CHAPTER 8
Assessing a New Venture’s Financial Strength and Viability

Introduction to Financial Management

An entrepreneur’s ability to pursue an opportunity and turn the opportunity into a viable entrepreneurial firm hinges largely on the availability of money. 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. It is important for a firm to have a solid grasp of how it is doing financially. One of the most common mistakes young entrepreneurial firms make is not emphasizing financial management and putting in place appropriate forms of financial controls.

Financial Objectives 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, liquidity, efficiency, and stability.

Profitability is the ability to earn a profit.

Liquidity is a company’s ability to meet its short-term financial obligations.

Efficiency is how productively a firm utilizes its assets relative to its revenue and its profits.

Stability is the strength and vigor of the firm’s overall financial posture.

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.

Financial Statements

Historical financial statements reflect past performance and are usually prepared on a quarterly and annual basis. Pro forma financial statements are projections for future periods based on forecasts and are typically completed for two to three years in the future.

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.

Income Statement

The 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. Income statements are typically prepared on a monthly, quarterly, and annual basis. Most income statements are prepared in a multiyear format, making it easy to spot trends.

Balance Sheet

Unlike the income statement, which covers a specified period of time, a balance sheet is a snapshot of a company’s assets, liabilities, and owners’ equity at a specific point in time. The left-hand side of a balance sheet (or the top, depending on how it is displayed) shows a firm’s assets, while the right-hand side (or bottom) shows its liabilities and owners’ equity. The assets are listed in order of their “liquidity,” or the length of time it takes to convert them to cash. The liabilities are listed in the order in which they must be paid. 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: Current assets include cash plus items that are readily convertible to cash, such as accounts receivable, marketable securities, and inventories.

■ Fixed assets: Fixed assets are assets used over a longer time frame, such as real estate, buildings, equipment, and furniture.

■ Other assets: Other assets are miscellaneous assets, including accumulated goodwill.

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. The statement of cash flows 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 separate activities: operating activities, investing activities, and financing activities. These activities, which are explained in the following list, are the activities from which a firm obtains and uses cash:

■ Operating activities: Operating activities include net income (or loss), depreciation, and changes in current assets and current liabilities other than cash and short-term debt. A firm’s net income, taken from its income statement, is the first line on the corresponding period’s cash flow statement.

■ Investing activities: Investing activities include the purchase, sale, or investment in fixed assets, such as real estate, equipment, and buildings.

■ Financing activities: 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 statements is through ratio analysis. The ratios are divided into profitability ratios, liquidity ratios, and overall financial stability ratios.

Comparing a Firm’s Financial Results to Industry Norms

Comparing its financial results to industry norms helps a firm determine how it stacks up against its competitors and if there are any financial “red flags” requiring attention. This type of comparison works best for firms that are of similar size, so the results 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.

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 factor or factors that will affect its future production capacity and product demand.

Forecast of Costs of Sales and Other Items

After completing its sales forecast, 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 item as a percentage of sales. For example, in the case of New Venture Fitness Drinks, its cost of sales has averaged 47.5 percent over the past two years. In 2014, its sales were $586,600 and its cost of sales was $268,900. The company’s sales are forecast to be $821,200 in 2015. Therefore, based on the percent-of-sales method, its cost of sales in 2015 will be $390,000, or 47.5 percent of projected sales. The same procedure could be used to forecast the cost of each expense item on the company’s income statement.

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 well-managed established firms also maintain these statements as part of their routine financial planning process and to help prepare budgets. The preparation of pro forma statements also helps firms rethink their strategies and make adjustments if necessary.

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. In the pro forma income statement, the constant ratio method of forecasting is used to forecast the cost of sales and general and administrative expenses, meaning that these items are projected to remain at the same percentage of sales in the future as they were in the past.

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 sheet is also used to project the overall financial soundness of a company.

Pro Forma Statement of 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 flows 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, and financing activities. Close attention is typically paid to the section on operating activities because it shows how changes in the company’s accounts receivable, accounts payable, and inventory levels affect the cash that it has available for investing and finance activities. If any of these items increases at a rate that is faster than the company’s annual increase in sales, it typically raises a red flag.

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 its cash position and its overall financial soundness.

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