New Venture Finance Concepts

TOPIC 4

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Describe and prepare a balance sheet and an income statement

Prepare a cash flow statement and explain how it helps monitor a venture’s cash position

Describe operating breakeven analysis in terms of breakeven revenues

Identify major drivers on the amount of revenues needed to survive

Describe how financial ratios are used to monitor a venture’s performance

Identify cash burn rate measures and liquidity ratios and explain how they are calculated and used

Identify specific leverage ratios and explain their usage by lenders and creditors

Identify and describe measures of profitability and efficiency that are important to the entrepreneur and equity investors

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Generally Accepted Accounting Principles (GAAP): guidelines that set out the manner and form for

presenting accounting information Accrual Accounting:

the practice of recording economic activity when recognized rather than waiting until realized

Depreciation: reduction in value of a fixed asset over its expected life

intended to reflect the usage of wearing out of the asset Accumulated Depreciation:

sum of all previous depreciation amounts charged to fixed assets

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Balance Sheet:financial statement that provides a snapshot of a venture’s financial position as of a specific date

Balance Sheet Equation:Total Assets = Total Liabilities + Owners’ Equity

Assets:financial, physical and intangible items owned or controlled by the business

Owners’ Equity:equity capital contributed by the owners of the venture is shown after listing all liabilities

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Current Assets:cash & other assets that are expected to be converted into cash in less than one year Cash:

▪ amount of coin, currency, and checking account balances

Receivables:▪ credit sales made to customers

Inventories:▪ raw materials, work-in-process, and finished products which

the venture hopes to sell Fixed Assets:

assets with expected lives of greater than one year

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Current Liabilities: Payables:

▪ short-term liabilities owed to suppliers for purchases made on credit

Accrued Wages:▪ liabilities owned to employees for previously completed work

Bank Loan:▪ interest-bearing loan of one year or less from a commercial bank

Long-Term Debts: loans that have maturities of longer than one year

Capital Leases: long-term, noncancelable leases whereby the owner

receives payments that cover the cost of the equipment plus a return on investment in the equipment

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Income Statement: financial statement that reports the revenues generated

and expenses incurred over an accounting period Sales or Revenues:

funds earned from selling a product or providing a service Gross Earnings:

net sales (after deducting returns and allowances) minus the cost of production

Net Income (or Profit): bottom line measure after all operating expenses,

financing costs, and taxes have been deducted from net sales

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Statement of Cash Flows:

shows how cash, reflected in accrual accounting, flowed into and out of a firm during a specific period of operation

Can be used to determine if a venture has been building or burning cash

“Net Cash Burn” occurs when the sum of cash flows from “operations” and “investing” is negative

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Assume: Company started business on January 1, began

production on July 1, and sold first unit in August▪ Sold 1,200 units @ $100/unit during the year ▪ Sold 100 units each in August and September; Sold 250 units each in

October and November; and Sold 500 units each in December

▪ All sales on credit, payable by customer in 30 days

Other expenses include:▪ Rent – $500/month

▪ Marketing – $12,500 (for the year)

▪ Other administrative expenses – $1,500/month

▪ Depreciation expense – assume 20 year useful life

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Assume: Company produced 1,600 units

▪ Produced 200 units each in July and August and Produced 300 units each in September, October, November and December

Cost to produce each unit:▪ Cost of parts, materials, etc. – $50/unit

▪ Cost of direct labor – $15/unit

All materials for production were purchased at the beginning of the month they were used▪ All materials were purchased on credit, payable to supplier in

30 days

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Other assumptions:

Company applied for and received two credit cards totaling a $30,000 line of credit with an introductory rate of 0% for the first 12 months

▪ Two cards held a $25,000 balance as of December 31

$3,000 of administrative wages incurred in December were paid the next month (in January)

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Assume the following beginning Balance Sheet as of January 1

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Income Statement as of December 31

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Basic Production Schedule as of December 31

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Cash Flow Statement as of December 31

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Balance Sheet as of December 31

Financial Ratios: show the relationship between two or more financial

variables Trend Analysis:

used to examine a venture’s performance over time Cross-sectional Analysis:

used to compare a venture’s performance against another firm at the same point in time

Industry Comparables Analysis: used to compare a venture’s performance against the

average performance in the same industry

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Measures of Financial Performance by Life Cycle Stage

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Company ABC Income Statement for Years Ended 2009 and 2010

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Company ABC Balance Sheet for Years Ended 2008, 2009, and 2010

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Company ABC Statement of Cash Flows for Years Ended 2009 and 2010

Net Cash Burn Rate:

represents the amount of cash expended on the venture’s operating and financing expenses and its capital investments in assets net of the cash generated from operations (sales) and financing

= Cash burn rate – Cash build rate

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Cash Burn Rate: cash expended by a venture on its operating and

financing expenses and its investments in assets = Inventory-related expenses + Admin expenses +

Marketing expenses + R&D expenses + Interest expenses + Change in prepaid expenses – (Change in accrued liabilities + Change in payables) + Capital investment + Taxes

For 2010, Cash Burn: = 425,000 + 65,000 + 39,000 + 27,000 + 20,000 + 0 –

(1,000 + 27,000) +50,000 + 8,000 = 606,000▪ Note 425,000 = 380,000 (COGS) + 45,000 (Change in Inv.)

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Cash Build Rate:

Cash build for a fixed period of time, typically a month

= Net Sales – Increase in Receivables

For 2010, Cash Build:

= 575,000 - 30,000 = 545,000

Net Cash Burn

= Cash burn – Cash build

= 606,000 - 545,000 = 61,000

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Liquidity Ratios:Indicates the ability to pay short-term liabilities when they come due Current Ratio:

= Average current assets/Average current liabilities= ((250,000+180,000)/2) ÷ ((204,000+110,000)/2)= 1.37

Quick Ratio = (Average current assets – Average inventories)/Average current liabilities(= (250,000 +180,000)/2 – (140,000+95,000)/2) ÷ ((204,000 + 110,000)/2)= .62

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Operating Cycle

Operating Cycle –time required to purchase, produce, and sell the venture’s products plus the time needed to collect receivables if the sales are on credit

Cash Conversion Cycle:

sum of the inventory-to-sale conversion period and the sales-to-cash conversion period less the purchase-to-payment conversion period

Conversion Period Ratio:

indicates the average time it takes in days to convert certain current assets and current liability accounts into cash

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Inventory-to-Sales Conversion Period:

is the period required to convert purchased materials into the sale of finished costs and represents the amount of cash tied up in inventories

= Average Inventories/(CoGS / 365)

= ((140,000 + 95,000)/2) ÷ (380,000/365)

= 112.9 days

What drives this number?

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Sales-to-Cash Conversion Period:

measures the average days of sales committed to the extension of trade credit

= Average Receivables/(Net Sales/365)

= ((105,000 + 75,000)/2) ÷ (575,000/365)

= 57.1 days

What is the significance of this measure?

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Purchase-to-Payment Conversion Period: measures the average time from a purchase of

materials and labor to actual cash payment and represents the days of production costs financed by trade credit and accrued wages/liabilities

= (Average Payables + Average Accrued Liabilities) / (COGS / 365)

= ((84,000+57,000)/2 + (10,000+9,000)/2) ÷(380,000/365)

= 76.8 days

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Cash Conversion Cycle (C3)

C3 indicates the average time it takes a venture to complete its operating cycle less a deduction for days supported by trade credit and delayed payroll financing

Goal is to keep C3 as close to ~0 days as possible

= Inventory-to-Sale Conversion Period + Sale-to-Cash Conversion Period – Purchase-to-Payment Conversion

= 112.9 days + 57.1 days – 76.8 days

= 93.2 days

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Interpreting Changes in Conversion Times

Leverage Ratio:

indicates the extent to which the venture is in debt and its ability to repay its debt obligations

Loan Principal Amount:

dollar amount borrowed from a lender

Interest:

dollar amount paid on the loan to a lender as compensation for making the loan

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Leverage (Total-Debt-to-Total-Asset) Ratio:

indicates the amount of assets “pledged” to debt holders and other creditors and also indicates the percentage of the assets left for equity holders

= Average total debt / Average total assets

= ((204,000 +110,000)/2 + (80,000 +90,000)/2) ÷((446,000 + 343,000)/2)

= .6134 or 61.34%

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How Does Company ABC ‘s Performance in 2010 Compare with Industry Peers?

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How Does Company ABC Compare with Industry Peers? (cont.)