Chapter 8: Assessing a New Venture’s Financial Strength and Viability
161
CHAPTER 8
ASSESSING A NEW VENTURE’S FINANCIAL
STRENGTH AND VIABILITY
LEARNING OBJECTIVES
1.
Learn about the importance of understanding the financial management of an
entrepreneurial firm.
2.
Identify the four main financial objectives of entrepreneurial ventures.
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 purposes.
6.
Discuss the role of forecasts in projecting a firm’s future income and expenses.
7.
Explain the purpose of pro forma financial statements.
CHAPTER OVERVIEW
This chapter focuses on the important task of assessing a new venture’s financial strength
and viability. For the purpose of completeness, we look at how both existing ventures and
start-up firms assess their financial strength and viability.
In the first section of the chapter, we focus on general financial management and discuss
the financial objectives of a firm, which include profitability, liquidity, efficiency, and
stability. We then articulate the steps involved in the financial management process. The
second section of the chapter focuses on the development of historical financial
statements, including the income statement, the balance sheet, and the statement of cash
flows. The importance of developing forecasts to project future income and expenses is
also discussed. The chapter closes with a discussion of the role of pro forma financial
statements in assessing a new venture’s financial strength and viability. The importance
of ratio analysis is discussed.
Raising money is an important part of the financial management process. We address that
topic in Chapter 10.
CHAPTER OUTLINE
I. Introduction to Financial Management
II. Financial Objectives of a Firm
III. The Process of Financial Management
IV. Financial Statements
A. Historical Financial Statements
1. Income Statement
2. Balance Sheet
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3. Statement of Cash Flows
4. Ratio Analysis
5. Comparing a Firm’s Financial Results to Industry Norms
V. Forecasts
A. Sales Forecast
B. Forecast of Costs of Sales and Other Items
VI. Pro Forma Financial Statements
A. Pro Forma Income Statement
B. Pro Forms Balance Sheet
C. Pro Forma Statement of Cash Flows
D. Ratio Analysis
CHAPTER NOTES
I. Introduction to Financial Management
A. Financial management deals with two things: raising money and managing a
company’s finances in a way that achieves the highest rate of return.
B. We cover the process of raising money in Chapter 10. This chapter focuses on
how a company manages its finances in an effort to increase its financial strength
and earn the highest rate of return.
C. The financial management of a firm deals with questions such as the following on
an ongoing basis:
a. How are we doing? Are we making or losing money?
b. How much cash do we have on hand?
c. Do we have enough cash to meet our short-term obligations?
d. How efficiently are we utilizing our assets?
e. How do our growth and net profits compare to those of our industry peers?
f. Where will the funds we need for capital improvements come from?
g. Are there ways we can partner with other firms to share risk and reduce the
amount of cash we need?
h. Overall, are we in good shape financially?
D. A properly managed firm stays on top of these questions through the tools and
techniques that are discussed in this chapter.
II. Financial Objectives of a Firm
A. Profitability is the ability to earn a profit.
B. Liquidity is a company’s ability to meet its short-term financial obligations.
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C. Efficiency is how productively a firm utilizes its assets relative to its revenue and
profits.
D. Stability is the strength and vigor of the firm’s overall financial position.
III. The Process of Financial Management
A. To assess whether its financial objectives are being met, firms rely heavily on
analysis of financial statements, forecasts, and budgets.
E. The final step in the process of financial management 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.
IV. 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.
A. 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.
1. 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
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expenses for the given period and shows whether the firm is making a profit
or is experiencing a loss.
a. The consolidated income statement for the past three years for New
Venture Fitness Drinks is shown in Table 8.1 in the textbook.
b. The three numbers that receive the most attention when evaluating an
income statement are the following:
i. Net sales consists of total sales minus allowances for returned goods
and discounts.
2. 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 specified point in time.
a. 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.
b. The consolidated balance sheet for New Venture Fitness Drinks is shown
in Table 8.2 in the textbook. Multiple years are shown so trends can be
easily spotted.
c. The major categories of assets listed on a balance sheet are the following:
i. Current assets include cash plus items that are readily convertible to
cash, such as accounts receivable, marketable securities, and
inventories.
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i. Current liabilities include obligations that are payable within a year,
including accounts payable, accrued expenses, and the current portion
of long-term debt.
ii. Long-term liabilities include notes or loans that are repayable beyond
one year, including liabilities associated with purchasing real estate,
buildings, and equipment.
3. 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 changes 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.
a. The statement of cash flows is divided into three separate activities:
operating activities, investing activities, and financing activities.
b. These activities, which are explained in the following list, are the activities
from which a firm obtains and uses cash:
i. 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 the income
iii. 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 debt, or buying back
outstanding bonds.
c. The statement of cash flows for New Venture Fitness Drinks is shown in
Table 8.3 in the textbook. As a management tool, it is intended to provide
perspective on the following questions:
i. Is the firm generating excess cash that could be used to pay down debt
or be returned to stockholders in the form of dividends?
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ii. Is the firm generating enough cash to fund its investments from
earnings, or is it relying on lenders or investors?
iii. Is the firm generating sufficient cash to pay down its short-term
liabilities, or are its short-term liabilities increasing as the result of an
insufficient amount of cash?
4. Ratio Analysis. The most practical way to interpret or make sense of a firm’s
historical financial statement is through ratio analysis. Table 8.4 in the
textbook is a summary of the ratios used to evaluate New Venture Fitness
Drinks during the time period covered by the previously provided financial
statements.
5. 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 fired flags” requiring
attention.
V. 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.
A. Sales Forecasts
1. 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.
B. Forecast of Costs of Sales and Other Items
1. Once a firm has completed its sales forecast, it must forecast the costs of sales
and the other items on its income statement.
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2. The most common way to do this is the percent-of-sales method, which is a
method for expressing each expense item as a percentage of sales.
3. Once a firm completes its forecast using the percent-of-sales method, it
usually goes through its income statement on an item-by-item basis to see if
there are opportunities to make more precise forecasts.
4. If a firm determines that it can use the percent-of-sales method and it follows
VI. 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.
A. Pro Forma Income Statement
1. 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.
2. Table 8.6 in the textbook shows the pro forma income statement for New
Venture Fitness Drinks.
B. Pro Forma Balance Sheet
1. 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.
C. Pro Forma Statement of Cash Flows
1. The pro forma statement of cash flows shows the projected flow of cash into
and out of the company during a specified period.
2. 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.
3. The pro forma consolidated statement of cash flows for New Venture Fitness
Drinks is shown in Table 8.8 in the textbook.
D. Ratio Analysis
1. The same financial ratios used to evaluate a firm’s historical financial
statements should be used to evaluate the pro forma financial statements.
2. This work is completed so the firm can get a sense of how its projected
BOXED FEATURES: QUESTIONS FOR CRITICAL THINKING
What Went Wrong?
Be Careful What You Wish For: How Growing Too Quickly Overwhelmed One
Company’s Cash Flow
1.
What lessons can be learned from Jim Picariello’s agreement with the high net
worth individual, who agreed to invest $1 million in Wise Acre Frozen Treats and
then reneged on the agreement when the economy turned sour?
Answer: To not spend money until it’s actually in the bank. According to the
feature, Picariello placed orders for the material and equipment that Wise Acre
Frozen Treats needed to fuel its growth, based on the promise from the investor
that the money could be put together fiquickly.” When the investor reneged on his
promise, Picariello had to scamble to try to make things work.
2.
Why is it that a company can grow too fast? If Wise Acre Frozen Treats
significantly increased its sales, why wouldn’t its increased income provide more
than enough cash to even out its cash flow?
Answer: Because, as explained in the chapter, there is often a lag between the need
for money and when a firm starts generating income from the increased sales.
Often, when a company is growing quickly, it has to buy new equipment, order
new materials, hire and train new employees, and so on, prior to the time the new
sales start generating revenue. This set of circumstances often creates a cash flow
bind, as cash is going out prior to the time it starts generating new income.
3.
Besides cash flow difficulties, what other problems can a firm experience by
growing too quickly?
Chapter 8: Assessing a New Venture’s Financial Strength and Viability
Answer: Several things. First, quality often suffers, as will be explained in Chapter
13. As a firm’s pace of activity quickens, it invariably can’t spend as much time on
each order, so quality can slip. Second, it may hire employees too quickly, and
find later that it hired employees that it regrets. Finally, a firm may need to buy
additional equipment to help fuel its growth. In many instances, this requires a
firm to raise additional capital, which can be a time-consuming and difficult
process, as Jim Picariello experienced.
4.
If Jim Picariello starts another company, make a list of the things you think he’ll
do differently as a result of his Wise Acre Frozen Treats experience.
Answer: This is a good question for an individual or group assignment.
Savvy Entrepreneurial Firm
Know the Facts Behind the Numbers
1.
Show the income statements for the three candidates to two or three friends who
are majoring in business. Ask them to select the best CEO from among these three
people on the basis of these income statements. In addition, ask your friends to
explain their choices to you. Did your friends choose the same candidate? If not,
what do you think caused the differences in their choices?
Answer: This is a good exercise for an individual or group assignment. Most
students will pick the third candidate, the CEO of New Venture Sea Food. It will
be a good exercise for your students to explain to their friends that an accurate
evaluation can’t be based simply on a firm’s income statement (for a single year).
The fifacts behind the numbers” are equally important.
2.
Based on material presented in this chapter, earlier chapters in the book, and your
general business knowledge, where would you go to find information about the
growth of the different segments of the restaurant industry? Where would you go
to find information about the profitability of the restaurant industry in general?
Answer: The best way to obtain this information is to ask a reference librarian for
help. There are a number of companies that maintain databases that are very useful
in obtaining information about the different segments of industries, some of which
are listed in Appendix 3.2. IBISWorld, Mintel, and Standard & Poor’s
NetAdvantage (in that order) are our favorites.
3.
What would have been the appropriate financial information to request from the
three candidates for the job?
Answer: Three years of historic balance sheets, income statements, and statements
of cash flows, along with three years of comparisons of a firm’s financial ratios to
industry averages (or industry peers, if available).
4.
What are the three most important insights you gained from studying this feature?
Which of these insights surprised you, and why?
Answer: Answers will vary to the questions. The most important single insight is
that financial statements, such as a company’s income statement, tell only part of
the story of a firm’s relative success or failure. Again, the fifacts” behind the
numbers are equally important.
Partnering for Success
Organizing Buying Groups to Cut Costs and Maintain Competitiveness
1.
Which of the four financial objectives of a firm, profitability, liquidity, efficiency,
and stability, does participating in a buying cooperative contribute to the most?
Answer: Most students will argue that participating in a buying group will have the
largest impact on a company’s profitability because it lowers the cost of goods
sold, which translates into high profits. It should also have a direct impact on
liquidity. If a company can get the same product bought at a lower cost, it will
have less money tied up in inventory and/or accounts payable.
2.
Do some Internet and/or library research to try to discern whether there is a small
business buying group or groups that New Venture Fitness Drinks, the fictitious
company introduced in Chapter 3 and used as an example throughout this chapter,
could benefit from. New Venture Fitness Drinks’ products contain all the
ingredients used to make smoothies and similar fitness drinks and shakes.
Answer: This is a good question for an individual or group assignment. There are a
number of food-buying groups (or cooperatives) in the United States. Urge your
students to find examples of buying cooperatives near your college or university.
3.
Identify three ways, other than buying cooperatives, that small businesses partner
with other small businesses to cut costs without sacrificing their competitiveness.
Answer: There are a number of possible answers to this question. Possibilities
include:
Sharing facilities
Sharing employees, such as a real estate firm and an insurance company,
located in the same building, sharing a receptionist
Cobranding, which involves sharing advertising and marketing expenses
4.
In an effort to improve the financial position of their firms, do you think the
majority of entrepreneurs spend an equal amount of time focusing on (1) cost
cutting and (2) increasing revenues? If not, which of the two do you think they
spend more time on and why?
Chapter 8: Assessing a New Venture’s Financial Strength and Viability
Answer: Most students will argue that entrepreneurs spend more time on
increasing revenues than cutting costs. The reason is that cost cutting is painful
whereas increasing revenues, through new product lines, extending operating
hours, or through acquisitions, is more straightforward and doesn’t involve as
much sacrifice. This isn’t to say that entrepreneurs should spend more time on
increasing revenues than cutting costs. An entrepreneur should do what’s best in
his or her individual circumstance.
REVIEW QUESTIONS
8-1.
What are the two primary functions of the financial management of a firm?
Answer: Raising money and managing a company’s finances in a way that
achieves the highest rate of return.
8-2.
What are the four main financial objectives of a firm?
Answer: Profitability, liquidity, efficiency, and stability.
8-3.
Why is it important for a company to focus on its liquidity? What special
challenges do entrepreneurial firms have in regard to remaining liquid?
MyLab Question.
8-4.
What is meant by the term efficiency as it relates to the financial management of
a firm?
Answer: Efficiency is how productively a firm utilizes its assets relative to its
revenue and its profits.
8-5.
What is meant by the term stability as it relates to the financial management of a
firm?
Answer: Stability is the strength and vigor of the firm’s overall financial posture.
8-6.
What is the purpose of a forecast? What factors does a firm use to create its
forecasts of future sales, income, expenses, and capital expenditures?
Answer: A forecast is 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
goods sold (based on a percentage of sales) and on other expenses.