Entrepreneurial Finance for MSMEs (eBook)

Joshua Yindenaba Abor is a Professor of Finance and the Dean at the University of Ghana Business School. He is a researcher with the African Economic Research Consortium. Joshua is a Visiting Professor of Development Finance at the UCT Graduate School of Business, University of Cape Town, South Africa, and has also held Visiting Scholar positions at the IMF, Washington DC, USA. 

Dedication 5
Foreword 6
Preface 7
Acknowledgements 9
Contents 10
List of Figures 12
List of Tables 13
Part I: The Entrepreneurial Setting 15
1: Introduction to Entrepreneurial Finance 16
1.1 Introduction 16
1.2 Entrepreneurship 17
1.3 Finance and the Entrepreneur 18
1.4 Entrepreneurial Finance and Corporate Finance 20
1.5 Micro-, Small- and Medium-Sized Enterprises 21
1.5.1 Characteristics of MSMEs in Developing Countries 22
1.5.2 Importance of MSMEs to Economic Development 24
1.5.3 Constraints to MSMEs Development 25
1.5.4 Overcoming the Constraints to MSME Development 27
1.6 Organisation of the Book 28
1.7 Summary and Conclusions 31
2: New Venture Development and Sources of Financing 33
2.1 Introduction 33
2.2 Business Ownership 34
2.2.1 Sole Proprietorship 34
2.2.1.1 Advantages of Sole Proprietorship 34
2.2.1.2 Disadvantages of Sole Proprietorship 35
2.2.2 Partnership 36
2.2.3 Limited Liability Company 37
2.2.3.1 Advantages of Limited Liability Company 38
2.2.3.2 Disadvantages of Limited Liability Company 38
2.2.4 Franchise 39
2.3 Information Asymmetry in New Venture and Small Business Financing 39
2.4 Stages of Venture Life Cycle 41
2.4.1 Research and Development Phase 41
2.4.2 Start-Up Phase 42
2.4.3 Growth Phase 42
2.4.4 Decline/Exit Phase 42
2.5 Financing Through the Venture Life Cycle 43
2.6 Sources of Financing 44
2.6.1 Sources of Equity Capital 44
2.6.1.1 Personal Savings/Financing 45
2.6.1.2 Family and Friends 45
2.6.1.3 Business Angels 46
2.6.1.4 Venture Capital Financing 46
2.6.1.5 Corporate Venturers 47
2.6.1.6 Private Placements 48
2.6.1.7 Public Offerings of Equity 48
2.6.2 Sources of Debt Capital 50
2.6.2.1 Bank Finance 51
2.6.2.2 Credit from Microfinance Institutions 51
2.6.2.3 Trade Credit 52
2.6.2.4 Factoring 52
2.6.2.5 Asset-Based Lenders 53
2.6.2.6 Bonds/Public Offer of Debt 53
2.6.2.7 Commercial Paper 54
2.6.2.8 Leasing 54
2.6.3 Hybrid Instruments 55
2.6.3.1 Mezzanine Finance 55
2.6.3.2 Preference Shares 56
2.7 Appropriate and Successful Sources of Financing 58
2.8 Elements of Deal Structure and Closing the Deal 60
2.9 Summary and Conclusions 60
3: Business Planning 63
3.1 Introduction 63
3.2 Business Plans and New Ventures 64
3.3 Purpose of a Business Plan 65
3.4 Strategic Planning and the Business Plan 67
3.5 Elements of a Business Plan 68
3.5.1 Title Page and Table of Content 68
3.5.2 Executive Summary 68
3.5.3 Business Description 69
3.5.4 Products and Services 70
3.5.5 Market and Competitor Analysis 70
3.5.6 Marketing Strategy 71
3.5.7 Organisation and Management 72
3.5.8 Operations 73
3.5.9 The Financial Component 73
3.5.10 Appendices 74
3.6 Attracting External Finance 75
3.7 Facilitating Due Diligence 75
3.8 Implementing the Business Plan 76
3.9 Revising the Business Plan 76
3.10 Why Some Business Plans Fail 77
3.11 Summary and Conclusions 77
Part II: The Financial Environment and Finance Providers 79
4: The Financial Environment and Small Businesses 80
4.1 Introduction 80
4.2 Financial Markets 81
4.2.1 Money and Capital Markets 82
4.2.2 Primary and Secondary Markets 82
4.2.3 Organised and Over-the-Counter-Markets 82
4.3 Financial Institutions 83
4.3.1 Depository Financial Institutions 83
4.3.1.1 Commercial Banks 84
4.3.1.2 Rural and Community Banks 84
4.3.1.3 Savings and Loans Institutions 84
4.3.1.4 Credit Unions 85
4.3.2 Contractual Savings Institutions 85
4.3.2.1 Insurance Companies 85
4.3.2.2 Pension Funds 86
4.3.3 Investment Intermediaries and Other Financial Institutions 86
4.3.3.1 Mutual Funds 86
4.3.3.2 Unit Trusts 87
4.3.3.3 Finance Companies 87
4.3.3.4 Venture Capital Companies 87
4.3.3.5 Microfinance Institutions 88
4.3.3.6 Development Finance Institutions 88
4.3.3.7 Informal Finance Providers 89
4.3.4 Functions of Financial Institutions 89
4.3.4.1 Providing Maturity Intermediation 90
4.3.4.2 Reducing Risk Through Diversification 90
4.3.4.3 Reducing the Costs of Contracting and Information Processing 91
4.3.4.4 Providing Payment Mechanisms 91
4.3.4.5 Dealing with Adverse Selection and Moral Hazard 91
4.4 Allocation of Funds and Interest Rates 92
4.4.1 Economic Growth 92
4.4.2 Inflation 92
4.4.3 Central Bank’s Policy 93
4.4.4 Budget Deficit or Surplus 94
4.4.5 International Flow of Funds 94
4.5 Summary and Conclusions 95
5: Venture Capital Finance 97
5.1 Introduction 97
5.2 The Nature of Venture Capital 98
5.3 Advantages and Disadvantages of Venture Capital 100
5.3.1 Advantages of Venture Capital 100
5.3.2 Disadvantages of Venture Capital 102
5.4 Organisation of Venture Capital Firms 103
5.4.1 The Venture Capital Investment Process 104
5.4.2 Raising Funds and the Role of Reputation in the Venture Capital Market 105
5.5 Venture Capital Contracting 106
5.5.1 Venture Capital Contracts with Investee Enterprises 107
5.5.2 Venture Capital Contracts with Investors 108
5.6 Venture Capitalists Considerations 109
5.6.1 Quality of Management 110
5.6.2 Competitive Edge 110
5.6.3 Financial Projections 110
5.6.4 Level of Financing Required 111
5.6.5 Industry Expertise 111
5.6.6 Viable Exit Strategy 111
5.7 Value Creation by Venture Capitalists 112
5.8 Summary and Conclusions 114
6: Microfinance Intervention 116
6.1 Introduction 116
6.2 Overview of Microfinance 117
6.2.1 The Beginning of Microfinance and the Grameen Bank 119
6.3 Benefits and Criticisms of Microfinance 121
6.3.1 Benefits of Microfinance 121
6.3.2 Criticisms of Microfinance 123
6.4 Operations of Microfinance Institutions 124
6.4.1 Products and Services of MFIs 124
6.4.2 Functions of Microfinance Institutions 125
6.5 Sustainability of Microfinance Institutions 126
6.5.1 Measures of MFIs’ Sustainability 126
6.5.1.1 Subsidy Dependence Index 126
6.5.1.2 Operational Sustainability 127
6.5.1.3 Financial Sustainability 127
6.5.2 Determinants of the Success and Sustainability of MFIs 131
6.6 Lending Models and Credit Risk Management 134
6.6.1 Lending Models of MFIs 134
6.6.1.1 Group-Based Lending 134
6.6.1.2 Village Banking 137
6.6.1.3 Individual Banking 137
6.6.2 Credit Risk Management Mechanisms of MFIs 138
6.6.2.1 Group-Based Lending 139
6.6.2.2 Graduated Loan Schemes 140
6.6.2.3 Frequent Collection of Loan Instalments 140
6.6.2.4 Compulsory Savings 141
6.6.2.5 Guarantors and Referees 141
6.6.2.6 Collecting Information on Clients 142
6.7 Challenges Affecting Microfinance Institutions 142
6.8 Banks and the Microfinance Market 145
6.8.1 Differences Between Banks and Microfinance Institutions 146
6.8.2 Complimentary Roles of Banks and Microfinance Institutions 147
6.8.3 Approaches to Banks’ Entry into the Microfinance Market 147
6.8.3.1 Direct Approaches 148
6.8.3.2 Indirect Approaches 149
6.8.4 Factors that Facilitate the Entry of Banks into Microfinance 151
6.8.5 Benefits of Banks’ Entry into Microfinance 154
6.8.6 Constraints to Banks’ Entry into the Microfinance Market 155
6.9 Summary and Conclusions 158
7: Public Sector Interventions and Small Businesses 162
7.1 Introduction 162
7.2 Channels of Government Support for MSMEs 163
7.2.1 Measures Aimed at Influencing Enterprise Behaviour and Improve Environment for MSMEs. 163
7.2.2 Support Given to Intermediary Agencies to Promote Inter-Firm Linkages and Networking 164
7.2.3 Government Policies to Encourage Financial Institutions to Provide Support for MSMEs. 164
7.3 Rationale for Public Sector Interventions 165
7.3.1 Improving Business Conditions 165
7.3.2 Providing Guarantees for MSMEs 165
7.3.3 Making the Financial System Accessible to MSMEs 166
7.3.4 Expanding the Supply of Finance Through the Non-­Financial Private Sector 166
7.4 The Role of the Public Sector in MSME Development 167
7.4.1 Creating an Enabling Regulatory Environment 167
7.4.2 Improving Access to Finance 168
7.4.3 Providing Business Development Services 171
7.5 Key Policy Choices 173
7.6 Government and Donor Support Programmes 174
7.7 Summary and Conclusions 175
Part III: Financial Performance and Planning 177
8: Understanding and Analysing Financial Statements 178
8.1 Introduction 178
8.2 Financial Statements 179
8.2.1 Income Statement 180
8.2.2 Balance Sheet 182
8.2.3 Statement of Cash Flows 185
8.3 Problems with Financial Statements 187
8.4 Analysis of Financial Statements 188
8.4.1 Vertical Analysis 189
8.4.2 Horizontal Analysis 190
8.4.3 Financial Ratio Analysis 190
8.4.3.1 Liquidity Ratios 190
8.4.3.2 Profitability Ratios 192
8.4.3.3 Activity/Efficiency Ratios 194
8.4.4 Leverage Ratios 197
8.4.4.1 Market/Investment Ratios 199
8.5 Uses of Financial Ratios 200
8.6 Limitations of Ratio Analysis 200
8.7 Summary and Conclusions 202
9: Financial Planning and Forecasting 205
9.1 Introduction 205
9.2 Financial Planning 206
9.2.1 Budgeting 206
9.2.1.1 Cash Budget 207
9.3 Financial Forecasting 209
9.3.1 Approaches to Forecasting 211
9.4 Forecasting Sales 211
9.4.1 Forecasting Financial Statements 213
9.4.1.1 Using Percentage of Sales Method to Forecast Financial Statements 213
9.5 Projecting Financing Needs and Growth 214
9.6 Financing Needs and Break-Even Analysis 221
9.6.1 Break-Even Analysis 221
9.7 Determinants of Financing Needs 224
9.7.1 Profitability 224
9.7.2 Cash Flow 224
9.7.3 Minimum Efficient Scale 225
9.7.4 Sales Growth 225
9.8 Summary and Conclusions 226
10: Working Capital Management 231
10.1 Introduction 231
10.2 Concepts of Working Capital 232
10.3 Working Capital Management 232
10.3.1 Determining Working Capital Requirement 233
10.3.1.1 The Operating Cycle 233
10.3.1.2 Working Capital Required per Dollar of Sales 234
10.3.2 Determinants of Working Capital Levels 235
10.4 Inventory Management 235
10.4.1 Economic Order Quantity of Inventory 236
10.4.2 Reorder Point Calculation 241
10.4.3 Just-in-Time Inventory System 242
10.4.4 The ABC System of Inventory Management 243
10.5 Accounts Receivable Management 243
10.5.1 Establishing Credit Policy 244
10.5.1.1 Credit Standards 244
10.5.1.2 Terms of Credit 245
10.5.1.3 Collection Policy 245
10.5.1.4 Analysing Accounts Receivable 246
10.5.1.5 Aging of Accounts Receivable 247
10.5.2 Financing Accounts Receivable 248
10.6 Cash and Marketable Securities Management 249
10.6.1 Reasons for Holding Cash 250
10.6.2 Managing Collection and Disbursement of Cash 250
10.6.3 Management of Marketable Securities 251
10.6.4 Cash Management Models 252
10.6.4.1 The Baumol Model 252
10.6.4.2 The Miller–Orr Model 254
10.7 Current Liabilities Management 256
10.7.1 Short-Term Debt Management 256
10.7.2 Accrued Liabilities Management 257
10.7.3 Accounts Payable Management 257
10.7.3.1 Cash Discounts 258
10.7.3.2 Trade Discounts 259
10.7.3.3 Quantity Discounts 259
10.8 Summary and Conclusions 260
Part IV: Valuation 262
11: Time Value of Money 263
11.1 Introduction 263
11.2 Simple Interest 264
11.2.1 Simple Interest and Treasury Bill Discount 266
11.2.2 Interest Equivalent Yield 268
11.3 Compound Interest 268
11.4 Future Value of a Lump Sum 270
11.5 Present Value of a Future Lump Sum 271
11.5.1 Finding the Interest Rate and the Number of Periods 273
11.6 Effect of Compounding 275
11.6.1 Stated Annual Interest Rate and Effective Annual Rate of Interest 276
11.6.1.1 Continuous Compounding 277
11.7 Perpetuities 278
11.7.1 Growing Perpetuity 280
11.8 Annuities 280
11.8.1 Future Value of Ordinary Annuity 281
11.8.2 Future Value of Annuity Due 284
11.8.3 Present Value Ordinary Annuity 286
11.8.4 Present Value Annuity Due 288
11.8.5 Growing Annuity 289
11.9 Amortisation 290
11.10 Summary and Conclusions 292
12: Evaluating Capital Investment Decisions: Capital Budgeting 296
12.1 Introduction 296
12.2 Capital Budgeting: An Overview 297
12.3 Factors Affecting Capital Budgeting 298
12.3.1 Changes in Government Regulations 298
12.3.2 Research and Development 299
12.3.3 Changes in Business Strategy 299
12.4 Steps in Capital Budgeting 300
12.5 Formulating an Investment Proposal 300
12.5.1 Costs in Capital Budgeting 300
12.5.2 Benefits and Importance of Capital Budgeting 301
12.6 Techniques of Capital Budgeting 302
12.6.1 Payback Period 303
12.6.2 Discounted Payback Period 305
12.6.3 Net Present Value 306
12.6.4 Internal Rate of Return 309
12.6.4.1 Problems of Using the Internal Rate of Return 311
12.6.5 Modified Internal Rate of Return 312
12.6.6 Profitability Index 313
12.6.7 Accounting Rate of Return 316
12.7 Making the Decision 318
12.8 Following Up 318
12.9 Taking Corrective Action 319
12.10 Summary and Conclusions 319
13: Valuation of New Ventures and Small Businesses 324
13.1 Introduction 324
13.2 Valuation of Business Ventures 325
13.3 Valuation Methods 326
13.3.1 Discounted Cash Flow Method 326
13.3.2 Risk-Adjusted Net Present Value 328
13.3.2.1 Risk and Return Models 328
13.3.3 Certainty Equivalent Method 331
13.3.4 Venture Capital Method 332
13.3.4.1 Valuation Assuming Future Dilution 337
13.3.5 Free Cash Flow to Equity 341
13.3.5.1 Estimates of Cash Flows 341
13.3.5.2 Valuation Using Free Cash Flow to Equity 343
13.3.6 Free Cash Flow to Firm 343
13.3.6.1 Free Cash Flow Valuation 344
13.3.6.2 Valuing a Firm’s Equity 344
13.3.6.3 Valuing the Entire Firm 345
13.3.7 Valuation Using Comparable Firms 347
13.3.7.1 Valuation Multiples 348
13.3.7.2 Other Multiples 351
13.3.7.3 How to Identify Comparable Companies 351
13.3.7.4 Identifying Comparable Valuations 352
Using Publicly Traded Companies 352
Using Mergers and Acquisition Transactions 353
Using Other Venture Investment 353
13.4 Selecting a Valuation Model 354
13.5 Summary and Conclusions 355
Part V: Financing Choice and Harvesting 359
14: Financing Choice 360
14.1 Introduction 360
14.2 Financing Options 361
14.3 Determining Financing Requirement 362
14.4 Factors Affecting Financing Choice 363
14.4.1 Stage of the Firm 364
14.4.2 Conditions Attached to the Finance 365
14.4.3 Tax Implications 365
14.4.4 Profitability and Cash Flows 365
14.4.5 Value of Assets 366
14.4.6 Cost of Finance 367
14.4.7 Relationship with Finance Providers 368
14.4.8 Time Frame Within Which Financing Is Required 368
14.5 Summary and Conclusions 369
15: Harvesting the Business Venture Investment 371
15.1 Introduction 371
15.2 Going Public 372
15.2.1 The Role of Investment Banks 373
15.2.2 Advantages of Going Public 375
15.2.3 Disadvantages of Going Public 376
15.3 Acquisition 378
15.3.1 Forms of Mergers and Acquisitions 378
15.3.1.1 Purchase of Shares of the Venture for Cash 378
15.3.1.2 Purchase of Assets of the Venture for Cash 379
15.3.1.3 Purchase of Equity of the Venture for Equity of the Acquirer 380
15.3.2 Types of Mergers and Acquisitions 381
15.3.3 Reasons for Mergers and Acquisitions 381
15.4 Management Buyouts 383
15.5 Employee Stock Ownership Plans 385
15.6 Harvesting Decisions 387
15.6.1 Current Market Conditions and Valuation Considerations 387
15.6.2 Size of the Enterprise 388
15.6.3 Stage of the Enterprise’s Development 388
15.6.4 Synergies 389
15.6.5 Control of Firm 389
15.6.6 Tax Considerations 389
15.7 Summary and Conclusions 390
Appendix A: Formula Sheet 391
Appendix B: Financial Tables 395
Glossary 407
Bibliography 426
Index 432