Entrepreneurial Finance

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Entrepreneurial Finance

• Session 2Foundations3/3/08
• Instructor
• David Hinds
• dhh123_at_bellsouth.net

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Todays Agenda

• Financial statements and accounting
• Balance Sheet
• PL Statement
• Cash Flow Statement
• Free Cash Flow
• Working Capital
• The Fit model and how to use it
• Preparing for The Knot case discussion

3
Why why why???

• Why create financial statements?
• They are useful for monitoring performance and
  making decisions
• Historical and projected financial statements are
  a fundamental source of information in valuing a
  business
• Why learn about Free Cash Flow?
• Projected Free Cash Flow is a critical factor in
  calculating return on investment and valuing a
  business
• Why learn about Working Capital?
• It is used in projecting Free Cash Flow
• It is important for day-to-day cash management

4
Profit and Loss Statement
Year 1
Year 2
Year 3
Year 4

• Revenues
• Cost of Goods Sold (COGS)
• Gross Profit
• Selling, General Admin Costs (SGA)
• Operating Profit (EBIT)
• Interest
• Net Profit Before Taxes
• Taxes
• Net Profit After Taxes

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Free Cash Flow
EBIT (Earnings Before Interest and Taxes) -
Taxes (EBIT x Tax Rate) Depreciation (and
other non-cash charges) -/ Increase/Decrease
Current Assets (1) /- Increase/Decrease
Current Liabilities (1) - Capital
expenditures Free Cash Flow (1) Changes in
net working capital
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Free Cash Flow (Illustrative Sample)
Year 1
Year 2
Year 3
Year 4

• Revenues
• Cost of Goods Sold (COGS)
• Gross Profit
• Selling, General Admin Costs (SGA)
• Operating Profit (EBIT)
• Taxes (EBIT x Tax Rate)
• Depreciation (and similar)
• Change in Net Working Capital (NWC)
• Capital Expenditures (CAPEX)
• Free Cash Flow (FCF)

EBIT Earnings Before Interest and Taxes
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Net Working Capital (NWC)
() Only applies to Cash or other Liquid
Investments balances required for normal
operation and not to excess of funds beyond
normal operating levels.
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Accounting

• Financial accounting
• Fairly present the financial status and
  performance of a company
• Computed in compliance with Generally Accepted
  Accounting Principles (GAAP)
• Primary reporting mode financial statements
• Management accounting
• Provide basis for making management decisions
• Computed in a useful way
• E.g. Free Cash Flow, Net Working Capital,
  breakeven points, fixed and variable costs,
  implications of scale

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Balance Sheet

• Reports the status of Assets, Liabilities and
  Equity of a company at a single point in time
  (a snapshot)
• Assets Things of economic value that are
  possessed by the company
• Liabilities and Equity Who has claim to the
  assets (taken as a whole)
• Liabilities the portion that non-owners
  (creditors) have claim to
• Equity the portion that owners (shareholders)
  have claim to
• Every financial transaction affects the balance
  sheet
• Accounting check Assets Liabilities Equities

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Balance Sheet for company A
(of as mm/dd/yyyy)
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Current vs. Long-Term

• Current assets and liabilities are expected to
  be sold or settled within an accounting period
  (usually one year)
• Long-term assets and liabilities are not
  expected to be sold or settled within the
  accounting period

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Actions which directly affect the Balance Sheet

• Collecting
• Producing/purchasing inventory
• Paying bills
• Capital expenditures (buy fixed assets)
• Securing/paying off loans
• Providing funds / Taking profits

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Selected Activities and Their Financial Statement
Impact
Balance sheet impact
A/R Inventory A/P Fixed Assets (accm.
depreciation) Debt Equity
Collect
Produce / Purchase Inventory
Pay Bills
Capital Expenditures
Secure / Pay Off Loans
Provide Funding / Take Profits
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PL Statement

• Reports Revenue and Expense of the company for a
  period of time
• Revenue earned income resulting from selling
  activities
• Expense cost of resources consumed / expended
  in seeking revenues
• Accounting check Profit Revenue Expense
• Various measures of Profit (or Income or
  Earnings or Margin)
• Gross profit
• Operating profit or EBIT
• EBITDA (usually not shown on PL Statement)
• Net profit before tax
• Net profit

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PL Statement for company A(for the 12 months
ended mm/dd/yyyy)
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Revenue

• Accounting rule
• Recognize revenue for the period in which the
  income was earned
• Example
• Sold 100 widgets to Bill on January 23 for 200
  (on credit)
• Collected 200 from Bill on March 8
• Revenue is recognized (and recorded) in month of
  January

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Expense

• Accounting rule
• Recognize expense for the period in which benefit
  was received from the cost
• Example
• Bought 1 case of paper from Office Depot on April
  7 for 30 on Amex
• Paid Amex statement (with 30 charge) on May 10
• Expense is recognized (and recorded) in month of
  April
• (Assumes that we used up the whole case in April
  even though that might not be true)

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Actions which affect the PL statement (and B/S)

• Make a sale
• Use/expend resources
• Work performed by employees
• Rent space
• Consume supplies
• Accounting entries
• Record depreciation expense
• Secure/pay off loans

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Selected Activities and Their Financial Statement
Impact
Balance sheet impact
A/R Inventory A/P Fixed Assets (accm.
depreciation) Debt Equity
PL impact
Collect
Sales COGS Operating Expense (excl.
depreciation) Depreciation Expense Interest
Expense
Make a Sale
Produce / Purchase Inventory
Pay Bills
Expend Resources
Capital Expenditures
Record Depreciation
Secure / Pay Off Loans
Provide Funding / Take Profits
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Cost of Goods Sold

• Inventory asset goods produced (or purchased)
  and held for sale
• Production costs include cost of raw materials
  and labor
• Production costs are recorded as an inventory
  asset
• When a sale is made, then the cost of that
  quantity of inventory is expensed in the period
  of sale this is called Cost of Goods Sold
  (COGS)
• COGS is calculated using a costing method such as
  FIFO or LIFO

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COGS example

• Company makes 1000 widgets in Jan.
• Purchase 100 in raw materials
• Contract 2 hours of labor at 50 per hour
• Record inventory addition of 200
• Inventory value per unit .20 per widget
• Company sells 200 widgets in Mar.
• Sell for price of 1.50 per unit
• Recognize 300 Revenue (200 units x 1.50)
• Recognize 40 Cost of Goods Sold (200 units x
  .20)

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Depreciation Expense

• Depreciation is applicable when an item is
  purchased which has a useful life that is longer
  than the current account period
• This type of purchase is referred to as a
  capital expenditure
• Accounting rule
• Recognize (expense) a portion of total
  expenditure in each year during the useful life
  of the item
• Calculate expense in each year using a straight
  line method (or other method)

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Depreciation example

• Purchase computer equipment on Jan. 1, 2007 for
  total of 1200
• Expected useful life is 3 years
• Depreciation schedule (using straight line
  method)
• For 2007 400
• For 2008 400
• For 2009 400
• For 2010 and beyond 0

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Cash Flow Statement

• Record changes in Cash for the company over a
  period of time
• Increase Cash inflow Source ( impact)
• Decrease Cash outflow Use (- impact)
• Accounting checks
• Ending cash on CF statement must always equal
  Cash on balance sheet
• Ending cash is reconciled with actual bank
  account balances
• Actions which affect the CF statement
• Operating, Investing, Financing
• Any action which affects the cash balance

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Selected Activities and Their Financial Statement
Impact
Operating
Balance sheet impact
A/R Inventory A/P Fixed Assets (accm.
depreciation) Debt Equity
PL impact
Collect
Sales COGS Operating Expense (excl.
depreciation) Depreciation Expense Interest
Expense
Make a Sale
Produce / Purchase Inventory
Pay Bills
Expend Resources
Capital Expenditures
Record Depreciation
Secure / Pay Off Loans
Provide Funding / Take Profits
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Selected Activities and Their Financial Statement
Impact
Investing
Balance sheet impact
A/R Inventory A/P Fixed Assets (accm.
depreciation) Debt Equity
PL impact
Collect
Sales COGS Operating Expense (excl.
depreciation) Depreciation Expense Interest
Expense
Make a Sale
Produce / Purchase Inventory
Pay Bills
Expend Resources
Capital Expenditures
Record Depreciation
Secure / Pay Off Loans
Provide Funding / Take Profits
27
Selected Activities and Their Financial Statement
Impact
Financing
Balance sheet impact
A/R Inventory A/P Fixed Assets (accm.
depreciation) Debt Equity
PL impact
Collect
Sales COGS Operating Expense (excl.
depreciation) Depreciation Expense Interest
Expense
Make a Sale
Produce / Purchase Inventory
Pay Bills
Expend Resources
Capital Expenditures
Record Depreciation
Secure / Pay Off Loans
Provide Funding / Take Profits
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Cash Flow Statement for company A(for the 12
months ended mm/dd/yyyy)
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Calculate cash flow statement from balance sheets

• Review the change in each major balance sheet
  item (except cash) from beginning balance sheet
  to ending balance sheet
• What is the cash impact of each item change?
• Positive net income (after adding back
  depreciation amortization) provides cash
  cash increase
• Increase in current assets uses cash cash
  decrease
• Increase in current liabilities provides cash
  cash increase
• Increase in (gross) fixed assets uses cash
  cash decrease
• Assess other relevant balance sheet items
• When done, ending cash on calculated cash flow
  statement should equal cash on ending balance
  sheet

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Free Cash Flow

• Free Cash Flow is cash flow that is freely
  available for debt service (paying interest
  and principal) to the banks and profit
  distributions to the owners (shareholders)
• Free cash flow vs. accounting cash flow (from the
  cash flow statement) whats the difference?
• Accounting cash flow reflects operations,
  investing and financing
• Free cash flow only reflects operations and
  investing but NOT financing (see next 3 slides)
• Why compute free cash flow?
• Free cash flow is useful in computing the
  return portion of the return on investment to
  the owners/investors of the business
• We exclude debt service so that decisions about
  the acquisition of debt can be made separately
  from the return on investment evaluation

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Free Cash Flow
EBIT (Earnings Before Interest and Taxes) -
Taxes (EBIT x Tax Rate) Depreciation (and
other non-cash charges) -/ Increase/Decrease
Current Assets (1) /- Increase/Decrease
Current Liabilities (1) - Capital
expenditures Free Cash Flow (1) Changes in
net working capital
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Free Cash Flow
Operating
EBIT (Earnings Before Interest and Taxes) -
Taxes (EBIT x Tax Rate) Depreciation (and
other non-cash charges) -/ Increase/Decrease
Current Assets (1) /- Increase/Decrease
Current Liabilities (1) - Capital
expenditures Free Cash Flow (1) Changes in
net working capital
33
Free Cash Flow
Investing
EBIT (Earnings Before Interest and Taxes) -
Taxes (EBIT x Tax Rate) Depreciation (and
other non-cash charges) -/ Increase/Decrease
Current Assets (1) /- Increase/Decrease
Current Liabilities (1) - Capital
expenditures Free Cash Flow (1) Changes in
net working capital
34
Working Capital

• Working Capital (or Net Working Capital) is
  money required to fund day-to-day operations
• Balance sheet formulas
• WC Cash A/R Inventory A/P
• WC Current Assets Current Liabilities

35
Selected Activities and Their Financial Statement
Impact
Working Capital
Balance sheet impact
Cash A/R Inventory A/P Fixed Assets (accm.
depreciation) Debt Equity
PL impact
Collect
Sales COGS Operating Expense (excl.
depreciation) Depreciation Expense Interest
Expense
Make a Sale
Produce / Purchase Inventory
Pay Bills
Expend Resources
Capital Expenditures
Record Depreciation
Secure / Pay Off Loans
Provide Funding / Take Profits
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Why Working Capital?

• So, why talk about working capital? We already
  know how to calculate cash flow and free cash
  flow from asset and liability changes
• To understand, lets step back to review the
  concept of capital in the context of return on
  investment

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Capital and return on investment

• Capital is money required to start and operate a
  business. Capital is required for
• One-time expenses (e.g. buying equipment)
• Ongoing (day-to-day) operations Working Capital
• Capital is supplied by owners and by financiers
  (banks)
• The return on investment to the owner is
  calculated based on capital invested by the owner
  (early) and cash returned to the owner (later)
• Capital requirements affect return on investment
  more capital required less return on investment

38
Required Working Capital

• A business will require a certain amount of
  working capital based on
• Level of operation of the business
• Working capital management effectiveness
• Why calculate Required Working Capital (RWC)?
• Useful for projecting Free Cash Flow in support
  of return on investment analysis and business
  valuation
• Useful for day-to-day management

39
Free Cash Flow
EBIT (Earnings Before Interest and Taxes) -
Taxes (EBIT x Tax Rate) Depreciation (and
other non-cash charges) -/ Increase/Decrease
Current Assets (1) /- Increase/Decrease
Current Liabilities (1) - Capital
expenditures Free Cash Flow (1) Changes in
net working capital
40
Free Cash Flow
EBIT (Earnings Before Interest and Taxes) -
Taxes (EBIT x Tax Rate) Depreciation (and
other non-cash charges) - Increase in Working
Capital - Capital expenditures Free
Cash Flow
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WC Management Effectiveness

• What management actions affect RWC?
• How quickly you collect your receivables
  (collection days)
• How fast you turn your inventory (turns)
• How quickly you pay your bills (payment days)
• In a financial projection, these become some of
  the key assumptions

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Selected Activities and Their Financial Statement
Impact
Working Capital
Balance sheet impact
Cash A/R Inventory A/P Fixed Assets (accm.
depreciation) Debt Equity
PL impact
Collect
Collection Days
Sales COGS Operating Expense (excl.
depreciation) Depreciation Expense Interest
Expense
Make a Sale
Produce / Purchase Inventory
Turns
Pay Bills
Payment Days
Expend Resources
Capital Expenditures
Record Depreciation
Secure / Pay Off Loans
Provide Funding / Take Profits
43
Selected Activities and Their Financial Statement
Impact
Working Capital
Balance sheet impact
Cash A/R Inventory A/P Fixed Assets (accm.
depreciation) Debt Equity
PL impact
Collect
Collection Days
Sales COGS Operating Expense (excl.
depreciation) Depreciation Expense Interest
Expense
Make a Sale
Produce / Purchase Inventory
Turns
Pay Bills
Payment Days
Expend Resources
Capital Expenditures
Record Depreciation
Secure / Pay Off Loans
Provide Funding / Take Profits
44
Calculate (Project) Required Working Capital

• WC Cash A/R Inventory A/P
• Financial scenario
• Sales 800 per month
• COGS 500 per month
• Op. Expense (excl. dep.) 200 per month
• WC management effectiveness (key ratios)
• Collection days 30
• Turns 6.0
• Payment days 30

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Required Cash

• Required Cash
• Monthly Expenses x 3 (more or less)
• Monthly Expenses Operating Expense (excl. dep.)
  plus COGS 200 500 700
• Required Cash 700 x 3 2100

46
Required A/R

• Required A/R
• Monthly Sales x (Collection Days / 30)
• Monthly Sales 800
• Collection Days Average number of days between
  sale and collection of sale 30 days
• Required A/R 800 x (30/30) 800

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Required Inventory

• Required Inventory
• (Monthly COGS x 12) / Turns
• Monthly COGS 500
• Turns Number of times (per year) that the
  inventory is turned over (Annual COGS / Avg.
  Inventory) 6.0
• Required Inventory (500 x 12)/ 6.0 1000

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Required A/P

• Required A/P
• Monthly Expenses x (Payment Days / 30)
• Monthly Expenses 700
• Payment Days Average number of days between
  purchase and bill payment 30 days
• Required A/P 700 x (30/30) 700

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Required Working Capital

• WC Cash A/R Inventory A/P
• Required Working Capital (RWC)
• Required Cash
• Required A/R
• Required Inventory -
• Required A/P
• RWC 2100 800 1000 - 700 3200

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Reduce Required Working Capital

• A/R Reduce Collection Days from 30 to 15
• A/R 800 x (15/30) 400
• Inventory Increase Turns from 6.0 to 10.0
• Inventory (500 x 12) / 10.0 600
• A/P Increase Payment Days from 30 to 60
• A/P (500200) / (60/30) 1400
• RWC 2100 400 600 - 1400 1700

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Effect on Required Working Capital

• RWC before 2100 800 1000 - 700 3200
• RWC after 2100 400 600 - 1400 1700
• Put 1500 in your pocket! or invest it.

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Elements of the Fit model
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Opportunity(The business model)

• Product or service
• Features and benefits
• Key advantages
• Product How to make it, sell it, service it?
• Service How to sell it, deliver it?
• The Market
• Size, growth, competitiveness
• Revenue model
• Who pays and on what basis?
• Financial implications
• Sales, gross profit, operating expense, working
  capital requirements, fixed asset requirements

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Context (Environment)

• The economy
• Political/regulatory landscape
• Social/cultural factors
• Technology status and advancement
• Financial implications
• Government incentives, RD expense, taxes

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People

• Management skills and track record
• Industry experience
• Functional expertise
• Access to people and resources
• Team chemistry and attitude
• Financial implications
• Management salaries, bonuses, stock options

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Deal

• Business valuation
• Financial and legal structure
• Decision making and governance
• Management responsibilities
• Exit strategy
• Financial implications
• Funding requirements, long-term debt, equity

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Preparing for The Knot

• Questions?...

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• END