Finance

Accounting system is the most critical element of a business. Many businesses fail due to improper business system. A company should hire professionals for setting up the accounting system and handling the legal matters to make the efficient system.

i.Sources

For setting up a business money is required. Now the question is where to get the money from and how will it be used. A business owner can look for the investors to invest money in his/her business.

A company owner should ask few questions to himself like:

•  How much money is required for the business?
•  What type of lender is required?
•  Lender’s minimum and maximum loan size?
•  Will the lender be able to meet all the needs?
• What type of collateral is accepted by the lender?

Lenders use the following eight C’s rules:

•  Credit – must be good
•  Capacity – owner should be able to repay the loan
•  Capital – money required in the business
•  Collateral – assets to secure the loan
•  Character - you
•  Conditions – any condition that can effect the business like financial condition
•  Commitments – ability and willingness to succeed
•  Cash flow – can it support the expenses and debts
• Money can be obtained either through banks or through other financial institutions.
• Banks – In India, the banks can grouped into four categories based on the ownership structure. These categories are as follows:
•  Nationalized banks – Majority stake is held by the Government of India
•  Private sector banks – Major stake is held by private sector
•  Foreign banks – Majority stake is held by foreign shareholders
•  Cooperative banks – Majority stake is held by members of the bank

Banks provide financial assistance to businesses in the form of providing working capital and long term loan facility. Banks secure themselves by taking security of assets. In general, nationalized banks and Cooperative banks are more open to provide small ticket financial assistance also. Reserve Bank of India recognizes Dairying as a priority sector and therefore banks are more open to lending in this sector.

Other Financial Institutions - Other then banks, there are other financial institutions like Development Finance Institutions (DFIs) and Non-Banking Finance Companies (NBFCs). DFIs specialize in providing long term financial assistance i.e., long term loans and NBFCs specialize in asset backed funding i.e., lending against a collateral security like vehicles, house, machines etc. In India, most of the DFIs have converted themselves into banks and only few areleft – IFCI, SIDBI. Some of the well run NBFCs are Sriram Chit Fund,
Sundaram Finance, Tata Finance. NBFCs are generally fast in approving a loan proposal though they may charge a higher interest rate.

The obtained money will be used for furniture, machinery, space occupied, inventory,improvements and in day to day basis activities. Your business plan should provide all the details. The business income should cover all the expenses made.

ii. Debt and Equity

Debt and equity are two types of finances. It is important to decide which kind of finance will be appropriate for your business. Lets us discuss each of them one by one:

Debt is borrowing money and repaying it with some interest over a period of time. In debt financing, the only liability of the borrower is repayment of loan on time and the lender does not get any ownership. Lenders generally require the guarantee before providing loan. Debt is usually given to a company which offers some asset that may be pledged by the lender in case of non repayment of loan.

Debt financing can be of two types:

•  Short term – In short term, full repayment of the loan should be done in less than a year.
•  Long term – Repayment of the loan can be done in more than a year

If a company has too much debt, it becomes a risky business. Also, it becomes difficult to handle the down falls of business or any unanticipated circumstances.The other disadvantage of debt financing is that the interest has to be paid by the company under any circumstances. For a lender it’s important that the loan should be repaid either through income from the business or by selling the assets.

Equity financing involves sharing of business ownership in exchange of money. In this case money is not needed to be repaid over a specific period of time. Equity can be obtained through non-professionals like family, friends, colleagues etc.The major disadvantage of equity financing is possible loss of control over a business.

iii. Critical Factors in Taking a Loan

The points that you should consider before taking a loan are:

•  A company should not over borrow the money. The money should be borrowed to the extent a company is able to repay it.
•  Repayment schedule should match with the cash flows
•  A company should look for more than one bank or financial institutions simultaneously before finalizing.
•  If a business is large enough, or you have large personal wealth which can be used for business, then try and take loan from two banks or two financial institutions.

iv. Various Financial Statements

A financial statement is a written report which shows the net worth, assets and liabilities of a person or a company as of a specific date. Financial statements include personal financial statement, balance sheet, income statement, and cash flow statements. There are a few points to remember before making the financial statements:

•  Make assumptions that are real and can be implemented in future if some risk comes.
•  Show links between the past, present and future projects.
•  Enough capital should be there to meet all the expenses. Ask for enough funds.
•  Maintain all records.
•  Keep a good financial manager to maintain accounts
•  Assure the lender that loan will be repaid.

Let us discuss each of them one by one:

a. Personal Financial Statement

Personal financial statement includes financial status of each person who guarantees the loan. Financial statements should be made correctly because lenders review these statements very carefully. Sometimes lenders may ask you the questions about the risks, be ready to answer the questions. Generally the lenders provide their own personal financial statement form but usually the information asked is the same.

b. Balance Sheet

Balance sheet shows the cash position of the business and the owner’s equity at a given point. Balance sheet keeps changing. Balance sheet is divided into three parts:

Assets show the things that a company or your business owns. It includes the following points:

•  Currents Assets – Current assets is anything that can be converted into cash within a year.
•  Account receivable – Account receivable is the amount a customer has to pay to the company.
•  Inventory – Inventory is the list of goods which are there in company’s stock.
•  Total current assets – If we add all the current assets we will get the total current assets.
•  Non-current assets – Non-current assets are the assets which take more than a year to be converted into cash.
•  Fixed assets – property, plant, equipment, office furniture etc. fall into this category.
•  Depreciation
•  Fixed assets (net) = Total Fixed assets less Total depreciation
•  Advances to owners – Advances to owners is money taken out by the owners from the business for repaying the loan.
•  Total non-current assets – adding up all the non-current assets give the value of total non current assets
•  Total assets = Current assets + Non-current assets

Liabilities section shows how much a company owes to others i.e. bank or other financial institutions, suppliers, employees etc. The liabilities section includes:
 Current liabilities – Liabilities that are due to be discharged with in a year.
 Current portion of long-term debt – One year’s worth of loan payment.
 Accounts payable – Accounts payable is purchases made by the company for

which company has not made the payment.

•  Total current liabilities – Total current liabilities is sum of all the short-term liabilities.
•  Long term liabilities – Long term liabilities are those that become due for payment after a year.
•  Loan payable – Any amount taken from any financial institution or other sources,on which a certain interest is charged and that needs to be repaid is called loan.

Loans can be short term loan or long term depending upon the duration for which they are taken.

•  Total long-term liabilities – Total long-term liabilities are sum of all the long-term
• liabilities
•  Total liabilities = Long-term liability + Current liability

Net Worth

Definition for a company - Total assets minus total liabilities. Net worth is an important determinant of the value of a company, considering it is composed primarily of all the money that has been invested since its inception, as well as the retained earnings for the duration of its operation. Net worth can be used to determine creditworthiness because it gives a snapshot of the company’s investment history. also called owner’s equity, shareholders’ equity, or net assets.

Definition for an Individual – Net worth is the value of a person’s assets, including cash, minus all liabilities. The amount by which the individual’s assets exceed their liabilities is considered the net worth of that person.

The net worth section includes:

•  Owner’s investment – Owner’s investment is the money invested by the owner’s in the business
•  Retained earnings – Retained earnings is income earned through the business and kept in the business itself.
•  Total capital = Owner’s investment + Retained earnings
•  Net Worth = Total Assets less Total liabilities

c. Income and Expenditure Statement

Income or expenditure statement shows the financial performance of the business over a period of time. Income statement is divided into three parts.

Sales is further subdivided into:

•  Net Sales – Net sales is income after returns and allowances.
•  Cost of goods sold – This is the cost incurred in making the product.
•  Purchases and stock – Purchases are the income used to make product or simply put total value of the inventory i.e. present raw material stock, work in progress stock, and finished good stock.

 Labor

Total cost of goods sold – It includes the total cost incurred to make one unit of finished product. Multiplying this with the number of units produced would give the total cost of goods sold. The simple formula for calculating COGS is -Opening inventory + additions during the year less year end inventory.
 Gross profit margin – It is defined as sales realization less cost of goods sold.

Expenses are subdivided into:

•  Selling expenses – Salaries and expenses incurred on sales
•  General and Administrative – All expenses incurred to run the company
•  Operating income – Shows how the business is performing
•  Interest expense
•  Net profit before taxes – Income tax depends on the legal status of the business

Profit section shows profits made by the company after paying up all expenses.

d. Funds Flow Statement

Cash flow provides the details about the inflow and outflow of the cash in a business. Cash flows due to following three activities:

•  Operating activities – flow of cash due to normal operations of a business like selling.
•  Investing activities – flow of cash due to the purchase and sale of income-producing assets.
•  Financing activities – flow of cash between owners and creditors.

In cash flow statements income is written on the top followed by the expenses and repayment of the loan.

v. Financial Formulae

For a company it is important to find out whether it is earning profit. If a company is neither earning a profit nor a loss it is said to be operating at a break-even point. So, for a profitable business it is important to know how much more sale is required to make profit and for that break even point should be calculated.

vi. Ratios

Financial statements help in analyzing the financial information and ratios help in making the decisions. Ratios are calculated by the lenders before making decisions.

Numbers to calculate these ratios are taken from balance sheet and financial statements. Some important ratios are:

1. Asset Management Ratios: Asset management ratio consists of:

a. Accounts Receivable Turnover – shows the time taken to collect the bills.

(Accounts Receivable × 365 (days in a year)) /Net Sales= Days taken to collect the bill (Account Receivable turnover)

b. Inventory Turnover – shows the time taken to sell the inventory

(Accounts Receivable × 365 (days in a year))/ Cost of goods sold= Days taken to sell the inventry

(Inventory turnover)

For both the turnovers lower answer is better.

2. Liquidity Ratios: Liquidity ratios calculate the amount of cash available to cover the expenses. Liquidity ratios consists of:

a. Working capital – shows whether the company is in a position to pay the bills.

Current Assets - Current Liabilities = Working Capitalb. Quick or Acid test – checks if the company can pay all the expenses without selling the inventories.

Total current assets − inventory The Answer should be one or more than 1 = else it is said that the company can not pay Total current liabilitie is the expenses without selling the stock

c. Current – shows a company’s short-term debt paying capability.

Total current Assets / Total current liabilities = Number of times a company can pay current liabilities

3. Debt Management Ratios: Debt management ratios include:

a. Debt-Equity – shows if the company has enough equity. Higher the ratio better it is from a lender’s perspective. Lenders prefer if this ratio comes to 2 or lower than 2.

Total liabilities / Total capital = Debt-Equity

b. Accounts payable turnover – shows how fast a company makes the payment of its suppliers.

(Accounts Receivable × 365 (days in a year))/ Purchases= Account payable turnover

Lower number is considered to be better.

4. Profitability Ratios: Profitability ratios consist of:

a. Profit margin on sales – shows the percentage of profit for each sale.

Net profit/ Net Sales = Profit margin

b. Cash flow to current maturities – shows company’s capability to pay term debts after owner’s withdrawals. Lenders prefer the value to be 2 or more than 2.
(Net Profit + Depreciation) / Current portion of long-term debt