Entrepreneurs

Those of us who have large investments in private businesses aren't like typical savers. We need a different strategy for our personal investments.

Most personal finance experts tell a fairly consistent story about the need to build a diversified investment portfolio focused on long-term growth. But that type of investment the strategy doesn't necessarily apply to entrepreneurs and owners of private businesses, especially high-growth businesses.

We are a unique lot. Our concentrated investment in a risky but highly attractive company means that our overall investment portfolio is skewed differently than the average investor. One business owner once told us, "My business is my retirement strategy." This perspective underscores the importance of building a plan that's unique to your risk profile and your appetite for entrepreneurial opportunities.

Here are different personal investment principles we have learned to keep in mind when your job is growing a business:

1. Build a "no-touch" portfolio.

When you invest in stocks, bonds, and mutual funds put them out of reach by creating "no-touch" portfolios in accounts that you will never access. This will reduce the temptation to dip into long-term investments to address a short-term need for a cash infusion if your business is struggling. You can create more protection by loading up your retirement accounts and your kids' education accounts. These are places where there is a huge financial penalty for accessing those funds, which will keep you honest.

2. Protect your assets.

Structure your investments--and your company--so that creditors can't reach your money if the business runs into financial or legal peril. In addition to structuring your business appropriately, this also involves transferring assets to spouses and children where possible and investing within retirement accounts and real estate, which in some cases are out of reach.

3. Diversify away from your business.

Seek investments in your portfolio that are counter-cyclical to your industry and business cycle. Investing in commodities may be risky in general, but if your business is heavily linked to the broader economy or public equity markets, a countercyclical asset such as commodities may be attractive.

4. Invest more conservatively outside your business.

Most investment professionals recommend a heavy equity portfolio for younger professionals and a larger fixed-income portfolio for older individuals. Given that an entrepreneur's business may largely cover her "equity risk," she may be better off with a more conservative portfolio outside of her business.

5. Build a cash cushion for future entrepreneurial ventures.

Most of us can't pass up a good deal when it comes along. That's why we became entrepreneurs in the first place. If you have the luxury of cash outflows from your business, put a sufficient amount aside so that you can keep some dry powder when new opportunities present themselves.

                  

6. Make smart business investments.

The best way to protect your personal finances is to ensure that your business has a sound, balanced approach to investing its capital. Our recent column on a growing business's investment strategy discussed this in some detail.

7. Build a great business model.

Of course, the best personal investment strategy maybe your business itself. After all, your business can be your retirement strategy if it's successful. Building your business should be what you do best. So focus your time and effort there and leave the investing to a professional.

We should note that although we advise private investors on investing in growth companies, we aren't investment advisers. We can share our own thoughts and experiences, but for more targeted advice you should seek a professional investment adviser.

Accounting Basic for Startups

“Accounting Basic for Startups”, this article will throw light on the calculation and interpretation of key financial ratios for evaluating the performance of concern. 

Working Capital Management is a process to check whether your current assets or easy convertible into liquid cash is enough to cover your current liabilities or expenses. Comfortable Working capital suggests financial viability and sustainability, as it indicates that the Startup has sufficient cash in order to meet its short-term debt obligations and operating expenses. 

Before discussing Working Capital Management, let’s get versed with some basic terms and concept of Working Capital. Working Capital measures both company’s efficiency and its short term financial health.

The working capital ratio is calculated as below - 

                  Working Capital = Current Assets + Current Liabilities 

Ingredients of Working Capital:

Current Assets - A balance sheet item which represents liquid cash and cash equivalents, accounts receivables, marketable securities, inventory, prepaid expenses and all other assets that could be converted to cash easily. 

Current liabilities – A company’s debts or obligations that are due in the near future, and includes short term debts, accounts payable, accrued liabilities and other debts. 

Value and Time Concept in Working Capital 

VALUE: From the value point of view, Working Capital can be segregated into Gross Working Capital or Net Working Capital. 

Gross Working Capital - It refers to the firm’s investment in current assets.

Net Working Capital - It refers to the difference between current assets and current liabilities A positive working capital means that the company is able to pay off its short term liabilities, whereas a negative working capital suggests that the company currently is unable to meet its short term liabilities. 

TIME: From the point of view of time, it is referred to as permanent or temporary. 

Permanent - Permanent working capital refers to the minimum level of investment in the current assets by the business at all times to carry out the minimum level of activities. 

Temporary - Temporary working capital is also known as variable working capital refers to that part of total working capital, which is required by a business over and above permanent working capital. 

Importance – Effective Working Capital Management Founder of a Startup is accountable to determine and ensure the requirements of working capital carefully in such a way that the amount of working capital available with him is neither too large nor too small for its requirement. An as a large amount of it would mean that the Startup has ideal funds. 

Since the funds have a cost, they have to pay interest on such funds. On the other hand, if there is inadequate working capital, then the business might run into the risk of insolvency, and the continued paucity of adequate working capital can seriously challenge the financial viability and sustainability of the business. Optimum Working Capital There is no standard rule for an Optimum Working Capital. The working capital requirements vary from industry to industry. 

Traditionally, the Current Ratio (Current Assets: Current Liabilities) of 1.5 to 2 is considered to be a comfortable liquidity position. However, it should be remembered that optimum working capital can be determined only with reference to particular circumstances. Thus, for an example: If a firm has sundry debtors, as good as liquid cash then, in that scenario even a current ratio above 1 would be comfortable for the business. 

DETERMINANTS OF WORKING CAPITAL Cash - Identification of cash balance for meeting day to day business expenses. 

Inventory - identifies the level of inventory needed for uninterrupted production, also which reduces the investment in raw materials. 

Debtors – It identifies the appropriate credit policy, i.e., credit terms which will attract customers. Small or Large Business - It is the determinant of working capital that it is affected by the nature of business. 

Small or Large demand – The urgency of the demand for the product in the market also determines the level of working capital required for a business. 

Technology and manufacturing policy – for instance, in some businesses the demand for goods is seasonal, in that case, a business may follow a policy for steady production throughout over the whole year or instead may choose a policy of production only during the demand season. Sign up for Newsletters Check out our popular newsletters and subscribe 

Price Level changes –businesses using a raw material having price volatility would require a higher level of working capital vis-à-vis a price-stable input raw material. 

Effect of external business environmental factors - There are external business environmental factors which affect the need for working capital like fiscal policy, monetary policy and bank policies and facilities. 

The business cycle – every business considering the cycle of business it is in, would have a different level of working capital requirements. 

To Conclude The actual sustainability of the business is established when it is able to pay off its day to day expenses from day to day revenue. 
Normally, businesses make a mistake of paying day to day expense with infrastructure resources in the absence of proper working capital requirement analysis.

Most Common Sources of Short-Term Working Capital Financing

Working capital is one of the most difficult financial concepts for the small-business owner to understand. In fact, the term means a lot of different things to a lot of different people. By definition, working capital is the amount by which current assets exceed current liabilities. However, if you simply run this calculation each period to try to analyze working capital, you won't accomplish much in figuring out what your working capital needs are and how to meet them.

A more useful tool for determining your working capital needs is the operating cycle. The operating cycle analyzes the accounts receivable, inventory and accounts payable cycles in terms of days. In other words, accounts receivable are analyzed by the average number of days it takes to collect an account. Inventory is analyzed by the average number of days it takes to turn over the sale of a product (from the point it comes in your door to the point it is converted to cash or an account receivable). Accounts payable are analyzed by the average number of days it takes to pay a supplier invoice.

Most businesses cannot finance the operating cycle (accounts receivable days + inventory days) with accounts payable financing alone. Consequently, working capital financing is needed. This shortfall is typically covered by the net profits generated internally or by externally borrowed funds or by a combination of the two.

Most businesses need short-term working capital at some point in their operations. For instance, retailers must find working capital to fund seasonal inventory buildup between September and November for Christmas sales. But even a business that is not seasonal occasionally experiences peak months when orders are unusually high. This creates a need for working capital to fund the resulting inventory and accounts receivable buildup.

Some small businesses have enough cash reserves to fund seasonal working capital needs. However, this is very rare for a new business. If your new venture experiences a need for short-term working capital during its first few years of operation, you will have several potential sources of funding. The important thing is to plan ahead. If you get caught off guard, you might miss out on the one big order that could put your business over the hump.

Here are the five most common sources of short-term working capital financing:

1.    Equity. If your business is in its first year of operation and has not yet become profitable, then you might have to rely on equity funds for short-term working capital needs. These funds might be injected from your own personal resources or from a family member, a friend or a third-party investor.

2.    Trade creditors. If you have a particularly good relationship established with your trade creditors, you might be able to solicit their help in providing short-term working capital. If you have paid on time in the past, a trade creditor may be willing to extend terms to enable you to meet a big order. For instance, if you receive a big order that you can fulfil, ship out and collect in 60 days, you could obtain 60-day terms from your supplier if 30-day terms are normally given. The trade creditor will want proof of the order and may want to file a lien on it as security, but if it enables you to proceed, that should not be a problem.

3.    Factoring. Factoring is another resource for short-term working capital financing. Once you have filled an order, a factoring company buys your account receivable and then handles the collection. This type of financing is more expensive than conventional bank financing but is often used by new businesses.

 

4.    Line of credit. Lines of credit are not often given by banks to new businesses. However, if your new business is well-capitalized by equity and you have good collateral, your business might qualify for one. A line of credit allows you to borrow funds for short-term needs when they arise. The funds are repaid once you collect the accounts receivable that resulted from the short-term sales peak. Lines of credit typically are made for one year at a time and are expected to be paid off for 30 to 60 consecutive days sometime during the year to ensure that the funds are used for short-term needs only.
 

5.    Short-term loan. While your new business may not qualify for a line of credit from a bank, you might have succeeded in obtaining a one-time short-term loan (less than a year) to finance your temporary working capital needs. If you have established a good banking relationship with a banker, he or she might be willing to provide a short-term note for one order or for a seasonal inventory and/or accounts receivable buildup.

In addition to analyzing the average number of days it takes to make a product (inventory days) and collect on an account (accounts receivable days) vs. the number of days financed by accounts payable, the operating cycle analysis provides one other important analysis.

You can see that working capital has a direct impact on cash flow in a business. Since cash flow is the name of the game for all business owners, a good understanding of working capital is imperative to making any venture successful.

Entrepreneurial Tips to Managing Working Capital

Managing working capital is a commonly overlooked task for the entrepreneur-to-be. However, once the business is underway it becomes apparent that it is a necessary task.

The goal is obvious: satisfy all debt with enough remaining capital to keep the business going while turning a profit. Luckily, there are multiple aspects of your business that, when focused on, can enhance and ease the task of managing working capital.

1. Stay Stocked but Streamline

This is a common pitfall for the type-A personality entrepreneur, that of overdoing it in stock. It’s true, not having the necessary inventory in place could cost you a sale, but excessive inventory could be costing you too.

There is no need for working capital to be tied up in an exorbitant amount of stock. Considerate planning will afford entrepreneurs to stock what they need without holding additional working capital hostage on a stagnant shelf.

The means of notation (computer, hand-written) does not matter, just focus on finding an inventory system that works for you and commit to sticking with it.

2. Plan for Lows

Industry trends and seasonal changes can affect the rate at which your business turns a profit. As an entrepreneur, your best bet is to forecast sales.

You can effectively plan and predict by checking up on your competitors, paying attention to industry shifts and setting modest goals. With some proactive planning, your business’s cash flow can withstand the lows by compensating in areas like inventory and labour.

3. Pay On Time and Not a Second Sooner

For some, it makes sense to pay suppliers as soon as their business receives an invoice. However, that cash could better serve your business in other areas (like investments and interest). Schedule out paying your creditors back so that payments are always received on time, but at a consistent rate that you can plan for and manage.

On the flip side, there are creditors out there who offer discounts for early payments. Inquire if such perks exist and see if by paying sooner, you can save your business some much-needed working capital. Also, if you are a loyal customer to certain creditors, see if you can establish a routine pay date at a time during each month that works the best with the flow of your business.

4. Borrow With Care

Financial lenders can offer short-term funding that can alleviate the working capital needs of a business. Entrepreneurs who are looking to make improvements (such as expansion, more inventory or new equipment) might consider a merchant cash advance so not to disturb their company’s cash flow.

Like any business decision, entrepreneurs should make the decision to borrow with care. In exchange for quick funding and minimal requirements, historically the rates are higher than others.

Credit Analysis

Credit Analysis Definition

Credit analysis is a process of drawing conclusions from available data (both quantitative and qualitative) regarding the creditworthiness of an entity, and making recommendations regarding the perceived needs, and risks. Credit Analysis is also concerned with the identification, evaluation, and mitigation of risks associated with an entity failing to meet financial commitments.

Credit Analysis Process

The below diagram shows the overall Credit Analysis Process

What does a Credit Analyst look for?

In layman terms, Credit analysis is more about the identification of risks in situations where a potential for lending is observed by the Banks. Both quantitative and qualitative assessment forms a part of the overall appraisal of the clients (company/individual). This in general, helps to determine the entity’s debt-servicing capacity, or its ability to repay.

Ever wondered why bankers ask so many questions and make you fill so many forms when you apply for a loan. Don’t some of them feel intrusive and repetitive and the whole process of submission of various documents seems cumbersome. You just try to fathom, as to what they do with all this data and what they are actually trying to ascertain! It is definitely not only your deadly charm and attractive personality that makes you a good potential borrower; obviously, there is more to that story. So here we will try to get an idea about what exactly a Credit Analyst is looking for.

The 5 C’s of Credit Analysis

Character

• This is the part where the general impression of the protective borrower is analyzed. The lender forms a very subjective opinion about the trustworthiness of the entity to repay the loan. Discrete inquiries, background, experience level, market opinion, and various other sources can be a way to collect qualitative information and then an opinion can be formed, whereby he can make a decision about the character of the entity.

Capacity

• Capacity refers to the ability of the borrower to service the loan from the profits generated by his investments. This is perhaps the most important of the five factors. The lender will calculate exactly how the repayment is supposed to take place, cash flow from the business, the timing of repayment, probability of successful repayment of the loan, payment history and such factors, are considered to arrive at the probable capacity of the entity to repay the loan.

Capital

• Capital is the borrower’s own skin in the business. This is seen as proof of the borrower’s commitment to the business. This is an indicator of how much the borrower is at risk if the business fails. Lenders expect a decent contribution from the borrower’s own assets and personal financial guarantee to establish that they have committed their own funds before asking for any funding. Good capital goes on to strengthen the trust between the lender and the borrower.

Collateral (or Guarantees)

• Collateral is a form of security that the borrower provides to the lender, to appropriate the loan in case it is not repaid from the returns as established at the time of availing the facility. Guarantees, on the other hand, are documents promising the repayment of the loan from someone else (generally family member or friends), if the borrower fails to repay the loan. Getting adequate collateral or guarantees as may deem fit to cover partly or wholly the loan amount bears huge significance. This is a way to mitigate the default risk. Many times, Collateral security is also used to offset any distasteful factors that may have come to the forefront during the assessment process.

Conditions

• Conditions describe the purpose of the loan as well as the terms under which the facility is sanctioned. Purposes can be Working capital, purchase of additional equipment, inventory, or for long term investment. The lender considers various factors, such as macroeconomic conditions, currency positions, and industry health before putting forth the conditions for the facility.

Credit Analysis Case Study

From times immemorial, there has been an eternal conflict between entrepreneurs/businessmen and bankers, regarding the quantification of credit. The resentment on the part of the business owner arises when he believes that the banker might not be fully appreciating his business requirements/needs and might be underestimating the real scale of opportunity that is accessible to him, provided he gets sufficient quantum of loan. However, the credit analyst might be having his own reasons to justify the amount of risk he is ready to bear, which may include bad experiences with that particular sector or his own assessment of the business requirements. Many times there are also internal norms or regulations which force the analyst to follow a more restrictive discourse.

The most important point to realize is that banks are in the business of selling money and therefore risk regulation and restraint are very fundamental to the whole process. Therefore, the loan products available to prospective customers, the terms and conditions set for availing the facility and the steps taken by the bank to protect its assets against default, all have a direct forbearance to the proper assessment of the credit facility.

So, let’s have a look at what does a loan proposal looks like:

The exact nature of proposals may vary depending on subsequent clients, but the elements are generally the same.

**To put things into perspective let’s consider the example of one Sanjay Sallaya, who is credited to being one of the biggest defaulters in recent history along with being one of the biggest businessmen in the world. He owns multiple companies, some sports franchises, and few bungalows in all major cities.

1. Who is the client? Ex. Sanjay Sallaya, reputed industrialist, owning majority share in XYZ ltd., and some others.
2. Quantum of credit they need and when? Ex. Starting a new airline division, which would cater to the high-end segment of society. Credit demand is $25 mil, needed over the next 6 months.
3. The specific purpose the credit will be employed for? Ex. Acquiring new aircraft, and capital for day to day operations like fuel costs, staff emoluments, airport parking charges, etc.
4. Ways and means to service the debt obligations (which include application and processing fees, interest, principal and other statutory charges) Ex. Revenue generated from flight operations, freight delivery, and freight delivery.
5. What protection (collateral) can the client provide in the event of default? Ex. Multiple bungalows in prime locations offered as collateral, along with the personal guarantee of Sanjay Sallaya, one of the most reputed businessmen in the world.
6. What are the key areas of the business and how are they operated, and monitored? Ex. Detailed reports would be provided on all key metrics related to the business.

Answers to these questions, help the credit analyst to understand the broad risks associated with the proposed loan. These questions provide the basic information about the client and help the analyst to get deeper into the business and understand any intrinsic risks associated with it.

Credit Analyst – Obtaining Quantitative Data of the Clients

Other than the above questions the analyst also needs to obtain quantitative data specific to the client:

• Borrower’s history – A brief background of the company, its capital structure, its founders, stages of development, plans for growth, list of customers, suppliers, service providers, management structure, products, and all such information are exhaustively collected to form a fair and just opinion about the company.
• Market Data – The specific industry trends, size of the market, market share, assessment of competition, competitive advantages, marketing, public relations, and relevant future trends are studied to create a holistic expectation of future movements and needs.
• Financial Information – Financial statements (Best case/ expected case/ worst case), Tax returns, company valuations and appraisal of assets, current balance sheet, credit references, and all similar documents which can provide an insight into the financial health of the company are scrutinized in great detail.
• Schedules and exhibits – Certain key documents, such as agreements with vendors and customers, insurance policies, lease agreements, picture of the products or sites, should be appended as exhibits to the loan proposal as proofs of the specifics as judged by above-mentioned indicators.

**It must be understood that the credit analyst once convinced will act as the client’s advocate in presenting the application to the bank’s loan committee and also guiding it through the bank’s internal procedures. The details obtained are also used to finalize the loan documentation, terms, rates, and any special covenants which need to be stipulated, keeping in mind the business framework of the client as well the macroeconomic factors.

Credit Analysis – Judgement

After collating all the information, now the analyst has to make the real “Judgement”, regarding the different aspects of the proposal which will be presented to the sanctioning committee:

• Loan – After understanding the need of the client, one of the many types of loans, can be tailored to suit the client’s needs. Amount of money, the maturity of the loan, expected use of proceeds can be fixed, depending upon the nature of the industry and the creditworthiness of the company.
• Company – The market share of the company, products, and services offered, major suppliers, clients, and competitors, should be analyzed to ascertain its dependence on such factors.
• Credit History – Past is an important parameter to predict future, therefore, keeping in line with this conventional wisdom, the client’s past credit accounts should be analyzed to check any irregularities or defaults. This also allows the analyst to judge the kind of client we are dealing with, by checking the number of times late payments were made or what penalties were imposed due to non-compliance with stipulated norms.
• Analysis of market – Analysis of the concerned market is of utmost importance as this helps us in identifying and evaluating the dependency of the company on external factors. Market structure, size, and demand of the concerned client’s product are important factors that analysts are concerned with.

Credit Analysis Ratios

A company’s financials contain the exact picture of what the business is going through, and this quantitative assessment bears the utmost significance. Analysts consider various ratios and financial instruments to arrive at the true picture of the company.

1. Liquidity ratios – These ratios deal with the ability of the company to repay its creditors, expenses, etc. These ratios are used to arrive at the cash generation capacity of the company. A profitable company does not imply that it will meet all its financial commitments.
2. Solvability ratios – These ratios deal with the balance sheet items and are used to judge the future path that the company may follow.
3. Solvency ratios – Solvency ratios are used to judge the risk involved in the business. These ratios take into the picture the increasing amount of debts which may adversely affect the long term solvency of the company.
4. Profitability ratios – Profitability ratios show the ability of a company to earn a satisfactory profit over a period of time.
5. Efficiency ratios – These ratios provide insight into the management’s ability to earn a return on the capital involved, and the control they have on the expenses.
6. Cash flow and projected cash flow analysis – Cash flow statement is one of the most important instruments available to a Credit Analyst, as this helps him to gauge the exact nature of revenue and profit flow. This helps him get a true picture of the movement of money in and out of the business
7. Collateral analysis – Any security provided should be marketable, stable, and transferable. These factors are highly important as a failure on any of these fronts will lead to complete failure of this obligation.
8. SWOT analysis – SWOT Analysis is again a subjective analysis, which is done to align the expectations and current reality with market conditions.

If you wish to learn more about financial analysis, then click here for this amazing Financial Statement analysis guide

Credit Rating

A credit rating is a quantitative method using statistical models to assess creditworthiness based on the information of the borrower. Most banking institutions have their own rating mechanism. This is done to judge under which risk category the borrower falls. This also helps in determining the term and conditions and various models use multiple quantitative and qualitative fields to judge the borrower. Many banks also use external rating agencies such as Moody’s, Fitch, S&P, etc. to rate borrowers, which then forms an important basis for consideration of the loan.

The 6 Questions Entrepreneurs Should Be Prepared for Investors to Ask

Q: What questions should entrepreneurs be prepared for investors to ask?
A: In my experience raising capital, investors have a tendency to ask similar questions to dig into six basic areas which are your team, market, product, outreach, business model and capitalization. In my opinion, there are better questions to ask (which I touch on later) but these are all important areas to cover and you should be prepared to answer:

1. Who is your team?

So start with yourself and your team. If you can effectively sell the investor on why you’re uniquely qualified to solve the problem you’re tackling, they’ll start to lean in and give you a fair listen. Share if you are working with advisors or whether angel investors have already indicated they’d like to invest.

2. What is the market opportunity?

What’s important here is to explain how what you’re doing is different and what uniquely positions you as a market leader. Consider the market or customers from which you will extract direct value to describe the true market size.

3. What is your product and what does it do?

When describing your product it’s essential to explain not only the problem it solves, but how is it tackling the issue differently, and how the difference is big enough to make people care and be competitive.

4. How will you drive awareness and early adoption for your product?

Investors will want to know what marketing and distribution plans are in place to support your product, and do you have any early results to share. Some investors may even ask what is the per-customer-acquisition cost.

5. What is your business model and how do you plan to make money? 

In other words, what is the market structure and dynamics and how to do these dynamics map against your strategy? Are you considering potential roadblocks such as legal or regulatory issues and are you prepared to address if they apply.

6. How much capital do you need to raise?

How will you use the capital you are raising and what do you expect to achieve with the funds.

As I mentioned above, I’m not a fan of most of these questions, though I agree they help to provide important information. I believe the questions to ask to really get a sense for the potential are what is driving you to see your idea come to life, and does your product capture the imagination. The answer to these questions helps investors like myself determine if you truly have the motivation to build a great company -- or have an idea big enough to inspire people and spark a movement. 

So when you prepare your deck, think about how you can weave in your motivation when you describe yourself and your team, and before you demo your product, pause and tell a story around how it will impact people’s lives. If you can effectively do this, you’ve got a very good shot at attracting the investor you want.