Solution Manual

to accompany

Small Enterprise Finance

Prepared by

Scott Holmes

John Wiley & Sons Australia, Ltd

Chapter 1 Small Enterprise Finance

Enterprise Experience: Cooking up a job and an investment, pp. 11-12 1. A 12-year lease seems like a long timeframe to commit to a rental lease for a restaurant. Why would the owners take such a long lease? What advice would you give as to an appropriate lease tem? A normal lease term would be 3-5 years renewable. You might take a 12 year lease because the location is highly sought after and you are keen to operate from this location for a significant period of time. It may also assist in reducing the possibility of significant increases in rental. It would depend on these types of factors as to the advice to give on an appropriate lease term, but 3-5 years renewable would be standard. 2. Mark and Louise have given up their jobs, to take on the risk and responsibility of their own business. Why would they choose to work such long hours and risk their capital to make the equivalent of wages? The major reason is control over their own lives, not being answerable to a boss and a sense of achievement. Remember most small businesses are an extension of their owner(s). In many cases people opt for business ownership to actually reduce the uncertainty associated with being employed by someone else. Also it gives some flexibility to Mark and Louise in that they are working together, which will allow them to support each other and to recognise when one of them needs to be away from the business. Mark and Louise are also hoping that in addition to making wages as they operate the business they will also make a significant capital gain when they ultimately sell it. 3. Why does Mark want to have control over the business? Control is really a matter of personal definition and motivation. But what it does mean is that Mark can decide on the menu, the dcor the operations of his business. This is an intrinsically human factor, that of not being answerable to another and to build an environment in which they are comfortable. 4. Why does Mark suggest that if you dont know enough about the business you should stay away? A major cause of bankruptcy is lack of management skills. What Mark is suggesting is that if you do not have experience in the sector, understand the industry and the marketplace, then the chances of failure are high, particularly in the formative period.

Enterprise Experience: Big Kev excited as float cleans up, pp. 20-21 1. Is Big Kev a traditional small business owner or an entrepreneurial owner? Explain the key differences between the business objectives of the traditional and entrepreneurial owner. Kev is seeking growth and is prepared to admit additional equity through a public float to achieve it. These are not the activities of a traditional owner, but more of an entrepreneurial owner. The key difference is that Kev is prepared to give up some degree of control to support his growth strategies. If the business grows then he will gradually lose more control over day-to-day operations and he will enter into a range of contracts with a number of parties. The traditional owner will seek to fund growth from profits, personal funds or funds provided by family and friends. They will also seek to minimise the number of contracts and cap the size of the business to this effect. 2. Do you think Big Kev can let his baby leave his control? Is Big Kev really like most small business owners: focused on the control of his operating entity? How do you think Big Kev will cope with his new equity partners? Keep in mind that the company floated is called Big Kev Ltd. The whole company is based around Kev. The name, the branding, positioning and even the commercials are about the owner Big Kev. What have they got without Big Kev? Just more cleaning products? It would seem that Kev is prepared to give up some control to achieve his objectives. But he still retains majority control of the equity and the company is firmly branded around him. Big Kev will have to cope with his partners as he is required by law to furnish certain information at certain times and is responsible and accountable for the firms performance. 3. What other funding options are readily available to owners like Kev McQuay, who are seeking funds to expand their business? Funding options are very limited. If he doesnt have assets to back applications for debt funds, it will prove almost impossible to secure; he obviously does not have the funds or has access to family and friends who might supply the levels of funding required; the only other alternative is to find a venture fund or business angel who could acquire the equity available, but the conditions they would normally set would not necessarily accept such conditions. Funding for small firm growth is a major problem and constraint for the sector.

Exercises, pp. 25-27 1. How could you go about measuring the size of a business enterprise? What approach would you recommend? Why? Size can be measured by adopting a quantifiable measure, such as number of employees (equivalent full-time); turnover; value of total assets. The most commonly adopted measure is number of employees. This is the measure used by the Australian Bureau of Statistics. Qualitative measures could also be used, such as the key business decisions are made by 1 or 2 people who own and manage the business. These measures are much more difficult to apply, hence the default by most researchers and government bodies to a quantitative factor. Whatever measure is adopted it will not capture all small firms, as there will be outliers. For example, some owner-controlled businesses are very large corporations, such as the Packer family controlled group of companies. Also there are firms that would meet the criteria with respect to size (number of employees), but the decisions are not made by the owners, a good example is that of franchise outlets. Most franchise agreements require that owners conform to particular branding, advertising, presentation etc and meet certain financial performance targets. Whatever measure is adopted, to support comparisons between firms the measure should be consistently adopted. One reason for this is that research shows that the alternative quantitative measures are not interchangeable. 2. Explain the agency theory view in defining firms by size. Agency theory seeks to explain the relationships between business owners (normally shareholders) and managers. Basically, where there is a separation of ownership and control then terms and conditions need to be established (normally in some contractual form) to align the interests of the parties and encourage behaviours consistent with those objectives. The same applies for the relationship between borrowers and lenders, in that debt holders need to be encouraged (or required) to behave in a way that minimises the risk of default on debt repayment. For small business there are relatively less agency relationships, because in most cases there is no (or minimal) separation of ownership and control. This has led to the view that small firms are firms with low agency relationships or costs and as firms grow, then so do agency costs. For example, as a firm grows more employment contracts are written; external funding may be required to support growth; parts of the business activity may be under the control of an employee as opposed to the owner. It is also argued that small firm owners will often actively avoid agency relationships. One example of this is the fact that most small firms stay small. 3. Arrange to interview the owner-manager of a small enterprise known to you and prepare a report which provides details of: (a) The enterprise (b) The owner-manager This question requires students to interview a business owner and to build a profile of both the business and the owner. Instructors could brief students before they proceed with this assignment, highlighting the need for students to actively collect all the information listed and to consider the feedback from the owner concerning their objectives in owning and operating a small firm. Students should be encouraged to present their profile to the group and to compare their results with those of other students.

4. Devise a definition of a small enterprise that you believe would be particularly suited to the study of the financing and financial management of such concerns. Defend your definition. This question specifically focuses on financial management, students should be reminded of this reasonably specific focus when devising their definition. It isnt sufficient to simply adopt the ABS definition or some other generic definition (turnover level; number of owners). Quantifiable measures may well be argued as a proxy for the qualitative aspects that students should at least consider. The types of factors to consider include: the education and knowledge level of owners; the objectives of owners; the relationship of personal assets to those of the business; the relative levels of debt and equity; the current phase of operations growth, decline, maturity. Encourage students to discuss these factors. One definition could then be: A business where the owners, who have limited formal training in finance and financial management, make decisions concerning the funding and financial systems of the business and rely on external professional assistance for major financial decisions. 5. Anticipate what might be the major differences between the financial management of a traditional small enterprise and that of a growth enterprise. What characteristics of such enterprises are likely to give rise to these differences? Students should be referred to the summary of information relating to this topic in chapter 5 p.154 Enterprise Characteristics and Growth. In a traditional small enterprise simple financial systems will be adopted, with feedback tending to be based on the annual tax return. There will be limited financial controls and planning and the primary source of funds will be from the existing owners, reinvestment of profits and bank debt (normally short term, such as an overdraft facility). Growth firms will normally have formal business and financial plans. They will have access to regular financial reports and established performance targets, often these will be required by lending institutions who are providing both long- and short-term debt. Feedback will also usually be sought from external professionals, particularly a practising accountant. Growth firms face liquidity problems and this often results in an increased focus on financial management and planning. However, many small firms will reduce the level of financial information and control once the growth phase ends. The main differentiating characteristics for growth firms will normally be: owners actively seeking growth; preparedness to give up some level of control to achieve growth; greater use of longterm debt and more than two owners. 6. What characteristics of small enterprises are likely to give rise to differences in capital structures between small enterprises? Capital structure refers to the mix of debt, equity and retained earnings used to fund operations. The desire for control on the part of owners will be the primary factor influencing capital structure. The greater the desire for control the greater the use of retained earnings and additional contributions by existing owners. There will be a trade-off between control and business growth. There are other factors which influence capital structure, such as the relative risk of the business; industry in which the business operates; relative size; overall performance of the business; track record of owner/managers; ability to offer assets as security for debt. This is a very complex question as all of these variables interact to influence the capital structure of a small firm. There is also the pecking order literature which suggests that there is an order of preference for funds owners equity, retained profits and additional owner contributions; debt short- then medium/long-term; new equity

holders. For small firms the pecking order is often constrained as small firms do not have ready access to equity markets or venture capital. 7. What are the key objectives of small enterprise ownership? How do these objectives compare with the objectives of shareholders in a large public company such as the National Australia Bank? The objectives of small business ownership are summarised on pages 6-11 and fall into two broad categories: Personal a means of control over life activities; support family members; achieve personal goals and respect of peers. Economic achieve a return on their investment of both capital and time. There will be a trade-off between the economic and social/personal objectives of ownership. Students should discuss how the personal objectives influence economic performance and also the financial decisions of owners. Shareholders of large public companies are not normally involved in the day-to-day management of the business and have two primary objectives: Return on invested funds dividends; capital growth of the investment increasing their net wealth. 8. Explain the types of financing decisions which confront an owner setting up a small business. The main decision will be the mix of funds to start and operate the business. Funding will support both the initial capital investment (purchase of a business or the assets to support it) and operating activities. Often there will be a cyclical difference between the timing of cash inflows and outflows, which will require some form of funding to cover the timing difference. The owner will need to consider how much of their own funds should be contributed to fund the capital and operating expenses; what personal assets can be committed to secure any debt required and the amount and form of debt. The types of decisions discussed here are detailed on page 3. 9. Explain the differences in financing decisions made by a small business owner, compared to those of the CEO of BHP. The financing decisions of a small business owner normally relate to funding and operating a specific set of assets, which are normally undiversified. The owner has a narrow set of funding options, normally commitment of their own funds or use of bank debt. Personal guarantees will normally be required to secure debt. Often the personal assets of the owner will form part of the assets of the business (their car, home etc). The owner will determine the amounts they can draw from the business and will evaluate their performance against their personal and financial goals. The CEO of BHP has a range of financial options in order to fund the diverse asset base and activities of BHP. He can issue bonds, debentures and preference shares; access loan funds, lines of credit and bank bills; issue additional share capital; allocate retained earnings. He will make these decisions in conjunction with a number of internal professionals and often with additional external expert advice. He will submit material funding proposals to the board of directors for approval. His effectiveness with regard to these and operating decisions will ultimately be reflected in the share price of BHP and his remuneration will be set by the board. He will not be required to offer his personal assets for use or as guarantee.

10. Identify any aspects of the customary textbook approach to financial management that do not appear to apply to small enterprises, or which are made difficult or impossible to apply in practice because of the circumstances of small enterprises as you now understand them. Give reasons to support your views. Small firms are constrained as to the mix of funding sources, so the concept of optimal capital structure is a function of the constrained access to both debt and equity funds. As most owner/managers are not expert in accounting or finance, accounting systems and information is kept to a minimum and accessed as required, rather than on any regular or systematic basis. The decision-making processes and ultimately business decisions are not based on maximising the financial/economic wealth of the owner(s), but represent a trade-off with the personal goals and objectives of the owners. Traditional models assume that individuals will invest in the options which give the highest economic returns, however, for many small business owners the objectives are personal and often about control over their own activities and life than maximum economic return. 11. Describe the major problems of a financial nature likely to be encountered in a small enterprise. Rank them in what you consider to be an appropriate order of importance. Would the ranking vary depending on the industry that a small firm operates in? The major problems of a financial nature by rank: sufficient assets (personal and business) to provide security for required bank debt; relatively higher interest rates and loan application costs (compared with large firms); need to reinvest profits to fund ongoing activities, so actual returns to owners are low; limited knowledge of the range of funding options available and their relative cost; inadequate monitoring of financial position and performance; lack of access to equity markets and quasi-debt; limited access to venture funds; inability to fund growth; limited knowledge of owners of appropriate financial management practices. This would be expected to vary by industry. In particular, businesses in the financial services sector would be expected to have a better level of financial management practice than other sectors. Also businesses subject to acute seasonal effects (fashion, food etc) will have to engage in a higher level of cash flow management than businesses with a relatively smooth cash flow. 12. Why should financial management be so important to the wellbeing of a small enterprise? Can you explain why financial management and financing issues appear to lack the required priority of owner-managers? Simply, without appropriate management of financial matters a business will not be viable. Liquidity stress is listed as one of the top five reasons for business bankruptcy in Australia. Financial management covers all aspects of operations from payment of expenses to collection of revenues, to the availability of funds to replace redundant physical assets. Small firm owners do not tend to have a financial background of any formal training in financial management. Many owners are drawn to a particular activity because it suits their personal preferences or they have some knowledge of training appropriate to the products or services provided by the business. The focus therefore tends to be on the operating activities of the entity not the financial aspects. As most owners do not understand financial information it is not an information set they routinely seek. Students might like to suggest how financial management could be explained to small business owners so that they appreciate the need to establish appropriate systems and to utilise the information to assist and support business decisions.

13. Who should be responsible for the financial management and financial decisions of a small enterprise? What role, if any, should external advisers play? The owners should be responsible. They are normally responsible for all key business decisions and business performance. They should access appropriate internal support, such as the business bookkeeper and, if large enough, the business accountant. They should include such staff in decision-making processes. Almost all small firms have an external professional accountant. However, this person is normally only consulted to assist in completion of statutory reporting requirements (normally annually). However, the research literature indicates that a significant proportion of owners will contact their accountant for advice with respect to significant capital expenditure decisions. The students should consider this problem small firm owners should access a greater and more detailed level of financial feedback on a regular basis, which will come at a cost. However, what incentive do they have to adopt this approach when they do not understand how to interpret and utilise the information? 14. Do you support the contention that financial management of a small enterprise should be properly considered in the context of its overall strategic management? Give reasons to support your views. Financial management is one part of the set of activities to be undertaken. There are many operating issues which need to be considered, including: staffing and staff relations; logistics and physical flows; customer relationships, sales and marketing. The financing of the business and related financial management should be about supporting these activities. However, they are not unrelated. Decisions about marketing or the introduction of a new product or service has a direct financial consequence that needs to be considered. Also, financial management decisions may well impact on business performance. For example, a change to credit terms on sales may result in a decrease or increase in sales depending on the preferences of customers and the options provided by competitors. 15. Consider the proposition: There is no real justification for undertaking a separate and particular study of a small enterprise finance. Businesses are businesses, whatever their size. Make a case for and against the proposition. Case for: Businesses operate in an economy with a financial framework that applies across the private sector; the issues are the same just on a smaller scale types of funds used to fund capital and operating activities; business success is about competitive advantage and relative size is one such factor. Case against: small firm owners personal assets/liabilities are not separate (or arms length) to business assets and liabilities; ownership objectives directly impact on activities; the institutional framework is skewed toward support for public companies and institutions creating enormous barriers to financing choices and options for small firms; lack of access to functional expertise on a day-to-day basis.

Case Study: SMEs prefer debt over equity, pp. 27-28 1. The article suggests that small business owners are familiar with the banking system, making it relatively easy to get access to debt finance. This contrasts with the number of businesses citing liquidity problems in operating the business. Is the access to debt funds as simple as the article suggests? What factors restrict access to debt by small business owners? Access to debt funds is far from simple. We know very little about businesses that do not start or close because they cannot secure funding. Access is constrained to those businesses that have assets they can supply as acceptable security. Factors restricting access to debt include: Lack of assets to secure debt; banks do not lend on risk but against a set of criteria which applicants need to meet; the costs of meeting the criteria are sometimes prohibitive, representing up to 20% of funds sort; lack of understanding on the part of owners as to funding options. 2. According to the article, only 16 per cent of small firms changed their finance service provider over a two-year period. Why would firms be reluctant to change finance service providers? There are normally transaction costs which act as a deterrent to changing institutions. Also, most owners are not aware of the range of options or costs, so are not aware of alternatives. You might ask the students to explain transaction costs in terms that assist a small business owner understand the concept. 3. How would a small firm raise external equity in the Australian economy? The article suggests that small firms do not seek external equity as there are few avenues of external equity readily available. Perhaps there are few avenues as demand is limited. Discuss this in the context of the objectives of small firm ownership. Particular reference should be made to the last paragraph of the article. Remember, most small firms cap growth to the point where they have achieved personal or financial objectives, without losing control. This means that to some extent there is limited demand for equity funds or debt that changes the status quo. In terms of raising external equity, there is a public float (this is expensive and the firm must be at a reasonable size to justify the expense); private placement (where investors are approached to invest in the firm, normally supported by a business case, financials and business plan), this group includes business angels; issue of equity to a venture fund (who will normally be seeking to exit within 3-5 years and make a significant capital gain in the process). Ask the class what they would do if they needed to raise funds and debt wasnt an option.