity that is important. While what is an acceptable relationship varies, most banks and other lenders require a dollar of equity for every one to three dollars of debt. If you seek to borrow $1,000, for example, you had better have from $333 to $1,000 of equity.
What financial statements do I need?
There are three statements that are almost always required for borrowing or for most other types of business dealings. These are the balance sheet, income statement, and cash flow statement.For a new business startup, these statements are projections of future expectations. For existing businesses, they are historical statements AND projections of future expectations.
Other statements might be required, depending upon the lender or the objective of the business. Most everything, however, can be obtained from these three basic statements.
What is a cash flow statement?
The simplest form of cash flow statement is a listing of cash coming into the business and cash going out. Think of a personal checkbook register. You record cash that you deposit into your bank account and you record each check that you write. You don’t record anything else – just cash you get and cash you pay out.With business cash flow, the same simple rule applies. If it is either cash received or cash paid, it is listed. If it is not cash, it is not listed. Selling something on account and not getting the money is not a cash flow statement transaction. If something is purchased, but no cash is paid, it is not recorded on the cash flow until the cash is actually paid out.
A cash flow statement is different from an income statement (profit and loss statement) that is kept on the accrual basis of accounting. Accrual accounting, which is used with most businesses, recognizes sales when they are made even if the cash is collected at a later time; and it recognizes expenses when incurred even if the cash is paid 30 or 60 days later. The accrual basis income statement, then, is no substitute for a cash flow statement.
Furthermore, there is spending in business that is not immediately reflected on the income statement. When inventory is purchased, there is no entry on the income statement even if cash is paid for the purchase. When equipment is bought with cash, only a part of that purchase is usually reflected in the current income statement. The rest is shown on future statements by way of depreciation expense.
These types of transactions would show up on a cash flow statement, but NOT on an income statement.
What is a balance sheet?
Often referred to as the basic business financial statement, the balance sheet shows three things about a business: assets, liabilities, and owner’s equity. Assets are things that are owned by the business. Liabilities are things that are owed to others. Owner’s equity is the difference between assets and liabilities.Owner’s equity can be thought of in this way: if the business were to liquidate all the assets and pay off all the liabilities, what is left would be owner’s equity. The owner would have a right to keep this equity. This is a little theoretical, however, because in liquidating assets one doesn’t always get the same amount as shown on the balance sheet. The listing of assets on the balance sheet is customarily done at cost or adjusted cost. Inventory, a common asset, would be recorded at cost value even though it may be sold for more or less than cost in a liquidation. A building, another common asset, might have appreciated in value, but this added value would not be recognized on the balance sheet.
It is important to know the rules used in recording assets and liabilities and in constructing a balance sheet. It is also important to understand the proper and improper uses of this statement. If you don’t know these things, either learn them or hire someone who can advise you.
What is an income statement?
An income statement (often called profit and loss statement or P & L) is the score card for business. It shows the revenue, expenses and profit or loss. It shows these things for some period of time, usually a month or a year. An income statement is usually titled: “Income Statement for X Business for the period January 1 to December 31, YYYY.”A very simple form of income statement could have just a few lines: Total revenue, total expense, profit before tax, taxes, and net profit. A more complex statement could show revenue by category (from store sales, from mail order sales, from leasing, etc.) and expenses by type (rent, utilities, wages, etc.).
Why are financial projections necessary?
Financial projections are estimates of future business activities. By estimating the future, you have a target to shoot at. You have a frame of reference, even if the projection is not highly accurate. It is always easier to make business decisions if those decisions are pointed at some target or objective.Financial projections are sometimes required for you to communicate with others. If you seek a business loan, for example, your bank will want to see what your expectations are about your future business activities. This is one way they determine your chances of repaying the loan.
The chief value of financial projections for a business owner is not so much the attempt to predict the future with accuracy as it is a plan to set a target or goal to work toward.
What kind of profits can I expect?
There are three kinds of profit: gross profit, profit from operations, and net profit. The last, net profit, is what we usually refer to when we talk about business profit. Net profit is what is left after all costs and expenses are paid and after all interest and taxes are settled.Most business net profit falls in the two percent to six percent range. This means that for every dollar of sales, from two cents to six cents will be earned in net profit. Clearly, many businesses do not do as well as this and some do much better. Net profits higher than fifteen percent of sales are unusual.
To learn the profits that you can expect, look at your industry figures. Like kind businesses usually experience net profits within a range. This range can be learned from industry trade associations. While this will not necessarily dictate what you can expect to earn, it will give you some insight.
What financial records do I have to keep?
You should have written records showing money coming into your business and money going out. With each transaction, you should record the source or destination of the money as well as the date.The manner you use to record this information is not as important as just doing it. You can use simple bookkeeping forms available at stationary stores or you can use accounting programs on computers. You can do it yourself or you can hire someone to do it for you. The two important considerations are these: do you understand it and can summary financial statements be prepared from these records?
To give you the best information for your use in controlling the business; and to satisfy the tax collectors, bank loan officers, and others looking at your business records, you should insure that your financial records are kept according to the rules of the game. These rules are called “generally accepted accounting principles.” If you don’t know these rules, either learn them or hire someone who knows them.
A common method used by small business owners who are not well trained in this area is to hire a CPA or other accounting specialist to help them set up their recording system. Once established, recording daily transactions can be accomplished by almost anyone. A specialist is again used to prepare periodic summary financial statements and to file taxes.
What if I don’t know anything about business finance?
Learn! There is no good way around the requirement that you learn something about business finance. If you try to run a business without this basic knowledge, you will be greatly reducing your chances of sustained success.You can hire others to do this for you or you can get outside experts to advise you, but in the final analysis, you are making the decisions. You are making the financial decisions. If you continue to make financial decisions without a good knowledge of finance, chances are good that many of these decisions will be poor. Poor financial decisions sooner or later lead to business failure.
How much do I need to know about accounting and bookkeeping?
Since numbers constitute the language of business, the more you know about this language, the better you will understand your business and the better will be your decisions. As a minimum, you should understand your bookkeeping system. This means you should understand how your money is spent and how much money you have coming in.You should also be able to read and understand the two basic summary financial statements: balance sheet and income statement.
Successful small business owners usually say that the two most important skills for “making it” in business are marketing and financial skills. Those who study business failure say that lack of understanding of one’s financial situation is a frequent cause of failure.
Should I hire a Certified Public Accountant (CPA)?
You can get accounting advice from different sources. A Certified Public Accountant is probably the most competent to give you advice on a wide variety of business topics. Others, such as public accountants, bookkeepers, and specialists who focus on small business record keeping, can also be useful. CPAs are usually the most expensive, but may still be the best value because of their breadth of knowledge and their ability to assist you with all aspects of your business finance, accounting and tax.Many small businesses can function with advice and assistance from bookkeepers on most routine matters. They get tax advice from professional tax preparers. A CPA is only used for more complex finance or tax questions.
If you choose not to incur the expense of a CPA for most of your financial and tax consulting, you should at least establish a contact with one so you can get advice and answers to complicated questions when you need them. It is false economy to save money and get poor advice.
Will a bank loan money to a small business?
Yes, provided you can satisfy their requirements and provide the information they need.Their requirements are best understood by remembering that banks are private businesses that exist only if they make a profit. The majority of their profits comes from loan activity. When banks do not make loans that are sound, their profitability suffers and they get into trouble with bank regulatory agencies. Unsound loans are those to businesses with poor liquidity, poor cash flow, insufficient collateral, excessive debt and poor management.
Businesses with only one or two of these problems may still be able to borrow if they are exceptionally strong in the other areas. For example, a business with excessive debt may be able to borrow if it has exceptional cash flow or exceptional liquidity. Cash flow is the quantity of money flowing into the business in excess of the amount flowing out. Liquidity is the amount of assets it has that can easily be converted into cash.
Banks use a cash flow ratio to measure the adequacy of cash flow to service debt. If you divide the earnings before interest and taxes by the interest paid on the loan, you will get this ratio. While an acceptable ratio varies with industry and business, it is seldom less than 1.2 to 1. A business with a consistent and dependable cash flow would quality with this low ratio of $1.20 of earnings before interest and taxes for every $1.00 of interest expense. For most businesses, this ratio would be much higher.
Liquidity is usually measured by what is called a current ratio. This is the relationship between all current assets and all current liabilities. A ratio of 2 to 1 means that there are $2 of assets for every $1 of liabilities. Banks will disagree on what is a satisfactory current ratio and different businesses will produce different satisfactory current ratios. As is perhaps obvious, not only is the ratio itself important, but the type and quality of the assets and liabilities is significant to this measure.
If, for example, the assets are difficult to convert to cash and most of the liabilities are due within a short time, even a high current ratio might not be good enough. Conversely, highly liquid assets coupled with liabilities with long maturates might make a low current ratio acceptable.
Collateral and debt, two other important factors in determining the banks willingness to make a loan, are measured in ways you should understand.
Collateral is viewed by banks differently than it is viewed by you. They look upon collateral as worth less than do you. This “discounting” of your collateral occurs because they must view your collateral in terms of liquidation value in usually distressed circumstances. From experience, they know that real estate will liquidate out at only 75% of value and equipment will bring only 50%. Accounts receivable might be worth from 35% to 80% of face value and inventory can range from 20% to 50% of cost value. In placing value on your collateral for loan purposes, you must think like the banker.
Debt is usually measured by the bank in relation to the equity of the business. If your debt AFTER the loan will be more than two to three times your equity, chances are you will fail on this measure. Sometimes, you might fail with a one-to-one ratio. For some businesses, having a dollar of debt for every dollar of equity is too much.
The final part of your business that will be closely scrutinized by the bank is your management skill. If they don’t think you can plan, organize and control your business, you won’t pass muster.
How can the government help me with financing?
The federal government can help you in two primary ways. These are bank participation loans and loan guarantees.A bank participation loan is where one or more entities combine with a bank to make the loan. Private lenders, government agencies, financing groups, non-profit organizations or others may combine forces with a bank in such a way that the bank holds all or most of the collateral from the borrower, but puts up only a portion of the money. Furthermore, the priority of payment in the event of loan default usually favors the bank. It gets its money back before the other “subordinated” participants get theirs.
Loan guarantees exist to make it possible for businesses not qualified for bank borrowing to obtain bank loans. The government guarantees such a loan and stands ready to repay the bank if the borrower can’t.
The Small Business Administration (SBA) is the primary U.S. government agency offering loan guarantees to banks. Their so-called 7a program is widely used for all types of business borrowing.
Their 504 loan program is an example of a participation loan. With 504, a bank puts up only about half the cash, but gets all of the collateral and has first priority in the event of default.
To learn about these government loans, contact your local bank, the Small Business Administration or your local SBDC.
How can I get equity financing?
Equity financing means getting a business partner. This partner puts money in the business in exchange for a share of ownership. For small businesses, the most common form of equity financing is with relatives or friends. They agree to put risk money (no guarantee of repayment) into the business and become part owners to share in the profits.”Angels” and other private investors also provide equity financing, but usually not for small businesses. These investors are particular about the investments they choose and usually want businesses that promise fast growth and high profits. Once in a while a private investor can be found that is willing to invest in ordinary small businesses (not fast growth or high profit), but they are difficult to locate. To search for one of these, it is best to “put out the word” in your local community that you are looking for an investor. You can tell banks, chambers of commerce, industrial development groups, and others interested in business development. Maybe an investor will turn up.
Investment bankers and other organized companies and groups who invest in business are for the big boys or for small companies that are involved in high technology, medical innovations, or other areas with high potential.
With any type of equity financing, you must remember that the cost is a surrender of some of your ownership interest.
How can I get a bank loan?
Start by determining how much you want and what it will be used for. Then assemble the information that the bank will want. Briefly stated, the bank wants to know three things: What is your business about; why do you need the money; and how will you pay it back.Explaining what your business is about involves writing down what your business does, where it does it, and who it serves. Data about your market and customers is essential. If you are an existing business, the banker will want to see historical financial information in the form of income statements and balance sheets. If you are a new startup, you won’t have a history, but you will be asked to provide projections of future business activity and results.
Telling why you need the money requires some detail, not just a generalization such as, “I need more working capital.” If the money is to be used for working capital, a listing of specific items of working capital is necessary. If the money is to be used to buy equipment or real estate, detail about these should be gathered.
Convincing the banker that you can repay the loan is the most important part of your preparation. If the bank cannot see clearly the loan repayment, it will not make the loan. If the repayment will come from the profits of the business, the projected profits must be set forth and they must be convincing. If collateral is to be an important aspect of the loan (and it usually is), its value in the eyes of the bank must be sufficient. If management and technical skill are important in operating the business so it will meet its profit projections, these skills must be present and evident.
This information is usually assembled and presented in a written business plan. The form of the plan is not as important as the content. If the bank sees the information it desires and can understand it, the form is not important. There are many planning guides available to help with the content and form. Check your major book stores, libraries, Small Business Development Centers, S.C.O.R.E. chapters, or the Internet.
DO NOT approach a bank until you have completed this preparation or until it is far enough along that you can speak intelligently about your needs and repayment ability. You can hurt your credibility with the bank if you go in unprepared. They will start to question your business abilities.
Will the Small Business Administration (SBA) loan money to me?
Except in isolated and special situations, the SBA does not make direct loans. Its loan activity is in the form of participating loans and loan guarantees. You must deal with a bank to reach the SBA. You can think of the SBA as a level above your bank that is providing incentives to your bank to make it easier for you to get debt financing. The bank plays a major role in evaluating your loan application and in administering the loan. The bank’s agreement is necessary before the SBA will get involved.
Can I get an SBA loan to refinance present debt?
Yes. Debt refinancing is allowed under the SBA programs. It is not the preferred form of SBA involvement, but it will be supported if the refinancing has a beneficial business consequence. Refinancing just to get out of a jam is usually not favored.
How do I keep track of my money?
In two ways. (1) Know what is happening now with your money. (2) Know what is likely to happen in the future.To keep track of what is happening now is a matter of recording money coming in and money going out. If you are a small sole proprietorship business, it is important that you keep your personal money and your business money separated. When you mix the two, you soon will not know what is happening. You can use a business bookkeeping book from any stationary store or you can get an inexpensive computer program.
To know what the future of your cash holds involves looking ahead a few months to what is likely to happen with your revenue and expenses. This involves projecting your sales and expenses. A spreadsheet (paper or computer) is the best tool for doing this. List the items of cash coming in and cash going out down the left side of the spreadsheet and make each column a week or month. If you have some history of operations, start with that and estimate the future. If you don’t have a history, study like kind businesses.
Keeping track of your business money is very much like keeping track of your personal money. If you apply good personal money management practices to your business, you will be okay.
What are some of the ways I can finance my business?
There are a number of places to get money for your business. They are listed in their order of use:
- Your own resources – cash, savings, personal assets
- Relatives and friends
- Suppliers and vendors
- Credit cards
- Banks (with and without government guarantees)
- Leasing contracts
- Receivables financing
- Fixed asset financing and mortgages
- Private investors (venture capitalists)
Approximately 75% of small business startups get their money from their own resources and relatives and friends. Some get additional help from suppliers and vendors as well as the use of personal credit cards. Only about one in four use borrowed money from banks and other lenders. Leasing, while technically not borrowing, is used to acquire equipment and other assets without heavy outlays of money.
Borrowing against accounts receivables and fixed assets is used by established businesses and private investors sometimes assist in high growth and high profit situations.
What do I do if I run out of money?
First, don’t panic. Running out of money or nearly running out of money is common in business. The more notice you have that you will run out of money, the easier it is to do something about it. Time is an asset that allows you to work the problem.However, if you do find yourself suddenly out of money for whatever reason, shift into a cash conservation mode. Stop all spending and speed up revenue generating activities. Even essential spending can be stopped for a time until you assess your situation. It is better to give notice to those expecting to be paid that you can’t pay them right now than to run completely out and for sure not be able to pay them anything. With what little cash you have or can muster quickly from increased sales activities, you can parcel it out to those making the most noise or controlling some critical aspect of your operation.
While you hold on to whatever cash you can gather, lay out a plan. Your plan should be in two parts. Part one is to get you past your immediate cash problem. Part two is more long range and seeks to identify the causes for running out of money so those causes can be treated.
Creditors are usually more understanding of your difficulty if you communicate with them and let them know what you are doing to get them their money. If you tell them nothing and let them find out about your problem through the grapevine, your ability to deal with them is reduced. Generally, people respect those who face a problem head on and say what they are doing to fix it.
No matter how bad your cash problem may be, it is made worse by trying to hide it or run from it.
Can I get special treatment as a minority or woman owned business?
Yes, but perhaps not as much as you may think. There are special programs and preferences for these groups, but they are not as significant as believed by the general public.In loan applications, these groups still have to meet all the requirements and provide the same type of information as anyone. In government contracting, they still have to compete and they have to perform. In business advising and other assistance programs, they are often singled out for special attention, but receive no concessions or waiving of requirements.
Most of the laws and regulations seek to protect these groups from discrimination rather than offering them special privileges. The commonly held belief that there is money available to these groups that is not available to others is largely untrue.
What if I borrow money and can’t pay it back?
Failure to live up to the terms of your borrowing agreement is a problem, but not a fatal problem. Usually what happens is that some new arrangement is worked out between you and the lender that allows you to catch up. It is not uncommon for business events to cause payment difficulties. If the borrower is open and honest with the lender and is willing to agree to some workout arrangement, this difficulty can be handled.This said, however, it is important to remember that the lender has every right NOT to cooperate with your workout efforts and force you to abide by the strict terms of your loan agreement. Before signing any agreement, therefore, be as certain as you can that you can make timely payments. A good business practice is to have a backup fund to protect you in such situations or to keep your debt low in relation to your cash generating capabilities.
Can I get a loan with bad credit?
Probably not. A bad credit history is interpreted by most lenders as an indication of poor money management capabilities. You may not be a bad money manager, but they will think that nevertheless. Your credit report or “credit score” is one of the acid tests you must pass.About the only time a bad credit history will be overlooked is if other aspects of the loan request are especially strong. If, for example, you are pledging some CD’s in the amount of the loan, you will probably be able to borrow even with a bad credit history.
Advice given to small business owners with bad credit is to try to go without borrowing. If they must borrow, make their application as strong as possible to lessen the impact of the bad credit. Offering to pay higher interest, giving more collateral, and things such as these will sometimes sway the lender – but don’t count on it.
Can I get a loan if I have declared bankruptcy in the past?
Probably not. Although filing bankruptcy is not the stigma it once was, it is still viewed as a large red flag to lenders. Most will not even talk to you with a bankruptcy on your record. They usually don’t care to hear the reasons. If it is there, it is a big problem and usually a disqualifying circumstance.
Can I sell stock to the public?
Yes, if your business fits the criteria of successful public stock offerings. The great majority of small businesses do not. They do not for a large number of reasons. To find out if your business qualifies, an investment banker is the specialist to see.Public stock offerings are expensive and require expert guidance. They are not “do-it-yourself” projects.
A limited sale of stock to a limited number of public shareholders is possible and less expensive, but expert guidance and advice is necessary here also. An investment banker is again the person to talk to.
Can I get money from a venture capitalist?
It isn’t likely. Venture capitalists finance a very small fraction of businesses. They are extremely particular about who they invest in and they are quite demanding. Their minimum requirements are such that most small businesses are excluded from consideration.They usually look for business prospects with unusually high growth potential and/or unusually large profit prospects. They demand high rates of return on their money (25% to 50% minimums) and they require significant input into the operation of the business.
There are a number of venture capital firms throughout the United States and they will usually review proposals that meet their minimum requirements. Of the proposals reviewed, only a small fraction will be picked.
Not withstanding this information, for a small number of businesses, venture capitalists can be an important source of money.
What is an investment banker?
An investment banker is not a banker in the usual meaning of the term. An investment banker is a specialist who deals as an intermediary between a business who desires to sell stocks or bonds to the public and investors who want to buy these items from new or existing companies. Investment bankers guide a business through the preparation process in getting ready to sell securities and deal with the investing public in getting them ready to buy. Often, the investment banker acquires an ownership position in the securities, at least temporarily. They make their money from fees and from the spread between what the public pays and what the business receives for the stocks or bonds.