Financial Management for Entrepreneurs I

1. Financial Management for Entrepreneurs I Business Innovation Competition Workshops Innovation & Entrepreneurship Institute

2. Business plan workshops • Idea Creation and Opportunity Assessment • - February 2 • Matching Products and Services with Markets • February 9 • Competitive Analysis • February 16 • Strategy & Business Model • February 23 • Marketing and Sales Strategies • March 2 • Management & Ownership • March 16 • Financial Projections and Funding Strategies • March 23 • Professional Presentations • March 30

3. Alchemy of wealth creation • A successful business organizes natural resources, human resources and sweat into product or service plus profit, • Thus transforming human and natural capital into financial capital., • One goal of business is to generate wealth and stores it as money, as capital, which can then be rented (lent) or invested to help build more wealth…

4. Capital vs cash • Cash is not always cash: There is a difference between the cash needed to run a firm and the capital needed to develop it. • Operating cash is a lubricant that facilitates the exchange of goods and services. • Successful firms are well lubricated: They cover operations from revenues. • Capital is stored energy and is used to build capability. • Capital (from investments and loans) is stored profit from past ventures. This energy from the past helps firms build more rapidly than would be possible with sweat and profit.

5. Financial statements & projections • Track the alchemical transformation of labor, land and capital into financial capital. • Monitor flow of money through a business – as cash and capital. • Support planning and measure progress. • Support judgments about the coherence of a business plan. • Help sell business plans to others.

6. Transparent financial statements • Use standard formats • With account categories and formats that fit one’s business • Support numbers with narrative and notes • Narrative: “After three months of losses, firm A turns profitable; by the end of year, two, firm A should show steady profits of and settles into profits of 10% per year.” • Notes: Assumptions, caveats, what-ifs. • Are checked by professionals • Taxes and acceptability

7. Financial statements • Income Statement • Definition: Profit or loss of a business over time • Use: Project & monitor profit & so operating efficiency • Cash Flow Statement • Definition: Tracks the inflows & outflows of cash • Use: Project & monitor the cash available foroperations & growth • Balance Sheet • Definition: Snapshot of a firm’s wealth – and how it has funded that wealth • Use: Project & monitor the growth or decline of a firm’s value/capital - and so potential

8. Income statement • Income Statement • Definition: Profit or loss of a business over time • Use: Project & monitor profit & so operating efficiency + Net Revenues - Cost of Goods Sold = Gross Profit - Operating Expenses = Operating Profit +/- Other Income/Expenses = Profit before tax - Tax = Profit after tax

9. Income statement Revenues Gross Profit Other Income OperatingProfit Net Profit P.A.T. COGS Op. Exp. R/E>B/S OtherExp. Tax Div>CF

10. Income statement • Net Revenues • Sales after discount, less returns • Cost of Goods Sold • Direct goods + direct labor per unit sold • Gross Profit • Amount left to cover operations • COGS/Sales • Constant or improving as percentage • Perils and pleasures of volume + Net Revenues - Cost of Goods Sold = Gross Profit

11. Income statement • Operating Expenses • Salaries (benefits, taxes) • Sales & Marketing • General Administration (supplies, IT, insurance) • Space (rent, maintenance, utilities) • Depreciation (spreading capital expense over use/ time) • Professional fees • Operating Profit • Basic measure of success = Gross Profit - Operating Expense = Operating Profit

12. Income statement • Other Income • Sidelines (can be very valuable and/or indicate new businesses or products) • Interest • Other Expense • Cost of financing, especially interest on loans • Other miscellaneous expenses • Profit before Taxes • Net income = Operating Profit +/- Other Inc or Exp = Profit before taxes

13. Income statement • Income Taxes • State and local • Don’t confuse tax management with management • Profit after Taxes • Captured wealth • Reinvest (retained earnings) > B/S • Distribute (dividends) > CF = Profit before Taxes - Income Taxes = Profit after Taxes

14. Account categories that matter • Revenues • Major lines and/or channels • Other income sources • COGS • Direct labor, raw materials, subcontracts • Operating Expenses • Reflect business model: Marketing/Sales, GA • Subdivide important categories; lump together unimportant ones • Other Expenses

15. Account categories exercise • Planning: What categories should matter? • Analysis: What categories has management chosen – and what do they tell you? + Net Revenues - Cost of Goods Sold = Gross Profit - Operating Expenses = Operating Profit +/- Other Income/Expenses = Profit before tax - Tax = Profit after tax

16. Cash flow projections • Cash Flow Statement • Definition: Tracks the inflows & outflows of cash • Use: Project & monitor the cash available for operations & growth + Revenues • Cost of Goods • Operating Expenses (excluding depreciation) = Cash flow from operations + Investment income - Acquisition of space, r&d, equipment, etc = Cash flow from investment + Equity investment + Loans - Repayments - Dividends / owner withdrawals = Cash flow from financing Cash on Hand – End of Period

17. Three sources of cash • Operations • Revenue less cash expenses (ultimately, retained earnings) • Investments • Financing • Loans, equity + Revenues • Cost of Goods • Operating Expenses (excluding depreciation) = Cash flow from operations +Investment income - Acquisition of space, r&d, equipment, etc = Cash flow from investment +Equity investment + Loans - Repayments - Dividends / owner withdrawals = Cash flow from financing Cash on Hand – End of Period

18. Three uses of cash • Operations • Cash necessary to operate • Capacity building • Cash necessary to build the platform • Pay back • Cash necessary to pay lenders, investors, owners + Revenues • Cost of Goods • Operating Expenses (excluding depreciation) = Cash flow from operations + Investment income - Acquisition of space, r&d, equipment, etc = Cash flow from investment + Equity investment + Loans - Repayments - Dividends / owner withdrawals = Cash flow from financing Cash on Hand – End of Period

19. Building the cash flow statement • Inflows • Operating: Adjust revenues for bad debt and timing • Investment: Any sales of hard assets? • Financing: Capital inflows? Loans? • Outflows • Operating: Inventory purchases • Operating: Operating expenses (without depreciation), adjusted for timing • Investment: Capital purchases • Financing: Principal repayment, investor repayment, owner withdrawals

20. Avoiding the cash wall • Detailed projections • Routine and extraordinary expenses • Monthly, even weekly (once operating) • Careful monitoring • Calculate burn rate • Cash outflow per month • Play with timing • Delay outflow or accelerate inflow • Manage expectations • Negotiate

21. Cash flow projections exercise • Planning: List one-time and recurring cash inflows and outflows. Juggle the timing to remain cash positive while growing. • Analysis: Calculate the cash available for to finance investment, new initiatives, etc. + Revenues • Cost of Goods • Operating Expenses (excluding depreciation) = Cash flow from operations + Investment income - Acquisition of space, r&d, equipment, etc = Cash flow from investment + Equity investment + Loans - Repayments - Dividends / owner withdrawals = Cash flow from financing Cash on Hand – End of Period

22. Balance sheet • Balance Sheet • Definition: Snapshot of a firm’s wealth – and how it has funded that wealth • Use: Project & monitor the growth or decline of a firm’s value/ capital - and so potential Current Assets Long-term Assets = Total Assets Current Liabilities Long-term Liabilities = Total Liabilities Capital Investment Retained Earnings = Total Equity

23. A = L + E • Assets = Wealth = Use of Funds • Cash, loans to customers (A/R), buildings, equipment, inventory, partnerships • Platform for growth • Liabilities = LeveragedSource of Funds • Nervous claims on wealth secured by contracts & collateral such as loans from vendors, banks, other sources, bonds • Expand possibilities while increasing risk • Equity = Capital = InvestedSource of Funds • More patient claim on wealth secured by control, especially owners’ capital plus retained profits

24. Balance sheet • Current Assets • Cash & similar • Accounts receivable • Inventory • Long-term Assets • Equipment • Leasehold Improvements • Net of depreciation Current Assets Long-term Assets = Total Assets

25. Uses of cash • Payments • Supporting customers by offering terms • Inventory • Investing in capacity: machinery, know-how, new products, partnerships • Investing in financial instruments

26. Balance sheet • Current Liabilities • Accounts payable • Deposits • Line of credit • Current portion of long-term debt • Long-term Liabilities • Loans • Bonds Current Liabilities Long-term Liabilities = Total Liabilities

27. Balance sheet • Equity • Capital Investment • Additional Paid-in Capital • Retained Earnings Capital Investment Retained Earnings = Total Equity

28. Sources of cash • Initial equity • owners, family, friends • Other equity: • angels, venture firms, partners, public markets • Informal loans: • terms from suppliers, customers, landlords, partners • Traditional loans: • credit cards, banks, leases, bonds • Revenues • Related business income • Investment income

29. Matching sources & uses of funds • Short-term sources of cash to fund short-term needs • A/P <> A/R • Deposits <> inventory • Long-term sources of cash to fund long-term needs • Loans for hard assets with collateral • Mortgage <> building • Lease <> equipment • Investments for softer assets like r&d • Angel <> r&d • Strategic investor <> new product

30. Matching sources & uses of funds • Farm Example • Seasonal cash flow – revolving line of credit • Equipment – leases • Buildings - mortgages • Software Application Example • Personal & angel investment for proof of concept • Stock options (personal investment) for building core staff • Venture capital for commercialization and marketing roll out • Short-term loans for equipment • Mid-term loans for leasehold improvements

31. Balance sheet exercise • Planning: List necessary assets & timing. Brainstorm possible sources of funds and timing. Match them up. • Analysis: Are sources and uses of funds well matched? Current Assets Long-term Assets = Total Assets Current Liabilities Long-term Liabilities = Total Liabilities Capital Investment Retained Earnings = Total Equity

32. Tying the statements together • Income Statement > Balance Sheet • Net income less dividends = additional retained earnings on B/S • Incomes Statement > Cash Flow • Direct method: All income (adjusted for timing) - all expenses (adjusted for timing) + depreciation = operating cash flow • (Remember other income/expense and taxes) • Interest payments provide clues about the loan situation

33. Tying the statements together • Cash Flow > Balance Sheet • New capital, new loan principal, repaid capital, repaid loan principal, purchases or sales of equipment • Dividends (which reduce net income’s contribution to retained earnings) • Cash Flow > Income Statement • Changes in loans should be reflected in changes in interest

34. Tying the statements together • Balance Sheet > Income Statement • Change in retained earnings = Net income less dividends • Balance Sheet > Cash Flow • Indirect method: Changes in balances (eg., Accounts receivable, accounts payable, etc) are used to calculate changes in cash • Similarly with changes in investing (equipment, equity) and financing categories (loans)

35. Bibliography • Richard A Brealey and Stewart C. Myers, Principles of Corporate Finance (McGraw-Hill, 1996) • Corporation for Enterprise Development: Financial Management for Entrepreneurs (1995) • Craig Fleisher & Babetter E. Bensoussan, Strategic and Competitive Analysis: Methods and Techniques for Analyzing Business Competition (Prentice-Hall, 2003) • TL Hill lectures, 2002 • Nick Rowling, Commodities: How the World Was Taken to Market (Free Association Books, 1987) • Clyde Stickney & Roman Weil, Financial Accounting: An Introduction to Concepts, Methods and Uses (Dryden Press/Harcourt Brace College Publishers, 1994) • G. Straughn & C. Chickadel, Building a Profitable Business (B Adams, 1994)