oct 14 ecd lecture 7 financing the business ii (student)(1)

Enterprise Creation & Development

Lecture 7:

Financing the Business IIMr Nicholas Tan Tian Leng

([email protected])

1ECD Oct 13/Lecture 7/ttl

Lecture Objectives

• Importance of Cash Flow

• Start-up Costs

• Capital & Operating Budgeting/ Pro Forma Financial Statements

• Break-even and Basic Financial Ratios

ECD Oct 13/Lecture 7/ttl 2

Recommended Reading

• Donald F. Kuratko ENTREPRENEURSHIP –THEORY, PROCESS AND PRACTICE, 9th Edition, CENGAGE, Chp 11

• Charles E. Bamford and Garry D. Bruton, ENTREPRENEURSHIP – A SMALL BUSINESS APPROACH (International Edition, McGraw-Hill, Chapter 6)


Importance of cash flow

• Cash flow is not = profit

• Common to have products ‘sold’ with no cash coming to the firm.

• Credit accounts may have terms that range from 30-90 days. A % of these credit accounts may become uncollectible.

• New biz usually have to pay cash for its goods & services because it has no credit history.


example


YOU, SMALL BIZ

OWNER

RETAILERSSUPPLIER

TO PAY $1500 IMMEDIATELY

BUY 10 XBOX KINECTS @

$150 EACH

TO RECEIVE $2000 60 DAYS LATER

SELL 10 XBOX KINECTS @ $200 EACH

Month of MAY 2011

example


P&L (for month of May) Cash flow (for month of May)

Sales 2,000 Receipts (Sales)

0

COGS 1,500 Purchases 1,500

Gross profit 500 Net cash flow (1,500)

A profit was made in May; but there is a negative cash flow in the same month.

Importance of Cash Flow

• For a new business, the viability of the firm will be decided by cash flow, not profitability.

• New biz owners should be wary of rapid growth.

• Growth requires funds to build products or provide services immediately, in a situation where the revenue from those activities will not be in hand until sometime in the future.

• As a result, the time lag during a rapid buildup of the business causes a cash crunch & is one of the leading sources of biz failure.


BEGINNING CASH

Plus Receipts:Cash SalesReceivable CollectionsInterest

Minus Disbursements:Cash PurchasesPayment of Accounts PayableWages and SalariesPayroll TaxesAdvertisingOffice SuppliesRent/MortgageUtilitiesTelephone

Owner ContributionsOther ReceiptsTotal Receipts

InsuranceLegal/AccountingTaxes and LicensesInterest PaymentsLoan Principal PaymentsDues and SubscriptionsTravelMiscellaneous DisbursementsTotal Disbursements

ENDING CASH (Beginning Cash + Receipts - Disbursements)

ECD Oct 13/Lecture 7/ttl8

SAMPLE CASH FLOW STATEMENT (BUDGET)

Important Cash Management Tools

• Managing Accounts Receivables

• Managing Accounts Payables

• Managing inventory

• Other cash management tools:o Negotiate credit terms with suppliers and vendors

o “JIT” manufacturing and purchasing

o Leasing instead of purchasing

o Request for customers’ deposit etc

o Selling ‘packages’


Start-up Costs• Costs incurred before the start of the business.

• Eg rental deposit, computers and other equipment, furniture and fixtures, training of employees.

• Talk to suppliers, contractors, manufacturers, landlords and others in the industry in order to determine what you need and how much it will cost.


Summary of Start-up Costs of a

24 hr Convenience StoreStart -up costs $

3 months rental deposit 15,000

Renovation costs 20,000

Furniture, fixture and equipment 30,000

Starting stock cost 10,000

Fees and licence 2,000

Advertising for opening 3,000

TOTAL 85,000


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Start-up Costs of First Step! Bazaar

Start-up costs $

Stall rental 60

Stall decorations 30

Promotional materials Eg flyers 10

Starting stock costs 100

TOTAL 200


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DON’T FORGET YOUR CASH FLOAT ON THE DAY OF BAZAAR!

Start-up Capital

Rule of thumb:

Start up capital = Projected monthly expenses for first month X 3 months (assume a typical operation takes about 3 months before sales trickle in

+Projected start up costs (Only-once expense)


Operating Budget1) Sales forecasts

- Process of projecting future sales through historical sales figures and the application of statistical techniques.

2) Expense forecasts

- Projecting purchases plus the corresponding desired beginning and ending inventories

3) Production forecasts

- Production budget, a material purchases budget and the corresponding direct labour budget

4) Operating expenses

- Fixed, variable and mixed costs


Pro Forma StatementsPro forma statements are projections of a firm’s

financial performance over a future

period (pro forma income statement)

or

financial position on a future date

(pro forma balance sheet).


The Income Statement• Commonly referred to as the P&L Statement (Profit & Loss)

Statement.

• Provides the owner/manager with the results of operation for a period of time.



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Pointers for Pro Forma Income Statements for Start-ups

• Opening Inventory

First Month

= Amt of Purchases or Cost of Production

Prior to the start of the business

2nd and subsequent months

= Prior month’s ending inventory



• Ending Inventory

= Next month’s sales x (1 – gross margin)% x (y%)

where y% is the % of next month’s sales that the firm needs to stock up at month end.



Depreciation method

• Use straight line depreciation method, butmay use other methods such as sum ofyear digits or reducing balance methods ifit gives a more accurate picture.


The Balance Sheet• Represents the financial condition (position) of a

company at a certain date.

• It details the items the company owns (assets) andthe amount the company owes (liabilities).

• It also shows the net worth of the company and itsliquidity.

Assets = Liabilities + Owners Equity



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Pointers for Balance Sheets for Start-ups

• Cash = ending cash balance from cash flow budget

• A/R = Nil if all on cash terms, otherwise based on credit terms

• Inventory = Ending Inventory per Income Statements

• Prepaid Rent/rental deposit = usually 3 months’ rental deposit


Pointers for Balance Sheets for Start-ups

• A/P = nil if on cash terms, otherwise, based on suppliers’ credit terms

• Capital = prior month’s ending capital + current month’s net income per income statement.

• Note : For application of credit terms for A/R and

A/P, students should revise their notes from

Financial Management module


Break-even Analysis• Used to assess expected product profitability.

• Helps determine how many units must be sold in order tobreak even at a particular selling price.

• The contribution margin is the difference between theselling price and the variable cost per unit.

• It is the amount per unit that is contributed to cover allother costs.

• The entrepreneur will be able to decide whether to add ordrop a product line, how to price a product or service &how to structure sales commissions or bonuses.


Break-even Analysis• Contribution margin approach

– Since the break-even point occurs when income equals expenses, the contribution margin approach formula is:

0 = (SP-VC)S – FC

Where:

SP = Unit selling price S = Sales in units

VC = Variable costs per unit FC = Fixed costs


FC

SP - VCS =OR

Break-even Analysis –Handling Questionable Costs

• Questionable Cost : Fixed or Variable?

Phone Bills, Repairs, Maintenance

• Technique : Calculate 2 break-even points under both assumptions.

• Rule :

– If sales > higher B/E point, product is profitable

– If sales < lower B/E point, product is unprofitable

– If lower B/E point < sales < higher B/E point, questionable cost needs further investigation.


Break-even Analysis • Estimate Sales, Fixed Cost and Variable Cost

• Formula: Fixed Cost divided by (Sales – Variable Cost) or Contribution Margin

Question: How does a Taxi Driver calculate its break-even sales dollar per day?

Rental $200 per day, petrol is 20% of sales (ie. Variable cost or cost of goods sold is 20%)

Breakeven Sales per day = Fixed Cost / Contribution Margin

= $200 / (1-0.2)

= $250


Ex

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Ex

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Mamor’s Chocolates Contribution Margin Income Statement for 2010

$’000

Sales 463

Less: variable costs

Cost of goods sold 231

Sales commissions 59

Delivery charges 14

Total variable costs 304

Contribution margin (159/463) (34.3%)

159

Less: fixed costs

Advertising 2

Depreciation 13

Insurance 5

Payroll 48

Rent 10

Utilities 18

Total fixed costs 96

Net operating income 63

S = FC / (SP – VC)%= 96 / 34.3%= 280

Where:

SP = Unit selling price

S = Sales in units

VC = Variable costs per unit

FC = Fixed costs

Ratio Analysis• Show relationships among financial

statement accounts

• Time series vs cross sectional analysisVertical analysis

Look ‘up and down’ a company’s statements to find signs of strengths and weakness.

Horizontal analysis

Look at financial statements and ratios over time.


• Liquidity ratios are used to measure short term solvency. (current ratio, the acid test /quick ratio)

• Leverage ratios analyse the firm’s capital structure.– Debt ratio assesses ability to meet obligations.– Debt to equity ratio assesses the firm’s debt load.

• Profitability ratios indicate firm’s ability to translate sales into profits (Gross & Net profit margin) ability to manage total investment in assets (ROI).

• Activity ratios measure efficiency of venture in managing and selling its inventory. (average collection period, inventory turnover)

Ratios to assess Financial Strengths

& Weaknesses (recap)


Financial Ratios


Ratio Formula What it measures What it tells you

Return on Investment (ROI)

Net income (or netprofit b4 tax)owner’s equity

Return on owner’s capital

How well is this company doing as an investment?

Return on Assets(ROA)

Net income (or net profit b4 tax)total assets

How well assets have been employed by management

How well has management employed company assets? Does it pay to borrow?

**RATIOS FOR OWNERS

Financial Ratios



Net profit margin Net income (or net profit b4 tax)Sales

Operatingefficiency; the ability to create sufficient profits from operating activities

Are profits high enough, given the level of sales?

Asset turnover Salestotal assets

Relative efficiency in using total resources to produce output

How well are assetsbeing used to generate sale revenue?

RATIOS FOR MANAGERS

Financial Ratios


Ratio FormulaWhat it

measuresWhat it tells you

Return on assets Net income (or net profit b4 tax)Total assets

Earning power on all assets; ROA ratiobroken into its logical parts: turnover and margin

How well hasmanagement employed company assets?

Average collection period

Average accounts Receivable X 365Annual credit sales

Liquidity of receivables in terms of average no. of days receivables are outstanding

Are receivablescoming in too slowly?

Inventory turnover

Cost of goods expenseAverage inventory

Liquidity of inventory, the no. of times it turns over per year

Is it too much cash tied up in inventories?

RATIOS FOR MANAGERS

Financial Ratios



Average age of payables

Avg accounts Payable X 365Net purchases

Approximate length of time a firm takes to pay its bills for trade purchases

How quickly does aprospective customer pay its bills?

Working capital

Current assets – current liabilities

Short-term debt-paying ability

Does this customer have sufficient cash or other liquid assets to cover its short-term obligations?

**Current ratio

Current assetsCurrent liabilities

Short-term debt-paying ability without regard to the liquidity of current assets

Does this customer have sufficient cash or other liquid assets to cover its short-term obligations?

**Quick ratio Cash + Marketable securities + Accounts receivableCurrent liabilities

Short-term debt-paying ability without having to rely on inventory sales

Does this customerhave sufficient cash or oth liquid assets to cover its short-termobligations?

RATIOS TO ASSESS SHORT-TERM LIQUIDITY

Financial Ratios



**Debt-to-equity ratio

Total debtTotal equity

Amount of assets creditors provide for each dollar of assets the owners provide

Is the company’s debt load excessive?

Times interest earned

Net income + interest + taxesInterest expense

Ability to pay fixed charges for interest from operating profits

Are earnings and cash flows sufficient to cover interest payments & some principal repayments?

Cash flow to liabilities

Operating cash flowTotal liabilities

Total debt coverage General debt-paying ability

Are earnings and cash flows sufficient to cover interest payments and some principal repayments?

LONG-TERM CREDITORS

Examples of Financial Ratios

GOOGLE INC

• http://www.reuters.com/finance/stocks/ratios?rpc=66&symbol=GOOG.O

APPLE

• http://www.reuters.com/finance/stocks/ratios?symbol=AAPL.O

ABERCOMBIE AND FITCH

• http://www.reuters.com/finance/stocks/ratios?symbol=ANF.N


http://www.reuters.com/finance/stocks/ratios?rpc=66&symbol=GOOG.O

http://www.reuters.com/finance/stocks/ratios?symbol=AAPL.O

http://www.reuters.com/finance/stocks/ratios?symbol=ANF.N

oct 14 ecd lecture 7 financing the business ii (student)(1)

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