ENTREPRENEURSHIPANDVENTURECAPITALChapter9.docx

ENTREPRENEURSHIPANDVENTURECAPITALChapter9.docx

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ENTREPRENEURSHIPANDVENTURECAPITALChapter9

ENTREPRENEURSHIPANDVENTURECAPITAL

Chapter9:

EvaluatingFinancialPerformance

Asnotedinthepreviouschapter,acquiringandproperlyusingfinancialresourcesisamajorfunctionoftheentrepreneurialteam.Someoneontheteam,andhopefullyallmembersoftheteam,needstobequiteknowledgeableabouttheroleoffinanceinthenewventureandmakingfinancialforecaststhatreflecttheoverallbusinessplan.Theyshouldalsounderstandfinancialstatementsandthewaythosestatementshelpmanagementincarryingoutitsfinancialresponsibilities.Managersroutinelyusewhattheyknowaboutthemarketplace,thecompetition,andthecustomersintheirdecisions.Whentheyalsoincorporatestrongfinancialanalysis,theirdecisionsarestronger.Goodfinancialanalysisgivesmanagersalookintothefutureandhelpsthemmakemoreinformeddecisions.

Itisabsolutelyrequiredthatthefinancialstatementsbepreparedcorrectlyandthatcertainrelationshipsamongtheactivitiesreportedonthestatementsbeunderstood.Thepurposeofthischapteristoprovideafewfinancialtoolsthatwillhelptheteammanagefinancialmatterssuccessfully.Wewillstartbyexaminingfinancialstatementsandunderstandingtheirpurposes.Thenwelookathowtomakeprojectionsofthosestatements.Finallywelookatsomeevaluationtechniquesthatareimportantforthenewenterprise.

FinancialStatements

Therearethreefinancialstatementsthatarethebasisoffinancialaccounting.Theyare:

incomestatement,balancesheet,andcashflowstatement.Eachstatementcontainsimportantinformationaboutthefinancialactivityofthecompany.Analysisisdonebothwithinandamongthestatementsaswillbeshownlater.Carefullydone,thisanalysiscanhelpmanagementunderstandhowoperationaldecisionsthataremadeaffectthefinancialprogressofthecompany.

Theincomestatementisarecordoftherevenueandexpensesofacompanyandshowstheaccountingprofit.Thereasonitisanaccountingprofit,isthattheincomestatement,likeallotherstatements,ispreparedaccordingtospecificaccountingrulesthatareinternationallyrecognized.Transactionsarerecordedaccordingtotheserulessothatusersofthestatementshaveacommonunderstandingandcanrelyontheaccuracyofthestatements.Inprinciple,theincomestatementtriestomeasurewhethertheproductsthatacompanyprovidesareprofitablewheneverythingisaddedup.Manyofthenumbersareestimatesandassumptionsthatareallowedbytherulesofaccounting.Thatisartoffinance.

PresentedinFigure9.1isageneralsummaryformatofanincomestatement.Inreality,thestatementmightbeverydetailedandmuchlongerthanshownhere,butthiswillgiveageneralideaofhowanincomestatementlooks.

Theincomestatementstartsbyshowingrevenueonthetopline–andforthisreasontherevenuenumberissometimesreferredtoasthe“topline”.NextistheCostofGoodsSold（sometimesshownbytheEnglishacronymCOGS）,whichrepresentsthetotalcostofmaterials,labor,andshippingoftheproductsthataresoldduringtheperiod.Thedifferencebetweenrevenueand

Figure9.1IncomeStatement

Revenue

Less:

CostofGoodsSold（COGS）

Grossmargin

OperatingExpenses（OPEX）

SalariesandWages

EmployeeBenefits

Sales,General,andAdministrative

Depreciation

Miscellaneous

TotalOPEX

Earningsbeforeinterestandtaxes（EBIT）

Less:

Interest

Taxes

NetProfit

COGSistheGrossMargin.Grossmarginbecomesanimportantnumberinfinancialanalysisofthecompanyasitisoneofthekeystoprofitability.Grossmarginistheamountthatisleftafterpayingthedirectcostsoftheproduct.Controlofallcosts,especiallythecostsofgoods,isoneofthemostimportantmanagementfunctionsinthebusiness.Acompanythathighergrossmarginshasabetterchanceofcreatingcashflowearlierinitslifeandhighercashflowsasitgrowsandmatures.

Nextcomeoperatingexpensesofallkinds.Thelistshownhereissignificantlyabbreviatedfromwhatwouldbeusedandisgivenonlytoillustratewherethesetypesofexpensesareshown.The“earningsbeforeinterestandtaxes”isthegrossmarginminustotalOPEX.EBITbecomesanothernumberthatisoftenusedinfinancialstatementanalysis.BankersandinvestorslookatEBITtoseewhetherthecompanywillbeabletopaydebtsandearnmoneyforshareholders.Vendorslookatittoseeifthecompanycanpayitsbills.FromEBITaresubtractedinterestandtaxpaymentstogetnetprofit.Netprofitissometimesreferredtoasthe“bottomline”becauseitisthelastlineontheincomestatement.Ifacompanywantstoincreasethe“bottomline”thenthereareonlythreewaystodoit.First,istoincreaseprofitablesales.Second,istocontrolCOGS.Third,itcancutoperatingexpenses,whichalmostalwaysmeansreducingthenumberofemployees.Theincomestatementreflectsmostofthenormaloperatingactivitiesofacompanyduringagivenperiodoftime,usuallyamonth,aquarter（threemonths）,orayear.

Thebalancesheetisasummaryoffinancialpositionorconditionasofacertaindate,usuallytheendofamonth,aquarter,orayear.Wheretheincomestatementshowsalloftheactivityofaperiod,thebalancesheetpresentsbalancesasofanendingdateonly.Thebalancesheetisbasicallyastatementofwhatthecompanyownsandwhatitowesatagiventime.Figure9.2showsashortenedexampleoftheformatofabalancesheet.

Figure9.2BalanceSheet

CurrentAssetsCurrentLiabilities

CashAccountsPayable

AccountsReceivableAccruedLiabilities

InventoryShorttermnotespayable

PrepaidExpenses

TotalCurrentAssetsTotalCurrentLiabilities

Property,Plant,&EquipmentLongtermDebt

Less:

AccumulatedDepreciationOtherLongtermLiabilities

NetPP&ETotalLongtermLiabilities

TotalAssetsCommonStock

RetainedEarnings

TotalEquity

TotalLiabilitiesandEquity

Assetsareshownonthelefthandcolumnsofthebalancesheetandarebrokenintotwomainsections,currentassetsandlongtermassets.Liabilitiesandequityareshownontherighthandsideandareinthreecategories:

currentliabilities,longtermliabilities,andequity.（Studentsnotfamiliarwithfinancialaccountingareencouragedtoconsultanaccountingtextforspecificdetailsanddescriptions.）TheimportantthingtorememberaboutthebalancesheetisthatTotalAssetsmustequalTotalLiabilitiesandEquity.Thinkingofitanotherway,ifyoutakewhatisownedandsubtractwhatisowed,yougetownersequity,ornetworth.

Anotherwaytolookatthebalancesheetisthatitshowsthesourcesandusesoffunds.Forexample,liabilitiesandequityshowallofthesourcesoffinancingthatthecompanyhasused.Capitalisprovidedinonlytwoways:

equityanddebt.Thebalancesheetshowsboththeequityinvestment（commonstockplusretainedearnings,whicharetheaccumulatednetprofitsofacompanyovertime）anddebt（bothcurrentandlongtermliabilities）,andinthiswayshowsthetotalsourcesoffundsthathavebeenmadeavailabletothecompany.TheusesofthecapitalthathasbeenprovidedareshownintheAssetsofthecompany.Suchusesincludebuyingplantandequipment,inventory,andinvestmentsinreceivablesandcash.Sothetotalsourcesoffundsmustequaltheusesofthem.Thisconceptbecomesimportantforourlaterdiscussionofcashflowandfinancialevaluation.

Thestatementofcashflowsisoftenoverlookedbynewentrepreneurs,butisactuallythemostimportantstatementbecauseitshowshowcashisbeinggeneratedandusedandtracksthegrowthorshrinkageinthecashbalanceshownonthebalancesheet.LookatFigure9.3foranexampleofsuchastatement.

Figure9.3StatementofCashFlows

OperatingActivity

NetIncome

Plusdepreciation

+or–changestocurrentassets

+or–changestocurrentliabilities

NetCashfromoperatingactivity

InvestingActivity

Capitalexpenditures

Acquisitionsandotherinvestments

NetCashforinvestingactivity

FinancingActivity

Proceedfromdebt

Issuanceofcommonstock

Dividendpayments

Netcashforfinancing

Netincrease（decrease）incash

Beginningcash

Endingcash

Thereareseveralthingsthatshouldbeunderstoodaboutthisstatement.First,therearethreemajorsectionsofthestatement:

operatingactivity,investingactivity,andfinancingactivity.Second,eachactivitysectionshowssomegeneralcategoriesofactivitythateitherisasourceorauseofcash.Finally,thenetincreaseordecreaseincashisthetotalofthesethreesections.Whenthisnetincreaseordecreaseisaddedtotheopeningcashbalance,wearriveattheclosingcashbalancefortheperiod.

Operatingactivitystartswiththenetprofitfromtheincomestatement.Rememberthattheincomestatementcapturestheoperationsofthecompany,sotheresultofthoseoperationsistheopeninglineofthecashflowstatement.Thendepreciationisaddedbacktothenetincome.Thisisbecausedepreciationisnotacashitem,butanaccountingconvention,sothenon-cashamountshownontheincomestatementisaddedbacktoreflectactualcashactivity.Notecarefullythatthenextentriesreflectactivityinthecurrentassetsorcurrentliabilitiesofthecompany.Increasesordecreasesinthoseaccountswilleitherprovideorusecash.Forexample,ifaccountsreceivableincreasefromonemonthtothenext,therehasbeenauseofcashtosupportthatincrease.Likewise,ifinventoriesincreasethencashhasbeenusedtobuytheadditionalinventory.Butifinventorieshavedeclined,thenthereisasourceofcashfromtheextrainventorythathasbeenso