Chapter 8
Assessing a New
Venture’s Financial
8-1 Strength and
Viability
Financial Management
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Financial Management
Financial management deals with two things: raising
money and managing a company’s finances in a way
that achieves the highest rate of return
Chapter 9 focuses on raising money. This chapter
focuses primarily on:
How a new venture tracks its financial progress through
preparing, analyzing, and maintaining past financial
statements.
How a new venture forecasts future income and expenses by
preparing pro forma (or projected) financial statements.
Financial Management
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The financial management of a firm deals with questions
such as the following on an ongoing basis:
• How are we doing? Are we making or losing money?
• How much cash do we have on hand?
• Do we have enough cash to meet our short-term obligations?
• How efficiently are we utilizing our assets?
• How do our growth and net profits compare to those of our industry peers?
• Where will the funds we need for capital improvements come from?
• Are
there ways we can partner with other firms to share risk and reduce the
amount of cash we need?
• Overall, are we in good shape financially?
Financial Objectives of a Firm
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Financial Objectives of a Firm
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Profitability
Is the ability to earn a profit.
Many start-ups are not profitable during their first one to three
years while they are training employees and building their
brands.
However, a firm must become profitable to remain viable and
provide a return to its owners.
Liquidity
Is a company’s ability to meet its short-term financial
obligations.
Even if a firm is profitable, it is often a challenge to keep
enough money in the bank to meet its routine obligations in a
timely manner.
Financial Objectives of a Firm
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Efficiency
Is how productively a firm utilizes its assets relative to
its revenue and its profits.
Southwest Airlines, for example, uses its assets very
productively. Its turnaround time, or the time its airplanes
sit on the ground while they are being unloaded and
reloaded, is the lowest in the airline industry.
Stability
Is the strength and vigor of the firm’s overall financial
posture.
For a firm to be stable, it must not only earn a profit and
remain liquid but also keep its debt in check.
The Process of Financial Management
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Importance of Financial Statements
To assess whether its financial objectives are
being met, firms rely heavily on analysis of
financial statements.
A financial statement is a written report that
quantitatively describes a firm’s financial health.
The income statement, the balance sheet, and the
statement of cash flows are the financial statements
entrepreneurs use most commonly.
Forecasts
Are an estimate of a firm’s future income and
expenses, based on past performance, its current
circumstances, and its future plans.
The Process of Financial Management
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Forecasts (continued)
New ventures typically base their forecasts on an
estimate of sales and then on industry averages or
the experiences of similar start-ups regarding the
cost of goods sold and other expenses.
Budgets
Are itemized forecasts of a company’s income,
expenses, and capital needs and are also an
important tool for financial planning and control.
The Process of Financial Management
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Financial Ratios
Depict relationships between items on a firm’s
financial statements.
An analysis of its financial ratios helps a firm
determine whether it is meeting its financial
objectives and how it stacks up against industry
peers.
Importance of Financial Management
Many experienced entrepreneurs stress the
importance of keeping on top of the financial
management of the firm.
The Process of Financial Management
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Financial Statements
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Historical Financial Statements
Reflect past performance and are usually prepared on a
quarterly and annual basis.
Publicly traded firms are required by the SEC to prepare
financial statements and make them available to the public.
Pro Forma Financial Statements
Are projections for future periods based on forecasts
and are typically completed for two to three years in
the future.
Pro forma financial statements are strictly planning tools and
are not required by the SEC.
Importance of Keeping Good Records
8-12
The first step toward prudent
financial management is
keeping good records.
New Venture Fitness Drinks
8-13
New Venture Fitness Drinks
To illustrate how financial statements are prepared, we
used New Venture Fitness Drinks, the fictitious sports
drink company introduced in Chapter 3.
New Venture Fitness Drinks has been in business for five
years.
Targeting sports enthusiasts, the company sells a line of
nutritional fitness drinks.
The company’s strategy is to place small restaurants, similar
to smoothie restaurants, near large outdoor sports
complexes.
The company is profitable and is growing at a rate of 25%
per year.
Historical Financial Statements
8-14
Three types of historical financial statements
Financial Statement Purpose
Reflects the results of the operations of a firm over a
Income Statement specified period of time. It records all the revenues and
expenses for the given period and shows whether the
firm is making a profit or is experiencing a loss.
Balance Sheet Is a snapshot of a company’s assets, liabilities, and
owner’s equity at a specific point in time.
Summarizes the changes in a firm’s cash position for
Statement of cash flows a specified period of time and details why the changes
occurred.
Historical Income Statements
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Historical Balance Sheets
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Assets
Historical Balance Sheets
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Liabilities and Shareholders’ Equity
Historical Statement of Cash Flows
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Ratio Analysis
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Ratio Analysis
The most practical way to interpret or make sense
of a firm’s historical financial statements is
through ratio analysis, as shown in the next slide.
Comparing a Firm’s Financial Results to
Industry Norms
Comparing a firm’s financial results to industry
norms helps a firm determine how it stacks up
against its competitors and if there are any
financial “red flags” requiring attention.
8-
Ratio Analysis – Profitability
20 Ratios
Return on Assets:
Investors can use ROA to find stock opportunities because the ROA
shows how efficient a company is at using its assets to generate
profits.
A ROA that rises over time indicates the company is doing well at
increasing its profits with each investment dollar it spends
Return on Equity:
The return on equity, or ROE, is defined as the amount of profit or
net income a company earns per investment dollar. It reveals how
much profit a company earns with the money shareholders have
invested.
Profit Margin
Profit margin is the ratio of profit remaining from sales after all
expenses have been paid.
8- Ratio Analysis – Liquidity Ratios
21
Current Ratio & Quick Ratio
Both the current ratio and the quick ratio are considered liquidity
ratios, measuring the ability of a business to meet its current debt
obligations. The current ratio includes all current assets in its
calculation, while the quick ratio only includes quick assets or liquid
assets in its calculation.
8- Ratio Analysis – Stability Ratios
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Debt Ratio
Debt Ratio is a financial ratio that indicates the
percentage of a company's assets that are provided
via debt.
Debt to Equity Ratio
The debt-to-equity ratio is a financial ratio indicating
the relative proportion of shareholders' equity and
debt used to finance a company's assets.
A ratio greater than 1 implies that the majority of the
assets are funded through debt. A ratio less than 1
implies that the assets are financed mainly through
equity. A lower debt to equity ratio means the
company primarily relies on wholly-owned funds to
leverage its finances
Historical Ratio Analysis
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Forecasts
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Forecasts
The analysis of a firm’s historical financial
statements are followed by the preparation of
forecasts.
Forecasts are predictions of a firm’s future sales,
expenses, income, and capital expenditures.
A firm’s forecasts provide the basis for its pro forma
financial statements.
A well-developed set of pro forma financial
statements helps a firm create accurate budgets, build
financial plans, and manage its finances in a proactive
rather than a reactive manner.
Forecasts
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Sales Forecast
A sales forecast is a projection of a firm’s sales for a
specified period (such as a year).
It is the first forecast developed and is the basis for most of
the other forecasts.
A sales forecast for a new firm is based on a good-faith estimate of
sales and on industry averages or the experiences of similar start-
ups.
A sales forecast for an existing firm is based on (1) its record of
past sales, (2) its current production capacity and product demand,
and (3) any factors that will affect its future product capacity and
product demand.
Pro Forma Financial Statements
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Pro Forma Financial Statements
A firm’s pro forma financial statements are similar
to its historical financial statements except that
they look forward rather than track the past.
The preparation of pro form financial statements
helps a firm rethink its strategies and make
adjustments if necessary.
The preparation of pro forma financials is also
necessary if a firm is seeking funding or
financing.
Class Balance Sheet of M/s XYZ & M/s ABC Company:
Assets XYZ ABC
Activity Long Term Assets
Account Receivables
200,000
100,000
300,000
200,000
Other Non Current Assets 50,000 75,000
Inventory 50,000 100,000
Cash 50,000 50,000
Total Assets 450,000 725,000
Liabilities
Calculate ROA, ROE, Profit Margin, Capital 200,000 300,000
Account Payables 100,000 100,000
Current Ratio, Quick Ratio, Debt Other Short Term Expenses 50,000 100,000
Ratio, Debt to Equity Ratio of both Long Term Debt 100,000 225,000
Total 450,000 725,000
companies and compare their
Income Statement of M/s XYZ & M/s ABC Company:
financial performance against each
ratio with interpretation.. Particulars XYZ ABC
Sales 200,000 300,000
Cost of Goods Sold 100,000 150,000
Gross Profit 100,000 150,000
Selling & Distribution Expenses 30,000 50,000
Depreciation 10,000 10,000
Earning before Interest and Tax 60,000 90,000
Interest 10,000 20,000
Earning before Tax 50,000 70,000
Taxes 20,000 28,000
Net Income 30,000 42,000