How to assessing financial needs?

This chapter deals with the need to examine one’s business carefully before deciding to apply for short-term credit. It looks at the basic financial structure of an enterprise and provides guidelines on equity and loan capital and their role in financing assets. It explains the notion of working capital and looks at ways to improve liquidity management by reducing current assets or increasing current liabilities, thus lessening the need to resort to
bank loans.

Improving the financial structure of your business may reduce your borrowing requirements. It will also increase your competitiveness as a trader or export manufacturer by cutting your overhead costs (especially financial charges).

A. Do you really need to borrow?
This is the first question you must always ask yourself. The answer may seem obvious to you. This is why you have picked up this book in the first place : to get tips on to how to approach a lender for money. You may be surprised at being advised not to borrow. Yet why go to all the trouble of raising a loan when you may have some or even all the financial resources you needs simply by putting the current assets and current liabilities of your
business into some order.
The sections that follow may help you to do this.
B. The advantages and drawbacks of borrowing:
You have orders from customers and the business looks profitable, but you are short of cash to buy the goods and services needed to fulfil those orders. There are also salaries, suppliers and other creditors to pay. Your obvious and immediate reaction may be to apply to a bank for credit, having calculated that the margins on your transactions are sufficient to cover the cost of the money borrowed.
But, before you consider this possibility, you will first have taken a closer look at your business to see whether you really need to borrow and, if so, how much. There may indeed be several other possibilities open to you.
Borrowing is risky because you have to pledge assets as security. If for any reason you cannot service the debt by paying interest when it is due and refunding the principal borrowed, you could lose control over those assets or even forfeit them altogether.
This chapter discusses the importance of having sufficient permanent capital and compares the advantages and disadvantages of borrowing.

C. Having sufficient equity capital

There is no golden rule. The amount of equity you should have in your compan depends on its size and the type of activity or business you are engaged in. Equity (i.e. shareholders’ funds, also called owners’ equity) equals share capital plus reserves, or total assets minus total liabilities. Equity serves to finance your assets, but if this equity is insufficient, the balance is financed by liabilities in the form of short- and long-term credit or loans or, for some companies, by what is sometimes referred to as quasi-equity, such as preference shares, debentures or income notes.

The level of liabilities compared with the amount of equity in a company is called the debt-to-equity ratio or gearing. The bigger the liabilities, the higher the debt-to-equity ratio or gearing and vice versa. Another term used for gearing is leverage. In most cases, quasi-equityl is considered part of a company’s permanent capital and is thus consolidated with equity when calculating the debt-to-equity ratio. But this is not always necessarily so
lenders, such as banks, may well decide that any quasi-capital secured by the company’s assets actually constitutes a debt rather than part of the company’s equity.

It is often said that, as a rule of thumb, debt-to-equity should not be greater than 2 to 1. Ideally, however, it should be 1:1. Though in reality the stipulated debt-equity ratio by the lenders may vary from to l: l, which rule applies to you depends principally on your cash flow. The less your funds are tied up in working capital (net current assets), the stronger your cash flow is likely to be, and, assuming your sales margins are positive, the more you can afford to be, leveraged and the higher your return on equity will be. How you can improve your working capital situation is discussed in the next section.

So why is equity so important? The simple answer is that the more equity you have in your business, the greater your level of financial protection against external events such as a downturn in the economy or a credit squeeze. By contrast, the higher the debt-to-equity ratio, the more your assets are financed by debt. And it is probable that the debt is secured by pledges on those very assets.

To you, this is perhaps of little consequence. Actually, you may find a major advantage in having a high level of debt because of the leverage effect. You could say that if the cost of borrowing is less than, for instance, half the profit margin you make on sales, then your return on present equity is higher than if you had used additional equity instead of debt.This is certainly true in many cases, particularly as the cost of borrowing is deductible at
source/chargeable against profits. The situation changes when you are faced with the need to borrow more.

l. Such as preference shares, unsecured debt obligations, or income notes (obligations on which interest is paid only if the company has sufficient earnings). In Bangladesh, preference shares and income notes have not yet been put into practice.

If, for example, you need more working capital to buy goods or raw materials for sale or production, you may find your high debt-to-equity ratio an obstacle to obtaining this capital from the banks. Lenders may not want to take the risk of advancing you money with little or no security, since your assets are already pledged to others. Though there are certain financing techniques that can overcome the problem (these are discussed in chapter 2, Methods of payment and financing techniques), they may not always be available in Bangladesh or your banker may not wish to consider them. In most cases, one of the best solutions is to increase your equity capital.

Although it is advisable to increase your equity, it may not always be possible. You may not have the resources yourself, or you may not want to dilute your own interest in the company by introducing new shareholders. Again, you may not be able to find investors ready to take up (non-voting) preference shares (even if introduced in Bangladesh),unsecured debentures, or any other form of unsecured debt. There may be another solution. This is to try to reduce your current assets and increase your current liabilities other than bank borrowings retaining compatibility with the scale of business. This is dealt with in the next section.

D. Fixed assets

Unproductive fixed assets tie down your equity and can actually be a cost if they are maintained or if you are paying rates and taxes on them. Typical of such assets are unused buildings, land or equipment.
Other assets may be productive, but you may have an alternative to ownership. Vehicles, for instance, can be hired or leased, with the tax advantages such arrangements can bring. Premises can be rented rather than owned. Production or storage areas can be allocated to more profitable activities, or even dispensed with, through subcontracting.

If you need funds to expand into profitable business activities:

Consider the possibility of selling your unproductive assets or assets that need not be owned but can be hired or leased.
Evaluate the market worth of your unwanted fixed assets.
Compare the cost of renting, leasing or hiring with the cost of the tied-up capital,using current interest rates on bank loans as your benchmark.
Compare your costs of production or warehousing with the costs of subcontracting.
Remember, though, that you may not dispose of assets that are already pledged to lenders without first obtaining their approval.

E. Working capital

Working capital consists of the funds that are tied up in accounts receivable (debtors or customer invoices), stocks and inventories of raw materials, finished goods or work in process, goods in transit, prepaid expenses, cash and positive bank balances. In other words, your working capital is made up of all your current assets less all your current liabilities (creditors, short-term loans, accrued debts). On your balance sheet, it is referred
to as net current assets.

All current assets have to be financed by some means or another. Your current liabilities are normally their first source of finance. The balance is financed by equity and, if that is insufficient, then by medium – or long-term liabilities (debt). In other words, when looking at your balance sheet, compare your current assets with current liabilities. If current assets are greater than current liabilities, which is normally the case — the difference between the two being your net current assets or working capital — see how this balance is financed. Do
you have sufficient equity capital (share capital and reserves) to cover the amount, or are you having to resort to longer-term debt obligations.

You can see how, by reducing your current assets, you can also either reduce your liabilities or liberate funds to finance productive assets. Examples of this are set out in the sections that follow.

F. Determining your working capital requirements

This is really all about treasury management. The paragraphs below provide checklists and ideas on how you can improve your liquidity by reducing unproductive assets and increasing short-term liabilities (obligations and commitments of less than one year excepting bank borrowings) that cost little or nothing.

G. Reducing your unproductive current assets
Consider the paragraphs below as a checklist and go through your balance sheet to see
how you can apply some of these ideas.

1 . Reducing your stocks of raw materials, consumables or commodities for export
You may have several good reasons for building up stocks of raw materials, consumables and other supplies for production, but does it save you money or does in fact cost you more? The advantages may seem obvious: bulk discounts; countering the risk if inflation, removing some of the uncertainties surrounding deliveries. But stocks tie up funds that may be more productively employed, and those funds may in fact be costly loans. Even if they are not, the opportunity cost is high because you may be able to invest the surplus cash more profitably.

Test whether the following reasons for building up stocks are really valid:
Bulk discount. Work out how much interest you are paying on stocks between the time they are paid for and the time (on average) they are consumed. Now do the same calculation for smaller amounts purchased more frequently, but without the discount.

Can you not negotiate a discount for smaller quantities bought on a regular basis?
Countering inflation risk. How do expected price increases compare with the current or forecast inflation rate? Is the rate of Increase higher or lower than the interest rate on loans or the yield you could obtain from a short-term investment?
Reducing deltvery risk. How serious is this risk in reality? Are there other suppliers? What are the financial consequences of a shortage of stocks? Calculate the cost per day and compare it with the interest rate you are paying on the safety margin stock.

Consider also storage costs

If you rent warehousing space, calculate how much less space you would need to pay for if you had reduced levels of stock.
Do your stocks take up space that could be more profitably used for production?
Consider the possibility of introducing the just-in-time method of deliveries of raw materials and other inputs. Under such a method your suppliers will deliver goods only when you actually need them (for production or export). The method supposes, of course, that your suppliers are absolutely reliable and that late deliveries will not penalize your business.
You should not also lose sight of the fact that though the above reasons may justify building up of stocks of raw-materials and other inputs, it should not avoid any risk of technological obsolescence of the materials. If the case is such, reduction of stock of materials and inputs is recommended.

2. Speeding up work-in-progress

• Can you reduce the time it takes to manufacture your products or prepare your goods for export?
• If it requires extra labour, compare the additional cost with the saving in interest.

3. Reducing your stocks of finished goods or inventories

• By how much can you reduce such stocks without running the risk of shortages?
• What would be the cost of a day’s or a week’s delay in supplying a customer or in shipping goods, compared with the cost of storing finished products or commodities? (Use the same parameters as for procurement of raw-material from the suppliers).

Reducing your debtors and receivables

• Do customers settle their invoices on time? If not, what are the procedures for collecting overdue receivables? Do you have access to a collection agency?
• Do you grant customers credit? If so, is it free, or do they pay an interest charge?
  Would you lose your customer if you ceased giving credit, reduced the credit period
  or if you charged interest?
• Calculate the cost of granting customers credit. Is it higher than your sales margin?
  Is it worth it?
• Have you considered discounting receivables with a bank?
• Do you have access to factoring services? Have you evaluated its worth?

It is possible that you are unfamiliar with discounting or forfaiting services which are yet to be introduced in Bangladesh for future reference, definitions of these are given in chapter 2.

5. Reducing prepaid expenses

Certain prepaid expenses cannot be avoided: insurance premiums, for instance. But are you paying for services in advance where it may be possible to obtain a delay or to pay in instalments? If you can pay in installments, but at a marginally higher rate, compare the additional cost with the interest cost of a loan.

H. Increasing your current liabilities at little or no extra cost

The checklist below suggests areas where you could improve your company’s liquidity position by negotiating delayed payment terms.

1. Obtaining longer payment terms from your suppliers

You and your suppliers are on opposite sides of the fence. Their objective is to be paid as soon as possible, but yours may be to delay payment for as long as possible. It is, of course, a mistake to withhold payment systematically until the final reminder. It ruins relations and suppliers retaliate by lowering the level of their services. The answer is to negotiate an arrangement that benefits both parties.

It pays to be open about your concerns and interests and to understand your suppliers’ concerns as well. If you can genuinely demonstrate to them that, by granting you trade credit (as it is called), your business will expand and their interests will follow in your wake, you are more likely to obtain concessions than by threatening to find another source of supply. But, if your suppliers are also in tight liquidity situations, it may be worth your while to agree to pay them interest on delayed payments. Credit from suppliers could be cheaper and certainly less complex than borrowing from financial institutions. Agreements can be reached quickly and informally and they are unlikely to ask for security or costly legal documentation.

2. Obtaining longer delays for paying taxes

You may be able to negotiate deferred tax payments with your tax authorities through frank presentation of the facts. If your accounts are audited and you have a good record of growth, you can show these financial statements as well as your cash-flow projections and try to agree upon a payment schedule that improves your liquidity. It is, after all, in the interest of the tax authorities to have companies trade profitably and grow.

3. Obtaining an extension of a loan repayment date

In chapter 5, the question of restructuring and rescheduling is discussed. Borrowers may have to resort to such expediencies, with the agreement of the lender, when they find themselves unable to honour the terms of their loan agreement, i. e., to repay the short term loans and current portion of their long-term loans. However, such situations may arise for companies that have no serious liquidity problems and what they require is simply a short extension to the fixed date for the repayment of a loan installment to allow for some event that could not have been foreseen.

In principle, lenders are flexible when it comes to delaying principal installments on two main conditions. The first is that interest is paid when due (this is known as keeping interest current). The second is that the reason for the delay is unlikely to recur, being the result of a temporary circumstance outside the control of the borrower and not seriously affecting longer-term performance.

In such situations, the matter should be raised as early as possible with the lender and discussed openly and frankly.
If, on the other hand, your objective is to obtain systematic delays, then you are talking of a restructuring of your existing debt. This is tantamount of approaching a lender for a renewed facility2 and is, therefore, the subject of a separate section in chapter 5.

2. A facility is the agreed amount of money to be advanced by a lender to a borrower. The actual amount of money disbursed is the loan or advance.

INTERNAL FINANCING CHECKLIST
Raising funds by reducing current assets

> Cash. Is there cash lying in deposit accounts with the bank or in savings accounts?
> > Marketable securities. Are there treasury bills, stocks and shares, bonds that can be sold on the stock exchange?
> > Accounts receivable. Can debtors be made to pay up more quickly? Are any bad debts or written-off receivables recoverable through an agency? Will a bank discount receivables such as invoices, bills or promissory notes? Would customers accept .to pay interest on trade credit given?
> >  Stocks and inventories. Can stocks of raw materials, commodities be reduced? Should production be slowed down or rescheduled to avoid stockpiling finished products?
> >  Prepaid expenses. Can insurance premiums and other prepaid services be settled in installments? And without any extra cost?
> >  Advances to third parties. Can loans be called in?

Raising funds by reducing fixed assets

> Land and buildings. Are they necessary for business? If so, can they be sold and leased back? If not, can they be disposed of?
> >  Machinery, equipment. Are they all required for production? What can be sold and leased back? What items can be disposed of altogether?
> >  Investments in subsidiaries, other businesses. Are they profitable, bringing in cash? If not, should they not be disposed of?

Raising funds by increasing current liabilities

• Trade creditors. Would creditors grant trade credit? With or without interest?
• Taxes. Can taxes be deferred without penalty? Or paid in installments?
• Short-term borrowings. Can the periods of credit limit adjustment be extended? Term loan installments rescheduled?

Raising funds by increasing equity

• Distribution of profits. Will shareholders or partners accept to defer or suspend dividend
  payments?
• Share capital increase. Will shareholders or partners increase their equity stake in the
  business by injecting fresh funds? Can you bring in one or more new shareholders who
  could be useful partners in your business as well?
• Income notes, bonds, preference shares. Are there investors prepared to invest in these instruments?

Note: The question of forfaiter buying invoices and the possibility of raising funds by issuing income notes, bonds and preference shares are not yet relevant in Bangladesh.

TIPS ON ASSESSMENT OF WORKING CAPITAL REQUIREMENTS BY EXPORTERS : BANGLADESH SCENARIO
A. Format used for Working Capital Estimate:
Amount
Items
1. Inventory
a. Imported raw and packing materials. Tied-up Period-days (at production cost)
b. Local raw and packing materials.Tied-up Period-days (at production cost)
c. Stores and Spares.Tied-up Period-days (at production cost)
d. Work-in Process. Tied-up Period-days (at production cost)
e. Finished’ Goods.Tied-up Period-days(at production cost)
2  . Receivables.Tied-up Period-days(at production cost)
3. Cash in hand-days (at production cost).Tied-up Period- Cash requirement for other expenses to be arranged by sponsors.
No. of days tied up under each item vary depending upon the specific industry sub-sector. Capacity utilization is fixed up based on last year’s actual capacity utilization in case of existing units and sanctioned/rated capacity in case of new units.
Source: Bangladesh Bank.

B. Assessment of Working Capital by Exporters:

• Banks assess working capital requirement of exporters both on the basis of L/C value (around 90%) and components of working capital.
• o In the case of export of traded items, procurement and packing constitute the major purposes of working capital, while in the case of export of manufactured items,purchase and processing of raw materials, packing provide the major elements of working capital.
• The amount of an average export order ranges from Tk. I million to Tk. 10 million. Exporters estimate the working capital requirement mostly on their own.
• Increasing equity and reduction of excessive current assets constitute the major sources of internal financing of working capital, whereas in case of external sources banks and suppliers (being the first and second choice respectively) are the major providers of working capital.
• The majority of the exporters advocate relatively high level of equity for meeting the financial needs of the project on the ground of protection against unexpected events.
• Most of the idle/unused fixed assets comprise land, followed by equipment.
• The majority of the exporters do not carry current assets at more than the required level. Those who do so resort to the reduction of current assets by decreasing excessive inventory and corresponding current liabilities.
  Source: Primary Survey.

Article Source: How to Approach Banks: A guide for Bangladesh Entrepreneurs Page 1-9

Assessing Financial needs