MODULE 7
OBTAINING CAPITAL
An entrepreneur needs money to start a business. In addition, an entrepreneur must
be able to manage the money to ensure that the enterprise reaches its fullest potential. The money and credit required to
run a business are its capital. Some entrepreneurs go into business with the few pesos they have saved, only to find that
this is not enough money. Unfortunately, they do not become aware of the problem until faced with a financial crisis, such
as not being able to pay their employees or suppliers. Entrepreneurs should not expect to avoid all money problems. However,
by anticipating their financial needs, entrepreneurs can plan ahead for the problems that may arise.
OBJECTIVES:
After
studying this module, the student should be able to:
1. Estimate start-up costs for a new enterprise.
2. Identify sources of funds.
3. Describe differences between short-term and long-term capital needs.
4. Identify factors in need for additional capital.
5. Suggest tips for requesting loans.
Estimating Start-up Costs
How much money will you need to start your new enterprise. There is no standard answer
to this question because each new business is different. For example, money needs vary according to the field of business
activity—that is, extractive, manufacturing, wholesaling, retailing, or service. Another determining factor is the size
or scale or operations. Obviously your immediate costs will be higher if you have several employees from the start than if
yours is a one-person business.
To determine starting costs, you need to estimate your sales volume for the first
year. Since your estimate is likely to differ from the actual sales volume, you should select a conservative estimate. A conservative sales estimate is one that
is ore likely to be too low than too high. This is desirable because a high estimate will lead you to invest too much money
at the beginning.
You should also select a conservative figure when estimating expenses. A conservative expense estimate is one that is more likely to be too
high than too low. By overestimating expenses, then, you are less likely to get caught short of money.
The two categories of start-up costs are one-time costs and continuing costs. One-time costs are expenses that will not have to be repeated once the business is
under way. The purchase of a sign to be place don the building is an example. On the other hand, continuing costs must be paid both at the beginning ad throughout the life of the enterprise. Examples are rent,
telephone, and advertising expenses. Plan to have enough cash on hand to pay continuing costs for more than just the first
month. Some experts say you should be prepared for at least the first three months’ expenses.
Types of Funds
The two types of funds for businesses are equity funds and debt funds. In operating
their businesses, most entrepreneurs use a combination of these two types.
Equity Funds
Equity is another word for ownership. Thus, equity funds consist of money or capital contributed by owners. Entrepreneurs’ personal sources of money
include savings, retirement benefits, sale of a home, or inheritance. If sufficient start-up money cannot be obtained from
personal sources of equity, an entrepreneur may take in a partner or form a corporation and sell shares of stock. Since, in
many cases, there is not enough equity money available, entrepreneurs resort to debt funds.
One-time Costs
Equipment, machinery, fixtures
Charges for installing equipment, machinery, fixtures
Decorating and remodeling costs
Beginning inventory of merchandise or raw materials
Deposits for utilities
Fees for accountants and lawyers
Licenses and permits
Advertising and sale promotion for “grand opening”
Cash for unexpected needs
Continuing Costs
Salaries for proprietor or partners
Salaries and wages for other employees
Rent
Advertising and sales promotion
Delivery or shipping expenses
Supplies and materials
Utilities (telephone, gas, water, electricity)
Insurance of all types
Taxes (federal, state, local)
Interest on debt
Repairs and maintenance
Fees for accountants and lawyers
Employee training costs
Unexpected needs
Debt Funds
Debt funds are dollars or capital you borrow. Banks, other financial institutions,
and individuals are all sources of debt funds. The privilege of paying for goods and services after they have been delivered
or provided is credit. Suppliers of merchandise or equipment may sell to business
on credit terms. When entrepreneurs borrow money or use credit, a charge is involved known as interest.
Comparison of Funds
An entrepreneur should use both equity funds and debt funds for sources off capital.
The type of funds used depends on these factors: risk, control, and availability.
Risk. There is little risk to the enterprise with equity capital. Owners do not have to be
repaid. By contrast, great risk is involved with debt funds. Failure to make loan payments when they are due could cause lenders
to require that the loan be repaid in full immediately. An entrepreneur may have to sell real estate or other business property
to obtain sufficient money to repay a loan, or lenders may take ownership of the entire business.
Control. An owner’s degree of control is usually directly related to
the percentage of ownership. That is, the more ownership an entrepreneur has, the more authority the entrepreneur will have
regarding the operation of the business. Entrepreneurs lose some control of their businesses every time they take in a partner
or sell shares of stock. An entrepreneur who started a business to be a boss may suddenly feel as though others are in control.
On the other hand, lenders do not ordinarily get actively involved in the operation of their borrowers’ businesses.
Availability. At a particular time, either debt funds or equity funds could be
difficult to obtain. Debt funds may not be available to the business because of high interest rates, the entrepreneur’s
poor personal credit record, or a history of low earnings or losses for the enterprise. The only sources of available funds
may be to obtain equity from new partners or to sell stock. In other situations, an entrepreneur may be unable to find equity
investors, leaving the entrepreneur with no alternative buy to borrow the money.
Sources of funds
Equity funds are invested in the business by an entrepreneur, one or more partners,
or stockholders. These people are owners and are usually willing to wait months or years to be repaid. Therefore, equity funds
are usually considered to be long-term funds. In contrast, some debt funds are short-term and must be repaid quickly, while
others are long-term.
Businesses need both current assets and fixed assets. Current assets are cash and any other assets that can be easily and quickly turned into cash. Inventory and accounts
receivable are examples of current assets. Inventory may include raw materials,
finished goods, or supplies. Accounts receivable are sums of money owed to the
business by customers.
Fixed assets are items that the business expects to own for more than one year.
These items are not used up, or converted into cash, in a short period of time. Typical examples are land, buildings, equipment,
and trucks.
The key to successful business financing is to obtain current assets with short-term
loans or credit and to obtain fixed assets with long-term loans. For example, an entrepreneur should consider a 90-day bank
loan to buy inventory or a 15-year loan to buy property.
Short-Term Loans or Credit
Short-term loans and credit are available from vendors, commercial banks, commercial
finance companies, and factors.
Vendors. Vendors are businesses from which entrepreneurs buy products. While vendors
do not usually lend money, they will often supply merchandise and allow businesses to pay for the merchandise by a specified
date. Under this arrangement, known are trade credit, entrepreneurs may have 30
or more days to pay their bills. The exact credit terms depend on the line of trade and the credit rating of the enterprise.
To those who have satisfactory payment records, a vendor may extend credit interest-free. An advantage of trade credit is
that an entrepreneur may sell the merchandise to obtain the money needed to pay a vendor’s bill.
Commercial Banks. Local commercial banks are one of the best sources of short-term loans.
The primary short-term loan is the commercial loan, usually made for 90 to 180
days. This loan is generally made without any specific collateral, which is something
of value the borrower pledges to the bank as security for the loan. Commercial loans are advanced to profitable businesses
with good credit ratings. Entrepreneurs are required to repay commercial loans in a lump sum.
When many of the current assets are held in unpaid customer accounts and the enterprise
needs more cash, an accounts receivable loan may be the answer. Available from commercial banks, accounts receivable loans involve the pledging of accounts receivable as collateral for a short-term loan. This
type of loan allows an entrepreneur to convert unpaid customer accounts into cash. Banks usually advance up to 80 percent
of the value of the accounts receivable, allowing themselves some protection for uncollectible accounts. Typically, the accounts
receivable loan is set up as a revolving line of credit for the business borrower. In a revolving
line of credit, funds are continually advanced to the enterprise, repaid, and advanced once again. The entrepreneur pays
interest on the remaining balance of the loan.
Commercial banks also engage in inventory financing. With inventory financing, an entrepreneur pledges inventory as collateral for short-term funds to receive a revolving
line of credit. Entrepreneurs repay inventory loans as cash flows into the enterprise from the sale of items in inventory.
When an established business is profitable, the enterprise may qualify for an unsecured
line of credit. For this type of loan, no collateral is pledged. Generally, an entrepreneur may borrow, repay, and borrow
again within a one-year period.
Commercial Finance Companies.
Commercial finance companies are specialists in accounts
receivable and inventory loans. They often combine the collateral of accounts receivable and inventory loans to provide a
business with a larger line of credit. They seldom make unsecured loans to small businesses.
Factors. Entrepreneurs may pledge account receivable as collateral for a loan,
and they can also sell accounts receivable to obtain short-term funds for the business. Selling accounts receivable is called
factoring. Financial firms that buy accounts receivable are factors. Factors purchase the accounts receivable at less than face value and then collect the full amounts from
customers when payments are due. While this service has a cost, businesses obtain funds without waiting for customers to pay
their bills.
Long-Term Loans
In most cases, part of the financing of the new enterprise will consist of long-term
loans, also known as term loans. Term loans are extended fro more than one year
and are usually to obtain land, buildings, equipment, and other fixed assets. Some commercial banks and commercial finance
companies make both short-term loans and long-term loans. Equipment manufacturers and distributors also provide long-term
financing.
Commercial Banks. One of the Primary sources of long-term loans, particularly those
extended for three to five years, is the commercial bank. The bank’s installment loan department generally processes
long-term loans. Most commercial banks require a written loan agreement for a
long-term loan. The agreement may limit the amount of salary entrepreneurs pay themselves or require entrepreneurs to obtain
approval form the bank before borrowing money from other sources. The bank may also require a compensating balance. A compensating balance is a sum of money deposited in the bank for the duration of the loan to serve as collateral.
Commercial banks may offer term loans with personal guarantees, equipment loans, and real estate loans.
Term Loans with Personal
Guarantees. Through personal guarantees, borrowers agree to pay the unpaid balance of the loan if the business, including a corporation,
is unable to repay it. Asking for a personal guarantee is standard procedure for small business loans, especially when the
business is not yet operating. This permits the bank to recover its money if the business fails. The personal guarantee is
also a measure of the entrepreneur’s confidence in the business.
Equipment Loans. Equipment
loans enable an enterprise to buy new equipment or
to obtain funds when the firm does not qualify for unsecured credit. Most banks limit their equipment loans to between 60
and 80 percent of the value of the equipment. The loans are usually repaid in monthly installments for a maximum of five years,
depending on the useful life of the equipment.
Real Estate Loans. Real
estate loans are usually made for up to 75 percent
of the value of the land and/or buildings and repaid over 10 to 20 years. The bank will require a first mortgage as security for the real estate loan. If the borrower fails to make the payments, ownership of
the property will be transferred to the bank.
Commercial Finance Companies. The three types of long-term financing offered by commercial finance
companies are equipment loans, real estate loans, and equipment leasing. Equipment loans are provided in the same form as
those granted by commercial banks. The loan period is determined by the useful life of the equipment. The equipment serves
as collateral for the loan, and the funds are advanced to cover up to 80 percent of the cost of the equipment.
Likewise, commercial finance companies offer real estate loans similar to those offered
by the commercial banks. However, these loans are not available from all commercial finance companies.
Through equipment leasing, individuals
may obtain and use equipment without owning it. Rather than paying for equipment in one lump sum, lease payments are made
as the equipment is used. Cash that would otherwise be tied up in a fixed asset is available to buy inventory or pay current
expenses.
Equipment Manufacturers
and Distributors. To encourage entrepreneurs to buy
their equipment, manufacturers and distributors often will finance the purchase. This can be an important source of funds
but only for the amount of the purchase price. Usually a down payment is required, and the balance is paid in monthly installments.
The payment period may extend over one of more years, depending on the type and price of the equipment.
factors in need for additional
capital
As a business grows, so does the need for more and more capital. Some of the more
common factors creating this need are sales growth, expansion of the business, opportunities to reduce costs, seasonal factors,
and economic conditions.
Sales Growth
To keep up with an increasing sales volume, entrepreneur will have to continually
buy more inventory. Because the goods must be available and ready for sale when customers want them, an entrepreneur must
buy inventory at a rate faster than the increase in sales.
Sales growth can create a larger volume of accounts receivable. In addition, sales
growth requires the business to have larger amounts of cash to pay wages to more employees and to pay wages to more employees
and to pay increased expenses brought about by increased sales. The business must sometimes borrow money until customers pay
their bills.
Expansion
When entrepreneurs expand to open an office at an additional location or to include
a new product or service line, they need more capital. Sometimes these expenses equal or exceed the initial start-up costs
of establishing the business.
Opportunities to Reduce Costs
Sometimes entrepreneurs must be prepared to spend money to save money in the long
run. For example, an entrepreneur may have the opportunity to buy new machinery t hat will lower the cost of producing the
firm’s primary product. Another example is spending money for more efficient heating and cooling equipment to reduce
the firm’s utility bill.
An entrepreneur may receive substantial savings by taking advantage of quantity discounts
on inventory purchases. A quantity discount is a reduction in price as a result
of the amount purchased. The discount could be based on the amount of one particular item ordered or on the total amount of
all items. For example, an order for 500 items at PhP 10 each instead of a usual order of 100 items may qualify the buyer
for a 5 percent discount. The discount saves the buyer 50 centavos per item. However, the entrepreneur must have cash or be
able to arrange credit to take advantage of the discount offer.
Seasonal Factors
Rather than having a constant level of sales from month to month, many businesses
experience peaks and valleys in their sales volumes. For instance, Toy manufacturers sell a large part of their annual production
in a few months each year. Retailers and wholesalers order toys in the spring and summer months for delivery prior to the
Christmas gift buying season. Likewise, suppliers of school supplies sell a major portion of their products for delivery just
prior to the beginning of the school year. As a result, large amounts of cash flow into these businesses in some months, while
little or no cash flows in during other months. Seasonal needs can create a need for additional capital. To prepare for major
selling seasons, entrepreneurs may have to borrow money to buy additional materials and supplies and to hire more employees.
Economic Conditions
Local or national economic conditions may cause temporary decreases in sales and
profits. For example, other businesses in the community suffer when manufacturing plants close, leaving employees without
jobs. The jobless people do not have the spending ability they once had, thereby reducing the sales of other businesses in
the community. Business owners may need to borrow money to pay expenses until conditions improve. Rent, utilities, and wages
must be paid, even when the sales volume is low.
TIPS FOR REQUESTING LOANS
Entrepreneurs should prepare themselves for meeting with a lender to ask for a loan.
While this discussion deals with commercial banks, many of the suggestions also pertain to obtaining loans from other types
of lenders.
Tips that may improve the entrepreneur’s chances of obtaining a bank loan are
(1) selecting a bank carefully, (2) preparing financial statements, (3) making an appointment, (4) preparing to answer typical
questions, and (5) preparing the guarantee the loan.
Select the Bank Carefully
Some banks deal mostly with large corporations. Others aim to serve consumers and
perhaps small businesses. Entrepreneurs should select banks that specialize in making loans to businesses, particularly those
banks having a history of working with firms similar in size and type to theirs. Loan processing time may be reduced when
the banker is familiar with the industry, the products and services sold, and the customers.
If, for reasons beyond their control, entrepreneurs are unable to make loan payments
on time, a banker who understands the business may be willing to make other arrangements for repayment. Other lenders may
not be as willing to discuss alternatives for repaying the loan.
Prepare Financial Statements
The lending officer of the bank will ask to see a complete set of financial statements.
Although some entrepreneurs prepare these statements themselves, it is wiser to have an accountant prepare the financial statements
to be assured of a thorough financial file. Without assistance from an accountant, an entrepreneur may not borrow enough money
in the beginning. Having to return for additional loans later could make the lending officer suspect that the entrepreneur
does ot know how to operate the business and may be a poor risk.
Make An Appointment
People walk into banks and apply for credit cards and car loans every day. This is
the common practice for these transactions. When seeking a business loan, however, it is customary to make an appointment.
Entrepreneurs who ask for appointments show they are business-minded.
Prepare to Answer Typical Questions
The lending officers of commercial banks will ask questions to determine if the borrower
qualifies for a loan. Entrepreneurs should be prepared to answer these typical questions:
·
How
do you plan to spend the money?
The funds should be used for equipment, inventory, or other expenses directly related to the sales and profits of the business.
A loan request is generally approved only if the money will be used directly I the business of if the plan is to start a low-risk
venture.
·
How
much money do you need? Entrepreneurs
should request neither too much nor too little money. The more specific borrowers are in the answering this question, the
more likely they are to get the loan.
·
When
do you need the money? A committee
will review loan requests. Because committee reviews of loan applications take time, borrowers should apply early for a bank
loan before their funds are gone. Lenders look more favorably on those who plan ahead.
·
When
will the loan be repaid? The
shorter the period of time the money is needed, the better the chances of getting the loan. Bankers associate shorter time
periods with lower risk.
·
What
is the source of the money for repaying the loan? Bankers will need to know how an entrepreneur plans to repay the loan. Money borrowed to buy inventory, for example,
can be repaid when the inventory is sold.
Prepare to Guarantee the Loan
Even the best credit prospects should be prepared to personally guarantee their loans.
If the business fails, the entrepreneurs may have to sell personal and family property to repay a business loan. Clearly,
this involves risk. On the other hand, if entrepreneurs are not willing to risk their assets, why should banks risk theirs?
Questions to Answer:
Part I.
Write a short answer to each of the questions below.
1. Why should conservative sales estimates and conservative expense estimates
be used?
2. Explain the difference between one-time costs and continuing costs. Give
an example of each.
3. What is the difference between equity funds and debt funds?
4. What factors should the entrepreneur consider when deciding whether to use
debt funds or equity funds in a particular situation? Explain each of these factors.
5. What types of assets should be obtained with short-term loans or credit?
Which assets should be obtained with long-term loans?
6. List four sources of short-term loans or credit.
7. List three sources of long-term loans.
8. Give five reasons why businesses may need more and more capital as they grow.
Part II.
Analyze the case and answer the questions
GONZALES CONSTRUCTION COMPANY
In six months or less, Sara and Roy Gonzales plan to have their construction company
in operation. They have twelve years of construction experience between them, and they believe they know what it takes to
run a successful company.
Roy prepared a list of rough estimates of all the one-time costs and continuing costs
for the new enterprise. Sara, an experienced accountant, closely reviewed each item on the list and revised the figures where
necessary. Finally Sara and Roy reviewed the list together until they were confident that each cost estimate was as accurate
as possible. Now that the couple know what their costs will be, they are not certain how or where they will obtain the funds
to start the business.
Roger Santos, a former construction company owner, contacted Sara and Roy. He offered
to invest in their business and become their partner. Santos’ investment would be larger than Sara and Roy’s investment.
The Gonzales couple are flattered that someone would come to them and offer to buy into their business. They also like the
idea that, with Mr. Santos’ investment, they would not have to borrow any money. At the same time, they do not want
to accept anyone’s investment until they have had the chance to think about all the alternatives available to them.
They are also wondering why Mr. Santos is interested in their business when it is not yet in operation.
Before Sara and Roy accept Mr. Santos’ offer, they are considering visiting
a bank to discuss the possibility of obtaining a loan.
Questions:
1. Would you advise the Gonzales couple to use only equity funds in starting
their business Why or why not?
2. Why do you believe Roger Santos wants to invest in the Gonzales Construction
Company?
3. What should the Gonzales couple do to prepare to meet with the loan officer
at the commercial bank?
