Summary Chapter 8

Chapter 8
Assessing a New Venture’s Financial Strength and Viablity

Financial Objective of a Firm

Most entrepreneurial firms-whether they have been in business for several years or they are starts up- have four main financial objective:

1.      Profitability : Ability to earn a profit. A firm must become profitable to remain viable and provide a return to its owners.

2.      Liquidity : A company’s ability to meet its short-term financial obligations. And even if a company is profitable, but still we should keep a close watch on account receivable and inventories. The reason why company should watch the account receivable because the money owed to it by its customers. And the inventories is its merchandise, raw materials, and product waiting to be sold.

3.      Efficiency : How productively a firm utilizes its assets relative to its revenue and its profits.

4.      Stability : The strength and vigor of the firm’s overall financial posture. For a firm to be stable, it must not only earning a profit and remain liquid but also keep its debt in check. If a firm continues to borrow from its lender and its debt to equity ratio, which is calculated by dividing its long term debt by its shareholders equity, get too high it may have trouble meeting its obligation securing the level of financing needed to fuel its growth.

The Process of Financial Management

A financial statement is a written report that quantitative describes a firm’s financial health. The income statement, the balance sheet, and the statement of cash low are the financial statements entrepreneurs use most commonly.

Forecasts are an estimate of a firm’s future income and expenses, based on its past performance, its current circumstances, and its future plans. New ventures typically base their forcasts on an estimate of sales and then on industry averages or the experiences of similar start ups regarding the cost of goods sold and on 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 a firm’s financial management:

1.      Tracking the company’s past financial performance through the preparation and analysis of financial statements.
These statements organize and report the firm’s financial transactions and it also help the firm to discern how it stacks up against its competitors and industry norms.

2.      Preparing forecast for two to three years in the future.

3.      Preparation of Pro Forma Financial Statements

4.      Ongoing analysis of a firm’s financial results.

Financial ratios is in which depict relationships between items on a firm’s financial statements, are used to discern whether a firm is meeting its financial objectives and how it stacks up against its industry peers.

Financial Statements

Historical financial Statements

Reflect past performance and are usually prepared on a quarterly and annual basis. Publicly traded firms are required by the Security and Exchange Commission (SEC) to prepare financial statements and make them available to the public.

Historical financial statements include the income statement, the balance sheet, and the statement of cash flows. The statements are usually prepared in this order because information flows logically from one to the next.

a.       Income statements : reflects the results of the operations of the firm over a specified period of time. It records all the revenues and the expenses for the given period and shows whether the firm is making a profit or is experiencing a loss. Income statements are typically prepared on a monthly, quarterly, and annual basis. And the most income statements are prepared in a multiyear format, making it easy to spot trends.
There are 3 numbers that receive the most attention when evaluating an income statement:
1. Net Sales: consist of total sales minus allowances for returned goods and discounts.
2. Cost of Sales (or cost of goods sold): includes all the direct costs associated with producing or delivering a product or service, including the material costs and direct labor.
3. Operating expenses: include marketing, administrative costs, and other expenses not directly related to producing a product or service.

b.      Balance Sheet : a snapshot of a company’s assets, liabilities, and owner’s equity at a specific point in time. The balance sheet must always balance because that mean a firm’s assets must always equal its liabilities plus owners equity.
The major categories of assets listed on a balance sheet are the following:
1. Current assets
2. Fixed assets
3. Other assets
The major categories of liabilities listed on a balance sheet are the following:
1. Current liabilities
2. Long-term liabilities
3. Owners equity

c.       Statement of cash flows : summarizes the changes in a firm’s cash position for a specified period of time and details why the change occurred. It reveals how much cash is on hand at the end of the month as well as how the cash was acquired and spent during the month.
Statement of cash flows is divided into 3 separated activities:
1. Operating activities
2. Investing activities
3. Financing activities

d.      Ratio Analysis : The most practical way to interpret or make sense of a firm’s historical financial statements is through ratio analysis.

e.       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.

Forecasts

Forecast are predictions of a firm’s future sales, expenses, income and capital expenditures.

a.       Sales Forecast: a projection of a firm’s sales for a specified period, though most firms forecast their sales for two to five years into the future.

b.      Forecast of cost of sales and other items : the most common way to do this is to use the percent of sales method which is a method for expressing each expense item as a percentage of sales. Once a firm completes its forecast using percent of sales method it usually goes through its income statement on an item by item basis to see if there are opportunities to make more precise forecasts.

Pro forma financial statements

Pro forma financial statements are projections for future periods based on forecasts and are typically completed for two to three years in the future. This statements are strictly planning tools and are not required by the SEC. This statements are similar to its historical financial statements except that they look forward rather than track the past.

Pro forma financial statements should not be prepared in isolation instead they should be created in conjunction with the firm’s overall planning activities.

a.       Pro forma income statements: merely a matter of plugging in the numbers. In the pro forma income statements, the constant ratio method of forecasting is used to forecast the cost of sales and general and administrative expenses, meaning that these items are projected to remain at the same percentage of sales in the future as they were in the past.

b.      Pro forma balance sheet : provides a firm a sense of how its activities will affect its ability to meet its short term liabilities and how its finances will evolve over time.

c.       Ratio Analysis: used to evaluate a firm’s historical finance statements should be used to evaluate the pro form financial statements.

It’s extremely important for a firm to understand its financial position at all time and for new ventures to base their financial projections on solid number because regardless of how successful a firm is in other areas, it must succeed financially to remain strong and viable.