Raising Entrepreneurial Capital

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Raising Entrepreneurial Capital

• Chapter 10
• Internal Financial Management

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Working capital per dollar sales, WC/Sales

• Working Capital defined as Current Assets
  Current Liabilities.
• a company that generates sales with a smaller
  investment in working capital is managing its
  current assets and current liabilities more
  efficiently.
• On average the Fortune 500 companies use 0.20 in
  working capital to generate 1.00 in sales.
  Efficient companies use in the 0.07 - 0.17
  range.

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Importance of Working Capital Management

• Careful management of current assets and
  liabilities should be a priority in any business
  start up.
• Focus should be on cash flow not profits
• Access to assets not ownership is critical

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Working capital managementin smaller firms

• Preserve cash by leasing fixed assets
• Relatively higher reliance on short-term debt
• Small firm is much more likely to be unable to
  withstand a cash flow crisis than its larger,
  more established counterpart

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Tools

• Non-interest earning current asset balances
  should be kept to a minimum.
• Accounts Receivable should be minimized by
  expediting collections from customers.
• Inventories at all levels should be minimized to
  reduce costs.
• On the liability side, Accounts Payable should be
  managed so that payments to suppliers take
  advantage of any free credit provided.

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Cash Conversion Cycle (CCC)

• calculates the time that money is tied up in the
  normal business cycle of the company.
• The CCC calculates the number of days cash which
  is invested in inventory and accounts receivable,
  and the extent to which this cash outflow is
  covered by the financing provided by a firms
  creditors.

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CCC calculation

• CCC ACP ICP DPO
• ACP, Average Collection Period Accounts
  Receivable/(Sales/365)
• ICP, Inventory Conversion Period
  Inventory/(Cost of Goods Sold/365)
• DPO, Days Payables Outstanding Accounts
  Payable/(Cost of Goods Sold/365).

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CCC usage

• Highlights the flow of dollars into current
  assets and from current liabilities, used to
  better manage those accounts to reduce the firms
  need for external financing.
• Reduction in the CCC leads to
• A one-time increase in cash as cash is converted
  from current assets.
• An ongoing increase in efficiency as the firm
  speeds up collections and inventory conversion.
• The goal of working capital management is to get
  the CCC to zero.

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Trade credit

• Never pay early, except to get discount
• Example terms of 2/10 net 30 mean the buyer may
  subtract 2 (the finance charge) from the invoice
  amount if paying by day 10, otherwise the full
  amount on the invoice is due on day 30.
• Here is an opportunity to obtain vendor financing
  for twenty days. What is the cost of foregoing
  the discount and paying on day 30? In this case a
  finance charge of 2 is charged for 20 days of
  financing.

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Effective cost of trade credit

• Periodic rate Discount Percentage/
• (1-Discount Percentage)
• Effective rate (1 periodic rate)n - 1
• Where n the number of compounding periods in a
  year and is calculated as 365/(payment date
  discount date).

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Cost of foregoing the discount

• On terms of 2/10 net 30
• Periodic Rate 2/(1.0-2) 0.02/0.98
  .0204
• N 365/ (30-10) 18.25
• Effective Rate (1 .0204) 18.25 1 44.56.

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Cash Budget

• The Cash Conversion Cycle indicates how many days
  of financing are needed but does not indicate the
  amount of external financing needed.
• To predict the amount of external financing
  needed, the financial manager must prepare a Cash
  Budget.
• The Cash Budget is a forecast of cash inflows and
  outflows, monthly over the next year or daily
  over the next month.

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Daily Budget

• A daily cash budget is critical because cash
  inflows and outflows do not occur uniformly
  throughout the month. While sales may occur
  uniformly (or may not) expenses almost certainly
  will be congregated on certain days, throwing off
  the validity of the monthly cash budget on
  certain days.
• The format of the daily cash budget is the same
  as the monthly budget except that cash flows are
  assigned to the actual days on which they occur.

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Financing Issues

• How should external financing be split between
  short-term and long-term sources of financing?
• Finance current assets with short-term loans and
  fixed assets with long-term sources of funds
• ignores the fact that all firms carry some
  permanent levels of current assets. It is
  unlikely that a firm will ever carry zero
  receivables or zero inventory.
• permanent level of current assets may be more
  efficiently financed with longer term sources of
  funds, either equity or long-term debt.

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Short-Term Alternatives

• Lines of Credit
• Asset Backed Loans
• Factoring
• Customers

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Lines of Credit

• for cyclical current asset needs use a revolving
  line of credit (LOC). A line of credit is
  essentially a pre-approved loan, available on
  demand in part or whole, up to the preapproved
  limit.
• As cash deficits occur, a check can be written
  against the line, drawing on it to a
  predetermined maximum.
• should you end up not needing the funds there is
  no charge. Also, unlike a term loan, there are no
  scheduled repayments of principal.

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Asset Backed Loans

• In the early stages of a companys life the bank
  may not be willing to extend an unsecured line of
  credit to the company and a secured loan may be
  the only option for obtaining financing.
• What assets are appropriate for securing a
  short-term loan? Personal assets are always an
  option. If the firm has a marketable securities
  portfolio, it would be good security for a loan.
  More likely assets to use as collateral are the
  firms inventories or accounts receivable.

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Collateral

• To be acceptable collateral, inventory items must
  be finished goods with a ready market for
  liquidation. The key is, would the bank be able
  to find a ready buyer for the asset in its
  current state?
• Accounts Receivable may also be used as
  collateral, but a bank is much more likely to
  accept your receivables as collateral if your
  customers are large corporate accounts. A
  business selling to individual consumers would
  not provide the type of receivables that a bank
  would typically accept.

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Factoring

• A firm can sell its accounts receivable to a
  third party, the factor. The factor may be a bank
  or a specialized factoring company.
• As with pledging, a factor will examine your
  receivables and only accept quality, current
  receivables. The difference is that you sell the
  receivables to the factor, realizing cash from
  the sale immediately and removing the receivables
  from your balance sheet.
• The factor may only advance 70-95 of the face
  value of receivables depending on their quality.

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Customers

• If your business provides a new or customized
  product or service, it may be in the customers
  best interest to help get your firm up to scale
  through a direct investment if there are no good
  substitutes for what you offer, the chance of
  direct investment by your customers rises
  substantially.
• Another option for customer financing is to
  demand full or partial payment in advance. This
  strategy works best when the service is ongoing
  (consulting) or the product takes some time to
  develop or is highly customized.

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Cash management techniques

• A basic goal of cash management is to get access
  to incoming funds as quickly as possible.
  Invoices should accompany goods out the door.
• Discounts may provide enticement to customers to
  pay sooner.
• All firms need a competent credit department.
  Credit standards must be set and enforced before
  credit is extended. Collections must be timely
  and forceful to ensure payment. Occasionally
  customers may need to be fired for nonpayment
  and no further credit extended.