Financial Preparation for

Entrepreneurial Ventures

10–1
 Why business needs finance

Finance refers to sources of money for a business. Firms need finance to:
❑ start up a business, eg pay for premises, new equipment and advertising
❑ run the business, eg having enough cash to pay staff wages and suppliers on time
❑ expand the business, eg having funds to pay for a new branch in a different city or
country
 The Importance of Financial
Information for Entrepreneurs

• Significant Information for Financial Management

– The importance of ratio analysis in planning
– Techniques and uses of projected financial statements
– Techniques and approaches for designing a cash-flow schedule
– Techniques and approaches for evaluating the capital budget
 Table 10.1 Financial Glossary for the Entrepreneur

Accrual Method of recording & allocating income & costs for period in which each
system of is involved, regardless of date of payment or collection. E.g., if you were paid RM
100 in April for goods you sold in March, RM 100 would be income for March under this system.
accounting
(Opposite of cash system of accounting.)

Asset Anything of value owned by you or your business.

Balance Itemized statement listing total assets & liabilities of your business at given
sheet moment. Statement of financial position.

Amount invested in business by proprietor(s) / stockholders. Money

Capital available for investment or money invested.
Cash flow Schedule of your cash receipts & disbursements.
Method of accounting whereby revenue & expenses are recorded when
Cash system received & paid (date), respectively, without regard for period to which
of accounting
they apply.
 Table 10.1 Financial Glossary for the Entrepreneur

Determined by subtracting value of ending inventory from sum of

Cost of
beginning inventory & purchases made during period. Gross sales less
goods sold
(minus) cost of goods sold gives you gross profit.

Cash & assets that can be easily converted to cash, such as accounts
Current assets
receivable & inventory.
Current
Debts you must pay within a year (short-term liabilities).
liabilities
Lost usefulness; diminution of service yield from a fixed asset or fixed
Depreciation asset group that cannot or will not be restored by repairs or by
replacement of parts.

An interest in property or in a business, subject to prior creditors. An

Equity owner’s equity in his / her business is the difference between value of
company’s assets & debt owed by company.
 Table 10.1 Financial Glossary for the Entrepreneur
Gross profit Sales less (minus) cost of goods sold.
Cost of borrowing money. Paid to lender & usually expressed as an
Interest
annual percentage of loan.
Money you owe to your creditors. Can be in form of a bank loan,
Liability
accounts payable, etc. Claim against assets.

When business’s total expenses for the

Loss period are greater than the income.

Total income for period less (minus)

Net profit total expenses for the period.

Net worth Same as Equity.

 3 key Financial Statements
(powerful tools entrepreneurs can use to manage their ventures)

(i) Balance Sheet (Statement of Financial Position)

Financial position - Snapshot view of assets &
liabilities of company at a particular point in time.

(ii) Income (Profit & Loss) Statement

Financial performance - Captures activities of
company during a period of time.
Revenues-Expenses
(iii) Cash-Flow Statement
Sources & uses of cash - Captures financing activities
& application of funds during a period of time.
Focused Application of Financial Planning Instruments
Can I fulfill my financial Am I profitable? Where has my capital
obligations at any time? been invested, and
Am I making money? where has it come from?
Can I pay what is due?
Equity
Outside capital

Cash flow Statement Income Statement Balance Sheet

(Statement of Financial Position)
Deposits Payments Proceeds Expenses Assets Equity + Liabilities
… … … … … …
… … … … … …
… … … … … …

Net Cash Inflow Total = Balance = Capital

( Net Cash Outflow)
Profit (Loss) Assets Sheet Total Invested

Cause of bankruptcy: Cause of bankruptcy:

Illiquidity (Cash Inflow < Cash Outflow) Excessive Debt
 Understanding Key Financial Statements
(i) Balance Sheet (Statement of Financial Position)
- a financial statement that reports a business financial position at a
specific time.
- Divided into 2 parts:
(i) financial resources owned by the firm (assets)
(ii) the claims against these resources
- creditors who have a claim to the firms’s assets
(liabilities)
- owners who have rights to anything left over after
the creditors’ claim have been paid
(owner’s equity)
➢ Assets = Liabilities + Owners’ Equity
 Understanding Key Financial Statements……cont.

Assets = Liabilities + Owners’ Equity

❑ An asset is something of value the business owns.

➔ Current and fixed assets
❑ Liabilities are the claims creditors have against the company.
➔ Short- and long-term debt
❑ Owners’ equity is the residual interest of the firm’s owners in
the company.
 Equity
• In accounting and finance, equity is the difference between the
value of the assets/interest and the cost of the liabilities of
something owned.
• For example, if someone owns a car worth $15,000 but owes
$5,000 on that car, the car represents $10,000 equity.
• Equity can be negative if liability exceeds assets.

10–11
 Account
(Statement of Financial Position) Left-hand side Right-hand side
Balance Sheet Debit Credit

Balance Sheet
Left-hand side Right-hand side
Assets Liabilities +
Owner’s Equity
 Table 10.2

Kendon
Corporation Non-current

Balance $235,000

Sheet $350,000

(Statement of Financial Position)

for the Year Ended
December 31, 2006

Note:
Assets = Liabilities
+ Owners’ Equity

$10,000 materials received

$100,000 bank loan
Assets Kendon Corporation Close-up view
Current Assets Balance Sheet
Cash 200,000
Accounts receivable 375,000
Less: Allowance for uncollectible accounts 25,000 350,000
Inventory 150,000
Prepaid expenses 35,000
Total current assets 735,000
Fixed Assets
Land 330,000
Building 315,000
Less: Accumulated depreciation of building 80,000 235,000
Equipment 410,000
Less: Accumulated depreciation of equipment 60,000 350,000
Total fixed assets 915,000
Total assets 1,650,000
Liabilities Kendon Corporation Close-up view
Current Liabilities Balance Sheet
Accounts payable 150,000
Notes payable 25,000
Taxes payable 75,000
Loan payable 50,000
Total Current Liabilities 300,000
Bank loan 200,000
Total Liabilities 500,000
Owners’ Equity
Contributed Capital
Common Stock, RM 10 par, 40,000 shares 400,00
Retained Earnings 750,000
Total Owners’ Equity 1,150,000
Total Liabilities & Owners’ Equity 1,650,000
Understanding Key Financial Statements
(ii) Income Statement
- Commonly referred to as P&L (profit & loss) statement
- Provides results of firm’s operations.
Income Statement Categories
❑ Revenues: Gross sales that business made for a period
❑ Expenses: Costs associated with producing goods or services
❑ Net Income: Excess (or deficit) of revenues over expenses (profit / loss)
❑ Usually cover a one-year interval, but sometimes monthly, quarterly
❑ If revenues exceed expenses ➔ net profit & vice versa
 Continue…
➢ profit is the surplus left from revenue after paying all costs. profit =
total revenue - total costs.
➢ For example, if a firm has a total revenue of £100,000 and a total cost
of £80,000, then they are left with £20,000 profit.
➢ A business can use profit to either:
invest in growth

reward owners save for the future

 Continue…
➢ A loss is made when the revenue from sales is not enough to cover all
the costs of production.
➢ For example, if a company has a total revenue of £60,000 and a total
cost of £90,000, then they have lost £30,000 from trading.
➢ Losses can be reduced or turned into profit by:

cutting costs increasing revenue

 Table 10.3

Kendon
Corporation
Income
Statement
for the Year Ended
December 31, 2006
 Kendon Corporation Close-up view

Income Statement
Sales Revenue 1,750,000
Less: Sales Return & Allowances 50,000
Net Sales 1,700,000
Cost of Goods Sold
Inventory, January, 2000 150,000
Purchases 1,050,000
Goods available for sale 1,200,000
Less: Inventory, December, 2000 200,000
Cost of Goods Sold 1,000,000
Gross Margin (Gross Profit) 700,000
Gross margin - company's profit before operating expenses, interest payments & taxes.
 Kendon Corporation Close-up view

Income Statement
Gross Margin (Gross Profit) 700,000
Operating Expenses
Selling expenses 150,000
Administrative expenses 100,000
Total operating expenses 250,000
Operating income 450,000
Financial Expenses 20,000
Income before income taxes 430,000
Estimated Income Taxes 172,000
Net Profit 258,000
Balance Sheet (Statement of
Financial Position) versus
Income Statement
 Understanding Key Financial Statements
(iii) Statement of Cash Flow (Cash-Flow)
➢ Analysis of cash availability & cash needs of business that shows effects of
company’s operating, investing & financing activities on its cash balance.

• How much cash did firm generate from operations?

• How did the firm finance fixed capital expenditures?
• How much new debt did the firm add?
• Was cash from operations sufficient to finance fixed asset purchases?

➢ provides info about a company’s cash receipts and cash payment

Solvency
Cash flow is the movement of
money in and out of the business.

the difference between

money in and money out
 Continue…
Profit and cash flow are two very different things.
Cash flow is simply about money coming and going from the business.
The challenge for managers is to make sure there is always enough cash to pay
expenses when they are due.

➢ Insolvency
If a business runs out of cash and cannot pay its suppliers or workers it is
insolvent.
The owners must raise extra finance or cease trading.
This is why planning ahead and drawing up a cash flow forecast is so
important.
 Preparing Financial Statements
Budget
➢ One of the most powerful tools the entrepreneur can use in planning
financial operations.
Operating Budget
➢ A statement of estimated income & expenses over a specified period of time.

Cash Budget
➢ A statement of estimated cash receipts & expenditures over a specified
period of time.
Capital Budget
➢ The plan for expenditures on assets with returns expected to last beyond one
year.
 The Operating Budget
• Forecasting
– Creating an operating budget through preparation of the sales forecast.
• Forecasting
– Linear regression: a statistical forecasting technique.
– Y = a + bx
• Y is a dependent variable—its value is dependent on the values of a, b, and x.
• x is an independent variable that is not dependent on any of the other variables
• a is a constant.
• b is the slope of the line of correlation (the change in Y divided by the change in
x).
 F i g u re 1 0 . 1 Re g re s s i o n A n a l y s i s fo r Fo re c a st i n g
Y = a + bx
Instead of Y,
S = Projected Sales
Instead of x,
A = Advertising
Expenditures

S = a + bA

2 Initial Assumptions:
(1) If no money is spent on advertising (A), total
sales (S) will be $200,
(2) For every dollar spent on advertising (A), sales
(S) will be increased by two times that amount.
 Table 10.5 North Central Scientific:
Sales Forecast for 20XX ($000)

➢ Commonly used technique for preparation of sales forecast is the

estimation that current sales will increase a certain percentage (%)
over prior period’s sales.
➢ This percentage is based on a trend line analysis.
➢ Needs 5 preceding sales periods – more established ventures.
 Table 10.7 General Widgets:
Production Budget Worksheet for 20XX ($000)

➢ Production budget is management’s estimate of number of units that need to be produced

to meet sales forecast. Predicted number of units that will be sold is first determined (Sales).
➢ Desired ending-inventory-level balance is added.
➢ Sum of these 2 figures = number of units needed in inventory (available for sale). Production requirement
calculated by subtracting period’s beginning inventory from inventory needed (available for sale).
 Cash Flow Budget
Cash-Flow Budget
➢ Provides overview of cash inflows & outflows during period. By
pinpointing cash problems in advance, management can make the
necessary financing arrangements.

Preparation of the cash-flow budget

Identification & timing of three cash inflows:
• Cash sales (from revenue)
• Cash payments received on account (funds arrive later)
• Loan proceeds (purpose of expansion – new building, etc)

❑ Minimum cash balance (desired by some firms – if not met, seek additional
financing)
Operating Budget
Cash Budget
Capital Budget
Budget
Table 10.9

Cash-Flow
 Capital Budgeting
❖ Entrepreneur may be required to make several investment decisions in the
process of managing their firms.

❖ Investment with returns extending beyond 1 year is called as capital

investment / capital expenditure.

➢ Capital budgeting ➔ a technique the entrepreneur can use to help plan for
capital expenditure.

➢ 3 capital budgeting techniques :

(1) Payback method
(2) Net Present Value (NPV) method
(3) Internal Rate of Return (IRR) method
 Capital Budgeting (cont’d)
(1) Payback Method
– Considers the length of time required to “pay back” (recapture) the original
investment.
• Any project that requires a longer period than the maximum time frame for the
selected will be rejected, and projects that fall within the time frame will be
accepted.
Example:
• John would like to purchase a new machine for his store
• He is unsure which proposal to accept
• Each machine in proposal A and B costs $1000
• An analysis reveals the following information
 Analysis of the projected return in 5 years
Year Proposal A Proposal B

1 $ 500 $ 100

2 400 200

3 300 300

4 20 400

5 11 500

• John decides to use payback method with a cutoff period of 3 years

• Proposal A will pay back his investment ($1000) in 28 months
• $ 900 will be paid back within 2 years and the last $ 100 in the third year
• Proposal B will require 4 years for its payback
• So, Proposal A is chosen.
 Capital Budgeting
(2) Net Present Value (NPV) Method
➢ The premise that a dollar today is worth more than a dollar in
the future.
• The cost of capital is the rate used to adjust future cash flows to determine their
value in present period terms.
• Procedure is referred to as discounting future cash flows — cash value is
determined by the present value of the cash flow.

(3) Internal Rate of Return (IRR method)

➢ Similar to the net present value method, but future cash flows are
discounted a rate that makes the net present value of the project equal
to zero.
 YEAR CASH FLOW DISCOUNT FACTOR* P R E S E N T VAL U E

N et P re s e nt Va l u e ( N P V ) M et h o d
1 500 0.9091 454.55

Proposal A
2 400 0.8264 330.56
3 300 0.7513 225.39
4 20 0.6830 13.66
5 10 0.6209 6.21
1030.37
Less: Initial outlay – 1000.00
* From present value tables
Net present value 30.37
YEAR CASH FLOW DISCOUNT FACTOR* P R E S E N T VAL U E

1 100 0.9091 90.91

Proposal B

2 200 0.8264 165.28

3 300 0.7513 225.39
4 400 0.6830 273.20
5 500 0.6209 310.45
1065.23
Less: Initial outlay – 1000.00
* From present value tables
Net present value 65.23
 YEAR CASH FLOW DISCOUNT FACTOR* P R E S E N T VAL U E

Internal Rate of Return (IRR Method)

1 500 0.8942 447.10

Proposal A
2 400 0.7996 319.84

11.83% IRR
3 300 0.7151 214.53
4 20 0.6394 12.80
5 10 0.5718 5.73
1000.00
Less: Initial outlay – 1000.00
* From present value tables
Net present value 0.00
YEAR CASH FLOW DISCOUNT FACTOR* P R E S E N T VAL U E

1 100 0.8928 89.27

Proposal B

2 200 0.7971 159.42

12.01% IRR
3 300 0.7117 213.51
4 400 0.6354 254.15
5 500 0.5673 283.65
1000.00
Less: Initial outlay – 1000.00
* From present value tables
Net present value 0.00
 Pro Forma Statements

➢ Projections of firm’s financial

position over a future period
(pro forma income statement) or
on future date (pro forma
balance sheet).
Table 10.10 Pro Forma Income Statements
Table 10.10 Pro Forma Statements
p ro fo r m a b a l a n c e s h e et
 Break Even analysis
• helps a firm to plan the levels of production it needs to be profitable.

➢ At low levels of sales, a business is not selling

enough units for revenue to cover costs. A loss is
made.
➢ As more items are sold, the total revenue
increases and covers more of the costs.
➢ The break-even point is reached when the total
revenue exactly matches the total costs and the
business is not making a profit or a loss.
➢ If the firm can sell at production levels above
this point, it will be making a profit.
 Break Even analysis
Limitations
• It makes assumptions about various factors - for example that all units are sold,
that forecasts are reliable and the external environment is stable.
• If new rivals enter the market or an
economic recession starts then it could
take longer to reach the break-even
point than anticipated.
• Many organisations add on a
margin of safety to the break-even
level of output when deciding on
their minimum sales target.
 Break Even analysis
• used to determine when your business will be able to cover all its
expenses and begin to make a profit.
• It is important to identify your startup costs, which will help you
determine your sales revenue needed to pay ongoing business
expenses.

• There are 3 approaches:

(1) Contribution Margin Approach
(2) Graphic Approach
(3) Handling Questionable Costs
 Break Even Analysis
(1) Contribution Margin Approach
– The difference between the selling price and the variable cost per
unit.
– It is the amount per unit that is contributed to covering all other
costs.
– 0 = (SP –VC)S – FC or FC = (SP – VC)S
• where:
– SP = Unit selling price
– VC = Variable cost per unit
– S = Sales in units
– FC = Total fixed costs
 Example

• FC (fixed cost) = 50 000

• SP (selling price) = 250
• VC (variable costs per unit) = 100
• S = sales in units (to break even)
FC = (SP – VC)S
S = FC/(SP – VC)
S = 50 000/ (250 – 100)
S = 333.33 = 334 units to be sold to break even
 Break Even Analysis (cont’d)
(2) Graphic Approach
– Graphing total revenue and total costs.
• The intersection of these two lines (that is, where total revenues are equal
to the total costs) is the firm’s break-even point.
– Two additional costs—variable costs and fixed
costs—also may be plotted.
 Break Even Analysis
(3) Handling Questionable Costs

– Certain costs can behave as either fixed or variable costs at different

levels of output
– For eg: are repairs and maintenance expenses fixed or variable
expenses

– 0=(SP-VC)S-FC-QC (if considered fixed cost) OR

– 0=[SP-VC-(QC/U)]S-FC (if considered variable cost)
– U is the number of units for which the questionable cost normally
would be appropriate
 Example
• From an analysis, Tim has determined that:
• VC = $9, FC = $1200, SP = $15
• But he is unable to classify one cost as either variable or fixed, that
is $200 for repair
• The $200 is appropriate for 400 units sold
• Break even point assuming the cost is fixed:
• 0=(SP-VC)S-FC-QC
• 0=(15 – 9)S-1200-200
• 6S = 1400
• S = 233.3 = 234 units must be sold to break even
 Example
• Break even point assuming the cost is variable:
• 0=[SP-VC-(QC/U)]S-FC
• 0=[15 – 9- (200/400)]S-1200
• 0=[6 – 0.5]S – 1200
• 5.5S = 1200
• S = 218.18 = 219 units must be sold to break even
General Manufacturing: Fixed-Cost Assumption

break-even point
General Manufacturing: Variable-Cost Assumption

break-even point
 Example:
Ali decide to use break-even analysis as a profit
planning tool. From operating costs, Ali determined
variable cost per unit is RM 9, while fixed costs are
estimated as RM 1200 (per month). Anticipated
selling price (SP) per unit is RM 15.

Ali unable to classify one cost as either variable or fixed - a RM 200 repair
& maintenance expense allocation. This RM 200 is appropriate for activity
level of 400 units; so, if cost were variable, it would be RM 0.50 per unit
(from RM 200/400 unit or QC/U). Finally, sales are projected to be 400
units during the next budget period.
Ali decide to use break-even analysis as a profit planning tool.
From operating costs, Ali determined the variable cost per unit is RM 9, while fixed costs
estimated as RM 1200 (per month). Anticipated selling price (SP) per unit is RM 15.
Ali unable to classify one cost as either variable or fixed. It is a RM 200 repair & maintenance expense
allocation. This RM 200 is appropriate for activity level of 400 units; therefore, if the cost were
variable, it would be RM 0.50 per unit (from RM 200/400 unit or QC/U). Finally, sales are projected
to be 400 units during the next budget period.
S = Sales in units
QC as fixed costs QC as variable costs
RM 15 RM 9 RM 1200 RM 200 RM 15 RM 9
0 = (SP−VC) S − FC − QC 0 = [SP−VC− (QC/U)] S − FC
0 = (15−9) S − 1200 − 200 0 = [15−9− (200/400)] S − 1200
0 = (15−9) S − 1400 0 = [6− (0.50)] S − 1200 Ali
(15−9) S = 1400 [5.50] S = 1200
(6) S = 1400 S = 219
S = 234 (rounded to next unit)
 Ratio Analysis
Ratios useful for:
➢ Anticipating conditions (predict firm’s earnings &
dividends) & as starting point for planning actions.
➢ Show relationships among financial statement accounts.

Vertical Analysis KFC KFZ

➢ Application of ratio analysis to identify ROI ROI
financial strengths & weaknesses. = 0.99 = 0.08

Horizontal Analysis
➢ Looks at financial statements &
ratios over time for positive &
2013 2014 2015
negative trends. R O I 0.82 0.94 1.1
 Overall Efficiency Ratios
Sales Measures: Relative efficiency in
Sales-to-Assets = using total resources to produce
Asset Turnover Total Assets output (sales)
Net Profit
Return on Assets = before Tax Measures: How well assets
(ROA) have been employed by
Total Assets management
Net Profit
Return on Investment = before Tax
Measures: Return on
(ROI) Net Worth owner’s capital
 Ratio Analysis: Financial Ratios
Current
Measures: Solvency – the
Assets number of dollar in current
Current = assets for every dollar in
Current
Liabilities current liabilities
Short term debt paying ability
Net Profit
Return on Measures: Return on owner’s
before Tax
Investment = capital or efficiency of net
Net Worth worth in generating net profit
(ROI) 16.1% ROI?
Total Measures: Financial Risk –
Liabilities the number of dollars of
Debt-To-Worth = debt owed for every $1 in
Net Worth
net worth
 Ratio Analysis: Financial Ratios
Net Profit
Return on before Tax Measures: How well assets
Assets = employed by management
Total Assets to generate net profit
(ROA)
Sales Measures: Relative efficiency in
Sales-to-Assets = using total resources (assets) to
Asset Turnover Total produce output (sales)
Assets

Accounts Sales Measures: Number of times per year

Receivable = that a business collects its average
Accounts accounts receivable
Turnover
Receivable Ratio is intended to evaluate ability of a company
to efficiently issue credit to its customers & collect
funds from them in a timely manner.
 Ratio Analysis: Financial Ratios
Inventory Cost of Goods Sold (expense)
=
Turnover (Average) Inventory

Measures: Rate at which

inventory is being used on
an annual basis
 Ratio Analysis: Financial Ratios
General Financial Guidelines

Guidelines
Financial Measure
Good Average Poor

Current Ratio  1.5 1.0 – 1.5  1.0

Return On Assets (ROA)  0.10 0.05 – 0.10  0.05

Asset Turnover  0.40 0.25 – 0.40  0.25