Chapter 8. Assessing a New Venture's Financial Strength and Viability

Introduction to Financial Management

Financial Management deals with two activities: raising money and managing a company's finances in a way that achieves the highest rate of return. Regardless of the quality of a product or service, a company can't be viable in the long run unless it is successful financially. Money either comes from external sources (such as investors or lenders) or is internally generated through earnings. One of the most common mistakes young entrepreneurial firms make is not emphasizing financial management and putting in place appropriate forms of financial controls.

Entrepreneurs and those managing established companies must be aware of how much money they have in the bank and if that amount is sufficient to satisfy their firm's financial obligations. Just because a firm is successful doesn't mean that it doesn't face financial challenges. It is important for a firm to accurately anticipate whether it will be able to fund its growth through earnings or if it will need to look for investment capital or borrowing to raise needed cash.

Financial Objective of a Firm

Most entrepreneurial firms⎯whether they have been in business for several years or they are start-ups⎯have four main financial objectives:

• Profitability: A company's ability to make a profit. A firm must become profitable to remain viable and provide a return to its owners.
• Liquidity: A company's ability to meet its short-term financial obligations. A firm must keep a close watch on accounts receivable and inventories. A company's account receivable is money owed to it by its customers. Its inventory is its merchandise, raw materials, and products waiting to be sold. If a firm allows the levels of either of these assets to get too high, it may not be able to keep sufficient cash on hand to meet its short-term obligations.
• Efficiency: How productively a firm utilizes its assets relative to its revenue and its profits. 
• Stability: The overall health of the financial structure of the firm, it must not only earn a profit and remain liquid but also keep its debt in check. If a firm continues to borrow from its lenders and its debt-to-equity ratio, which is calculated by dividing its long-term debt by its shareholder's equity, gets too high, it may have trouble meeting its obligations and securing the level of financing needed to fuel its growth.

The Process of Financial Management

To assess whether its financial objectives are being met, firms rely heavily on analyses of financial statements, forecasts, and budgets. 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 its past performance, its current circumstances, and its future plans. New ventures typically base their forecasts on an estimate of sales and then on industry averages or the experiences of similar start-ups regarding the cost of gods sold (based on a percentage of sales) and on other expenses. Budgets are itemized forecasts of a company's income, expenses, and capital needs and are also an important tool for financial planning and control.

The process of a firm's financial management begins by tracking the company's past financial performance through the preparation and analysis of financial statements. These statements organize and report the firm's financial transactions. The next step is to prepare forecasts for two or three years in the future. The final step in the process is the ongoing analysis of a firm's financial results. Financial ratios, which depict relationships between items on a firm's financial statements, are used to discern whether a firm is meeting its financial objectives and how it stacks up against its industry peers. 

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It is important that a new venture be familiar with the entire process, however. Typically, new ventures prepare financial statements quarterly so that as soon as the first quarter is completed, the new venture will have historic financial statements to help prepare forecasts and pro forma statements for future periods.

Financial Statements

Historical financial statements reflect past performance and are usually prepared on a quarterly and annual basis. Publicly traded firms are required by the Security and Exchange Commission (SEC) to prepare financial statements and make them available to the public. The statements are submitted to the SEC through a number of required fillings. The most comprehensive filling is the 10-K, which is a report similar to the annual report except that it contains more detailed information about the company's business.

Pro forma financial statements are projections for future period based on forecasts and are typically completed for two to three years in the future. Pro forma statements are strictly planning tools ad are not required by the SEC.

Historical Financial Statements

Historical financial statements include the income statement, the balance sheet, and the statement of cash flows. The statements are usually prepared in this order because information flows logically from one to the next. In start-ups, financial statements are typically scrutinized closely to monitor the financial progress of the firm. On the rare occasion when a company has not used financial statements in planning, it should prepare and maintain them anyway. If a firm does not have these statements, it may be preluded from serious consideration for an investment or a loan. Lets look at each of these statements.

Income statement → Reflects the results of the operations of a firm over a specified period of time. It records all the revenues and expenses for the given period and shows whether the firm is making a profit or is experiencing a loss (which is why the income statement if often referred to as the "profit-and-loss statement)

The three numbers that receive the most attention when evaluating an income statement are the following:

• Net Sales: Consist of total sales minus allowances for returned goods and discounts.
• Cost of Sales (or cost of goods sold): Includes all the direct costs associated with producing or delivering a product or service, including the material costs and direct labor.
• Operating Expenses: Include marketing, administrative costs, and other expenses not directly related to producing a product or service.

One of the most valuable things that entrepreneurs and managers do with income statements is to compare the ratios of cost of sales and operating expenses to net sales for different periods. Profit margin is a ratio that is of particular importance when evaluating a firm's income statements. A firm's profit margin, or return on sales is computed by dividing net income by net sales. A firm's profit margin tells it what percentage of every dollar in sales contributes to the bottom line. Price-to-earnings ratio, or P/E ratio is a simple ratio that measures the price of a company's stock against its earnings.

Balance Sheet → A snapshot of a company's assets, liabilities, and owners' equity at a specific point in time. A balance sheet must always "balance", meaning that a firm's assets must always equal its liabilities plus owners' equity.

The major categories of assets listed on a balance sheet are the following:

• Current Assets: Include cash plus items that are readily convertible to cash, such as accounts receivable, marketable securities, and inventories.
• Fixed Assets: Assets used over a longer time frame, such as real estate, buildings, equipment, and furniture.
• Other Assets: Miscellaneous assets, including accumulated goodwill.

The major categories of liabilities listed on a balance sheet are the following:

• Current Liabilities: Include obligations that are payable within a year, including accounts payable, accrued expenses, and the current portion of long term-debt.
• Long -Term Liabilities: Include notes or loans that are repayable beyond one year, including liabilities associated with purchasing real estate, buildings, and equipment.
• Owners' equity: The equity invested in the business by its owner plus the accumulated earnings retained by the business after paying dividends.

Balance sheets are somewhat deceiving. First a company's assets are recorded at cost rather than fair market value. Second, intellectual property, such as patents, trademarks, and copyrights receive value on the balance sheet in some cases and in some cases they don't, depending on the circumstances involved. Third, intangible assets, such as the amount of training a firm has provided to its employees and the value of its brand, are not recognized on its balance sheet. Finally, the goodwill that a firm has accumulated is not reported on its balance sheet, although this may be the firm's single most valuable asset.

Statement of Cash Flows → The statement of cash flows summarizes the changes in a firm's cash position for a specified period of time and details why the change occurred. It is similar to a month-end bank statement. It reveals how much cash is on hand at the end of the month as well as how the cash was acquired and spent during the month. The statement of cash flows is divided into three activities from which a firm obtains and uses cash:

• Operating Activities: Include net income (or loss), depreciation, and changes in current assets and current liabilities other than cash and short-term debt.
• Investing Activities: Include the purchase, sale, or investment in fixed assets, such as real estate, equipment, and buildings.
• Financing Activities: Include cash raised during the period by borrowing money or selling stock and/or cash used during the period by paying dividends, buying back outstanding stock, or buying back outstanding bonds.

Ratio Analysis → The most practical way to interpret or make sense of a firm's historical financial statement.

Comparing a Firm's Financial Results to Industry Norms → Helps a firm determine how it stacks up against its competitors and if there any financial "red flags" requiring attention. This type of comparison works best for firms that are of similar size, so the result should be interpreted with caution by new firms. Many sources provide industry-related information.

Forecasts

Forecasts are predictions of a firm's future sales, expenses, income, and capital expenditures. A firm's forecasts provide the basis for its pro forma financial statements. A well-developed set of pro forma financial statements helps a firm create accurate budgets, build financial plans, and manage its finances in a proactive rather than a reactive manner. As a result, a completely new firm's forecast should be preceded in its business plan by an explanation of the sources of the numbers for the forecast and the assumptions used to generate them. This explanation is called an assumptions sheet. Investors typically study assumptions sheets like hawks to make sure the numbers contained in the forecasts and the resulting financial projections are realistic.

Sales Forecast

A sales forecast is a projection of a firm's sales for a specified period (such as a year), though most firms forecast their sales for two to five years into the future. It is the first forecast developed and is the basis for most of the other forecasts. A sales forecast for an existing firm is based on (1) its record of past sales, (2) its current production capacity and product demand, and (3) any factors or factors that will affect its future production capacity and product demand.

Forecasts of Costs of Sales and Other Items

A firm must forecast its cost of sales (or cost of goods sold) and the other items on its income statement. The most common way to do this is to use the percent-of-sales method, which is a method for expressing each expense items as a percentage of sales. Obviously, a firm must apply a common sense in using the percent-of-sales method.

Pro Forma Financial Statements 

A firm's pro forma financial statements are similar to its historical financial statements except that they look forward rather than track the past. New ventures typically offer pro forma statements, but will managed established firms also maintain these statements as a part of their routine financial planning process and to help prepare budgets. A firm's pro forma financial should not be prepared in isolation. Instead, they should be created in conjunction with the firm's overall planning activities.

Pro Forma Income Statement

Once a firm forecasts its future income and expenses, the creation of the pro forma income statement is merely a matter of plugging in the numbers.

Pro Forma Balance Sheet

The pro forma balance sheet provides a firm a sense of how its activities will affect its ability to meet its short-term liabilities and how its finances will evolve over time. It can also quickly show how much of a firm's money will be tied up in accounts receivable, inventory, and equipment. The pro forma balance is also used to project the overall financial soundness of a company.

Pro Forma Statement Cash Flows

The pro forma statement of cash flows shows the projected flow of cash into and out of the company during a specified period. The most important function of the pro forma statement of cash flow is to project whether the firm will have sufficient cash to meet its needs. As with the historical statement of cash flows, the pro forma statement of cash flows is broken into three activities:

• Operating activities
• Investing activities 
• Financing activities

Close attention is typically paid to the section on operating activities because it shows how changes in the company's account receivable, account payable, and inventory levels affect the cash that it has available for investing and finance activities.

Ratio Analysis

The same financial ratios used to evaluate a firm's historical financial statements should be used to evaluate the pro forma financial statements. This work is completed so the firm can get a sense of how its projected financial performance compares to its past performance and how its projected activities will affect the cash position and its overall financial soundness.

The liquidity ratios show a consistently health ratio of current assets to current liabilities, suggesting that the firm should be able to cover its short-term liabilities without difficulty. The overall financial stability ratio indicate promising trends.

In summary, it is extremely important for a firm to understand its financial position at all times and for new ventures to base their financial projections on solid numbers. As mentioned earlier, regardless of how successful a firm is in other areas, it must succeed financially to remain strong and viable.