The New Venture Business Plan part 4 12

Looking Ahead After studying this chapter, you should be able to: 1. Describe the purpose and content of the income statement and the balance sheet. 2. Compute a firm’s cash flows. 3. Forecast a new venture’s profitability. 4. Estimate the assets needed and the financing required for a new venture. Copyright © by South-Western College Publishing. All rights reserved. 2

Understanding Financial Statements • Financial Statements (Accounting Statements) – Reports of a firm’s financial performance and resources, including an income statement and a balance sheet ØHelps determine a startup’s financial requirements ØAssesses the financial implications of a business plan Copyright © by South-Western College Publishing. All rights reserved. 3

Understanding Financial Statements • Income Statement – A report showing the profit or loss from a firm’s operations over a given period of time. – “How profitable is the business? ” – Sales – Expenses = Profits ØRevenue from product or service sales ØCosts of producing product or service ØOperating expenses (marketing, selling, general and administrative expenses, and depreciation) ØFinancing costs (interest paid) ØTax payments Copyright © by South-Western College Publishing. All rights reserved. 4

The Income Statement: An Overview Operating Activities Financing Activities Taxes Sales Revenue Operating Income Earnings Before Taxes – Cost of producing or acquiring product or service (cost of goods sold) = Gross profit – Marketing and selling expenses, general and administrative , expenses and depreciation (operating expenses) – Interest expense on debt (financing costs) = Earnings Before Taxes – Income taxes = Net Income Available to Owners = Operating Income Fig. 12. 1 Copyright © by South-Western College Publishing. All rights reserved. 5

Income Statement for Bates & Associates Leasing Company for the Year Ending December 31, 2002 Sales revenue $850, 000 Cost of goods sold _550, 000 Gross profit $300, 000 Operating expenses: Marketing expenses General and administrative expenses Depreciation Total operating expenses $200, 000 Operating income $100, 000 Interest expense __20, 000 Earnings before taxes $ 80, 000 Copyright © by South-Western College Publishing. All rights reserved. $90, 000 80, 000 _30, 000 Fig. 12. 2 6

The Balance Sheet • Balance Sheet – A report showing a firm’s assets, liabilities, and owners’ equity at a specific point in time – Outstanding debt + Owner’s equity = Total assets Copyright © by South-Western College Publishing. All rights reserved. 7

The Balance Sheet: Types of Assets • Current assets (working capital) – Assets that can be converted to cash within the firm’s operating cycle—cash, accounts receivable, and inventories. • Fixed Assets – Relatively permanent resources intended for the use of the firm. – Net fixed assets = gross fixed assets – accumulated depreciation • Other Assets – Intangible assets (patents, copyrights, goodwill) Copyright © by South-Western College Publishing. All rights reserved. 8

The Balance Sheet: Types of Financing • Debt Capital – Financing provided by a creditor • Short-term (current) Debt ØAccounts payable ØAccrued expenses ØShort-term notes • Long-Term Debt – Loans and mortgages from banks and other lenders with maturities greater than one year Copyright © by South-Western College Publishing. All rights reserved. 9

The Balance Sheet: Types of Financing • Owners’ Equity – Money that the owners invest in the business – Owners are “residual owners” of the firm ØCreditors have first claim on the assets of the firm. Owners’ Cumulative Owners’ cash – = + Equity investment profits withdrawals Owners’ Earnings retained = + Equity investment within Business Copyright © by South-Western College Publishing. All rights reserved. 10

Balance Sheets for Bates & Associates Leasing Company for December 31, 2001 and 2002 2001 2002 Changes $ 45, 000 75, 000 180, 000 $300, 000 $ 50, 000 80, 000 220, 000 $350, 000 $ 5, 000 8, 000 40, 000 $ 50, 000 $790, 000 ( 360, 000) $430, 000 70, 000 $500, 000 $890, 000 ( 390, 000) $500, 000 70, 000 $570, 000 $ 100, 000 ( 30, 000) $ 70, 000 0 $ 70, 000 $920, 000 $120, 000 Assets Current assets: Cash Accounts receivable Inventories Total current assets Fixed assets: Gross plant and equipment Accumulated depreciation Net plant and equipment Land Total fixed assets TOTAL ASSETS $800, 000 Copyright © by South-Western College Publishing. All rights reserved. 11

Balance Sheets for Bates & Associates Leasing Company for December 31, 2001 and 2002 2001 2002 Changes Debt (Liabilities) and Equity Current liabilities: Accounts payable and accruals Short-tern notes Total current liabilities Long-term notes payable Total liabilities Common stock Retained earnings Total stockholders’ equity TOTAL DEBT AND EQUITY Copyright © by South-Western College Publishing. All rights reserved. $ 15, 000 60, 000 $ 75, 000 150, 000 $225, 000 $300, 000 275, 000 $575, 000 $800, 000 $ 20, 000 80, 000 $100, 000 200, 000 $300, 000 320, 000 $620, 000 $920, 000 $ 5, 000 20, 000 $ 25, 000 50, 000 $ 75, 000 $ 0 5, 000 $ 45, 000 $120, 000 12

Assets Current Assets Cash Accounts receivable Inventories + Debt (Liabilities) and Equity (Net Worth) Debt Capital Current Debt Accounts payable Accrued expenses Short-term notes Long-term Debt Long-term notes Mortgages Fixed Assets Machinery and equipment Buildings and land + Other Assets Long-term investments, patents + Owner's Equity Owner's net worth or Partnership equity or Common stock equity = Total Assets The Balance Sheet: An Overview = Total Debt and Equity Fig. 12. 3 Copyright © by South-Western College Publishing. All rights reserved. 13

Determining Cash Flow: Key Terms • Accrual-Basis Accounting – A method of accounting that matches revenues when they are earned against the expenses associated with those revenues. • Cash-Basis Accounting – A method of accounting that reports transactions only when cash is received or a payment is made. Copyright © by South-Western College Publishing. All rights reserved. 14

Determining Cash Flow: Key Terms • Depreciation Expense – Costs related to a fixed asset, such as a building or equipment, distributed over its life. • Sustainable Growth – Growth that can be financed from the cash flows generated from operating the business. Copyright © by South-Western College Publishing. All rights reserved. 15

The Fit of the Income Statement and the Balance Sheet Income statement reports the profits from January 1, 2002 through December 31, 2002 January 1 2001 Balance Sheet Reports a firm's financial position at beginning of 2002 (end of 2001) December 31 2002 Balance Sheet Reports a firm's financial position at end of 2002 Fig. 12. 5 Copyright © by South-Western College Publishing. All rights reserved. 16

Computing Cash Flows from Assets After-Tax Cash Flows from Operations Changes in Operating Working Capital Cash Flows from Assets Cash After-tax cash flows from = from operations assets Investments in operating working capital Changes in Long-Term Assets Investments in long-term assets Fig. 12. 6 Copyright © by South-Western College Publishing. All rights reserved. 17

Computing Other Cash Flows • After-Tax Cash Flows From Operations After-tax cash = Net income flows from operations + Depreciation expense + Interest Expense • Operating Work Capital Operating Working Capital = Current assets Copyright © by South-Western College Publishing. All rights reserved. – Account payable and accruals 18

Cash Flows from Financing Increase in Debt Increase in Equity (firm issues new debt) (firm issues new stock) Increases in Cash Flows from Financing Decreases in Cash Flows from Financing Interest and Dividends Decrease in Debt Paid to Investors (firm repays debt) Decrease in Equity (firm repurchases outstanding stock) Fig. 12. 7 Copyright © by South-Western College Publishing. All rights reserved. 19

Financial Forecasting • Pro forma Financial Statements – Reports that provide projections of a firm’s financial position – Purposes of pro forma statements ØHow profitable can the firm be expected to be, given the projected sales levels and the expected sales expense relationships? ØWhat will determine the amount and type of financing (debt or equity) to be used? ØWill the firm have adequate cash flows? If so, how will they be used; if not, where will the additional cash come from? Copyright © by South-Western College Publishing. All rights reserved. 20

Forecasting Profitability • Net Income Depends On: – Amount of sales – Cost of goods sold and operating expenses – Interest expense – Taxes “If we’re doing so well, then why am I always so broke? ” Copyright © by South-Western College Publishing. All rights reserved. 21

Forecasting Assets and Financing Requirements • Estimating Asset Requirements – Use industry ratios for assets-to-sales – Use breakeven analysis and empirical data • Percentage-of-Sales Technique – Forecasting asset investment and financing requirements using a percentage of the total sales for a firm as the basis forecasting the level of assets to be held by a firm. Copyright © by South-Western College Publishing. All rights reserved. 22

Assets-to-Sales-Financing Relationships Increase in Sales Results in Increase in Asset Requirements Results in Increase in Financing Requirements Fig. 12. 9 Copyright © by South-Western College Publishing. All rights reserved. 23

Ratio Analysis • Liquidity – The degree to which a firm has working capital available to meet maturing debt obligations. • Current Ratio – The firm’s relative liquidity, determined by dividing current assets by current liabilities • Debt Ratio – Debt as a fraction of assets; total debt divided by total assets. ØSpontaneous financing—debts such as accounts payable that increase as the firm grows. Copyright © by South-Western College Publishing. All rights reserved. 24

Sources of Equity Capital • External Equity – Owners’ original investment • Internal Equity – Profit retention (retained profits) • Forecasting financial requirements (in total) Total asset requirements = Profits Total Spontaneous retained sources of = financing within the financing business Copyright © by South-Western College Publishing. All rights reserved. + + External sources of financing 25