Glossary of Financial Terms

Accounts payable: Amount owing to creditors for goods and services on an open account.

Accounts receivable: Amount due from customers for merchandise or services purchased on an open account.

Asset: Anything owned by a business or individual that has commercial or exchange value.

Balance sheet: Financial statement that presents a “snapshot” of what the business owns, what it owes, and what equity it has on a given date.

Capital: See Equity.

Capital expenditures: Purchases of long-term assets, such as equipment, used in manufacturing a product.

Cash flow: Incoming cash to the business less the outgoing cash during a given period. Also used to refer to the figure derived from net income plus noncash items charged off in the accrual accounting process.

Collateral: Assets pledged to secure a loan.

Collection period ratio: Indicates how quickly your customers pay you. Average accounts receivable divided by net sales, multiplied by 365.

Community Reinvestment Act (CRA): Under provisions of the Community Reinvestment Act of 1977, banks and thrift institutions seek opportunities to help meet the credit needs of their local communities, including low- and moderate-income neighborhoods, consistent with safe and sound operation of the institutions. Compensating balance: Money a bank requires a company to leave in a deposit account as part of a loan agreement.

Corporation: Form of business ownership that is a legal entity on its own and puts stockholders and the board of directors in control. Owners have limited liability for the corporation’s actions. A corporation has unlimited life and in most cases is taxed as an entity on its own.

Cost of goods sold: Figure representing the cost of buying raw materials and producing finished goods.

Current assets: Cash or other assets you expect to use in the operation of the firm within one year.

Current liabilities: Debts you expect to pay within one year.

Current ratio: Shows the firm’s ability to pay its current obligations from current assets. Current assets divided by current liabilities.

Days purchases in accounts payable ratio: Indicates how quickly you pay your suppliers for inventory purchases. Average accounts payable divided by the cost of goods sold plus change in inventory, multiplied by 365.

Days to sell inventory ratio: Indicates the firm’s efficiency at matching purchases to expected sales. Average inventory divided by the cost of goods sold, multiplied by 365.

Debt ratio: Indicates the firm’s debt level, or leverage. Total liabilities divided by total liabilities plus capital.

Depreciation: Amortization of the cost of a fixed asset, such as plant and equipment, over several years, or the “depreciable life.”

Dividend: Distribution of earnings to shareholders.

Equal Credit Opportunity Act (Federal Reserve Regulation B): Prohibits lenders from denying your application on the basis of race, color, religion, national origin, sex, marital status, or age, or from discouraging you from applying, or giving you less favorable terms than any other applicant, on such a basis. Regulation B also contains specific rules governing credit transactions.

Equity: The ownership interest in a business remaining after its liabilities are deducted. Also known as common stock plus retained earnings, or capital.

Extraordinary items: Unusual or nonrecurring event that must be explained to shareholders or investors, such as a manufacturer’s sale of a building.

Finance company: Competitors of commercial banks in providing credit to households and firms. Unlike banks, they do not accept deposits.

Financial projections: Estimates of the future financial performance of a firm.

Financial statements: Written record of the financial status of an individual or organization. Commonly include profit and loss, or income, statement; the balance sheet, which includes a statement of the company’s retained earnings; and the cash flow statement.

Fixed assets: Long-term assets such as buildings, equipment, or property that are not expected to be converted to cash in the near term.

Gross profit: Indicates the revenues of the firm before consideration of its operating expenses Net sales less cost of goods sold.

Gross profit margin: Measures a firm’s profitability. Gross profits divided by net sales.

Gross income: Net sales less cost of goods sold.

Installment loan: Loan type that is paid in periodic payments, such as an automobile loan.

Inventory: Value of a firm’s raw materials, work in process, supplies used in operations, and finished goods.

Investor: An individual who takes an ownership position in a company, thus assuming risk of loss in exchange for anticipated returns.

Leverage: Measures the firm’s use of borrowed funds versus those funds provided by the shareholders or owners (equity).

Line of credit: Although not a contract, a bank’s promise to lend to a specific borrower up to a pre-agreed amount during a specific time frame. Usually reviewed annually and subject to cancellation without notice.

Liquid assets: Those assets that can be readily turned into cash.

Liquidity: Gauges firm’s ability to quickly turn assets into cash.

Marketable securities: Securities that are easily sold.

Net income: The sum remaining after all expenses have been met or deducted. Also called profit.

Net sales: Gross sales minus returns and allowances.

Net worth: Excess of assets over debt.

Niche: Particular speciality in which a firm has gained a large market share.

Operating expenses: Those costs associated with the day-to-day activities of the business.

Operating profit (loss): Income or loss before taxes and extraordinary items resulting from transactions other than those in the normal course of business.

Operating profit margin: Measures a firm’s profitability by examining the pre-tax profit generated from primary operations (versus extraordinary items) in relation to net sales. Operating profit divided by net sales.

Partnership: Can be general or limited, but in either case the general partners are in control. The tax burden is shared by all the partners at their personal rate, and the general partners have unlimited liability. Limited partners have limited liability.

Principal: The currently unpaid balance of a loan, not including interest owed. Also can refer to a primary owner or investor.

Profit: Compensation an entrepreneur receives for the assumption of risk in a business venture. Also called net income.

Profit and loss statement: Summary of the revenues, costs, and expenses for a business over a period of time. Also called the income statement.

Pro forma financial statements: Financial statements for a business where certain amounts shown are hypothetical, or estimated, for the period depicted.

Quick ratio: Liquidity ratio that focuses on the firm’s most liquid assets by excluding inventory. Also known as the acid test ratio. Cash, marketable securities, and accounts receivable divided by current liabilities.

Retained earnings: Net profits kept to accumulate in a business after dividends are paid.

Seasonal loan: A loan made for the purpose of meeting predictable and periodic funding needs, such as funding of camping gear inventory before summer purchases.

Small Business Administration (SBA): Federal agency created in 1953 to provide management and financial assistance to small businesses. Mainly, the SBA guarantees loans through financial institutions. The loans may be used for working capital, machinery and equipment acquisition of real estate, and expansion.

Sole proprietorship: A type of business where the owner has full control and unlimited liability. A sole proprietorship is taxed at the personal income tax rate.

Reprinted with permission of Tracy L. Penwell, Tuko Fujisaki, Publication Productions and the Federal Reserve Bank of New York.

The Federal Reserve Bank of New York
Public Information Dept.
33 Liberty Street
New York, NY 10045
(212)720-6134

Resources and How to Use Them

There are numerous programs available to assist prospective and existing small business owners. Many are wholly or partially funded by federal or local government entities and can provide services to you at low or no cost. Sometimes staffed by university professors and graduate business students, retired business executives, or small business consulting specialists, these programs are excellent sources of advice.

Types of Assistance

Small business assistance programs generally fall into two categories: training programs, which teach business owners technical and financial skills, and loan programs, which offer loans or loan guarantees for small businesses.

Training Programs

Depending on the organization and on your particular needs, training programs offer skill-building assistance either in the classroom for several weeks or in individual counseling sessions.

TECHNICAL ASSISTANCE PROGRAMS can cover a wide range of topics and their applicability depends on the nature of your business. Topics may include production, marketing, distribution, packaging, import/export documentation, and human resources or staff management.

FINANCIAL SKILLS ASSISTANCE PROGRAMS may include basic accounting, cash flow management, sales projections, feasibility studies, and tax planning.

BUSINESS PLAN DEVELOPMENT COURSES include components of both the technical and financial programs and assist you with composing, preparing, and presenting your business plan and loan proposal to prospective lenders.

Loan Programs

LOAN PROGRAMS are among the resources offered by small business investment corporations and state or local development corporations. These programs typically have funds available to lend directly to new or expanding businesses. They also may offer guarantees or other support for a loan given by a traditional lender, such as a bank, to help mitigate the bank’s risk of lending directly to a new small business.

One advantage of approaching an organization with a loan program rather than a bank is that the organization may have funds dedicated solely to the new small business market. It also may be receiving some type of government subsidy that permits it to offer lower interest rates for small business loans. Programs that provide guarantees from a government agency to pay the loan if your business fails may convince a bank to lend to your business when it otherwise wouldn’t.

Small Business Administration

Created in 1953, the Small Business Administration (SBA) provides management and financial assistance to small businesses. Mainly, the SBA guarantees loans through financial institutions. The loans may be used for working capital, machinery and equipment, acquisition of real estate, and expansion.

Information Guide

More information about technical assistance programs and loans offered by not-for-profit groups and government agencies in New York and New Jersey is available in the “Resource Guide for Small Business Lending.”

To order the Resource Guide, write: Federal Reserve Bank of New York Community Affairs Office 33 Liberty St. New York, NY 10045

The following is a partial list of the organizations that appear in the Resource Guide.

New Jersey

Economic Development Corporation of Essex County (EDC)
Burton Sebold, Executive Director
443 Northfield Ave.
West Orange, NJ 07052
(201) 731-2772

Middlesex County Certified Local
Development Corp.
Angel Guikoff, Management Specialist
303 George St., Suite 304
New Brunswick, NJ 08901
(908) 745-4005

Somerset Alliance for the Future (SAF)/District Management Corp.
of the Borough of Somerville (DMC)
Richard Close, Design Coordinator
(SAF), or Richard Reitman, Chairman (DMC)
166 W. Main St.
Somerville, NJ 08876
(908) 704-1010

Downstate New York

ACCION New York
Delma Soto, Director, or
Hector Carino, Operations Manager
235 Havemeyer St.
Brooklyn, NY 11211
(718) 599-5170

Bedford Stuyvesant
Restoration Corp.
Bernice McRae, Project Coordinator
1368 Fulton St.
Brooklyn, NY 11216
(718) 636-6924

Brooklyn Economic
Development Corp. (BEDC)
Joan Bartolomeo, President
30 Flatbush Ave., 4th Floor
Brooklyn, NY 11217
(718) 522-4600

Greater Jamaica
Local Development Co., Inc.
William F. Johnson, Assistant Secretary
90-04 161st St.
Jamaica, NY 11432
(718) 291-0282

Harlem Restoration Project, Inc.
Dorothy Keller, Counsel
461 W. 125th St.
New York, NY 10027
(212) 662-8186

Long Island Development Corp.
Roslyn D. Goldmacher, Executive Director
255 Glen Cove Rd.
Carle Place, NY 11514
(516) 741-5690

Manhattan Borough
Development Corp.
Patricia Swann, Executive Director
15 Park Row, Suite 510
New York, NY 10038
(212) 791-3660

Nassau/Suffolk Minority Business
Development Center
Kathleen Percival Greene, Executive Director
150 Broad Hollow Rd., Suite 304
Melville, NY 11747-4901
(516) 549-5454

New York City Comptroller’s Office
Stuart Baron, Project Manager
1 Centre St., Room 736
New York, NY 10007
(212) 669-2017

New York City Economic
Development Corp.
Allison Clark, Urban
Fellow (Finance/Lending)
110 William St.
New York, NY 10038
(212) 312-3900

New York State Small Business Development Center
Judith M. McEvoy, Director
Harriman Hall
State University of New York
at Stony Brook
StonyBrook, NY 11794-3775
(516) 632-9070

PortJervis Development Corp.
John A. Russell, Executive Director
P.O. Box 3105, 19 East Main
St. Port Jervis, NY 12771
(914) 858-8358

Queens Minority Business Development Center
Albert G. Longoria, Executive Director
110-29 Horace Harding Expressway
Flushing, NY 11368
(718) 592-1001

Upstate New York

Adirondack Economic Development Corp.
Jamie Y. White, Economic Specialist
Trudeau Rd., Box 747
Saranac Lake, NY 12983
(518) 891-5523

Alternatives Federal Credit Union
Mary Ziegler, Director of Lending
301 West State St.
Ithaca, NY 14850
(607) 273-4666

Erie County Industrial
Development Agency
Miguel Coty, Director of Communication
424 Main St., Suite 300
Buffalo, NY 14202-3595
716) 856-6525

Ibero American Investors Corp.
Emilio L. Serrano, President & CEO, or
Jerry Murtha, Chief Lending Officer
104 Scio St.
Rochester, NY 14604
(716) 262-3440

Mohawk Valley Rehabilitation Corp.
Michael Reese,
Executive Vice President & CEO
26 W. Main St.
Mohawk, NY 13407
(315) 866-4671

Monroe County Industrial
Development Corp.
Judith Seil,
Economic Development Specialist
One West Main St., Suite 600
Rochester, NY 14614
(716) 428-5060

New York Business
Development Corp.
Robert W. Lazar, President & CEO
41 State St., PO. Box 738
Albany, NY 12201
(518) 463-2268

Rochester Economic
Development Corp.
Charles Andrus, Secretary
30 Church St.
Rochester, NY 14604
(716) 428-6808

Rural Opportunities, Inc.
RobertJ. Aronson
Deputy for Economic Development
339 East Ave.
Rochester, NY 14604
(716) 546-7180

NY State Government Programs

New York State
Science & Technology Foundation
Tom Smith, Finance Associate
99 Washington Ave., Suite 1731
Albany, NY 12210
(518) 473-9741

New York State
Urban Development Corp.
Leslie R. Byrd, Vice President
1515 Broadway
New York, NY 10036
(212) 930-0452

Federal Government Programs

Farmers Home Administraffon
Lowell Gibson, Chief,
Community and Business Programs
James M. Hanley Federal Bldg.
Room 871
Syracuse, NY 13261
(315) 423-5290

U.S. Department of Commerce,
Minority Business
Development Agency
John F Iglehart, Regional Director
Jacob K. Javits Federal Building
Room 3720
New York, NY 10278
(212) 264-3262

Small Business Administration
Ronald Goldstein, Chief of Finance
26 Federal Plaza
New York, NY 10278
(212) 264-1480

Walter Barnes, Chief of Finance
Military Park Building
60 Park Plaza
Newark, NJ 07102
(201) 645-3582

Regulatory Agencies

The following is a list of Community Reinvestment Act contacts in New York and New Jersey.

Federal Reserve Bank of New York
James K. Hodgetts,
Community Affairs Officer
(212) 720-5898
Elizabeth Rodriguez-Jackson,
Special Assistant for Community Affairs
33 Liberty St.
New York, NY 10045
(212) 720-5921

Office of the Comptroller of the Currency
Pamela Lea Mount, Compliance Manager
112 Madison Ave., Suite 400
New York, NY 10016-7416
(212) 779-4537

Office of Thrift Supervision
Ada Moran, Community Affairs Liaison
10 Exchange Place Center
Jersey City, NJ 07302
(201) 413-1000

Federal Deposit Insurance Corp.
Donna Gambrell, Community Affairs Officer
452 Fifth Ave., 17th Floor
New York, NY 10018
(212) 704-1230

New York State Banking Department
Consumer Services Division
Peter Zanko, Assistant Deputy Superintendent
2 Rector St.
New York, NY 10006
(212) 618-6408

New Jersey State
Banking Department
Paul Buytkins, Administrative Analyst
CN040
20 West State St.
Trenton, NJ 08625
(609) 989-4151

Reprinted with permission of Tracy L. Penwell, Tuko Fujisaki, Publication Productions and the Federal Reserve Bank of New York.

The Federal Reserve Bank of New York
Public Information Dept.
33 Liberty Street
New York, NY 10045
(212)720-6134

Financial Ratio Analysis

Another tool the lender will use is financial ratio analysis. Ratios permit review of a company’s current financial performance versus that of previous years. In the same way that a medical checkup tests one’s heart, lungs, and changeable factors such as body weight, an analysis of a company’s financial performance considers the status, changes, and relationships of critical components of a company’s health.

The lender also may use financial ratio analysis to consider how a company is doing when compared to another company. A limitation of such comparative analysis is that different industries are driven by different factors. As a result, the financial ratios of a manufacturer and retailer can be quite different even though both companies may be similarly successful.

Lenders are trained to appreciate both the benefits and limitations of ratio analysis and to consider financial results in the context of the company’s “peer group” of similar companies within its industry. To find out what the benchmarks are for your type of business, you may refer to guides published by Robert Morris Associates and others.

The following pages present some widely used ratios from four financial ratio categories: profitability, liquidity, leverage, and turnover. Also review an example of the ratios calculated for the sample company, F.E.D. Foods Company. Your lender’s analysis also may include ratios specific to your particular industry. For additional information on financial analysis and calculation of ratios, check with an accountant, your lender, or one of the sources listed in the Information Guide in this booklet.

Profitability

Profit is the compensation an entrepreneur receives for the assumption of risk in a business venture. The profitable business must cover its overhead expenses and generate profits for its owner out of its “after-product-costs” cash.

Gross Profit Margin One commonly used measure of profitability is gross profit, which is your sales minus your product costs. In ratio form, it is called the gross profit margin:

Gross Profit Margin = Net Sales – Cost of Goods Sold
——————————
Net Sales

The gross profit margin for F.E.D. Foods Company for 1993 is:

$633,000-$358,000 x 100 = 43.4%
———————–
$633,000

(from profit and loss statement,(lines a-b)/line a)

Operating Profit Margin

Another measure of your profitability is the operating profit margin. This is the core cash flow source that is expected to grow year to year as your business grows, and it excludes interest expense, taxes, and “extraordinary items” such as the sale of property or other assets.

Higher profitability from one year to the next is generally considered a good sign for a company.

Operating Profit Margin = Operating Profit
—————-
Net Sales

The operating profit margin for F.E.D. Foods Company for 1993 is:

$164,000 x 100 = 25.9%
————–
$633,000

(from profit and loss statement,line h/ line a)

Liquidity

How much cash does your business have on hand for immediate use?

Quick Ratio The quick ratio shows what assets your business can immediately convert to cash, such as the business checking account and money market accounts.

Cash +Marketable Securities
+ Accounts Receivable
Quick Ratio = ———————-v Current Liabilities

The quick ratio for F.E.D. Foods Company for 1993 is:

$3,000 + $8,000 +$42,000
————————- = 0.45
$118,000

(from balance sheet, line 1 + line 2 + line 3/line 15)

Current Ratio
The current ratio is a broader indication of liquidity because it includes inventory. For purposes of showing your immediate access to cash, many lenders find it less useful than the quick ratio. In general, lenders look for your current assets to exceed your current liabilities.

Current Assets
Current Ratio = ——————-
Current Liabilities

The current ratio for F.E.D. Foods Company for 1993 is:

$212.000
——— = 1.8
$ 118,000

(from balance sheet, line 6/line 15)

Leverage

The leverage ratios measure the company’s use of borrowed funds in relation to the amount of funds provided by the shareholders or owners. These ratios tell the lender how much money you have borrowed versus what money you and other owners have put into your company. This is important because borrowed money carries interest costs and your business must generate sufficient cash flow to cover the interest and principal amounts due to the lender. Generally speaking, companies with higher debt levels will have higher interest costs to cover each month, so low to moderate leverage is nearly always viewed more favorably by prospective lenders.

Debt Ratio
The most common leverage ratio is called, simply, the debt ratio:

Total Liabilities
Debt Ratio = ——————————
Total Liabilities + Capital

The debt ratio for F.E.D. Foods Company for 1993 is:

$195,000
——————- X 100 = 17.5%
$ 1,112,000

(from balance sheet, line 18/line 21)

Turnover

The turnover ratios focus on the operating cycle of your business by examining its cash flow. They show the amount of time it takes for cash to move through the accounts receivable, inventory account, and accounts payable in your business.

It is important to know how many days it takes your company to purchase inventory, pay for it, sell it, and collect the cash for the sales. Those sales you make on the customer’s promise to pay at a later date (also known as credit sales) may not actually produce cash for 30 to 60 days. You can get squeezed if you don’t understand this cycle and find that you have to pay for new supplies before your customers have paid you.

Gaining an understanding of the cash flow of your business is the most important financial planning tool you have. An examination of the turnover ratios can help you to understand the operating cycle in your business.

The three turnover ratios are the collection period ratio, the days to sell inventory ratio, and the days purchases in accounts payable ratio.

Collection Period Ratio
First, the collection period ratio indicates how quickly you collect the cash your customers owe you. The earlier you collect it, the sooner you can put it to work purchasing more inventory or paying for current orders; so the lower the number, the better.

Average Accounts
Receivable
Collection Period Ratio = —————– X 365
Net Sales

The collection period ratio for F.E.D. Foods Company for 1993 is:

($42,000 + $33,000)/2
——————— X 365 = 22 days
$633,000

(from balance sheet, and profit and loss statement, page 12, ((line 3 (1993) + line 3 (1992)/two)/line a) X 365)

Days to Sell Inventory Ratio Along the same lines is the second turnover ratio, the days to sell inventory ratio. The days to sell inventory ratio tells how efficient you are at matching your purchases to your sales. Low inventory days indicate that you’ve accurately forecasted the demand for your product. That way excess inventory isn’t accumulating on your shelves and adding to costs.

Days to Sell Average Inventory
Inventory Ratio = ——————– X 365
Cost of Goods Sold

The days to sell inventory ratio for F.E.D. Foods Company for 1993 is:

($157,000 + $150,000)/2
———————— X 365 = 156 days
$358,000

(from balance sheet and profit and loss statement. page 12, ((line 4 (1993) + line 4 (1 992)/two)/line b) X 365)

Days Purchases in Accounts Payable Ratio The days purchases in accounts payable ratio is the third turnover ratio. This ratio measures how quickly you pay your suppliers for inventory purchased. Generally speaking, it is advantageous for small businesses to pay for products promptly so they can take advantage of price discounts.

Days Purchases Average Accounts Payable
in Accounts —————————- X 365
Payable Ratio Cost of Goods Sold
+ Change in Inventory

The days purchases in accounts payable ratio for F.E.D. Foods Company for 1993 is:

($38,000 + $42,000)/2
———————- x 365 = 40 days
$358,000 + $7,000

(from balance sheet and profit and loss statement, page 12, ((line 13 (1993) + line 13 (1992)/two)/(line b + change in lines 4)) X 365)

Reprinted with permission of Tracy L. Penwell, Tuko Fujisaki, Publication Productions and the Federal Reserve Bank of New York.

The Federal Reserve Bank of New York
Public Information Department
33 Liberty Street
New York, NY 10045
(212)720-6134

Sample Documents Required by Lenders

Provides you with a snapshot of your business at a specific time, such as the end of the year. It keeps track of your company’s assets, or what the company owns (including its cash), and the company’s debts, or liabilities (generally loans from others). It also shows the capital, or equity, put into the business. This balance sheet is an example of a statement for a small, hypothetical food manufacturer called F.E.D. Foods Company. ****************************************************************

F.E.D. Foods Co. Balance Sheet

As of December 31, 1993 1992
($Thousands)
—————————————————————- Assets
Current Assets
1. Cash $ 3 $ 2
2. Marketable Securities 8 12
3. Accounts Receivable 42 33
4. Inventories 157 150
5. Prepaid Expenses 2 3
— — 6. Total Current Assets 212 200
7. Plant, Property, and Equipment 1,067 983
8. Less Accumulated Depreciation 450 417
— —
9. Net PPE 617 566
10. Investments 267 217
11. Other Assets 16 17
— —
12. Total Assets 1,112 1,000

Liabilities
Current Liabilities
13. Accounts Payable 38 42
14. Notes Payable 80 66
— —
15. Total Current Liabilities 118 108
16. Long-Term Debt 0 0
17. Deferred Tax Liability 77 67
— —
18. Total Liabilities 195 175

Capital
19. Common Stock 367 327
20. Retained Earnings 550 498
— —
21. Total Liabilities and Capital 1,112 1,000
—————————————————————– A Profit and Loss Statement

Shows the profit or loss for the year. The profit and loss statement, also called the income statement, takes the sales for the business, subtracts the costs of goods sold, then subtracts other expenses. This is a profit and loss statement for F.E.D. Foods Company.

F.E.D. Foods Co.
Profit and Loss Statement (Income Statement)

Years Ended December 31, 1993 1992
($ Thousands)
—————————————————————-
a. Net Sales $ 633 $ 500
b. Cost of Goods Sold 358 300
— —
c. Gross Profit 275 200

d. Selling and Administrative Expenses 27 20
e. Lease Payments 17 12
f. Depreciation 50 42
g. Repairs and Maintenance 17 18
— —
h. Operating Profit 164 108
Other Income (Expense)
i. Interest Income 3 1
j. Interest Expense 0 0
— —
k. Earnings Before Income Taxes 167 109

1. Income Taxes 57 37
— —
m. Net Earnings 110 72
— —

A Statement of Cash Flows

Presents the sources of cash in your business–from net income, new capital, or loan proceeds–versus the expenditures, or uses of the cash, over a specified period of time. An example of the cash flow statement for F.E.D. Foods Company is shown below.

It’s at this stage that you will appreciate having an effective accounting system. Without this system, you won’t know if you are profitable or not, let alone if you are liquid enough (simply put, have enough cash on hand) to pay for the next order of merchandise. A good system also will help you track your company’s growth and anticipate future cash needs.

F.E.D. Foods Co. Cash Flow Statement
($ Thousands) Sources/(Uses)
—————————————————————– Operating Activities
Net Income $ 110
Plus: Depreciation 50
Decrease in Prepaid Expenses 1
Increase in Deferred Tax Liability 10
—
171
Less: Profit on Sale of Equipment (25)
(line 9(1992) + Note I – f – 9(1993) – Note 2) Increase in Inventories (7)
Increase in Accounts Receivable (8)
Decrease in Accounts Payable (4)
—
Net Cash Provided From Operating Activities 127
Investing Activities
Capital Expenditures (167)
Increase in Investments (50)
Proceeds From Sale of Equipment 92
—
Net Cash Provided From Investing Activities (125)
Financing Activities
Proceeds From Sale of Stock 40
Proceeds From Notes 13
Dividends (58)
—
(Line m (1993)- change in line 20 (1992-1993) Net Cash Provided From Financing Activities (5)
Increase in Cash and Marketable Securities (3)
—

Notes: 1. Capital Expenditures in 1993 were $167,000.
2. Equipment sold in 1993 for $92.000.

Reprinted with permission of Tracy L. Penwell, Tuko Fujisaki, Publication Productions and the Federal Reserve Bank of New York.

The Federal Reserve Bank of New York
Public Information Department
33 Liberty Street
New York, NY 10045
(212)720-6134

Lender Review Process

Credit Analysis Regardless of where you seek funding–from a bank, a local development corporation, or a relative–a prospective lender will review your creditworthiness. A complete and thoroughly documented loan request (including a business plan) will help the lender understand you and your business. The basic components of credit analysis, the “Five C’s,” are described below to help you understand what the lender will look for.

The ”Five C’s” of Credit Analysis

CAPACITY to repay is the most critical of the five factors. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships–personal or commercial–is considered an indicator of future payment performance. Prospective lenders also will want to know about your contingent sources of repayment.

CAPITAL is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Prospective lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding.

COLLATERAL or guarantees are additional forms of security you can provide the lender. Giving a lender collateral means that you pledge an asset you own, such as your home, to the lender with the agreement that it will be the repayment source in case you can’t repay the loan. A guarantee, on the other hand, is just that–someone else signs a guarantee document promising to repay the loan if you can’t. Some lenders may require such a guarantee in addition to collateral as security for a loan.

CONDITIONS focus on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender also will consider the local economic climate and conditions both within your industry and in other industries that could affect your business.

CHARACTER is the general impression you make on the potential lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be reviewed. The quality of your references and the background and experience levels of your employees also will be taken into consideration.

IF YOUR APPLICATION IS NOT APPROVED

If your loan is not approved, ask why. You are entitled by law to a written statement of the reasons for a loan denial, if you request it. Many banks automatically supply the reasons for denial in writing. Knowing the reasons for a loan denial can inform you of areas in your proposal that didn’t meet the lender’s standards. Since all lenders do not share identical standards, another lender may reach a different credit decision. Review your loan proposal in light of the lender’s comments. See how you can use the resources or ideas presented in this site to strengthen your application. Go through the process of reviewing your technical and financial material again, and then review your business plan. Find any areas that could be augmented further and lead to an approval on your next request. If you believe you have been denied credit unlawfully, you should contact the regulatory authority that supervises the institution. The Equal Credit Opportunity Act (Federal Reserve Regulation B) prohibits lenders from denying your application on the basis of race, color, religion, national origin, sex, marital status, or age, or from discouraging you from applying, or giving you less favorable terms than any other applicant, on such a basis.

Reprinted with permission of Tracy L. Penwell, Tuko Fujisaki, Publication Productions and the Federal Reserve Bank of New York.

The Federal Reserve Bank of New York
Public Information Dept.
33 Liberty Street
New York, NY 10045
(212)720-6134

Developing a Winning Business Plan

Printed with permission from Don Greenfield of Greenfield Management Group, LLC. Prepared for Universal Technical Resource Service, Inc.

Purpose of a Business Plan

Basically, a business plan is a vehicle for internal and external communication that provides a statement of where a business is going. The business plan can be in several formats. While the structure and length may vary from format to format, there is one common central theme regarding the development of a business plan: it is absolutely necessary. Without some form of plan, a business is doomed to almost certain failure.

Internally the business plan ensures agreement about the direction of the business, and externally it conveys to outside organizations (e.g., a lending institution) what the business intends to do. A business plan serves the same purpose as a map. It will guide you in your journey, helping you avoid roadblocks and detours on the path to success in business. However, just like a map, it can only guide you; it cannot actually take you to your destination.

One of the major benefits of writing a business plan is the process itself, since it requires you to put your goals and plans down on paper. Even if there is no need to present the plan to an outside person or institution, the exercise of writing the business plan, if done carefully, will provide a clear direction of where the business is going and how you hope to get there. The business plan can also be used to measure progress toward the stated goals of the business. For businesses that need outside funding, the business plan is a primary requirement to attract financial backing.

Organizing and Writing a Business Plan

There is no standard format or length for a business plan, nor are there shortcuts to writing a good business plan. Just like running a business, it takes a good deal of time and effort. If done correctly, the result makes it well worth the time and effort.

The first step in developing a good business plan is to simply write until you have said all you need to say and no more. While every point needs a thorough explanation, it is important not to bore the reader with redundant or highly technical jargon. (You may want to put the technical information in appendices so the reader can choose whether or not to read it.) The plan will likely be in the “draft” stage for up to the first six months of planning activities. Ideally, the business plan is never fully completed, because it should become a dynamic, living document.

Because each situation is unique, this section presents a generic approach to organizing and writing a business plan. A standard business plan outline is provided in Figure 4-1. Each section and subsection of this outline is fully discussed below. The approach is flexible. For each section of the outlined plan, numerous options in the form of questions are provided; select the options that are applicable to the requirements of your business. This “shopping list” approach enables you to tailor the items to your situation. The question format will stimulate you to think about what you need to say about each item. If a question does not apply, pass over it; if it does apply, answer it as thoroughly as possibly.

As anyone who has ever tried to write a business plan can attest, the hardest part of the writing process is getting started. In reality, however, you have already started your plan. Your vision statement and the thought you have already given to involving others, demonstrating your product’s value, and developing a new product have given you the basis for your plan. Because your industry, product, and market are so critical to your ultimate success, these areas will receive more detailed attention as you proceed to develop the written plan. But you have already begun your journey. The following information will help you complete your plan. Good luck on your journey, and remember, no shortcuts.

BUSINESS PLAN OUTLINE
(Figure 4-1. Organization of a Standard Business Plan)
I. Executive Summary
II. The Company, the Industry, and the Competition
III. The Product and the Production Process
IV. The Market and Marketing the Product
V. Management and Personnel
VI. Financial Data
VII. Exhibits
A. Company Financial Information Checklist
Pro Forma Income Statements
Pro Forma Cash Flow
Pro Forma Balance Sheet
Break-Even Analysis
Schedule of Sources and Use of Project Funds
Historical Income Statements, Cash Flows, and Balance Sheets (if available)
B. Supporting Documents Checklist
Resumes of Principal Parties
Personal Financial Statements (when appropriate) Market Research Information
Documentation of Customer Demand (customer orders, requests for the product, letters of support, etc.) Legal Documents
List of Key Advisors (CPA, attorney, etc.)

The Business Plan

I. Executive Summary

The executive summary should be at least one page, but no more than two pages, and should be written after the business plan is complete. Make sure the summary is well written and brief, highlighting the significant points of the plan or proposal.

The executive summary is an overview of the business plan. When composing the executive summary, remember that it is an essential component to any business plan. A well-written executive summary should describe, in realistic terms, the opportunity for the reader to become involved in your business and the benefits of investing in the future of the company. Like the introductory chapter of a good mystery novel, the executive summary should arouse the curiosity of the readers and compel them to continue

Paragraph One

1. Briefly describe the business (i.e., new or existing).
2. Mention significant milestones (e.g., future goals, etc.).
3. Where will the business be located?
4. What will be the structure of the business (e.g., sole proprietorship, partnership, or subchapter S)?

Paragraph Two

1. What product or service will be sold?
2. What competitive advantages does the product have?
3. Why will the customer buy it?

Paragraph Three

l. Who and what is the target market?
2. What is the market size and what percent will you capture?
3. What will be the marketing strategy?
4. Who is the competition and how will you compete with them?

Paragraph Four

1. Who will manage the business?
2. Discuss the people involved with the business; mention any previous experience in this or related fields.
3. What contributions will each person make to the organization?

Paragraph Five

1. What are the capital requirements of the venture, both immediate and in the foreseeable future?
2. List the source of funds (e.g., debt or equity).
3. How will the funds be used?

II. The Company, the Industry, and the Competition

The purpose of this section of the business plan is to familiarize the reader with the business and how it is positioned in relation to the rest of the industry. It requires knowledgeable insight and a realistic self-assessment of the situation.

The subsection titled “The Company” should give past, present, and future information about the company. The subsection titled “The Industry” can be a valuable learning experience for both the reader and the writer. Researching industry information and putting it in writing provides you with an opportunity to realistically assess your chances for success. This process of research and writing provides the business person with knowledge of which companies do well, why they do well, and what your chances are of successfully competing in the industry. It also provides the necessary information to convince investors that the business is viable and has a high probability of success.

The Company

1. Give a brief history of the company to the present, if applicable.
2. Is the business a start-up or expansion?
3. When and where did the business open?
4. What type of business is it (e.g., manufacturing, wholesale, retail, or service)?
5. What products or services does the company offer?
6. Is the business seasonal?
7. Is it a franchise operation?
8. What milestones and significant events has the company experienced?
9. What are the strengths and weaknesses of the company?
10. What does the future hold (e.g., new products, new people, etc.)?

The Industry

1. Are there many or few suppliers?
2. Are there many or few customers?
3. Will the business be at the mercy of suppliers or too dependent on a few customers?
4. Are there many or few substitutes for what your business offers?
5. Are there significant barriers to entry in this industry?
6. Is the industry cyclical with the economy?
7. What are the industry trends?
8. What changes are taking place in the industry, and why?
9. What government regulations apply to the business?

The Competition

1. Who are your closest competitors?
2. Approximately how many companies/competitors are in the industry?
3. Do the companies compete mainly in price, service, quality, or advertising?
4. What are the competitors’ strengths and weaknesses?
5. What are the strengths and weaknesses of the business?
6. Have any companies recently appeared or disappeared, and why?
7. What have you learned from watching the competition?

III. The Product and the Production Process

This section of the business plan explains the product or service the company offers as well as what the product does and who might use it. It describes any unique features or advantages the product has over its competitors. It also mentions any patents or copyrights that the company holds, or plans to hold, as well as any exclusive distribution rights.

In addition, this section explains whether the product or service is simple and easy to provide and has a wide range of application, or whether it is complicated and has limited application that only a few businesses offer. It should also address whether a competitor could easily duplicate the product or service and what measures can be taken to ensure that the product’s unique features cannot be easily copied or exploited.

In this section, discuss research and development that is currently being done on the product and explain current changes in the product, as well as in the industry. These discussions should be detailed. Assume the reader knows nothing about your company or the industry. Be careful, however, to avoid the pitfall of supplying too much technical or unnecessary information that the reader cannot understand or is distracting.

The Product (or Services)

1. What product will be sold?
2. What are its unique features?
3. What is the current development stage of the product (e.g., research, prototype, produced in quantity, etc.)?
4. What research has been completed?
5. Is the product still in the research stage? If so, what research needs to be completed?
6. Is the product durable or nondurable?
7. What new products will be developed?

The Production Process

1. How will the product be produced?
2. Will the production process be capital-or labor-intensive?
3. What materials are used to produce the product?
4. What does it cost to produce the product? Does this cost allow you to charge a competitive yet profitable price?
5. What facilities are needed to support the manufacturing process (e.g., rail access, loading docks, etc.)?
6. Will any work be subcontracted?
7. Is it feasible to have someone else manufacture the product?

IV. The Market and Marketing the Product

A very important point to remember when writing a business plan is to write the plan from the reader’s point of view, not your own. Anticipate the reader’ s questions and answer them before they are asked. Keep in mind that there are some all-important questions the reader will want answered: “Will anyone purchase what you have to sell? Will enough people buy the product or service to support the business. If so, why?” This section of the business plan must answer these questions and explain, in detail, who will purchase the product or service, and why. This approach ensures that the business plan is market-driven rather than product-driven. Also, it shows that the product is being produced and sold because consumers want it. If market demand is strong enough, sales will support the business, and the investor or lender will get what he or she wants: a return on investment. Unless your business plan presents realistic evidence that consumers will purchase the product or services, investors and lenders will not support the project, thus decreasing your chances of success.

The Market
1. Who or what is your target market? 2. What is the size of the target market? 3. What are the geographical boundaries of your target market? 4. Will your product be targeted at a specific market segment? 5. In detail, describe your average customer (e.g., age, sex, income range, etc.). 6. What share of the market will you have? 7. What is the growth potential of the market? 8. At what stage of the market life-cycle is the product (e.g., introduction, growth, maturity, or decline)? 9. Will you be exploiting a market niche? 10. Is exporting a possibility?

Marketing the Product

1. How will you penetrate the market?
2. What price will you charge for the product or service?
3. How did you determine the price?
4. How does the price compare with that of similar products or services?
5. What will be the primary form of advertising?
6. How much money will be used for advertising?
7. Will direct mail or telemarketing be used?
8. How will you maintain and increase market share?
9. How will the product or service be distributed?
10. Will your business offer credit to customers?
11. Are you doing anything different from current industry practices, and why?

V. Management and Personnel

The purpose of this section is to provide financial information to the reader and substantiate whether the business has financial stability in the current marketplace. Three key ingredients determine whether a business succeeds or fails: money, marketing, and management. These factors are all equally important. Meeting these three criteria will increase, although not guarantee, the chances for success. If any of these criteria are not met, the chance of failure increases. This is the approach taken by investors and lenders. You have shown that the market is viable, and with capital you can make the business a success. It is essential to show in this section that given the financial security, you are the best person to take advantage of this opportunity.

When assessing the strength of the management team, heavy emphasis is placed on experience in the proposed area of business or an area that is similar. Because the initial stages of operation are normally the most critical in deciding the fate of a business, there is good reason to lean heavily on background. Errors can be costly, sometimes fatal. Experienced managers can often recognize a problem and solve it quickly or prevent it from ever occurring. It is very important to demonstrate that management has the knowledge and ability to meet problems head on and solve them expediently.

Management

1. What is the business background of management personnel?
2. What is their educational background?
3. Provide personal histories of management personnel.
4. Do you have managerial experience in this or a similar business?
5. Do you have managerial experience in other fields of business?
6. Who will do what for the company?
7. What will management be paid?
8. Are other resources available (e.g., lawyer, accountant, consultants, etc.)?
9. How would the loss of a key member of the management team affect the business?
10. Do you have an organizational chart drawn up?
ll. Who are the owners of the business? Supply names and percentage of ownership.

Personnel

1. How many full-time employees will be needed immediately and in the future?
2. How many part-time employees will be needed immediately and in the future?
3. What skills must these employees have?
4. Will the size of the labor pool meet the needs of the business?
5. Will workers be paid hourly, salary, commission, or a combination?
6. Will there be fringe benefits?
7. What training will be required?
8. Will seasonal employees be hired?

Stakeholders and Champions

1. Who are the key stakeholders in your company?
2. Who are the key internal champions?
3. Who are the key external champions?

VI. Financial Data

This section incorporates all of the preceding information in the business plan. It is important to show that a product is innovative and attractive and that people are willing to purchase it. However, if you cannot show the ability to produce revenue by selling your product or service, your audience will not be interested. Lenders and investors are looking for the answer to one all-important question: “When and how will I be paid back?”

This section summarizes the financial projections that are described in the exhibits in Section VII and provided in Appendix A. It also explains the assumptions and data used to develop the financial projections. Although it is necessary to show that the business will generate revenue, it is important that these numbers are determined using reasonable and realistic assumptions. To demonstrate the potential of the company as accurately as possible, it is necessary to prepare financial projections for the business. Forms are provided in Appendix A to determine profit and loss projections, cash flow, and start-up costs. These completed forms will be included in Section VII, Exhibits. The monthly profit and loss projections and cash flow sheets should also be completed for the first year of operation.

1. What is the company’s financial situation?
2. What are the total capital requirements for the business?
3. What is the purpose of the funding?
a. Short term:
- Specific one-time need
- Seasonally recurring need
b. Long term:
- Permanent working capital
- Fixed assets
4. What will be the sources of funding (e.g., bank, equity, other)?
5. What will be the source of repayment?
6. What are the funding terms?
7. Provide a detailed listing of what will be used as collateral.
8. What is the projected net income and cash flow for the first three years?
9. What assumptions are these projections based on?
10. What is the break-even point for the venture in the first year?
11. What percentage of costs are fixed?
12. Will all the money be required immediately or can it be drawn down in installments?
13. What are the advantages of purchasing vs. leasing or vice versa?

VII. Exhibits

A. This section provides the details regarding the financial status and projections of the business. It should contain the following forms to be completed by you, as applicable:

Pro Forma Income Statements
Pro Forma Cash Flow
Pro Forma Balance Sheets
Break-Even Analysis
Schedule of Sources and Use of Project Funds
Historical Income Statements, Cash Flows, and Balance Sheets (if available)

For your convenience, samples of these forms are provided in Appendix A.

B. This section provides the following supporting documentation, as appropriate:

Resumes of the principal parties Personal financial statements Market research information Documentation of customer demand (customer orders, requests for the product, letters of support, etc.) Legal documents List of key advisors (CPA, attorney, etc.)`

Financing – The First Step

When you apply for a business loan, you will need to provide certain information about yourself and your business in the form of a business plan. A business plan can act as an ongoing management guide to help you establish production goals and measure actual performance. Your business plan can help demonstrate to a prospective lender that you have the knowledge, managerial competence, and technical capability to run a successful business.

The plan must be thorough and well organized. The finished document should be typed and placed in a binder. Make several copies for each of your prospective lenders and keep several copies for your files. Lenders recommend that you prepare the plan with the help of your accountant or a professional at a small business development center. Resources to assist you in writing your business plan and loan request are listed in the Information Guide in the back pocket of this booklet.

The Business Plan

The business plan should include the following sections:

TITLE PAGE. List the name of the business, the owner(s), the address, and telephone and fax numbers.

EXECUTIVE SUMMARY. Provide a brief summary of the plan and tell the reader how it is organized. The executive summary should be written last because it will draw on the other parts of the business plan. It tells who you are, the function of the company, and gives a summary of your purpose for borrowing.

COMPANY DESCRIPTION. Give an overview of the function and history of your company, its size, products or services, and markets.

MARKET ANALYSIS. Present your research and a discussion of the conditions and trends within the industry. Review the market for your product and the demand for it. Describe how many major competitors you have, how much of the market each of your competitors controls, and your strategy for gaining a share of the market or developing a new niche. You should be able to explain any barriers to entry into new markets you are considering and how you plan to overcome them.

PRODUCTS AND SERVICES. Explain your product or service and its function.

OPERATIONS. Explain how you make your product or provide your service. Specify how you get your product out the door to the customer. Where will you get your raw materials or inventory? If a manufacturing process is involved, describe it here, including the size of the factory, stages of production, and work flow. Or, if you have a retail business, give the location of your store. How was the site selected? Where will inventory be warehoused?

MARKETING PLAN. Describe how you intend to sell your product or service and who will buy it. Also, discuss your distribution plans, advertising arrangements, and sales force.

OWNERSHIP. Indicate what type of legal entity your company is and its ownership structure: sole proprietorship, partnership, or corporation. If you have partners, who are they? How much of your company do they own? Describe how these individuals became principals and what you have agreed to give them in return for their investments.

MANAGEMENT AND PERSONNEL. Review who is in charge, who works for you, and why you hired them. Describe how their experience will contribute to the success of your business. Include resumes of key people, including yourself.

FUNDS REQUIRED AND EXPECTED USE. Summarize why you need a loan and how you will use the money. Ask for a specific amount. Include documentation on collateral, guarantor agreements, and signed contracts. Describe your repayment plan and present a contingency plan should your initial source of repayment fail.

FINANCIAL STATEMENTS AND PROJECTIONS. Include a personal financial statement, personal tax returns, and business financial statements–balance sheet, profit and loss statement, cash flow analysis for the last three to five years (if you have been in business that long), and projections for the expected performance of your business for the upcoming three-year period. In this section you will need to demonstrate your understanding of basic accounting and the financial concepts that are crucial to the success of your business. By using complete and correct financial statements, you will be able to communicate to a prospective lender how these concepts are successfully applied in your business. (An overview of the financial statements you need and how a prospective lender will analyze them appears in the next section of this booklet entitled “What the Lender Will Review.”)

APPENDICES/EXHIBITS. This section should document any issues that can’t be addressed in the text. For example, distribution agreements, contracts for the purchase of your product, and your operating licenses would all be included as appendices.

Financial Term Glossary

Reprinted with permission of Tracy L. Penwell, Tuko Fujisaki, Publication Productions and the Federal Reserve Bank of New York.

The Federal Reserve Bank of New York
Public Information Department
33 Liberty Street
New York, NY 10045
(212)720-6134

Sources and Types of Financing

Getting credit for a business can be a dilemma because until you’ve developed a good track record with business credit, many commercial banks and other traditional lenders will be reluctant to extend credit to you.

In order to identify the type of financial institution most likely to lend to your business, it’s helpful to pinpoint which of the four early stages of development your business is in.

Stages of a Developing Business

Stage one: Businesses are start-ups.

Stage two: Businesses have business plans and product samples but no revenues.

Stage three: Businesses have full business plans and pilot programs in place.

Stage four: Businesses have been in operation for some time and have documented revenues and expenses.

Lenders suggest that rather than approaching a bank, owners of businesses in stages one and two should seek financing from informal investors. Such sources of funding may include friends or relatives, partners, local development corporations, state and local governments offering low-interest micro loans, private foundations offering program-related investments, credit unions featuring small business lending, and universities with targeted research and development funds.

Lenders say that businesses in stage four, and some in stage three, are sufficiently developed to approach a commercial bank or another traditional lender for a loan.

If your business is in stage three or four and you intend to approach a commercial bank, lenders suggest that you first submit an application to a bank with which you have an established relationship. If you do not have an established relationship with a bank, lenders recommend that you ask an experienced accountant or lawyer to contact a bank and present your proposal.

Also, keep in mind that you must choose a legal designation–sole proprietorship, partnership, or corporation–and execute the necessary documentation for your small business before approaching a bank or another lender.

Reason to Borrow
There are three major reasons why businesses borrow; the first and most common reason is to purchase assets. A loan to acquire assets could be for buying short-term, or current, assets–such as inventory–and would be repaid once the new inventory is converted into cash as it is sold to customers. Or, the funds could be for the addition of long-term, or fixed, assets, such as equipment.

The second reason is to replace other types of credit. For example, if your business is already up and running, it may be time to take out a bank loan to repay the money you borrowed from a relative. Or, you may wish to use the funds to pay suppliers more promptly to get a discount on the price of the merchandise.

The third reason is to replace equity. If you wish to buy a partner’s share in your business but you don’t have the cash to do it, you may consider borrowing.

Loan Types
The purpose of your loan is critical in determining the type of loan you request. You also should make sure that the timing of the repayment schedule on your loan matches the incoming cash flow you will use to make the payments.

There are a number of loan types available to commercial borrowers, including lines of credit, seasonal commercial loans, installment loans, collateralized loans (which are secured with assets), credit card advances, and term loans. Regardless of the type, most loans have the following features:

Common Loan Features

* Loans are long-term or short-term.

* Interest rates vary depending on the term, type, size, and risk of the loan.

* Repayment may be a lump sum or on a monthly or quarterly schedule.

* Payments may be delayed until the funds help your business generate cash flow.

* The loan may be committed, meaning the bank agrees to lend to you under certain terms as you need funds without requiring you to re-apply each time.

* Some loans require that you maintain compensating balance levels in a deposit account.

Loan Agreements
You also should be aware that the lender will expect you to agree to certain performance standards and restrictions in order to ensure that your business can repay the loan. These restrictions, known as covenants, representations, and warranties, commonly include the following:

Common Loan Restrictions

* Maintenance of accurate records and financial statements
* Limits on total debt
* Restrictions on dividends or other payments to owners and/or investors
* Restrictions on additional capital expenditures * Restrictions on sale of fixed assets
* Performance standards on financial ratios * Current tax and insurance payments

Reprinted with permission of Tracy L. Penwell, Tuko Fujisaki, Publication Productions and the Federal Reserve Bank of New York.

The Federal Reserve Bank of New York
Public Information Department
33 Liberty Street
New York, NY 10045
(212)720-6134

Growing Company Revenue

Branding for Competitive Edge

Seen and Heard – White Papers

One of the most commonly overlooked sources of competitive advantage is brand. Branding is not just advertising, nor is it simply a catchy name for a company or product. The most important value in a brand is the value that it holds for actual customers. This value is very difficult and expensive to build – and fragile and easy to destroy. The difficulty of building and maintaining a brand is one reason why managers the world over tend to avoid spending much time or money on branding – especially in smaller companies. This is a shame, because a well-managed brand is so powerful that it can overcome almost any other competitive advantage. This one fact is the reason why larger companies with lots of managerial horsepower tend to spend a lot of time and money on branding.

What makes a brand valuable?

Brands are valuable simply because they cause customers to be inclined to purchase your product rather than someone else’s. In a way, a brand is shorthand for the things the customer can expect from your product. In products that hold little meaning for the customer, this might be worth less, but in markets where the customer invests his or her ego in the purchase of a particular brand, that meaning can be priceless. Let’s look at some examples to see where branding may or may not be important.

First of all, let’s look at some examples of brands with tremendous pull. These brands will sell well just about anywhere they show up, because the customer associates the brand with qualities they prefer. Examples include:

Disney – Nintendo – Sony – Harley Davidson and Apple

Interestingly, none of these brands has universal appeal, in that not every possible customer will prefer the attributes of the brand over their alternatives. For example, the Disney brand is applied to many products:

• Theme Parks
• Movies
• Licensed products such as clothing and toys
• Computer games
• Time shares
• Cruise line
• Broadway shows
• Television programming

In each of these very different product areas, the Disney brand means something a little different. For example, in theme parks, Disney means clean, family-oriented, creatively designed, expensive and (to many) crowded. The negative elements of the Disney branding in their theme park business are inevitable – you always have to accept the negative with the positive. But the positive elements are so compelling that millions of people from around the world spend a significant portion of their income to travel to a Disney theme park.

The Apple brand has a similar story. Apple carries a number of meanings, including well designed, easy to use, less popular and expensive. As with any great brand, this brand has a lot of ego invested in it for some people. This aspect of branding is more visible in computers because it is significantly more difficult and time consuming to use a computer operating system that isn’t the most popular (in other words, Microsoft). Despite this difficulty, Apple has a hard core of fans who wouldn’t think of using another brand, given a choice. Clearly, this doesn’t translate into top market share for Apple, but it is a significant advantage that has clearly kept the Apple name alive when others have fallen by the wayside. Apple’s newer products – notable the iPod – have drawn upon the positive elements of the Apple brand. The negative elements of the Apple brand have been far less problematic for the iPod because it is competing in a new product area where niche status has not been seen as a drawback. This is an excellent example of using a brand to grow beyond the core product line.

Why branding is important in the global marketplace

In an increasingly global market, branding can serve two distinct functions that may be useful to you: first, a “local” brand gives you and entrenched customer base that is more difficult (and expensive) to displace, and second, a “global” brand can give you a foot in the door when seeking to enter new geographic areas. Be forewarned: building a “global” brand is expensive, and often a “local” brand can be just as costly. Even so, the brand can be a useful offensive tool and defensive tool when you are competing with non-local companies.

There is one reason why “local” brands can be more cost-effective, and a good tool for defending your home turf from foreign competition: brand success is built upon three critical factors:

1. Understanding the key values in the mind of your customer
2. Knowing how to put the customer’s values into your product or service
3. Effectively associating your brand with those values

Two of these factors, understanding your customer and associating your brand with values, are very much defined by culture. Thus, someone from outside your culture – and this could even be someone who speaks the same language from a different region – will find it much more difficult to get an accurate read on what your customer’s key values are, and how to convince the customer that his product or service embodies those values. This is not saying that a foreign competitor cannot do this – just that it’s a lot more expensive and difficult.

How to evaluate your brand

Objectively evaluating your brand is difficult, especially if you want to put an exact dollar number on it. Fortunately, this is usually not required for good strategic decision-making. Still, it’s a good idea to have at least a general concept of the value of your brand when you are considering strategic options.

The most objective way to evaluate your brand is to measure the outcomes that occur with and without the use of your brand. Sometimes this is simple, because the way you market may well lend itself to testing different hypothesis about your brand. For example, a seminar company might test mailing brochures that feature (or don’t feature) specific brands, to find out the extent to which one of those brands is pulling in attendees at the seminars. Likewise, if you have the wherewithal, you might go so far as to test selling a “generic” version of your product in the marketplace to see if it can carry the same price as your current brand – at acceptable volumes. This is a little more difficult with retail products, as some retailers will insist on only stocking brand name products on their shelves. In addition, retail stores – especially large chains – typically demand some kind of compensation for the use of their shelf space, which makes retail brand testing quite expensive.

If testing is out of the question, you can also approximate brand value by looking at the popularity and price of competing brands with little or no brand power. If you don’t have an absolutely generic “no-name” competitor, it can be difficult to be objective about this – after all, how do you decide which competitor has the least brand power? Also, there may be some confusion about value because there are several components to the success of a brand:

Brand Sales = (Cost + Margin) * Volume

If you were to attempt a calculation of brand value, you would be faced with extracting non-brand factors, which affect these three numbers. For example, cost can go up or down depending on operation skills, management, underlying cost structure, and purchasing skills. Margin may be driven by brand power, pricing skill, and power in the distribution/retail channels. And volume can be affected by both cost and margin, brand power, and distribution network, as well as underlying demand for the products or services being offered.

Even so, at the end of the day your brand gets you one of two measurable outcomes: margin or volume. Comparing your margins to the competition is one way to assess the value of your brand, if you take heed of the caveat about other factors, which may change margin. Comparing volume is less likely to yield a good estimate of brand value, because you can – in many markets – drive higher volumes with no brand value at all by charging lower prices. This, by the way, is a terrible strategy to be following if you are concerned about cheaper foreign competition, because there are significant costs that you simply will not be able to beat your foreign competitors on.

So your brand isn’t that valuable – is there hope?

In some cases, companies run into a “brick wall” when they objectively evaluate their own brand. This can be caused by a number of factors, but the outcome is the same: some brands just don’t mean anything to the customer, and so do not carry any premium in the marketplace. Naturally, such brands offer little defense against inexpensive foreign competition, and companies that rely too heavily on brand power that doesn’t really exist inevitably get into hot water as foreign competition uses its compelling power – the lower price – to erode the market share of domestic competitors.

Is there a “crash course” way to build brand? Yes – but it’s inherently risky and not for the faint of heart. This is because the brains of our customers, not our desires, drive branding. In order to build a strong, positive awareness of your brand in a hurry, you will have to do something that stands out. By “stands out” we don’t mean “is a bit better” – we mean something that is truly remarkable, or, in other words “worthy of remark”. Customers don’t make remarks about brands that are a little better – they remark on differences that they find really interesting.

An excellent example of something remarkable is the Honda Element. This is a truly distinctive design in the overcrowded sport utility vehicle market. The design is, in fact, so unusual that it almost never made it into production. Marketing people at Honda were extremely uncomfortable that the design was so different from any other brand in the SUV market that they wanted to scrap it. The designers won the fight to manufacture a small number of Elements as a “niche” product, along with a more mainstream design. By the end of the first year of production, the Element was outselling the “safe” design by five to one!

The lesson here is clear: if you are behind some savvy competitors, you should be prepared to seriously consider strategic options that make you uncomfortable. We wouldn’t recommend betting the farm on outlandish new brands – in most cases – but we would suggest that having one or two every couple of years might just push your brand into the lead by giving you a reputation for having edgy, innovative products.

Article originally presented by the Center for Simplified Strategic Planning. Robert Bradford is the President and CEO of Center for Simplified Strategic Planning, Inc. www.cssp.com

For more information on how to get help identifying your businesses’ brand, please contact Creative Business Consulting Group at info@cbc-group.net