Purpose of This Site

You are young and thinking about starting a business. Perhaps you are in the early stages of your business. To you, finance is both a mystery and a worry but your common sense tells you need to understand it … and you do. This site is intended as a start. It will lay out the tools and show you how to start using them.

Who I Am

My name is Ted Cape. I have spent almost thirty years lending to, investing in and raising money for businesses. (You can see my Bio elsewhere on this site.) In September 2006, I resigned my position as Chief Financial Officer at Black Press Ltd., one of Canada’s largest publishers of community newspapers to do something else. My last act in the finance business is to pass on what I have earned.

The Purpose of Finance

The purpose of finance is to

• generate the information you need to understand the health of your business and
• raise the money you need for your business on terms that won’t blow it up when (not if) bad times come.

Lousy finance is the poison that kills businesses when recessions push them to the edge. Good finance is part of the vaccine that protects them and helps them prosper.

This Site – All You What You Need to Know About Finance

Finance has many moving parts. But at root it is a discipline any intelligent businessperson can understand. It is also a discipline any person starting out in business, especially those who want to have their own business, must understand.

Over the next 11 weeks, I will explain the basics. I owe more than I can repay to the good humoured, honourable and competent colleagues and professionals who are best of the finance craft who taught me every day of my career. To help take the worry and mystery out of finance for those walking up to the start line of their own business is a way to honour that craft.

Rewarding Greed & Incompetence

How to Get Rich – Become CEO and Blow Up Your Employer

Daniel Mudd, CEO of Fannie Mae and Richard Syron of Freddie Mac led their businesses off a cliff. Incompetent employees like these are usually fired with little or no severance. These two are entitled to walk off with over $20 million between them.

Stanley O’Neal led Merrill Lynch to losses exceeding $30 billion as a result of its disastrous expedition into the world of sub-prime mortgages … and walked away with $150 million +, in addition to the over $45 million salary he received the year before.

Having worked inside a bank, I can say with absolute certainty that Mudd, Syron and O’Neal were advised by the sensible voices within their institutions that the sub-prime mortgage was a disaster waiting to happen. It was just one more attempt to overcome the law of financial gravity and anybody with a cycle’s worth of experience knew where this would end up. What these CEO’s did to their organizations was unforgivable …. and the fact they walked off rich as Croesus is a disgrace.

Where are the Directors?

The directors who approve these ridiculous compensation arrangements are operating multiple zones away from reality. What’s wrong with saying “Stan, an $8 billion hit and you expect us to pay you $150 million?” or “Dan, you invested in these crazy mortgages and you want $9 million?”.

Where are the Shareholders who Elect Them?

The institutions that own the stocks of these companies need to elect directors who will bring executive compensation back into the world of the sensible. In the meantime, CEO’s of public companies will live in a consequence free zone.

Honesty is the Best Policy

Honesty is the Best Policy

In business we compete hard. We want to outperform the world. It isn’t just a money thing. We want to be the best we can be and we are usually arrogant enough to believe that is better than most.

But we don’t cheat.

The Honesty Test

Too much is made of the supposed difficulty of knowing right from wrong in business.

The test is simple.

If someone has misled, done what they promised they wouldn’t do, or failed to do what they promised they would do in order to enrich themselves at somebody else’s expense, he or she is dishonest.

Finance and Temptation

Finance offers plenty of ways to be dishonest.
• If you need some profit, you can reduce expenses by recording them as capital expenditures
• If you are worried about your bank security, you can record as inventory a pile of stuff you know is unsaleable
• You can hide your profits from the taxman
• You can trade some shares on a hot tip from an insider

As Woody Guthrie said, some people rob with a six-gun and some with a fountain pen. Either way, it’s stealing.

Those white-collar crooks you see being led to the slammer – the ones with the nice suits that don’t go with the handcuffs – most were involved in schemes like these.

Crooks Get Caught

The law is slow. But it has a long memory and it is patient and thorough.

Someone always has a very long-term interest in seeing you get caught – the victim. Victims and their contingency fee lawyers have big incentives to chase you forever. The file never dies.

Secondly, crooks almost never act alone. Somebody usually knows you did it. If the law so much as sniffs around them, they panic. When the law offers them a choice of their skin or yours, for some reason they always choose yours.

The World of the Crook

Lots of crooks sleep soundly. Lots of them are rich. Lot’s don’t get caught.

However, they are jerks and all the normal people in the world know it. They traded their souls away so long ago they can’t remember having them.

A crook lives in an ugly little world. It includes only:
• other crooks
• people they pay to be nice to them (usually family members)
• those who have no choice but to deal with them.

Most of these people don’t like crooks but they tolerate them out of self-interest.

But honest people make crooks invisible. They cross the street to avoid them. They leave a party if they see them arrive. They won’t let their kids play with the crook’s kids.

With all that money, crooks end up on a desert island.

The Honest Man is a Free Man

Honest people in business are tempted too. Fear of financial failure or the prospect of enormous profit tempt them at some point to do something dishonest.

The difference between them and the crooks is that that they make the harder choice.

Except that it isn’t harder.

The single most liberating moment in a business career is doing the honest thing in face of great temptation. It is almost as if the devil has been waiting for you since you were a kid. He prepares a trap just for you – but you jump right over it.

You do the right thing and from then on, you know you can’t be bought.

The Value of an Honest Reputation

As a reputation for honesty builds over a career, it buys a lot of good will.

At important points, you need someone to trust you. You are in a bind. You have made a promise about something to a lender, supplier or customer. You need them to believe it in order to get yourself out of the bind.

I have seen lenders give time and money to customers in trouble because of trust. Everyday you are honest is a day of good will in the bank. A time will come when that deposit pays for what makes the difference.

Looking Your Kids in the Eye

I often wonder what crooks say to their children. “You know son, don’t believe all that bad stuff about tax evasion” or “Insider trading gets a bad rap.”

The reward of being honest is that your kids know it. That gives you the right to look them in the eye and that is one of the most precious rights of all.

Why Forecast? – Part 2, The Operating Forecast

The operating forecast drives the financial forecast. In all other respects, it is a completely different animal. It looks out only one year. Its audience is you and your managers, not your banker.

The operating forecast is a one year detailed product-by-product, service-by-service prediction of revenues, operating costs and capital requirements. Unlike the financial forecast, it is a real prediction.

Who Does the Operating Forecast?

The employees responsible for these products and services do the forecasts. If you want to know what is likely to happen, they give you the best guess. They are the ones with greatest influence over whether the forecast come true.

The Operating Forecast – The Great Debate

You don’t just accept the managers’ first cuts. You make them explain the forecast. They may “sandbag” you with a “low-ball” forecast. The lower the forecast, the more likely they will receive their performance bonuses.

But you are the owner. You know the business and you push back. You test their assumptions. You ask abut specific clients to make sure they are close enough to them to know what the issues are in them buying more from you.

You go back and forth with your managers until you both walk out comfortable that the forecast is an achievable stretch.

In the process, you have renewed your comfort that your managers are on top of their operations. They walk out comfortable you understand their reality and still have the senior management skills they need for their success.

Give Forecasting the Attention It Needs

Schedule the operating plan process for quiet periods. The best business for which I ever worked was owned and operated by someone who had come up through the ranks. He knew the dead period and he scheduled his planning period within it. That way, his managers always had time to think about their business before they committed to a forecast and he had time to hear them out.

Conclusion: Operating Forecast = Accountability

Your operating forecast is a discipline. It forces you once a year to take stock. You think about your business. You assess your managers face to face.

You look at it every month to see whether you are ahead or behind. There is often good reason for patience in the face of underperformed forecasts. The important thing is that the forecast gives you a basis for having an intelligent discussion, which will tell you whether patience is warranted or not.

Why Forecast? – Part 1, Financial Forecasts

Why forecast? Forecasts are invariably wrong so why bother.

The answer is simple. Financial forecasts don’t predict the future. They test your ability to survive a bad future and take advantage of a good one. If your forecast covers reasonable pessimistic and optimistic outcomes, it is doing its job.

“Cases”

Your forecast should have three different cases:

• Base Case – what you think will happen based on your operating forecast (covered in “Why Forecast? – Part 2”).

• Conservative Case – what will happen if a recession hits, the competition strikes harder than you predict or your costs rise unexpectedly.

• Optimistic Case – what will happen if everything works out perfectly.

Financial Forecasts – How Long? How Often?

You do forecasts once a year.

The standard financial forecast covers five years for two reasons.

• Banks require most companies to repay their term loans in 2 – 5 years. You make the bank comfortable lending to you now by making it comfortable you can also borrow in the future when you need the money to repay the bank.

• Capital requirements must be assessed well ahead of need to allow for an intelligent capital-raising program.

Financial Forecasts Tell You What is Safe to Borrow ….

When you borrow money, you put your business at risk. If you can’t pay the interest, repay the principal and comply with the financial performance tests in the loan agreement, you may lose your business.

Recessions are inevitable. Bad things happen to good businesses. The conservative case tells you whether you can accomplish the three things you need to do in bad times.
• Survive
• Comply with the financial ratios in your bank agreement and
• Refinance your loan if it comes due.

Before you approach the bank for a loan, you want to have know how much you can borrow knowing that, even in a pessimistic case, you can make all the payments and observe all the performance tests likely to be in the loan agreement.

… and What to Negotiate For

The financial forecast also tells you what to negotiate for. It is smart to trade a higher interest rate for the lower default risk resulting from looser performance tests. A good forecast tells you what you need to negotiate for to know it will take a catastrophe for you to default.

Good News Can Be a Problem

Great performance can be a problem.
• You need more capital equipment and people to meet your production requirements.
• You need to finance more inventory, work in progress and receivables to keep up with your higher sales.

The optimistic case alerts you and your lender to your potential capital requirements so that you don’t run out of gas just as you are ready to pull ahead of the pack.

Conclusion: Financial Forecasting is Testing, Not Predicting

Financial forecasts do not try to predict the future. They test your ability to survive a bad future and take advantage of a good one. Their practical value is to tell you whether you have the capital you need, how much you can safely borrow and what terms to negotiate for in your loan agreement.

What Happens When You Have Too Much Debt?

What happens when you have too much debt is that when a recession comes, you will have a very unpleasant experience. It may include losing everything you have.

We will discuss how much debt is to much elsewhere on this site. Here, let’s just concentrate on the consequences.

Recessions

Recessions come every 10-15 years.

A recession sends clear warning signs it is coming.
• Working capital starts rising. Your inventory takes a lot longer to sell and some customers stop paying your bills.
• Profit margins and revenues fall … and keep falling .

So far, the problem is survivable. You cut production and costs until you break even.

But even then, you need an operating loan. You still need to finance your inventory and receivables. If you have borrowed materially less than the bank will give you and you are well within your bank’s debt rules, no problem. You hunker down and wait the recession out.

But if you have too much debt, you will hit the limit of your credit quickly. When you ask for more money, the bank will refuse.

Banks & Recessions

When a recession hits, your bank has problems. It soon has a lot of customers who stop paying interest. The bankers who lent to them suddenly feel the wind blowing over their own necks.

In a recession, the banks realize they need to clean out the stables. They spend one or two years ridding their portfolio of bad loans. If you have too much debt, even if you have made your interest payments, you are a loan they want to get rid of.

They don’t encourage you to stay on by increasing your credit limit.

First You Run Out of Cash

You then start dragging out your payments to your suppliers. They start harassing you. At some point, they won’t send you anything unless you pay cash … which you don’t have.

Then You Lose Your Business

Then you miss an interest payment.

The nice banker is replaced by your new best friends – the collections group. Their only goal is to minimize their loss from the business.

It now becomes “the business” not “your business”. When the bank starts to move, they own the business. They allow you to run it for them but if they decide they can minimize their losses by closing the business and selling off the pieces, that’s what will happen.

Then You Lose Everything Else

You will likely give a personal guarantee of the bank loan for some years until the bank is satisfied they do not need it. If after selling off the pieces, you still owe the bank something, the next thing to go on the block is your house. This is when , if you are normal, your soul is destroyed.

Even Survival is Painful

At best, you will spend a few years fighting for your life, wasting time pleading with bankers and suppliers to buy time. Equally likely is that one day, the bank will put you into bankruptcy.

You do not want to be anywhere near this. Even if you come through it, you will have aged fifty years, you will be much poorer and your reputation will have suffered.

There is a simple way to avoid this: don’t borrow too much debt!

How to Read Your Statements: Important Ratios

When you design your financial statements, they should automatically generate some key ratios which you should track relentlessly. Included in these are a few financial ratios which tell you almost all of what you need to know about the financial health of your business.

The key finance ratios are those dealing with
• Leverage
• Coverage
• Operating Loan Margin and
• Profit Margin.

They are applied to the last 12 months performance i.e. a “rolling” year, as if every quarter was a year-end.

Banks Use These Ratios, So Should You

Banks use these as core ratios because they are smart. They give you the most reliable picture of your
• ability to withstand adversity such as a recession of a loss of some major accounts
• ability to pay your bills as they come due and
• profitability.

What is Profit?

There are two main definitions of profit:
• Net income after taxes and
• Earnings before interest, taxes and depreciation and amortization (“EBITDA”).

I think EBITDA is the most useful. More importantly so do the banks. EBITDA is the cash left after all operating costs have been paid. It is the cash available to service the debt you have borrowed, to pay your taxes and to fund the bare-bones capital expenditures needed to keep the lights on.

The Leverage Ratio …

… is the ratio of your debt to your EBITDA.

The higher the ratio, the greater the risk. You won’t be in doubt as to what your bank thinks is reasonable. The maximum will be written right into your loan agreement.

The maximum depends on your type of business. The banks want to keep the ratio inside the level that creates too much risk of trouble for a business like yours.

In your conservative forecast of the future, you never want your debt to more than 75% of the maximum the bank will allow.

The Coverage Ratio

… is the ratio of your EBITDA to the total of your
• interest,
• taxes,
• principal repayments and
• maintenance capital expenditures.

It measures the margin of comfort you have in not only paying your operating costs but all the other items you have to pay to stay in business.
• If it is less than 1:1, you are going out of business.
• If it is more than 1.5X you are building up cash nicely.
• If it is at least 1.2X you are comfortable.

Operating Loan / Loan Value

… is the ratio of your operating loan to the bank valuation of your inventory and receivables in your loan agreement. This value is usually the sum of:
• 25-50% of inventory and
• 50-75% of receivables.

This ratio measures the amount of debt capacity you have used up. Less is better.
• If it is more than 1: 1, you have run out of credit and can expect a call from your bank.
• If it is less than 75%, you have adequate room in your operating line to cover contingencies.

Profit Margin

… is the ratio of your EBITDA to your sales.

Whatever industry you are in, there is a range of profit margins from outstanding to poor. If your ratio is materially lower than these norms, you will have a tougher time getting loans or getting them on the best terms, than those with good margins.

How Much Debt is Safe to Borrow?

Debt helps you grow. You borrow money against the value of your business. You use the money to buy equipment and supplies to increase your sales and to pay bills while you wait for the extra cash to come in.

In finance, we call that “leverage”. You “lever” your business to get capital from the bank. This allows you to grow it faster than if you rely solely on the cash from your profits. Leverage is a key element of any intelligent financing plan.

We have dealt with how much the banks will lend you. How much it is safe to borrow?

The answer is simple: a lot less than the bank will allow you to borrow. If you respect this simple rule, you will never run into trouble.

Borrow Less than the Bank Will Lend – Part 1

Your operating loan will be a “revolver” which moves up and down as you need it. The maximum will be the lesser of
• a fixed amount you negotiate and
• a percentage of the value of your inventory and your receivables. As we have discussed, typically the maximum is 50-75% of your receivables plus 25-50% of your inventory.

Your operating loan should never be more than 75% of the maximum you are allowed. That 25% margin is what allows you to sleep at night, knowing the bank is unlikely to come knocking, asking for the keys.

If you start to eat into that margin, your business is under-performing or you need a bigger loan. Either way, it is a problem. Deal with it. Fix the business, get more shareholder capital or request an increase in your loan.

Borrow Less than the Bank Will Lend – Part 2

As you grow, you can borrow money to buy a new plant or some new equipment. You can even borrow to buy another business.

The market has rules as to the debt a company can borrow. The maximum debt is expressed as a multiple of your operating profit, typically 2-6X your cash flow, depending upon the nature of your business.
• Stable businesses like cable TV companies can support debt of as much as 6x operating profits.
• Small, more cyclical businesses will be restricted to 2-3x operating profits.

This rule is applied as long as your loan is outstanding, not just when you borrow it. As part of the loan, you will agree to keep the loan at an agreed multiple of operating profit at all times.

Your total debt at any time, now and in your conservative forecast, should never be more than 75% of the amount that the bank will allow you to have.

If it is, borrow less and face the fact you can’t do it all with debt. You need some shareholder capital.

If your loans subsequently creep over the 75% level, deal with it. Persuade the banks to change the maximum. If you can’t, get the debt down by selling something or bringing in more capital. Get ahead of the problem while you can because at some point, you won’t be able to.

Debt Part 2 – How to Deal With Bankers

Bankers – The People Every One Loves to Hate

In our age, bankers are portrayed as tiresome bureaucrats who
• won’t lend you the money you need,
• demand it back before you can repay it and
• overcharge you for services you don’t understand.

This is fairy-tale nonsense. Good bankers, and there are plenty of them, are hugely helpful in building a business.

Bankers Add Value

Long before the Internet, banks invented one of their own. Banks have moved money and information electronically for decades. They give us transaction information instantly and all the banking reports we could possibly need at least once a month.

Their debit and credit cards, ATM’s, telephone payment systems, pre-authorized payments, foreign exchange risk and cash management products are indispensable tools of a well-run business.

Banks are by far the cheapest source of capital in the market and they provide it to any reasonable risk. If the bank won’t lend you the money, you probably shouldn’t try to borrow it.

Believe it. Bankers add huge value. Running a business without all their services would be like heating a skyscraper with a wood stove.

How to Deal with a Banker 1: Tell the Truth

Bankers are the first to admit they don’t understand nearly as much about your business as you. It is easy to hide bad stuff from them … for a little while. Don’t.

They are your partners. They will find out about the bad stuff eventually. Once they do, they will never forgive you for hiding it.

Get ahead of bad news. It is part of life and experienced bankers deal with customer bad news all the time. Warn the banker it is coming and go in to explain it. If you are straight with your banker, they will trust you forever.

How to Deal with a Banker 2: Be Prepared

Even before you borrow, take a banker to Starbucks two or three times a year to find out about current lending practices. Later, when you walk in to ask for money, you will have crafted your request to respect these practices.

When you ask for a bank loan, give the banker the written information any intelligent person would need to respond:
• your bio,
• financial statements,
• a financial forecast with supporting analysis and
• a thorough written description of the business and assets, including its history.

Put it together so that the banker can cut and paste from your work into the presentation he or she has to make to their bank’s credit authorities. That way, you can almost write the internal bank credit application yourself.

Preparing all this will prepare you to defend your request. It will also show you the weaknesses in your case and cause you to amend it as necessary to be consistent with the market.

How to Deal with a Banker 3: Don’t Ask for the Impossible

Water cannot be made to flow upstream, snow cannot be made to fall in the Sahara and bankers cannot be made to lend outside their comfort zone. Find out what that is. Stay within it. If you need more money, you need an investor as well as a banker.

Also, find out what the lead times are. Respect them. Banks do not lend instantly. They need time. Plan accordingly.

Debt Part 1 – How Much Will Banks Lend You?

Why Good Businesses Need Financing

As you grow, you need financing. You need to purchase equipment. You need to pay the bills that come in before you generate the profit to cover them.

Strong growth makes things worse. The cash flow you receive today is always from your last 3-6 months operations. Assuming you are profitable, it is enough to pay the bills required for these operations.

But if you are growing fast, the cash flow may not be enough, even if you are profitable. You have to pay more bills for supplies, salaries and operating costs today than you did in the last 3-6 months because you are selling more. The cash flow you receive from yesterday’s operations may not be enough for today’s.

Growth is a nice problem to have but it is still a problem.

Banks – a Source of Inexpensive Capital

We will discuss raising money from investors in a future post. However, banks provide money much more cheaply (well under 10% vs. at least 15-20% for investors) and demand much less say in your business than investors. They also will provide valuable banking services you need, including the ability to “revolve” the loans up and down, depending upon your need.

How Much Will Banks Lend You Now?

Banks will lend as much as they believe will be repaid if things go wrong. In the start-up, this likely means zero – the banks will not led to an unproven business unless they have good security from outside the business e.g. the equity in your house.

Once you are past start-up, banks will lend an amount equal to a conservative value of the security you provide, typically
• 50-75% of your customer receivables
• plus
• 25-50% of your inventory
plus
• 25-50% of the value of your equipment
plus
• a percentage of the value of any security you provide from outside the business, depending upon the nature of the security.

You will move up the range of lending values as the bank becomes comfortable with you and your business.

Over and above this security, you will have to put up your personal guarantee until the banks are satisfied that if you get run over by a truck, your business can run without you and that it has a value to third parties.

These are timeless laws of finance. Don’t waste your breath trying to change them. It is like trying to make a compass point south.

How Much Will Banks Lend You Later?

As you prove yourself, banks will start to lend against a conservative value of your business as a whole.
• These values are 50-75% of the price at which they believe your business could be sold.
• This value is determined from the banks’ experience with the sales prices of similar businesses in the market.
• They calculate the average multiple of operating earnings reflected in these prices and apply that multiple to your operating earnings to estimate the value.

By then, you will know these multiples as well as the banks and will always be able to estimate the lending value of your business.

Next post …. What are reasonable banking terms?