Financial statements. S643: Digital Entrepreneurship Spring 13

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1 Financial statements I. Understanding financials What is a financial plan? Types of financing and capital II. Developing a financial statement What goes into it? How do you make projections? III. Pricing the product or service Pricing strategies

2 I. Understanding financials Financial forecasts are the core of most business plans and usually the starting point in their preparation They express intentions in terms of profit and cash Uses assumptions about what will happen in the future which cannot be substantiated at present The amount and type of financial information needed depend on the company s stage of development A mature company will be expected to have and use historical data A new company will describe in general terms the type and amount of funding being requested

3 I. Understanding financials What is a financial plan? It is a statement that outlines the financial requirements needed to achieve the goals of the business plan It is a quantified vision of your project upon which much of your credibility with investors will rest - get it right and you will give them confidence Innovateur It should be based on other information in the business plan It will be carefully read and analyzed

4 I. Understanding financials Financial statements are the core of the business plan s financial information section They present both the company s past results and its forecasts for the future future For companies seeking additional financing, investors want to see balance sheets, income statements, and 3 year cash-flow statements, 5 year cash flow, income statements, and balance sheet forecasts For companies seeking seed capital, investors want to see sales forecasting, information on cost of operations, selling and administrative costs, and cash flow

5 I. Understanding financials Key questions: Have you carefully analyzed current and historical financial statements to explain results to investors and to form the foundation for the projections? Are assumptions consistent with the results of the market analysis and the other sections of the business plan? Given the current stage of the business, what type of financing is needed? Who will provide the financing? When and in what amounts will financing be needed?

6 I. Understanding financials Key questions: In what form (or forms) will financing be needed? Have you completed several different financial projections to understand the impact of different scenarios on the key financial metrics of your business? How will you use the funds obtained? How do you plan to finance further company growth? What is a realistic plan for repaying creditors and/or investors? What is the exit strategy?

7 I. Understanding financials Key components: Profit and loss statement: shows underlying profitability of the operation and focuses on operating performance Cash flow statement: shows movement and use of capital to fund operations in the P&L account Acquisition or disposal of assets in the balance sheet Balance sheet: statement of assets and liabilities at a point in time Money owed to creditors, the bank (loans), fixed assets (equipment, land...), owed by customers, investment by shareholders...

8 I. Understanding financials What is needed to develop the plan Operating plans and budgets Sales forecasts: product/service revenues Marketing budget Historical financial statements and budgets Published financial data for industry overview Operating policies Personnel policies: vacations, benefits, healthcare Inventory and purchasing procedures Credit practices

9 I. Understanding financials Forms of financing Debt financing: funds borrowed from a creditor under a legal contractual agreement Stipulates terms of borrowing and repayment Legally limits the involvement and influence of the creditor in the firm Short-term: credit extended by suppliers and short term loans for purchase of goods This obligation is a current liability Long-term: typically 15 or 30 years This obligation is a long-term liability

10 I. Understanding financials Equity financing Investor has ownership interest in the business in exchange for the investment May be cash or stock purchases Assumed to continue for the life of the firm with returns reinvested in the firm Internal financing Funds from normal operations remaining after creditors, taxes and (perhaps) shareholders are paid May be additional investment by the owners

11 I. Understanding financials Types of financing Seed money: used to develop and refine the business concept Could fund a prototype or meet start-up costs Not easy to find because the business is new and unproven Start-up capital: short-term working capital that gets the business up and running (initial operations) Long-term capital to support human and operational resources Also difficult to obtain because of the risk to investors

12 I. Understanding financials A successful argument for seed and start-up capital emphasizes that There is evidence of market acceptance of the concept There is evidence of potential for commercial success There is potential for large scale returns on investment The management team has excellent credentials in the industry The problem to overcome is that short term loans to a new business are very high risk This is when pitches to venture capitalists become very important

I. Understanding financials Working capital: short-term financing to cover costs of recurring accumulation of assets Inventory, accounts receivable Expected to turn into

13 I. Understanding financials Working capital: short-term financing to cover costs of recurring accumulation of assets Inventory, accounts receivable Expected to turn into cash flow at the end of a cycle Money provided by commercial banks Trade creditors will extend credit anticipating future payment

14 I. Understanding financials Venture capital is a type of private equity used for the launch, early development or expansion of a business Provides equity capital to enterprises not publicly held Can be used to develop new products and technologies To expand working capital To make acquisitions To improve a company s operations Can be used to resolve ownership and management issues (succession in family-owned companies) or the buy-out or buy-in by experienced managers

15 I. Understanding financials Venture capital involves investments in unquoted companies Is considered equity capital Is medium to long-term and targeted at companies with growth potential Is combined with an active shareholder influence by the investor Money comes from private and institutional investors Managers are in charge of the funds VCs provide clients with management skills, contacts, market access and even external managers

16 I. Understanding financials VC deals have been increasing since 09

I. Understanding financials How the process works www.themanager.

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I. Understanding financials How the process works II www.themanager.

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19 I. Understanding financials An overview of venture capital funding Efiltro. New Idea Center. (2003). Developing new business in new markets. newideacenter.com/home/ Disclaimer.htm

20 Financial statements I. Understanding financials What is a financial plan? Types of financing and capital II. Developing a financial statement What goes into it? How do you make projections? III. Pricing the product or service Pricing strategies

21 II. Developing a financial statement What goes into it? Break even analysis Work with the main variables to understand how they interact and affect profit Fixed costs and overhead: main costs incurred regardless of business activity They are fixed within a period of time Human resources: staff, stationery, insurance, lawyer, accountant Other resources: mortgage, rent, utilities, insurance

22 II. Developing a financial statement Break even analysis Variable costs: costs that vary directly with changes in business activity The material costs to produce a single unit Each unit incurs these costs - 10 will incur 10 lots of this cost Sales price: the price you expect to sell the good or service Sales volume: the number of units you expect to sell to cover your costs Profit: the point at which revenues exceed expenses

23 II. Developing a financial statement Calculate the break even point Unit price 20 Unit costs 5 Fixed costs 1000 BE point (units) Must sell 67 units BE point (revenue) Must generate $1,333 BE point (units) = fixed costs/(unit price - unit costs) BE point (revenue) = fixed costs/((unit price - unit costs)/unit price))

24 II. Developing a financial statement Calculate the price required to break even Unit costs 5 Number of units to sell 67 Fixed costs 1000 Price required to break even $19.93 Price = (fixed costs/(number of units to sell) + unit costs

25 II. Developing a financial statement home.ubalt.edu/ntsbarsh/business-stat/otherapplets/breakevent.gif

26 II. Developing a financial statement Income statement: profit and loss How much money is left after all expenses are paid? Does not provide an overall picture of the business value Begins with sales (revenues) and each subsequent line in the statement represents another cost (expenses) Gross sales: $ Then: employee benefits, depreciation/amortization, office supplies, marketing, travel, entertainment/meals, insurance, professional services, maintenance, communication/computing

II. Developing a financial statement www.

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28 II. Developing a financial statement Cash-flow projections: how much money the company has in the bank Money going in and out of the business on a monthly basis How much is needed to meet all regular expenses Does not indicate profitability Should account for seasonal change, fluctuations in inventory, sales based on credit Should be compiled monthly Separate revenue from business activities from loans or investments

29 II. Developing a financial statement Cash-flow projections also include money coming in Cash sales, collections, interest income, loan proceeds Include money going out Costs of goods, services, operating expenses, owner s draw Include money held back as reserves Net cash flow: money left after disbursements have been deducted from all cash received Opening cash balance: money in the bank at the start of the month (should match last month s cash balance)

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32 II. Developing a financial statement Assumptions are important because they put the numbers into a context The table makes a number of assumptions The average product price will increase annually by 5% The volume sold will increase annually by 15% Depreciation is computed using IRS tables for a 7 year property Tax depreciation is used because it affects the outflow of cash in the form of tax payments Fixed costs will increase by an annual rate of 5% The tax rate is calculated at 34%

33 II. Developing a financial statement Start up expenses: everything contributing to the initial start up of the business Standard start up expenses include The cost of registering your business with the local and federal authorities Set up costs Down payments or deposits on utilities, equipment, rent or land Permits, licenses and fees to join regulatory bodies Inventory

34 II. Developing a financial statement Operating expenses: the cost of day-to-day operations and expenses that are paid every month for the duration of the businesses' life cycle Some standard operating expenses include Wages and salaries Rent, mortgage, lease and utilities, bank and loan fees Advertising, marketing and promotions Office supplies Storage and distribution Maintenance

35 II. Developing a financial statement The bottom line issue is deciding how much capital is needed to get the business up and running - for example Area of expenditure Finance Required Office equipment 20,000 Production tools 50,000 Working capital and stock 40,000 Marketing 50,000 Overhead 100,000 Contingency 40,000 Total financing required 300,000

36 II. Developing a financial statement A related issue is how much of the business equity you are willing to exchange for investment dollars For example Shareholders Pre-financing Post-financing CEO / Founder 50% 40% Other Management 30% 24% Current Investors 20% 16% New Investors 20% Total Equity 100% 100%

37 II. Developing a financial statement A balance sheet provides a snapshot of a business at a specific point in time It lists all assets Current assets: cash, accounts receivable, inventory, prepaid expenses Fixed assets: land, buildings, equipment, furniture, fixtures (less accumulated depreciation) Other assets Total assets

38 II. Developing a financial statement A balance sheet provides a snapshot of a business at a specific point in time It lists all liabilities Current liabilities: accounts payable, accrued payroll, taxes payable, short-term notes payable Long-term liabilities : long-term notes payable Net worth: shareholder equity, retained earnings Total liabilities and net worth Total assets should match total liabilities

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40 II. Developing a financial statement Other financial concerns Handling the money Merchant account Typically with a bank and enables credit card payments to be processed There are usually costs associated with setting up a merchant account Set-up cost, a monthly fee and per-transaction fees A good arrangement: $100 setup, $10 per month and $.30 per transaction fee

41 II. Developing a financial statement Digital certificates To accept payments through your website a digital certificate is needed (Verisign) Also a secure server and secure sockets layer (SSL) Payment information can be encrypted Payment processing For authentication of credit card numbers and passing payments to the bank you use a payment processing service (CyberCash, Paypal) The service that you use may depend on the ISP and shopping cart that you use

42 II. Developing a financial statement Back end processing of orders Many ebusinesses rely on to get orders from their web sites into their order processing departments Typically they are re-keyed into their existing system You can remove intermediate processing and have online orders load directly into the order fulfillment and/or accounting systems Many types of software packages that will do this The tricky part is integrating the web front end with back end legacy systems

43 Financial statements I. Understanding financials What is a financial plan? Types of financing and capital II. Developing a financial statement What goes into it? How do you make projections? III. Pricing the product or service Pricing strategies

44 III. Pricing the product or service Retail cost and pricing Use the manufacturer's suggested retail price Problem: doesn't adequately account for the competition Competitive position Base price on those of small-store competitors and highlight competitive factors, like personalized customer service and convenient location Problem: bigger stores buy in larger volume and their cost per unit is less

45 III. Pricing the product or service Pricing below the competition Provides competitive advantage Problem: reduces profit margin, forces reduction of costs and starts price wars Obtain the best prices possible for merchandise, Locate the business in an inexpensive location Closely control inventory Limit the line to fast-moving items Design advertising to concentrate on price specials Limit other services

46 III. Pricing the product or service Pricing above the competition Good when price is not the customer s greatest concern Service considerations Delivery, speed of service, satisfaction in handling customer complaints, knowledge of product or service, and helpful, friendly employees A convenient or exclusive location Exclusive merchandise Problem: encourages competition

47 III. Pricing the product or service The funding request State how much money you need, why you need it, and what you will do with it Be consistent: the explanation of how you plan to use financing must be consistent with the other forecasts Provide for slippage: when considering the request, allow room for flexibility, so small deviations from the plan don t create a cash squeeze As a new company, explain how you have been capitalized, who the stockholders are, what their positions in the company are, how much stock they own, and how much they paid for it

48 III. Pricing the product or service The funding request Describe additional financing plans: explain plans for obtaining financing besides the venture capital, private equity or loan funds described in the funding request Monitor debt: decide on the mix of debt and equity capital Debt capital may be cheaper, but obtaining it depends ability to repay and to provide adequate security for the loan Avoid becoming too leveraged

49 III. Pricing the product or service The funding request Don t plan for a very high debt-to-equity ratio which makes your company less attractive to investors and lenders Describe future needs: explain, clearly and concisely, anticipated future funding needs If the project will take several years, you may only be able to obtain capital investment in stages When will you require the next round of funding? What are the milestones for reaching that point?

FAQ: Statement of Cash Flows

FAQ: Statement of Cash Flows Question 1: What sources are used when the statement of cash flows is being prepared, and what information does each source provide? Answer 1: The statement of cash flows is prepared differently from the