{"id":161,"date":"2018-12-27T17:21:25","date_gmt":"2018-12-27T22:21:25","guid":{"rendered":"http:\/\/pressbooks.library.upei.ca\/smallbusinessmanagement\/chapter\/financial-management\/"},"modified":"2020-01-06T09:58:30","modified_gmt":"2020-01-06T14:58:30","slug":"financial-management","status":"publish","type":"chapter","link":"https:\/\/pressbooks.library.upei.ca\/smallbusinessmanagement\/chapter\/financial-management\/","title":{"raw":"Chapter 11: Financial Management","rendered":"Chapter 11: Financial Management"},"content":{"raw":"
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\r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"461\"]\"image\" The Notch Store. Used with permission from Frank Salvatore.[\/caption]\r\n\r\n<\/div>\r\n

No small business, or for that matter no large business, becomes a landmark and community-gathering place overnight. It takes time along with some very sharp management skills. In the case of the Notch Store, a local legend in Cheshire, Connecticut, it took ninety years and three generations of family members.<\/p>\r\n

The business began in 1921 when Pauline Salvatore recognized a business opportunity. Her husband Mike worked in the nearby quarry, and she recognized that the employees needed a location where they could buy groceries for their lunch or to bring home for dinner. She began to sell them from her living room. Soon the business located to a facility next to her home. The name Notch Store came from its use in the quarry.<\/p>\r\n

A few years later, Mike left the quarry and began to work with Pauline. Over the years, the Notch Store evolved as customer needs changed. They began to expand their offerings. The physical store was enlarged. A gasoline pump was installed, and for several years, one wall of the store carried auto parts.<\/p>\r\n

In 1967, Mike and Pauline\u2019s son Frank and his wife Josephine took over the operation of the business. In the 1970s, the Notch Store extended its offerings to include deli items and lunches. It even offered a homemade cider every fall. The business grew and included its third generation of Salvatores\u2014Frank Jr.<\/p>\r\n

In the early 1990s, Frank Jr. was in charge of operations. Like any business man, he was open to suggestions from others, including his employees. One woman who worked for Frank Jr. suggested that he add breakfast sandwiches to the menu. To make these sandwiches, Frank Jr. needed a restaurant-quality stove. In one of those strange twists of life, Frank Jr. had a friend who knew Joe Namath and his wife. The Namaths were building a new home, and Joe\u2019s wife did not like the stove in the home. Frank Jr. acquired it, and since then, the breakfast sandwich offerings have become a major staple in the Notch Store.<\/p>\r\n

No business develops without encountering problems, and the Notch Store was no exception. Several years ago, a number of customers complained that they had become ill from the Notch\u2019s cider. This was followed by several lawsuits. For most businesses, this might have been a fatal crisis and financial ruin. Fortunately, years before, Frank Jr. had listened to his brother Robert\u2019s advice (Robert was in the insurance industry). The Notch Store had $2.3 million in insurance coverage, which was more than enough to ensure its survival. For several reasons, including recognition of the risk of serving food to the public, the Notch Store has adopted a limited liability corporation format. Even with the best of financial planning and risk reduction strategies, many businesses have to deal with factors beyond their control. The recent economic downturn has meant that there is a significant reduction in new homes being built in Cheshire. This means that there are far fewer builders buying breakfasts and lunches, but Frank Jr. is coping with a small line of credit at a local bank. The future is still bright for the Notch Store and so is the possibility of it continuing into a fourth generation.Frank Salvatore (owner), in discussion with the authors.<\/span><\/p>\r\n\r\n<\/div>\r\n<\/div>\r\n

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The Importance of Financial Management in Small Business<\/h1>\r\n
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Learning Objectives<\/h3>\r\n
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  1. Understand the difference between accounting and finance for small businesses.<\/li>\r\n \t
  2. Understand the major activities of finance.<\/li>\r\n \t
  3. Understand how finance can affect the selection of a business form.<\/li>\r\n \t
  4. Understand the various sources that can be used to finance the start-up operations of a business.<\/li>\r\n \t
  5. Understand what factors might affect the extent to which a firm is financed by either debt or equity.<\/li>\r\n<\/ol>\r\n<\/div>\r\n<\/div>\r\n

    Chapter 10 \"Accounting and Cash Flow\"<\/a> discusses the critical importance of a small business owner understanding the fundamentals of accounting\u2014\u201cthe language of business.\u201d This chapter examines finance and argues that the small business owner should acquire a basic understanding of some key principles in this discipline. One question that might come to someone\u2019s mind immediately is as follows: \u201cWhat is the difference between accounting and finance?\u201d As an academic discipline, finance began in the early decades of the twentieth century. We have already seen that accounting predates the formal study of finance by millennia.<\/span>[footnote]\u201cDifference between Accounting and Finance,\u201d DifferenceBetween.net<\/em>, accessed February 1, 2012, www.differencebetween.net\/business\/difference-between -accounting-and-finance<\/a>.<\/span>[\/footnote] Yet some have argued that accounting should be seen as a subset of finance.<\/span>[footnote]\u201cDifference between Accounting and Finance,\u201d DifferenceBetween.net<\/em>, accessed February 1, 2012, www.differencebetween.net\/business\/difference-between -accounting-and-finance<\/a>.<\/span>[\/footnote]. Others have argued that both accounting and finance should be seen as subdisciplines of economics. Not surprisingly, others have argued in favor of the primacy of accounting. If we get beyond this debate, we can see that accounting is involved with the precise reporting of the financial position of a firm through the financial statements, which is presented in Chapter 10 \"Accounting and Cash Flow\"<\/a>. The accounting function is expected to collect, organize, and present financial information in a systematic fashion. Finance can be seen as \u201cthe science of money management\u201d and consists of three major activities: financial planning, financial control, and financial decision making. Financial planning deals with the acquisition of adequate funds to maintain the operations of a business and making sure that funds are available when needed. Control seeks to assure that assets are being efficiently used. Decision making is associated with determining how to acquire funds, where to acquire funds, and how those funds should be used and within the context of the risk assessment of the aforementioned decisions. As an academic discipline, finance has grown tremendously over the last four decades.<\/p>\r\n

    Much of the work produced during this period possessed both an esoteric analytical quality and profound practical consequences. One only has to look at newspapers and the business press, during the last few years, to see how financial theory (efficient market hypothesis) and financial models (options pricing, derivatives, and arbitrage models) have played a dominant role in the global economy. Fortunately, most small businesses have no need to directly involve themselves with these analytical abstractions. But this does not mean that small business owners do not need to concern themselves with fundamental issues of financing their firms.<\/p>\r\n\r\n

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    Impact of Organization Type on Finance Decisions<\/h2>\r\n

    Selecting the form of business organization that is adopted by a business depends on many factors. One could begin by anticipating the eventual size and nature of the business.[footnote]\u201cTypes of Business Organizations,\u201d BusinessFinance.com<\/em>, accessed December 2, 2011, www.businessfinance.com\/books\/startabusiness\/startabusinessworkbook010.htm<\/a>.[\/footnote]<\/span> The complexity of a business may dictate the type of business organization that is adopted. However, many of the factors that go into this determination are either directly or indirectly financial in nature. The indirect factors are as follows: the extent to which a business owner wishes to attain control of the business, the relationship that the owner would have with partners or investors, and the perceived risk associated with the business. This last factor is tied to the question of the extent to which the owner will invest his or her own money and assets. The direct financial factors that go into selecting the type of the business organization include the following: expected profits or losses, tax issues, the vulnerability and threat from lawsuits, and the ability to extract profits from the business for the owner\u2019s use. The federal government recognizes six forms of business organizations for tax purposes: [pb_glossary id=\"952\"]sole proprietorship[\/pb_glossary]<\/strong><\/em>,\u00a0partnership, [pb_glossary id=\"1427\"]C-corporation[\/pb_glossary]<\/strong><\/em>,[pb_glossary id=\"1428\"]S-corporation[\/pb_glossary]<\/strong><\/em>, trust, and nonprofit. The last two are unlikely to be adopted by small businesses. It is useful to examine the financial implications of organizing along the remaining four basic formats.<\/p>\r\n\r\n

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    Sole Proprietorship<\/h2>\r\n

    Many small businesses operated by a single individual adopt sole proprietorship format of business organization. It is the most basic type of business organization. It is also the least expensive to create and the easiest to operate and dissolve. Sole proprietorships can be incorporated if the owner so desires. Not being a legal entity, single scratch sole proprietorships disappear after the death of the owner. This type of business is essentially a format for a single-person business (although many have between one and ten employees), where the owner makes all<\/em> the decisions related to the business\u2019s operations. The owner can extract all profits from the business for his or her personal use, or the owner can decide to reinvest any portion of the profits back into the business. It is interesting to know that 70 percent of all businesses in the United States are sole proprietorships yet they only produce 20 percent of all the nation\u2019s profits.[footnote]\u201cBusiness Finance\u2014by Category,\u201d About.com<\/em>, accessed December 2, 2011, bizfinance.about.com\/od\/income tax\/a\/busorgs.htm<\/a>.[\/footnote]<\/span> Because a single proprietorship is not a legal entity, any income generated by the business goes directly on the owner\u2019s personal tax return. However, the single owner is also personally responsible for any debts that the business acquires. This means that the owner may put his or her own personal assets at risk. In addition, this business organization means unlimited liability for its owner. The format means that there is very little opportunity to raise funds from sources other than the owner\u2019s own capital or consumer loans.<\/p>\r\n\r\n<\/div>\r\n

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    Partnerships<\/h2>\r\n

    Partnerships generally are unincorporated businesses. From a financial standpoint, partnerships offer a few advantages over sole proprietorship. By having more than one owner (investor), it is often easier to raise additional capital. In some businesses, such as law firms and accounting firms, the prospect of becoming a partner may be an attractive inducement to gain employees. There are several versions of partnerships.<\/p>\r\n

    The [pb_glossary id=\"954\"]general partnership[\/pb_glossary]<\/strong><\/em> is composed of two or more owners who contribute the initial capital of the business and share in the profits and any losses. It is similar to a sole proprietorship in that all partners are personally responsible for all the debts and the liabilities of the business. A general partnership is comparable to a sole proprietorship in that neither is a taxable entity; therefore, the partners\u2019 profits are taxed as personal income. They can deduct any business losses from their personal income taxes. The exact proportion of ownership of the firm is generally found in a written document known as the partnership agreement.<\/p>\r\n

    A [pb_glossary id=\"955\"]limited partnership<\/strong><\/em>[\/pb_glossary] is a business that may have several general partners and several more limited partners. The major difference with a general partnership is that the limited partners do not have unlimited liability. Their losses are limited to their original investment in the business. Common practice means that these limited partners do not play a major decision-making role in the life of the business.<\/p>\r\n\r\n<\/div>\r\n

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    C-Corporations<\/h2>\r\n

    Selecting a C-corporation form of business entails more effort and expense in creating this format. Corporations must be chartered by the state in which they are headquartered. Corporations are viewed as legal entities, meaning that they can enter into legal agreements with individuals and other corporations. They are also subject to numerous local and state regulations. This often results in extensive paperwork that can be costly. Corporations are owned by their shareholders. The shareholders are liable only for their original investment in the business. They cannot be sued for more than that amount. One of the major advantages of adopting a corporate format is that in this type of business, it is sometimes much easier to raise capital through either debt or the issuance of stock. Profits derived from this type of business are taxed at the corporate rate. It is important to note that dividends paid to shareholders, unlike interest expenses, are not deductible. So in a real sense, this form of income is doubly taxed.<\/p>\r\n\r\n<\/div>\r\n

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    S-Corporations<\/h2>\r\n

    The S-corporation is a special format designed to eliminate the problem of double taxation that one might find with a C-corporation format. It first differs from a C-corporation in that it is limited to a hundred shareholders, although it can be created with just one shareholder. If a shareholder is an employee of the business and contributes any service to the business, then the corporation is required to pay that individual a salary. The term that is used is \u201creasonable\u201d salary. This definition may vary under several conditions. A failure to comply with this ambiguous definition of \u201creasonable\u201d salary means that the IRS can reclassify the profits as wages and tax the amount at the personal income rate.<\/p>\r\n\r\n<\/div>\r\n

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    Limited Liability Company<\/h2>\r\n

    A [pb_glossary id=\"957\"]limited liability company[\/pb_glossary]<\/strong><\/em> is an organizational form that can be limited to a single individual or several other owners or shareholders. Like a general partnership, there is a requirement for documents that define the distribution of responsibilities, profits, or losses. Generally, the members of a limited liability company are liable for the debts of the company. This format may provide tax and financial benefits for the participants. This format cannot be used in the banking or insurance industries.<\/p>\r\n\r\n<\/div>\r\n<\/div>\r\n

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    Acquisition of Funds<\/h2>\r\n

    Capital is the lifeblood of all businesses. It is needed to start, operate, and expand a business. Capital comes from several sources: equity, debt, internally generated funds, and trade credits (see Figure 11.1 \"Sources of Capital\"<\/a>).<\/p>\r\n\r\n

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    Figure 11.1<\/span> Sources of Capital<\/h3>\r\n\"image\"\r\n\r\n<\/div>\r\n

    Equity financing raises money by selling a certain share of the ownership of the business. It involves no explicit obligation or expectation, on the part of the investors, to be repaid their investment. The value of equity financing lies in the partial ownership of the business.<\/p>\r\n

    Perhaps the major source of equity financing for most small start-up businesses comes from personal savings. The term bootstrapping<\/em> refers to using personal, family, or friends\u2019 money to start a business.[footnote]\u201cFinancing,\u201d Small Business Notes<\/em>, accessed December 2, 2011, www.smallbusinessnotes.com\/business-finances\/financing<\/a>.[\/footnote]<\/span> The use of one\u2019s own money (or that of family and friends) is a strong indicator that a business owner has a strong commitment to and belief in the success of the business. If a business is financed totally from one\u2019s personal savings, that means the owner or the operator has total control of the business.<\/p>\r\n

    If a business is structured as a corporation, it may issue stock. Generally, two major types of stock may be issued: common stock and preferred stock. It should be noted that in most cases, owners of common stock have what are known as voting rights. They have a proportional vote (directly related to the number of shares they own) for members of the board of directors. Preferred stock does not carry with it voting rights, but it has a form of guaranteed dividend.<\/p>\r\n

    Corporations that issue stock must comply with several steps to meet both federal and state statutes, including the following: outlines to issue stock to shareholders, determining the price and number of shares to be issued, creating stock certificates; developing a record to record all stock transactions; and meeting all federal and state securities requirements.<\/span>[footnote]\u201cChecklist: Issuing Stock,\u201d San Francisco Chronicle<\/em>, accessed December 2, 2011, allbusiness.sfgate.com\/10809-1.html<\/a>.<\/span>[\/footnote] Smaller businesses may choose to issue stock only to those who were involved in the initial investment of the business. In such cases, one generally does not have to register these securities with state or federal agencies. However, one may be required to fill out all the forms.[footnote]\u201cHow to Form a Corporation,\u201d Yahoo! Small Business Advisor<\/em>, April 26, 2011, accessed February 1, 2012, smallbusiness.yahoo.com\/advisor\/how-to-form-a-corporation -201616320.html<\/a>.[\/footnote]<\/span><\/p>\r\n

    Venture capitalists are looking for substantial returns on their initial investment\u2014five, ten, sometimes even twenty-five times their original investment. They will be looking for firms that can rapidly generate significant profits or significant growth in sales. Angel investors may be more attracted to their interest in the small business concept than in reaping significant returns. This is not to say that they are not interested in recouping their original investment with some type of significant return. It is much more likely that angel investors, as compared to venture capitalists, will play a much more active role in the decision-making process of the small business.<\/p>\r\n

    One area for possible capital infusion into a small business may come from a surprising source. Many students (and some adults) may find funding to start up a business through business plan competitions. These competitions are often hosted by colleges and universities or small business associations. The capital investment may not be large, but it might be enough to start very small businesses.<\/p>\r\n

    Debt financing represents a legal obligation to repay the original debt plus interest. Most debt financing involves a fixed payment schedule to repay both principal and interest. A failure to meet the schedule has serious consequences, which might include the bankruptcy of the business. Those who provide debt financing expect that the principal will be repaid with interest, but they are not formal investors in the business.<\/p>\r\n

    There are numerous sources for debt financing. Some small businesses begin with financing by borrowing from friends and family. Some firms may choose to finance business operations by using either personal or corporate credit cards. This approach to financing can be extraordinarily expensive given the interest rates charged on credit cards and the possibility that the credit card companies may change (by a significant amount) the credit limit associated with the credit card.<\/p>\r\n

    The largest source of debt financing for small businesses in the United States comes from commercial banks.[footnote]\u201cHow Will a Credit Crunch Affect Small Business Finance?,\u201d Federal Reserve Bank of San Francisco<\/em>, March 6, 2009, accessed December 2, 2011, www.frbsf.org\/publications\/economics\/letter\/2009\/el2009-09.html<\/a>.[\/footnote]<\/span> Bank lending can take many forms. The most common loan specifies the amount of money to be repaid within a specific time frame for a specific interest rate. These loans can be either secured or unsecured. Secured loans involve pledging some assets\u2014such as a home, real estate, machinery, and plant\u2014as collateral. Unsecured loans provide no such collateral. Because they are riskier for the bank, they generally have higher interest rates. For a more comprehensive discussion of bank loans, see Section 10.2.1 \"Relationships with Bank and Bankers\"<\/a>.<\/p>\r\n

    The Small Business Administration (SBA) has a large number of programs designed to help small businesses. These include the business loan programs, investment programs, and bonding programs. The SBA operates three different loan programs. It should be understood that the SBA does not make the loan itself to a small business but rather guarantees a portion of the loan to its partners that include private lenders, microlending institutions, and community development organizations. To secure one of these loans, the borrower must meet criteria set forth by the SBA. It should be recognized that these SBA loan rules and guidelines can be altered by the US Congress and are dependent on prevailing economic and political conditions. The following subsections briefly describe some of the loan programs used by the SBA.<\/p>\r\n\r\n

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    (a) Loan Programs<\/h2>\r\n

    This class of loans may be used for a variety of reasons, including the purchase of land, buildings, equipment, machinery, supplies, or materials. It may also be used for long-term working capital (paying accounts payable or the purchase of inventory). It may even be used to purchase an existing business. This class of loans cannot, however, be used to refinance existing debt, to pay delinquent taxes, or to change business ownership.<\/p>\r\n\r\n