How to Analyze Business Funding Sources and Develop Business Funding Strategies

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Article Outline

      I.        Business Funding Source Feasibility Factors

A.     Cost

B.    Risk

C.    Flexibility

D.    Control

E.    Availability

     II.         Internal Capital Analysis

    III.        Trade Credit and Debt

A.    Trade Credit

B.    Debt

   IV.        Relationship of Debt and Equity

A.    Leveraging

B.    Cost of Debt and Equity

C.    Factors

    V.        Combining Business Capital Sources

   VI.        Effective Business Funding Strategy

  VII.        Business Funding Resources

This Article is Part Three of ABC Business Consulting’s Business Finance Series.  In part one, Financing a Small Business, we talked about the importance of a Business Plan: financing from a position of strength, leveraging Equity; how to utilize Debt Finance; Business Finance relationships of Cash, Risk & Value; and IPO Funding.  In part two, Funding Sources for your Business, we looked at Business Capital Needs, Pitfalls & Considerations and Commercial Finance Forms & Sources (Short- Term and Long- Term Finance, Supplier Funding, Debt Capital, Equity and Venture Capital Finance and Alternative Business Finance Sources).  In this Part Three Business Finance Article, we will look more closely at Analyzing Business Funding Sources and developing an Effective Business Funding Strategy.   We will examine Business Finance Feasibility Factors, Internal Capital Generation, Trade Credit, Debt Finance; the Relationship (and Combination) of Debt and Equity Finance; how to combine different Business Funding Sources; developing an Effective Business Funding Strategy; and, providing Business Funding Resources.  Business Finance can be tricky and complicated.  We will try to uncomplicated this critical part of your Business’ Growth so you can find the right sources, and most importantly, combination of business Capital for your particular company needs and requirements.  Having a well developed Business Funding Strategy is an absolute must before implementing a Finance Initiative.

      I.        Business Finance Feasibility Factors:

A.     Cost:  How will each Funding Source affect our Company’s Earnings?

1.     Plug in the Interest Rate and Equity Participation Models into your Income & Expense Statement and Cash Flow Statement to see the effects of Debt and Equity Finance on your short- term and long- term Earnings and Cash Flows.

B.    Risk:  What levels of risk exposure are associated with the different Sources of Funding you are considering?

1.     Equity Finance holds less risk to the Company than Debt Finance as the Equity Investor is taking all the risk.

a)     Determine the Risks on your Cash Flows which Debt Capital imposes.  How does mixing Debt and Equity Finance affect your Risk Threshold?

b)    Remember:  Debt Finance is conservative but it does present an inherent interest rate and default risk.  Leveraging your Debt exposure with Equity Funding can be a very effective means of reducing your Total Finance Risk.

C.    Flexibility:  Will covenants and conditions imposed by your Potential Funding Sources reduce your Flexibility in obtaining future Capital or leveraging internally generated Capital?

1.      Business Loans and Commercial Finance can carry stipulations which might prevent you from pledging receivables, inventory or other collateral for future borrowing.

a)     Be careful in packaging your collateral and asset classes when negotiating your Debt Finance.

2.     Consider Sale- Leaseback Structures to maximize Loan to Values and Tax Advantages on your Equipment and Machinery.

a)     Lease Structures are very flexible and are structured specifically for certain assets.

3.     Consider Cross- Collateralizing your Assets only if absolutely necessary as this Business Finance Practice can take away a lot of the future flexibility for collateralizing loans.

4.     Rolling Credit Lines can be set up using a variety of Collateral Sources and provide instant opportunity Capital when needed.

a)     You could use rental income from a Real Estate Investment to secure a Line of Credit.

b)    You can use Blue Chip Stock Portfolios as LOC collateral.

c)     Think outside the box and reserve your major Asset Classes for your Major Finance needs.

i.e. Real Estate Assets for Long- Term Finance.

    -Equipment and Machinery for Lease Finance.

    -Receivables for factoring when needed.

    -Inventory for short term finance needs.

    -Cross Collateralize Personal Assets for your Line of Credit Opportunity fund:     Rental Property, House, Condo, Stocks, Cash Value Life Insurance, etc.

     -Utilize supplier credit to leverage your LOC if necessary.

Note:  Short- Term Finance is often much more expensive than Long- Term Finance so ensure your anticipated Revenue Growth & Cash Flow can quickly pay it off.  Remember the Matching Rule

D.    Control:  Can your ownership control be affected?

1.     Determine the effect of Board of Directors representation.

2.     What Operating Mandates does a potential Equity Sharing Agreement contain?

3.     Will pledging of Shares for Equity or Debt Finance inhibit your control down the road? i.e. May not affect present day operations but could affect Operations down the road as your Stock Structure, Ownership Structure or Business Structure changes over time.

E.     Availability:  How has availability to certain Business Funding Sources been affected?

1.      Economic Conditions can severely limit the availability of Bank Finance.  Prolonged Economic Downturns can limit Equity availability.

2.     Timing is key for Equity Funding.  Are the Venture Capital Funds you are interested in still investing in opportunities or have they closed the fund or pledged their remaining funds already?

3.     What Alternative Funding Sources are in your Funding Strategy if availability for anticipated, preferred Finance Sources dries up?

F.    Analyzing Funding Factors:

1.     Which of the prescribed Business Finance Factors are most important?

a.     Prioritize your Factors to be applied to your development of the Company Funding Strategy (to be discussed in a later section).

b.    Prioritizing will allow you to easily assess how certain Finance Sources can or cannot be used, as well as, enable you to you to begin structuring your Funding Instruments and Products.

    II.        Internal Business Capital Analysis

A.     Sources of Internal Capital

1.     Retained Earnings:

a.     Profit improvement.

b.    Expense Reduction.

c.     Reducing Owners Distributions (dividends/ drawings).

d.    Watching levels of Principals’ Salaries during early stages of Company Growth.

e.     Practicing good Budgeting practices.*

f.     Successful Milestone achievements.*

2.     Asset Management:

a.     Disposing non-performing Assets.

b.    Control Systems for Inventories, Receivables, Equipment, Machinery and other Fixed Assets.

i.              Understanding how lease finance can improve Internal Capital Generation.

c.     Schedule of Real Estate Control System to effectively manage your Company’s Real Estate Holdings. **

                3.  Cost Controls:

a.     Supplier pricing.

b.    Office supplies management.

c.     Cost Control Systems to minimize costs and increase cash flows.

B.     Cost Factors:

1. Customer Controls are too tight.

2. Reducing inventories too much- not being prepared for increased Sales or Production levels.

3. Poor Performing or High Expense Ratio Fixed Assets.

4. Old, Expensive-to-Run Equipment/ Machinery.

5. If Investor Funds are necessary, need to find a Capital Structure which will enhance Retained Earnings, yet award Investors a tolerable Dividend Payout Level and Capital Gains.

     a. Try to minimize Dividend payouts to Investors to enhance Earnings, while promoting a

         higher Capital Gain payout.

b.    Run several Financial Structure Models to find a Mix of Dividends and Capital Gain Payouts which enhance Earnings and mollify the Investor.

C.     Risk Factors:

1. Not having links from Product Development to Marketing Planning to Strategic Planning    to Financial Statement Modeling.

     a. Lack of Coordination will leave a lot of money on the table.

     b. Company inefficiencies can snowball and severely hamper a Company’s ability to                                 

          generate cash.

c.     Unrealistic Financial Management will significantly reduce a Business’ Internal Capital Generation.

D.     Flexibility Factors:

1. Increased Internal Capital Generation can give your Company enhanced Financial Flexibility.

     a. Can tap Opportunities when they arise in the Market.

     b. Can carry you through rough Economic periods.

2.  Mismanagement of Internal Capital will bring about costly inflexibility and unresponsiveness to Market opportunities.

     a. Mismanagement can cause a reliance on higher Loan to Value/ Cost Debt Structures, which severely hamper a Business’ Cash Generation.

E.    Control Factors:

1. Have a solid Operating Agreement in Place with Investors so Control Issues don’t hurt future Cash Generation.

2. Internal Control Struggles between Company Principals can cause a Rift in Company Management and significantly affect the Company’s earnings potential.

3.  Proper Budgeting Control Systems in place for effective Cash Management.

4.  Effective Cash Flow Management.

            F.  Availability Factors:

1.     Retained earnings can be enhanced no faster than Profits are realized; therefore, Cash Generation is integrally tied to the effectiveness of your Strategic Plan, which is derived from solid Marketing Plan and Product Develop Plan.

2.     An Effectively Developed and Implemented Business Plan will ensure the availability of Internally Generated Cash and produce Financial Structures to effectively generate and manage Cash Flows.

3.     Increasing the availability of Internal Capital will create less reliance on other more costly sources of Capital, such as Debt or Equity Finance.

a.     Moreover increased levels of Cash Generation increases confidence levels of prospective Lenders and Investors, proving the Company has an Effective Business Plan and can effectively manage its internal affairs.

   III.        Trade Credit & Debt:

A.  Trade Credit / Supplier Credit & Finance:

1.     Meet short-term capital needs quickly and with less red tape than other short term finance instruments.

2.     Cost:

a. Can be high cost:

                                                            i.        Supplier Terms of 2% Cash Discount within 10 days, net 30 days.  By not taking advantage of the Discount, the Company is allowing use of its money for an additional 20 days at 2%.  On an Annualized basis, this is equivalent to a 36% Interest Rate.

                                                           ii.        Late Payments can run 1-1.5%, monthly basis, which annualized is the equivalent of 12-18% Interest Rate.

b.    If used effectively for short-term needs, the higher costs associated with Trade Credit can be justified.  Over-reliance on Supplier Credit and using it as an intermediate or longer term finance need will significantly hamper Cash Flows and Growth

                3.  Risk:

a.     Suppliers can cut off credit at any time or demand upfront cash payments during difficult business periods.

                                                              i.        A solution could be adopting your Key Supplier as a small Equity Investor, which promotes more flexible finance terms during cash strapped periods.  The Supplier has a better understanding of your potential upside as an Equity Investor.

                4.  Flexibility:

a.     Be careful of Suppliers offering Extended Payment Terms as you can get locked in or over committed to these suppliers, overshadowing other Suppliers who offer lower prices, a better product and more reliable delivery.

                  5.  Control:

a.     Can lose effective Control of Company Operations if Trade Credit was over-extended to such a level where your Suppliers take Legal Action, which can result in attaching Assets and forcing the Company into Receivership.

                  6.  Availability:

a.     This is a short-term need and your short-term Strategic and Cash Management must be up to the task.

b.    Can be significantly curtailed during Economic downturns; therefore, having a backup Line of Credit is mandatory.

                  7.  Short-Term Needs:

a.     Best utilized for small, short-term needs.

b.    Necessary to have excellent Planning in place to avoid unnecessary costs, such as forfeiting Cash Discounts or incurrence of Delinquency Fees.

            B.  Debt:

                 1.  Timing:

a.     The money market may be tight so having a well developed Business Plan is essential toward obtaining Debt.

b.    Banking relationships are Key when times are tight in the lending markets.***

                2.  Financial Condition:

a.     A strong Equity Component in your Company’s Financial Structure will promote a Debt Ratio which is amendable to a Bank or Commercial Lender.

                3.  Stability:

a.     A company’s capacity to withstand periods of lower earnings or losses without defaulting on Debt Obligations.

b.    A Company’s ability to carry more Debt.

c.     Ratio Analysis:

                                                              i.        Debt-Equity Ratio = Total Liabilities divided by Total Equity.  Compare to Industry’s Average to determine an Acceptable Threshold.

                                                             ii.        Debt Capacity = Acceptable Debt to Equity Ratio x Equity.  Estimate the amount of Debt that a Company can carry based on its Equity Strength. 

               4.  Liquidity:

a.     Company’s ability to meet short-term obligations.

b.    Relationship between Current Assets & Current Liabilities.

c.     Ratio Analysis:

                                                                i.        Working Capital = Current Assets – Current Liabilities.

                                                               ii.        Current Ratio = Current Assets divided by Current Liabilities.

                                                              iii.        Acid Test = Quick Assets divided by current Liabilities. ****

               5.  Long Term verses Short Term Debt:

a.     Liquidity Analysis can indicate whether a Company should obtain Short Term or Long Term Debt.

                                                                i.        Short Term Loan reduces the Current Ratio, while Long Term Finance often improves the Current Ratio.

b.    The trick is to find the right mix between Short-Term and Long-Term Debt to meet Stability and Liquidity thresholds.

                 6.  Collateral:

a.     The Quality & Quantity of Collateral both matter equally.

b.    Free & Clear Collateral, not encumbered by Liens is artificial.

c.     Receivables Factors:  Aging, Customers’ Credit Standing and Bad Debt History.

d.    Inventory Factors:  Market Value Determination, Sales Track Record and Turnover.

e.     Equipment, Machinery & Real Estate Factors:  Market Valuation, Repayment Ability and Disposability of Assets.

f.     Understand how to Package Collateral Classes and leverage Cross- Collateralized Assets.

Note:  For a detailed explanation of Financial Formulas and Ratios, please refer to ABC Business Consulting’s Comprehensive Business Planning Guide and Workbook.

IV.  Analyzing the Relationship between Debt & Equity

A.    Concept of Leveraging:

1.     Utilizing a Low Rate of Interest Debt Structure to leveraging into Investing the Loan Proceeds into an opportunity at a projected higher Rate of Return.

a.     Compare the relationship of using Debt verses Equity.  Variables would be the Interest on the Debt, the Effect of Taxes and the Economic Reality. 

b.    Calculate Return on Equity:  Earnings divided by Equity

                                                                i.        Consider the effect of Harvesting the Asset in an upside & Downside market.

                                                               ii.        So while a Debt structure, allows you to leverage Equity, in an Economic Downturn, the Loan Interest can cause the Equity Investment to lose money.

2.     Equity and Debt should not be an either/ or proposition but a proper mix to meet your Financial Modeling Scenarios Goals.

B.    Cost of Debt Capital:

1.     Cost of Debt = Interest Rate x (1.00 – the Effective Income Tax Rate).

C.    Cost 0f Equity Capital:

1.     Cost of Equity =

a.     Earnings Participation divided by Investment or Earnings per Share divided by Selling Prize per Share.

D.    Comparisons of Equity verses Debt Capital:

1.     Cost:

a.     Equity Capital is more costly than Debt Capital, as the Investor is exposed to much Higher Risks than the Lender, and to justify the Risk, the Investor seeks a High Return.

b.    Investors Risks verses Lender Risks

i.   Interest deducted from earnings prior to distribution to Investors.

  ii.  Legal requirement to repay debt, not equity.

  iii. Lender has greater access to collateral and liquidity availability.

  iv. In the event of business failure, Lenders are paid before Investors.

2.     Risk:

a.     Equity risk lies with the Investor, yet, Debt Capital Risk are high to the Company:

i.   Interest penalties.

ii.  Repayment demand during low Cash Flow Period.

iii. Collateral Claims.

iv. Personal Guarantees.

v.  Unsuccessful Re-Finance or Expensive Re-Finance Terms.

3.     Flexibility:

a.     Equity Capital much more flexible and efficient.

b.    Alternative Debt Sources (Hard Money, Bridge Loans, Factoring, etc.) are Expensive but offer Flexible Debt on a short term acquisition schedule for a short term period (i.e. Rent Money).

c.     Equity can limit Debt and vice versa depending on Covenants and Agreement Terms.

d.    When combining Equity and Debt, Equity can make Debt much more Flexible, Attainable and Economical.

4.     Control:

a.     Equity has Board Seat and Share Ownership.

b.    Hybrid Debt Products (Hard Money, Mezzanine Finance) can have an Ownership Component.

c.     Debt can control a business with a high Loan to Value/ Cost, high interest rate and steep penalty/ default terms.

d.    The proper Mix of Debt and Equity is the answer.

V.  Combining Capital Sources:

               A.  Typical Mix Considerations:

1.     Internal Cash Generation:  Retained Earnings Maximization, Good Asset Management, Solid Cost Control, etc.

2.     Trade Credit/ Supplier Credit.

3.     Matching Principle:  Short-Term Debt for short term needs and Long-Term Debt for long-term needs.  Utilize the Current Ratio Formula.

4.     Debt to Equity Mix:

a.     Founder & Angel Investor Contribution = 20%

b.    Long- Term Debt = 40%

c.     Short- Term Debt = 10%

d.    Equity Capital = 30%

-other successful mixes:

*10-50-10-30

*10-60-10-20

                       5.  Debt Capacity = Acceptable Debt to Equity Ratio x Equity

a.     A typical Acceptable Debt to Equity Ratio is 1.00.

b.    The above Formula measures the proper level of Debt to Equity with the injection of additional Equity.

 VI.  An Effective Business Funding Strategy

A.    How do you Develop an Effective Funding Strategy?

1.     Good Communication with Lenders and Investors:

a.     Realistic, Well- Developed Facts & Figures.

b.    Bridge the Gap with a Well Developed, Presented and Packaged Business Plan, Loan Package, Executive Summary, and Investment Overview.

2.     Understanding the following Flow Chart of Business Plan Development Relationships:  Company Experience & Track Record = > Product Development => Marketing Analysis & Plan => Strategic & Sales Plan = REALISTIC Financial Projections & Forecasts.

3.     Integrate your Funding structure & Strategy into your Cash Flow statement, showing the effects of different Capital Structures based upon your Strategic Plan Findings.

a.     Cash Flow Statement shows the Banker how your Loan will be repaid and the Investor how much and when Investment Proceeds will be accumulated and disbursed, all based on Realistic, Believable numbers via a solid Business Plan Development Process (see above Flow Chart).

B.    Conclusion:

1.     An Effective Financial/ Funding Strategy begins with an Effective Business Plan Process incorporates Excellent Financial Analysis and runs various Financial Model outcomes via Cash Flow Statement Development & Analysis.

2.     Understanding the right mix of Financial Instruments, is key when modeling your Cash Flow Scenarios. 

*:  See ABC Business Consulting’s Business Planning Workbook & Guide  for more details on Budgeting Systems and Milestone Achievement.  

**:  For an example Schedule of Real Estate Holdings, see ABC Business Consulting’s Business Plan Workbook.

***:  Please see the previous Article in this Business Finance Series, Funding Sources for your Business, for more information on establishing good Banking relationships.

****:  Can be converted to cash in 30 days. –Indicates the adequacy of a Company’s Short-Term Capital position.

About the Author:  This article was written the ABC Business Consulting Business Success Consultant, Frank Goley, who has many years experience helping companies start, grow, turn-around and succeed.  Please visit The ABC Business Consulting Website for more information on what a Business Consultant can do for your Company.

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