Tag Archives | capital

Capital Budgeting Methods

See Also:
Capital Budgeting Phases
Cost of Capital
Discount Rates NPV
Net Present Value
Cost of Capital Funding

Capital Budgeting Methods Definition

Most small to medium sized companies have no idea how to approach capital investments. They treat it as if it were an operating budget decision rather than a long-term, strategic decision that will impact their cash flow, efficiency of their daily operations, income statement, and taxable income for years to come. They need your help understanding the importance of and then making the right capital budgeting decisions.

Capital budgeting decisions relate to decisions on whether or not a client should invest in a long-term project, capital facilities and/or capital equipment/machinery. Capital budgeting decisions have a major effect on a firm’s operations for years to come, and the smaller a firm is, the greater the potential impact, since the investment being made could represent a substantial percent of the firm’s assets.


Managing capital is one of the many ways that a financial leader can improve profitability. Start developing your financial leadership skills!

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Capital Project Examples

A capital project is usually identified by functional needs or opportunities, although many are also identified as a result of risk evaluation or strategic planning. Some typical long-term decisions include whether or not to:

  • Buy new office equipment, cars or trucks;
  • Add to or renovate existing facilities, including the purchase of new capital equipment/machinery;
  • Expand plant or process operations;
  • Invest in facilities for a new product line or to expand services;
  • Continue or discontinue an existing product line;
  • Replace existing capital equipment/machinery with new equipment/machinery;
  • Invest in software to meet technology-based needs or systems designed to help improve process and/or efficiency;
  • Invest in R&D or intangible assets;
  • Build or expanding a foreign or satellite operation;
  • Reorganize assets or services; or,
  • Acquire another company.

Refer to capital investment (or, expenditure) decisions as capital budgeting decisions. They involve resource allocation, particularly for the production of future goods and services, and the determination of cash out-flows and cash-inflows. Plan and budget the determination of cash out-flows and cash-inflows over a long period of time. Get involved from the beginning. Then, guide them through this process. This is a very complicated accounting issue.

Capital Budgeting Phases

The capital budgeting phases process include:

  • Description of the need or opportunity
  • Identification of alternatives
  • Evaluation of the options and the relevant cash flows of each
  • Selection of best alternative
  • Conducting a post-completion audit of the projects

Identifying Capital Budgeting Needs

The first step is to identify the need or opportunity. Mid-management level employees usually do this. It is the result of a shared vision of company goals and strategies coupled with a “where the rubber meets the road” perspective of “local” clients needs, tastes and behavior. They see a need or opportunity and communicate it to senior management. This is usually done in the form of proposals, which both include:

  • Identification of the need or opportunity
  • Potential solutions and/or recommendations

Senior management evaluates the merit of each proposed opportunity. Then they make a determination of whether or not to look into it further.

While project need identification is usually a decentralized function, capital initiation and allocation decisions tend to remain a highly centralized undertaking. The reason for this revolves around the need for capital rationing. This is particularly true when funds are limited and upper-management wishes to maximize its returns/benefits from any capital project undertaken.

The information needed to make this determination usually comes from both internal and external sources. It is also based on both financial and non-financial considerations. Interestingly enough, the factors examined in this process can be both firm-specific and market-based in nature. Companies should be seeking qualified financial guidance since the consequences of both a poor decision and of the implementation of a good decision can be far-reaching.

Capital Project Evaluation

Have upper management develop an objective methodology so that you can evaluate alternate capital projects on a reasonable basis. Consider both quantitative and qualitative issues and use the whole organization as a resource.

Marketing should provide data on sales trends, new demand and opportunities for new products. Managers at every level should identify resources that are available to upper-management that may lead to the use of existing facilities to resolve the need/take advantage of the opportunity. They should also communicate any needs they/their departments or divisions have that should be part of the capital decision. Involve your financial analysts, or in their absence, qualified external financial experts such as your firm, in the following tasks:

  • Identifying the target cost of capital
  • The evaluation of startup costs
  • The calculation of cash flows for those projects chosen for evaluation purposes

Critical part of this process involve both calculating the appropriate discount rate and calculating conservative cash flows. An independent accounting firm can best look at the project/these issues impartially. Estimation bias can be dangerous.

Evaluate (predict) how well each capital asset alternative will do. Also determine if the net benefits to the firm are consistent with the required capital allocation, given the scarcity of resources most firms face.

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Measurements Used in Capital Budgets

The purpose of the evaluation phase is to predict how well a new asset will benefit the firm. Consider the following possible measures, which you should help the firm develop.

Net Income

Managers of net income evaluate the incremental increase in accounting net income between alternatives.

Net Cash Flow

The most widely used measure is net cash flow. This measure looks at the actual cash flows (out and then in) resulting from the capital investment for each alternative. Evaluate these for both overall value (several techniques will be discussed next) and from the standpoint of the effect on daily cash flow and the ability of the firm to meet its financial obligations in a timely manner. Projects with high projected future returns may not be as attractive when adjusted for the time value of money or the costs involved in borrowing funds to meet operating obligations such as payrolls and accounts payable.

Cost Savings

Cost savings are not designed to generate revenues directly. But instead, they are designed to both save costs and increase productivity. Best evaluate these projects on the basis of incremental savings generated.

Cash Flows

Equality of cash flows tend to vary from year to year. The timing of cash flows may be an important consideration to the firm.

Salvage Value

Salvage value and functionality of an existing asset when replacing it with a new asset while the historical cost of an existing asset is not relevant to a capital budgeting decision, the net proceeds from disposal of the existing equipment is. So is the question of how well existing equipment operates given that capital budgeting decisions are only concerned with incremental costs and incremental savings/profits.

Depreciation

Depreciation, earnings and income tax effects need to be considered based on the form of the firm (sole proprietorship, partnership, corporation, etc.). The differences in the financial and tax accounting treatments available to the firm, especially as they apply to salvage value, useful lives and allowed depreciation methods, and, consideration of the marginal tax rate (which may vary from country to country). Most firms fail to consider this cost or choose a tax or financial accounting treatment that does not maximize the firm’s return on invested capital.

Inflation

Inflation the effects of inflation need to be considered in estimating cash flows as well, especially if is projected to increase in future periods and varies between capital projects being considered.

Risk

Risk considerations political risk, monetary risk, access to cash flows, economic stability, and inflation should all be considered in the evaluation process since all are hidden costs in the capital budgeting process.

Interest

Interest and the cost of capital the venture has to have a return that is greater than its cost of capital, adjusted for tax benefits, if any.

Subjective Decisions

The firm should also make a subjective decision as to its preferences in terms of characteristics of projects in addition to the regular selection criteria it has set. For example, does the firm prefer:

  • Projects with small initial investments? Earlier cash flows? Or, perhaps, shorter payback times?
  • New projects or expansion of the existing operations?
  • Domestic projects or foreign operations?
  • If the firm is risk neutral, would the prospects of additional potential cash flows in riskier investments make a capital project more attractive?

Evaluating Risk of Capital Projects

Analyze risk carefully, regardless of which valuation method you used to evaluate the project. The more popular risk-assessment techniques include Sensitivity Analysis, Simple Probability Analysis, Decision-Tree Analysis, Monte Carlo Simulations and Economic Value Added (EVA):

Sensitivity Analysis considers what will happen if key assumptions change. It also identifies the range of change within which the project will remain profitable.

Simple Profitability Analysis assesses risk by calculating an expected value for future cash flows based on their probability of success to future cash flows.

Decision-tree Analysis builds on Simple Profitability Analysis by graphically outlining potential scenarios and then calculating each scenario’s expected profitability based on the project’s cash flow/net income. Managers use this technique to visualize the project and make more informed decisions. Although decision trees can become very complicated, consider all scenarios (e.g., inflation, regulation, interest rates, etc.).

Monte Carlo Simulations use econometric/statistical probability analyses to calculate risk.

EVA, which is growing in popularity, is a performance measure that adjusts residual income for “accounting distortions” that decrease short-term income but have long-term effects on shareholder wealth (e.g., marketing programs and R&D would be capitalized rather than expensed under EVA).

Once you have assessed the risk, which valuation method should the firm/you use for a project? The answer depends on considerations such the nature of the investment (the timing of its cash flows, for instance), uncertainty about the economy and the time value of money if it is a very long term capital project.

Capital Project Evaluation Methods

The four most popular methods are the payback period method, the accounting rate of return method, the net present value method, and the internal rate of return method.

Payback Period Method

This method favors earlier cash flows and selects projects based on the time it takes to recover the firm’s investment. Weaknesses in this method include the facts it does not consider:

  • Cash flows after the payback period
  • The time values of money

Use this method to select from projects with similar rates of return and that were also evaluated using a discounted cash flow (DCF) method. For example, refer to this as the Payback Method based on Discounted Cash Flows or Break-Even Time Method.

Accounting Rate of Return Method

The Accounting Rate of Return (ARR) Method uses accounting income/GAAP information. Calculate it as the average annual income divided by the initial or average investment. Compare the projected return to a target ARR based on the firm’s cost of capital, the company’s past performance and/or the riskiness of the project

Net Present Value Method

Base the Net Present Value (NPV) Method on the time value of money. It is a popular DCF method. The NPV Method discounts future cash flows (both in- and out-flows) using a minimum acceptable cost of capital (usually based on the weighted average cost of capital or WACC, adjusted for perceived risk). Refer to this as the “hurdle rate.” NPV is the difference between the present value of net cash inflows and cash outflows. And a $0 answer implies that the project is profitable and that the firm recovered its cost of capital.

Internal Rate of Return Method

The Internal Rate of Return (IRR) Method is based on the time value of money. It calculates the interest rate that equates the present value of cash outflows and cash inflows. This calculated rate of return is then compared to the required rate of return, or hurdle rate, to determine the viability of the capital projects.

Soft Costs and Benefits in Capital Budgeting Methods

Other considerations the firm/you should consider as part of the valuation process are “soft” costs and benefits. Soft costs and benefits are difficult to quantify by are real non-the-less. Soft costs might be a capital investment in a manufacturing process that results in added pollution to the atmosphere. A soft benefit might be the enhancement of a firm’s overall image as a result of investing in R&D for high-tech products. Ignoring soft benefits and costs can lead to strategic mistakes. This is especially true if you are taking about investments in advanced manufacturing technology. Estimate soft benefits and costs. Then include them as part of the method to determine if a capital project is desirable.

Post Completion Project Evaluation

Once you choose the project and put into operation, a qualified financial services firm, such as yours should undertake a post completion audit of the project. They can evaluate the project objectively. This audit by an independent party will function as a control mechanism to ensure that the capital project is performing as expected. In the event it is not, the audit will make it easier to terminate the project by eliminating any bias of those involved in the project. It will also serve as a learning mechanism for upper management. They will compare actual performance to expected results. In addition, they will improve the processes and estimates they use in future investment decisions.

Control mechanism, which can be expensive, is essential to the success of future capital investment decisions… Especially when considering the long life of most capital projects.

One final word regarding implementation of this control mechanism. Successful post-completion auditing processes require that upper management understand that the purpose of the audit is to learn from past experiences,. Do not penalize managers for the decisions they made. But instead give them the opportunity to learn from them. Learn more of how to becomes a valuable financial leader; download the free 7 Habits of Highly Effective CFOs whitepaper.

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5

Business Plan

See Also:
Value Drivers: Building Reliable Systems to Sustain the Growth of the Business
Business Cycle
Business Intelligence and Finance
Make-or-Buy Business Decision
Acquisition Capital
Marketing Plan

Business Plan Definition

The business plan definition is the plan of action for business operations which has the goal of creating and growing sustainable profits. It is necessary for any business venture. A business plan has 3 main purposes: forming a strategic plan for future business initiatives, serving as a retrospective measure of the success of the business and it’s plans for expansion, and an explanation of the business for the purpose of raising capital. Business plans can vary greatly depending on creator, industry, operations, needs, phase in the business cycle, and more. Ultimately, the term business plan is used to describe a myriad of written documents which lay out the plans a business has for the future. Despite this, the goal is the same; creating profits for the shareholders of the venture.

Business Plan Explanation

Business plans are either internally or externally focused. Internally focused plans serve as a document to “rally the troops”; organize the stakeholders, especially employees, of a business and give an overall strategy to each of their regular tasks and actions. This has particular benefit for organization and motivation around the strategic goals that company leaders want to achieve. An internal business plan is the tool used to communicate these goals in a clear, effective, and calculated manner.

External business plans serve the purpose of raising capital. Banks constantly visit with small businesses desiring a loan to finance a new project. Meanwhile, venture capital firms accept roughly 1 out of 1000 companies that contact them for financing. An external business plan serves as a tool to show that the business concept is developed, evaluated, and planned. Investors and lenders want to eliminate as much risk as possible, and an external business plan provides them a way to measure and mitigate these risks. In short, an external business plan is a way for a developing company to stand out from other businesses while showing that goals and aspirations have been considered and documented.

These plans begin by following boilerplate sections and explanations. They then become unique documents. They are customized based on a variety of factors. For example, a web marketing firm has little use for the structure of an operations plan which is common to a manufacturing firm. In a similar fashion, a retail e-commerce store will even have a different business plan from a brick-and-mortar retail store. The factors of success, operations, marketing, risk, and measurement dictate this.

A Living Document

A business plan is often referred to as a “living document”. This is because a these plans are constantly changing. Whenever new developments in competition, marketing tools, the legal factors which relate to an industry, or others change a business plan must be updated so as to keep relevant. In this way a business plan is constantly evolving. A simple business plan is generally 20 pages, where a complicated one should not exceed 40 pages, on average.


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Business Plan Format

For a business plan, combine parts to make a whole. These parts, though different for each plan, generally follow common purposes. The standard business plan format is as follows:

1) Executive Summary

2) Business Description

3) Products and/or Services

4) Marketing Plan

5) Operations Plan

6) Management and Organizational Structure

7) Benchmarks and Milestones

8) Legal Entity Structure

9) Capitalization

10)Financial Plan and Projections

11) Appendix

Example

For example, Alejandro has decided to start a micro-lending firm in his native country of Mexico. Combining philanthropy with his enlightened self-interest, Alejandro plans to make a profit while also fostering the entrepreneurial spirit in people who face a difficult future. Alejandro is excited to start his company and therefore, make his impact on the world.

Alejandro knows that he has to create a business plan for his new venture. Despite this, he is a young adult and is not sure where to begin. Determined, Alejandro starts by searching the internet for the term how to write a business plan. He finds some results which begin his thought process. Alejandro picks up a few books from his local bookstore and begins his journey.

Writing the Business Plan

To start the business plan format, Alejandro starts by writing his executive summary. This process is difficult. Alejandro then learns from his research that to write the executive summary after the rest of the business plan. Alejandro stops this section and begins the business explanation.

After writing a rough draft explanation of his business, he begins the competitive analysis. Here, he does as much research as possible into competitors on the market. Alejandro searches the web and personal contacts for this information.

Then, Alejandro assembles industry statistics and information for his industry analysis section of the business plan. He will need to summarize these into a section which serves his purposes.

Alejandro continues and eventually finishes the plan. With a rough draft in his hand, he seeks some advice for what he has made. Alejandro knows that he has a lot to learn, so he prepares himself for a lot of criticism. He finds his local S.C.O.R.E. chapter and prepares to begin the mentoring process.

In conclusion, Alejandro knows that he has a lot to learn. Still, he realizes that anyone who has achieved greatness started somewhere. Alejandro prepares his plan more, parks his ego at the door, and walks into his meeting with a smile.

Template

Find a variety of business plan templates at S.C.O.R.E.

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business plan definition, Business Plan Format

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0

Angel Investor

See Also:
The Dilemma of Financing a Start-up Company
How to Prepare an Investor Package
What is a Term Sheet
Working Capital
Why Venture Capital?

Angel Investor Definition

The angel investor definition is someone who invests in private startup companies. They often provide the first source of outside capital for a startup company.

Role of an Angel Investor

Angel investors also provide cash and managerial expertise to startup companies in their earliest stages of development. They work with businesses even if it is only an idea. In return, the angels receive a stake in the company’s equity. Angels also influence business decisions in the company.

Furthermore, angel investors can be individual investors or groups of investors. In addition, Angels can be wealthy friends or relatives of the business owner, or they may be venture capitalists.

Finding an angel investor can be difficult. As a result, the entrepreneur seeking startup capital from angel investors must work to establish a network of affluent community and industry contacts.

Angel investors will expect you to increase the value of your company. If you want to remove any “destroyers” that may be impacting value negatively, then download the Top 10 Destroyers of Value.

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Acquisition Capital

See Also:
Capital Structure Management
Capital Expenditures
Working Capital
Cost of Capital
Business Plan

Acquisition Capital Definition

When a business decides to grow, you need acquisition capital. Define acquisition capital as the capital used to acquire other assets. You use this capital to purchase assets like equipment, inventory, software, or even a business itself. The purpose of these acquisitions are, ultimately, to grow the overall profits of a business. As such, the process of acquisition financing requires an ability in strategic analysis of the asset to be acquired, as well as the various financing options. Acquisition capital is used in one of two situations: when the growing business does not itself have the cash to grow or when the growing business will experience greater firm value from financing the purchase as opposed to paying out of the free cash flow of the company.


As you are expanding your company, it’s important to protect your company from “destroyers.”

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Acquisition Capital Explanation

Explained often as the fuel for company growth, acquisition capital is in many cases an industry of it’s own. This is due to the fact that so many companies desire to grow using existing methods and assets rather than creating new campaigns for marketing or cost management. Acquisition capital comes from two main sources: debt or equity financing. Because of this it is not exclusive to one type of firm; companies can provide only acquisition capital, only one type of acquisition capital, or provide other types of capital for operations. Additionally, many types of capital can be used for this, including factoring or personal finances. This makes the term acquisition capital as much an industry term as it is a simple label used to describe money shortly before it changes hands in a purchase.

Acquisition Capital Debt

One of the two main forms of acquisition capital is debt financing. Many describe debt financing more commonly as a loan. When someone is paid back, usually with interest, in the form of loan payments rather than dividend payments one can be sure that debt financing is being used. In this way, an acquisition loan works the same as any other loan.

You can find acquisition capital, in the form of debt, through a variety of sources. First, one could simply access friends and family who can spare the money needed for the loan. We suggest that a business person do this under a specific agreement. Unfulfilled business agreement have damaged many close relationships.

Funding

Next, funding can come in the form of a bank loan. This will, for anyone who does not have access to a wealthy personal contact, almost always be the cheapest form of capital. One can access better interest rates, often, through government lending programs like the Small Business Association (SBA) or Patriot Express loans.

Often thought, mezzanine debt providers act as the middle ground between debt and equity financing. Here, one can receive a loan without collateral. Additionally, the loan contract also allows conversion of the debt to company common stock. Mezzanine debt, however, bears a higher interest rate due to the riskiness of the investment. It is usually provided by venture capital firms or private equity funds.

Asset based lending is another option for financing for acquisition. With an asset based lender, company uses their assets as collateral to back loans. The major disadvantage with this method is that using assets for collateral means that when loan agreements are not met, the assets are seized by the lending party. Logically, if the assets of a growing business are taken it is considerably more difficult to continue growth, if not all operations.

Acquisition Capital Equity

Equity financing is another form of acquisition capital. Rather than receiving a loan which must be paid back, a company which receives equity financing provides company stock, either common or preferred, for the capital it receives. Equity financing is, essentially, payment in exchange for partial ownership in a company. Private equity and venture capital firms, the common providers of equity capital, will receive payback for their investment in one of 2 ways: company cash disbursements in the form of dividends or profit from the final sale of the company which includes their ownership stake. This means, often times, that equity financiers will take greater involvement in the company they have invested in.


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Acquisition Capital Example

For example, Eddy has started and grown a successful restaurant chain. Fighting the odds, he has grown his company from a single small shop to several locations. Using the recipes his grandmother once cooked, Eddy brings delicious food to the city while protecting his trade secrets. Recently, demand for his food has outpaced his ability to produce it. Eddy is now considering acquiring restaurants which serve French food, the cuisine that has risen him to success. Despite this goal, Eddy does not currently have the money to finance his own growth and will need acquisition capital to continue growing his business.

First, Eddy evaluates receiving a bank loan. He meets with a banker, an old high school friend, to discuss options for funding. Sadly, he discovers that he does not have the assets necessary to receive the standard bank loan. The bank will need to see, beyond Eddy’s dream, operations which Eddy has not yet achieved.

Eddy does research on Mezzanine and asset based lending. Here, he finds that he also does not qualify. For mezzanine, Eddy can not afford the interest rates required by lenders. For asset backed lending, Eddy does not have the proper set of company assets to convince the lender that he is worth their risk. Even if he did, Eddy does not see much benefit in promising away his tools for success.

Equity Financing

Eddy then evaluates equity financing. He looks at local and national private equity firms. Here, he finds experience requirements which he does not meet. Additionally, these firms will want increased control over Eddy’s business operations. Eddy is concerned that this might take away from his home-style cooking which has gained attention near his brick-and-mortar locations.

As Eddy is evaluating equity financing, he attends a family reunion. Here, he sees his uncle Ted for the first time in a while. An experienced restauranteur in his own right, Ted has also created a successful restaurant chain which serves Cajun food. Eddy has a very pleasant conversation with Ted and eventually expresses his needs. Ted, wealthy from his success, offers the idea that he could finance the budding series of French kitchens. They discuss the concerns of becoming business partners connected by blood relations. Though this is worry some, the two driven entrepreneurs resolve to continue the conversation later in the week.

Eddy looks forward to talking with Ted. By accessing friends and family, usually the cheapest and easiest of all forms of financing, he may be able to provide success for more than just himself. Additionally, Ted’s experience makes him a wealth of knowledge on acquisition; best practices are key to creating the standards that customers expect. Eddy makes a mental plan of what he will need to prepare in order to convince his uncle that he is worth an acquisition funding.

If you want to maximize the value of your company as your add capital, download the Top 10 Destroyers of Value.

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Logistics Chain

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5 Cs of Credit (5 Cs of Banking)

See Also:
What are the 7 Cs of banking
How to Manage Your Banking Relationship
Line of Credit
Trade Credit
Collateralized Debt Obligations

5 Cs of Credit (5 Cs of Banking)

The 5 Cs of credit or 5 Cs of banking are a common reference to the major elements of a banker’s analysis when considering a request for a loan. Namely, these are Cash Flow, Collateral, Capital, Character, and Conditions. Below is an in-depth description of each of the 5 Cs of credit or banking to help you understand what your banker needs to understand about your business in order to approve your loan. You will have insight as to where your banker is coming from and will therefore better prepare you to handle their questions and concerns.

Cash Flow
Collateral
Capital
Character
Conditions

Cash Flow Importance

Cash Flow After Tax is the first “C” of the 5 Cs of credit (5 Cs of banking). Your banker needs to be certain that your business generates enough cash flow to repay the loan that you are requesting. Therefore, your banker will be looking at your company’s historical and projected cash flow and compare that to the company’s projected debt service requirements. There are a variety of credit analysis metrics used by bankers to evaluate this, but a commonly used methodology is the “Debt Service Coverage Ratio” generally defined as follows:

Debt Service Coverage Ratio = EBITDA – income taxes – unfinanced capital expenditures divided by projected principal and interest payments over the next 12 months

Generate more cash flow in your company with our free 25 Ways to Improve Cash Flow whitepaper! You can access it by clicking here.

Historical Ability to Service Debt

Typically, the bank will look at the company’s historical ability to service the debt. Your company’s past 3 years free cash flow will be compared to your projected debt service. In addition, they will compare free cash flow to the past twelve months to the extent your company is well into its fiscal year. While projected cash flow is important, the banker will generally want to see that the company’s historical cash flow is sufficient to support the requested debt. Usually projected cash flow figures are higher than historical figures due to expected growth at the company; however, your banker will view the projected cash flows with skepticism as they will generally entail some level of execution risk.

If your historical cash flow is insufficient, the banker must rely on your projections. Therefore, you must be prepared to defend your future cash flow projections with information that would give your banker visibility to future performance, such as backlog information.

Margin of Error

The banker will also want a comfortable margin of error in the company’s cash flow.

A typical minimum level of Debt Service Coverage is 1.2 times.

This means that the company is expected to generate at least $1.20 of free cash flow for each dollar of debt service. This margin of error is important. The banker wants to be comfortable. If there is a blip in the company’s performance, they want to know that the company will still meet its obligations.


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Importance of Collateral

In most cases, the bank wants the loan amount to be exceeded by the amount of the company’s collateral. The reason the bank is interested in collateral is because it acts as a secondary source of repayment of the loan. If the company is unable to generate sufficient cash flow to repay the loan at some point in the future, the bank wants to be comfortable that it will be able to recover its loan by liquidating the collateral and using the proceeds to pay off the loan.

Assess Available Collateral

How doest the banker assess your company’s available collateral? It is common place for borrowers to think that the bank will lend a dollar for every asset that their company owns. This is not the case.

Certain Asset Classes

First, the banker is interested in only certain asset classes as collateral – specifically accounts receivable, inventory, equipment and real estate – since in a liquidation scenario, these asset classes can be collected or sold to generate funds to repay the loan. The banker will not consider other asset classes as collateral. Since in a liquidation scenario, they would not fetch any meaningful amounts. These asset classes include goodwill, prepaid amounts, investments, etc.

In the case of accounts receivable, the debtor (your company’s customer to whom a good was sold or service rendered) is legally required to pay their bill with the company, and in a liquidation scenario the bank will collect the accounts receivable and use those amounts to pay down the loan. In the case of inventory, equipment and real estate, the bank can sell these assets to someone else and use the proceeds to pay down the loan.

Historical Liquidation Values

Secondly, the bank will discount or “margin” the value of the collateral based on historical liquidation values. For example, bank’s will generally apply margin rates of…

  • 80% against accounts receivable
  • 50% against inventory
  • 80% against equipment
  • 75% against real estate

These advance rates are not arbitrary. These are the amounts that in the bank’s historical experience they have realized in a liquidation scenario against the respective asset class. While you might think that your accounts receivable would collect 100% on the dollar, the amounts have actually been historically closer to 80%. In liquidation scenarios, account debtors will come up with reasons why they don’t owe the entire amount. Or worse, they won’t pay at all and force the bank to sue them for collection.

The amount of the receivable would be exceeded by the legal costs of collection in some cases, and thus the bank simply won’t pursue collection. In the case of inventory, 50 cents on the dollar is usual since the buyers of this inventory know that it is a distressed sale and are in a position of leverage to buy the goods for less than what it cost you to buy them.

Third Party Appraisals

In the case of equipment and real estate collateral, the bank needs a completed third party appraisal on these assets. The bank will margin the appraised value of these asset classes to determine the amount of the loan… As opposed to using the company’s carrying value of these assets on its balance sheet. You will be responsible for the cost of third party appraisals. So, be sure to factor in the time needed to complete the appraisals.

Due Diligence

Also, the bank will in many cases want to complete due diligence on your accounts receivable and inventory to confirm asset values as well as the reliability of the reports you provide to the bank. This due diligence is called a “collateral exam” or “field audit”, and involves the bank sending an auditor to the company’s offices to review books and records to:

(1) Ensure that the company-generated reports for accounts receivable (your accounts receivable aging) and inventory are accurate and reliable

(2) Determine and confirm the amounts of any “ineligibles” within these asset classes.

In general, ineligibles are amounts that the bank will not lend against. This includes the following:

  • A/R over 90 days past due
  • Accounts that are due from foreign counter-parties
  • Accounts that are due from counter-parties that are related by common ownership to your company

In the case of inventory, ineligibles will generally include any work-in-process inventory, any consignment inventory, and inventory that is in-transit or otherwise not on your company’s premises.

Importance of Capital to Banks

When it comes to capital, the bank is essentially looking for the owner of the company to have sufficient equity in the company. Capital is important to the bank for two reasons…

First, having sufficient equity in the company provides a cushion to withstand a blip in the company’s ability to generate cash flow. For example, if the company were to become unprofitable, then it would burn through cash to fund operations. The bank is never interested in lending money to fund a company’s losses, so they want to be sure that there is enough equity in the company to weather a storm and to rehabilitate itself. Without sufficient capital, the company could run out of cash. Then they would be forced to file for bankruptcy protection.

Secondly, when it comes to capital, the bank is looking for the owner to have sufficient “skin in the game”. The bank wants the owner to be sufficiently invested in the company such that if things were to go wrong, the owner would be motivated to stick by the company and work with the bank during a turnaround. If the owner simply handed over the keys to the business, then the bank would have fewer, less viable options to obtain repayment of the loan.

Debt to Equity Ratios

There is no precise measure or amount of “enough capital”, but rather it is specific to the situation and the owner’s financial profile. Commonly, the bank will look at the owner’s investment in the company relative to their total net worth, and they will compare the amount of the loan to the amount of equity in the company – the company’s Debt to Equity Ratio. This is a measure of the company’s total liabilities to shareholder’s equity.

Remember, banks typically like to see Debt to Equity Ratios no higher than 2 to 3 times.

Conditions

Another key factor in the 5 Cs of credit is the overall environment that the company is operating in. The banker assesses the conditions surrounding your company and its industry. They determine the key risks facing your company. They also determine whether these risks are sufficiently mitigated. Even if the company’s historical financial performance is strong, the bank wants to be sure of the future viability of the company. The bank won’t make a loan if your company is threatened by some unmitigated risk not sufficiently addressed. In this assessment, the banker is going to look to things such as the following:

The Competitive Landscape of Your Company

Who is your competition? How do you differentiate yourself from the competition? How does the access to capital of your company compare to the competition and how are any risks posed by this mitigated? Are there technological risks posed by your competition? Are you in a commodity business? If so, what mitigates the risk of your customers going to your competition?

The Nature of Your Customer Relationships

Are there any significant customer concentrations (do any of your customers represent more than 10% of the company’s revenues?) If so, how does the company protect these customer relationships? What is the company doing to diversify its revenue base? What is the longevity of customer relationships? Are any major customers subject to financial duress? Is the company sufficiently capitalized to withstand a sizable write-down if they can’t collect their receivable to a bankrupt customer?

Supply Risks

Is the company subject to supply disruptions from a key supplier? How do they mitigate any risk? What is the nature of relationships with key suppliers?

Industry Issues

Are there any macro-economic or political factors affecting, or potentially affecting the company? Could the passage of pending legislation impair the industry or company’s economics? Are there any trends emerging among customers or suppliers that in the future will negatively impact operations?

Drivers of Business

The banker will need your help to identify and understand these key risks and mitigants, so be prepared to articulate what you see as the primary threats to your business, and how and why you are comfortable with the presence of these risks, and what you are doing to protect the company. The banker will need to understand the drivers of your business, which is equally as important to the banker as understanding the company’s financial profile.

Character

While we have left “Character” for last, it is not the least important of the 5 Cs of credit. Arguably it is the most important. Character gets to the issue of people – are the owner and management of the company honorable people when it comes to meeting their obligations? Without scoring high marks for character, the banker will not approve your loan.

How does a banker assess character?

Character is an intangible. It is partly fact-based and partly “gut feeling”. The fact-based assessment involves a review of credit reports on the company, and in the case of smaller companies, the personal credit report of the owner as well. The bank will also communicate with your current and former bankers. They want to determine how you have handled your banking arrangements in the past. The bank may also communicate with your customers and vendors. This is to assess how you have dealt with these business partners in the past. They will determine the soft side of character assessment by how you deal with the banker during the application process. Thus, their resultant “gut feeling” will be a determining factor.

Bankers Want to Deal With Trustworthy People

In the end, bankers want to deal only with people that they can trust to act in good faith at all times – in good times and in bad. Banks want to know that if things go wrong, that you will be there. They want to know that you will do your best. In addition, they want to ensure that the company honors its commitments to the bank. Even if the company’s financial profile is strong and scored well in all of the other 5 Cs of credit, the banker will reject the loan if they fail the character test. To be clear – it is not necessarily an issue if your company has gone through troubled times in the past. What is more important is how you dealt with the situation.

Were you forthright and proactive with the bank in communicating problems?

Or did you wait until a default situation was already in effect before reaching out to the bank?

Were you cooperative with the bank while getting through the distressed period?

We cannot stress enough the importance of character.

Five Cs of Credit Management

To summarize, the 5 Cs of credit forms the basis of your banker’s analysis as they are considering your request for a loan. The banker needs to be sure that (1) your company generates enough CASH FLOW to service the requested debt, (2) there is sufficient COLLATERAL to cover the amount of the loan as a secondary source of repayment should the company fail, (3) there is enough CAPITAL in the company to weather a storm and to ensure the owner’s commitment to the company, (4) the CONDITIONS surrounding your business do not pose any significant unmitigated risks, and (5) the owners and management of the company are of sound CHARACTER, people that can be trusted to honor their commitments in good times and bad.

Hopefully, this article has succeeded in helping you understand where your banker is coming from. With a better understanding of how your banker is going to view and assess your company’s creditworthiness, you will be better prepared to deliver information and position your company to obtain the loan that it needs to grow and thrive. You should use these 5 Cs as a credit management tool to run your company. To improve your cash flow, download the free 25 Ways to Improve Cash Flow whitepaper.

5 Cs of credit, 5 Cs of Banking

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The 5 C’s of Banking

“The “5 C’s of credit” or “5 C’s of banking” are a common reference to the major elements of a banker’s analysis when considering a request for a loan. Namely, these are Cash Flow, Collateral, Capital, Character and Conditions. This article will provide an in-depth description of each of the 5 C’s of credit or banking to help you understand what your banker needs to understand about your business in order to approve your loan. By the end of this article, you will have insight as to where your banker is coming from. As a result, it will better prepare you to handle their questions and concerns.

The 5 C’s of Banking – Cash Flow Importance

Cash Flow is the first “C” of the 5 C’s of Credit (5 C’s of Banking). Your banker needs to be certain that your business generates enough cash flow to repay the loan that you are requesting. In order to determine this, the banker will be looking at your company’s historical and projected cash flow and compare that to the company’s projected debt service requirements. There are a variety of credit analysis metrics used by bankers to evaluate this. A commonly used methodology is the “Debt Service Coverage Ratio” generally defined as follows…”

For more tips on how to improve cash flow, click here to access our 25 Ways to Improve Cash Flow whitepaper.

5 C's of Banking
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5 C's of Banking

More at WikiCFO.com

1

The 5 C’s of Credit

The 5 C’s of credit or 5C’s of banking are a common reference to the major elements of a banker’s analysis when considering a request for a loan.

The 5 C’s of Credit

Namely, these are Cash Flow, Collateral, Capital, Character and Conditions. This article will provide an in-depth description of each of the 5 C’s of credit or banking to help you understand what your banker needs to understand about your business in order to approve your loan. By the end of this article, you will have insight as to where your banker is coming from. Therefore, it better prepare you to handle their questions and concerns…

More at WikiCFO.com

If you want more tips on how to improve cash flow, then click here to access our 25 Ways to Improve Cash Flow whitepaper.

5 C's of credit
Strategic CFO Lab Member Extra

Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

5 C's of credit

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