Chapter 8 Assessing a New Venture’s Financial Strength and Viability Bruce R. Barringer R. Duane Ireland Copyright ©2016 Pearson Education, Inc. 8-1 Chapter Objectives 1 of 2 1. Learn about the importance of understanding the financial management of an entrepreneurial firm. 2. Identify the four main financial objectives of entrepreneurial firms. 3. Describe the process of financial management as used in entrepreneurial firms. 4. Explain the difference between historical and pro forma financial statements. 5. Describe the different historical financial statements and their purpose. Copyright ©2016 Pearson Education, Inc. 8-2 Chapter Objectives 2 of 2 6. 7. Discuss the role of forecasts in projecting a firm’s future income and expenses. Explain the purpose of pro forma financial statements. Copyright ©2016 Pearson Education, Inc. 8-3 Financial Management 1 of 2 • Financial Management – Financial management deals with two things: raising money and managing a company’s finances in a way that achieves the highest rate of return – Chapter 10 focuses on raising money. This chapter focuses primarily on: • How a new venture tracks its financial progress through preparing, analyzing, and maintaining past financial statements. • How a new venture forecasts future income and expenses by preparing pro forma (or projected) financial statements. Copyright ©2016 Pearson Education, Inc. 8-4 Financial Management 2 of 2 The financial management of a firm deals with questions such as the following on an ongoing basis: • 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? Copyright ©2016 Pearson Education, Inc. 8-5 Financial Objectives of a Firm 1 of 3 Copyright ©2016 Pearson Education, Inc. 8-6 Financial Objectives of a Firm 2 of 3 • 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. Copyright ©2016 Pearson Education, Inc. 8-7 Financial Objectives of a Firm 3 of 3 • 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. Copyright ©2016 Pearson Education, Inc. 8-8 The Process of Financial Management 1 of 4 • 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. Copyright ©2016 Pearson Education, Inc. 8-9 The Process of Financial Management 2 of 4 • Forecasts (continued) – 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 goods sold and 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. Copyright ©2016 Pearson Education, Inc. 8-10 The Process of Financial Management 3 of 4 • Financial Ratios – Depict relationships between items on a firm’s financial statements. – An analysis of its financial ratios helps a firm determine whether it is meeting its financial objectives and how it stacks up against industry peers. • Importance of Financial Management – Many experienced entrepreneurs stress the importance of keeping on top of the financial management of the firm. Copyright ©2016 Pearson Education, Inc. 8-11 The Process of Financial Management 4 of 4 Copyright ©2016 Pearson Education, Inc. 8-12 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 SEC to prepare financial statements and make them available to the public. • Pro Forma Financial Statements – Are projections for future periods based on forecasts and are typically completed for two to three years in the future. • Pro forma financial statements are strictly planning tools and are not required by the SEC. Copyright ©2016 Pearson Education, Inc. 8-13 Importance of Keeping Good Records The first step toward prudent financial management is keeping good records. Copyright ©2016 Pearson Education, Inc. 8-14 New Venture Fitness Drinks • New Venture Fitness Drinks – To illustrate how financial statements are prepared, we used New Venture Fitness Drinks, the fictitious sports drink company introduced in Chapter 3. • New Venture Fitness Drinks has been in business for five years. • Targeting sports enthusiasts, the company sells a line of nutritional fitness drinks. • The company’s strategy is to place small restaurants, similar to smoothie restaurants, near large outdoor sports complexes. • The company is profitable and is growing at a rate of 25% per year. Copyright ©2016 Pearson Education, Inc. 8-15 Historical Financial Statements Three types of historical financial statements Financial Statement Income Statement Balance Sheet Statement of cash flows Purpose 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. Is a snapshot of a company’s assets, liabilities, and owner’s equity at a specific point in time. Summarizes the changes in a firm’s cash position for a specified period of time and details why the changes occurred. Copyright ©2016 Pearson Education, Inc. 8-16 Historical Income Statements Copyright ©2016 Pearson Education, Inc. 8-17 Historical Balance Sheets 1 of 2 Assets Copyright ©2016 Pearson Education, Inc. 8-18 Historical Balance Sheets 2 of 2 Liabilities and Shareholders’ Equity Copyright ©2016 Pearson Education, Inc. 8-19 Historical Statement of Cash Flows Copyright ©2016 Pearson Education, Inc. 8-20 Ratio Analysis • Ratio Analysis – The most practical way to interpret or make sense of a firm’s historical financial statements is through ratio analysis, as shown in the next slide. • Comparing a Firm’s Financial Results to Industry Norms – Comparing a firm’s 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. Copyright ©2016 Pearson Education, Inc. 8-21 Historical Ratio Analysis Copyright ©2016 Pearson Education, Inc. 8-22 Forecasts 1 of 4 • Forecasts – The analysis of a firm’s historical financial statements are followed by the preparation of 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. Copyright ©2016 Pearson Education, Inc. 8-23 Forecasts 2 of 4 • Sales Forecast – A sales forecast is a projection of a firm’s sales for a specified period (such as a year). – It is the first forecast developed and is the basis for most of the other forecasts. • A sales forecast for a new firm is based on a good-faith estimate of sales and on industry averages or the experiences of similar startups. • 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 that will affect its future product capacity and product demand. Copyright ©2016 Pearson Education, Inc. 8-24 Forecasts 3 of 4 Historical and Forecasted Annual Sales for New Venture Fitness Drinks Copyright ©2016 Pearson Education, Inc. 8-25 Forecasts 4 of 4 • Forecast of Costs of Sales and Other Items – Once a firm has completed its sales forecast, it 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 percentageof-sales method, which is a method for expressing each expense item as a percentage of sales. • If a firm determines that it can use the percent-of-sales method and it follows the procedures described in the textbook, then the net result is that each expense item on its income statement will grow at the same rate as sales (with the exception of items that can be individually forecast, such as depreciation). Copyright ©2016 Pearson Education, Inc. 8-26 Pro Forma Financial Statements • 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. – The preparation of pro forma financial statements helps a firm rethink its strategies and make adjustments if necessary. – The preparation of pro forma financials is also necessary if a firm is seeking funding or financing. Copyright ©2016 Pearson Education, Inc. 8-27 Types of Pro Forma Financial Statements Financial Statement Pro Forma Income Statement Purpose Shows the projected financial results of the operations of a firm over a specific period. Pro Forma Balance Sheet Shows a projected snapshot of a company’s assets, liabilities, and owner’s equity at a specific point in time. Pro Forma Statement of Cash flows Shows the projected flow of cash into and out of a company for a specific period. Copyright ©2016 Pearson Education, Inc. 8-28 Pro Forma Income Statements Copyright ©2016 Pearson Education, Inc. 8-29 Pro Forma Balance Sheets 1 of 2 Assets Copyright ©2016 Pearson Education, Inc. 8-30 Pro Forma Balance Sheets 2 of 2 Liabilities and Shareholders’ Equity Copyright ©2016 Pearson Education, Inc. 8-31 Pro Forma Statement of Cash Flows 1 of 2 Operating Activities Copyright ©2016 Pearson Education, Inc. 8-32 Pro Forma Statement of Cash Flows 2 of 2 Investing Activities and Financing Activities Copyright ©2016 Pearson Education, Inc. 8-33 Ratio Analysis • 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. Copyright ©2016 Pearson Education, Inc. 8-34 Ratio Analysis Based on Historical and Pro-Forma Financial Statements Copyright ©2016 Pearson Education, Inc. 8-35 Copyright ©2016 Pearson Education, Inc. 8-36 290 PART 3 MOVING FROM AN IDEA TO AN ENTREPRENEURIAL FIRM The downside to using Fundbox as a fix for cash flow gaps is the costs involved. While the loans are short-term, an interest rate of between 0.7 percent and 3 percent per month, as reported above, results in a high annual APR. The best thing for any small business to do is to check with an accountant regarding the wis- dom of using Fundbox or a similar product to minimize cash flow shortfalls. Fundbox has raised $17.5 million from a collection of venture capitalists to fund and grow its operations. effects of a small entrepreneurial firm's decision to use Fundbox on the components of that firm's statement of cash flows? 8-36. If Fundbox's co-founders (Yuval Ariav, Eyal Shinar, and Tomer Michael) were to ask your advice about the importance of pro forma statements to their firm's continuing success, what would you say to them? What pro forma statements would you recommend the co-founders develop and why? 8-37. As a young entrepreneur, what lessons about the financial management of a firm can you learn from the actions taken by the three cofounders of Fundbox? Discussion Questions 8-34. Toward the beginning of this case, the following statement appears: “Almost all small businesses experience cash flow shortfalls.” What is cash flow? Why is cash flow so critical to an entrepreneurial firm's success? Why do almost all small businesses experience cash flow shortfalls? 8-35. As explained in this chapter, a firm's statement of cash flows is divided into three separate activities. Which of the activities from the statement of cash flows would be affected by a firm's decision to use Fundbox's service? What are some of the potential Sources: L. Rao, “Lending Startup Fundbox Raises $17.5 from Khosla to Help SMBs Improve Cash Flow," TechCrunch, avail- able at http://techcrunch.com/2014/04/10/lending-startup- fundbox-raises-17-5m-from-khosla-to-help-smbs-improve-cash- flow/, posted on April 10, 2014, accessed on August 29, 2014; M. Prosser, “Fundbox: An Alternative to Invoice Factoring or Discounting," FitSmallBusiness, available at http://fitsmallbusiness. com/fundbox/, posted on August 6, 2014, accessed on August 29, 2014; R. Shafaghi, "Meet: Fundbox-Turn Unpaid Invoices into Cash," available at http://www.freshbooks.com/blog/2014/05/28/ meet-fundbox-turn-unpaid-invoices-into-cash/, posted on May 28, 2014, accessed on August 29, 2014. CASE 8.2 289 CHAPTER 8 ASSESSING A NEW VENTURE'S FINANCIAL STRENGTH AND VIABILITY sooner rather than later and avoid short-term gaps in its cash flow. The interest rate for Fundbox's service varies. According to a review published by the FitSmall Business blog, rates range from 0.7 percent to 3 percent per month, with the typical borrower at about 2 percent per month. About 40 percent of businesses that apply are accepted by Fundbox. Fundbox uses sophisticated data analytics to build a picture of a potential borrower's overall financial health and likelihood of repayment. Fundbox doesn't talk much about how this actually works. It is a core feature of their business and considered to be a trade secret. B2B Players Fundbox's loans are most suitable for business to busi- ness (B2B) companies. These are businesses that do work for other businesses and issue invoices for the work they do. Most business to consumer companies (B2C) are paid at the point of sale. For example, when you eat at a restaurant or buy a book from Amazon.com, you pay for it right away. The B2B category includes freelancers who do work for businesses. These are individuals who may benefit especially from Fundbox's service. For example, an independent software developer may spend 100 hours developing a mobile app for a small business and invoice the business $15,000. If the payment terms are net 60, the business will have 60 days to pay the bill. Via Fundbox, the independent software developer could get his money right away. For a freelancer, getting money sooner rather than later may make the difference in making rent or pay- ing a mortgage on time. Partnerships with Bookkeeping Companies To make it easy for clients, Fundbox has established partnerships with many of the top online bookkeeping programs, including Quickbooks, Freshbooks, Xero, and Harvest. For Freshbooks, for example, once a business- person creates a Fundbox account (sign-up is free), it can easily be tied to the business's Freshbooks account. When an invoice is entered into Freshbooks, Fundbox will analyze all pertinent data to see if a 12-week loan to cover the amount of the invoice can be made. The business will receive an e-mail message indicating whether a loan can be made. The business can then evaluate the terms of the loan and either accept or pass on the offer. If the offer is accepted, the funds will be deposited in the business's bank account, usually within a day. Fundbox only works with the borrower. In the Home Depot example provided above, if the borrower defaulted on Fundbox's loan, Fundbox would not try to collect the loan amount from Home Depot. Each bor- rower is given a maximum line of credit from Fundbox, so offers will not be made on all invoices. y (say $4.50 mpany then or . Fundbox's Future According to TechCrunch, Fundbox launched in stealth mode, presumably to test its service and work the bugs out. Since it has gone live, it has signed up thousands of active users (mostly small businesses) and clears tens of thousands of invoices daily in 42 states. Fundbox is among a growing number of “alterna- tive lenders” that small businesses are relying on, largely because banks have pulled back from small business lending. Firms offering services that are similar to those provided by Fundbox include Kabbage, OnDeck, and Lending Club. What is unique about Fundbox is that it connects loans to specific invoices, which helps small businesses minimize cash flow challenges. mpany's custo ternative bez ect relations mpany become invoice , ima with its custo Days Sales Out a business AUTO ed has hay Fundbox has partner- ships with many of the top online bookkeeping programs. If a business has a Freshbooks account, for example, it can easily be tied to the business's Fundbox's account. STE to the name Creativa Images/Shutterstock 1 500ner rather th 1 cash flow. T 288 PART 3 MOVING FROM AN IDEA TO AN ENTREPRENEURIAL FIRM varies. Accord siness blog month, w se accepted per month. Ak Fundbox a picture of a even fish. There is cooked chicken and beef available as substitutes. Along with sushi, each restaurant also sells miso soup, seaweed salad, and green tea ice cream. It is an experience that is totally unique in the sushi industry. It also provides fast-casual food patrons an alternative to ne standard fare of burgers and chicken sandwiches. Do You Roll? is growing via franchising. It cur- y has eight franchise units and two company-owned es. It has penned several development agreements, Ich may add up to 70 additional franchise units over next 10 years. According to the company, it costs between $304,295 and $508,780 to open a How Do You Roll? restaurant. The initial franchise fee is $30,000, and the ongoing royalty is 7 percent of gross sales. In spring 2013, Yuen Yung and Peter Yung pitched the business on the popular ABC show Shark Tank. Along with a $1 million investment from shark Kevin O'Leary, Yung said restaurant sales jumped 30 percent. In addi- tion, he and his brother received more than 600 inquiries from potential franchisees interested in opening How Do You Roll? restaurants. 8-32. Based on the material covered in this chapter, what questions would you ask the firm's founders before making your funding decision? What answers would satisfy you? 8-33. If you had to make your decision on just the informa- tion provided in the pitch and on the company's web- site, would you fund this firm? Why or why not? and likelihoo about how t business an partnersh To make it partnershi programs Harvest A person cr can easil When ar wil anal o cover busines whethe evalua an the depos a day Home defal colle TOW SOC CASE 8.1 Fundbox: Designed to Help Small Businesses Minimize Cash Flow Shortfalls • Web: www.fundbox.com • Facebook: Fundbox • Twitter: @fundbox exchange for a lump sum of money (say $4,500 for a Introduction $5,000 invoice). The factoring company then proceeds Fundbox is an entrepreneurial start-up that offers 12- to collect the money from the company's customer. week loans to small businesses. The loans are tied to Many businesses don't like this alternative because it specific invoices that the businesses have outstanding. involves a third party having a direct relationship with Payment for the loans (including principle, interest, and their customer. If the factoring company becomes fees) is deducted from a company's bank account in 12 aggressive in trying to collect the invoice, it could equal amounts on a weekly basis. Once the money for affect the business's relationship with its customer. the invoice comes in, the loan can be paid in full. There To further complicate things, Days Sales Outstanding is no penalty for early payment. (DSO), or the time between when a business issues an Fundbox was launched in 2012 by Yuval Ariav, Eyal invoice and the payment is received, has been increasing Shinar, and Tomer Michael, who are technological inno- across the board in recent years. vators and financial professionals. The firm's mission is to offer small businesses a common-sense approach to cash-flow management. Fundbox Fundbox offers a novel solution to the problem. When The Problem an invoice comes in, it will issue a 12-week loan for the Almost all small businesses experience cash flow amount of the invoice. Because the loan is matched shortfalls. Think of how business works. Businesses with a specific receivable, it prevents the repayment of often win a contract, purchase the materials and sup- the loan from creating a new cash flow problem for the plies that are needed to produce the firm's product or business. The interest rate on the loan is tied to both the service, pay employees, and then have to wait 30 to creditworthiness of the borrower and the company that 60 days to receive payment from the customer. This owes the amount on the invoice. This practice encour- scenario causes even healthy businesses to be short ages borrowers to borrow money on invoices that they on cash at times. There are two traditional solutions to are confident will be paid. For example, say a business the problem. The first is to maintain a line of credit at does $10,000 of work for Home Depot. It knows Home a bank. A line of credit allows a business to borrow up Depot will pay the invoice, but Home Depot may operate to a certain amount of money and pay it down when on a net 30 or net 60 day payment schedule (meaning money comes in. The problem with this solution is that that it has 30 days or 60 days to make the payment). If banks are increasingly reluctant to establish lines of the business has an account with Fundbox, it could get credit for small businesses. Banks also don't like to make short-term loans for specific amounts. The sec- the $10,000 right away, minus Fundbox's fee. Weekly ond solution is invoice factoring. With invoice factoring, payments would start immediately. When Home Depot a company sells its invoices to a factoring company in paid the invoice, the loan to Fundbox would be paid in full. This scenario allows a business to get its money
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