Chapter 27

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Text of Chapter 27

Outline: Chapter 1 Why Financial Management Matters The Issue of Small Business Finance
The business plan
Other government programs
Financial performance analysis
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No clear-cut definition
In government statistics, firms with fewer than 100 employees in the manufacturing sector, fewer than 50 employees in the service sector, or less than $5 million in sales
Small business is important to Canada's economy
As of June 1999, there were 1,833,005 registered businesses in Canada, of which 97.6 percent had fewer than 50 employees and 78 percent had less that 5 employees
Businesses with few than 100 employees accounted for almost 99 percent of all Canadians employed in the private-sector
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(concluded)
There were only 2,337 businesses in Canada with more than 500 employees
Between the second quarter of 1998 and the second quarter of 1999 more than 175,000 new jobs were created. Business with less than 50 employees accounted for 18 percent (32,177) of those new jobs, and medium-size firms, those with between 50 and 300 employees, accounted for 42 percent (69,677)
Small businesses constitute a large share of Canada's employment, sales and profits, and GDP
There is a high level of risk associated with small businesses during the first few years
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The Business Plan
The business plan is important both as a management tool and a vehicle for raising the necessary financing
Every business plan should contain the following elements
Executive summary
Brief discussion of the products, services, or technologies of the company, the market potential, a description of management personnel, and abbreviated financial forecasts
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The Business Plan
The business
Should contain a detailed description of the company, its environment, and its products or services
The financial section
Includes projected income statements, cash flows, and balance sheets
Integrates all of the other elements of the plan, expressed in dollars, and is a means of being able to consider whether the business is an attainable project
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Funding
The most common source of start-up financing is from personal funds through savings, a home mortgage, or relatives
Small businesses that want to expand find it difficult to raise funds
It has been estimated that less than 1 percent of external financing for small and medium-sized businesses is raised through the public equity markets
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Taxes
Individuals who own an unincorporated business share in the profits of the business based on a formal, or informal, agreement
Each owners share of the business's profits is then taxed at his or her personal tax rate, even if the profits are retained in the business
The maximum personal and large corporation tax rates are about the same. Therefore, if taxes were our only concern, it would seem as if taxation does not provide a significant incentive to incorporate
However, there is a significant difference between the federal tax rate for large and small corporate income
Currently, the federal small business tax rate of 21 percent applies to the first $200,000 of taxable income for all Canadian-controlled private corporations (CCPC)
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Taxes
(continued)
Since most small businesses earn less than $200,000, the correct comparison is between personal and small business total tax rates (49% versus 29.9% or 13.9% for non manufacturing businesses)
With this comparison we see that there may be a significant tax advantage to incorporation
If the owner's personal tax rate is higher than what the small business corporate tax rate is on the same amount of income then the business should be incorporated
If not, it would benefit the owner to operate an unincorporate business, i.e., a sole proprietorship or a partnership
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Taxes
(concluded)
Another incentive for a small business to incorporate is that all capital gains earned on the stock of small businesses are eligible for a $500,000 lifetime exemption
That is to say that the common shareholders of a small firm pay no taxes on their first $500,000 of capital gains
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Operating loans are lines of credit negotiated with the bank
Term loans of up to five years are made by chartered banks for plant expansion, renovation, equipment, land and buildings
Equipment financing loans are made by chartered banks to purchase equipment
Letters of credit are useful in international trade
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Seed money financing
A small amount of financing is needed to prove a concept or develop a product
Start-up and first-level financing
Financing for firms that need money for research and development, initial production, marketing, and the like
Second-level or developmental financing
Financing for firms that are producing and selling a product but are not breaking even yet
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Third-level or mezzanine financing
Financing for a firm that is producing a product, breaking even, and considering an expansion
Fourth-level of bridge financing
Financing provided for firms that are likely to go public within the next year
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(continued)
Because of the very high risk in first and second-level financing, and the long time before the firm is successful (if it ever is), venture capital firms are reluctant to invest in these stages
Venture capitalist will provide third-level, or mezzanine, financing for firms that are breaking even, and considering an expansion
Some venture capitalist will also provide fourth-level, or bridge, financing for small firms that are likely to go public shortly
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Extremely important since small businesses carry higher percentages of both current assets and current liabilities
Pledge or factor accounts receivable to secure funds
Use inventory financing techniques
Leasing
Allows a small business the use of machines, vehicles, office equipment, and buildings without a capital investment, responsibility for maintenance, or threat of rapid technological change
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Business improvement loans
Are offered under the Canada Small Business Financing Act (CSBFA) to finance up to 90% of new or additions to equipment, buildings, and leasehold improvements
Project financing
Project financing is the form of term loans provided by the Business Development Bank of Canada (BDC) to new and existing businesses that cannot obtain funds on reasonable terms and conditions from private-sector institutions to finance a specific undertaking
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Canada Small Business Financing Act (CSBFA)
The government guarantees to cover 85% of any losses due to failure of a qualified borrower up to $250,000
To qualify for a loan the firm's gross revenue must not exceed $5,000,000 in the application year
The lender charges a maximum interest rate of 3% over prime for floating-rate loans and the residential mortgage rate plus 3% for fixed-rate loans
The loans are secured by the assets financed and must be repaid within 10 years
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Business Development Bank of Canada (BDC)
Promotes and assists small and medium-sized businesses at either the start-up stage or at some other stage in their development
BDC financing is available through loans, loan guarantees, equity participation, or by any combination of these that best meets the needs of the small business
The majority of the financial assistance is in the form of term loans for the purchase of long-term assets
To be eligible for a BDC loan a firm must show that it is unable to obtain financing from private-sector institutions at reasonable rates and conditions
Thus the BDC is a "supplementary" source of funds to small- and medium-sized businesses and, therefore, is not in competition with private-sector institutions
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Other government programs
Because small businesses tend to be distributed across Canada, regional agencies have been set up to focus on specific regional concerns
Atlantic Canada Opportunities Agency
Federal Office of Economic Development for Northern Ontario
Western Economic Diversification Canada
Provide funds for business start-ups and expansions requiring longer time horizons to recoup investments, and take greater risk than the chartered banks will
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Obtaining Equity Financing
Small businesses have difficulty going public because of lack of marketability as well as disproportionately high issue costs
Small companies typically seek private sources of equity first, then enter the venture capital market
BDC has formed a venture capital division to address the problems of providing small business equity capital
BDC takes only a minority position and holds its investments for an average of from 4 to 7 years
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(concluded)
Small firms in "high tech" industries are likely candidates for an initial public offering - raising equity capital by going public with a stock issue
Potential costs result from flotation costs, underpricing of the new issue, the emphasis placed on short-term earnings by the requirement to filing quarterly financial statements, and undertaking lower NPV projects to bolster short-term earning at the expense of long-run firm value
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Liquidity is crucial to the success of small businesses
A basic need of small business management is the ability to prepare a monthly cash budget
There are many electronic spreadsheet programs that simplify this cash budgeting process immeasurably
The control of cash calls for a replanning process because of the need to make changes quickly so that the correct policy is properly executed
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Credit collection policy should include standards to assess the credit collection performance
Two important inventory strategies
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Financial Performance Analysis
Small businesses should use ratio analysis to achieve balanced growth and ensure survival
The most important ratios for small businesses
Current ratio
Quick ratio
Times interest earned
Net profit margin
Financial Control and Planning
Planning the Financial Future
Financial planning should be an integral part of the business plan
Financial planning allows the entrepreneur to anticipate financial problems and to develop solutions in advance
The basic components of financial planning are
The income statement
The balance sheet
The capital budget
(concluded)
Financial planning is an indication of what the entrepreneur perceives will happen and should reflect the ultimate profits resulting from operations
The goals, objectives and strategies of the firm should be considered
A system for providing continuous feedback about the progress being made in reaching the objective is necessary
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Small businesses face new challenges and opportunities from the information economy
Computer and telecommunication technologies have increased office efficiency and business capability
Small firms can now be competitive
Small business must look beyond local markets
Small business must make use of technology to remain competitive
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(concluded)
Small firms can enter into joint ventures to gain entry into broader markets and obtain current technology
Large firms can provide capital, expertise, technology and entry into new markets
Small firms can retain their flexibility and independence

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