Case study
Review of financial statements
Normalized statement of cash flow
Uses and sources of funds The financing proposal — a tiered approach
Summary
A Structured Approach to
Business Financing, Part 3:
Putting It All Together — A Case
Study
By MARK EIKELAND, CGA
This article is the third in a three-part series by Mr. Eikeland on the subject of Corporate Finance — Strategic Financing to be carried on PD Net.
The second article in this series discussed the financing proposal, a key component in every business plan, and how a tiered financing approach could be applied. This last article will go through an actual case study of how this approach was used and applied successfully.
To begin with, a financing program is not a static “do it once only” occurrence in the lifetime of a business. A business goes through many stages of growth:
• Seed • Start-up • Expansion • Maturity
• Divesture/Decline
And very often these stages of growth can even repeat themselves within an organization as an established (mature) company introduces a new product or begins to manufacture its own supply. In this case, a mature business begins a new start-up phase, which may even include setting up a new independent business unit. In this example, a business that installs electrical panels (purchased and supplied through an outside third-party source) might establish a new company that can now manufacture the electrical panels to supply the installation company. The business model makes a case for vertically integrating and controlling supply, quality, and price. Here we have a new business cycle within a business cycle, a start-up within an established mature company.
Furthermore, each new significant level of sales is a new stage of growth, often with a new financing requirement. In many cases, the financing requirements may be unique and, as a result, the appropriateness of the financing product and lender will vary. For example, unique seasonal patterns in an industry may affect the limits required of an operating line of credit (LOC). For example, an operating line of credit may be set up to match the seasonal cash flow ups and downs. During the peak sales months in a year, an LOC facility may have a higher limit and then be reduced during off-peak periods when inventory and sales levels are reduced.
The financing program should be reviewed annually and updated to meet the new requirements and operating environment of the business. As you will see in the following case study, when the financing program does not keep in step with sales growth, a
This company began in 1995 to supply and install insulation panels for commercial and industrial projects throughout Western Canada. Sales have grown significantly over the last few years, and during this entire growth period the company has operated with its original line of credit facility of $250,000. As a result, the years of sales growth have outgrown the available credit facility limit, resulting in negative working capital implications. Current sales were $3.3 million over the previous year’s $2 million. Accounts receivable balances now average close to $1 million per month.
In this example, the company is in an expansion/growth cycle. Sales are expanding, yet their financing facility has not been updated to accommodate this growth. As a result, the company needs to increase its credit facility to meet the new operating demands imposed by a new level in sales in order to operate efficiently. An ideal financing program would address the current working capital needs of the company and allow some room to grow.
Our financing proposal case study includes the following components: 1. Financial statement review
2. Normalized statement of cash flow 3. Uses and sources of funds
4. Projected cash flow statement (not provided)
Review of financial statements
In preparing a financing proposal, the first step is to review current financial statements, including the balance sheet and income statement. A review of the balance sheet will indicate the financial problems the company is experiencing and/or the opportunities for establishing a properly structured financing program.
ABC Sample LTD.
Balance sheet as at December 31, 2xxx Current assets
Cash and equivalents $ 2,598
Accounts receivable, net 961,367
Inventories 40,123
1,004,088
Capital assets
Automotive 84,074
Office/computer 37,171
Equipment 150,401
Less: Accumulated depreciation (133,826) Total capital assets, net 137,820
Total assets $ 1,141,908
Current liabilities
Line of credit $ 263,446
Accounts payable 396,368
Income taxes 61,054
Long-term debt
Long-term debt 0
0
Equity
Common shares 100
Retained earnings 415,105
Shareholder advances 5,835
421,040
Total liability and equity $ 1,141,908
A review of the balance sheet shows the following financial picture: • No long-term debt
• Debt to equity ratio of 1.71:1 • Current ratio of 1.39:1 • Working capital of $283,220 • Good equity/well capitalized • Good accounts receivable coverage • Some capital assets
As a general rule, for presentation purposes, the balance sheet is restated to show any shareholder advances as equity (see example).
Upon further review, accounts payable showed amounts of $175,000 over 90 days. The company is maxing out its supplier payable 30-day terms and using this as longer-term financing. There is a risk the suppliers will cut back on their extension of credit. The company does not have the ability to pay its current corporate taxes of $61,054, is over its approved LOC facility of $250,000, and is at risk of having its credit facility pulled.
This company is on the verge of insolvency, not able to pay its debts in a timely fashion. Yet, at the same time, its sales are growing and it has good net income.
ABC Sample LTD.
Income statement
For the year ended December 31, 2xxx
Sales $ 3,240,909
Cost of sales 1,163,005
2,077,904
Expenses 1,802,793
Income before taxes 275,111
Income taxes 64,441
Net income $ 210,670
A more detailed review of the income statement reveals the following:
• Strong sales growth — 65% increase (current year $3.3 million, previous year $2 million) • Good net income
• Amortization of $35,725 • Shareholder bonus of $30,000
• Unusual professional fees (non-recurring) $12,000
In this case, it would be appropriate to restate the income statement on a normalized cash flow basis to determine available cash flow for debt servicing.
A restatement of the income statement on a normalized cash flow basis would add back the following:
1. Amortization — This is a non-cash expense.
2. Shareholder bonus — This is a discretionary expense at the discretion of management. It is not an operation expense, but the result of tax planning.
3. Professional fees — One-time non-recurring expenses should be identified and added back. These are not expected to occur in future operating years.
4. Long-term interest expense would be added back to show cash flow available for a new financing program with new terms and rates. In this case, there is no long-term debt.
ABC Sample LTD.
Normalized statement of income For the year ended December 31, 2xxx
Sales $ 3,240,909
Cost of sales 1,163,005
2,077,904
Expenses 1,802,793
Income before taxes 275,111
Income taxes 64,441
Net income 210,670
Add backs:
Amortization 35,725
Shareholder bonus 30,000
Interest on long-term debt 0
Unusual professional fees 12,000
77,725
Normalized cash flow $ 288,395
Normalized cash flow is $288,395 before debt servicing and any shareholder loan repayments.
The debt servicing costs of the proposed new financing program could be calculated and deducted from the above to reflect the net cash flow after debt servicing. In any case, a normalized statement of income provides the lender with valuable information on the debt servicing ability of the company.
Uses and sources of funds
Uses (Purpose)
1. New term loan financing
The first step is to address the immediate working capital shortfall as follows: • to bring trade accounts payable current
• to pay off corporate income taxes • to pay down line of credit
Accounts Payable > 90 days $ 175,000
Corporate Taxes 61,054
Working capital 78,946
2. Operating line of credit
The next step is to address future requirements and provide a financing solution to accommodate future growth. An increased operating line would be the most appropriate solution to address the current and future operating needs of the company. In this case, the operating line was increased to $350,000. (This LOC level would be based on cash flow projections showing monthly cash flow balances and requirements.)
Sources (Product/Lenders)
Now the task is to identify and match the most appropriate financing products and lenders for the uses established. In this case, the proposed financing program called for the following financing products:
• Term loan — to address the working capital shortfall and re-structure the balance • Operating line increase — to address future operating requirements
Term Loan — $315,000
The balance sheet is typical of a company operating in a service-based industry — nominal capital assets and inventory with a book value of $137,820. A review of the normalized statement of income shows good cash flow that could more than adequately debt service on $315,000 in-term financing. Considering the weak asset collateral for the full amount of the term loan, the proposed new term financing would be made up of two components or sources:
#1 Equipment term loan: $100,000 — good conventional loan/value coverage
This loan would be secured by a first charge on the capital assets of the company, with equal payments over 60 months and interest at the base rate plus 1%. This is conventional term loan financing secured by specific equipment assets with loan-to-value coverage of 60–70%.
Note: Capital assets are stated at cost on the balance sheet and as such may be understated in value, hiding significant equity. Though this was not done here, it may be appropriate to obtain an appraisal of the assets for fair market value and increase the value of available collateral. This would provide the lender with better security coverage and may increase the amount to be financed.
#2 Sub-debt term loan: $215,000 — cash flow financing (unsecured)
This loan is based on cash flow and secured by a General Security Agreement subordinated to a chartered bank for the accounts receivable and inventory. It has equal payments over 60 months with interest charged at the base rate plus 3%. Rate on this term loan was higher due to the under secured and subordinate position of the lender. This is a typical subordinated debt financing program whose main focus is on available cash flow, whereas conventional
financing is based on a combination of available assets, equity, and cash flow. (A normalized statement of income can make a very important case for this specialized type of financing.) The above program would increase working capital by $315,000 and adequately address the immediate working capital problems of the company (defined previously as $315,000).
Operating Line of Credit — $350,000
Inventory is minimal and as such would not be considered as good security. The accounts receivable balances average between $700,000 and $1 million per month. As a rule, a line of credit is margined against 75% of eligible accounts receivable balances that are under 90 days due. In this case, available margined receivables would average between $525,000 and $750,000 without considering accounts over 90 days due. It would appear that the company has excellent line of credit coverage with average accounts receivable balances. This excess margin can also provide good additional security comfort for the subordinated term loan. (A definition of subordinated debt is found in the glossary.)
based on projected cash flows (not provided), the company should not require a line of credit facility beyond $350,000.
Note: A loan proposal can always include an annual review to increase the line of credit based on the company reaching certain financial milestones. This can often be written right into the loan agreement.
Balance sheet before and after new financing program ABC Sample LTD.
Proforma balance sheet As at December 31, 2xxx Reflecting new term financing
Before After
Current assets
Cash and equivalents 2,598 2,598
Accounts receivable, net 961,367 961,367
Inventories 40,123 40,123
1,004,088 1,004,088
Capital assets
Automotive 84,074 84,074
Office/computer 37,171 37,171
Equipment 150,401 150,401
Less: accumulated depreciation (133,826) (133,826)
Total capital assets, net 137,820 137,820
Total assets 1,141,908 1,141,908
Current liabilities
Line of credit 263,446 1 78,946 184,500
Accounts payable 396,368 1 175,000 221,368
Income taxes 61,054 1 61,054 0
720,868 405,868
Long term debt
Long-term debt — #1 1 100,000 100,000
Long-term debt — #2 1 215,000 215,000
Equity
Common shares 100 100
Retained earnings 415,105 415,105
Shareholder advances 5,835 5,835
421,040 421,040
Total liability and equity 1,141,908 315,000 315,000 1,141,908 1 Proceeds from term loan
The above program has achieved the following: • Increased available working capital by $315,000 • Increased current ratio from 1.39:1 to 2.48:1
• Improved monthly cash flow by terming out short-term debt • Payout of critical short-term payables and taxes
• Stabilized balance sheet (eliminate short-term debt being used as long term) • Reduced trade payable accounts (from overdue to current)
• No increase in debt to equity ratio 1.71:1
Additional tiered possibilities
The above financing program addressed the biggest issues facing the company: • Immediate working capital crisis
• Allowance for future growth
The company has increased its operating credit by $184,500, taken some immediate pressure off its short payables, and now is well positioned to move forward. To further stabilize its future financing requirements, the company could consider the following value-added financing options for future working capital needs (say in the next 12 months):
1. Unsecured top-up line of credit — Many chartered banks are now providing line of credit financing of up to $100,000 for small businesses on an unsecured basis — only requiring the personal guarantee of the shareholders. In this way, the company can access this top-financing without affecting or infringing on existing credit arrangements. The benefit of this product is that it is available on a standby basis and can be used when needed.
2. Factoring— A factoring program can supplement an existing line of credit facility. For many businesses, a growth spurt has consumed the entire LOC, yet there may be excess margin available. A factoring company can work with the bank to purchase invoices over margin. Again this is set up in advance, provided for on a standby basis, and used in tandem with an existing operating line.
3. EDC insurance — This is a federal government organization (Export Development Canada) that provides accounts receivable insurance to a company in cases where the customer account goes bad and does not pay. If EDC has insured the account, the
company does not suffer a loss but is paid by EDC for the amount of the unpaid customer invoice(s). As a result, with this enhanced protection, chartered banks will provide additional margin — as high as 90% — on EDC-insured accounts receivable balances. This can work well when a company is exporting and/or customer payment terms exceed 90 days.
The financing proposal — a tiered approach
If the company was to fully incorporate the previously outlined program, the tiered financing structure would resemble the following:
Use of funds Sources of funds
Payables/working capital $ 315,000 2-Term loan — sub debt $ 215,000 1-Term loan — secured 100,000 Accounts receivable 550,000 1-Line of credit — secured 350,000
3-EDC insured — margin to 90%
4-Line of credit — unsecured 100,000 5-Factoring facility — top up 100,000
Total $ 865,000 $ 865,000
Note: In the above example, there would be five different lenders involved working in tandem. Another alternative might be to increase the line of credit facility from $350,000 to $565,000 and eliminate the sub-debt lender #2. This type of financing is more costly (prime plus 4% versus prime plus 1% on the operating line), and there appears to be a lot of accounts receivable margin to accomplish this. In this case though, long-term debt (sub debt) was used to increase balance sheet stability (reduce short liabilities), increase working capital by $215,000 (which would not be achieved by increasing the operating line), and leave the operating line increase as an option available in the future.
Access to capital is one of the biggest issues facing entrepreneurs and one of the best opportunities for CGAs to deliver valuable professional services to their small and medium-sized business clients.
In the past, if the bank refused a loan, the business owner would likely be without a suitable financing alternative. Fortunately, these days there are many alternatives and solutions to successfully finance a business. A tiered or layered financing approach uses multiple financing products and funding sources. Today, a small business financing program might include some, all, or more of the following products:
1. Operating line — Secured 2. Operating line — Unsecured 3. Factoring
4. Capital term loan — Secured 5. Capital lease — Secured
6. Working capital term loan — Unsecured 7. Operating lease — Secured
Each of these products, in many cases, would be provided by different lenders. As a result, successful financing is a puzzle with many pieces. Developing the structure for a proposed financing program is therefore critical to success. A proper financing structure identifies and matches the:
• Purpose to the product • Product to the asset • Asset to the lender • Lender to the industry
CGAs can play a valuable role in guiding their clients through the ever-expanding maze of options to establish an effective, tiered financing strategy. By providing lenders with a financing proposal structured to the lender’s requirements, the chances for success in obtaining financing are greatly increased.
Mark Eikeland, CGA, is the founder and President of NetFinance.ca (e-Capital
Networks Group), an online corporate finance resource for accountants and accounting firms in BC and Alberta. He has been an entrepreneur, a business counsellor with the Business Development Bank of Canada, a college business lecturer, a sought-after seminar leader, and has held a variety of senior financial positions including Senior Finance Officer within the banking industry. Prior to forming NetFinance.ca in 2002, Mr. Eikeland operated a successful 10-year private practice as a professional accountant and business consultant to clients throughout BC and Alberta. Focusing in the area of Corporate Finance, he raised capital for small to mid-sized businesses to finance their start-up, acquisition,
re-organization, and expansion plans.
Visit NetFinance.ca for more information about NetFinance.ca. Or contact Mr. Eikeland at
This is the third of three articles by Mr. Eikeland on the subject of Corporate Finance — Strategic Financing to be carried on PD Net.
