Whether you're preparing to launch a startup or want to grow your business, one thing is for certain: Youre going

to need money. Debt and equity financing are two different financial strategies: Taking on debt means borrowing money for your business, whereas gaining equity entails injecting your own or other stakeholders cash into your company. Debt Financing Business owners may have some trepidation about borrowing from a financial institution, as it means relinquishing some cash profits. But it could be a good option so long as you expect to have sufficient cash flow to pay back the loans, plus interest. The major benefit for debt financing, unlike with equity financing, you'll retain full ownership of your business. The interest on business loans is also tax-deductible, and youll build your credit. Small businesses frequently take bank loans. They are usually easy to obtain so long as you have good credit, enough equity to cover the payments and you're not already carrying heavy debts. These loans are generally granted either on a short-term basis of less than one year or long-term basis of more than one year. If you want to raise $100,000 or less, you may be able to receive a bank loan based on your personal credit. This is called an unsecured loan. Secured loans are granted in larger amounts. Banks usually expect you to put up assets to back the loan. These assets could include property, your personal investments, equipment or other tangible holdings that the bank could seize if you default on the loan. Commercial finance companies also lend money and are willing to fund riskier ventures that don't have solid financials. But this type of funding usually comes with high interest. Equity Financing Small business owners when weighing debt and equity financing options often opt for equity financing because they have concerns about either qualifying for a loan or having to channel too much of their profits into repaying the loan. Investors and partners can provide equity financing, and they generally expect to profit from their investments. No debt payments means more cash on hand. Moreover, if no profit materializes, you arent obligated to pay back equity contributions. The major drawback of equity financing is that you are no longer the full owner of a business once you have other financial contributors who expect a share. As such, you will be relinquishing not just financial control, but will no longer be the sole arbiter of the businesss creative and strategic direction. There are also so-called angel investors: wealthy individuals or networks that are willing to fund small businesses. Angels are the largest source of seed and start-up capital for businesses, investing $25.6 billion in businesses in 2006, according to the Center for

Venture Research at the University of New Hampshire. Angel investors tend to fund small businesses for longer periods of time and expect a lower return on investment than do venture capital firms. Venture capital firms, on the other hand, provide equity for businesses and expect high returns on their investments within three to five years. They generally fund companies with significant growth potential -- Microsoft and Google attracted VC funding -- not small businesses. Most businesses have a mix of debt and equity financing. Too little equity could prevent you from securing or repaying loans, while carrying little or no debt could indicate that you are too risk-averse, and that your business might not grow as a result. Check with your industry association to find the average debt-to-equity ratio for your sector.

Financial Ratio Analysis

It is difficult to infer organizational performance from one or two simple numbers. Nevertheless, in practice a number of different ratios are often calculated in strategic planning endeavors and, taken as a whole and with some caution, these ratios do provide some information about the relative performance of an organization. In particular, a careful analysis of a combination of these ratios may help you to distinguish between firms that will eventually fail and those that will continue to survive. Evidence suggests that, as early as five years before a firm fails, one may be able to detect trouble from the value of these financial ratios.1 In this note, the basic financial ratios are reviewed, and some of the caveats associated with using them are highlighted. The ratios tend to be most meaningful when they are used to compare organizations within the same broad industry, or when they are used to make inferences about changes in a particular organization's structure over time. LIQUIDITY RATIOS In order to survive, firms must be able to meet their short-term obligationspay their creditors and repay their short-term debts. Thus, the liquidity of the firm is one measure of a firm's financial health. Two measures of liquidity are in common: Current ratio = current assets / current liabilities Quick ratio = (cash + marketable securities + net receivables) / current liabilities The main difference between the current ratio and the quick ratio is that the latter does not include inventories, while the former does. Which ratio is a better measure of a firm's short-term position? In some ways, the quick ratio is a more conservative standard. If the quick ratio is greater than one, there

would seem to be no danger that the firm would not be able to meet its current obligations. If the quick ratio is less than one, but the current ratio is considerably above one, the status of the firm is more complex. In this case, the valuation of inventories and the inventory turnover are obviously critical. A number of problems with inventory valuation can contaminate the current ratio. An obvious accounting problem occurs because organizations value inventories using either of two methods, last in, first out (LIFO) or first in, first out (FIFO). Under the LIFO method, inventories are valued at their old costs. If the organization has a substantial quantity of inventory, some of it may be carried at relatively low cost, assuming some inflation in overall prices. On the other hand, if there has been technical progress in a market and prices have been falling, the LIFO method will lead to an overvalued inventory. Under the FIFO method of inventory valuation, inventories are valued at close to their current replacement cost. Clearly, if we have firms that differ in their accounting methods, and hold substantial inventories, comparisons of current ratios will not be very helpful in measuring their relative strength, unless accounting differences are adjusted for in the computations. A second problem with including inventories in the current ratio derives from the difference between the inventory's accounting value, however calculated, and its economic value. A simple example is a firm subject to business-cycle fluctuations. For a firm of this sort, inventories will typically build during a downturn. The posted market price for the inventoried product will often not fall very much during this period; nevertheless, the firm finds it cannot sell very much of its inventoried product at the socalled market price. The growing inventory is carried at the posted price, but there really is no way that the firm could liquidate that inventory in order to meet current obligations. Thus, including inventories in current assets will tend to understate the precarious financial position of firms suffering inventory buildup during downturns. Might we then conclude that the quick ratio is always to be preferred? Probably not. If we ignore inventories, firms with readily marketable inventories, appropriately valued, will be undeservedly penalized. Clearly, some judicious further investigation of the marketability of the inventories would be helpful. Low values for the current or quick ratios suggest that a firm may have difficulty meeting current obligations. Low values, however, are not always fatal. If an organization has good long-term prospects, it may be able to enter the capital market and borrow against those prospects to meet current obligations. The nature of the business itself might also allow it to operate with a current ratio less than one. For example, in an operation like McDonald's, inventory turns over much more rapidly than the accounts payable become due. This timing difference can also allow a firm to operate with a low current ratio. Finally, to the extent that the current and quick ratios are helpful indexes of a firm's financial health, they act strictly as signals of trouble at extreme rates. Some liquidity is useful for an organization, but a very high current ratio might suggest that the firm is sitting around with a lot of cash because it lacks the managerial acumen to put those resources to work. Very low liquidity, on the other hand, is also problematic.

LEVERAGE Firms are financed by some combination o debt and equity. The right capital structure will depend on tax policyhigh corporate rates favor debt, high personal tax rates favor equityon bankruptcy costs, and on overall corporate risk. In particular, if we are concerned about bankruptcy possibilities, the long-run solvency or leverage of the firm may be important. There are two commonly used measures of leverage, the debt-toassets ratio and the debt-equity ratio; Debt-to-asset ratio = total liabilities / total assets Debt-equity ratio = long-term debt / shareholder's equity As with liquidity measures, problems in measurement and interpretation also occur in leverage measures. The central problem is that assets and equity are typically measured in terms of the carrying (book) value in the firm's financial statements. This figure, however, often has very little to do with the market value of the firm, or the value that creditors could receive were the firm liquidated. Debt-to-equity ratios vary considerably across industries, in large measure due to other characteristics of the industry and its environment. A utility, for example, which is a stable business, can comfortably operate with a relatively high debt-equity ratio. A more cyclical business, like manufacturing of recreational vehicles, typically needs a lower D/Ea reminder that cross-industry comparisons of these ratios is typically not very helpful. Often, analysts look at the debt-equity ratio to determine the ability of an organization to generate new funds from the capital market. An organization with considerable debt is often thought to have little new-financing capacity. Of course, the overall financing capacity of an organization probably has as much to do with the quality of the new product the organization wishes to pursue as with its financial structure. Nevertheless, given the threat of bankruptcy and the attendant costs, a very high debtequity ratio may make future financing difficult. It has been argued, for example, that railroads in the 1970s found it hard to find funds for new investments in piggybacking, a large technical improvement in railroading, because the threat of bankruptcy from prior poor investments was so high. RATES OF RETURN There are two measures of profitability common in the financial community, return on assets (ROA) and return on equity (ROE). ROA = net income / total average assets ROE = net income / total stockholders equity

Assets and equity, as used in these two common indexes, are both measured in terms of book value. Thus, if assets were acquired some time ago at a low price, the current performance of the organization may be overstated by the use of historically valued denominators. As a result, the accounting returns for any investment generally do not correlate well with the true economic internal rate of return for that investment. Difficulties with using either ROA and ROE as a performance measure can be seen in merger transactions. Suppose we have an organization that has been earning a net income of $500 on assets with a book value of $1000, for a hefty ROA of 50 percent. That organization is now acquired by a second firm, which then moves the new assets onto its books at the acquisition price, assuming the acquisition is treated using the purchase method of accounting. Of course, the acquisition price will be considerably above the $1,000 book value of assets, for the potential acquirer will have to pay handsomely for the privilege of earning $500 on a regular basis. Suppose the acquirer pays $2,000 for the assets. After the acquisition, it will appear that the returns of the acquired firm have fallen. The firm continues to earn $500, but the asset base is now $2,000, so the ROA is reduced to 25 percent. Indeed, the ROA may be less as a result of other factors, such as increased depreciation of the newly acquired assets. Yet in fact nothing has happened to the earnings of the firm. All that has changed is its accounting, not its performance. Another fundamental problem with ROA and ROE measures comes from the tendency of analysts to focus on performance in single years, years that may be idiosyncratic. At a minimum, one should examine these ratios averaging over a number of years to isolate idiosyncratic returns and try to find patterns in the data.

STOCK MARKET RATIOS Several ratios are calculated not from the income statements and balance sheets of organizations, but from data associated with their stock market performance. The three most common ratios are earnings per share (EPS), the price-earnings ratio (P/E), and the dividend-yield ratio: EPS = (net income - preferred dividends) / common shares outstanding P/E = market price per share / earnings per share Dividend yield = annual dividends / price per share EPS is one of the most widely used statistics. Indeed, it is required to be given in the income statements of publicly traded firms. As we can see, the ratio tells us how

much the firm has earned per share of stock outstanding. As it turns out, this is not generally a very helpful statistic. It says nothing about how many assets a firm used to generate those earnings, and hence nothing about profitability. Nor does it tell us how much the individual stockholder has paid per share for the rights over that annual earning. Further, accounting practices in the calculation of earnings may distort these ratios. And finally, the treatment of inventories is again problematic. The P/E is another ratio commonly cited. Indeed, P/Es are reported in daily newspapers. A high P/E tends to indicate that investors believe the future prospects of the firm are better than its current performance. They are in some sense paying more per share than the firm's current earnings warrant. Again, earnings are treated differently in different accounting practices. Finally, from the perspective of some stockholders at least, dividend policy may be important. The dividend-yield ratio tells us how much of its earnings the firm pays out in dividends versus reinvestment. Rapidly growing firms in new areas tend to have low dividend-yield ratios; more mature firms tend to have higher ratios. SUMMARY In this note, we have briefly reviewed a variety of ratios commonly used in strategic planning. All of these ratios are subject to manipulation through opportunistic accounting practices. Nevertheless, taken as a group and used judiciously, they may help to identify firms or business units in particular trouble. Finding profitable new ventures requires rather more work. The cash flow statement discloses how a company raised money and how it spent those funds during a given period. It is also an analytical tool, measuring an enterprises ability to cover its expenses in the near term. Generally speaking, if a company is consistently bringing in more cash than it spends, that company is considered to be of good value. A cash flow statement is divided into three parts: operations, investing and financing. The following is an analysis of a real-world cash flow statement belonging to Target Corp. Note that all figures represent millions of dollars. Cash from operations: This is cash that was generated over the year from the companys core business transactions. Note how the statement starts with net earnings and works backward, adding in depreciation and subtracting out inventory and accounts receivable. In simple terms, this is earnings before interest and taxes (EBIT) plus depreciation minus taxes. Interpretation:This may serve as a better indicator than earnings, since noncash earnings cant be used to pay off bills. Cash from investing: Some businesses will invest outside their core operations or acquire new companies to expand their reach.

Interpretation: This portion of the cash flow statement accounts for cash used to make new investments, as well as proceeds gained from previous investments. In Targets case, this number in 2006 was -4,693, which shows the company spent significant cash investing in projects it hopes will lead to future growth. Cash from financing: This last section refers to the movement of cash from financing activities. Two common financing activities are taking on a loan or issuing stock to new investors. Dividends to current investors also fit in here. Again, Target reports a negative number for 2006, -1,004. But this should not be misconstrued: The company paid off 1,155 of its previous debt, paid out 380 in dividends and repurchased 901 of company stock. Interpretation: Investors will like these last two items, since they reap the dividends, and it signals that Target is confident in its stock performance and wants to keep it for the companys gain. A simple formula for this section: cash from issuing stock minus dividends paid, minus cash used to acquire stock. The final step in analyzing cash flow is to add the cash balances from the reporting year (2006) and the previous year (2005); in Targets case thats -835 plus 1,648, which equals 813. Even though Target ran a negative cash balance in both years, it still has an overall positive cash balance due to its high cash surplus in 2004.

1 Understand what makes up the cash flow statement. The cash flow statement is comprised of three parts: the operations, investing and financing sections. Each section examines the company's cash flow from a different angle.

2 Examine the operations section first. This shows the incoming and outgoing cash form the company's core operations. Ideally, this figure should be positive, and most of the company's cash should be from this area. That would indicate that the company's core operation is generating a healthy cash flow and the company is stable.

3 Review the investing section of the cash flow statement. This section reveals the changes in cash due to equipment, assets or company investments. For example, cash goes out when new equipment is bought and cash comes into the company when an asset is sold.

4 Examine the financing section of the cash flow statement. This section will show you the changes in cash due to the financing activities of the company, such as loans or dividends.

5 Look for positive cash flow. Positive cash flow is the lifeblood of any company. A strong cash flow is a sign that the company is healthy.