Finance for small- and medium-sized entities (SMEs): formula sheet

Key formulas

Matching principle

Long-term assets → long-term finance; fluctuating current assets → short-term finance

A guide, not a fixed rule. Aggressive or conservative policies depart from it.

Life cycle funding pattern

Seed/start-up → equity from owners and angels; growth → debt, leasing, venture capital; maturity → cheaper debt, listing or sale

A typical pattern, not a rule. Always adjust it to the scenario facts.

Annual cost of forgoing an early settlement discount

[(100 ÷ (100 − d)) ^ (365 ÷ N) − 1] × 100%

d is the discount % and N is the extra days of credit gained by not taking the discount (credit period minus discount period). This is the effective annual cost of trade credit.

Cash advanced by a factor

Invoice value × advance %

Typical advance is a stated percentage of approved invoices. The balance is paid when the customer pays or at the end of the agreed period, less charges.

Factor service fee

Credit sales × fee %

Often charged on turnover. Interest is charged separately on the amount advanced.

Matching principle

Short-term need → short-term finance; long-term need → long-term finance

A rule of good practice, not a law. Some businesses finance part of their permanent current assets with long-term funds.

Capital gain on exit

Gain = Exit proceeds − Original investment

Proceeds are the investor's percentage holding × value of equity at exit.

Investor's share of exit value

Proceeds = Shareholding % × Equity value at exit

Use the equity value, not the enterprise value, unless told otherwise. Deduct any debt first.

Annual return on a single exit

Annual return = (Proceeds ÷ Investment)^(1 ÷ n) − 1

n is the number of years held. This is a compound rate, not a simple average.

Equity value at exit using P/E

Equity value = Exit-year earnings × P/E ratio

Often used to value the company at flotation or trade sale.

Typical VC exit time

Exit usually within about 3 to 7 years

A general guide, not a rule. State it as typical.

Gearing (debt/equity)

Debt ÷ Equity

Define debt consistently (long-term debt, or including overdraft). Say which version you use.

Interest cover

Profit before interest and tax ÷ Interest expense

Low cover means profit gives little protection for the lender.

Current ratio

Current assets ÷ Current liabilities

Compare with the industry norm rather than a fixed target.

Quick ratio

(Current assets − Inventory) ÷ Current liabilities

Removes inventory, which may be slow to turn into cash.

Receivables days

Trade receivables ÷ Credit sales × 365

Use credit sales if given, otherwise revenue.

Inventory days

Inventory ÷ Cost of sales × 365

Use cost of sales for inventory and payables.

Payables days

Trade payables ÷ Credit purchases × 365

Use cost of sales if purchases are not given.

Cash operating cycle

Inventory days + Receivables days − Payables days

A longer cycle means more finance is tied up in working capital.

Closing cash balance

Opening balance + Receipts − Payments

Carry each closing balance forward as the next opening balance.

Quick revision

• SMEs are often owner-managed, have limited security, short track records and no access to public markets.
• The finance gap is the shortfall between the finance SMEs want and the finance providers will supply.
• Lenders worry about risk, lack of security, weak information and the high cost of assessing small loans.
• Match the term of finance to the need: short-term needs to short-term sources, long-term assets to long-term funds.
• Retained profit and owner funds are cheap and fast but limit growth.
• Trade credit, overdrafts and factoring support working capital but can be costly or withdrawn.
• Leasing lets an SME use an asset without a large upfront payment.
• Venture capital brings money and expertise but the investor expects a stake, influence and an exit route.
• Government support can include grants, loan guarantees and tax reliefs; availability depends on the country.
• When assessing a proposal, check purpose, amount, repayment ability, security, risk and the owners' own commitment.
• Cash shortage, not lack of profit, is a leading cause of SME failure, so forecast cash and plan buffers.
• In every answer, tie the advice to facts in the scenario.

Common mistakes

• Treating SMEs as small versions of listed companies. Fix: Remember that SMEs usually have no access to public markets. Think owners, banks, trade credit, leasing and venture capital.
• Recommending bank debt for a start-up with no assets or cash flow. Fix: Check security and cash flow. Banks lend against these. Start-ups usually need equity or angel funds first.
• Defining the finance gap as any lack of finance. Fix: Define it as the gap between funds needed and funds supplied on reasonable terms.
• Describing information asymmetry the wrong way round. Fix: State that the owner-managers know more than the lender, so the lender cannot judge risk.
• Recommending a long-term source for a short-term need, or the reverse. Fix: State the time horizon first and check that the source repayment period fits it.
• Treating trade credit as free. Fix: Remember the lost discount, the risk of supplier damage and the possible loss of future supply. Calculate the effective cost when a discount is offered.
• Saying a loan guarantee means the government lends the money. Fix: A guarantee is a promise to cover part of the bank's loss on default. The bank still provides the loan.
• Treating grants as free of any conditions. Fix: Mention eligibility rules, spending conditions, delays and possible clawback if conditions are broken.
• Listing generic loan criteria without using the scenario. Fix: Tie every point to a fact given, such as the firm's age, receivables days or lack of security.
• Treating profit as if it were cash. Fix: Remember depreciation is not a cash flow and credit sales are not yet received. Build the forecast from cash timing.

Exam tips

• Always identify the life stage first. Most scenario marks depend on matching the source to the stage.
• In written answers, link every characteristic to a financing consequence. A bare list earns little.
• Check the scenario for owner control, security available and cash flow. These decide which options are suitable.
• Do not recommend only one source. Give a short-term and a long-term source where the need has both.
• For OT questions, eliminate options that break the matching principle first.
• Always define the finance gap in one sentence, including 'acceptable terms'.
• Write from the lender's perspective when the question asks why finance is refused.
• Tie each point to scenario facts, since generic lists score poorly.