Chapter 9

1. Chapter 9 Managing the Money

2. Objectives • Understand financial statements • Understand budget & cash flow • Interpret return on investment • Understand break even analysis • Analyze investment decision • Understand fund raising

3. Introduction • The financial statements are the tools through which the company communicates its financial condition to others. • Financial statements include the balance sheet, income statement or profit and loss statement, statement of cash flows, and supplemental financial information.

4. The Balance Sheet • The balance sheet provides a picture of the business financial position at a particular point in time. • The balance sheet is a snapshot of the company’s assets, its liabilities, as well as the owner’s equity. • Balance sheet equation: Assets = Liabilities + Shareholder equity • Assets are current assets if they can be converted into cash within one year. Otherwise they are considered long term assets. • Equity is calculated by subtracting total liabilities from total assets (Table 9-1, page 234).

5. Analysis of the Balance Sheet • Book value = Assets – liabilities. • Book value / # of shares outstanding = value of each share • If a company is trading for less than its book value, its stock may be a good investment. • Goodwill = Selling value – book value • Goodwill includes added value such as brand name and market share. • The burn rate is the rate at which a new company is using up its cash before generating positive cash flow from operations. • Time left before cash runs out = Cash reserves/ Burn Rate

6. Ratios for Financial Analysis • Ratios can be used to analyze a balance sheet: • 1. Current Ratio: is the total current assets divided by the total current liabilities. The current ratio indicates the company’s ability to meet its obligations for the next year (table 9-3, page 239). • 2. Quick Ratio: Only includes current assets that can be used to pay bills (cash and accounts receivable). It is a good indication of being able to meet current liabilities in a crunch situation (maintain a quick ratio of 1:1). • 3. Current liabilities to net worth ratio: the smaller the ratio the more secure the creditors. • 4. Debt to equity ratio: The higher the ratio the higher the risk borne by the creditors. • 5. Fixed assets to net worth ratio: A lower ratio indicates a better cushion for short term cash needs or sudden liquidation.

7. The Income Statement (Profit & Loss Statement) • The P&L statement summarizes the revenue (income) and expenses of a company (Table 9-4, page 242): • Inventory costs: costs assigned to inventory before they are sold. • Production Costs: costs identified with the product. • Operating expenses: costs not identified with the product – R&D, sales and marketing, general and administration, & financial expenses. • Net profit (or loss) = Gross sales – Total expenses • Operating income (EBIT: earning before interest & taxes): The EBIT to interest ratio should be at least 3:1. If operating profits were $30,000 than interest on loans should be no more than $10,000.

8. Using Ratios • Most common ratios: • 1. Return on investment (ROI) = Net income / shareholders equity • 2. Level of reliability of ROI: ROI should be examined in relationship to the business and environment rather than just mechanically. • 3. Return on total assets = net income/total assets. Measure of how effectively the entrepreneur is employing the assets to generate profits. • 4. Gross profit margin = gross profit/ gross sales. Investors are looking for high gross margin projections (60% or more). • To analyze profitability compare these percentages to industry standards or immediate competitors.

9. Statement of Cash Flows (SCF) • SCF (Statement of cash flows) summarizes where cash comes from and where it goes (Table 9-5, page 244). • The SCF is divided into 3 parts: cash from operations, cash from financing activities, and cash from investing activities. • The SCF begins with the net income from the income statement. • The bottom line is the net change in working capital.

10. Footnotes in Financial Statements • 6 important footnotes are: • 1. General Description of Business: Any events that have an impact such as a acquisition or increased competition. • 2. Acquisitions and Divestitures/Discontinued Operations: Acquired or sold stock of a company or discontinued segment of business. • 3. Intangible Assets: Goodwill, capitalized patents, capitalized research and development. • 4. Debt: Classify debt by loan instrument and bank, current interest rates and payoff schedule. • 5. Legal Proceedings: By or against the company. Review to determine financial viability of company. • 6. Subsequent events: Any unusual and material events.

11. Financial Projections • 3 methods to measure financial performance: • 1. Measuring Sales Volume: Increasing sales is a part of the financial plan. • 2. Measuring Profits: Sales must be profitable for the business to succeed. • 3. Measuring Cash Generated: Frequently businesses, though profitable, run out of cash, because when a sale occurs the cash from the sale is not collected until a later date. A major cause of failure for start up companies is poor cash management.

12. Annual Budget • The annual budget presents a month by month projection of revenues and expenses over a one year period (Table 9-6, page 247). • 1. Sales: The budget should include sales by product line, and geographic region. • 2. Cost of Goods Sold: Materials cost, shipping cost, overhead, cost of goods sold for each product line, and gross profit for each product line. • 3. Gross Profit: Sales minus cost for product lines, and geographic regions. • 4. Operating Expenses: R&D, sales & marketing, and general administrative. Under each category budgeted expenses by salary, benefits, rent, and telephone. • 5. Operating Profit/Loss: Operating profit/loss for each sales category. • 6. Other Income and Expenses: Interest expense, debt (leases, equipment, credit, loans), legal settlement, loss due to fire, etc. • 7. Pretax Income: Income that will be subject to corporate tax. • 8. Income Taxes: Federal and state taxes owed. • 9. Net Income: Amount available for dividend or reinvestment. • 10. EBIT: Earning before interest expense and taxes. Measures profitability. • 11. EBITDA: Earnings before interest, taxes, depreciation, and amortization.

13. Cash Flow Forecast • One of the major problems of start up companies is cash flow. • A cash flow forecast shows the amount of cash coming in (receivables) and cash going out (payables) during a certain month (Table 9-7, page 251). • The cash flow worksheet can be used to control the financial liquidity of the business. • 1. Cash Flow Revenues: For a start up it can be average monthly sales of a similar sized competitor operating in a similar market. Reduce figures by 50% for start up months. • 2. Cash Flow Disbursements: Suppliers, wages, rent, and equipment cost for each month. • 3. Reconcile Revenue and Disbursement: Starts by showing the balance carried over from the previous month’s operation. Net inflows/outflows of current month are added. The adjusted balance will be the first line of next month’s statement.

14. Breakeven Analysis • Breakeven occurs when the total revenue equals total cost. • Fixed costs are expenses that do not change. • Variable costs change according to volume produced. • Price is the amount received on the sale of one unit. • Revenue is the price times the # of units sold. • Profit is total revenue minus total cost. • Breakeven Formula: P(X) = F + V (X) where P = price per unit, X = # of units sold, F = fixed cost and V = variable cost. • Solving for X will give the breakeven point.

15. Investment Decision • The time value of money recognizes that it is better to receive a dollar today than it is to receive a dollar next year. • The net present value (NPV) method is a way to determine whether to make an investment. • The internal rate of return (IRR) is the rate of return that equates the present value of future cash flow to the investment. If the IRR of a potential investment is greater than the required rate of return the investment should be undertaken.

16. Evaluating Company Statements • The SEC (Securities and Exchange Commission) requires public companies to file a variety of forms quarterly, annually, or on an as needed basis. • S-1: The prospectus. It contains details of the company’s operations including recent quarterly results. Check the competitors section and risk factors to determine risks. • 10-Q: The Quarterly Report. Company’s balance sheet, income statement, & cash flow. Check management section for acquisitions, new customers, & unexpected losses. • 10-K: The Annual Report. Includes employment details, credit & lease agreements, & pending legal actions. • 8-K: The Current Report. Reveal material information to all investors simultaneously. • 144: Insider Trades. When officers, board members, or major shareholders buy or sell stock, they must register their intent with the SEC under form 144. • 13D: Beneficial Ownership: Any individual that acquires more than 5% of shares is required to report to the SEC. • DEF-14A: Proxy Statement. Details director’s compensation and insider’s shareholding and changes to corporate governance.

17. Taxes and Filing • Entrepreneur is required to withhold federal and state taxes from employees. • Each month or quarter (depending on size of payroll) deposits need to be made. • Generally federal taxes, state taxes, Social Security, and Medicare are withheld from employees salaries. • If payments are late high interest and penalties are assessed. • Company may also be required to pay federal unemployment taxes, FICA and Medicare tax, and other business taxes. • A tax accountant should be consulted for advice and help in planning and budgeting funds for these expenses.

18. Stresses of Managing Money • Managing money is one of the most important aspects of building a company. • Engage a financial advisor who you can trust to help you set up the systems. • Raising money always takes longer than expected. • Yet employees and suppliers expect to be paid promptly. • Sound financial accounting systems help manage this stress.

19. Summary • Financial statements include the balance sheet, income statement or profit and loss statement, statement of cash flows, and supplemental financial information. • Balance sheet equation: Assets = Liabilities + Shareholder equity • Assets are current assets if they can be converted into cash within one year. Otherwise they are considered long term assets. Equity is calculated by subtracting total liabilities from total assets. • The P&L statement summarizes the revenue (income) and expenses of a company. • Book value = Assets – liabilities. • Goodwill = Selling value – book value • Return on investment (ROI) = Net income / shareholders equity • SCF (Statement of cash flows) summarizes where cash comes from and where it goes. • The annual budget presents a month by month projection of revenues and expenses over a one year period. • Breakeven occurs when the total revenue equals total cost. • EBIT: Earning before interest expense and taxes. Measures profitability. • 10-K: The Annual Report. Includes employment details, credit & lease agreements, & pending legal actions. • Generally federal taxes, state taxes, Social Security, and Medicare are withheld from employees salaries.

20. Home Work • 1. Name the different financial statements? • 2. What is the balance sheet equation? • 3. What is current ratio and what is its implication? • 4. What is quick ratio and what does it indicate? • 5. What is the 10 K?