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EXPERIENCE
UNIT 16 - FUNDING
Demand for Funds
investment proposals all involve funds and have to be evaluated.
the format for evaluation has already been discussed in the separate units dealing with feasibility analysis , viz:-
Feasibility Studies
Discounted Cash Flow
Investment Appraisal
Buying or Selling an Agency
each proposal will impact on both the balance sheet and profit and loss statement and therefore on the funds statement (see also the unit “Funds Statements”).
the demand for funds from these investment proposals is shown on the funds statement under the heading “Use of Funds”
other “demands” for funds arising out of the continuation of normal business include
the need for working capital (to finance increases in stock and debtors etc)
the need to repay loans or return capital
the need to finance expected losses
Supply of Funds
the best way to approach the process for identifying and evaluating alternative supplies of funds is perhaps to look at a case study
the case study which follows is called “Tour Products” and illustrates the evaluation process for alternative sources of supply of funds in terms of availability, cost and impact on liquidity, profitability and security. The supply options that will be considered are bank overdraft, short term loans, long term secured and unsecured loans, additional capital, off balance sheet leasing, asset disposal, sale and lease-back, joint venture and takeovers and mergers.
Case Study : TOUR PRODUCTS INC.
BACKGROUND
Tour Products Inc makes an array of specially shaped metal products used in the tourism and hospitality industry for gifts, mementoes, kitchen utensils and dining room cutlery. A new metallurgical process is used which combines high pressure moulding in very precise moulds for the shapes desired together with heat treatment. This process makes the products very distinctive with odd shapes that are difficult or impossible to produce by ordinary machining processes. Furthermore, the heat treatment process adds strengths and hardness which is a competitive advantage and the overall process achieves reduced unit costs and waste.
Four years ago, total industry sales of similar products was $108m. By last year, this had increased to $217m. Industry experts anticipate that whilst this rate of growth will not be maintained, an average increase over the next 10 years of 20% is anticipated.
Equipment purchased for use by this industry has on average an economic life of seven years.
CURRENT PERFORMANCE
After eights years the factory is now running on a two shift basis. The margin between prices and costs is improving reflecting an ability to get more attractive orders and improved efficiency in the factory. The company now has a four month backlog of orders.
The improvement in net profit in the last five years has been remarkable going from a staggering deficit to a 19% return on investment on shareholders’ funds.
Income Statement: (nearest $’000)
1990 1989 1988 1987 1986
Sales 3732 3019 1778 821 316
Cost of Sales 2631 2262 1325 644 530
Gross Profit 1101 757 453 177 - 214
Selling, & admin. 797 484 386 294 189
Net Profit 304 273 67 - 117 - 403
No Income Tax has been paid
because of the carried forward losses. At the beginning of 1990 the
loss carryover was $375,000.
FINANCING
Obtaining the capital necessary to finance Tour Products Inc has been a strain. In the early years the company relied on equity by the owner-founder, Mr Ogilvie, and his friends. Equipment was usually purchased at least in part with equipment mortgages. Other loans were secured.
About 3 years ago the company was successful in a significant re-capitalisation. $50,000 shares were sold to the public at $10 per share by a local investment banker.
An SBIC (Small Business Investment Corporation) called Development Finance Inc made a $2m mortgage loan to the company. The Development Finance loans runs for 10 years with $50,000 maturing quarterly ($200,000 per year) with an interest rate of 8.5% pa. As part of the deal, Development Finance receives share options for 50,000 shares at $8 per share which can be exercised any time during the 10 years that the loan is outstanding.
The injection of capital has not been adequate to support expanding production. New equipment to expand capacity has been financed with equipment mortgages. $300,000 of such mortgages were outstanding a year ago and an additional $600,000 were issued during the past year. These mortgages mature at the rate of $100,000 per year and bear 10% interest. Development Finance was willing to subordinate its claim on this new equipment because the added capacity improves its position and the viability of the share options.
Debts outstanding at that time
were either paid off or converted to shares.
The present financial structure of the company reflecting all of these funding arrangements is shown in Appendix A.
FUTURE OPPORTUNITIES
Top Management View
Mr Ogilvie is jubilant. “At long last we have the opportunity to have a balance sheet look the way the bankers like it. Assuming our net earnings stay constant, our cash flow from operations will be $520,000 from Net Profit of $304,000 and with depreciation added back $216,000. With this amount of cash we can make the annual debt repayments of $300,000 and still increase current assets by $220,000.”
”In two years time our current ratio would be 2:1 and our long term debt would only be 82% of shareholders’ funds. For anyone who has been squeezed for capital as we have for eight years, this is a good picture. Maybe the equipment mortgage people would stop insisting on my personal guarantee for those mortgages.”
“But we didn’t enter the business to tread water. We believe the industry will continue to grow rapidly and we want to be part of that. The risks are of course that too many competitors will try to get a piece of the action and/or some new technique may replace our technology. Even so, I feel that a 20% pa. growth factor is very conservative. We should be able to handle that and at the same time be more choosy about the orders we take to help our profit margin. Of course, if a real recession descends upon us, its a new ball game.”
“The main catch is that fast growth means more capital which we do not have. With an additional $500,000 in equipment we could produce a sales volume of $5m. Our factory building is big enough to handle $7m but as we move beyond the $5m, all kinds of machinery will be needed. Once we go beyond the $5m threshold for every extra sales dollar, we will need 80 cents worth of new machinery which means at the $7m level we would need new equipment of $1.6m.”
“Extra sales means extra working capital for inventory and debtors. This could be partially financed through creditors and accruals but my rough estimate is that the net increase in working capital would be about one-sixth of annual sales. Where is all that money coming from? Retained earnings will help, but in any one year during the growth period the profit on the added volume (say 9% of sales) won’t provide the necessary working capital (17% of sales).”
“I have asked our financial manager to explore all the different ways we might finance the business over the next four years. Once we look at each alternative we can sit down and figure out whether its wise to take the plunge.”
Alternative Sources of Capital
The financial manager has summarised the various potential ways Tour Products Inc might finance its growth as follows:
Bank Overdraft
The company’s bank suggests that we assume no growth this year and cut inventories by $100,000. This would allow the company to significantly improve its working capital position. Then the bank would make a short term loan of $500,000. If the inventory reduction were not feasible, it would require the pledging of its debtors. The interest cost would be prime rate plus 1.5% and a minimum balance requirements at all times of 20% of the loan. This minimum balance requirement is customary and means that the company would only get $400,000 for other uses. Assuming an 8% prime rate the interest cost would be 9.5% of $500,000 or $47,500 pa. On $400,000 this is equivalent to almost 12% pa.
Share Issue
The investment banker who helped sell the shares three years ago thinks that the improved company performance would create an interest in an additional share issue, in spite of the present depressed share market. However, the selling price to the public would be only $7.50 per share and after underwriting charges and other costs the company would receive $6.70 per share. Thus an issue of 75,000 shares would yield $502,000. Such an issue would improve debts/equity ratios. It would also water down the returns for the existing shareholders. For example, after the new issue the people who invested $500,000 three years ago when the risks were greater, would hold only 18% of the new total equity, whereas the new shareholders would have 27%.
Sale and lease-back
An investment broker, recommended by the bank, suggests selling the land and buildings (for $800,000) and the new equipment ($500,000). The $800,000 would be used to pay off existing equipment mortgages. The company would pay an annual lease rental equivalent to 9.5% on the amount advanced, initially $1.3m with a surcharge of 5% to cover the depreciation on the building and equipment. The lease would run for 20 years at which time the company would have an option to re-purchase the land, buildings and equipment for a residual value of 20% of the total $1.3m.
The company would continue to pay land tax and insurance just as if it owned the property. The interest portion of the rent would drop as the depreciation portion retired the loan. There would be a book loss on the land and buildings when the transaction is completed ($941,000 - $800,000) but this is not a real loss since the property could eventually be recovered on the basis of the $800,000 figure. Presently depreciation on the buildings is about $25,000 pa.
It is anticipated that Development Finance will waive its mortgage priority on the land and buildings because it will obtain a first mortgage on the equipment when the $800,000 equipment mortgages are paid off and because its share options will become more attractive.
Merger
Mr Fulton, a Sydney financier and president World Travel Corporation, proposes a merger with another small firm that he controls. The firm has a profitable bus operation which would be merged into Tour Products Inc. so that the profits from the bus operations would be off-set by the carry-forward losses of Tour Products Inc. World Travel Corporation owns the bus firm and would get 75% of the shares of the merged companies. Mr Fulton says he can always find capital for profitable investments, and he would be able to devise some scheme to provide whatever capital was required.
Merchant Bank Debt/Equity Placement
Development Finance is willing to advance more capital if the total debt structure is improved. It proposes a combined package of:
A $500,000 loan for the new equipment on the same terms as its present loan plus;
Purchase of 80,000 shares at $6 per share. The $480,000 generated, together with the $100,000 from reduction of inventories and the current earnings are to be used to retire the equipment mortgages.
The financial manager concludes that all five of the proposals focus primarily on raising $500,000 to expand production facilities and that this will enable the company to increase its sales to $5m.
At the projected rise in sales that takes care of the needs for only about 18 months. Consequently, any plan adopted must also consider the ability of the company at that time to raise further growth capital.
The financial manager also poses the following critical questions to be answered:
Should we buy the $500,000 worth of new equipment at this time?
If so, how should the expansion be financed?
What’s in it for the shareholders?
APPENDIX A Balance Sheet as at 30th June 1990
1989 1990
CURRENT ASSETS ($’000) ($’000)
Cash 89 199
Debtors 651 650
Inventories 308 637
Prepayments 61 89
Total Current Assets 1109 1575
FIXED ASSETS
Land and Buildings 909 941
Plant & Equipment 2244 2853
Furniture & Fittings 230 260
Sub-Total 3383 4054
less Provision for Depreciation 531 747
Total Fixed Assets (WDV) 2852 3307
INTANGIBLE ASSETS
Research & Development 83 74
TOTAL ASSETS 4044 4956
CURRENT LIABILITIES
Creditors 345 517
Accruals 73 109
Current portion of long-term debt 200 300
Total Current Liabilities 618 926
LONG TERM LIABILITIES
Long Term Loan 1800 1600
Equipment Mortgages 300 800
Total Long-term Liabilities 2100 2400
SHAREHOLDERS FUNDS
Issued Capital (200,000 shares at $1) 200 200
Share Premium 1800 1800
Paid Up Capital 2000 2000
Retained Earnings (674) (370)
Total Shareholders Funds 1326 1630
TOTAL LIABILITIES 4044 4956
Case Study Solution :
Step 1: Financial Analysis
Always analyse the financial statements first, before you read the detailed case notes (even in real life). This will help you maintain perspective and not get side-tracked on low priority issues and detail
Profitability:
Net Profit 304 / S.Funds 1326 is 22.9% (no tax impact)
Carry forward losses (see Retained earnings) are now 370 and will probably be consumed next year. Therefore the ROI after tax for the following year after that will fall significantly and may become unacceptable. This business needs continual profit improvement to improve liquidity, retire debt and build up healthy reserves to stimulate investor confidence and meet possible cyclical downturns
The profit history before 1986 has also been poor (reminding us to dig deeper than financial statements offered to us), calculated as follows
Retained Earnings 1990 (370)
Net profit 1988-1990 644
Retained Earnings 1987 (1014)
Net Loss 1986-1987 520
Retained Earnings 1986 (494)
the 22.9% becomes the minimum benchmark for assessing expansion proposals and funding alternatives
Liquidity:
Current Assets 1575 : Current liabilities 926
Current ratio 1.7 is too low
We need 1852 of current assets to secure a ratio of 2 which means another 277
Q. what sources are possible for this 277?
A. Increase in profit, long term liabilities or a reduction in fixed assets
Security:
LTLiabilities 2400 : SFunds 1630
Gearing is 1.47 : 1
A target of .5 would be more realistic which at current levels suggests that LTL should be no more than 815. In other words the business is already over-geared by as much as 1585
The significance of this is that the existing business operations (without expansion) must be improved to strengthen capital and retire debt etc
We must have a prima facie bias against further debt to finance expansion
Funds Statement for 1990
Source of Funds
Net Profit 304
+ Depreciation 216
Funds from Operations 520
Creditors 172
Equipment Mortgages 500
Current Portion LT Debt 100
Accruals 36
Research & Development 9
Debtors 1
1338
Use of Funds
Cash 110
Inventories 329
Prepayments 28
Land & Buildings 32
Plant & Equipment 609
Furniture & Fittings 30
Long Term Loan 200
1338
Conclusions
Q. How was the demand for funds (Use) financed?
A. In priority order by the supply (Source) of operating funds flow and equipment mortgages
Step 2 : Establish the
minimum funds required
We must establish the minimum case for demand for funds to finance the expansion including the extra fixed assets and working capital required and to sustain our debt repayments
Q. How much do we need?
A. The total minimum needed is $404,000 calculated as follows:-
extra current assets
extra working capital estimated 220
assume inventory cut
(as proposed by bank) 100 120
extra fixed assets 500
reduced long-term debt 300
Total Demand for funds (Use) 920
extra profit (say ) 300
add-back depreciation 216
minimum funds for any alternative (balancing item) 404
Total Possible Supply (Source) 920
Step 3: Examine the balance sheet impact for minimum funding
1990 Next Year
Current Assets 1575 +120 1695
Fixed Assets (Cost) 4054 +500 4554
Depreciation (747) - 216 ( 963)
Other Assets 74 - 74
Total Assets 4956 +404 5360
Current Liabilities 926 - 926
Long-term Liabilities 2400 -300 2100
Capital 2000 2000
Retained Profit (370) +300 (70)
Unclassified (minimum funds) - +404 404
Total Liabilities 4956 +404 5360
This can be portrayed in the following format (for each alternative)
|
MINIMUM FINANCE |
LAST YEAR |
+ |
- |
NEXT YEAR |
|
CURRENT ASSETS |
1575 |
120 |
|
1695 |
|
OTHER ASSETS |
3381 |
500 |
-216 |
3665 |
|
TOTAL ASSETS |
4956 |
|
|
5360 |
|
|
|
|
|
|
|
CURRENT LIABILITIES |
926 |
|
|
926 |
|
LONG-TERM LIABILITIES |
2400 |
|
-300 |
2100 |
|
CAPITAL |
2000 |
|
|
2000 |
|
RETAINED EARNINGS |
-370 |
300 |
|
-70 |
|
TOTAL LIABILITIES |
4956 |
|
|
4956 |
|
MINIMUM FINANCING |
0 |
404 |
|
404 |
|
ADJUSTED TOTAL LIABS |
4956 |
|
|
5360 |
Liquidity: 1695
/ 926 = 1.83 (a slight improvement on 1.7 but not enough. This
assumes the 404 is funded by LT Liabs or S Funds.
Security: 2100 / 1930 = 1.09 (a distinct improvement on 1.47 but this assumes the 404 is funded solely by S Funds)
Profitability:
300 / 1930 = 15.5% ROI (declining, suggesting 300 is not enough, certainly not enough if future taxes are allowed for).
the 15.5% would fall if interest was allowed for (assuming the 404 came from LT Liabs)
if the 404 was added to 1930 the result would be worse....300 / 2334 = 12.8%
to simplify the analysis for the rest of this case we shall ignore interest, but in real life this should be allowed for
Preliminary Conclusions:
the 300 profit improvement is only a continuation of the previous year and should be achieved without the expansion.
the expansion proposal must generate more profit if additional funds (from any source are to be considered).
this kind of preliminary homework must be done before anyone is approached for funds.
there are other considerations eg where is the business plan? Lenders and investors are sure to ask for this as well as answers to the basic questions we have already posed before we (and they) get carried away with the details of the proposal
Step 4: The Bank Loan alternative
we will assume the loan is short-term (a current liability)
there are two approaches
|
BANK LOAN |
MIN. FIN |
+ |
- |
NEXT YEAR |
|
CURRENT ASSETS |
1695 |
96 |
|
1791 |
|
OTHER ASSETS |
3665 |
0 |
0 |
3665 |
|
TOTAL ASSETS |
5360 |
|
|
5456 |
|
|
|
|
|
|
|
CURRENT LIABILITIES |
926 |
500 |
|
1426 |
|
LONG-TERM LIABILITIES |
2100 |
|
0 |
2100 |
|
CAPITAL |
2000 |
|
|
2000 |
|
RETAINED EARNINGS |
-70 |
0 |
0 |
-70 |
|
TOTAL LIABILITIES |
4956 |
|
|
5456 |
|
MINIMUM FINANCING |
404 |
0 |
-404 |
0 |
|
ADJUSTED TOTAL LIABS |
5360 |
|
|
5456 |
benchmark the bank loan alternative against the minimum finance alternative (as the chart below has done)
or (and?) benchmark against last years balance sheet. This approach is preferred
1990 Next Year
Current Assets 1575 +216 1791
Fixed Assets (Cost) 4054 +500 4554
Depreciation (747) -216 ( 963)
Other Assets 74 - 74
Total Assets 4956 +500 5456
Current Liabilities 926 +500 1426
Long-term Liabilities 2400 -300 2100
Capital 2000 2000
Retained Profit (370) +300 (70)
Unclassified (minimum funds) - - -
Total Liabilities 4956 +500 5456
note that the current assets 216 is the 120 from the minimum finance calculations (see above) plus the extra 96 from the bank (500 - 404)
the change of 216 for both current assets and depreciation is purely coincidental and there is no relationship between these figures
Liquidity: 1791 / 1426 = 1.26 (forget it! Why would the bank drag us into this option? A loan shark would do this to get you on the ropes so they could step in and pick up the pieces via selective breach of contract clauses)
Security: 2100 / 1930 = 1.09 (a distinct improvement on 1.47 but this statistic is of academic interest only given the disastrous liquidity prospect defined above)
Profitability:
300 / 1930 = 15.5% ROI (declining, suggesting 300 is still not enough, certainly not enough if future taxes are allowed for).
the 15.5% would fall if interest on the bank loan was allowed for
to simplify the analysis in this case we have ignored interest, but in real life this should be allowed for
Preliminary Conclusion:
we can safely rule this option out without wasting any time on detailed proposals and negotiations with the bank
a long-term loan may be worth looking at
this proves the value of ratios as financial objectives for use in preliminary screening
to save time (in other situations) we should prepare a “brief” laying down the criteria by which we (the prospective borrower’s are prepared to borrow)
Step 5 : Share Issue Alternative
there are two approaches
benchmark the bank loan alternative against the minimum finance alternative (as the chart below has done)
|
SALE OF SHARES |
MIN.FIN |
+ |
- |
NEXT YEAR |
||
|
CURRENT ASSETS |
1695 |
98 |
|
1793 |
||
|
OTHER ASSETS |
3665 |
0 |
0 |
3665 |
||
|
TOTAL ASSETS |
5360 |
|
|
5458 |
||
|
|
|
|
|
|
||
|
CURRENT LIABILITIES |
926 |
|
|
926 |
||
|
LONG-TERM LIABILITIES |
2100 |
|
0 |
2100 |
||
|
CAPITAL |
2000 |
502 |
|
2502 |
||
|
RETAINED EARNINGS |
-70 |
0 |
0 |
-70 |
||
|
TOTAL LIABILITIES |
4956 |
|
|
5458 |
||
|
MINIMUM FINANCING |
404 |
0 |
-404 |
0 |
||
|
ADJUSTED TOTAL LIABS |
5360 |
|
|
5456 |
||
or (and?) benchmark against last years balance sheet. This approach is preferred
1990 Next Year
Current Assets 1575 +218 1793
Fixed Assets (Cost) 4054 +500 4554
Depreciation (747) -216 (963)
Other Assets 74 - 74
Total Assets 4956 +502 5458
Current Liabilities 926 - 926
Long-term Liabilities 2400 -300 2100
Capital 2000 +502 2502
Retained Earnings (370) +300 (70)
Unclassified (minimum funds) - - -
Total Liabilities 4956 +502 5458
note that the current asset 218 is the 120 from the minimum finance calculation (see above) plus 98 (502 raised from the share issue, 75000 shares @ $6.70 = $502,500, say 502, minus the 404 minimum finance requirement)
the change of 216 for both current assets and depreciation is purely coincidental and there is no relationship between these figures
Liquidity: 1793 / 926 = 1.93 (an improvement on 1.7 last year)
Security: 2100 / 2432 = 0.86 (a distinct improvement on 1.47)
Profitability:
300 / 2432 = 12.3% ROI reflecting the watering down effect for the existing shareholders ie the same net profit must be shared over more shareholders
the target for the following year would need to be at least 486 (say 20% of 2432) to make it worthwhile for all shareholders
Preliminary Conclusion:
a better option for liquidity but questionable for profitability
the basic profitability issue remains. “Why can’t this business earn more than its current momentum profit 300 with the expansion?
Step 6 : The Sale & Lease-back Alternative
there are two approaches
benchmark the bank loan alternative against the minimum finance alternative (as the chart below has done)
|
SALE & LEASEBACK |
MIN.FIN |
+ |
- |
NEXT YEAR |
|
CURRENT ASSETS |
1695 |
96 |
|
1791 |
|
OTHER ASSETS |
3665 |
0 |
-1441 |
2224 |
|
TOTAL ASSETS |
5360 |
|
|
4015 |
|
|
|
|
|
|
|
CURRENT LIABILITIES |
926 |
0 |
|
926 |
|
LONG-TERM LIABILITIES |
2100 |
|
-800 |
1300 |
|
CAPITAL |
2000 |
0 |
|
2000 |
|
RETAINED EARNINGS |
-70 |
0 |
-141 |
-211 |
|
TOTAL LIABILITIES |
4956 |
|
|
4015 |
|
MINIMUM FINANCING |
404 |
0 |
-404 |
0 |
|
ADJUSTED TOTAL LIABS |
5360 |
|
|
4015 |
or (and?) benchmark against last years balance sheet. This approach is preferred
1990 Next Year
Current Assets 1575 +216 1791
Fixed Assets (Cost) 4054 -941 3113
Depreciation (747) -216 (963)
Other Assets 74 - 74
Total Assets 4956 -941 4015
Current Liabilities 926 - 926
Long-term Liabilities 2400 -1100 1300
Capital 2000 2000
Retained Earnings (370) +159 (211)
Unclassified (minimum funds) - - -
Total Liabilities 4956 -941 4015
note that the current asset 216 is the same as the minimum finance calculation (see above)
the change of 216 for both current assets and depreciation is purely coincidental and there is no relationship between these figures
the fixed assets last year of 4054 included 941 for land & buildings which are to be sold for 800 producing the following effects
capital (once only) loss of 141 which pulls the next year estimated profit down from 300 to 159
the remaining fixed assets (4054 - 941) are still held for 3113
we have ignored the fact that depreciation on the buildings is $25,000 and assumed (this time around during the rough screening process) that
none of the 747 accumulated depreciation relates to the land & buildings and therefore will not be considered in the 141 loss on sale calculation
the 216 depreciation will continue and be related to the remaining fixed assets
Liquidity: 1791 / 926 = 1.93 (an improvement on 1.7 last year)
Security: 1300 / 1789 = 0.73 (a distinct improvement on 1.47)
Profitability:
159 / 1789 = 8.8% ROI (as a once-only, this may be digestible), assuming the lease deal was done on the last day of the year
the 8.8% would fall if the lease rental was included. This would produce a net loss of 29 (159-188), assuming the lease deal was done on the first day of the year, calculated as follows
9.5% of $1.3m 123 ($123,500)
plus 5% depreciation surcharge 65 ($ 65,000)
188
if the following years result was 300 before lease rental the net profit would be only 112 (300 - 188)
the target for the following year would need to be at least 300 after lease rentals and if so the ROI would be 300 / say 2089 (1789 + 300) or 14.4%. Still not good enough to leave enough left over for shareholders after tax (the carry forward losses would be used up)
Preliminary Conclusion:
a better option for liquidity but highly questionable for profitability.
the basic profitability issue remains. “Why can’t this business earn more than its current momentum profit 300 with the expansion?
Step 7 : The Merger Offer
to vague to be capable of analysis
can be safely excluded for consideration
Step 8 : Merchant Bank Offer
there are two approaches
|
MERCHANT BANK OFFER |
MIN.FIN. |
+ |
- |
NEXT YEAR |
|
CURRENT ASSETS |
1695 |
76 |
|
1771 |
|
OTHER ASSETS |
3665 |
0 |
-300 |
3365 |
|
TOTAL ASSETS |
5360 |
|
|
5136 |
|
|
|
|
|
|
|
CURRENT LIABILITIES |
926 |
0 |
0 |
926 |
|
LONG-TERM LIABILITIES |
2100 |
500 |
-800 |
1800 |
|
CAPITAL |
2000 |
480 |
|
2480 |
|
RETAINED EARNINGS |
-70 |
0 |
0 |
-70 |
|
TOTAL LIABILITIES |
4956 |
|
|
5136 |
|
MINIMUM FINANCING |
404 |
0 |
-404 |
0 |
|
ADJUSTED TOTAL LIABS |
5360 |
|
|
5136 |
benchmark the bank loan alternative against the minimum finance alternative (as the chart below has done)
or (and?) benchmark against last years balance sheet. This approach is preferred
1990 Next Year
Current Assets 1575 +196 1771
Fixed Assets (Cost) 4054 +500 4554
Depreciation (747) -216 (963)
Other Assets 74 - 74
Total Assets 4956 +480 5436
Current Liabilities 926 - 926
Long-term Liabilities 2400 -300 2100
Capital 2000+480 2480
Retained Earnings (370) +300 (70)
Unclassified (minimum funds) - - -
Total Liabilities 4956 +480 5436
note that the current asset 196 is the minimum finance calculation of 120 (see above) plus the 76 surplus (480 - 404 minimum required)
the change of 216 for both current assets and depreciation is purely coincidental and there is no relationship between these figures
the change of 300 for LT Liabs is the normal repayment of 300 plus an additional 500 for retiring the equipment mortgages, totalling 800, and minus 500 for new loans
Liquidity: 1771 / 926 = 1.91 (an improvement on 1.7 last year)
Security: 2100 / 2410 = 0.87 (a distinct improvement on 1.47)
Profitability:
300 / 2410 = 12.4% ROI
the 12.4% would need to be adjusted favourably by interest calculations
Preliminary Conclusion:
a better option for liquidity and security but still questionable for profitability.
the basic profitability issue remains. “Why can’t this business earn more than its current momentum profit 300 with the expansion?
Step 9 : Final Conclusion
the search for funds is premature
no demonstrable improvement because of the expansion
need longer term profit & loss forecasts (say 5 years)
no business plan
no guarantee that the mistakes of the past have been finally dealt with (how were the losses for 1987, 1986 and before caused? Will these problems emerge in the next 5 years eg obsolescent product, business cycle, management problems)
the most promising alternative is the merchant bank offer, followed by the sale and lease-back offer. Both offers are premature and should only have been masked for and made after the long-term budgets and business plan were prepared
after the 5 yearly budgets are finalised we can then screen the alternatives using the ratios
wouldn’t it have been easier for the company (and us) to use a financial model on the computer!
What have we learned?
on the demand side we must make sure that realistic budgets and feasibility studies are prepared, particularly before we run around trying to get funds. Lenders and investors expect us to have done our homework on budgeting and business planning before-hand.
on the supply side we can pre-determine the best financial strategy by using our ratio analysis. Before we go in the door to request and negotiate we need to be sure we have the right strategy brief.
the rest of the process concerning finance contacts, meetings and detailed proposals is the easier part of the exercise. Fortunately there are specialists (who for a fee) can help the process.
What did you think of the fee for the investment banker? (75,000 shares @ $0.80 = $ 60.000). Not bad if it was only a few hours work to place most of the shares with a few institutional clients. However if a prospectus was involved together with the underwriting risk of taking up any shortfall in shares applied for, the fee might be quite reasonable. Shop around
Copyright © Bill Wright 1994
Copyright © 2000 Genesis Management Services Pty Ltd
Last modified: July 18, 2006