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Analysis and
Interpretation of FinancialInformation
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Before we begin lets have a
look at the recentfinancials of Ryanair
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Comments
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Main topics
Analysis and
interpretation
of financial
statements
Financial ratios
Limitations of
ratio analysis
Financial ratio
classificationThe need for
comparison
The key steps in
financial ratio
analysis
The ratios
calculated
Profitability
GearingInvestment ratios
Trend analysis
Ratios and
prediction
models
The Effects
of GearingInvestment
ratiosIndustry
Comparison
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Financial Ratios
A relatively quick and simple way of analysing a firm is to
calculate ratios based on freely available information in the
accounts.
We will be learning how to extract pertinent information from
accounts and how to interpret that information. We will also
examine how to measure the financial performance of the firm
using a number of different metrics.
The following slide mentions the main classes of ratios:
Ratio Analysis
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Financial Ratio Classification
Categories
Profitability
Shareholder
Gearing / Financial
Structure
Working Capital
Liquidity
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Ratios and Comparison
Ratios are just numbers until compared in a meaningful way
with something. Therefore we require benchmarks. This
may be:
1. Similar data from other firms within an industry
2. Company data from previous accounting periods
3. Some planned performance targets.
Key Steps in Financial Ratios
In module 1 we focused on accounting as being primarily an
information system that should take its users needs into
account. Interpretation of accounts and the preparation of
ratios should follow similar principles:
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1. Identification of user group and their information needs
2. Calculation of appropriate ratios
3. Interpretation and Evaluation of resulting ratios
As with any system, its success depends on carrying out each of
the steps correctly. Misidentifying user needs may lead to
poor ratio analysis. The final step can be subjective and
would require judgement and knowledge of the business
being examined.
Financial Ratio Analysis: the key steps
Calculate
required
ratios
Identify
users and
their
information
needs
Interpret
and
evaluate
results
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These ratios indicate levels of profitability after different
levels of costs are included. The allow us to identify where
margins are improving and where cost control is an issue.
Accounting texts tend to generalise these ratios and provide
formulas that depend on financial terms. The key thing to
remember is that the most important profit figures are
towards the bottom of the income statement. Each ratio is a
profit figure as a % of sales.
Gross Profit
Operating Profit
Earnings / Profit before interest and tax
Earnings / Profit after interest and tax
Profitability Ratios
1
100Pr xSales
ofitGross
1
100Prx
Sales
ofitOperating
1
100xSales
EBIT
1
100x
Sales
EAIT
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These ratios reflect the capital structure of a firm, or the
makeup of its long term funding and the risks arising thereof.
Capital Gearing Ratio
This gives the proportion of debt as a percentage of the capital
employed. Anything greater than 50% would be considered
high.
Long Term Debt / Capital Employed x 100/1
Where capital employed is Total Assets less Current Liabilities
Interest Cover
This indicates how many times a company can cover its
existing interest payments out of current profits. The higher the
safer.
EBIT / Interest
Gearing / Financial Structure Ratios
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The effect of financial gearing
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Used by investors and analysts to evaluate companies and their
performance. They relate to returns received in relation to what
was paid for those returns (The Share Price).
Earnings Per Share (EPS) =Where TSO is total ordinary shares outstanding
Dividend Per Share (DPS) = EPS x Payout RatioWhere payout ratio is the dividend paid as a percentage of earnings attributable to
ordinary shareholders
Price Earnings Ratio =
Market to Book Value =
Dividend Yield =
Return on Equity =
Return on Capital =
Employed
Investor / Shareholder Ratios
1
100
xTSO
dividendpreferenceEAIT
EPSiceShare Pr
erShareBookValueP
iceSharePr
1
100
Pr
xiceShare
DPS
1
100x
talEquityCapi
EAIT
1
100x
loyedCapitalEmp
EBIT
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Dividend Yield Ratios
By Industrial Group
0
1
2
6
5
4
3
Constructi
on
Chemic
als
Engine
erin
g
Pharm
aceuticals
Tobacco
Leisurea
ndhotels
Electricity
Water
Banks
Media
Foodre
tai l
ers
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Price/Earnings Ratios
By Industrial Group
0
45
40
Constructi
on
Chemicals
Engineering
Pharmace
uticals
Tobacco
Leisureand
hote
ls
Electricity
Water
Banks
Media
Foodretai l
ers
35
30
25
20
15
10
5
50
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Trend Analysis
Plotting ratios over time on a graph can be a useful aid for
detecting trends or changes over time. Take the following
Example:
Plotting Ratios Against Time
Current
ratio
Time
2000 200320022001 2004
Printer
Ltd
Industry
average
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Ratios and Prediction or Forecasting
When forecasting future figures, many firms find it helpful to
use ratio analysis as a starting point and to then extrapolate
forward. In some cases ratios have been developed as proxies
for predicting whether for example a company is vulnerable to
takeover.
Uses and Limitations of Ratio Analysis
Ratio analysis can provide useful information to investors,
company management and financial institutions. Further
information is available from financial databases.
Ratios on their own mean little: they must be compared with
benchmarks, such as target ratios, ratios of similar companies,
industrial norms or ratios from previous years.
A systematic approach to ratio analysis could look at ratios
concerned with profitability, activity, liquidity, gearing and
investment, always remembering to compare like with like.
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Problems with ratio analysis include:
That balance sheet figures are static
That similar companies for comparison are hard to find
That accounting policies may be different
That creative accounting may have been used together with
complex financing methods.
Newer Performance Metrics
In recent years a number of firms and consultancies have
brought forward models that attempt to measure the
performance of a firm and to use these to tie in with
managerial remuneration.
The best known of these is Economic Value Added orEVA.
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Working Capital Management
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Working Capital Management
Main topics
The
management
of working
capital
Ratios for
Working Capital
Management
The Nature andPurpose of
Working Capital
The
Management of
Debtors
Working Capital
Policies
The Cash
Conversion
Cycle
The
Management of
Cash
The
Management of
Trade Creditors
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The Nature & Purpose of Working Capital
Major elements Major element
Prepayments
Trade debtors
Cash (in hand
and at
bank)
Trade
creditors
lessequals
Currentliabilities
Workingcapital Currentassets
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What is Working Capital?
It is usually defined as current assets less current liabilities. By
current we mean amounts realisable or due within 12 months.
These figures will include cash, debtors, prepayments creditors
amounts due etc... These items will appear in the balance sheet
and should be familiar to you.
The size and composition of working capital will vary widely
between industries and companies. Oracle unlike a
manufacturing firm doesnt hold stock as a current asset. Now
lets take a quick look at Oracles working capital...
Why is it Important?
Decisions taken regarding the items in our current assets and
current liabilities can have a large impact on the survival and
profitability of a firm.
The dual objectives of working capital management areprofitability and liquidity.
Companies may adopt aggressive, moderate or conservative
working capital policies regarding the level and financing of
working of capital.
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Level ofWorkingCapitalInvestment
Conservative
Moderate
Aggressive
Turnover ()
Each of these three types of policy reflect different attitudestowards risk and return
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Conservative
Carry a level of working capital in excess of the firms needs.This will have an additional cost in financial terms
Moderate
Commensurate with the level of business of the firm
Aggressive
Use working capital as source of finance. Effectively
overtrading on purpose.
Working Capital Policies
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This is the movement of money and resources through the
production cycle from purchases to sales and back into
cash.
The Working Capital Cycle
CashTrade
debtorsTrade
creditors
Sales Product
Cycle
Purchase
s
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Overtrading
Overtrading is defined as carrying on a level of business in
excess of the companies financing ability.
Overtrading can lead to business failure and must be corrected
if found. Corrective measures could include
1. Introducing new capital
2. Improving working capital management
3. Reducing business activity
Because there can be significant amounts of cash tied up in
financing the business items like cash and debtors. These
areas need to be managed carefully.
Management of Cash
Companies should attempt to optimise the amount of cash held.
Cash problems can be minimised by the forecasting of cashneeds with cash flow forecasts and cash budgets. Any surplus
cash should be invested to earn a return in short-term
instruments such as money market deposits, treasury bills and
certificates of deposit.
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Why hold Cash?
Cash may be held for the following reasons:
1. Transaction - The primary reason to facilitate
business. Cash flow needs etc...
2. Precautionary - As a buffer against unforeseen
circumstances or to allow the firm flexibility to exploit
new opportunities
3. Speculative - This is the opposite of hedging. It involves
taking bets on future exchange rates, interest rates etc...
Done well it can dramatically increase profits. Done
poorly it can bankrupt the firm. Examples of bad
speculation include Orange County in California
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Risks
(1) Renewal
It may need to be continually renegotiated, with the risk that
changing circumstances may make this difficult. There is also
the cost of negotiation.
(2) Interest Rate Stability
Changing interest rates will affect a company having to renew
funding.
Which approach?
The overall approach is down to firm type, management; and it
may be determined by industry-wide factors.
Short Term Finance
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Objectives of Short Tern Investment
Liquidity
Safety
Profitability
Illiquidity
Essential Payments
Interest on loans
Wages/Salaries Revenue Commissioners
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Which customers should receive credit?
The five Cs of credit
Capital
Capacity
Collateral
Conditions
Character
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1: Capital
The customer must appear to be financially sound before any
credit is extended. Where possible, an examination of the
customers accounts should be carried out with particular
regard being given to liquidity and profitability. Theirfinancial commitments should also be taken into account.
2: Capacity
Must be able to make payments. Where possible their payment
record to date should be examined. The value of goods
they wish to buy on credit and their total financial
resources are also relevant.
3: Collateral
It may be necessary to ask for some security on certain
occasions.
4: Conditions
The general and firm specific economic conditions should beexamined. In addition some stress testing would be
desirable.
5: Character
The character of the customer honesty and integrity. In the
case of limited firms the character of the directors is also
important.
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Credit Policy Requires the following:
1. Use of trade references
2. Bank references
3. Credit agencies
4. Salesmens reports
5. Information within industry
6. Financial statements
7. Credit Scoring (systematic approach to granting credit)
Length of Credit Period
The terms offered to customers will have an impact on both
sales and profitability and may vary between customers,
firms and industries.
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Factors include:
1. Typical industry terms
2. Degree of competition within the industry
3. Relative bargaining power customer and supplier
4. Default Risk (Credit Risk)
5. Capacity of the business to offer credit.
6. Marketing factors.
Cash Discounts
Cash Discounts may be offered to encourage prompt payment.The costs and benefits of such discounts should be
weighed up carefully taking particular account of the costs
of financing versus the explicit cost of the discount.
Collection Policies
An efficient collection policy requires an efficient accountingsystem. Modern systems have simplified this function
considerably. Ratios can be used to determine whether
this function is being efficiently managed. An aged
schedule may be produced to check up on individual
accounts.
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1: Factoring
A factoring firm may, take over clients ledgers, offer 100%bad debts protection or advance client firm money with the
debts as collateral
2: Undisclosed Factoring
In this case the factoring company will use the client as a debt
collection agent.
3: Invoice Discounting
Advances money based on a % of sales invoices. Firm has
recourse to client in event of bad debts
Debtor Financing
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Many companies regard trade credit as an important source of
finance. It has been described as a spontaneous source as ittends to increase in line with increases in sales. This reasoning
has led many firms to regard it as a free source of finance and
therefore a good thing for a business to use. There are costs
however. This includes reputation effects as well as the costs of
foregoing favorable payment terms (discounts).
In the same way as with debtors, the costs and benefits of using
credit or extending payment should be examined. Ratios can
also be used to examine whether the amount of time taken to
pay creditors is increasing or decreasing.
The Management of Creditors
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Working Capital Ratios can be divided into two sections;
1: Activity Ratios which measure the working capital
function, and,
2: Liquidity Ratios which are a measure of short term
solvency.
Working Capital Ratios
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Activity Ratios
These show how short term capital is being managed and are
also linked to liquidity and working capital.
Debtors Ratio or debtor days
This gives the average period of credit being taken by
customers, the lower the better since debtors have to be
financed at a cost to the company.
Debtors / Credit Sales (Sales) x 365 / 1
Creditors Ratio or creditor days
This gives the average period your suppliers must wait for
payment, creditors are a form of finance, however both of these
ratios need to be examined in terms of opportunity cost as there
may be interest charges or discounts foregone.
Creditors / Credit Purchases (Cost of Sales) x 365 x 1
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Stock Turnover
Shows how long it takes a company to turn stocks into sales,
the shorter the period the lower the costs to the company. It will
vary with the nature of the companies business.
Stock / Cost of Sales x 365 / l
The Cash Conversion Cycle
This gives some indication of the amount of working capital
financing that is needed. It is given by
Stock Turnover + Debtors Days - Creditors Days
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The Cash Conversion Cycle
Purchase
of goodson credit
Paymentfor
goods
Sale of
goodson credit
Cash
receivedfrom
debtors
Stockholding
period
Cash
Conversion
Cycle
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Calculating the Cash Conversion Cycle
equals
plus
Operating cash cycle
Average payment period for
creditors
Average settlement period for
debtors
plus
Average stockholding period
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Liquidity Ratios
These ratios are used to determine if a company will be able to
meet its financial obligations as they fall due and are therefore a
proxy for the financial strength and level of risk attached to a
firm.
The Current Ratio
This measures a companies ability to meet its debts as they fall
due. The textbook level is two but again this may vary with the
type of business a firm is involved in.
Current Assets / Current Liabilities
The Quick (Acid Test) Ratio
A more stringent guide since it realistically doesnt include
items already paid for or stock, since neither of these
necessarily constitutes ready cash
Current Assets Stock and Prepayments / Current Liabilities
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Financing the
Enterprise
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For most SMEs, finance will consist of a mix of funding from
a number of sources. Since growth requires finance, small
firms will be reliant on the suppliers of finance that are
available to them. Relationship management is therefore
an important consideration.
Finance can generally be classified as either Equity (implies
ownership) or Debt. When considering the forms of
finance to use, there are three key characteristics. These
are:
1. Cost
2. Risk
3. Timescale
In terms of the timescale , the main sources of finance can be
classified as short term (less than 1 year) and medium
term (generally 1 5 years)
The following figure lists the main forms of finance that are
available to SMEs:
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Figure 1: Main sources of short and medium term finance
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Debt Finance
Each of the aforementioned forms of finance are essentially
debt. In general, this implies both interest and capital
repayments. The interest represents the cost of the debt finance
while the capital repayment relates to the intrinsic value of
what was borrowed.
Cost and Riskiness of Debt
Debt is generally less expensive than equity finance given that
from an investors perspective it is less risky. This relates to the
fact that there debt carries legal guarantees in terms of priority
whereas equity finance has no such conditions. The investor
will therefore require a lower return.
The riskiness of the borrower is therefore the primary
consideration in terms of the cost of the debt. It is therefore in
the interests of the borrower to present the lowest risk profile
possible when seeking to raise debt finance.
Another issue for the borrower is the underlying business risk
they face since repayments continue irrespective of business
environment. Higher debt levels therefore constitute a risk to
the existence of the firm. This will be demonstrated in the case
study later in the course.
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Bank Borrowing
Why use it?
It is quick
It is flexible
It is available to firms of all sizes including smaller firms
Administration and legal costs are low
Factors to consider when borrowing
Is there are arrangement fee?
This may be of the order of 1% although it may be bargaineddown or away depending on the relative bargaining
strength of the lender and borrower
Should fixed or variable (floating) rate be used
Floating rate loans will change as the underlying interest rate
(EURIBOR) fluctuates. Therefore the borrower should
form a view on interest rate changes and their probableeffects and weigh that against the additional costs of
fixed rate finance.
The interest rate being paid
Ideally the borrower can negotiate a favourable rate.
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Information Asymmetry and Security
The bank is aware that they do not have all of the information
required to judge the riskiness of the proposed borrower.
They less information they have, the more risky the loan.
Banks will therefore charge a premium that is directly
related to the ability of the borrower to assuage the banks
worries about the riskiness of the proposed loan.Information flow between the borrower and the bank is
therefore crucial both at the initial stages and during the
course of the loan.
Collateral
Sometimes the bank will require security in the form of
collateral that covers the bank in the event of a default.Either a fixed charge (relating to specific assets) or a
floating charge (general) may be applied. In terms of
priority the fixed charge is higher. This simply means the
a bank with a fixed charge gets paid before a bank with a
floating charge.
Covenants
These are restrictions on managerial actions that the bank may
require of the borrower. They are designed to reduce the
risk of default during the life of a loan
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Personal Guarantees
The bank may in certain cases require directors or shareholders
of the firm to go guarantor. This means that the private
assets of a director/shareholder may be used as collateral.
This bypasses the limited liability clause and may be a
necessary condition for smaller firms to raise debt
finance.
Repayment Considerations
The firm should give serious thought to their ability to repay
both interest and capital and schedule the loan in a way
that is compatible with the probable future cash flows of
the company. This may require some flexibility being
built into the loan agreement.
Main Types of Finance
Overdraft
Term Loan
Trade Credit
Factoring
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Overdraft
An overdraft is a permit to overdraw on an account up to a
stated limit. The advantages are flexibility and low cost.
The Drawbacks are that the bank retains the right to withdraw
the facility at short notice and that security will be required in
most cases
Term Loan
A term loan is a loan of a fixed amount for an agreed time and
on specified terms. The.typical timeframe is three to seven
Years. They may be flexibly scheduled in terms of repaymentsespecially if the loan is for a particular project. Similarly the
drawdown of funds may be spread out to meet funding
requirements.
Trade Credit
Given by suppliers where payment for goods is deferred a setnumber of days. Usually requires that trade and bank
references be supplied. Un satisfactory receipt trade credit may
be advanced in line with usual industry terms.
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Overdraft or Trade Credit?
Example - Invoice
Option 2 Paying in 60 days
Where d = daily interest and i = annual interest
Assume that annual APR interest on overdraft is 10% then we
have:
Interest Charge for 46 days
or 1.208%
Settlement Terms 217.3
2.5% discount may be deducted for payment
within 14 days of invoice date, otherwise due
30 days strictly nett 255.33
( )
1)1(
11
365
365
+
+=+
i
id
00026116.01)1.01(365 =+
Option 1 - Discount for early payment
217.30 x 0.025 5.43
( ) 01208.000026116.01 46 =+
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Interest Charge for 46 days is:
Since the interest cost is less than the value of the discount it
would be advantageous to take the discount and finance
the early payment with an overdraft
Note however that not all suppliers will offer a discount for
early payment which encourages the use of trade credit.
The problem with over reliance on trade credit is
reputation effects as many suppliers will soon tire of a
persistent late payer.
( ) 02.301208.043.533.255 = x
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Factoring
The provision of finance
Sales ledger administration
Credit insurance
Recourse and non-recourse
Invoice discounting
Factoring is essentially the provision of finance at a rate similar
to overdraft rates (depending on borrower) on the basis of
the working capital needs of a firm (stock and debtors)
Factoring is generally offered as a service by the clearing banks
so in Ireland it is handled by companies such as
Enterprise Finance Europe (A Bank of Ireland subsidiary)
among others.
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Other Forms
Leasing and Hire Purchase
These are broadly similar in terms of their advantages to
business. The key advantages are:
Small initial outlay
Certainty
Availability
Fixed Costs
Tax relief
Transfer of obsolescence risk (for operating leases)
Bills of Exchange
Primarily for export sales. Basically a legal commitment to pay
a sum at some future date. (like an IOU). They are
generally discounted with a discount house who advances
money (e.g. 90% of the value of the bill) and charges an
interest rate.
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Equity Finance
Equity finance has a different set of characteristics from the
firms perspective. Its low risk in that
Owners/Shareholders earn only the residual income of the
firm and have no legal rights in terms of insisting on a
return.
The downside of equity is related to control. The more equity
finance is used, the more control of the firm that is ceded
assuming that the equity finance raised is not coming
from the current owners / shareholders.
Finally, although equity finance is low risk from the
perspective of the firm, it is relatively high risk from the
investors perspective. They will therefore require a high
return in order to consider putting their money into a
business. An additional consideration is that lenders
generally look more favorably on projects where the
investor is prepared to risk his/her own money as this is apositive signal of their view of the project.
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