Position your Business for Funding Opportunities
Small, Medium and Micro Enterprises (SMMEs) contribute a fair amount to the economic growth of the country while also contributing to innovation and job creation. As part of the National Development Plan (NDP), government sets a target of generating 11 million new employment opportunities by 2030 in South Africa with 90% of those expected to be created within the entrepreneurial environment. However, statistics indicate that 80% of South African SMMEs will fail in their first year while 63% of small business will fail in the first 2 years. Access to finance, necessary to facilitate growth or survival of these business, is one of the main challenges experienced.
According to the FinFind South African Smme Access To Finance Report, there is a large demand for SMME funding but a high percentage of the demand is from early stage SMMEs that battle to meet the traditional credit risk assessment requirements. The report findings also suggest that many business owners lack the financial knowledge or literacy needed to raise funding nor are they finance ready even if they have viable business models. Finance readiness refers to being able to produce the financial documentation required by lenders to assess how safe lending money to the company is, how much money to lend and what interest rates and terms should apply. These documents include up to-date management accounts, latest financial statements of both the business owner and the business, projections, break even analysis, business plan, and tax clearance certificates, amongst others. These documents serve as evidence of the business eligibility for funding, bankability and affordability. Financial statements consist of 4 critical statements:
The balance sheet, which is a depiction of the company’s overall financial health and stability at a certain point in time i.e., “what do we have”;
The profit and loss statement, which measures how the company performed during the course of operations over a certain period, usually a quarter or a year. It is made up of the revenue and expenses which yield a profit or loss for the period i.e., “how did we do”;
The statement of changes in equity, which measures the cumulative profits or losses of the business that have been retained and reinvested back into the business;
The cash flow statements which is a summary of how the business has been generating its cash and spending its cash resources and its solvency thereof.
However, just having the documents is not sufficient. It is important that you understand the purpose of these documents as well as some of the key business metrics lenders might be interested in when assessing the business because let’s face it, no business owner wants to waste their time on seeking funding that won’t be successful. Many viable business owners are unable to access finance simply because they are not finance ready. Furthermore, these business owners are also typically ill-equipped to make financial decisions or properly manage their cash flow as a result of not having their basic business management principles in place. It is therefore important that you understand your business financial position so that you can continuously work on positioning it for funding opportunities.
So, what do lenders look for in your financial records when evaluating if they should lend your business money or not? We focus on the most common business metrics you should be keeping an eye on in order to be successfully funded.
1. Cash Flow and Liquidity
Lenders are concerned whether your operations will generate enough cash to repay the loan advanced. The cash flow statement in your financial statement gives insight into the historic trends of business cash cycles, management competence, management decision making, and any significant changes in the business over time. A cash flow statement is composed of 3 activity centres:
Operating Activities - the money that goes in and out of the business from its operations or quite simply, this states the amounts received from customers and paid to suppliers and employees;
Investing Activities – the money invested in property and equipment, as well as financial investments, including their disposals;
Financing Activities – activities related to financing the business with both debt and equity instruments such as loans and dividends.
A lenders primary interest would be if the business generates sufficient sales in order to service the loan and other obligations. Cash flow from operating activities is a focus area therefore it is a good idea to also continuously focus on continuously improving your cash flow to achieve positive trending cash flows.
While a variety of factors may affect cash flow, liquidity ratio’s derived from the financial statements also give the lender insight into the businesses bankability. Liquidity ratios evaluate a businesses short-term ability to keep up with debt. The key liquidity ratio which lenders scrutinise is the current ratio which is calculated as current assets divided by current liabilities. Current assets refer to assets that can easily be converted to cash or exhausted within a year like cash, cash equivalents, accounts receivable, inventory, short term investments, pre-paid liabilities, and other liquid assets. Current liabilities are the liabilities which are due to be paid by the business within a year. A current ratio above 1:1 is favourable and suggests that the business has good liquidity whereas a ratio below that suggests that the business is illiquid and may be unable to service short term debts. Ideal ratios may vary depending on which industry the business operates in as the operational requirements are different. Further to the current ratio, if the business holds inventory, the quick ratio would be another liquidity indicator. The quick ratio (also known as the acid test ratio) disregards inventory held so that it gives a more conservative measurement of how quickly the company can liquidate its assets to pay off its current liabilities.
On the other hand, projections answer the question – “How will you use our money?”. Many entrepreneurs, eager to secure funding, make the mistake of presenting unrealistic or poorly constructed projections and fail to recognise that what they say or present in their plan needs to be mirrored in their projections. Each industry also has published industry benchmarks against which you can project average revenue to expenses ratios in computing realistic projections. You should be able to clearly demonstrate the return on investment your backers can expect. Your projections need to consider that the allocations are reasonable and justified – for example, does your marketing budget reflect the marketing strategy in your business plan? A trivial budget could result in your entire plan losing credibility because it is disconnected from your strategy. Viability means being able to demonstrate that your business is going to be able to generate future income - Tie your projections to real traction milestones like securing your first client. Your revenue projections should speak to this, or alternatively, your marketing efforts should reflect the return on investment. Well-constructed projections will validate your claims on the use of the funds you are asking for, and don’t forget, always have plan B to demonstrate an alternative scenario!
2. Debt Position
2 simple leverage ratios, offering a quick glimpse at the business ability to repay debt, are often used to evaluate the company's debt position. If the business is highly leveraged by debt these ratios would indicate that it is not capable of taking on any more debt or that cash can barely keep up with short term debt.
The debt ratio is the total liabilities divided by total assets. It can be interpreted as the proportion of a company’s assets that are financed by debt. A ratio greater than 1 indicates that the business has more debt than assets and would be at risk of defaulting on its debts if interest rates were to rise suddenly. This business is highly leveraged and could be a greater financial risk. On the inverse, a ratio less than 1 is favourable and indicates that the assets are mostly funded by equity. Capital intensive businesses often have higher debt ratios than other industries like service industry.
Debt-to-equity is total liabilities divided owners' equity. This ratio is closely related to the debt ratio and is more common than the debt ratio. It measures the degree to which a business is financing its operations through debt versus wholly owned funds, for example, for a company with a ratio of 2.5 this means that for every R1 an owner has invested in their company; they have let the bank invest an additional R2.50. The higher the ratio, the more risk a lender sees when evaluating the business.
3. Earnings before Interest Tax and Depreciation and Amortisation
This ratio, often shortened to EBITDA, is a measure of overall financial performance of the business and is often used by lenders and analysts to measure the long-term debt capacity of the business by applying an industry specific factor and thereafter subtracting the long term liabilities on the balance sheet in order to calculate available long term debt capacity available. While this ratio does not follow generally accepted accounting principles, there is an argument that it gives a clearer indication of the business performance as it disregards expenses that distort how the company is actually performing.
In conclusion, lenders and analysts use a combination of indicators to determine if a business is fundable. No one indicator is conclusive but together, they give a full picture of the overall financial health of the business. A well-rounded business would satisfy the 5 fundamental factors that lenders focus on when evaluating a loan: capacity, collateral, capital, character and conditions. If your business is lacking in any of these areas, obtaining a small business loan may prove difficult