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Chapter 09
 

Chapter 09

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    Chapter 09 Chapter 09 Document Transcript

    • CHAPTER 9 FINANCIAL PREPARATION FOR ENTREPRENEURIAL VENTURES CHAPTER OUTLINE I.Introduction A. Three resources available to entrepreneur 1. Human 2. Material 3. Financial II.The Importance of Financial Information for Entrepreneurs A. Key questions are answered B. The accounting equation C. Three critical statements: balance sheet; income statement; and cash flow statement III. Preparing Financial Statements A. Operating budgets 1. Estimating sales forecast a. By linear regression b. By certain percentage over prior period's sales 2. Estimating expenses a. Cost of goods sold b. Fixed variable and mixed costs B. Cash flow statement 1. Provides overview of cash inflows and outflows 2. Cash inflows a. Cash sales b. Cash payments on account c. Loan proceeds IV. Pro forma statements A. Two kinds 1. Income statements 2. Balance sheet V. Capital budgeting A. Steps 1. Identify cash flows and timing 2. Obtain reliable estimates of savings and expenses B. Methods 1. Payback method a. Easiest b. Ignores cash flows beyond payback period 2. Net present value Harcourt, Inc. 109
    • a. Minimizes shortcomings of payback method b. Dollar today worth more than future dollar 3. Internal rate of return a. Cash flows discounted b. Must begin with NPV of zero and work backward through tables VI. Break-Even Analysis A. Break-even point computation 1. Assesses expected product profitability 2. Determines how many units must be sold at a particular selling price 3. Approaches used: a. Contribution margin 1. Difference between selling price and variable cost per unit 2. FC = (SP - VC) S b. Graphic approach 1. Deals with total revenue and total costs 2. Enables visualization of cost structure c. Handling questionable costs 1. Used with difficult-to-assign costs VII. Ratio Analysis A. Key relationships B. Measuring and interpreting VIII. Decision Support Systems A. Facilitates financial planning process B. Can perform a sensitivity analysis for sales and expenses IX. Summary CHAPTER OBJECTIVES 1.To explain the principal financial statements needed for any entrepreneurial venture: balance sheet, income statement, and cash flow statement 2.To outline the process of preparing and operating budget 3.To discuss the nature of cash flow and to explain how to draw up such a document 4.To describe how pro forma statements are prepared 5.To explain how capital budgeting can be used in the decision-making process 6.To illustrate how to use break-even analysis 7.To describe ratio analysis and illustrate some of the important measures and meanings 8.To describe the value of decision support systems in the management of financial resources CHAPTER SUMMARY 110 Harcourt, Inc.
    • "Financial Preparation for Entrepreneurial Ventures," explains the importance of budgets, pro forma statements, and break-even analysis. It explains the resources and steps needed in constructing budgets. Formulas that are necessary for budget construction and financial understanding are also given. This chapter communicates the importance of break- even analysis and three approaches to take when conducting break-even analysis. Finally, the chapter touches on the use of a decision support system. The first part of this chapter explains the importance of financial information for entrepreneurs. Then, the process of preparing an operation budget is covered. The first step in constructing an operating budget is to estimate the sales forecast. This can be done using a statistical forecasting technique such as linear regression. Next, the expenses must be estimated. The first expense that should be estimated is cost of goods sold. This estimation is done in different ways by retail and manufacturing firms. Fixed, variable, and mixed costs are key factors when estimating expenses. The next budget presented is the cash flow statement. This financial statement gives the entrepreneur an overview of the cash inflows and outflows during the budget period. The first step in creating the cash flow statement is to identify and time cash inflows. Cash inflows come from cash sales, cash payments received on account, and loan proceeds. The preparation of pro forma statements is a key step for entrepreneurs. These statements are projections of the company's future financial position for either a future date or a future period of time. The pro forma income statement is prepared before the pro forma balance sheet. The last balance sheet prepared before the budget period, the cash flow budget, and the operating budget are all needed to construct a pro forma balance sheet. The accuracy of this balance sheet can be checked by applying the traditional accounting equation: Assets = Liabilities + Owner's Equity. An entrepreneur can use capital budgeting to help plan for investments that are expected to go beyond one year. These investments are known as capital investments or capital expenditures. Identifying cash flows and their timing is the first step in capital budgeting. Maximizing the value of the firm is the main objective of capital budgeting. It is designed to answer these questions: (1) Which of several mutually exclusive projects should be selected? (2) How many projects, in total, should be selected? There are three methods used in capital budgeting. The first and simplest is the payback method. In this method, the entrepreneur formulates a maximum time frame for a payback period. All projects with a longer payback period than the time frame allows are rejected. Those projects that fall within the time frame are accepted. The drawback of this method is that it does not consider the cash flows beyond the payback period. The second method of capital budgeting is net present value. Unlike the payback method, net present value recognizes cash flows beyond the payback period. This method works on the concept that "a dollar today is more than a dollar in the future." The rate used to determine the present value of future cash flows is the cost of capital. The net present value is determined by finding the present value of expected net cash flows and subtracting it from the initial cost of the project. The project with the highest net present value should be selected. The third method is internal rate of return. In this method, the future cash flows are also discounted. However, they are discounted at a rate that makes the net present value equal to zero. This rate is the internal rate of return. Just as with the net present value, the project with the highest internal rate of return should be selected. This method can be difficult when working with uneven cash flows. Harcourt, Inc. 111
    • Break-even analysis is used to help the entrepreneur price competitively and earn a fair profit. This technique is used to determine product profitability. It helps the entrepreneur know how many units should be sold at what price to break even. There are three approaches to break-even analysis. Contribution margin approach is the first approach to break-even analysis. Contribution margin is the amount per unit that is used to help cover all other costs. It is determined by subtracting the variable cost per unit from the selling price. The second method is the graphic approach. The entrepreneur must at least plot total revenue and total costs. The break-even point is the intersection of these two lines. By plotting two additional points, variable and fixed costs, the entrepreneur can visualize various cost structure relationships. The last approach, handling questionable costs, was designed specifically for entrepreneurial firms. This lets the entrepreneur see if the product's profitability is sensitive to cost behavior by calculating break-even points for different fixed or variable costs. The entrepreneur can then see if the product will be profitable, unprofitable, or if the costs should be investigated further. Financial statements report both on a firm's position at a point in time and on its operations over some past period. However, the real value of financial statements lies in the fact that they can be used to help predict the firm's earnings and dividends. From an investor's standpoint, predicting the future is what financial statement analysis is useful both as a way to anticipate conditions and, more importantly as a starting point for planning actions that will influence the course of events. An analysis of the firm's ratios is generally the key step in a financial analysis. The ratios are designed to show relationships between financial statement accounts. Ratio analysis can be applied from two directions. Vertical analysis is the application of ratio analysis to one set of financial statements. Here, an analysis "up and down" the statements is done to find signs of strengths and weaknesses. Horizontal analysis looks at financial statements and ratios over time. In horizontal analysis, the trends are critical. All the numbers increasing or decreasing are particular components of the company's financial position are getting better or worse. Finally, this chapter presents the idea of decision support systems in small business. This technique can help a firm manage its financial resources. Decision support systems help calculate a desired minimum cash balance and the amount of sales needed to meet this minimum balance. It can also calculate different net incomes to see how it compares to targeted profits. Sensitivity analysis can also be done for other levels of sales and expenses. This is an important technique that can give the entrepreneur a more complete view of the financial characteristics on which to base a plan of action. LECTURE NOTES FINANCIAL PREPARATION FOR ENTREPRENEURIAL VENTURES I.Introduction A. Characteristics of competitive environment for the entrepreneur 1. Government regulation 112 Harcourt, Inc.
    • 2. Competition 3. Resources B. Three types of resources 1. Human 2. Material 3. Financial C. Chapter focus 1. Budgets as planning tools 2. Preparation of pro forma statements 3. Break-even analysis as a profit planning tool 4. The use of ratio analysis for financial analysis 5. Value of decision support systems II.The Importance of Financial Information for Entrepreneurs A. Key Questions to be Answered 1 What is your total estimated income for the first year? 2. What is your estimated monthly income for the first year? 3. What will it cost you to open the business? 4. What will be your monthly cash flow during the first year? 5. What will your personal monthly financial needs be? 6. What sales volume will you need in order to make a profit during the first three years? 7. What will be your break-even point? 8. What will be your projected assets, liabilities, and net worth on the day before you expect to open? III. Preparing Financial Statements A. The operating budget 1. Estimating the sales forecast a. Statistical forecasting technique b. Trend line analysis 2. Estimating expenses a. Cost of goods sold should be first 1. Determine the predicted number of units to be sold 2. Figure the desired ending inventory balance 3. Determine production requirement b. Determine materials requirement c. Determine direct labor requirement d. Estimate operating expenses for period 1. Fixed costs 2. Variable costs 3. Mixed costs B. The cash flow statement 1. Identification and timing of cash flows 2. Cash inflows come from three sources a. Cash sales Harcourt, Inc. 113
    • b. Cash payments received on account c. Loan proceeds IV. Pro forma statements A. Pro forma income statement B. Pro forma balance sheet 1. Requires operating budget 2. Requires cash flow budget 3. Requires last balance sheet prepared before budget period 4. Verify accuracy with traditional accounting equation V. Capital budgeting A. Identify cash flows and their timing B. Main objective is to maximize value of firm C. Should answer two questions 1. Which of several mutually exclusive projects should be selected? 2. How many projects, in total, should be selected? D. Three most common methods 1. Payback method a. Determining criterion is time needed to payback investment b. Drawback is that it ignores cash flows beyond payback period c. Reasons to continue using this method 2. Net present value a. Based on premise that a dollar today is worth more than a dollar tomorrow b. Cost of capital is the rate used to adjust future cash flows to present value c. Subtract present value of future cash flows from initial cost to get net present value d. Select project with highest net present value 3. Internal rate of return a. Discount future cash flows at a rate that makes net present value equal to zero b. Select project with highest internal rate of return c. Difficulty of technique is a major drawback VI. Break-Even Analysis A. Break-even analysis provides information to 1. Price competitively 2. Earn a fair profit VII. Break-even point computation A. Contribution margin approach 1. Difference between selling price and variable cost per unit 2. Formula is FC = (SP - VC) S B. Graphic approach 1. Must graph at least two numbers a. Total revenue b. Total costs 114 Harcourt, Inc.
    • 2. Intersection is the break-even point 3. May plot two additional costs a. Variable costs b. Fixed costs C. Handling questionable costs 1 Designed specifically for entrepreneurial firms 2. Calculate break-even points a. Under fixed and variable costs b. Test if product's profitability is sensitive to cost behavior 3. Decision rules a. Product should be profitable if expected sales exceed the higher break-even point b. Product should be unprofitable if expected sales do not exceed the lower break-even point c. Investigate the questionable cost's behavior further if sales fall between the two break-even points 4. Substitute the cost as fixed, then variable a. For fixed cost use 0=(SP-VC)S-FC-QC b. For variable cost use 0=[SP-VC-(QC/U)]S-FC VIII. Ratio Analysis A. Key Relationships 1. Return on investment (ROI) 2. Return on assets (ROA) 3. Net profit margin 4. Asset turnover 5. Return on assets 6. Average collection period 7. Inventory turnover 8. Working capital 9. Current ratio 10. Quick ratio B. Measuring and Interpreting IX. Use of Decision Support Systems A. Technique used in managing financial resources B. Used to facilitate financial planning process through: 1. Integrated pro forma statements 2. Generation of alternatives that can be quickly explored C. Allows entrepreneurs to: 1. Specify desired minimum cash balance 2. Determine minimum level of sales needed to meet this requirement 3. Calculate net income at various points to see how it compares with targeted profits D. Sensitivity analysis can be performed for other levels of sales and expenses E. Provides more complex view of: Harcourt, Inc. 115
    • 1. Financial characteristics 2. Interaction of the business 3. Formulation of plan of action SUGGESTED ANSWERS FOR DISCUSSION QUESTIONS (END OF CHAPTER) 1. What is the importance of financial information for entrepreneurs? Briefly describe the key components. Financial information pulls together all the information presented in the other segments of the business; marketing, distribution, manufacturing, and management. It quantifies all the assumptions and/or historical information concerning business operations. The key components of the financial segment include the balance sheet which represents the financial condition of a company at a certain date. It details the items owned by your company (assets) and the amount owed by the company (liabilities). It also shows the net worth of the company and its liquidity. The balance sheet must follow the traditional accounting equation: Assets=Liabilities + Equity. Another key statement is the income statement commonly referred to as the P & L (profit and loss) statement, which provides the owner manager with the results of operations. It measures the success of the business. Finally, the statement of cash flow is an analysis of the cash availability and cash needs of the business. The projected cash flow is a planning tool to allow management to make borrowing and investing decisions. 2. What are the benefits of the budgeting process? Budgeting allows top management to determine the company's goals. This is a benefit because top management is more familiar with the goals, strategies, and available resources of the company. Another benefit can be the involvement of operating management in the budget process. This is more likely to get a commitment from them than the top-down approach is. 3. How is the statistical forecasting technique of simple linear regression used in making a sales forecast? Simple linear regression is used to show the relationship between three variables. The equation for simple linear regression is Y=a+bx. Y represents expected sales, x is the factor on which sales are dependent, b is the change in Y divided by the change in x, and a is a constant. The entrepreneur uses this analysis to draw conclusions about the relationship between x and Y. 4. Describe how an operating budget is constructed. The operating budget is constructed by estimating sales, expenses, and cost of goods. These three budgets are combined to make up the operating budget. 5. Describe how a cash flow budget is constructed. 116 Harcourt, Inc.
    • The cash flow budget is created by first determining the cash inflows and their timing. Then the cash outflows must be determined. These are combined to make up the cash flow budget. 6. What are pro forma statements? How are they constructed? Be complete in your answer. Pro forma statements are projections of a firm's financial position over a future period of time or on a future date. The pro forma income statement is created first. It is a combination of all of the pro forma income statements that were created for the preparation of the operating budget. Preparing the pro forma balance sheet requires the last balance sheet prepared before the budget period began, the operating budget, and the cash flow budget. Projected balance sheet totals are created by adding the projected changes as shown on the budgets, starting with the beginning balance sheet balances. The accuracy of the pro forma balance sheet is checked by using the traditional accounting equation: Assets = Liabilities + Owner's Equity. 7. Describe how a capital budget is constructed. The first step is to identify the cash flows and their timing. The formula is represented by capital budgeting. Expected Returns = x (1-T) + Depreciation. x is equal to the net operating income and T is the tax rate. The principal objective is to maximize the value of the firm. The three most common methods are the payback method, net present value method, and the internal rate of return. 8. One of the most popular capital budgeting techniques is the payback method. How does this method work? Give an example. The entrepreneur will select a maximum time frame for the payback period. Any project that requires a longer period will be rejected, and those projects that fall into the time frame will be accepted. Year Proposal A Proposal B 1 500 100 2 400 200 3 300 300 4 20 400 5 10 500 Each machine costs $1,000 This is the payback method with a cutoff period of 3 years. Proposal A would be paid back in 2 1/3 years; $900 of the original investment will be paid back in the first 2 years and the last $100 in the third year. Proposal B will require 4 years for its payback. Proposal A should be chosen. 9. Describe the net present value method. When would an entrepreneur use this method? Why? Harcourt, Inc. 117
    • The net present value (NPV) method is a technique that helps to minimize some of the shortcomings of the payback method by recognizing the future cash flows beyond the payback period. The concept works on the premise that a dollar today is worth more than a dollar in the future. The entrepreneur is adjusting future cash flows to determine their value in present period terms. The entrepreneur would use this method when he's not satisfied with the results of the payback method. 10. Describe the internal rate of return method. When would an entrepreneur use this method? Why? Future cash flows are discounted; however, they are discounted at a rate that makes the NPV of the project equal to zero. The project with the highest IRR is selected. When using the IRR concept, the entrepreneur must begin with a NPV of zero and work backward through the tables. The entrepreneur must estimate the approximate rate. When future cash flows beyond the payback are to be considered, the NPV and the IRR are the methods to be used in determining the best proposal. 11. When would an entrepreneur be interested in break-even analysis? When the entrepreneur needs relevant, timely, and accurate information that will enable him or her to price competitively and yet be able to earn a fair profit. It helps determine how many units must be sold in order to break even at a particular selling price. 12. If an entrepreneur wants to use break-even analysis but has trouble assigning some costs as either fixed or variable, can break-even analysis still be used? Explain. If the entrepreneur has trouble assigning fixed or variable costs, he can still do break- even analysis using a technique specifically designed for entrepreneurial firms. This technique is known as handling questionable costs. This technique calculates break-even points under alternative assumptions of fixed or variable costs to see if a product's profitability is sensitive to cost behavior. There are three decision rules for this cost. (l) The product should be profitable if sales exceed the highest break-even point. (2) The product should be unprofitable if expected sales do not exceed the lower break-even point. (3) If expected sales fall between the two break-even points, then the questionable cost's behavior needs to be looked at further. 13. What is Ratio Analysis? How is horizontal analysis different from vertical? Financial statements report both on a firm's position at a point in time and on its operations over some past period. However, the real value of financial statements lies in the fact that they can be used to help predict the firm's earnings and dividends. From an investor's standpoint, predicting the future is what financial statement analysis is all about; from an entrepreneur's standpoint, financial statement analysis is useful both as a way to anticipate conditions and, more importantly as a starting point for planning actions that will influence the course of events. An analysis of the firm's ratios is generally the key step in a financial analysis. The ratios are designed to show relationships between financial statement accounts. 118 Harcourt, Inc.
    • Ratio analysis can be applied from two directions. Vertical analysis is the application of ratio analysis to one set of financial statements. Here, an analysis "up and down" the statements is done to find signs of strengths and weaknesses. Horizontal analysis looks at financial statements and ratios over time. In horizontal analysis, the trends are critical: are the numbers increasing or decreasing, are particular components of the company's financial position getting better or worse? 14. What is a decision support system? How can it be of value in helping entrepreneurs manage their resources? A decision support system is a technique that a firm can use in managing its financial resources. It can facilitate the financial planning process by using integrated pro forma financial statements and generating alternatives that can be explored quickly. By using this technique, the entrepreneur can determine the desired minimum cash balance and the minimum level of sales needed to meet this requirement for the budget period or business plan. Net income can be calculated at various points to compare it with targeted profits. The decision support system can be used for sensitivity analysis for other levels of sales and expenses. All of this information can give the entrepreneur a more complete view of the financial characteristics and interaction of the business so that he can make a sound plan of action. TEACHING NOTES FOR END-OF-CHAPTER CASES CASE: IT'S ALL GREEK TO HER 1. What is the purpose of a cash flow budget? What does it reveal? Of what value would it be to an entrepreneur? It tells the overall cash inflows and outflows of a period. It reveals to a manager when the business may have cash problems in the future, so he can try to overcome the problems in an efficient way. The value to an entrepreneur is that this sort of budget lays out the business on a monthly basis. It pinpoints good times of sales and bad, so the entrepreneur can work on those spots of bad times. 2. How does the payback method work? How does the net present value method work? How would you explain each of these methods to Regina? The payback method determines when the project will pay for itself. The initial cost is the starting point, and then you subtract the first year's projected earnings the second year's earnings, etc., until the initial cost has been covered. This can be measured in fractions of years. Net present value determines the future cash flows worth in the present. This is done by multiplying the year's cash flows by the net present value factor from a chart or with a financial calculator. The payback period method is exactly what it says. It tells you how long it will take to get your initial cash outlay back, whereas the net present value method gives you an up-to-date figure of the projected cash flows. These cash flows are multiplied by a Harcourt, Inc. 119
    • present value factor, added together and then subtracted from the original cash outlay. The project with the most money left over is the choice to make. 3. How does the internal rate of return method work? How would you explain this? The internal rate of return is sort of an estimated percentage of capital. The net present value method is equal to zero as the expected cash flows are multiplied by a value factor, and when added would equate to the initial cash outlay. This method is similar to the net present value method. The only difference is that the interest rate is unknown. When the net present value equals zero, the estimated percentage rate of return is assigned. CASE: THE CONTRACT PROPOSAL 1.What is the break-even point for this project? Will the company make money if it manufactures the components? Show your calculations. Fixed cost question: Selling price = $800.00 Variable cost = $400.00 Fixed cost = $35,000.00 Number of units sold = S Question cost = QC (800 - 400)S - 35,000 - 1,000 = 0) 400S - 36,000 = 0 36,000 = 400S 90 = S = break-even point Variable cost question: (S - VC - QC/U) S - FC = 0 (400 - 8.34)S - 35,000 = 0 391.66s - 35,000. = 0 35,000 = 391.66s 89.36 = S = break-even point 90 units The break-even point is 90 units; therefore, if 120 units are sold a profit will occur. 2. If the project is profitable, will it provide Dennis the desired 20 percent? Explain. This project will provide the 20 percent return that Dennis requires. Break-even point is 90 units at $800 per unit and that equals $72,000 in sales revenue. Twenty percent is $14,400 added to $72,000 equals $86,000. So, Dennis sells 120 units making $96,000, well above the desired return according to the project. 3. Of what value is break-even analysis to Dennis? Be complete in your answer. Dennis relies on this analysis approach to help him to decide which project to undertake and which to decline. This approach also gives him a set number of units to 120 Harcourt, Inc.
    • go by when evaluating a project. If the break-even point is too many units produced, then Dennis will know quickly to stay away from that deal. This keeps him in a safe financial state. ADDITIONAL EXPERIENTIAL EXERCISES "Working the Financials" Divide the class into groups of four or five students. Give each group information (financials) on a small business. Have the group do a budget, either operating or cash flow, and have them go through all of the necessary steps that are required to make these budgets work. Next, instruct the group to prepare the pro forma balance sheet and the pro forma income statement if time allows. Have the group do one of the forms of capital budgeting by putting them in a situation where these methods will be applicable. Finally, have the group perform a break-even analysis on their respective company by using either the contribution margin approach or the graphic approach. (OR) "Keeping a Journal" Survey two small businesses and watch their biweekly or weekly profits and compare the two businesses profit-wise. Write down a journal of profits and/or losses and then write up a 2 to 3 page summary. For example, state how the businesses could improve or where they went wrong or how they could possibly expand, in your own viewpoint. Harcourt, Inc. 121