Chapter 27

©2002 Pearson Education Canada Inc., Toronto, Ontario 27-1

Economic Significance of Small Business The Issue of Small Business Finance

The business plan Funding Taxes

Obtaining Debt Financing Private sources Public sources Business Development Bank of Canada Other government programs

Outline: Chapter 27Small Business Finance


Obtaining Equity Capital Financial Control and Planning

Controlling credit, collections, and inventory Financial performance analysis Planning the financial future

Small Business in the Future

Outline: Chapter 27Small Business Finance

(concluded)


What is a small business? 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

Economic Significance of Small Business


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

Economic Significance of Small Business(concluded)


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

The Small Business Finance IssueThe 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

The Small Business Finance IssueThe Business Plan

(concluded)


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

The Small Business Finance IssueFunding


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)

The Small Business Finance IssueTaxes


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

The Small Business Finance IssueTaxes(continued)


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

The Small Business Finance IssueTaxes(concluded)


Types of bank loans 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

Obtaining Debt Financing Private Sources


Venture capital Initial financing stages are

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


(continued)


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


(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


(continued)


Working capital management 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 Trade credit is widely used

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


(concluded)


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

Obtaining Debt Financing Public Sources


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


(continued)


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


(continued)


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 Regional Development - Quebec 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


(concluded)


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

Obtaining Equity Financing


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

Obtaining Equity Financing(concluded)


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

Financial Control and Planning


The most difficult task is establishing a management policy

Credit collection policy should include standards to assess the credit collection performance

Two important inventory strategies Ordering economic quantities Establishing re-order points for inventories

Financial Control and Planning Controlling Credit, Collections, & Inventory


Small businesses should use ratio analysis to achieve balanced growth and ensure survival

The most important ratios for small businesses Current ratio Quick ratio Days sales outstanding Inventory turnover Total asset turnover Total debt to total assets Times interest earned Net profit margin Return on total assets Return on equity

Financial Control and Planning Financial Performance Analysis


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 statement of changes in financial position The capital budget

Financial Control and Planning Planning the Financial Future


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

Financial Control and Planning Planning the Financial Future

(concluded)


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

Small Business in the Future


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

Small Business in the Future(concluded)

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Chapter 27

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