INTRODUCTION TO ENTREPRENEURSHIP

Sirje Ustav2014 / 2015

Finance in entrepreneurship

TOPICS• The aims of firms financial

management• Financial sources• Incomes and expenses• Salary calculation• Self-cost and pricing• Break-even point• Income statement• Balance sheet• Cash flow statement• Financial ratios

Financial managementfinancial management deals with two things:

• raising money and • managing a company’s finances in a

way that achieves the highest return

aim of financial management in entrepreneurship:

• How a new venture tracks its financial progress through preparing, analysing, and maintaining past financial statements.• How a new venture forecasts future

income and expenses by preparing pro forma (or projected) financial statements.

Financial questions• How are we doing? Are we making or losing

money?

• How much cash do we have on hand?

• Do we have enough cash to meet our short-term obligations?

• How efficiently are we utilizing our assets?

• How do our growth and net profits compare to those of our industry peers?

• Where will the funds we need for capital improvements come from?

• Are there ways we can partner with other firms to share risk and reduce the amount of cash we need?

• Overall, are we in good shape financially?

Financial objectives of a Firm

• Profitability– Is the ability to earn a profit.• Many start-ups are not profitable during

their first one to three years while they are training employees and building their brands.• However, a firm must become profitable to

remain viable and provide a return to its owners.

• Liquidity– Is a company’s ability to meet its short-term

financial obligations.• Even if a firm is profitable, it is often a

challenge to keep enough money in the bank to meet its routine obligations in a timely manner.

Financial objectives of a Firm

• Efficiency– Is how productively a firm utilizes its assets

relative to its revenue and its profits.• Southwest Airlines, for example, uses its

assets very productively. Its turnaround time, or the time its airplanes sit on the ground while they are being unloaded and reloaded, is the lowest in the airline industry.

• Stability– Is the strength and vigor of the firm’s overall

financial posture. • For a firm to be stable, it must not only

earn a profit and remain liquid but also keep its debt in check.

The Process of Financial Management

• Importance of Financial Statements– To assess whether its financial

objectives are being met, firms rely heavily on analysis of financial statements.• A financial statement is a written report

that quantitatively describes a firm’s financial health. • The income statement, the balance sheet,

and the statement of cash flows are the financial statements entrepreneurs use most commonly.

• Forecasts– Are an estimate of a firm’s future income and

expenses, based on past performance, its current circumstances, and its future plans.

Income

• Companies income = revenue streams from sales, services, rents, leasing, subscription fees, loan interests etc.

• Think: Facebook – what are the companies revenue streams?

Expences• Periodic costs General and Administrative costs– Top management, office personnel, other

staff costs– Office supplies– Office rent (or depreciation), heating,

electricity, water– Research and development

Marketing costs– Other general and administrative– Advertising costs– Market research costs– Sales personnel staff costs– Intermediaries’ costs– Completed products’stock costs– Sales costs

Expences

• Other business expences– Losses, fees, penalties– Member fees of associations,

unions etc– Environmental damages

compensations

Expences of a company

Divided according to objective• Direct costs• Indirect costs

According to dependence on production output volume costs are divided:• Variable costs - directly dependent

on production output volume• Fixed costs - not dependant on

production volume

Self cost

Exercise

A company is producing T-shirts, 2 000 units a month. Total material costs are 1 200 EUR a month, direct staff costs are 500 EUR a month, company’s administration’s staff costs 1 500 EUR a month. The purchase price of the machinery was 8 980 EUR, transportation costs 20 EUR. The forcasted lifetime of the machinery is 10 years.

Calculate the self-cost of one T-shirt

Break-even analysis

• An analysis of cost behaviour, based on the relation of costs, sales volume (production volume) and profit.

• REVENUE - COSTS = PROFIT

• Break-even point is the sales (production) volume in case of which the company covers its costs and gets neither profit or loss.

Break-even analysisTo make the analysis easier we make the following assumptions:

• One type of product• Fixed costs remain constant, variable

costs remain constant per unit• Prices do not change• All production that is produced is

sold• Technology and production

effectiveness do not change• Time value of money and risks are

ignored

Break-even point

Revenue-expenses=profitAt break-even point:Revenue-expenses=0No of units of product=xSales price per unit*x – variable costs per unit*x – fixed costs = 0Find x to calculate the number of units at break-even pointTo get the break-even point revenue calculate sales price*the number of units at break-even point

Break-even calculationBreak-even fixed costs Point = in units sales price per unit – variable costs Break-even variable costs per unit Point of = 1 -Sales revenue sales price per unit

revenue

costs

break-even point

revenue

variable costs

fixed costs

loss area

profit area

Q2Q1 Q3 Q

Break-even calculation

Exercise

A company produces computer desks. Variable costs are 24 EUR per a unit of product, fixed costs are 1 920 EUR a month. The company sells the desks for 40 EUR/a desk. The forecasted sales volume is 200 desks.

How many desks does the company have to sell to cover the costs?

Margin of safety

• Margin of safety is the amount of money by which the forcasted sales revenue exceeds the sales revenue at the break-even point. It can be also calculated in units of product.

• The closer the forecasted sales revenue (sales volume) is to the break-even point, the bigger the risk that the company may fall into a loss.

Margin of safety calculation

The calculation of the margin of safety: Margin of safety (as sales revenue) =

forecasted sales revenue – sales revenue at break-even point

Margin of safety (in units of product)=forecasted sales volume – sales volume at break-even point

Margin of safety can be also as % The margin of safety rate = margin of safety / forcasted sales revenue (volume)

Financial statements of the company

Flow statements:• Cash flow statement• Income statement

Stock statement: • Balance sheet

These financial statements are based on double entry bookkeeping on accounting documents - every entry to an account requires a corresponding and opposite entry to a different account

Income statement

• Also called profit/loss statement

• Reflects the results of the company’s economic activity during accounting period

REVENUE – EXPENSES = PROFIT

• The accounting period is one year, usually the calendar year

• All numbers are without value-added-tax in income statement

Income statement format

According to the Estonian Accounting Act the companies are allowed to choose between two formats of the income statement:

• FORMAT 1 divides the expenses into groups according to their character (staff costs, depreciation etc.)

• FORMAT 2 divides the expenses into groups according to their function in the company (cost of sales, marketing expenses, administrative and general expenses)

Income statement (format 2)

Sales revenueCost of sold goodsGross profit (loss)Marketing expensesAdministrative and general expensesOther operating revenueOther operating chargesOperating profit (loss)Financial income and expenses

Profit (loss) before income taxIncome tax expenseNet profit/loss for financial year

Balance sheet

• Balance sheet is the statement of the company’s financial status at a certain moment (reflects company’s assets, liabilities and equity at a certain moment)

ASSETS = LIABILITIES + EQUITY • Shows a balance between assets

and their financial sources (liabilities and equity)

Balance sheet - assets

Current assets:• Cash • Short-term investments• Receivables and prepayments• InventoriesTotal current assets

Fixed assets:• Long-term investments• Investment properties• Tangible fixed assets• Intangible fixed assetsTotal fixed assetsTotal assets

Balance sheet - liabilities

Liabilities

Current liabilities:• Loan liabilities• Debts and prepayments• Total current liabilities• Long-term liabilities:• Long-term loan liabilities• Other long-term payables• Total long-term liabilities

Total liabilities

Balance sheet - equity

Equity:

• Share capital (nominal value)• Retained profit/loss• Net profit/loss for financial

year

Total equity

Total liabilities and equity

Cash flow statement

The purpose of the cash flow statement:

• to give information about the change of cash balance of the company

• to plan and check cash inflow and outflow

• To help to evaluate company’s ability to pay dividends to shareholder and interests to debitors

Cash flow statement

Cash flow is the money that is moving in and out of the company during a given period

Cash flows are divided into three groups:–cash flows from operations–cash flows from

investments–cash flows from financing

ExersiseMr Jones decided to start his own company. He has 2000 euros and machinery (production machinery) worth 500 euros to pay in as share capital (the machinery’s remaining forcasted lifetime is 5 years). He needs to take a bank loan of 4000 EUR (annuity-loan, interest rate 8%, duration 4 years, yearly payments). Staff costs of the company are 1600 EUR a month, paid at the beginning of the next month (900 EUR of the staff cost is administrative staff cost and 700 EUR production staff cost). Monthly sales revenue is 3000 EUR (10% of it is received in the next month). Production costs are 1000 EUR a month (15% of the costs are paid out in the next month). Monthly rent is 300 EUR (paid in the same month). Please compile cash flow statement and income statement for the first two years.

Please compile the income statement and balance sheet for the first two years

Cash flow statement

The basic structure of cash flow statement:

• Cash balance at the beginning of the period

• Cash inflows• Cash outflows• Net cash flow• Cash balance at the end of the

period

Cash flow statementExercise

A company is founded with 2500 EUR of share capital (all in cash). Machinery is bought for 2000 EUR. The rent of office and production space is 500 EUR a month, production costs are 1000 EUR a month. A loan of 2 000 EUR is taken with the duration of 2 years (interest rate 12%). Staff costs are 1500 EUR a month. Sales revenue is 3000 EUR a month.

Compile the cash flow statement of the first year.

Financial ratios

Financial ratios are used for comparisons between different periods of one company, between different companies or between a company and the industry’s average.

Ratios

• Liquidity ratios

Current ratio = current assetscurrent liabilities Quick ratio (acid-test ratio) = current assets −(inventories +prepayments )current liabilities

• Activity ratios

assetsrevenue salesover Asset turn

value)residual(in assets fixedrevenue salesoverasset turn Fixed

revenue salesexpense general and tiveadministraratios expense general and tiveAdministra

revenue salescosts staffratiocost Staff

Ratios

• Profitability ratios

Gross margin = gross profitsales revenue

revenue salesprofit operatingmargin Operating

revenue salesprofitnet margin Profit

Return on assets (ROA) = net profitassets

equityprofitnet (ROE)equity on Return

Ratios

• Debt ratios

assetssliabilitie ratiodebt

equitysliabilitieratio D/E

equity) es(liabilitiequityratioEquity

Interest coverage ratio = operating profitinerest expense