CHAPTER 11 FINANCIAL PREPARATION FOR ENTREPRENEURIAL

VENTURES

CHAPTER OUTLINE

I. The Importance of Financial Information for Entrepreneurs

II. Understanding the Key Financial Statements
A. The Balance Sheet
1. UNDERSTANDING THE BALANCE SHEET
a. Current Assets
b. Current Liabilities
c. Long-Term Liabilities
d. Contributed Capital
e. Retained Earnings
2. WHY THE BALANCE SHEET ALWAYS BALANCES
a. A Credit Transaction
b. A Bank Loan
c. A Stock Sale
B. The Income Statement
1. UNDERSTANDING THE INCOME STATEMENT
a. Revenue
b. Cost of Goods Sold
c. Operating Expenses
d. Financial Expense
e. Estimated Income Taxes
C. The Cash-Flow Statement
III. Preparing Financial Budgets
A. The Operating Budget
B. The Cash-Flow Budget
IV. Pro Forma Statements
V. Capital Budgeting
A. Payback Method
B. Net Present Value
C. Internal Rate of Return
VI. Break-Even Analysis
A. Break-Even Point Computation
1. CONTRIBUTION MARGIN APPROACH
2. GRAPHIC APPROACH
3. HANDLING QUESTIONABLE COSTS
VII. Ratio Analysis

FEATURED CONTENT

The Entrepreneurial Process: Watching Your Accounts Receivables

The Entrepreneurial Process: Characteristics of Credible Financials
LECTURE NOTES

I. The Importance of Financial Information for Entrepreneurs

Financial information pulls together all of the information presented in the other
segments of the business: marketing, distribution, manufacturing, and management. It
also quantifies assumptions and historical information concerning business operations.
Entrepreneurs make assumptions to explain how numbers are derived, and they correlate
them with information presented in other parts of the business operations. Entrepreneurs
should follow a clear process to develop the key components of a financial segment.
II. Understanding the Key Financial Statements
Basic financial statements an entrepreneur needs to be familiar with are the balance sheet,
the income statement, and the cash-flow statement.

The Balance Sheet

Reports a business’s financial position at a specific time.

The balance sheet is divided into two parts:

 The financial resources owned by the firm
 The claims against these resources

The financial resources the firm owns are called assets.

The claims creditors have against the company are called liabilities.
 Short-term (or current) liabilities must be paid during the coming 12 months.
 Long-term liabilities are not due and payable within the next 12 months.

The residual interest of the firm’s owners is known as owners’ equity.

UNDERSTANDING THE BALANCE SHEET

The balance sheet has three sections: assets, liabilities, and owners’ equity.
Current Assets
Cash and other assets expected to be turned into cash, sold, or used up during a
normal operating cycle (cash, accounts receivable, inventory, prepaid expenses).

Current Liabilities
Obligations due and payable during the next year or within the operating cycle
(accounts payable, notes payable, taxes payable, loans payable).

Long-Term Liabilities
Obligations not due or payable for at least one year or not within the current
operating cycle (bank loans).

Contributed Capital
When a corporation is owned by individuals who have purchased stock in the
business; various kinds of stock can be sold by a corporation, the most typical
being common stock and preferred stock.

Retained Earnings
The accumulated net income over the life of the corporation to date; every year
this amount increases by the profit the firm makes and keeps within the company.

WHY THE BALANCE SHEET ALWAYS BALANCES

The balance sheet always balances because if something happens on one side of
the balance sheet, it is offset by something on the other side.
 A Credit Transaction
When a company orders materials from a supplier, its inventory goes up and
accounts payable also goes up by the amount the supplier charged. The increase
in current assets is offset by an increase in current liabilities.

When the bill is paid by the company by issuing a check, cash declines by the
billed amount. At the same time, accounts payable decreases by this same
amount. Again, these are offsetting transactions, and the balance sheet remains in
balance.

A Bank Loan
A company may have an outstanding bank loan of $200,000 in 2021. If the
company increases this loan by $110,000 in 2022, cash goes up by $110,000, and
the bank loan increases by the same amount. In addition, if the firm uses this
$110,000 to buy new machinery, cash decreases by $110,000 and equipment
increases by the same amount.

A Stock Sale
A company issues and sells shares of common stock. The balance sheet action
shows that common stock increases as well as cash.

The Income Statement

Shows the change that has occurred in a firm’s position as a result of its operations over a
specific period.

Revenue: obtained every time a business sells a product or performs a service

Expenses: costs associated with producing goods or services
Net income: excess of revenue over expenses

UNDERSTANDING THE INCOME STATEMENT

The typical income statement has five major sections: (1) sales revenue, (2) cost
of goods sold, (3) operating expenses, (4) financial expense, and (5) income taxes
estimated.
Revenue—sales revenue is often referred to as gross revenue.
Cost of Goods Sold—the cost of goods for a given period equals the beginning
inventory plus any purchases the firm makes minus the inventory on hand at the
end of the period.
Operating Expenses—major expenses, exclusive of costs of goods sold, are
classified as operating expenses. Expenses often are divided into two broad
subclassifications: selling expenses and administrative expenses.
Financial Expense—financial expense is the interest expense on long-term loans.
Estimated Income Taxes—corporations pay estimated income taxes.

The Cash-Flow Statement

The cash-flow statement shows the effects of a company’s operating, investing, and
financing activities on its cash balance.
 Key questions answered by the cash-flow statement:
 How much cash did the firm generate from operations? Operating cash flows: cash
generated from or used in the course of business operations of the firm.
 How much new debt did the firm add? Investing activities: cash flow effects from
long-term investing activities, such as purchase or sale of plant and equipment.
 Was the cash from operations sufficient to finance fixed asset purchases? Financing
activities: cash flow effect of financing decisions of the firm (sale of stocks and
bonds, repurchase of securities, and payment of dividends).

III. Preparing Financial Budgets

The operating budget is a statement of estimated income and expenses during a specified
period of time. Another common type of budget is the cash-flow budget, which is a
statement of estimated cash receipts and expenditures during a specified period of time.

The Operating Budget

The first step in an operating budget is the preparation of the sales forecast.

Simple linear regression is a technique in which a linear equation states the relationship
among three variables.
Y = a + bx
Y is a dependent variable, x is an independent variable, a is a constant, and b is the slope
of the line (the change in Y divided by the change in x).

After forecasting sales for the budget period, expenses must be estimated.

Production budget: estimate of the number of units to be produced to meet the sales
forecast.

The last step in preparing the operating budget is to estimate the operating expenses for
the period.
 Fixed costs
 Variable costs
 Mixed costs

The Cash-Flow Budget

A statement of estimated cash receipts and expenditures over a specified period of time is
considered the cash-flow budget.
 Cash sales
 Cash payments received on account
 Loan proceeds
IV. Pro Forma Statements
The final step in the budget process. These are projections of a firm’s financial position
during a future period or on a future date. There are two kinds of pro forma statements.
 Income statements—done first, as in normal accounting. The firm will have already
prepared the pro forma income statements for each month in the budget period.
 Balance sheet—following the income statement as in the normal accounting cycle but
more complex. The last balance sheet prepared before the budget period began, the
operating budget, and the cash-flow budget are needed to prepare it.

V. Capital Budgeting
A technique the entrepreneur can use to help plan for capital expenditures. The first step
is to identify cash flows and timing. The second step is to obtain reliable estimates of
savings and expenses.

There are three common methods used in capital budgeting.

Payback Method
 The easiest method.
 The length of time required to “pay back” the original investment is the determining
criterion.
 A problem that occurs is that it ignores cash flows beyond payback period.

Net Present Value

 This technique helps to minimize some of the shortcomings of the payback method
by recognizing the future cash flows beyond the payback period.
 This concept works on the premise that a dollar today is worth more than a dollar in
the future—how much more depends on the applicable cost of capital for the firm.

Internal Rate of Return

 This method is similar to NPV in that the future cash flows are discounted. They are
discounted at a rate that makes the NPV of the project equal to zero. This rate is what
is referred to as the internal rate of return on the project. The project with the highest
IRR is then selected. Thus, a project that would be selected under the NPV method
would also be selected under the IRR method.
 One of the drawbacks to using the IRR method is the difficulty that can be
encountered when using the technique.

VI. Break-Even Analysis

Entrepreneurs need relevant, timely, and accurate information that will enable them to
price their products and services competitively and still earn a fair profit.

Break-Even Point Computation

It helps determine how many units must be sold to break even at a particular selling price.
 CONTRIBUTION MARGIN APPROACH
Difference between selling price and variable cost per unit is the amount per unit
that is contributed to cover all other costs.

0 = (SP – VC)S – FC or FC = (SP – VC)S

SP = Unit selling price

VC = Variable costs per unit
S = Sales in units
FC = Fixed cost

GRAPHIC APPROACH
The entrepreneur needs to graph at least two numbers: total revenue and total
costs. The intersection of these two lines is the firm’s break-even point.

HANDLING QUESTIONABLE COSTS

This approach is used when firms have expenses that are difficult to assign. This
technique calculates break-even points under alternative assumptions of fixed or
variable costs to see if a product’s profitability is sensitive to cost behavior.

The decision rules for this concept are as follows: If expected sales exceed the
higher break-even point, then the product should be profitable, regardless of the
other break-even point; if expected sales do not exceed the lower break-even
point, then the product should be unprofitable.

VII. Ratio Analysis

An analysis of the firm’s ratios is generally the key step in a financial analysis. The ratios
are designed to show relationships among financial statement accounts.

Ratio analysis can be applied from two directions: vertical and horizontal.

Vertical analysis is the application of ratio analysis to one set of financial statements; an
analysis “up and down” the statements is done to find signs of strengths and weaknesses.

Horizontal analysis looks at financial statements and ratios over time. The trends are
critical.