Understanding what makes banks and lenders tick is no longer a major challenge for entrepreneurs. Nonetheless, there is often a gap that you should be aware of when you approach a lender. Generally, a banker will be looking critically and solely at the numbers, whereas you, the business owner, may be more concept or action oriented. The goal of your planning is to help narrow the gap.
Fair Market Value, Refinancing Your Business
The first step is to valuate your business, and there are three methods for determining fair market value:
- Asset-based approach — Total all asset and personal investments in the business to date. If possible, choose fair market values for assets.
- Market value approach — Look at comparable businesses that have sold recently and estimate the value of your business based on these considerations.
- Earnings approach — Use one or more years of historical or future earnings.
Next, look at ways to improve the value of the business using the following methods. Devise ways in each area that will make a difference to your business value in terms of:
- Increased income
- Improved assets
- Reduced liabilities
Businesses with an operating history may be asked for a financial analysis using key financial ratios. A financial ratio by itself is meaningless. It only becomes useful when compared over time or with industry standards. Industry ratios are available from the Industry Canada website and/or your industry association.
Debt-Paying Ability Ratios
- Current ratio: Current assets/Current liabilities
(should be 1.25:1 or 2:1)
- Quick ratio: Cash + accounts receivable/Current liabilities
(should be 1:1 or more)
- Debt to equity ratio: Total liabilities/Owner + investor equity
(should be 1:1 or 3:1)
Return on Investment Ratios
- Return on equity %: Net Profit x 100/Owner + investor equity (generally, should be above regular investment yields)
Efficiency and Performance Ratios (generally compared to the industry)
- Average collection period in days: Accounts receivable x 365 / Accounts receivable
- Cost of goods vs. inventory: 365 days / (Cost of Goods Sold / Inventory Value)
- Gross profit margin: Gross profit / Sales revenues
(should be steady or increasing each year)
- Sales growth %: Sales minus previous year sales x 100 / previous year sales
(should be above inflation)
Types of Loans Available to Finance Business Expansion
Accounts receivable financing: A form of financing in which receivables are pledged as security. Using receivables as security, usually less than 60-90 days old, borrowers sometimes receive up to 90% (typically 75%) in advance from a lender. This is also called 'factoring'.
Bridge loans: A form of borrowing to create cash flow over short periods, bridging the period of time between completion of a project and its payment.
Demand loan: A short-term loan with no fixed payments and a floating rate. Unlike some loans, borrowers can sometimes pay it off early without penalty. The lender's ability to "demand" full payment any time makes it risky for those with a peak-and-valley business.
Inventory financing: A form of financing in which inventory is pledged as security. The loan may be limited to 50% of the value on the inventory.
Line of credit: An agreement between a borrower and a lender that establishes the maximum amount that a borrower may draw upon. The agreement also sets out other conditions, such as how and when money borrowed against the line of credit is to be repaid.
Operating loan: A loan intended for short-term financing to support cash flow or to cover day-to-day operating expenses. These types of loans are often part of the line of credit.
Subordinated debt: A non-conventional financing instrument whereby the lender accepts a reduced rate of interest in exchange for equity participation.
Term loan: A loan intended for medium-term or long-term financing to supply cash to purchase fixed assets such as machinery, land or buildings, or to renovate business premises.