School of Mechanical And

Industrial Engineering

Entrepreneurship for engineers

Lecture 5
: Financing and accounting in business

Prepared by: Fekadu B.

2
 What is Finance
 Finance: can be defined as the art and science of managing
money.
 Finance: is making the best decision when that decision
involves money.
Finance have macro and micro level definition
 At the macro level, finance: is the study of;
financial institutions.
financial markets and how they operate within the financial system
in global economies.
 At the micro level, finance: is the study of;
financial planning,
asset management, and
3 fund raising for businesses and financial institutions.
 Financial planning
 Financial planning: is the process of formulating policies
and strategies relating to;
Procurement,
Investment; and
Administration of funds for an enterprise.
While formulating a financial plan, the entrepreneur has to
answer the following questions:
How much money is needed?
Where the money comes from?
When should the money be available?
 These three questions are concerned respectively financial
needs, sources of finance, and the time of raising funds.
4
 The Financial Planning Process
 The financial planning process is a logical, and have six-step
procedure:
1. Determining current financial situation
2. Developing financial goals
3. Identifying alternative courses of action
4. Evaluating alternatives
5. Creating and implementing a financial action plan, and
6. Reevaluating and revising the plan.

5
 The Financial Planning Process
1. Determine Current Financial Situation
 Determination of current financial situation with regard to;
income,
 savings,
 living expenses, and
 debts.
2. Develop Financial Goals
 Periodically analyze your financial values and goals.
 i.e. analysis is to differentiate your needs from your wants.
 This involves identifying
how you feel about money and
why you feel that way.
6
 The Financial Planning Process
3. Identify Alternative Courses of Action
 Developing alternatives for making good decisions.
Continue the same course of action.
 Expand and change the current situation.
 Take a new course of action.
4. Evaluate Alternatives
 Evaluate possible courses of action, considering
 life situation,
 personal values, and
 current economic conditions.
 Evaluating Risk

7
 The Financial Planning Process
5. Create and Implement a Financial Action Plan
Develop action plan, achieve your goals and prioritize of
goals
 Implement your financial action plan.
6. Reevaluate and Revise Your Plan
 Regularly assess the financial decisions.
 i.e. Financial planning is a dynamic process that does not
end when you take a particular action.

8
 Developing Financial Plan
 Project implementation: requires bringing together the
inputs of;
 land,
 labor,
 machinery,
 staff and etc.
 Finance: is required to assemble these inputs.
 Proper financing of business is essential for success in both
small and large enterprises.

9
 Financial requirements
Financial requirement: is an actual or estimated
sum of cash needed to perform a plan, venture, or
program.
Some types of financial requirements are:
Working Capital
Cash's which is spending in short-term assets is known as
working capital.
 Sum of cash on the activities of the business center.
It includes: the purchasing of raw materials, payment of
salaries and incomes, rent, energy, power and water, servicing
and, marketing, etc.
 Besides, the sale of goods on credit brings to the borrower’s
10
balance and bills receivable.
 Financial requirements
Fixed Capital
Sum of cash which is fixed amount of money for the business
center and used as spending long term assets
The funds needed to buy a set or resilient resources are also
known as the set investment.
 The set or resilient resources include land, structures, and
instrument, etc.
Medium-Term Capital
It includes funding certain activities like the remodeling of
structures, modernization of instrument, heavy costs on
marketing, etc.
Long-Term Capital
 It is needed for a longer time i.e. five decades or more.
 The set resources, as well as the long-lasting part of the funds, are
11 funded by it.
 Estimation of Financial needs
This leads us to know our investment cost and operation cost.
Investments costs are costs that result in addition to end
items. Such costs benefit future periods and generally are of a
long-term character.
Operating costs are the ongoing expenses incurred from the
normal day-to-day of running a business.
1. Investment Costs
Fixed Investment
Land and site preparation
Technology (lump sum and initial payments)
Equipment
Production
Auxiliary
 Estimation of Financial needs
Costs for environmental protection technology, waste disposal,
internal infrastructural services,
Spare parts, wear-and tear-parts, tools.
 Civil works
 Site preparation and development
 Buildings
 Outdoor works
 Engineering and design costs (unless included in equipment).
 Incorporated fixed assets (intangibles)
 Project design costs (engineering etc.) (unless included above groups).
 Transport, handling costs and charges
 Insurance duties
13
 Cont…
Pre-production expenditures
 Cost of previous studies
 Preliminary and capital issue
 Project and site management
 Pre-production marketing costs
 Pre-production implementation costs
 Personnel recruitment, training, administration and
overheads.
 Trial runs, start-up and commissioning
 Interests on loan, accrued during construction
14
 Production Cost Items
A. Factory Costs
Factory Costs are the expenses incurred by the business to
manufacture goods intended to be sold to the customers
Factory Costs include all costs linked to production like direct
material, direct labor, and other manufacturing overheads.
e.g.
Material inputs (usually direct variable costs), in particular raw
materials and factory supplies.
 Human resource costs like wages, salaries, mostly direct costs,
either fixed or variable, depending on type.
 Products rejected or returned
Waste treatment, environmental protection costs.
15
 Cont…
B. Factory overheads:
Factory overhead is the costs incurred during the
manufacturing process, not including the costs of direct
labor and direct materials.
 Direct and indirect fixed cost of production
Services (supervision, quality control, indoor climate control,
internal transport, consulting engineers etc.)
Royalties (fixed and variable costs).
Rents, leasing fees for production buildings, machinery and
equipment (fixed variable costs).
Research and development costs
Product storage costs (direct and indirect costs).
16
 Cont…
C. Administrative overheads: is an annual charge for
administrative services to units that generate some or all of their
budgets from income producing or revenue producing activities.
Usually direct costs, basically fixed costs
Salaries, wages (management, administrative staff etc.)
Office supplies, materials
Rents, leasing fees for office buildings and equipment
Services (communications, transports etc.)
D. Operating Costs (A+B+C)
E. Depreciation Costs (usually indirect fixed costs)
F. Cost of financing
17
G. Production costs (D+E+F)
 H. Marketing costs: is the money a business spends on
advertising and promoting its products or services.
Direct marketing costs
Packaging, storage
Costs of sales (sales force, commissions, discounts, returned
products, royalties etc.)
Promotional costs (advertisements, samples etc.)
Distribution costs (transport, interim storage, insurance etc.)
Indirect marketing costs
Overhead costs of the marketing department (personnel,
communications, materials and services, marketing research,
general promotional activities etc.)
I. Total costs of products sold (G+H)
18
 BREAK-EVEN ANALYSIS
Break-even analysis is a tool used to determine the level of
production / sale at which the business will cover both fixed and
variable costs.
 It indicates the minimum amount of revenue that a business
must earn in order to cover the total cost incurred so that it does
not incur any loss.
i.e.
Total sales are at least = Total Cost
 The point of equality of total revenue and total costs is a point of
zero profits and zero losses.
 The break-even analysis principally determines the viability of
the business.
19
 Break-even analysis is a useful tool that provides
answers to the following questions:
Does it make sense at all to engage in a business?
Is the expected profit stable and big enough to allow for
unforeseen risks, and for drawings for you as owner?
At what level of production will the business be able to cover
all its costs?
What is the minimum price required for the product to be
viable at different levels of production?
What happens if financial assumptions of costs or prices are
changing?
What are the best, worst and probable scenarios of the
20
project?
 Diagrammatic presentation
The break-even can be presented diagrammatically.
It gives an overview of the compact picture of the operating
activity.
For the break-even analysis, costs are categorized into variable
and fixed costs
Breakeven Quantity = Fixed Costs/(Price/unit – Variable cost/unit)
Uses of break- even analysis
It enables a business organization to:
Measure profit and loss at different levels of production and sales
To predict the effect of changes in price of sales
To analyze the relationship between fixed cost and variable cost
 To predict the effect on profitability if changes in cost and efficiency
21
 Graphical representation of the breakeven analysis:

22
 Costs classification
 When you spend your money for salaries, services, materials,
logistics, promotion or other, this is considered a COST.
 Costs can be classified as the following:
 Fixed costs: remain constant in total (not per unit) regardless of
the volume of production or sales, over a relevant range of
production or sales.
 Rent and salaries are typically fixed costs.
 Variable costs: fluctuate in total (not per unit) as the volume of
production or sales fluctuates.
More production means more raw material cost.
Direct labor costs, direct material costs used in production, and sales
commissions are examples of variable costs.
 Mixed costs: contain elements of fixed and variable costs. Costs of
23
supervision and inspections are often mixed costs.
 The fundamental accounting equation
Profit = Revenues - Costs
Revenue = SP*units sold
Where:
SP = selling price
Costs = FC + VC(units sold)
where: FC = fixed cost
VC = unit variable costs.
 We are assuming that units manufactured equal units sold
 In Break-even analysis (profit=0):
Total Revenue = Total Costs
Total Revenue (TR)= Price per unit x Number of units sold
24
  If we want to know how much product we must sell to
break even?
The breakeven point is the point where profit is zero
So; Profit /Loss = 0
= Revenue - Cost
= SP*units sold - FC - VC*units sold
= (SP - VC)*units sold - FC
Units sold = FC/(SP - VC)
 Demerits of Break Even analysis
 It is only a forecast!
 Assumes all products are made AND sold
 Assumes that sales prices are constant at all levels of output
 Costs may change
25
 It can only apply to single product or single mix of products
 Characteristics of small business finance
1. High proportion of working funds:
Due to labor-intensive technology, a large proportion of total
funds are required in the form of liquid assets.
2. High gearing:
Generally, the ownership funds of the small-scale entrepreneur
are limits.
Depend on a great extent on borrowed funds.
[Link] control:
The entrepreneur wants to control the enterprise.
4. Low credit standing:
The credit worthiness of a new small entrepreneur is generally low.
5. Poor documentation:
 A small-scale entrepreneur is rarely familiar with legal
26
formalities involved in financing the business.
 Source of finance

27
 Source of Finance

28
 Internal sources (Equity capital)
 Owners capital /owners equity: represent the personal
investment of the owner or owners in a business.
it is sometimes called risk capital.
i.e. These investors assume the primary risk of losing their
funds if the business fails.
 It requires no repayment in the form of debt and much safer
for new ventures than debt financing.
 It also requires sharing the ownership and profits with the
funding sources.

29
 Source of equity capital
1. Personal savings
 The entrepreneurs should take for start up money is in their
own pockets /their pool of personal savings.
 It is the least expensive source of funds available.
 As a general rules, entrepreneurs should expect to provide at
least half of the start up funds in the form of equity capital.
 If the entrepreneur is not willing to risk his own money
potential investors are not likely to risk their money in the
business.
2. Friends and relatives:
 Because of their relationships with the founder, these people
30
are most likely to invest.
 Source of equity capital
But having them invest can lead to controversy if their
participation is not clear to everyone.
 To avoid such problems, entrepreneur must honestly
present the investment opportunity.
3. Angels
 Angels: are; private investors , wealthy individuals, often
entrepreneurs, who invest in business start ups in exchange for
equity stakes in the companies.
 Angels: are a primary source of start up capital for companies
in the embryonic stage through the growth stage and their roles
in financing small business and significant.

31
 Source of equity capital
4. Partners:
Whenever an entrepreneur gives up equity in his/her
business (through what ever mechanisms), he/she runs the
risk of losing control over it.
As the founder’s ownership is a company becomes
increasingly diluted, the probability of losing control of its
future directional and the entire decision making process
increases.

32
 Source of equity capital
5. Venture capital companies
 Venture capital companies: are private, for profit
organizations that purchases equity positions in young
businesses if they believe young businesses have high growth
and high profit potential.
They provide start up (seed money) capital to new ventures,
 Development funds to businesses in their early growth stage,
and
 Expansion funds to rapidly growing ventures that have the
potential to go public or that need capital for acquisitions.
 Two things make a deal attractive to venture capitalists:
 high returns and
33  profitable exit strategy.
 Source of equity capital
6. Public stock sale (going public)
 Entrepreneurs can go public by selling shares of stock in their
corporation to outside investors.
 This is an effective method of raising large amounts of capital,
but it can be an expensive and time consuming process
 Going public is not for every business.
In fact, most small companies do not meet the criteria for
making a successful public stock offering.
 It is almost impossible for a start up company with no track
record of success to raise money with a public offering.

34
 Advantages and disadvantages of going public
1. Advantages of going public
 Size of capital amount:
fastest ways to raise large sum of capital in a short period of
time.
Liquidity:
provides liquidity for owners since they can readily sell their
stock.
Value:
the market place puts a value on the company’s stock
Image:
corporation often is stronger in the eyes of suppliers,
financers and customers.
Attracting and retaining key employees:
35 to attract and retain quality employees.
 2. Disadvantage of going public
Costs:
 High expenses involved in public offering than other sources of capital.
Dilution of founder’s ownership:
 Entrepreneur sells stock to the public, they automatically dilute their
ownership in the business.
Loss of control:
 If enough shares are sold in the public offering, the founder risks losing
control of the company
Disclosure:
 Detailed disclosure of the company’s affairs must be made public
information that was once private must be available for public scrutiny.
Shareholder pressure:
 Management decisions are sometimes short term in nature for good
record to earnings and dividends the shareholders.
 This pressure can lead to a failure to give adequate consideration to the
36
company’s long-term growth and improvement.
 B. External source (Debt capital)
 Borrowed capital or debt capital is the external
financing that a small business owner has;
 borrowed and
repay with interest.
 Small enterprises have few choices than large firm
for obtaining debt financing.

37
 B. External source (Debt capital)
1. Commercial banks
 In most cases commercial banks give;
Short-term loan (repayable with in one year or less) and
 Medium term loan (maturing in above one year but less than five
years) as a working capital.
 Long term loans (maturing in more than five years)
 for the;
 purchase of property and
 purchase equipment project loan with the purchased asset
or the project itself serving as collaterals.

38
 B. External source (Debt capital)
Unsecured and secured loans
 Unsecured loan is a loan in which collateral is not requested.
 The loan is granted against personal guarantee or corporate customers
of the bank.
 Unsecured loans will have high interest charges and not
necessarily applicable by all banks
 Secured loans are those with security pledged to the bank as
assurance that the loan will be paid.
 To secure a bank loan, an entrepreneur typically will have to answer
a number of question,
 What do you plan to do with the money (credit facility)?
 How much do you need?
 When do you need it?.
 How long will you need it?
39  How will you repay the loan?
 B. External source (Debt capital)
 Bank lending decision
 Most bankers governed by the five C’s of credit in making
lending decision.
The five C’s are;
Capital
Capacity
Collateral
Character and
Conditions

40
 Cont…
 There are some reasons that forces entrepreneurs to
look beyond the bank:
1. To Acquire More money.
2. To improve networking and community visibility
3. To support innovation
4. To Reduce Dependence on advantage.
5. To Overcome Bank’s Conservatism
6. To accommodate the diversity of the small business sector.
7. To nourish success.
8. To Forestall failure
9. To finance substantive growth.
41
 B. External source (Debt capital)
2. Trade credit
 Trade credit: is the credit given by suppliers who sell goods
on account.
 Getting suppliers to extend credit in the form of delayed
payments
 Usually much easier for a small business than obtaining bank
financing.
 This credit is reflected on the entrepreneur’s account payable
and it must be paid in 30 to 90 days or more days interest free
because of its ready availability

42
 B. External source (Debt capital)
3. Equipment suppliers
 Most equipment vendors encourage business owners to
purchase their equipment by offering to finance then
purchase
 In some cases, the vendors will repurchase equipment for
salvage value at he end of its useful life and offer the business
owner another credit agreement on new equipment.

43
 B. External source (Debt capital)
4. Commercial finance companies:
 when denied a bank loan, small business owner often looks to a
commercial finance company for the same type of loan.
 Commercial finance companies depend on collateral to
recover most of their losses.
5. Accounts receivable financing
 Short term financing that involves either the pledge of
receivables as collateral for a loan or the sale of receivables
(factoring).
 Account receivable bank loans are made on a discounted value of the
receivables pledged.

44
 B. External source (Debt capital)
6. Credit Unions:
Credit unions are non-profit financial cooperatives that
promote savings and provide credit to their members, are
best known for extending loans.
7. Insurance Companies:
 Insurance companies offer two basic types of loan:
 Policy Loans and
 Mortgage Loans
 Policy loans are extended on the basis of the amount of money
paid through premiums into the insurance policy.
 Mortgage loans are based primarily on the value of the real
property being purchased.

45
 B. External source (Debt capital)
8. Bonds
 A bond: is long-term contract the borrower, agrees to
make principal and interest payments on specific dates to
the holder of the bond.
 Bonds are a popular source of debt financing for large
companies.

46
 Control of Finance Resources
what is financial control
 Financial control: is the control of financial resources, Such
as financial resources
 Flow into the organization(e.g. revenues, share holder
investments etc.)
Held by the organization,( i.e. working capital, retained
earnings) and
Flow out of the organization (i.e.., Salaries, bills payable etc.)
 Companies: must manage their finance. so that
revenues are sufficient to cover the cost and
earn profits to the firm’s investors as a return on
investment
47
 Characteristics of Effective control of Finance
 The most general characteristics of effective
controls finance resources are:
1. Focus on critical control points
2. Integration
3. Acceptability
4. Timeliness
5. Economic feasibility
6. Accuracy
7. Comprehensibility

48
 Kinds of financial controls
1. Financial statements
 Balance Sheet:
shows the firms financial position at a particular instant in time.
 a financial “ snapshot” profile of the organization.
 Income statements:
 profit &loss account or revenue & expenses:
 shows the firm’s financial performance over a period of time
(usually three months or a year)
 Cash flow statements :
shows where funds come from? (net profit plus depreciation,
increased debt, sale of stock, sale of assets) and
what they are used for (plant and equipment, debt reduction,
stock repurchase, and dividends)
49
 Kinds of financial controls
3. Financial audits:
 Audits: are investigations of an organization's activities to
verify their correctness and identify any need for
improvement.
i.e. External audits;
Internal audits
4. Cost accounting
Standard costing
Activity-based costing
5. Budgets
 This also used to control finance by budgeting money for special needs
50 expressed in financial or numerical terms.
 Budgetary control of finance
Budget control: it is the statement of planned allocation of
resources expressed in financial or numerical terms.
 Types
 Capital budgets: is a statement of planned expenditure of funds for
facilities and equipment.
 Also known as capital expenditure budget.
 Operating budgets: is a statement of planned income and expense of
a business or a unit.
 Also known as revenue and expense budget.
Other types of Budgets:
 Time, space, material, and production budgets
 Fixed budget  Cash budget and
 Variable budget  Profit budgets
51
 Accounting
 Proper financial and accounting records make it
possible for the owner to
 exercise effective control of funds and
 overall performance of his business.
 Such records also make it possible to know whether the firm
is earning profits or loss.
 Accounts also help to know the financial position of the
business at any time and at the end of the year.

52
 Business Transaction And Accounting Equation
 A business transaction is the occurrence of an event or condition
that must be recorded.
Examples;
 payment of a monthly telephone bill,
 purchase of merchandise on credit and
the acquisition of land and a building ; are examples of business
transactions.
 A particular business transaction may lead to an event or a condition
that results in another transaction.
For example,
 The purchase of merchandise on credit will be followed by
payment to the creditor, which is another transaction.
 These events must be recorded.
53
 Accounting Equation
 Assets: are the properties owned by a business enterprise or
any thing owned by a business enterprise.
 Equities, the rights or claims to the properties
 The sum of assets is equal to sum of equities.
 Equities may be subdivided into two principal types:
the rights of creditors and
the rights of owners.
 The rights of creditors represent debts of the business and
are called creditor’s equities or liabilities.
 The rights of owner or owners are called owner’s equity or
owner’s capital.
54
 Accounting Equation
 Expansion of the equation to give recognition to the
two basic types of equities yields the following, which is
known as the accounting equation:
Assets = equities
Assets = creditor’s equities owner’s equities
Assets = liabilities + capital
 It is customary to place “liabilities“ before “owner’s
equity” in the accounting equation because creditors have
preferential rights to the assets.

55
 Accounting Equation
 Assets: any physical thing (tangible) or right (intangible) that has a
monetary value is an asset.
 Assets: are customarily divided into two:
1. Current assets and
2. Plant assets
 Current assets: are cash and other assets.
Example: cash, accounts receivable, notes receivable, supplies, prep
aid expenses, stock (inventory), etc.
 Plant assets: are tangible assets used in the businesses that are of a
permanent or relatively fixed nature. It is also known as fixed assets.
Example: equipment, machinery, building, vehicles and land
56
 Accounting Equation
Owner equity:
 For a corporation, owner’s equity is frequently called
stockholders equity, shareholder’s equity or stockholder’s investment.
Capital: is the owner’s equity in a sole proprietorship and
partnership
Capital stock: represents the investment of the stockholders.
Expense: costs that have been consumed in the process of
producing revenue are expired costs or expenses.
It results in a decrease in capital.
Example: Wages expense, rent expense, supplies expense,
57 utilities expense, etc.
 Accounting Equation
Preparation of financial statements
 For sole proprietorship, partnership and corporation the financial
statements prepared are almost the same.
 The major difference is in the capital section of the balance sheet.
 The capital section of these enterprises indicates
 the name of the owner, and partners
 the capital stock (common stock)/or the preferred stock
Preparation of the income statement (profit or loss statement)
 Income statement: a summary of the revenue and the expenses
of a business entity for a specific period of time, such as a month or
a year.
58
 Accounting Equation
ABC trading
Income statement
For month ended December 31, 2004
Sales 10,000
 Operating expenses:
Wages expense 3,000
Rent expense 2,000
Suppliers expense 2,000
Utilities expense 750
Miscellaneous expense 250
 Total operating expense 8,000
 Net income 2,000
59  Net Profit: the excess of the revenue over the expenses incurred.
 Accounting Equation
Preparation of the statement of owner’s equity
Statement of owner’s equity is a summary of the changes in
the owner’s equity of a business entity that have occurred during
a specific period of time such as a month or a year.
ABC trading
 Statement of owner’s equity
For month ended December 31, 2004
Investment during the month 15,000
Net income for the month 2,000
Less withdrawals 500
Increase in owner equity 1,500
 Mr. X, Capital, December 31,2004 16,500
60
 Accounting Equation
Preparation of balance sheet
 Balance sheet: is a list of
assets,
liabilities and
owner’s equity of a business entity as of a specific date,
usually at the close of the last day of a month / year.

61
 Accounting Equation
ABC trading
Balance sheet, December 31, 2004
 Assets
Cash 10,000
Supplies 1,000
Land 8,000
Total asset 19,000
 Liabilities
Accounts payable 3,000
 Owner’s equity
Mr. X, capital 16,500
Total liabilities and capital 19,500
62
 Accounting Equation
Statement of cash flows
 Statement of cash flows: is a summary of the cash receipts
and cash payments of a business entity for a specific period of
time, such as a month or a year.
 It is customary to report cash flows (cash receipts and cash
payments) in three sections:
1. Operating activities
2. Investing activities, and
3. Financing activities

63
 Accounting Equation
ABC trading, Statement of cash flows
Four month ended December 31,2004
 Cash flows from operating activities:
Cash received from customers 10,000
Less cash payments for expense and payments to creditors 7,300
Net cash flow from operating activities 2,700
 Cash flows from investing activities:
Cash payments for acquisition of land 8,000
 Cash flows from financing activities:
Cash received as owner’s investment 15,000
Less cash withdrawal by owner 500
Net cash flow from financing activities 14,500

64 Net cash flow and December 31,2004 cash balance 9,200
65