Chapter 8: Assessing a New Venture’s Financial Strength and Viability
8-7.
On what factors or conditions do completely new firms base their forecasts?
Answer: 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.
8-8.
What is the purpose of an income statement? What are the three numbers that
receive the most attention when evaluating an income statement? Why are these
numbers important?
Answer: 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. The three numbers that receive the most attention when evaluating an
income statement are the following:
Net sales consists of total sales minus allowances for returned goods and
discounts.
Cost of sales 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.
These numbers are instrumental in figuring the net income of a firm over a given
period of time (usually a month or a year).
8-9.
How does a firm compute its profit margin? What is the significance of this
ratio?
Answer: A firm’s profit margin, or return on sales, is computed by dividing net
income by net sales. A rising profit margin means that a firm is either boosting
its sales without increasing its expenses or that it is doing a better job of
controlling its costs. In contrast, a declining profit margin means that a firm is
losing control of its costs or that it is slashing prices to maintain market share.
8-10.
How does a firm compute its price-to-earnings ratio? Why does a high price-to–
earnings ratio indicate that the stock market thinks the firm will grow?
8-12.
What are the major categories of assets and liabilities on a balance sheet? Briefly
explain each category.
Answer: 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 are assets used over a longer time frame, such as real estate,
buildings, equipment, and furniture.
Other assets are 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.
8-13.
What is meant by the term working capital? Why is working capital an
important consideration for entrepreneurial firms?
MyLab Question.
8-14.
How does a firm compute its current ratio? Is this a relatively important or
unimportant financial ratio? Explain your answer.
Answer: A company’s current ratio is its current assets divided by its current
liabilities. Current ratio is an important financial ratio. It provides the managers
of a firm another picture of the relationship between its current assets and its
current liabilities. This relationship provides an indication of whether a firm can
pay its short-term liabilities.
8-15.
What is the purpose of a statement of cash flows?
Answer: 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
Chapter 8: Assessing a New Venture’s Financial Strength and Viability
8-16.
What are the three separate categories of activities that are reflected on a firm’s
statement of cash flows? Briefly explain the importance of each activity.
Answer: The statement of cash flows is divided into three separate activities:
operating activities, investing activities, and financing activities. These activities
are explained below:
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.
8-17.
What is the purpose of financial ratios? Why are financial ratios particularly
useful in helping a firm interpret its financial statements?
Answer: Financial ratios depict relationships between items on a firm’s financial
statements. They are used for three purposes: (1) to depict relationships between
items on a firm’s financial statements; (2) to discern whether a firm is meeting
its financial objectives and how it stacks up against industry peers; and (3) to
assess trends. 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
provides a summary of the ratios used to evaluate New Venture Fitness Drinks
during the time period covered by the statements. The ratios are divided into
profitability ratios, liquidity ratios, and overall financial stability ratios. These
ratios provide a means of interpreting the historical financial statements for New
Venture Fitness Drinks and provide a starting point for forecasting the firm’s
financial performance and capabilities for the future.
8-18.
What is the purpose of an assumptions sheet?
Answer: Completely new firms typically base their forecasts on a good-faith
estimate of sales and on industry averages (based on a percentage of sales) or the
experiences of similar start-ups for cost of goods sold and other expenses. 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.
8-19.
Why is a firm’s sales forecast the basis for most of its other forecasts?
8-20.
What is meant by the percent-of-sales method as it relates to forecasts?
Answer: 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 percent-of-sales method, which is a
method for expressing each expense item as a percentage of sales.
APPLICATION QUESTIONS
8-21.
Suppose a friend of yours showed you the pro forma income statements for his
start-up and exclaimed excitedly that during the first three years of operations his
firm will make a net income of $150,000 per year, which is just the amount of
money ($450,000) the firm will need to pay off a three-year loan. Given your
study of the chapter, why is it that your friend may not actually have $450,000 in
cash, even though his pro forma income statements say that he will earn that
amount of money?
Answer: Although pro forma income statements do report a company’s profit or
loss, they do not reflect a company’s cash position. Often, a company’s cash
position is lower than its profit, because it has cash tied up in inventory or
accounts receivable, or it has reinvested its cash in the business.
8-22.
Kate Snow just retired from a career with Walmart, cashing out a sizable
retirement fund at the time of doing so. To start a second career, she is looking at
the possibility of buying three different businesses. She has three years’
historical financial statements for each business and has been poring over the
numbers. She was puzzled when she read the following statement in a book
about small business financial management: “Be careful when looking at balance
sheets to fully understand what you’re looking at. In some respects balance
sheets are very revealing, and in other respects they can be very deceiving.”
What do you think the author of the book meant by that statement?
Answer: The statement in the small business financial management book is
accurate. Reading a balance sheet takes a little practice. A company’s assets are
recorded at cost rather than fair market value. For example, a firm may have
invested $500,000 in real estate several years ago that is worth $1 million today.
The value that is reflected on the firm’s current balance sheet is the $500,000
purchase price, rather than the $1 million fair market value. Another example is
intellectual property. A firm may have a patent worth $1 million, but it may not
be valued at all on the balance sheet, or only the costs involved with obtaining
8-23.
Chipotle Mexican Grill is a publicly traded company. Calculate the firm’s price–
to–earnings ratio (P/E). What does Chipotle’s P/E ratio tell you about investors’
expectations regarding the company’s growth? How do Chipotle’s financial
ratios compare to restaurant norms at the time of your analysis?
Answer: At the time this manual was written (October 2017) Chipotle Mexican
Grill’s P/E ratio was 69.81. A firm’s P/E ratio is a simple ratio that measures the
price of its stock against its earnings. The higher the ratio, the greater the market
thinks a company will grow. A P/E ratio of 69.81 is high, which indicates that
the market thinks Chipotle Mexican Grill will grow. The P/E for the restaurant
industry in general is 25.90. What this means is that investors think that Chipotle
will grow at a rate much faster than the industry in general.
8-24.
Jorge Martinez is thinking about buying an existing printing business and has
been carefully studying the records of the business to get a good handle on its
historical financial performance. Jorge heard that you are taking a class in
entrepreneurship and asks you, “What suggestions do you have for me to make
the best use of this financial information (i.e., three years of audited income
statements, balance sheets, and statements of cash flows)?” What suggestions
would you give Jorge for making the maximum use of the financial statements?
Answer: This is a good question for an individual or group assignment.
Obviously, Jorge will want to determine if the firm is on firm ground financially,
in regard to its overall financial soundness (determined by its balance sheets), its
ability to make money (determined by its incomes statements), and its sources
and uses of funds (statements of cash flows). Jorge will want to determine
whether the firm is gaining or losing each year in terms of financial soundness
and earnings. Jorge should also compare the firm to its industry peers.
8-25.
Casey Cordell is the owner of a digital photography service in Madison, WI. The
company has been profitable every year of its existence. Its debt ratio is currently
68 percent, its current ratio is 1:1, and its debt-to-equity ratio is 72.2 percent. Do
these financial numbers cause any reason to be concerned? Why or why not?
Answer: These numbers are of concern. A company debt ratio is computed by
dividing its total debt by its total assets. A debt ratio of 68 percent means that 68
percent of Casey’s total assets are financed by debt and the remaining 32 percent
is owners’ equity. This means that the majority of Casey’s assets are financed by
debt rather than equity, which gives him little freedom to maneuver without
consulting his creditors. A current ratio of 1:1 is also of concern. A firm’s
current ratio is its current assets divided by its current liabilities. Casey’s current
ratio of 1:1 means that for every dollar of short-term assets the company has, it
has one dollar of liabilities. This situation leaves Casey with no liquidity to meet
Chapter 8: Assessing a New Venture’s Financial Strength and Viability
high), it may have trouble meeting its obligations and securing the level of
financing needed to fuel its growth.
8-26.
What items on the left side (or top) and what items on the right side (or bottom)
of a firm’s balance sheet should receive the greatest scrutiny? In regard to each
of these items, what are the most important factors that a new venture should
focus on to maintain its overall financial health?
Answer: One important factor is the working capital that a firm has, which is its
current assets minuses its current liabilities. Thus, a firm’s current assets versus
its current liabilities are numbers that are scrutinized. A firm’s inventory levels
and its accounts receivable are individual numbers that are often looked at. A
firm wants to minimize the inventory it has on hand and also minimize its level
of accounts receivable. A firm’s overall assets and its overall liabilities are also
looked at. The ratio of overall assets to overall liabilities (debt-to-asset ratio) is
an indication of a firm’s level of overall financial strength.
8-27.
Suppose a colleague of yours is gearing up to write a business plan for a business
she intends to start. She told you she plans to prepare the financial statements
first, to get that job out of the way before she tackles the rest of the plan. What is
the flaw in your colleague’s logic as described to you?
Answer: Writing the financial statements section of the plan first won’t work.
The financial portion of a firm’s business plan relies heavily on numbers
generated in other sections of the plan (or at least on the descriptions provided in
other sections of the plan). For example, the marketing plan section of the
business plan normally includes a marketing budget, which is plugged into the
pro forma financial statements. Similarly, a start-up’s market analysis will
normally include an estimate of the company’s sales for the first one to three
years of operations. These figures are also plugged into the financial statements.
YOU BE THE VC 8.1
Company: CyPHY Works (www.cyphyworks.com)
Business Idea: Build cutting-edge drones for the consumer, commercial, and defense
markets that empower people by making the drones accessible, reliable, and practical.
Chapter 8: Assessing a New Venture’s Financial Strength and Viability
178
You Be the VC Scorecard
CyPHY Works
(www.cyphyworks.com)
Score/Comments
1 2 3 4 5
The nine-member leadership team of CyPHY Works
(accessed at
https://www.cyphyworks.com/about/leadership/) is quite
impressive. Given the technology that goes into drones,
the team has both technical and business experts. In
addition, given that the regulatory pathway for drones is
still largely undecided, the company has a general
counsel as part of the team.
1 2 3 4 5
The opportunity is quite attractive as the company is one
of the early entrants to this fast-growing field. The case
points out several uses of drones – deliver packages,
event security – and more uses may be identified in the
near future.
Strength of the Industry
1 2 3 4 5
As the case indicates, drones are a $3.3 billion industry
and could grow a lot more once the many uses of drones
become widely accepted. CyPHY makes various kinds
of drones for various applications and so the prospects
look bright.
1 2 3 4 5
The company’s business model is still unclear and this is
understandable as the regulations surrounding drones are
still undecided. We don’t know the sources of revenues
for the company and also its cost structure.
3.75/5.00
Decision: We would not invest in CyPHY Works. Although we admire the company and
the product they are producing, we don’t know much about the business side of drones
and the cost structure of drone manufacturing and marketing. Perhaps these factors will
become clearer in the future, at which point it may be a good idea to revisit the company.
Chapter 8: Assessing a New Venture’s Financial Strength and Viability
YOU BE THE VC 8.2
Company: nuTonomy (www.nuTonomy.com)
Business Idea: Develop and deploy fully autonomous vehicles.
You Be the VC Scorecard
nuTonomy
(www.nuTonomy.com)
Score/Comments
1 2 3 4 5
As the case indicates, nuTonomy came out of MIT when
two engineers, Dr. Karl Iagnemma and Dr. Emilio
Frazzoli, co-founded the firm. Since then they have
added business experience to the top management team
by bringing in Doug Parker and Gretchen Effgen. All in
all, this looks like a capable management team with a
good blend of expertise.
1 2 3 4 5
Difficult to assess, except to state that this is part of the
overall transportation market. By partnering with a ride-
share company, nuTonomy is tipping its hat in terms of
its future direction. Given that companies like Uber and
Lyft in the U.S. and similar companies elsewhere have
popularized ride sharing, this seems like a good
opportunity.
1 2 3 4 5
The ride sharing industry is large and is still growing.
Driverless cars can cut the costs of transportation and so
this is a potential strength.
1 2 3 4 5
We don’t know the company’s business model yet
because it is still in the product testing stage. It could
simply license or sell its software to others or vertically
integrate to becoming a ride share company on its own.
Chapter 8: Assessing a New Venture’s Financial Strength and Viability
4.0/5.00
Decision: We would fund this firm. We like the founders, like the business concept, and
believe they have identified a fruitful gap in the ride sharing marketplace. They are
spending a lot of time testing their product, which augurs well for its safety and
acceptance.
CASES
Case 8.1
Mary Lynn Schroeder: Building a Successful Business with Limited Money and Limited
Business Experience
DISCUSSION QUESTIONS
8-32
What can a first-time entrepreneur, who may have a good idea but not much
money or business acumen, learn from Mary Lynn Schroeder’s experience?
Answer: Mary Lynn Schroeder benefitted enormously from an ecosystem that
entrepreneurs have access to. She did not have a lot of money and had very little
business and zero coding experience and yet she was able to create a slick website
(students can go to inbluehandmade.com and see for themselves), create an online
shop, and become an active seller on Etsy!
8-33
To what degree do you think you’d be capable of building a website on
Squarespace and setting up an online store on Shopify? If you don’t think you’re
capable of either of these tasks, what can you do now to obtain the necessary
capabilities?
Answer: The typical student would be more than capable of easily setting up a
website on Squarespace. The instructions are quite simple to follow and quite
intuitive. Some may need a little bit of help on Shopify, though. However, they
can get help on YouTube (a search on YouTube on how to set up a shop on
Shopify yielded 225,000 results!).
8-34
To what degree do you believe ready-made platforms like Squarespace, Shopify,
and Etsy have contributed to the entrepreneurial ecosystem in the United States
and abroad? To what degree could you envision using one or more of these
platforms if you launched a business of your own?
Answer: There is absolutely no doubt that providers such as Squarespace, Shopify,
and Etsy have helped tremendously in lowering the entrepreneurial entry barriers
for many. They help in creating a professional interface with little effort and at a
very low cost.
Chapter 8: Assessing a New Venture’s Financial Strength and Viability
Student responses will vary in terms of whether they would use one or more of
these in their own ventures.
8-35
Identify and describe a ready-made platform, like Squarespace or Shopify that is
not a direct competitor of either one of these platforms but fills a similar role in
that it allows an entrepreneur to perform a vital task with very little capital
investment.
Answer: This is a good question for an individual or group assignment. They can
be asked to identify good candidates for a class presentation.
8-36
Why do you think this case was placed in the chapter titled “Assessing a New
Venture’s Financial Strength and Viability”?
Answer: Mary Lynn Schroeder, like many entrepreneurs, did not have a lot of
capital, nor did she have a business that generated sizeable cash flows. That she
could grow her business and become an online seller of goods even with a
resource constraint, makes this an apt case in this chapter on a small business’s
finances.
Case 8.2
Fundbox: Designed to Help Small Businesses Minimize Cash Flow Shortfalls
DISCUSSION QUESTIONS
8-37
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?
Answer: A business’s cash flow is the money that comes into the business and the
money that goes out. The amount of money coming into a business and the amount
going out is a result of three activities: operating activities, investing activities, and
financing activities. Cash is critical to an entrepreneurial firm’s success in the
same way it’s critical to an individual’s success. A business, just like a person,
needs a positive balance in their bank account to pay for routine expenses, make
payments on loans, and for other purposes. Almost all businesses experience cash
flow shortfalls at times. Often equipment must be purchased and new employees
hired and trained before the increased customer base generates additional income.
Chapter 8: Assessing a New Venture’s Financial Strength and Viability
8-38
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 effects of a small entrepreneurial firm’s decision to use Fundbox on the
components of that firm’s statement of cash flows?
Answer: A firm would use Fundbox’s service to cover cash flow shortfalls created
by operating activities. Often when a business invoices a customer, the customer
has up to 30 days (and in some cases 60 days) to make payment. This is what
causes cash flow challenges. A business incurs expenses to service a client, and
then has to wait 30 to 60 days to get paid (which covers the expenses plus provides
a profit). Fundbox solves this problem by loaning a business the amount of the
invoice, so the business doesn’t have to wait 30 to 60 days to get their payment. Of
course, Fundbox charges for their service, but for many businesses it is well worth
it to get paid earlier rather than later.
8-39
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?
Answer: They absolutely should complete pro forma statements for Fundbox. Pro
forma statements are useful for a business’s routine financial planning and to help
prepare budgets. They should complete pro forma income statements, balance
sheets, and statements of cash flow.
8-40
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?
Answer: This is a good question for an individual or group assignment. Most
students will say that the Fundbox case draws additional attention to the
importance of cash flow management.