Entrepreneurship and Business

Plan Session6th

By : -Neeraj Gupta

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Financial Considerations

Finance is the life-blood of an enterprise. All the key and critical decisions are based on finance. The success and failure of the business enterprise is to a great extent, dependent on financial planning.

Therefore, every entrepreneur should clearly draw up a financial plan at the initial stages. A clear-cut financial plan would determine the need of finance at different stages of business.

Financial plans are drawn from the marketing plan, from the production plan and from the human resource plan etc).

Sales plan, production plan and organizational plan can give a fair idea of cost estimates from all the functional area, they can be utilized to project the cost estimates.

Financial Needs for a New Venture

Financial needs can be classified under 4 heads: - Start-up expenses: The expenses incurred in starting a business.

They include: Land and Building Machinery, equipments and tools Furniture and office equipments Raw material and inventory Connection of power Advertising and promotion Requirements like legal certificates Partnership agreements etc.

Operational expenses: These expenses are incurred in the day-to-day operations of the business.

For example, electricity charges, monthly rental, etc. Personnel expenses: The cost involved in maintaining and training

the employees. The personnel expenses component of cost head is higher in the case of a service organization compared to a manufacturing organization.

Contingency expenses: The expenses incurred to meet crises, sudden shutdowns/ breakdowns, changes in customer preferences, sudden drop in sales due to some defect sighted by customers.

Financial Plan THE FINANCIAL PLAN

The financial plan provides a complete picture of: How much and when the funds are coming into the

organization. Where the funds are going. How much cash is available. The projected financial position of the firm.

The financial plan provides the short-term basis for budgeting and helps prevent a common problem—lack of cash.

The financial plan must explain how the entrepreneur will meet all financial obligations and maintain its liquidity.

In general, the financial plan will need three years of projected financial data for outside investors.

Sequence ofFinancial Statements

Budgets Operating- Short-Term Capital- Long-Term

If the entrepreneur is a sole proprietor, he or she will be responsible for the budgeting decisions.

In a partnership, or where employees exist, the initial budgeting process may begin with one of these individuals.

Final determination of budgets will ultimately rest with the owners or entrepreneurs.

Sales Budgets Manufacturing/Production Budgets

Operating Budgets An operating budget is the annual budget of an activity stated in

terms of Budget Classification Code, functional/sub functional categories and cost accounts.

Generally, a budget covering operating expenses, for normal operations. Operating expenses can be budgeted and accounted for on a monthly, quarterly, and/or annual basis.

Fixed expenses (those incurred regardless of sales volume) include rent, utilities, salaries, interest, depreciation, and insurance.

The entrepreneur will need to calculate variable expenses, which may change from month to month depending on sales volume, such as advertising and selling expenses.

This budget provides the basis for the pro forma statements.

Capital Budgets

Capital budgets are used for evaluating expenditures that will impact the business for more than one year. A capital budget may project expenditures for new equipment,

vehicles, computers, or new facilities. These decisions can include computing of cost of capital and

anticipated return on investment using present value methods. The entrepreneur should enlist the assistance of an accountant. Many formal methods are used in capital budgeting, including the

techniques such as: 1. Net present value 2. Profitability index 3. Internal rate of return 4. Modified Internal Rate of Return 5. Equivalent annuity

Popular methods of capital budgeting include net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period.

Pro Forma Statements

Pro Forma Income Sales Budget By Month Expenses Are Function Of Sales Level

Pro Forma Cash Flow Cash Receipts Cash Payments

Pro Forma Balance Sheet Pro Forma Sources & Applications of Funds

Pro-Forma Income Statement Pro forma income statements look at revenue and expense projections for future periods. Pro forma income statements are generated by looking at financial performance the year before, comparing it to the current year figures and using the changes to make projections into the future.

In preparing the pro forma income statement, sales by month must be calculated first. Market research, industry sales, and trial experience might provide the basis for

these figures. It may be possible to find financial data on similar start-ups. Forecasting techniques, such as a survey of buyers’ intentions or expert opinions,

can also be used. The costs for achieving increases in sales can be higher in early months.

Sales revenues for an Internet start-up are often more difficult to project. Expensive advertising is needed to attract visitors to the site. There will be little sales revenue until site traffic increases. A giftware Internet start-up could project the number of average hits expected per

day or month based on industry data. From the number of “hits” it is possible to project the number of consumers who will

buy products and the average dollar amount per transaction.

Pro-Forma Income Statement

The pro forma income statements also provide projections of all operating expenses for each month of the first year. Selling expenses as a percentage of sales may also be higher initially. Salaries and wages reflect the number of personnel employed and

their roles in the organization. Any unusual expenses, such as those for a key trade show, should be

flagged and explained at the bottom. In addition to the monthly pro forma income statement for the first

year, projections should be made for years 2 and 3. Investors generally prefer to see three years of income projections. Some expenses will remain stable over time, like depreciation,

utilities, rent, insurance, and interest. Selling expenses, advertising, salaries and wages, and taxes may be

represented as a percentage of projected net sales. When calculating the projected operating expense, it is important to

be conservative for initial planning purposes. For the Internet start-up, capital budgeting and operating expenses

will involve equipment purchasing or leasing, inventory, and advertising expenses.

Daily Knowledge On Financial Position

Cash Balance On Hand Bank Balance Daily Summaries Of Sales/Cash

Receipts Problems In Credit Collections Record Of Money Paid Out

Slow-Paying Accounts Receivable Discounts Offered On Accounts Payable Payroll- Hours Worked & Payroll Owed Taxes- When Taxes Due & Reports

Required

Weekly Knowledge On Financial Position

Monthly Knowledge On Financial Position

Provide Records Receipts Disbursements Bank Accounts Journals

Review Income Statement Balance Sheet

Reconcile Checking Account

Balance Petty Cash Account

Review Tax Requirements & Make Deposits

Review/Age Accounts Receivable

Sales Budget Calculate Sales Expectations In Units Utilize

Marketing Research Industry Sales Experience

Forecasting Techniques Survey of Buyers Sales Force Opinions Expert Opinions Time Series Analysis

Proforma Cash Flow Cash flow is not the same as profit.

Profit is the result of subtracting expenses from sales. Cash flow is the difference between actual cash receipts and cash

payments. Cash flows only when actual payments are made or received. Depreciation is an expense, which reduces profit, not a cash outlay.

For an Internet start-up, transactions would involve the use of a credit card—1-3% of the sale would be paid as a fee to the credit card company.

On many occasions, profitable firms fail because of lack of cash; therefore, using profit as a means of success may be deceiving.

There are two standard methods used to project cash flow. In the indirect method some adjustments are made to the net income

based on the fact that actual cash may not have actual been receive or disbursed.

The direct method, a simple determination of cash in less cash out, gives a fast indication of the cash position of the new venture at a point in time.

Proforma Cash Flow It is important for the entrepreneur to make monthly projections of cash, pro

forma cash flow. If disbursements are greater than receipts in any time period, funds will have to

be borrowed or cash reserve tapped. Large positive cash flows may need to be invested in short-term sources. Usually the first few months of start-up will require external cash in order to cover

cash outlays. Negative cash flows are very likely for a new venture.

The most difficult problem with projecting cash flows is determining the exact monthly receipts and disbursements. Assumptions should be conservative so enough funds can be maintained to cover

the negative cash months. Using conservative estimates, cash flow can be determined for each month. These cash flows will also help determine how much money will need to be

borrowed. The pro forma cash flow is based on best estimates and may need to be

revised to ensure accuracy. It is useful to provide several scenarios, each based on different levels of

success.

Cash Flow: (Cash Flow From Operating Activities)

Net Income XXX

Adjustments to NI

Noncash/Nonoperating Items

+Depreciation XXX

Cash Changes in Current Assets/Liabilities

+/- Accounts Receivable XXX

+/- Inventory XXX

+/- Prepaid Expenses XXX

+/- Accounts Payable XXX

Net Cash From Operations XX,XXX

Cash Flow: (Cash Flow From Other Activities)

Capital Expenditures (-) (XXX)

Payments of Debt (-) (XXX)

Dividends Paid (-) (XXX)

Sale of Stock XXX

Net Cash From Other Activities (XXX)

Net Cash From Operations XXX

Net Cash From Other Activities (XXX)

Increase/(Decrease) in Cash XXX

Pro-Forma Balance Sheet The entrepreneur should also prepare a projected balance sheet depicting the

condition of the business at the end of the first year. The pro forma balance sheet reflects the position of the business at the

end of the first year. Every business transaction affects the balance sheet. The balance sheet is a picture of the business at one moment in time and

does not cover a period of time. Assets.

Assets represent everything of value that is owned by the business. Value is not necessary replacement cost—it is the actual cost expended for the

asset. The assets are categorized as current or fixed.

Current assets include cash and anything that will be converted into cash within a year., Prepaid expenses, Payment in advance, Inventories, Sundry Debtors, Temporary investments, marketable investments

Fixed assets are those that will be used over a long period of time. Management of receivables, or money owed by customers, is important to the business’

cash flow of the business. Non-current Assets: -Tangible assets, Intangible assets, fictitious assets like

brokerage, investments etc,

Pro-Forma Balance Sheet

Liabilities. Liabilities accounts represent everything owed to creditors. Current liabilities are due within a year. Others are long-term debts. It is often necessary to delay payments of bills in order to more

effectively manage cash flow. During recessions many firms hold back payment of their bills to

better manage cash flow. Owners equity is the excess of all assets over all

liabilities. Owner equity represents the net worth of the business. Any profit from the business will also be included in the net worth

as retained earnings.

Pro Forma Balance Sheet

Assets Current Assets

Cash $50,400

Accounts Receivable 46,000

Merchandise Inventory 10,450

Supplies 1,200

Total Current Assets $108,050

Fixed Assets

Equipment $240,000

Less Depreciation 39,600

Total Fixed Assets $200,400

Total Assets $308,450 =======

Pro Forma Balance Sheet (cont’d)

Total Liabilities & Owners’ Equity Current Liabilities

Accounts Payable $23,700Current Portion of L.T. Debt 16,800

Total Current Liabilities $40,500

Long-Term LiabilitiesNotes Payable $209,200

Total Liabilities $249,700

Pro Forma Balance Sheet (cont’d)

Owners’ EquityC. Peters, Capital $25,000

K. Peters, Capital 25,000

Retained Earnings 8,700

Total Owners’ Equity $58,750

Total Liabilities & Owners’ Equity $308,450=======

Pro Forma Balance Sheet (cont’d)

Break Even Analysis Break-even analysis shows the relationship between costs and profits with

the sales volume. It determines the activity where total cost is equal to total sales i.e. point of zero profit and zero loss. It can be used to determine probable profits at any level of activity.

Breakeven is that volume of sales at which the business will neither make a profit nor incur a loss.

The break-even sales point is the volume of sales needed to cover total variable and fixed expenses.

Mathematical Calculation of Break-even Analysis Break-Even Point (Rs) =Fixed Cost/(P/V) Ratio

Break-Even Point (Units) =Fixed Cost/Contribution per unit

P/V Ratio = (Contribution/Net Sales)*100

Contribution = Sales-Marginal Cost **** Margin of Safety = Actual Sales Revenue/Break-even Sales Revenue **** Margin of Safety Ratio =Marginal of Safety/Actual Sales (Rs)

Profit = Margin of Safety*P/V Ratio ********

Break-Even Graph

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Break-EvenBreak-Even

TR = TCTR = TC

Sources and Applications Of Funds

The pro forma sources and applications of funds statement illustrates the disposition of earnings from operations and from financing.

Its purpose is to show how net income and financing were used.

It is often difficult for the entrepreneur to understand how the net income was disposed of.

Typical sources of funds are from operations, new investments, long term borrowing, and sale of assets.

The major uses or applications of funds are to increase assets, retire long term liabilities, reduce owner equity, and pay dividends.

This statement emphasizes the interrelationship of these items to working capital.

Funds Flow StatementsFunds Flow Statements It is very important for an entrepreneur to make the

estimates about the sources and uses of funds for the following reasons: It estimates the total cash requirements It enables proper planning for next year in terms of amount of

funds required It identifies the direction and volume of flow of funds It helps in judging whether the organization is making progress

or problems are arising. Funds flow statement can be prepared on the following

basis: Funds Flow Statement on the basis of working capital Funds Flow Statement on the basis of cash Funds Flow Statement on the basis of total revenues

Funds Flow Statement on the Basis of Working CapitalFunds Flow Statement on the Basis of Working Capital

The objective of preparing this is to estimate the working capital requirements of the business. The sources of working capital will include: Operations: Net Income + Depreciation Issue of share capital Long-term borrowing Sale of goods other than current assets and investments.

The uses of capital include: Payment of dividend and taxes Purchase of other current assets Redemption of debenture and redeemable preference shares Repayment of long-term liability

Pro Forma Sources & Applications of Funds

Sources of Funds Mortgage Loan $150,000

Term Loan 75,000

Personal Funds 50,000

Net Income From Operations 8,750

Add Depreciation 39,600

Total Funds Provided $323,350

Applications of FundsPurchase of Equipment $240,000

Inventory 10,450 Loan Repayment 16,800

Total Funds Expended $267,250

Total Funds Provided $323,350Total Funds Expended 267,250Net Increase in Working Capital $56,100

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Pro Forma Sources & Applications of Funds(cont’d)

Sources of Capital Savings and Investments Angel Investors: Angel investors are affluent individuals who

provide capital for a business start-up, usually in exchange for ownership equity. These individuals are looking for a higher rate of return than would be given by more traditional investments (typically 25% or more). Angel investors are an excellent source of early stage financing and high-growth start-ups.

Peer to Peer Lending: Peer-to-peer lending is a means by which borrowers and lenders may transact business without the traditional intermediaries, such as banks. It can also be known as social Lending, ordinary people lending money.

Money Pool: Instead of a bank loan, borrow smaller sums from several family members, friends, or colleagues. The lenders have no legal ownership in the business, but can act as advisors and cheerleaders for your venture.

Sources of Capital Credit Cards: Many business owners use their credit cards to fund their

businesses. Credit cards offer the ability to make purchases or obtain cash advances and pay them at a later time. But as a long-term financing method, they can be expensive. Most credit cards will charge you 2% to 4% of the face value of a cash advance as a "fee" making this method of financing very risky.

Bootstrapping: Another source of capital for setting up a business is bootstrapping. It is a way to finance a business by saving rather than borrowing money. It's being as frugal as possible so your business can be started on as little cash as possible. The use of private credit cards is the most known form of bootstrapping, but a wide variety of methods are available for entrepreneurs. Other forms of bootstrapping include owner financing, minimization of accounts receivable, joint utilization, delaying payment, minimizing inventory and subsidy finance.

Sources of Capital

Venture Capital: Venture capital is not suitable for all entrepreneurs. It is an option for small companies that have a seasoned management team and very aggressive growth plans; however, venture capitalists will rarely invest in small businesses that have no intention of going public. If a company does have the qualities venture capitalists seek such as a solid business plan, a good management team, investment and passion from the founders, a good potential to exit the investment before the end of their funding cycle, and target minimum returns in excess of 40% per year, it will find it easier to raise venture capital.

Some well known Venture Capital Funds

Mr NarayanaMurthy is the latest person to take a dip in Venture Capital Fund Industry to promote entrepreneurship.

Venture Capital FundsVenture Capital Funds The Venture funds in India can be classified on the

basis of: Genesis: Financial Institutions Led By ICICI Ventures, RCTC,

ILFS, etc. Private venture funds like Indus, etc. Regional funds like Warburg Pincus, JF Electra (mostly operating

out of Hong Kong). Regional funds dedicated to India like Draper, Walden, etc. Offshore funds like Barings, TCW, HSBC, etc. Corporate ventures like Intel.

Investment Philosophy: Early stage funding is avoided by most funds apart from ICICI ventures, Draper, SIDBI and Angels. Funding growth or mezzanine funding till pre IPO is the segment where most players operate. In this context, most funds in India are private equity investors.

Venture Capital FundsVenture Capital Funds Size of Investment: The size of investment is generally less than

US$1mn, US$1-5mn, US$5-10mn, and greater than US$10mn. As most funds are of a private equity kind, size of investments has been increasing. IT companies generally require funds of about Rs30-40mn in an early stage which fall outside funding limits of most funds and that is why the government is promoting schemes to fund start-ups in general, and in IT in particular.

Value Addition: The venture funds can have a totally "hands on" approach towards their investment like Draper or "hands off" like Chase. ICICI Ventures falls in the limited exposure category. In general, venture funds who fund seed or start ups, have a closer interaction with the companies and advice on strategy etc., while the private equity funds treat their exposure like any other listed investment. This is partially justified, as they tend to invest in more mature stories.

Some Companies that have Some Companies that have received funding through received funding through Venture Capital FundsVenture Capital Funds

Mastek, one of the oldest software houses in India Geometric Software, a producer of software solutions for the CAD/CAM market Ruksun Software, Pune-based software consultancy SQL Star, Hyderabad based training and software development company Microland, networking hardware and services company based in Bangalore Satyam Infoway, the first private ISP in India Hinditron, makers of embedded software PowerTel Boca, distributor of tele-computing products for the Indian market Rediff on the Net, Indian website featuring electronic shopping, news, chat, etc Entevo, security and enterprise resource management software products Planetasia.com, Microland's subsidiary, one of India's leading portals Torrent Networking, pioneer of Gigabit-scaled IP routers for inter/intra nets Selectica, provider of interactive software selection Yantra, ITLInfosys' US subsidiary, solutions for supply chain management.

Venture Capital Funding In India Recent developments have shown that India is maturing into a more developed

market place, unconventional investments in a gamut of industries have sprung up all over the country.

This includes Indus League Clothing, a company set up by eight former employees of

readymade garments giant Madura who set up shop on their own to develop a unique virtual organisation that will license global apparel brands and sell them, without owning any manufacturing units. They dream to build a network of 2,500 outlets in three years and to be among the top three readymade brands.

Shoppers Stop, Mumbai's premier departmental store innovates with retailing and decides to go global. This deal is facing some problems in getting regulatory approvals.

Airfreight, the courier-company which has been growing at a rapid pace and needed funds for heavy investments in technology, networking and aircrafts.

Pizza Corner, a Chennai based pizza delivery company that is set to take on global giants like Pizza Hut and Dominos Pizza with its innovative servicing strategy.

Car designer Dilip Chhabria, who plans to turn his studio, where he remodels and overhauls cars into fancy designer pieces of automation, into a company with a turnover of Rs1.5bn (up from Rs 40mn today).

Characteristics of Venture Capital Ideas and innovations, which have potential for high growth but with inherent uncertainties, are financed by Venture capitalists.

Further, venture capitalists provide networking, management and marketing support as well. Therefore, venture capital refers to risk finance as well as managerial support.

Start-ups are seldom funded by Venture capitalist. However, a rare combination of product opportunity, market opportunity, and proven management may attract venture fund.

Though the fundamental principle underlying the operations of a venture capital fund is "No return without risk; and greater the risk, greater will be the returns", the ultimate aim of the venture capitalist is the same as that of the promoters, i.e., the longterm profitability and viability of the invested company.

Characteristics of Venture Capital They generally have wider horizon and innovative solutions that maximise the chances of the project success. In India, Venture capitalists have followed a broad approach in funding the enterprise. They have supplied funds to new, high risk, not necessarily high tech ventures, and have also extended management, marketing and financial skills to assisted ventures. In the beginning, they supported high-tech unproven technologies but with the experience of the first few years, it has been broad based now. They expect a very high growth rate in the assisted enterprise, bring management and business skills, expect medium term gains (5-10 years), and do not insist for any collateral to cover the capital provided.

Types of Venture Financing

The venture capitalist may invest in an enterprise through equity, quasi-equity, conditional loans and income notes. Investment in the form of equity is the most desirable form of venture financing as it reflects an approach of sharing risks and rewards; and does not put any pressure on the cash flow of the company in the initial teething period.

Equity contribution from the venture capitalist should be slightly lower than that of the promoters' equity so that promoter feels secure and carries on with innovation and business development.

The quasi-equity instruments are converted into equity at a later date. Convertible debentures and convertible preference shares are the convertible instruments.

The conditional loan is a misnomer. It really is not a loan because there is no repayment of principal and there is no interest on such loans. In this instrument, the company pays royalty to the venture capital undertaking that is linked to the turnover, after the unit goes into regular production. This is based on the true concept of sharing risk and reward. Income Notes is a hybrid of simple loan and conditional loan.

The outstanding debt carries concessional rate of interest and royalty attached to the turnover.

Ratio Analysis and Its UsageRatio Analysis and Its Usage A tool used by individuals to conduct a quantitative analysis of

information in a company's financial statements. Ratios are calculated from current year numbers and are then compared to previous years, other companies, the industry, or even the economy to judge the performance of the company. Ratio analysis is predominately used by proponents of fundamental analysis.

Some common ratios include the price-earnings ratio, debt-equity ratio, earnings per share, asset turnover and working capital.

Importance of Ratio Analysis Ratio analysis is used to assess the performance of the

firm in the following aspects: Trend Analysis Inter-firm Comparison Operating Efficiency Analysis Long-term financial viability Reveals strength and weakness of business Overall profitability of the business

Financial Ratios Financial ratios are the indicators of the financial

well being of a business plan. These are used as tools to determine the financial viability of a business plan. Financial ratios are corroborated with other facts before any judgmental action is taken.

These allow comparison of the projected performance with similar industries or similar businesses. Financial ratios, fall into four general categories. These can be classified as, (i) liquidity ratios, (ii) profitability ratios, (iii) operations ratios, and (iv) leverage ratios.

Liquidity Ratios Liquidity ratios are indicators of the venture’s capability to meet

short-term financial obligations. Short term obligations imply cash demand to be met in next 12 months. Maximum use of this ratio is made by the providers of the short term credit to the ventures. Three of the most common liquidity ratios are (a) current ratio or working capital ratio, (b) quick ratio or acid test ratio, and, (c) cash ratio.

Current Ratio = Current Assets/Current Liabilities Quick Ratio= (Current Assets-Inventory)/Current Liabilities Cash Ratio= (Cash + Cash Equivalent Securities)/Current

Liabilities

Profitability Ratios Profitability ratios are indicators of measures of the

success of the venture in generating profits for the entrepreneur. A wide range of ratios is used to measure profitability. We shall be concentrating on the three major indicators. These consist of, (a) gross profit margin, (b) return on assets, and, (c) return on equity or return on investment (ROI).

Gross Profit Margin=(Sales-Cost of Goods Sold)/Sales Return on assets= Net Income/Total Assets Return on Equity= Net Income/Stake Holder’s Equity

Operations Ratios These include the ratios used to measure internal operational

efficiency of the venture. Any isolative interpretation derived from these will largely be unproductive, sometimes even misleading. These should be viewed in conjunction with other ratios and industry environment. We shall be focusing only on three types of operations ratios that shall include, (a) accounts receivable turnover ratio, (b) inventory turnover ratio, and (c) average days payable ratio.

Accounts Receivables Turnover Ratio= Net Credit Sales/Average Accounts Receivables

Inventory Turnover Ratio= (Sales/Inventory) or (Cost of goods sold/Average Inventory)

Average Days Payables= (Days in the Period*Average Accounts Payables)/Purchases in Credit

Leverage Ratios These ratios measure financial leverage of the venture to meet

financial obligations it has created. Additionally, these indicate the capital structure of the venture and resultant strength and weaknesses. The most significant ones focus on debt, equity, assets and interest features of the venture. These include (a) debt-to-equity ratio, (b) degree of combined leverage1 and, (c) degree of operating leverage.

Debt to Equity Ratio= Total Liabilities/Equity Degree of Combined Leverage= (% Change in Earning Per

Share (EPS)) / (% change in sales) Degree of Operating Leverage= (% Change in profits before

Interest and taxes) / (% Change in sales)

Thank You