The cash flow statement is used to analyze the cash inflows and outflows
(where the money went) during a designated time period. Recall from the
introduction that there are three major components of cash flow: operations,
investing and financing.

If you regularly do a monthly profit and loss statement, you will be aware
that there are certain items which may not affect your profit and loss statement
for some time, such as:

• Substantial increase in inventory purchases;
• Increase in accounts receivable (money owed to you by customers);
• Reduction of credit by suppliers;
• Purchase of equipment;
• Unrecognized obsolescence of inventory (stale items);
• Bank’s refusal to renew or extend loan; and
• Lump sum payment of debt.

A cash flow statement will highlight these activities in a way that an income
statement will not. And certainly your banker will want to see a cash flow
statement showing how you have used the funds from a previous loan before they approve an extension or a new one. Without the cash flow statement, you will have an incomplete picture of your business (refer to the Interrelationship of
Financial Statements).

Preparing the Cash Flow Statement
In the lesson for preparing your annual cash flow projection, we detailed all
the operating sources and uses of cash (cash revenues, purchases, salaries,
rent, etc., etc.). This method may be easier when you are preparing a
projection, and can also be used to prepare your actual cash flow
statement at the end of the period. But you can also obtain the same result in
an easier manner, which we will illustrate in this lesson.

To determine operating cash flow, you start with net income and add back expenses which did not result in inflows or outflows of cash. The most
common non-cash expense is depreciation. When working with historical figures,
adjusting net income with depreciation and other non-cash expenses is much
simpler than determining all the revenues and expenses which require or provide
funds.

Next, you identify all the balance sheet accounts that are
associated with operations and determine the change in the account from
the end of the last period to the end of the current period. What balance sheet
accounts are we referring to? Let’s take another look at the operating cycle to
see what accounts to include.

Click on the cash cycle image for more information.

Operating cash flow will include all the balance sheet accounts that are a
part of normal operations. Trade receivables and payables as well as accrued
expenses, prepaid expenses and other current assets that are a part of
day-to-day operations are included in operating cash flow as we’ll show in the
example.

But what about the other balance sheet accounts - how do they fit in to this
picture? The remaining balance sheet accounts will either be investing
activities or financing activities. Once again, you determine the
change in each balance sheet account from the beginning of the period to the end of the period, tally them up, and there you have it — a complete picture of the cash flow for your company.

Let’s take a look at an example. We’ll begin with the Balance Sheet that we
used in the lesson on financial statements. You might want to go to this sample
Balance Sheet and print it out so that you can follow along. Ready, okay, then
let’s turn to the example and walk through the steps to preparing the cash flow
statement.

Catherine has what is known as a "cash flow problem. " That means that the cash flowing into her business is out of synch with the cash moving out. The result is that she is temporarily caught short when her bills come due. Catherine needs to plan ahead so she will know whether or not she will have enough cash available when she needs it.

How many of you have had something similar happen to you? Business analysts report that poor management is the major reason why most businesses fail. It would probably be more accurate to say that business failure is due to poor
cash management. So how can you manage your cash situation better? In this section we’ll take a look at the cash flow process to find out.

WHAT IS CASH?
Cash is ready money in the bank or in the business. It is not inventory, it
is not accounts receivable (what you are owed), and it is not property. These
might be converted to cash at some point in time, but it takes cash on hand or
in the bank to pay suppliers, to pay the rent, and to meet the payroll. Profit
growth does not necessarily mean more cash — as we will see.

A lesson that all entrepreneurs learn is the difference between profit and
cash. Profit is the amount of money you expect to make if all customers paid on
time and if your expenses were spread out evenly over the time period being
measured. However, it is not your day-to-day reality. Cash is what you
must have to keep the doors of your business open, while you are busy trying to
make a profit. Over time, a company’s profits are of little value if they
are not accompanied by positive net cash flow. You can’t spend profit;
you can only spend cash.

WHAT IS CASH FLOW?
Cash flow simply refers to the flow of cash into and out of a business over
a period of time. Watching the cash inflows and outflows is one of the major
management tasks of an owner. The outflow of cash is measured by those checks you will write every month to pay salaries, suppliers, and creditors. The
inflows are the cash you receive from customers, lenders, and investors.

POSITIVE CASH FLOW
If the cash coming "in" to the business is more than the cash going "out" of the business, the company has a positive cash flow. A positive cash flow is very good and the only worry here is what to do with the excess cash. Like good health, a positive cash flow is something you’re most aware of if you don’t have it.

NEGATIVE CASH FLOW
If the cash going "out" of the business is more than the cash coming "in" to the business, the company has a negative cash flow. A negative cash flow can be caused by a number of reasons. For example: too much or obsolete inventory or poor collections on your accounts receivable (what your customers owe you) can cause you to be short of cash. If the company can’t borrow additional cash at this point, the company may be in serious trouble.

WHAT ARE THE COMPONENTS OF CASH FLOW?
A Cash Flow Statement is typically divided into three components so that you can
see and understand the sources and uses of cash. These components include
internal and external sources: 

Operating Cash Flow
Operating cash flow, often referred to as working capital, is the cash flow generated from internal operations. It is the cash generated from sales of the product or service of your business. It is the real lifeblood of your business, and because it is generated internally, it is under your control.

Investing Cash Flow
Investing cash flow is generated internally from non-operating
activities. This component would include investments in plant and equipment or other fixed assets, nonrecurring gains or losses, or other sources and uses of cash outside of normal operations.

Financing Cash Flow
Financing cash flow is the cash to and from external sources, such as lenders,
investors and shareholders. A new loan, the repayment of a loan, the issuance
of stock and the payment of dividend are some of the activities that would be
included in this section of the cash flow statement.

HOW DO I PRACTICE GOOD CASH MANAGEMENT?
Catherine might have been able to avoid using her credit card to pay an
"unexpected" bill if she had been practicing good cash management. Good cash management is simple. It means:

1. Knowing when, where, and how your cash needs will occur,
2. Knowing what the best sources are for meeting additional cash needs; and,
3. Being prepared to meet these needs when they occur, by keeping good
   relationships with bankers and other creditors.

The starting point for avoiding a cash crisis is to develop a cash flow
projection. Smart business owners know how to develop both short-term (weekly, monthly) cash flow projections to help them manage daily cash, and long-term (annual, 3-5 year) cash flow projections to help them develop the necessary capital strategy to meet their business needs. They also prepare and use historical cash flow statements to gain an understanding about where all the
money went.

EQUITY

When an individual or an institution "invests" in your company,
they are making a capital contribution to your business. In return, they own and
have control over some portion of the business and will get repaid through profit sharing or when the company is sold.

The business has to have the following characteristics in order to be attractive to investors:

• High profit margins to provide attractive profit-sharing income (dividends) to the investors.
• Product or service must have significant market appeal and show the potential for rapid future expansion.
• Potential for a significant return on investment through an "exit strategy" such as "going public" or acquisition by a larger corporation.
  

Size of Equity Investment and potential Sources:
     Under $500,000:  go to private investors such as Ace-Net.
      $500,000 and up:  Small Business Investment Corporations
      $1 million and up:   Venture Capital
 

Funding Process:  lengthy and expensive

Attracting Private Investors

Most equity injections are provided through private investors.
This so-called angel market is estimated to be 5 to 10 times greater than the
institutional venture capital pool. The angel market is most often in search of
investments in the $50,000 - $500,000 range. The difficult task is finding these
investors because this market is highly fragmented and disorganized and has
often been part of the "old boy’s network."

Where to look for investors?

• Start with business acquaintances that understand and know
  your business acumen.
• Look for people in a similar business who could provide
  needed expertise and can see the potential of your business.
• Talk to your banker. (e.g. a recent client wanted to open a restaurant. When she talked to her local banker about financing he immediately referred her to several people in the community who would be interested in investing in a local restaurant.)
• Ace-Net, a new SBA computer matching service for investors and
  business owners.
• MIT Forum: started at MIT and the format has now been take around the
  world.

Many large cities in the U.S. have MIT Forums. Two types of services are offered:

Business Plan Review Committee A group of experts is gathered to
review your business plan and discuss it with the business owner.

Investor Forum Entrepreneurs can present their business concepts to
a group of potential investors and interested parties.

MIT Enterprise Forum Chapters can be found in:

California
Pasadena
San Diego
San
Francisco
Santa Barbara
 

Connecticut - Hartford

Illinois - Chicago

Massachusetts -
Cambridge

New York - New York City

Oregon - Portland

Pennsylvania - Pittsburgh

Texas:
Dallas/Fort Worth
Houston

Washington - Seattle

Washington, D.C.

International
Toronto, Cananda
Israel
Mexico
Taiwan
 

What are private investors looking for?

• Better returns than they could get on a portfolio of blue chip stocks but
  less than professional venture capitalists look for.
• In addition to financial gain, they also look for "psychic income." Based on their background, many investors want to contribute their expertise as well.
• Investors are looking for good management and industry potential.

What deal do I offer them?

When most people are faced with asking friends and family and other private
investors for capital, they have very little knowledge on how to approach the
deal to make it favorable for both the entrepreneur and the investor. With
investor financing as opposed to conventional financing, you can be creative and
flexible for the needs of the business.

For example: You could structure an agreement that has both debt and equity elements. Offer to repay the principal of the investment like a loan over a
certain period of time. Because the investor has offered to risk his/her capital
on your business, it is often required that you provide a "kicker" as well. This "kicker" could be a percentage of profits for several years. In the first year or so there may be no profits and therefore no "kicker". However in the ensuing years the investor may reap extra income as your business becomes profitable. Many people want to structure an agreement with an investor so that there is a timely exit for that investor. Many people do not want an investor involved in their business forever, but want to ensure they are paid off and out of the business in a reasonable period of time. Likewise investors want to know when they can reap their investment.

Be sure and consult with an attorney and get her to help you make all the
necessary disclosures, etc. — even though you are working with a private offering it requires careful analysis and legal agreements. Here’s some suggestions for communicating with potential investors:

1. Have a carefully designed business plan with a two or three page investor
   prospectus.
2. Investor prospectus should include:
   • how return on investment will be calculated and distributed
   • guarantees (if any) to reduce risk
   • exit requirements for the investor
   • length of time for the terms of the prospectus

For more information on the pros and cons of obtaining equity financing,
refer to the equity section of
Understanding Money Sources

Why do women have more difficulty in accessing equity? Unfortunately, it is still a fact that women business owners have more difficulty accessing capital than men. There are a number of reasons this is still the case.

1. Women lack financial networks.
2. Women are more reluctant to ask for money - "they want to do it on their own"
3. Women generally turn to debt financing first and are not aware of other
   options.
4. Women business owners are often not sophisticated in business finance.
   They don’t understand
   The Power of Leverage or how properly balance debt and equity capital.
5. Not enough women business owners "think big". Few women start their business with a vision on how it can expand into new markets and product lines.

Solutions

1. Educate women business owners on the options of obtaining equity
   financing.
2. Provide a better network for women who need assistance preparing for
   equity financing and finding potential investors.
3. Advocate incentives to increase the flow of investment capital to
   women-owned businesses.
4. Develop and expand equity networks targeted to women-owned businesses.

Have thoughts or questions on women’s access to capital? Post your comments in the
Info Exchange/Women’s Access to Capital
 

DEBT

Debt financing is when you borrow money from a bank or alternative financial
institution. The lender expects to get paid back over a specified period. In order to make sure that the lender will be paid back, the lender determines if there is enough cash flow to repay the debt and asks for a lien on additional assets that can be sold to repay the debt if a borrower defaults. A business is considered to be attractive to lenders if it displays the following characteristics:

• Borrower has good personal and business credit history that indicates good
  "character".
• Business financial history indicates there is enough cash flow to repay
  the loan or,
• There is substantial information provided which shows the potential for
  the business to generate enough profit to repay the loan.
• The business is not carrying significant debt already (debt/net worth
  should not be more than 4:1).
• The business and borrower have sufficient collateral to offer as a second
  source of repayment.

Types:

Term loans: Usually for start-up, expansion, purchasing of fixed
assets, real estate and other one-time costs that have to amortized over time.
Working capital can often be included in a term loan.

Line of Credit: Usually to cover variable/seasonal or working
capital needs of the business. Money is borrowed for short periods of time,
can be repaid, and then is required again.

Special Loan Programs: Government (SBA, state, city) and alternative
loan programs (e.g.microloans) offer primarily term loans and some lines of
credit . Most loan programs are offered in conjunction with a bank. Special
loan programs are used when:

• There is insufficient collateral
• There is insufficient owner equity or downpayment
• Loan is considered "risky" because of the type of industry, the business is a start-up or emerging business, or there may be a problem in the ability to repay the debt through traditional means.
• Loan size is small (under $25,000 are often originated through microloan
  programs).

Funding Process: Once all documentation has been received and reviewed, many bank loans can be closed within 2-3 weeks. If a special loan program is used the processing time can increase to 6-8 weeks.

For more information check out the following:
Understanding Money Sources for additional information on the types
of loans and collateral and Borrowing and Lending for a complete discussion on the loan process.

ALTERNATIVE FINANCING

Accounts receivable financing, purchase order financing, contract financing,
and leasing are other types of financing. For more information on this type of
financing check out Understanding Money Sources

OBJECTIVES FOR THIS LESSON

This lesson has been designed to help the small business owner in the following
ways:

• Recognize those situations that create a need for additional capital.
• Identify the capital sources that are available to the small business owner.
• Manage the business judiciously to take full advantage of the capital that can
  be generated internally.
• Understand how to take full advantage of trade credit without jeopardizing
  credit status.
• Identify various types of debt available to the small business.
• Identify collateral that can be used to secure loans.
• Introduce the concept of equity capital and related issues.

HOW THE NEED FOR CAPITAL ARISES

As your business grows, so does your need for more and more capital. Remember
there is more than one way and more than one place to raise the money you need.
You need to understand the reasons that additional capital is needed — this
will play an important role in choosing the right form of additional capital for
your business.

There are many factors that can create a need for additional capital. Some of
the more common are as follows:

• Sales growth requires inventories to be built to support the higher sales
  level.
• Sales growth creates a larger volume of accounts receivable.
• Growth requires the business to carry larger cash balances in order to
  meet its current obligations to employees, trade creditors, and others.
• Expansion opportunities such as a decision to open a new branch, add a new
  product, or increase capacity.
• Cost savings opportunities such as equipment purchases that will lower
  production costs or reduce operating expenses.
• Opportunities to realize substantial savings by taking advantage of quantity discounts on purchases that will lower production costs or reduce
  operating expenses.
• Opportunities to realize substantial savings by taking advantage of quantity discounts on purchases for inventory, or building inventories prior
  to a supplier’s price increase.
• Seasonal factors, where inventories must be built before the selling
  season begins and receivables may not be collected until 30 to 60 days after
  the selling season ends.
• Current repayment of obligations or debts may require more cash than is
  immediately available.
• Local or national economic conditions which cause sales and profit to
  decline temporarily.
• Economic difficulties of customers that can cause them to pay more slowly
  than expected.
• Failure to retain sufficient earnings in the business.
• Inattention to asset management may have allowed inventories or accounts
  receivable to get out of hand.

Combination.   Frequently, the cause cannot be entirely attributed to
any one of these factors, but results from a combination. For example, a
growing, apparently successful business may find that it does not have
sufficient cash on hand to meet a current debt installment or to expand to a new
location because customers have been slow in paying.

Short- and Long-Term Capital.   Capital needs can be classified as
either short- or long-term. Short-term needs are generally those of less than
one year. Long-term needs are those of more than one year.

Short-Term Financing.   Short-term financing is most common for
assets that turn over quickly such as accounts receivable or inventories.
Seasonal businesses that must build inventories in anticipation of selling
requirements and will not collect receivables until after the selling season
often need short-term financing for the interim. Contractors with substantial
work-in-process inventories often need short-term financing until payment is
received. Wholesalers and manufacturers with a major portion of their assets
tied up in inventories and/or receivables also require short-term financing in
anticipation of payments from customers.

Long-Term financing.   Long-term financing is more often associated
with the need for fixed assets such as property, manufacturing plants, and
equipment where the assets will be used in the business for several years. It
is also a practical alternative in many situations where short-term financing
requirements recur on a regular basis.

Recurring Needs.   A series of short-term needs could often be more
realistically viewed as a long-term need. The addition of long-term capital
should eliminate the short-term needs and the crises that could occur if capital
were not available to meet a short-term need.

Steady Growth.   Whenever the need for additional capital grows
continually without any significant pattern, as in the case of a company with
steady sales and profit from year to year, long-term financing is probably more
appropriate.

AVAILABLE SOURCES OF CAPITAL

In order to secure the capital they need, small business owners must
understand the various sources of money that are available to them such as the
following:

• Capital generated internally
• Capital available from trade creditors
• Borrowed money
• Sale of an ownership interest in the business to equity investors.

Each of these capital sources has unique characteristics. These characteristics must be fully understood by the small business owner so that he
or she will know what sources are available and which source is best suited to
the needs of the business.

MANAGING INTERNAL CAPITAL

Internal sources of capital are those generated within the business. External
sources of capital are those outside the business such as suppliers, lenders,
and investors. For example, a business can generate capital internally by
accelerating collection of receivables, disposing of surplus inventories,
retaining profit in the business or cutting costs.

Capital can be generated externally by borrowing or locating investors who
might be interested in buying a portion of the business.

Before seeking external sources of capital from investors or lenders, a
business should thoroughly explore all reasonable sources for meeting its
capital needs internally. Even if this effort fails to generate all of the
needed capital, it can sharply reduce the external financing requirements,
resulting in less interest expense, lower repayment obligations, and less
sacrifice of control. With a lower requirement, the business’s ability to secure
external financing will be improved. Further, the ability to generate maximum
capital internally and to control operations will enhance the confidence of
outside investors and lenders. With more confidence in the business and its
management, lenders and investors will be more willing to commit their capital.

Internal Sources of Capital.   There are three principal sources of
internal capital:

• Increasing the amount of earnings kept in the business.
• Prudent asset management.
• Cost control.

Increased Earnings Retention.   Many businesses are able to meet all
of their capital needs through earnings retention. Each year, shareholders’
dividends or partners’ draws are restricted so that the largest reasonable
share of earnings is retained in the business to finance its growth.

As with other internal capital sources, earnings retention not only reduces
any external capital requirement, but also affects the business’ ability to
secure external capital. Lenders are particularly concerned with the rate of
earnings retention. The ability to repay debt obligations normally depends
upon the amount of cash generated through operations. If this cash is used
excessively to pay dividends or to permit withdrawals by investors, the
company’s ability to meet its debt obligations will be threatened.

Asset Management.   Many businesses have non-productive assets that
can be liquidated (sold or collected) to provide capital for short-term needs.
A vigorous campaign of collecting outstanding receivables, with particular
emphasis on amounts long outstanding, can often produce significant amounts of capital. Similarly, inventories can be analyzed and those goods with relatively slow sales activity or with little hope for future fast movement can be liquidated. The liquidation can occur through sales to customers or through sales to wholesale outlets, as required.

Fixed assets can be sold to free cash immediately. For example, a company automobile might be sold and provide cash of $2,000 or $3,000. Owners and employees can be compensated on an actual mileage basis for use of their personal cars on company business. Or if an automobile is needed on a full-time basis, a lease can be arranged so that a vehicle will be available.

Other assets such as loans made by the business to officers or employees,
investments in non-related businesses, or prepaid expenses should be analyzed closely. If they are non-productive, they can often be liquidated so that cash is available to meet the immediate needs of the business.

Any of the above steps can be taken to alleviate short-term cash shortages.
On a long-term basis, the business can minimize its external capital needs by
establishing policies and procedures that will reduce the possibility of cash
shortages caused by ineffective asset management. These policies could include
the establishment of more rigorous credit standards, systematic review of outstanding receivables, periodic analysis of slow-moving inventories, and establishment of profitability criteria so that fixed asset investments are most closely controlled.

Cost Reduction .   Careful analysis of costs, both before and after the fact, can improve profitability and therefore the amount of earnings available for retention. At the same time, cost control minimizes the need for cash to meet obligations to trade creditors and others.

Before the fact, a business can establish buying controls that require a written purchase order and competitive bids on all purchases above a specified amount. Decisions to hire extra personnel, lease additional space, or incur other additional costs can be reviewed closely before commitments are made.

After the fact, management should review all actual costs carefully. Expenses can be compared with objectives, experience in previous periods, or with other companies in the industry. Whenever an apparent excess is identified, the cause of the excess should be closely explored and corrective action taken to prevent its recurrence.

TRADE CREDIT

Trade credit is credit extended by suppliers. Ordinarily, it is the first source of extra capital that the small business owner turns to when the need arises.

Informal Extensions.   Frequently, this is done with no formal planning by the business. Suppliers’ invoices are simply allowed to "ride" for another 30 to 60 days. Unfortunately, this can lead to a number of problems. Suppliers may promptly terminate credit and refuse to deliver until the account is settled, thus denying the business access to sorely needed supplies, materials, or inventory. Or, suppliers might put the business on a C.O.D. basis, requiring that all shipments be fully paid in cash immediately upon receipt. At a time when a business is obviously strapped for cash, this requirement could have the same effect as cutting off deliveries all together.

Planning Advantages.   A planned program of trade credit extensions can often help the business secure extra capital that it needs without recourse to lenders or equity investors. This is particularly true whenever the capital need is relatively small or short in duration.

A planned approach should involve the following:

• Take full advantage of available payment terms. If no cash discount is
  offered and payment is due on the 30th day, do not make any payments before
  the 30th day.
• Whenever possible, negotiate extended payment terms with suppliers. For
  example, if a supplier’s normal payment terms are net 30 days from the receipt
  of goods, these could be extended to net 30 days from the end of the month.
  This effectively "buys" an average of 15 extra days.
• If the business feels that it needs a substantial increase in time, say 60
  to 90 days, it should advise suppliers of this need. They will often be
  willing to accept it, provided that the business is faithful in its adherence
  to payment at the later date.
• Consider the effect of cash discounts and delinquency penalties for late
  payment. Frequently, the added cost of trade credit may be far more expensive
  than the cost of alternate financing such as a short-term bank loan.
• Consider the possibility of signing a note for each shipment, promising
  payment at a specific later date. Such a note, which may or may not be
  interest-bearing, would give the supplier evidence of your intent to pay and
  increase the supplier’s confidence in your business.

Ready Availability.   Trade credit is often available to businesses on a relatively informal basis without the requirements for application, negotiation, auditing, and legal assistance often necessary with other capital sources.

Usage.   Trade credit must be used judiciously. Its easy availability is particularly welcome in brief periods of limited needs. Used
imprudently, however, it can lead to curtailment of relations with key suppliers
and jeopardize your ability to locate other, competitive suppliers who are willing to extend credit to your business. Remember, that on the other side of the transaction there is another business that is trying to manage its sources
of capital, too!
 

DEBT - TYPES & AVAILABILITY

Debt capital.  Debt is an amount of money borrowed from a creditor. The amount borrowed is usually evidenced by a note, signed by the borrower, agreeing to repay the principal amount borrowed plus interest on some predetermined basis.

Borrowing Term.   The terms under which money is borrowed may vary widely. Short-term notes can be issued for periods as brief as 10 days to fill an immediate need. Long-term notes can be issued for a period of several years.

Discounted Notes.   In some case, particularly in short-term borrowing, the total amount of interest due over the term of the note is deducted from the principal before the proceeds are issued to the borrower. Such a note is called a discounted note.

Short-term Borrowing.   Short-term borrowing usually requires repayment within 60 to 90 days. Notes are often renewed, in whole or in part, on the due date, provided that the borrower has lived up to the obligations of the original agreement and the business continues to be a favorable lending risk.

Credit Lines.   When a business has established itself as being worthy of short-term credit, and the amount needed fluctuates from time to time, banks will often establish a line of credit with the business. The line of credit is the maximum amount that the business can borrow at any one time. The exact amount borrowed can vary according to the needs of the business but cannot exceed its established credit line.

These arrangements give the business access to its requirements up to the
credit limit or line. However, it pays interest only on the actual amount
borrowed, not the entire line of credit available to it.

Long -term Debt.   Long-term debt is borrowing for a period greater than one year. This general classification includes "intermediate debt" which is borrowing for periods of one to 10 years.

Repayment Schedules.   When the terms of a debt are negotiated, a payment schedule is established for both interest obligations and principal repayment. The dates on which principal and interest payments are due should be scheduled carefully. For example, a manufacturer with heavy sales just before Christmas and receivables collections through January might best be able to schedule repayments in February. If a payment were due in October or November, when inventories were high and receivables were climbing, the payment could be crippling.

Mortgage Loan Repayment Schedules.   Principal and interest payments on mortgages usually involve uniform monthly payments that include both principal and interest. Each successive monthly payment reduces the amount of principal outstanding. Therefore, the amount of interest owed decreases and the portion of the monthly payment applicable to principal increases. In the early years of a mortgage, the portion of the monthly payment applied against the principal is relatively small, but grows with each payment.

Term Loan Payment Schedules.   For term loans, payment of principal and interest is ordinarily scheduled on an annual, semiannual or quarterly basis.

For example, a 5-year, $50,000 term note bearing 10%
interest might have the following payment schedule specified in the note
agreement:

 

End of Year	Principal Repayment	Principal Outstanding	Interest Payment @ 10%
1	$10,000	$50,000	$5,000
2	$10,000	$40,000	$4,000
3	$10,000	$30,000	$3,000
4	$10,000	$20,000	$2,000
5	$10,000	$10,000	$1,000

Availability.   Commercial banks are the ordinary source of short-term loans for the small business. For small businesses, borrowed capital for periods greater than 10 years is usually available only on real estate mortgages. Other long-term borrowing usually falls into the "intermediate" classification and is available for periods up to 10 years. Such loans are called "term loans."

Selecting Type and Term.   The type and term of the loan should be based on the purpose for which the funds will be used. Your banker or accountant can help you determine what type of loan is best to meet your needs. See if you can

"pass the test" and match the loan request with the appropriate borrowing arrangement.
 

COLLATERAL

Loans may be secured or unsecured. In a secured loan, the borrower pledges certain assets as collateral (security) to protect the lender in case of default on the loan or failure of the business. If the business defaults on the loan
through failure to meet interest obligations or principal repayments, the
noteholder (lender) assumes ownership of the collateral. If the business fails,
the noteholder claims ownership of those specific assets pledged as collateral
before the claims of other creditors are settled.

Typical Collateral.   In long-term borrowing, fixed assets such as real estate or equipment are usually pledged as collateral. For short-term borrowing, inventories or accounts receivable are the usual collateral.

Inventory Financing.    Inventory financing is most commonly used in automobile and appliance retailing. As each unit is purchased by the retailer, the manufacturer is paid by the lender. The lender is repaid by the retailer when the unit is sold. Interest is determined separately for each unit, based upon the actual amount originally paid by the lender and the period between the time the money is paid the lender is reimbursed by the retailer.

Accounts Receivable Financing.    Basically, accounts receivable financing falls into two categories as follows:

• Assignments. The business pledges, or "assigns" its receivables as collateral for a loan
• Factoring. The borrower sells its accounts receivable to a lender
  (factor).

Although these arrangements are not loans, in a pure sense, the effect is the
same.

Receivables Assignments.   When receivables are assigned, the amount of the loan varies according to the volume of receivables outstanding. Normally the lender will advance some specified percentage of the outstanding accounts receivable up to a specific credit limit.

For example, look at the schedule below. The company can
borrow up to 80% of assigned receivables, up to a maximum of $100,000.

On the first line, accounts receivable are $100,000 and the amount loaned is
80% of $100,000 or $80,000. Similarly, on the second line, outstanding
receivables are $125,000. The amount loaned increases to $100,000 ($125,000 X
0.80). On the third line, accounts receivable are $150,000. Eighty percent of
this amount would be $120,000. However, this exceeds the established limit of
$100,000. Therefore, borrowing is restricted to the $100,000 limit.

In many industries, accounts receivable financing is considered a sign of
weakness. However, it is quite common in others. This is particularly true in the garment industry and in personal finance companies. When accounts receivable
are assigned, the borrower is still responsible for collection. Upon collection of any receivable, the amount borrowed should be repaid. Interest is based upon
the amount borrowed and the time between receipt of proceeds by the borrower and repayment.

Factoring Accounts Receivable.   When accounts receivable are factored, they are sold to the factor and the borrower has no responsibility for collection. The borrower pays the factor a service charge based upon the amount of each receivable sold. In addition, the borrower pays interest for the period between the sale of the receivable and the date the customer pays the factor

Since the factor is responsible for collection, it will only purchase those
receivables for which is has approved credit. When customers must pay invoices
directly to a factor, it may create doubts about the company’s financial stability and, therefore, its ability to deliver. However, factoring is also common in some industries. For example, high tech companies often factor receivables to finance growth and research and development and consider this a way to outsource part of their accounting activities.

Unsecured Debt.    The secured creditor’s risk is reduced by the claim against specific assets of the business. In default or liquidation, the secured creditor can take possession of these assets to recover any unpaid amounts due from the business. Holders of unsecured notes do not enjoy the same protection. If the company defaults on a payment, the unsecured creditor, under normal circumstances, can only re-negotiate the amount due, perhaps by seeking collateral, or force the company to liquidate. In liquidation, the holder of an unsecured note would normally have no rights that are superior to those of any other creditors.

Restriction On business.    When accepting an unsecured note, the lender will often place certain restrictions on the business. A typical restriction might be to prevent the company from incurring any debt with a prior claim on the assets of the business in the event of default or failure. For example, a term note agreement might prevent a company from financing its receivables or inventories since this would result in a prior claim against the assets of the business in liquidation. Such restrictions may have no effect on
the business’ ability to operate. However, in other cases, such restrictions could be severe. For example, a business may have a chance to sell to a major new customer. The new customer may insist upon 60 day credit terms which will
require the business to seek additional external financing. Normally, this financing might be readily available on realistic terms from a factor. However, the restriction of the unsecured note could prevent the business from taking
advantage of this significant opportunity for sales and profit improvement.

Personal Guarantees.    The liability of a corporation’s shareholders is generally limited to the assets of the business. Creditors have no normal claim against the personal assets of the stockholders if the business should fail. Therefore, many lenders, when issuing credit to small corporations, seek the added protection of a personal guarantee by the owner (or owners). This protects the creditors if the business fails, since they retain a claim against
the personal assets of the owners to fulfill the debt obligation.

Interest Rates.    The interest rates at which small businesses borrow are often relatively high. Banks and other commercial lending institutions normally reserve their lowest available interest rate, the so-called prime rate, for those low risk situations such as short-term loans for major corporations and public agencies where the chances of default are slim and the costs for collection, credit search, and other administrative tasks are minimal. Because of the higher risks involved in loaning to small businesses, lenders often seek greater collateral while charging higher interest rates to offset their added
costs of credit search and loan administration.

EQUITY CAPITAL

Unlike debt, equity capital is permanently invested in the business. The
business has no legal obligation for repayment of the amount invested or for
payment of interest for the use of the funds.

Share of Ownership.    The equity investor shares in the ownership of the business and is entitled to participate in any distribution of earnings through dividends, in the case of corporations or drawings in the case of partnerships. The extent of the equity investor’s participation in the
distribution of earnings of a corporation depends upon the number of shares
held. In a partnership, the equity investor’s participation will depend upon the
ownership percentage specified in the partnership agreement.

Voting Rights.    The equity investor’s ownership interest also carries the right to participate in certain decisions affecting the business.

Legal liability.    The personal liability of equity investors for debts of the business depends upon the legal form of the organization.
Basically, the investor who acquires equity in a partnership could be personally
liable for debts of the business if the business should fail. In a corporation,
the liability of equity investors (shareholders) is limited to the amount of their investment. In other words, if a partnership should fail, creditors could have a claim against the personal assets of the individual partners. If a corporation should fail, the only claims of creditors would be against any remaining assets of the corporation, not against any personal assets of the shareholders.

Equity Investor’s compensation .    The purchaser of an equity interest in a business expects to be compensated for the investment in any of the three following ways:

• Income from earnings distribution of the business, either as dividends
  paid to corporate shareholders or as drawings in a partnership.
• Capital gain realized upon sale of the business.
• Capital gain realized from selling his or her interest to other partners.

Capital Gains .    Capital gain is the term used to describe any excess of the selling price of an investment over the initial purchase price. For example, if you purchased an equity interest in a business for $5,000 and later sold it for $8,000, you would realize a capital gain of $3,000 ($8,000 -
$5,000).

Tax Advantages .    Long-term capital gains are those realized on investments held for a period longer than six months. These gains are subject to federal income tax at a lower tax rate than on ordinary income. Therefore, income tax advantages are often a major reason for the investor’s desire to acquire an equity interest.

Earnings Distribution.    The equity investor in a partnership is entitled to a share of all drawings paid out to partners at a percentage established when the interest was purchased (and defined in the partnership agreement). For example, assume an investor acquired a 20% interest in a partnership. The distribution of earnings to all partners in a given year is $20,000. The holder of the 20% interest would receive $4,000 ($20,000 X 0.20).

Sale (or Liquidation) of business.   If a business is sold or liquidated, the equity investor shares in the distribution of the proceeds. As
with an earnings distribution, the share of the proceeds in a corporation sale
depends upon the number of shares held. In a partnership, each partner’s share
of the proceeds is based upon the percentages specified in the partnership
agreement. If the proceeds received by the equity investor exceed the original
purchase price, this excess is considered a capital gain and taxed accordingly
at effective rates more favorable than those for ordinary income. If the business were liquidated, the assets would be sold and the proceeds would first be used to discharge any outstanding obligations to creditors. The balance of the proceeds, after these obligations had been fulfilled, would be distributed
to the equity investors in accordance with their shareholdings or percentages of
interest.

Sale of equity Interest.   As a business prospers and grows, the value of an equity interest grows with it. Therefore, the equity investor may be able to sell his or her interest at a price higher than the initial acquisition cost. For example, an equity investor in a corporation may have purchased his or her interest at $10.00 per share. As the business grows, he or she is able to sell the shares at $15.00 per share, realizing a capital gain of $5.00 (15.00 - $10.00) on each share sold.

Capital Gains vs Dividends.   In many cases, the equity investor in a small business is primarily interested in capital gains. Aside from the tax advantages described earlier, the equity investor usually realizes that the
earnings of the small business are better retained in the business than distributed as dividends or drawings. Retention of earnings permits the business
to grow so that the value of the equity interest increases. The investor can
realize a return on the investment through a capital gain derived from selling
his or her shares or upon sale of the business.

Public Stock Offerings.   When businesses are first organized, equity capital is usually secured from a combination of sources such as the original owners’ personal savings and through solicitations from friends, relatives, or other persons known to have financial capability for such investments. As the need for equity capital becomes greater, say $50,000 to $200,000, it is customary to seek capital through the services of professional finders, who receive a fee for securing the capital needed. These professionals normally have access to wealthy individuals, capital management companies, estates, trusts, and others with sufficient capital to make such an investment.

As higher levels of capital need, shares are sold through public offerings. The public offering seeks to attract a large number of investors to purchase stock, in large or small amounts. A market is then created for the stock. Shares purchased by the public, as well as the shares held by the original owners and any subsequent equity investors, can also be sold at the going market price. These transactions do not have a direct effect on the business’ capital position since it does not receive the proceeds from the sale. The equity investor can realize a capital gain by selling shares at prices higher than the original purchase price.

Risks of Equity Investment.   The equity investor assumes substantial risk. Unlike the secured creditor, the equity investor has no specific claim against any assets of the business. In liquidation, all claims of all creditors must be satisfied before any remaining assets become available for distribution to the owners. Even then, the equity investor’s participation in the proceeds is restricted to a share that is proportionate to the number of shares held or the partnership interest. Since the risks of equity investment are so substantial, particularly in the case of small businesses, equity investors expect a
considerably higher return than the lender.

A lender might be willing to loan money to a business at an interest rate of
10% or 12% since it has certain legal protections in the event of default or
liquidation. The investor of equity capital in the same business might seek a
far higher return, perhaps 20%, 50% or even more in order to compensate for the added risk of equity investment.

SUMMARY OF KEY POINTS

The following key points were covered in this lesson:

1. There are various sources of capital available to the small business
   owner. Terms, collateral, cost (interest rate and control) vary for each
   alternative.
2. The need for additional capital occurs frequently in many small
   businesses.
3. The ability of the owners to anticipate the need and to match the type of
   capital with that need will help them secure capital on the most favorable
   terms.
4. Those businesses that are alert to opportunities for internal capital
   generation will often find that this effort not only minimizes the need for
   external capital, but also opens the doors of the outside money market to
   them.
5. You can minimize your need for external financing through proper asset
   management, cost control and retention of earnings.
6. Trade credit can be utilized to maintain favorable supplier relations
   while taking full advantage of the credit that is available to you from this
   vital and convenient source.
7. Various types of loan arrangements were also explored, considering both
   short- and long-term needs as well as typical requirements for security
   through pledging of specific assets or the owners’ personal guarantees.
8. Finally, the equity capital market was included so that you understand
   what the equity investor expects in return for a commitment of capital and the
   effect that the equity investor’s interest can have on your business.

With this information you should now understand the advantages and
disadvantages of various capital sources. This will help you select the source
or combination of sources that is most appropriate for your needs.

One of the most important skills that a business owner must learn concerns
financial management. Becoming the master of your business’s financial fate is
not difficult. It just takes knowledge and discipline. It requires you mastering
four simple steps:

1. Learning the basic financial language and rules of business, so that you
   can translate your business vision and goals into quantitative terms (i.e.
   numbers);
2. Being pro-active, not reactive, by using your financial statements as a business decision-making tool;
3. Mastering the skill of financial management, so that you can recognize any
   danger signs that may be occurring in your business; and
4. Honing your strategic financial decision-making skills, so that you make
   sure that the strategies that you implement maximize your company’s profits.

Take the following online quiz to compare your financial management practices
to the "best practices" of successful companies. Although there are no "absolute
right" answers, the higher your score, the closer you are to these best
practices.

LESSON SUMMARY
 

Many owner-managers run their businesses without a planned goal. In trying to survive from week to week and from month to month, such owner-managers overlook an important management tool — budgeting. Would you ever consider going on a journey without determining what supplies you might need, the mode of transportation or how to take care of things at home while you’re away? Of
course you wouldn’t. Why then would you set off on one of your most important
adventures, starting or managing your business, without a clear picture of
what’s ahead and what resources you’ll need to get there?

Whether the plan is for next year, for the next three years, or for the next
five years, budgeting can help just as a map helps you keep on the right road.
Once you’ve developed your business plan, preparing the first budget is easy —
think of your budget as the "financial picture" of your future.

Because small business is not a cut-and-dried affair, the first budget you
prepare often uncovers problems with your plan and helps you determine whether or not your financial goals are within reach. The budget will also help you focus and select from alternatives so that your plan is realistic and
achievable.

When the figures are all together, you have answers to questions such as:
What sales will be needed to achieve the desired profit? What will the equipment
that is needed cost? Can you afford the marketing and advertising that you
outlined in your plan? And many more.

And, when you complete your budget you will have one of the most effective
management tools of all — something that you can use each and every month to
check your progress in achieving your business dream.

First we’ll cover the basics of budgeting for a small business and
then we’ll provide you with an example that illustrates the principles of
budgeting in a small business. Let’s begin by discussing why you need a
budget…

WHAT CAN YOU DO WITH A BUDGET?
 

We’ve already said that a budget is a translation of your business plan into
"numbers." In its simplest form a budget is a detailed plan of future receipts and expenditures - a projected profit and loss statement. Right from the
beginning you can use your budget to validate the activities you have planned
for the coming year. Will you be able to afford additional staff? Do you need to
expand your facilities or equipment? When will be the best time to start your
new sales campaign? Do you have a period where sales are slow and making ends meet is a challenge? Knowing what all your business activities will cost and
when such expenses will occur will help prevent any unexpected surprises that
could lead to financial problems.

Once the period for which you have budgeted is completed, you can compare
actual results with anticipated goals. Get into the habit of making this a
regular part of your business routine. You may find it takes discipline at
first, but the rewards are high. You don’t have to do anything elaborate– just
a simple comparison of your budgeted figures to your actual results. Then begin
by asking yourself "why" the are figures different. If some of your expenses, for example, are higher than you expected, do you need to look for ways to cut them or has business increased? If your sales aren’t on track, what has happened to cause the difference? Don’t fall into the trap of "blaming it on a bad budget." Use the information constructively and improve your budget the next time around.
 

A PLAN FOR INCREASED PROFIT
 

An increase in profits should always be a consideration when you think about
the future prospects for your small business. Before you can use a budget as a
plan for increased profit, you have to be sure that your present profit is what
it should be. In a small business, the year-end profit should be large enough to
make a return on your investment and return on your own work — pay you a
salary. Your budget can help you assess whether the rewards of being in business are adequate to compensate you for the risks.

VALUE OF OWNER’S SERVICE.  Skilled crafts people who own service businesses are kidding themselves if their firms’ profits are less than they can earn working for someone else. Your net profit after taxes should be at least as much as you can earn if you worked at your trade for a weekly pay
check.

RETURN ON INVESTMENT.  The year-end profit is too low if it does not also include a return on the owner-manager’s investment. That investment includes the money you put into the firm when you started it and the profit of prior years that you left in the firm. You should check to be sure that the rate of return on your investment is what it should be. You wouldn’t leave money in a savings account without a reasonable return and your business is no different. Your trade association should be able to provide guidelines about the rate of return on investment in your line of business. Your accountant and banker are also sources of help.

YOUR TARGETED INCOME.  After you know what you made last year, you can set a profit goal for next year. Be sure that your goal includes payment for your services and a return on your investment as noted above. Your goal should also include an amount for state and federal taxes. For example, if you want to make $10,000 after taxes, your goal before taxes should be about $13,333. You have to add this $3,333 to take care of state and federal taxes. Keep in mind that the larger your goal, the larger the amount that will have to be added to cover your taxes. Your accountant can help you determine the tax amount or give you a tax rate to use for budgeting purposes.

CAN YOU REACH YOUR GOAL?
 

The next step in preparing a budget is to determine whether you can achieve
your profit goals. To do this, you must project your fixed costs and your variable costs. From these three figures — targeted profit, fixed expenses, and variable expenses — you can determine your required level of income. Many businesses start with a forecast of profits and work up to a forecast of sales. Even large corporations can determine the required return on investment that shareholders require, then work back to planned revenue goals. Alternatively, you can start with a sales forecast, but don’t forget the bottom line must still give you the required return.

In gathering your figures, keep in mind that without accurate information
budgeting becomes guessing. The owner-manager who has never budgeted should talk with an accountant about the process. Or, visit the Info Exchange and post your budget question under the appropriate discussion forum!

You may need to make some changes to your record keeping system to ensure that you are collecting enough information in the right format to assist with your budget. Or, it may be that you need to have a profit and loss (or income) statement at more frequent intervals to determine the seasonal fluctuations of your revenues and expenses. A good place to start is with your Chart of Accounts. Consider each expense category listed and estimate the amount that you will spend for this category in the next year. Last year’s income statement is a good reference point, but don’t rely entirely on it — consider changes in your markets, price changes, cost increases, etc., always going back to your business plan to make sure you are addressing all the goals and activities you’ve planned.

You will also need to approach fixed expenses a little differently than variable expenses.

FIXED EXPENSES.  Regardless of sales, fixed expenses generally stay the same. Several examples of fixed expenses are insurance, rent, taxes on property, wages paid to salaried employees, depreciation of equipment, interest on borrowed money, building maintenance costs, office salaries and office expenses.

VARIABLE EXPENSES.  This type of expense varies with sales. In a product business, the cost of materials or goods for resale are the largest variable expenses. In some service businesses, the cost of labor is the biggest factor. Sales commissions, direct wages, payroll taxes, insurance, advertising, and delivery expense are other examples of variable expenses.

REVENUE.  The next step in preparing your budget is to determine and evaluate your required revenues (sales). Step 1 is to calculate revenue from the figures you’ve already determined. Step 2 is to take a realistic look at the revenues you will have to generate in order to make your targeted profits. If you’re a service business, what is the hourly rate you will have to charge and is it realistic? Will you need to increase your customer base? If so, is this increase achievable? If you manufacture and sell a product, are you able
to make that many units with your current equipment? If the answers to these questions aren’t favorable, then you need to go back and re-evaluate your
plans.

LEARNING BY EXAMPLE:  LUCY’S BEAUTY SHOP
 

Lucy’s Beauty Shop illustrates the principles of budgeting in a small service
and product sales business. This example also illustrates the concepts of fixed
and variable expenses.

The owner-manager is Ms. Lucy Doe. The shop’s income is from two sources: (1)
from beauty services that are performed by three operators and (2) from
cosmetics and perfumes that are sold by the receptionist. The receptionist also
answers the telephone, keeps the shop’s daily records, and prepares the checks
for Ms. Doe to sign.

TARGETED INCOME. Ms. Doe decided that she wanted to increase her net profit after taxes. She set her target income at $10,000 for net profit after taxes.
This figure meant that the shop’s profit before taxes had to be about $13,333
because she figured that her taxes would amount to about 25% or $3,333.

This goal was an ambitious one because her previous year’s net profit before
taxes was $8,390 as shown below in Lucy’s Beauty Shop - Profit and Loss
Statement.

DETERMINING FIXED EXPENSES.  As shown in the Profit and Loss Statement, Lucy determined that the shop’s fixed expense items included:  depreciation of equipment, receptionist’s salary, insurance, rent, interest on a loan, and utilities (heat and air conditioning). In addition, about one half of the laundry and shop maintenance expense is fixed. In budgeting her fixed expenses for next year. Ms. Doe took into account: (1) the raise she intended to give the receptionist; (2) a change in amount of interest based on her new loan balance; and (3) a change in her insurance expense.

She estimated that her fixed expenses for next year would be $11,000.

DETERMINING VARIABLE EXPENSES.  In Ms. Doe’s beauty shop, the variable expenses — those that vary with sales — are cost of cosmetics sold, shop supplies, operator’s salaries and taxes, utilities (water and electricity),
about one-half of laundry and shop maintenance. Operator’s salaries are variable
expenses in this example because each operator receives one-half of the total
price charged the customer — their salaries are based on business volume.
 

When determining variable expenses, Ms. Doe uses her trade journals for
information on budgeted percentages in addition to her business history. For
budgeting purposes, all costs are expressed as a percentage of the sales dollar
to make the calculations easier. In her case, the percentages are: beauty shop
supplies 10%; laundry, including uniforms 3%; water and variable utilities 1%;
and payroll costs 5%.

Lucy’s Beauty Shop
Profit & Loss Statement
For Year Ended December 31, 1997

Lucy estimates her total payroll costs at 5 percent of gross revenue from
service or 10 percent of salaries. Payroll taxes both state and federal, account
for 7.9 percent of the 10 percent, and payments for workers’ compensation and
other employee insurance account for 2.1 percent.
 

DETERMINING EXPECTED SERVICE INCOME. The next step in preparing a budget for
Lucy’s Beauty Shop is to determine the expected service income contribution. 
The basis for estimating this income for next year is the average revenue for
each operator’s appointment with one customer. This figure is $4.
 

One-half of the $4 belongs to the operator. Other variable expenses take 76
cents. Thus, from each $4 unit of services that is sold, $1.24 is left for
service income contribution.
Ms. Doe arrived at these estimates and calculates her Service Income
Contribution per operator as follows:
 

1. From the appointment book, she learned that each operator averages 15
   appointments a day.
2. The shop’s revenue from each operator is $30 a day (15 times $4 average
   per visit less 50% paid to operators).
3. Each operator works 5 days a week.
4. Each operator contributes $630 a month to the shop’s income (21 days times
   $30).

On this $630, the shop clears $390.60 calculated as follows:

LUCY’S BEAUTY SHOP
SERVICE INCOME CONTRIBUTION -
EXPRESSED AS A PERCENT OF SALES DOLLAR
 

The shop’s cosmetic sales contribute a net revenue of 50 cents on the sales
dollar. Mrs. Doe estimated, based on past experience, that she could sell
another $2,000 of cosmetics without additional advertising (an increase of 17%).

COMPARING REVENUE AND COST. After Ms. Doe determines her variable expenses,
fixed expenses, and the service income contribution, she is ready to test her
budget. She does this by adding her total fixed expenses of $11,000 and the
desired gross profit of $13,333. This total comes to $24,333.

But her initial budget shows that shop revenues will only be
$21,061 as shown below. Thus, the store’s revenues will not cover Ms. Doe’s
fixed expenses and desired profit. Resources will be about $3,300 short of the
desired goal.

 WHERE CAN SHE GO?
 

Because resources are not enough to cover fixed expenses and the desired
profit, Ms. Doe needs to consider adjusting her budget (and business plan) for
the coming year. She can go in at least three directions. One possibility is to
add another operator. Another is to try to increase cosmetic sales. A third
solution is to reduce her expected profit. In order to decide what to do, Ms.
Doe needs answers to several questions about each possibility. She may have to
work up several tentative budgets to determine what to do. Let’s take a look at
each alternative that Ms. Doe considered:
 

ADD ANOTHER OPERATOR. This possibility brings up a number of questions: Is
there space for an additional booth? What additional fixed expenses will be
incurred? Can another operator be kept busy? Is the relationship between fixed
expenses and revenue in line with industry trends?

Ms. Doe considers each question and determines that:
1.  Her expenses are generally in line with industry standards, with the
exception of rent expense. The average is 10 percent of gross beauty service
income — Ms. Doe’s rent is just over 11%, which is slightly higher than the
average for her line of business.
2.  The shop has sufficient space for another booth, so rent expense would not increase.
3.  However, if a booth is added, fixed expenses will increase because equipment for the new booth will mean additional depreciation.
4. Interest expense will also go up because she would have to finance the
additional equipment.
 

INCREASE COSMETIC SALES. This possibility seems to be a logical way to
increase income because each dollar of sales will increase the revenue by 50
cents. The first question is how much of an increase in cosmetic sales will be
needed? Ms. Doe calculated that these sales must be increased by about 70
percent rather than by 17 percent as she originally planned. In order to reach
her budget profit goal, she would need a additional revenues of $3,272 — or
approximately $6,500 more in product sales than in the first budget. This would
require cosmetic sales of $20,500, which is an increase of 71% over last year!

Other questions to answer here are: Is this a realistic increase in product
sales? By what method will sales be increased? By reducing prices? What effect
will these methods have on revenue? How much additional inventory will be
needed? How will it be financed? Is storage and display space sufficient to
accommodate increased sales? Will she have to add new products that will require
promotions? What advertising and selling costs would be incurred.
 

REDUCE EXPECTATIONS. Sometimes the only practical solution is to reduce the
expected profit. Ms. Doe decided that $10,000 net profit after taxes was not in
the picture next year. Based on her knowledge of the beauty shop business, she
felt that her shop was not quite ready to add another operator. For one thing,
she foresaw the possibility of personnel trouble if a new operator was not kept
busy.
 

She also felt that trying to push cosmetic sales up so dramatically could
cause customer dissatisfaction. Her shop prides itself on having a relaxing
environment without high pressure sales. This alternative would require a change in that culture. She reminded herself that customers regarded the shop’s beauty service highly and decided that any major growth in sales must come from that end of the business. Another operator and $10,000 or more net profit after taxes might be feasible the year after next. Although she would not make her profit goal (and her return on investment is below target), she believes that another year of building a steady customer base will enable her to make her target in the following year.

PERIODIC FEEDBACK AND CONTROL
 

A budget provides a tool for control. You start building this facility when
your budget for 12 months is completed. Break it down into quarters, or better
yet into monthly amounts. Such a breakdown allows you to check for any
discrepancies that may not show up readily in the annual figures. When many
items are added together, it is easy for an error to creep into the totals or
for you to overlook items.
 

During the year, the monthly or quarterly budget provides you with one of the most important financial management tools. For example, by looking at next
quarter’s budget you can anticipate peak periods and schedule stock and labor to handle peak sales volume. You can plan vacations, special promotions, and
inventory-taking for the slow periods.

A comparison of your monthly or quarterly profit and loss statement shows
whether or not you are achieving your business plan goals. Set up a simple
worksheet to compare actual expenses to your budget and get in the practice of
reviewing a) where all the money goes, and b) any differences from the amounts
you budgeted. Thus, you can pinpoint and work on the problems that have occurred during the month or the quarter. Your objective is to guide your activities toward the most profitable type of operations and help you navigate the road to your business dream.
 

RECAP OF KEY POINTS

In this lesson we have covered the following points:

1. Your budget is a "financial picture" of your business plan. You can’t
   prepare a budget without a good plan — and preparing your budget will help
   you identify any weaknesses in your plan.
2. You may need to evaluate a number of alternatives … it is an iterative
   process, so once you settle on your final budget, make sure it is consistent
   with your business plan.
3. Breaking down expenses between fixed and variable can help you analyze
   your profits and make better decision about alternatives.
4. Your business must provide you with an adequate return on investment.
5. Compare actual results to your budget on a regular basis (at least
   quarterly, although monthly is recommended). Go through your Profit and Loss
   statement and make sure you understand any differences.

Bookkeeping and Accounting:  From Start to Finish
OWNERS’ REVIEW CHECKLIST

Even if you hire someone to do your accounting and bookkeeping, there are a number of items that that you as the business owner should do periodically. Many small businesses have suffered serious losses when the owner lost track of the numbers and the trusted bookkeeper "borrowed money" and left for an extended cruise. The following checklist will keep you in touch with your business, and perhaps even prevent you from serious losses.

1. Compare actual results to budget. Each and every month
   you need to compare your income and expenses to your budget. This review is perhaps one of the most important tools for a small business owner. It’s a great way to learn what’s working and what’s not working with your business. The goal is not to have an accurate budget… but for you to have a thorough knowledge of what is happening and to know if anything unexpected is
   happening so that you can adjust your actions in a timely manner. What?? You don’t have a budget? Stop right now and let’s go over to the Budget Workshop!
2. Scan the check register. Periodically (say every 3-4 months) you should take a look at the check register just to make sure all the payees are familiar to you. Multiple checks written around the same time to the same vendor could be an indication that funds are being diverted. (You also might want to reduce the time spent writing and posting multiple checks.)
3. Review the bank reconciliation. This should be done on a monthly basis (or if you skip a month take a look at all the reconciliations since your last review.) This step is important, particularly if you have one person doing all the bookkeeping: writing checks, posting entries, preparing financials, etc. Look at any adjustments to the bank accounts, stale items, etc.
4. Look at canceled checks. Occasionally (say 1-2 times a year) pull out a bank statement and flip through the canceled checks making sure that all those signatures are yours, that you recognize the vendors and scan the endorsements on the back. Obviously, this can’t be done if you don’t get your canceled checks back from the bank. In this case you might want to spend a little extra time with the check register.
5. Review statements from vendors. Every now and then (say 3-4 times per year) take the time to open the mail and look at statements from vendors (many vendors have stopped sending statements, but they will send late notices). Here you want to make sure that your business is in good standing with vendors — long overdue invoices might be an indication that a check you thought was going to a vendor actually went in someone else’s pocket, or that an invoice has been overlooked.
6. Review Payroll register and handout the paychecks. Now of course this isn’t an issue for a business with only 1-2 employees. But "padding the payroll" is a common problem in some industries — such as construction or cleaning services where it is common for the crew to go straight to the jobsite and perhaps not come into regular contact with the owner.
7. Review your Accounts Receivable and aging. This needs to be done on a regular basis. Of course you need to know if you have any slow paying customers and a periodic review would also disclose any scheme of "misapplying" customer payments.
8. Take a physical inventory. Many small businesses have very poor inventory records, so if you have a large amount of inventory or a high volume business, you probably will want to work with your accountant and get some type of perpetual inventory system set up. Again, there are some excellent
   software packages available for the small business that will make this process relatively painless. Once you have a system in place, you should take a physical inventory at least once a year and compare the actual goods on hand to the inventory records.

If you have any other tips and techniques that you have found to be particularly helpful, please send us an email and we’ll add to this list. Our goal for the Online Women’s Business Center is to share information to help all women business owner’s with their business dreams.

Bookkeeping and Accounting:
From Start to Finish

HOW TO USE THIS WALK-THROUGH GUIDE
 

Okay, here’s the scenario for this walk-through lesson: Let’s assume that you are sitting down to do your monthly bookkeeping. It is a day slightly past the end of the month you are doing the books for - say, the tenth. The sun is shining, a bird is chirping outside your window… oops, sorry I got a little carried away there. Anyway, you paid as many bills as you could before the end of last month, you’ve received most bills you’re going to get and - you’re ready to do the monthly accounting.

In this walk-through guide we’ll cover the activities associated with your monthly accounting, section by section. We’ll include a description of
what you’ll be doing as well as why you’re doing it. We’ll also include an explanation of the "debits & credits" in this guide, but as we’ve noted in a prior section, if you are using an accounting software application, the debits & credits are generally taken care of for you — at least until you have to record journal entries, etc. So our approach will be based on a "semi-manual" set of books so that you learn more about the "why" — this will make the job easier in the long run and provide you with a better foundation for really using your monthly financial statements.

Here’s a list of what will be covered in this walk-through uide:

Expenses paid by check. Go through and enter all the other checks you have written by check number and to whom they were written. In general, all those entries will be credit cash; debit expense (decrease cash, increase expense). Make sure you put everything in the correct expense account. (And, since you have followed your "rule" about writing down the expense category right when you made the purchase you don’t have any trouble remembering what this purchase was for, right?) The exceptions to this have been noted above: payments on loans, payments made on large equipment or fixtures, or additions to inventory.

Expenses paid by cash. You may have paid for some things with cash. The entry here is exactly the same as if you paid with a check - it’s just keeping track of these things that’s different. You should have a file of receipts, and most of them will match a check (it will be easier to confirm if you’ve written the check number on the receipt). Any that were paid with cash should have that noted on them, along with what the item or account number was. Same entry - debit, expense, credit, and cash.

If you have more than one cash account, have a separate account number for each bank account, and credit the account from which you are actually taking the money out of. If you move money from a savings to a checking account, the entry will be: credit (reduce) savings; and debit (increase) checking.

Accounts Payable. At the end of any given month, you have things you have used or purchased, but have not paid for. These are listed as accounts payable. When you enter these bills, your entry is debit expense, credit accounts payable. Each month, you need to make and keep a list of items that were in accounts payable at the end of the month. When you are closing out our
sample month, you will have paid these bills, which were in AP the previous month, reducing your cash. Using your list, identify the checks written for items that were listed in accounts payable the month before. You already listed the expenses the prior month - so you don’t list them again. The entry to show on your books that you have paid your accounts payable is: debit accounts payable, credit cash. Reduce your cash; reduce your accounts payable. Assuming
you pay all your bills each month, this step will bring your accounts payable to zero (and if not, the accounts payable balance per your books should equal all the outstanding bills). Later, you will rebuild a new AP list for the current month.

Cash Discounts - purchases. In our sample chart of accounts we have set up account number 7100 for cash discounts on purchases. If you are paying a material order and get to deduct 2% for paying early, by all means, try to do so. This is where that amount goes: you debit the entire expense to the materials account as if you didn’t take the discount, but credit the actual amount of your check to cash, and credit the remainder to the cash discounts account. This helps you see the value of paying early, and if you’re in a position to do this fairly regularly, it looks great to your banker - so take the time to book it correctly.

Petty Cash. Petty cash is a handy item to have for small purchases, but it needs to be accounted for correctly. Do a one-time entry in your books to set up the petty cash account. If you want $300 in the account, credit the bank account you are taking the cash from, and debit your petty cash account. Then put that petty cash in a box. Every time you take some out to spend, keep track of what you’ve taken out, with a receipt, and at the end of the month you’ll
have a list that looks like this:

Write a check to petty cash, which will be for the total of what you spent over the month, or $60.82. When you enter that check, credit cash and debit the three appropriate expense account numbers - supplies, small tools and postage. Cash the check, put the cash into the box, and start all over again. You can do this as many times over the month as you need to - every time you need to replenish the petty cash box, just write a check and make the balancing entries
the same way. You never make the entries to Petty Cash itself after you initially set up the account, unless you want to make it larger or smaller at some point.

Payroll. This one’s a bit trickier…you’ve actually done a lot of things when you write that paycheck. If you have an accounting system and are using payroll, you should be in good shape - but even then, you may need some understanding of exactly what that system is doing for you. If you’re doing payroll by hand, you will calculate and record the components described below.

In Payroll you have:

the wages themselves,
the taxes the government makes you withhold,
and taxes that you have to pay that you don’t withhold.

Gross wages get debited to the wages expense account - divided properly between direct and indirect labor. (Recall that gross wages for people actually producing your goods or providing your services are direct expenses; gross wages for the office help and sales are indirect expenses.)

Payroll taxes. Some of these come out of the employee’s check - the federal withholding and the employee’s share of FICA. Others come out of your pocket, like the employer portion of FICA, state and federal unemployment taxes. The ones that come out of your pocket require two entries: they get debited to payroll tax expense (either direct or indirect, depending on where the employee’s wages go), and credited to the proper liability account - either FICA
payable, Fed payable, UI payable, FUTA payable or Workers Compensation payable.

Determining tax liabilities. For each of these you have to figure the total due based on the gross wages for that period - these taxes are figured as a percent of gross. For example, when the FICA and Medicare tax is 7.65% of gross wages, you take the gross wage, multiply it by .0765, and that is what you owe for the employer portion of FICA. You can get a chart which shows the Federal and state taxes due for each employee, based on their W-4 status and earnings. Unemployment will be based partly on a state multiplier and partly on your company’s unemployment history. Workers ompensation will depend on the industry code your employees work under, as well as your company’s performance.

All the taxes that are withheld from the employee’s check as well as those which come out of your pocket - are listed as liabilities, and are easier to deal with if you sort them out by what kind of tax they are. In the liability accounts, there is no need to separate direct from indirect numbers - it’s just plain money you owe, and it doesn’t matter whether it comes out of the employees check or out of you pocket. The FICA payable, for example, will contain all the FICA that was withheld from everyone’s check, in addition to the amount that you
are matching as the employer.

Here’s the picture of what you do with payroll, using a fictitious shop person who’s going to have his salary listed under 4010, direct labor. In this payroll period, he made $700.00. His workers’ compensation rate is 13.2 %.

Up to this point, the entries balance, as they must. Now, to enter the
employer’s tax expenses:

As a side note, here’s a point you need to keep in mind: that person, who you thought was costing you $585.45, because that’s what her paycheck says, or is costing you his gross wage of $700.00, is actually costing you $871.15 ($700 wages plus the payroll tax costs to you, which in this case total $171.15). If you’re adding any benefits like insurance or retirement, put those
on top. This is a prime example of the kind of overhead you need to make sure gets added into your pricing structure.

Sales & Customer Deposits. OK, now you’ve entered your accounts payable, your expenses, your payroll. Now for the good stuff - let’s enter your sales.
Remember: sales accounts are credit accounts. So when you want to increase the amount of sales. You have made, you make the entry as a credit entry. These entries are pretty easy, on the surface: you receive a check and put it in your account: debit cash. The sale, if it is an item you have on hand and give to the buyer, you enter as an immediate sale. Credit sales, the equal amount that you
debited cash.

HOWEVER, if you have just signed a contract, and have not actually done any work on that project this month, you have not yet earned that sale. You’re just holding the person’s money for them, keeping it safe. Right? So, it is not yet truly a sale - it’s a b>customer deposit. The entry will be debit to cash (it’s in the bank, either way) and credit customer deposit, which is a liability account (you would have to refund the money if you don’t do the job). If you have a lot of jobs going at any one time, you’ll make your job easier if you
give each job its own number in customer deposits, so you can easily keep track of how much has been turned into sales, and how much remains to be earned.

Customer deposits turn into cash as you earn them - through the purchase of materials or labor performed. It’s a bit of a call, how you evaluate each month what part of each job is done, and this is beyond the scope of this walk-through guide. So if you need help with accounting for contractors, send us an email and we’ll forward some information to you.

Accounts Receivable- Accounts Receivables and sales operate much the same as Accounts Payables and your purchases. Under the accrual method, you’ll be entering sales as you earn them and invoice your customers. Have a simple chart that shows who owes you money each month - have a beginning balance which
equals last months’ ending balance. Enter any payments they’ve made or new charges they’ve incurred, and come up with an ending balance. That must equal the amount you list as AR on your books - if it doesn’t, your task is to figure out where the discrepancy is.

Inventory.  Inventory is a current asset account, which means it is something you have that can be turned into cash quickly. When you purchase inventory, you do so out of cash, so one side of the entry is credit cash - the other side, to increase inventory, is debit inventory. Basically, by listing an inventory item, you’re just saying, I bought it this month, but I plan to keep
it - or at least part of it - around, so the entire cost should not show up this month. The trick with inventory is knowing how to book it when you use it.

Some common inventory items are materials - which is simple. You have a value of raw material in inventory - which matches what you paid for it. (You cannot increase the value of your inventory as it sits in the yards, as prices go up. You make your gain when you use that cheaper material in a project where you’re able to charge more for it than it cost you.) As you use your raw materials, you credit nventory, to reduce it, and debit the 4101 account, materials. Basically, think of it as buying the material from yourself, with no cash changing hands.

Another way that inventory might come up is when you buy $5,000 worth of brochures. Put that as a lump sum in your books for any given month, and you’ll be a sad business owner, you’ll think you’re losing money hand over fist. So, try this: decide how long those brochures will last you, say three years. Divide $5,000 over 36 months, and you’ll find that each month you need to book $138.89
(Call it $140 and be done with it).

The whole sequence will look like this:
First, you buy the brochures and put them in inventory:
 

Then, each month as you use the brochures, you will make an entry:
 

What you’re saying is that each month, you have to cover $140 as the cost of your brochures. It’ll show up on your income statement as an actual cost. Each month the value of that inventory will decrease by that amount, until it’s all gone. Theoretically your brochures will be gone about the same time - or
outdated.

Deposits. Another item that has its own spot in your books is deposits you pay for various things, from workers compensations to the cleaning deposit on a rental, to a deposit with the post office for express mail. These are items that will be returned to you when you finish using the service - technically, it’s your money that they’re holding. These amounts all go into the account called deposits, in our system #1800, which is of course under the Asset section of your Balance Sheet.

Gain or Loss on Sale of Assets. This is where you account for assets you sell or dump. If you sell a vehicle, you have its value on that up to date list of assets you keep. You also have a record of how much it has been depreciated. You enter the cash you make off that sale in 1001, cash. Then you balance that entry with a credit to the asset account and a debit to the accumulated depreciation account, and whatever it takes to make those number
balance is your gain, or loss, on that sale.

Say you sold a truck which you bought for $6,780. It has depreciated by $3,200. You managed to get someone to pay you $5,400. The entry to record this sale would be as follows:

If your balancing entry had been a debit, it would have meant you lost money on the sale. Here’s how to think about it: You paid $6,780. On your books, its value had decreased by $3,200, meaning you had expensed out that amount of money over the period of time you had the truck. So, to you it’s actually worth $3,580, and you sold it for $5,400, which was a gain of $1,820.

Depreciation. This is an entry that you can make the call on whether you’re going to deal with it monthly or annually. It’s not a cash expense, in fact it’s often sniffed at as a "paper expense" but if you have a pretty good sized company and you think you’re making great money, don’t count those chickens until you figure in your depreciation. It’s real stuff, because things DO in fact wear out and have to be replaced, and this is where that process is
built into your books.

Basically, your accountant will give you a sheet listing your assets and the amount they will depreciate this year. You take those totals, and say, OK, my tools are going to depreciate a total of $890 this year. Take that number and divide by 12, and you have your monthly depreciation, which in this case is $74.17. So to give yourself a really good idea of where you are, each month make the entry of debit account 5341 (depreciation expense) $75, and credit 1601
(accumulated depreciation, tools) by the same amount. If you have office equipment, vehicles, buildings, all those will have their separate totals that you work with the same way.

Most computer accounting systems have a setup where you can tell it to make those entries for you automatically each month, and you won’t have to worry about it. Don’t worry about being too exact - at the end of the year, you’ll go through each of these numbers and adjust it so it’s exactly in line with your depreciation schedule. Making the entries monthly saves you the shock when you thought you’d made $20,000, and your depreciation expense at the end of the year
cuts that in half.

Suspense.  Now I’m going to let you in on a secret if you promise not to take advantage of it. If you are making all these entries and they don’t balance, do this: first, check the number they don’t balance by - maybe you just left out an entry. Divide that number by two and see if anything becomes obvious. Divide it by nine and if it divides cleanly and evenly by nine, that means you have transposed an entry somewhere - maybe you said 765 instead of
756. (No, this is not an old wive’s tail - but I do have some good hiccup cures for you after class). IF you have tried everything you can think of, and you have just got to turn your computer off and go home, put the remainder that won’t balance in suspense. Then, while you’re out of the system, look at all your entries, all your notes, and figure out the problem. Come back in, make the correcting entry, and take it back out of suspense by making the opposite entry you did before. If you had to credit suspense to make things balance, this time debit it - or you’ll drive yourself even crazier.

Suspense may end up with little bits and pieces of numbers - but it should never be allowed to get large. $1.31, you can let go. $500, and you’d better get serious about finding out what that is.

Month End Adjustments.  Now that you’re sure you have the right amount of cash in your system, you’re ready to check the rest of the books. How intense you get about this can well depend on what time of year it is - in a mid-year month, like March or July, you might be a little more lax about how closely you check every account, whereas at the end of the year you will want to tie every
single account down exactly. Even those accounts you don’t check over with a fine-toothed comb should at least be glanced at, to make sure they make basic sense. If a $3,500 car liability all of sudden turns into a $15,293 item, you’ll know something is entered in the wrong place.

The process is this: go through your balance sheet, item by item. You’ve already done cash, and petty cash is a static account, so the next item is inventory. Check what your inventory was last month, total up what you know you’ve added to or deleted from it, and that should be your current total
inventory. To make this easy, keep a list of what is in inventory: office supplies, raw materials, etc. Each item should have a beginning balance, an amount of current activity, and an ending balance.

If inventory shows on your books as a higher number than you actually know you have, adjust that against the material expense. If you have $250 less value in actual office supplies than you show on the books, the adjustment will be to debit office supplies (account 5550) and credit inventory. That will reduce your inventory - which will, by the way, also reduce your profitability…sorry!

When you close your books for the end of the year, you need to take actual inventory - count it all up and make sure you’ve really got what you think you do. At other times of the year, whether or not you go through this step will depend on how much inventory you carry. Any materials you have a large value of on hand, it will pay you to take a physical inventory of more often. Failing to do that may result in a shock at the end of the year when it turns out you’ve
been underestimating your use of material all year, giving your perceived profitability one more opportunity to fly out the window. It’s amazing how that bird can get up and go at the smallest opportunity!

This same process gets followed for each item on your balance sheet. If your books are computerized, you will find a good friend in your Detail Trial Balance and Detail Transaction Reports. These reports will show you the beginning balance for each account, what was added to or subtracted from that account over the month, and then an ending balance. This will be the easiest place for you to look for those items entered in the wrong account, items
entered backwards (credit when you should debit, can you imagine?), items overlooked, or items that were transposed when they were entered, which are the top four ways to end up out of balance.

The good news is that you don’t have to do this to every expense account - just check out that your asset and liability accounts are correct. If you have large loans, make sure you’re accounting for principal and interest correctly - putting interest in its own account, and taking principal against the liability account. The easiest way to do this is to call the loan officer and get an actual report (loan history) of how much you owe as of this date, and make sure
your books reflect that. As with any of this work, if you’re talking about a small loan it may not be worth adjusting every month - you may want to adjust those once a year. The items you adjust monthly are the ones that can throw off your books by a large enough amount that it’s worth the time it will take to adjust for them.

This process, completed through your entire balance sheet, will give you the assurance that your book are correct, and you can trust the bottom line on your income statement. This is actually about the first point in the process that I would actually look at the income statement - until you have adjusted your books to match physical reality, it can be relatively meaningless.

Paper Trail. One last point: all these numbers that are going into your books need to be backed up by something that will give you a clue about them. You or someone else will at some point need to go back and recreate something you’ve entered, and you need a good clean system for keeping this information.

Keep a list of everything you’ve done. Have a list and update it monthly, of what makes up Accounts Payable - and the total of that list needs to equal the AP entry on your balance sheet. Have a list of customer deposits, accounts receivable and a list of your assets. You need to be able to say what’s in each number on your balance sheet. It’s not nearly as intimidating as it sounds, and it will save you hours of head scratching later.

You will also need to keep good supporting documentation for your income and expenses. For more information on the types of records you need to keep, check out Documenting your journey.

Congratulations! You’ve now got a real set of books that you can use to analyze your profitability and pricing, you can take to the bank or use to produce a tax return. Every month, you’ll find this process easier to follow and less time consuming, and you’ll understand the inner workings of your business in a way that will make you much more powerful and confident in your decision
making. And, did you know that the word in the English language with the most consecutive double consonants is sub bookkeeper? A heady responsibility, I’d say.

Happy bookkeeping! And now you’re ready to move on and learn to use your financial statements to manage by the numbers!

Here are some of the ways in which an accountant can assist your business:

* Prepare periodic financial statements and annual audit reports.
* Assist you in analyzing your financial statements, looking for problems or opportunities for improvement.

* Determine working capital and cash flow requirements.
* Help you develop a budget and setup system for your monthly review of budget vs actual results.
* Prepare tax returns and assist with tax planning.
* Establish tax calendar for you and set up system to help you comply with the myriad filing requirements.
* Help set up your accounting systems, including computer based systems.
* Assist with determining loan or capital requirements.
* Act as your advisor and sounding board in financial and administrative matters.
* Perform operational reviews and help you find ways to run more efficiently.
* Determine product and customer profititability analysis and breakeven analysis.

THE FIVE "C’s" of CREDIT

Your bank is not a charitable institution. It is in business to make (not lose) money. Consequently when a bank lends money it wants to ensure that it will get paid back. To maximize the possibility of being paid back, the bank wants to make sure that there is sufficient assurance that a person can pay back a loan and that she has met such obligations before. The bank must consider the 5 "C’s" of Credit each time it makes a loan.

Capacity to repay is the most critical of the five factors. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships–personal and commercial–is considered an indicator of future payment performance. Prospective lenders also will want to know about your contingent sources of repayment.

Capital is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Prospective lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding. If you have a significant personal investment in the business you are more likely to do everything in your power to make the business successful.

Collateral or "guarantees" are additional forms of security you can provide the lender. If for some reason, the business cannot repay its bank loan, the bank wants to know there is a second source of repayment. Assets such as equipment, buildings, accounts receivable and in some cases inventory are considered possible sources of repayment if they are sold by the bank for cash.
Both business and personal assets can be sources of collateral for a loan. A guarantee, on the other hand, is just that–someone else signs a guarantee document promising to repay the loan if you can’t. Some lenders may require such a guarantee in addition to collateral as security for a loan.

Conditions focus on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender will also consider the local economic climate and conditions both within your industry and in other industries that could affect your business.

Character is the general impression you make on the potential lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be reviewed. The quality of your references and the
background and experience of your employees also will be taken into
consideration.