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Financing CHAPTER 5 • Preferred stock may have sinking fund provisions for the repurchase of the stock. • Debt holders have a superior claim to assets in case of liquidation and have first claim to earnings. However, preferred stockholders’ claims are superior to common stockholders’. Taxes affect the amount of earnings needed to meet debt service and preferred stock dividends. However, because they receive different tax treatment, they affect earnings differently. Suppose that both debt and preferred stock command a return of 12 percent and the applicable corporate tax rate is 46 percent. To pay the 12 percent interest rate on debt, the firm has to earn 12 percent before taxes. Interest on debt is paid in before-tax dollars. To pay the 12 percent dividend for preferred stock, the firm has to earn 12 percent in after-tax dollars. For a 12 percent earnings after taxes, 22.2 percent—12 percent/ (1 − .46)—is required in before-tax dollars. Because dividends are paid in after-tax dollars, the firm has to earn more to pay a dividend of comparable worth to an investor than it has to earn for interest. The tax rate the company pays will have a great deal to do with the amount of dividend paid for two reasons: 1. The lower the company’s real tax rate, the more disposable cash it will have to reinvest and pay dividends. 2. The lower the company’s tax rate, the more flexibility it can have in designing dividend policies to be attractive to investors and enhance the goodwill and value of the firm. Private Placement of Stock A company may find itself with an excessive proportion of debt in relation to its equity, or there is no way to obtain additional debt, forcing the owner to go in search of equity. A private company accomplishes this through a private stock placement, where shares are sold to a limited number of individuals or business entities. It may be possible for company management to sell shares on an informal basis to friends and family, but this is at best a limited 157 SECTION Operating the Business II source of equity. When more equity is needed, you must search outside your circle of acquaintances. A formal private placement of stock may require the services of an investment banker with far-reaching connections. A reputable investment banker will require an in-depth review of the company to ensure that it is an acceptable investment vehicle for potential investors. Next the banker will construct an offering memorandum, which describes the type and terms of stock to be offered, its price, the company, and how the company plans to use the funds. The offering memorandum will then be sent to a group of prospective investors, followed by investment meetings where the management team makes presentations to investors. If all goes well, the investment banker then coordinates a closing where the investors pay the company for the proffered stock. Sounds easy? It is not. Finding the right investment banker who works well with the company is difficult, as is the writing of an offering memorandum, and presentations require long preparation and role-playing. And do not forget the investment banker’s fee. This can vary substantially, but expect some variation on the Lehman Formula, which is 5 percent of the first $1 million raised, 4 percent of the second $1 million, 3 percent of the third $1 million, 2 percent of the fourth $1 million, and 1 percent of all funds raised above that amount. For example, the fee for an investment banker who raises $5 million on behalf of the company will be $150,000. In addition, a banker may request a large number of warrants on the purchase of company stock in order to take advantage of any potential increase in the company’s value at a later date. Swapping Stock for Expenses Often equity is obtained to pay off short-term expenses. This is a two-step process of obtaining the equity from one party and using the resulting cash to pay off suppliers. You sometimes can short-cut this process by issuing stock directly to suppliers in exchange for their services. Although this can be an effective way to eliminate debts, it also sends a clear message to suppliers that the company is 158 Financing CHAPTER 5 short on cash. Thus, this approach usually only works once: when suppliers have already sent their bills to the company, and it responds by negotiating a stock payment in lieu of cash. If a company tries to convince suppliers in advance to take stock as payment, it is unlikely to have many takers. Stock Warrants A stock warrant is a legal document that gives the holder the right to buy a specific amount of a company’s shares at a specific price, and usually for a limited time period, after which it becomes invalid. The stock purchase price listed on the warrant is usually higher than the current market price at the time of issuance. A stock warrant can be used as a form of compensation instead of cash for services performed by other entities to the company, and it may be attached to debt instruments in order to make them appear to be more attractive investments to buyers. For example, say you are interested in obtaining debt at an especially low interest rate and attach stock warrants to a new bond offering in order to do so. Investors attach some value to the warrants, which drives them to purchase the bonds at a lower effective interest rate than would have been the case without the presence of the attached warrants. A company rarely sells stock warrants on their own in the expectation of receiving a significant amount of cash in exchange. Consequently, this is not a good way to directly obtain equity funding; rather it is used to reduce the cost of other types of funding or to reduce or eliminate selected supplier expenses. Stock Subscriptions Stock subscriptions allow investors or employees to pay a company a consistent amount over time and receive shares of stock in exchange. When such an arrangement occurs, a receivable is set up for the full amount expected, with an offset to a common stock subscription account. When the cash is collected and the stock is 159 SECTION Operating the Business II issued, the funds are deducted from these accounts and shifted to the standard common stock accounts. Stock subscriptions can be arranged for employees, in which case the amount invested tends not to be large, and is not a significant source of new equity financing. When it is used with investors, it typically involves their up-front commitment to make payments to the company as part of a new share offering and so tends to occur over a short time period, rather than involving small incremental payments over a long time frame. How to Obtain a Bank Loan A businessperson making a first-time loan application has greater reporting responsibilities and requirements than does a borrower who has been dealing on a continuing basis with a bank for shortterm financing. Once a bank has had good experience with a borrower, a loan request is much simpler. Usually the borrower need only provide updated information for an application that is on file. Bankers are also interested in information that is not always reflected in the financial statements. For example, they like to be informed about the borrower’s management capability, organizational strength, experience, and reputation. However, in addition to this reputation information, the bank generally will require completion of certain standardized reporting forms in order to evaluate the creditworthiness of the borrower. Some of these filing requirements will be discussed next. Projected Cash Flow Statements One of the most effective tools to determine the amount of the loan needed and its repayment date is the projected cash flow statement. The projections should disclose the significant assumptions used by management in preparing the cash forecast. Generally, past performance will serve as the basis for preparation, but it should be adjusted to reflect current trends. Two ways of making these adjustments are (1) pro forma and (2) an attrition allowance. Pro forma adjustments reflect changes in a company’s projected cash flow that 160 Financing CHAPTER 5 are nonrecurring; an attrition adjustment can be used to reflect recurring changes and expenses. For example, if the company has an agreement with labor for an annual increase of 7 percent, this would be treated as an additional allowance and grouped together with other recurring costs as an overall percentage adjustment to expenses. Nonrecurring expenses can be treated as one-item adjustments to individual expenses. An example of a typical nonrecurring item may be the payment of damages due to a loss in a personal injury lawsuit. It is not anticipated that in any succeeding period the company will lose a similar lawsuit. If it does, it should be treated as an attrition allowance. The cash flow statement should show a monthly estimate of receipts from all sources, such as cash sales, accounts receivable, miscellaneous income, and loans. The estimated expenditures should include capital improvement, accounts payable, taxes, payroll, other operating expenses, and repayment of loans. Financial Trends When bankers look at a company’s financial results, they are concerned not only with cash flow but also with other financial trends. The question may not be what the ratios are for the year, but rather how they compare with those of the previous years. The question that will be asked is: How does your financial picture (past, present, and projected) relate to the general economy and to the borrower’s industry? Banks generally keep a record of clients’ financial trends by periodically transcribing all of the vital balance sheet and operating statistics to a worksheet. Banks may calculate some of these key financial factors: • Profitability • Net working capital • Working capital or current ratio • Net quick ratio • Ratio of debt to net worth • Number of days of sales in accounts receivable • Number of days of purchases in accounts payable • Number of days of supply of inventory (related to cost of sales) 161 SECTION Operating the Business II These are discussed in Chapter 6, but the relevant ones are defined and briefly discussed here. Profitability. Profitability is a measure of how well the business has been doing. At least three ratios generate meaningful potential measures of a firm’s profitability: 1. Net profit to net sales 2. Gross profit to sales 3. Net profit to net worth It is important that a company be able to earn profits in a manner consistent with the capital invested and the expected growth. When the company shows that it has a high net profit, not only does it have debt-paying dollars, but it also has fresh capital to reinvest and support its own growth. These are indications of good management. A bank will be interested in looking at year-to-year profitability and noting any trends in ratios. Bankers will also want to see if the company’s flow of net profits into its working capital is growing. They will be interested in whether profits must be reinvested constantly in fixed assets. Also, a company that pays out all of its profits in dividends and salaries will be unable to show growth in net worth from this source. Bankers usually will add back noncash items, such as depreciation, to the net profit of the company to arrive at the cash flow or debt-servicing dollars available from profit. Caution must be emphasized here, for what the bank might be doing is looking to funds that are earmarked as a “reserve” for equipment replacement. Although the bank may be interested in the potential use of those funds for debt servicing in the worst case, enlightened bankers will also care about replacement of worn-out assets. The best bankers are concerned with the long-term needs of the business as well as protecting their own interests. Net Working Capital. The net working capital of the company is defined as the excess of the current assets over the current liabilities and is a significant factor to be considered for credit purposes. A bank expects a company to provide enough of its own normal 162 Financing CHAPTER 5 working capital to carry its inventory, accounts receivable, and other current assets at prudent levels. The company should be able to meet these obligations during nonpeak sales periods of the year. Thus, even during slow times, the bank expects the company to cover its current liabilities within the customary terms of trade. Working Capital or Current Ratio. This is the ratio of current assets to current liabilities. It is even more significant in the bank’s appraisal than in the working capital budget. For example, company A has current assets of $200,000, current liabilities of $100,000, and net working capital of $100,000. The working capital ratio is $200,000 to $100,000, or 2 to 1. Company B has current assets of $500,000, current liabilities of $400,000, and net working capital of $100,000. The working capital ratio is $500,000 to $400,000, or 1.25 to 1. Both firms show the same net working capital of $100,000, yet the first company is in a more favorable position because it has $2.00 in current assets from which to pay for each $1.00 in current liabilities in the event that it must liquidate assets. The second company has only a $1.25 to meet its current liabilities of $1.00. Therefore, based on this ratio, company A would be considered to be in a much stronger financial position. Net Quick Ratio. Another indicator bankers use to determine the ability of a company to pay its bills is the net quick ratio. This ratio is determined by taking the total of cash, short-term marketable securities, and net receivables, and dividing it by the total of current liabilities. This is a simple measure of the firm’s liquidity or the company’s ability to pay its debts. Again, a bank will be more concerned with the trend established by several years of net quick ratios. This will show the bank whether the company is increasing or decreasing its liquidity and hence its ability to meet its debt. Since cash and accounts receivables are far more current than inventory, this ratio is a good indicator of the relative short-term liquidity risk of the company. Ratio of Debt to Net Worth. Another test of the adequacy of the company’s net worth is the ratio of total debt, including current 163 SECTION Operating the Business II liabilities, to net worth. Banks, again, generally will rely on the trend in the ratio as well as the specific number itself. Other debt ratios are discussed in Chapter 6. Number of Days of Sales in Accounts Receivable. In calculating this number, these assumptions are made: • An even flow of sales • A uniformity in collecting accounts receivable The question here is the average number of days it takes the company to collect its accounts as compared with other firms within the same industry. The banks will factor in the number of days normal for the terms of the sale and those of the industry. For example: Assume a firm has average daily credit sales of $20,000 and accounts receivable are $1.8 million. The terms of the sale are 30 days. The first step is to divide the accounts receivable of $1.8 million by $20,000, the average daily credit sales. This indicates that 90 days of sales are still in accounts receivable and that the accounts receivable are taking longer to collect than the normal 30-day terms. In fact, on average, this company is collecting its accounts receivables 60 days after the expiration of the due date. This is 60 days more than the pricing policy allows; it is probably having considerable financial effects on cash flow. This also indicates that management may not be doing a good job of managing its accounts receivable. However, this may also be typical for the industry. If this is your situation, you should take some steps to try to improve your accounts receivable collection policy. You are loaning money to your customers for an average of 60 days more than you intended when you set your terms of sale. Number of Days of Purchases in Accounts Payable. This figure is computed by dividing the average daily purchases into the accounts payable. If, for example, the average daily purchases are $5,000 and the accounts payable are $150,000, the number of days purchases in accounts payable is 30 days. This number tells a banker quickly if the company is paying its bills promptly. Significant variations 164 Financing CHAPTER 5 from normal trade terms must be explained. If the company is on a net 30-day cycle, then it is meeting its obligations and perhaps obtaining all of the discounts it is entitled to under the terms of its purchase agreements. That question requires further examination. The ratio is helpful, but you should also be concerned with those accounts payable for which discounts were lost and not only the average payments. The company should be examining its aging of payables and monitoring discounts lost. Number of Days of Supply of Inventory. This number is computed by dividing the cost of the inventory by the average daily cost of sales, assuming an even flow of sales. The answer gives the banker the average number of days it takes the company to turn over inventory. The abuse that the bank is looking for here is excess inventory. This ratio will vary substantially from business to business. Supermarkets generally have very short inventory cycles, whereas automobile dealers have longer cycles. Other Supplemental Data. Other information that should be considered for submission in the loan request presentation includes: • A summary of insurance coverage. • An analysis of profitability by product line, if available and applicable. • Unusual events, historical or prospective, affecting the company. • Concentration, if any, of sales within a small number of customers. This shows the bank the reliance on a few select customers. If sales are concentrated in very few buyers, as in the aerospace industry, the risk associated with that industry may be considered to be somewhat higher. • Analysis of the effect of special situations on the company, such as a last-in, first-out (LIFO) method of inventory evaluation. Letters of Credit A company may not want to borrow any money from a bank; however, a prospective subcontractor or provider of raw materials may 165 SECTION Operating the Business II be unsure as to the company’s creditworthiness. A method for improving assumed creditworthiness that may be available at low cost is to purchase a letter of credit. If the company is new or is experimenting with a new product or product line, some vendors will refuse to sell it materials on a trade accounts payable basis. They would instead prefer to have the company establish creditworthiness by showing good payment records. A possible way around this problem is to obtain a letter of credit and, in effect, to use the good credit standing of a bank. By obtaining a letter of credit, the company is saying: “If we fail to pay you, the bank will pay you.” The bank then has recourse to the company for its money. In this way, the company is advancing the bank’s creditworthiness. Typically, letters of credit cost 1 percent of the amount the company wishes to advance, and a letter of credit normally is good for one year. The real cost of a letter of credit depends on how frequently the company wishes to purchase while using the letter of credit as a guarantee of payment. For example, suppose a supplier of raw materials wants money net 30 days but is willing to extend credit for 90 days if the company provides a letter of credit. Also, suppose that the letter of credit costs 1 percent. Because the company is having money advanced for two additional months for the cost of 1 percent, this is the same as borrowing money at 6 percent per annum, assuming the letter of credit and the materials purchased are the same amount. However, each time the company uses the guarantee of the letter of credit during the year, it is still taking advantage of that one-time payment of 1 percent. The more the firm uses the letter of credit, the cheaper (on a cost-per-transaction basis) the cost of the guarantee. The company may consider joint ventures. Joint ventures are, essentially, a technique whereby a company changes its organizational structure. However, this is still a form of financing whereby the financial creditworthiness of a collective entity is used to improve the market appearance to lenders and investors. The financial strength of two or more entities is put behind the joint venture entity. 166