Financial Management for Entrepreneurs I

Business plan workshops Idea Creation and Opportunity Assessment - February 2 Matching Products and Services with Markets February 9 Competitive Analysis February 16 Strategy & Business Model February 23 Marketing and Sales Strategies March 2 Management & Ownership March 16 Financial Projections and Funding Strategies March 23 Professional Presentations March 30 Last week tried to get you to think about who might want the product or service you provide -- and how you might serve them. This week, I will try to help you learn some concepts and tools that will help you think about the competitive context in which you will operate. I want to talk about the industry, the environment in which the industry operates, the structure of the industry itself, and your actual competitors… Next week, we will turn to strategy and business models...

Business plan outline Executive Summary Company Description Including product/service & technology/core knowledge Target Market Industry Analysis & Trends Competition Strategy/Business Model Marketing & Sales Sketch Production & Operations Sketch Development & Milestones Basic Financials Revenue model Rough costs Break even Appendix We’re in the midst of working on the context of your business -- on the environment, industry, competition -- on what the world gives you to work with. Before this we looked a little at what you bring to the table: your vision, skills, idea, networks. The next step is to combine the two. To take stock of what the world offers and what you bring and to fit them together into a strategy in which you use your strengths to take advantage of opportunities, shore up weaknesses, stave off threats, etc. Your strategy is summarized as a business model -- the gist of your plan to take advantage of an opportunity. This is the heart of your plan. Once you have the model, it’s a matter of working out the details of how you will implement the model. And then reassuring the investors that you’ve thought through the risks.

Business model What a firm does, and how, to build and capture wealth for stakeholders. Translates strategic position into a business structure and a set of functional strategies. Includes a trajectory of growth: a timeline, milestones, infusions of capital, growing revenues, growing, changing expenses.

Alchemy of wealth creation A successful business organizes natural resources, human resources and sweat into product or service plus profit, Thus transforming human and natural capital into financial capital., One goal of business is to generate wealth and stores it as money, as capital, which can then be rented (lent) or invested to help build more wealth…

Capital vs cash Cash is not always cash: There is a difference between the cash needed to run a firm and the capital needed to develop it. Operating cash is a lubricant that facilitates the exchange of goods and services. Successful firms are well lubricated: They cover operations from revenues. Capital is stored energy and is used to build capability. Capital (from investments and loans) is stored profit from past ventures. This energy from the past helps firms build more rapidly than would be possible with sweat and profit. Why three statements? Because cash is not always cash.

Financial statements & projections Track the alchemical transformation of labor, land and capital into financial capital. Monitor flow of money through a business – as cash and capital. Support planning and measure progress. Support judgments about the coherence of a business plan. Help sell business plans to others.

Transparent financial statements Use standard formats With account categories and formats that fit one’s business Support numbers with narrative and notes Narrative: “After three months of losses, firm A turns profitable; by the end of year, two, firm A should show steady profits of and settles into profits of 10% per year.” Notes: Assumptions, caveats, what-ifs. Are checked by professionals Taxes and acceptability

Financial statements Income Statement Cash Flow Statement Definition: Profit or loss of a business over time Use: Project & monitor profit & so operating efficiency Cash Flow Statement Definition: Tracks the inflows & outflows of cash Use: Project & monitor the cash available for operations & growth Balance Sheet Definition: Snapshot of a firm’s wealth – and how it has funded that wealth Use: Project & monitor the growth or decline of a firm’s value/capital - and so potential

Income statement Income Statement Definition: Profit or loss of a business over time Use: Project & monitor profit & so operating efficiency + Net Revenues - Cost of Goods Sold = Gross Profit - Operating Expenses = Operating Profit +/- Other Income/Expenses = Profit before tax - Tax = Profit after tax

Income statement Revenues Gross Profit Other Income Operating Profit Net Profit P.A.T. COGS Op. Exp. R/E>B/S Other Exp. Tax Div>CF

Income statement Net Revenues Cost of Goods Sold Gross Profit Sales after discount, less returns Cost of Goods Sold Direct goods + direct labor per unit sold Gross Profit Amount left to cover operations COGS/Sales Constant or improving as percentage Perils and pleasures of volume + Net Revenues - Cost of Goods Sold = Gross Profit

Income statement Operating Expenses Operating Profit = Gross Profit Salaries (benefits, taxes) Sales & Marketing General Administration (supplies, IT, insurance) Space (rent, maintenance, utilities) Depreciation (spreading capital expense over use/ time) Professional fees Operating Profit Basic measure of success = Gross Profit - Operating Expense = Operating Profit

Income statement Other Income Other Expense Profit before Taxes Sidelines (can be very valuable and/or indicate new businesses or products) Interest Other Expense Cost of financing, especially interest on loans Other miscellaneous expenses Profit before Taxes Net income = Operating Profit +/- Other Inc or Exp = Profit before taxes

Income statement Income Taxes Profit after Taxes State and local Don’t confuse tax management with management Profit after Taxes Captured wealth Reinvest (retained earnings) > B/S Distribute (dividends) > CF = Profit before Taxes - Income Taxes = Profit after Taxes

Account categories that matter Revenues Major lines and/or channels Other income sources COGS Direct labor, raw materials, subcontracts Operating Expenses Reflect business model: Marketing/Sales, GA Subdivide important categories; lump together unimportant ones Other Expenses

Account categories exercise + Net Revenues - Cost of Goods Sold = Gross Profit - Operating Expenses = Operating Profit +/- Other Income/Expenses = Profit before tax - Tax = Profit after tax Planning: What categories should matter? Analysis: What categories has management chosen – and what do they tell you?

Projections from the bottom up Revenues Unit X net price Line by line, distribution channel by distribution channel Month by month, quarter by quarter, year by year Support with evidence and commitments Compare: interviews, Morris, S&P, market size Expenses Get prices Support with evidence and contracts and price lists Compare: interviews, Morris, S&P, source book

Revenues exercise + Net Revenues - Cost of Goods Sold = Gross Profit - Operating Expenses = Operating Profit +/- Other Income/Expenses = Profit before tax - Tax = Profit after tax Planning: Create structure (assump-tions and process) for your revenue projections. Analysis: Critique revenue projections: On what are they based? Do you believe them? What would improve your confidence?

Cash flow projections Cash Flow Statement + Revenues Cost of Goods Operating Expenses (excluding depreciation) = Cash flow from operations + Investment income - Acquisition of space, r&d, equipment, etc = Cash flow from investment + Equity investment + Loans - Repayments - Dividends / owner withdrawals = Cash flow from financing Cash on Hand – End of Period Cash Flow Statement Definition: Tracks the inflows & outflows of cash Use: Project & monitor the cash available for operations & growth Allows one to test: Will the firm live long enough to turn a profit? To repay investors? To survive ebbs and flows?

Three sources of cash Operations Investments Financing + Revenues Cost of Goods Operating Expenses (excluding depreciation) = Cash flow from operations + Investment income - Acquisition of space, r&d, equipment, etc = Cash flow from investment + Equity investment + Loans - Repayments - Dividends / owner withdrawals = Cash flow from financing Cash on Hand – End of Period Operations Revenue less cash expenses (ultimately, retained earnings) Investments Financing Loans, equity

Three uses of cash Operations Capacity building Pay back + Revenues Cost of Goods Operating Expenses (excluding depreciation) = Cash flow from operations + Investment income - Acquisition of space, r&d, equipment, etc = Cash flow from investment + Equity investment + Loans - Repayments - Dividends / owner withdrawals = Cash flow from financing Cash on Hand – End of Period Operations Cash necessary to operate Capacity building Cash necessary to build the platform Pay back Cash necessary to pay lenders, investors, owners

Building the cash flow statement Inflows Operating: Adjust revenues for bad debt and timing Investment: Any sales of hard assets? Financing: Capital inflows? Loans? Outflows Operating: Inventory purchases Operating: Operating expenses (without depreciation), adjusted for timing Investment: Capital purchases Financing: Principal repayment, investor repayment, owner withdrawals

Avoiding the cash wall Detailed projections Careful monitoring Routine and extraordinary expenses Monthly, even weekly (once operating) Careful monitoring Calculate burn rate Cash outflow per month Play with timing Delay outflow or accelerate inflow Manage expectations Negotiate

Cash flow projections exercise + Revenues Cost of Goods Operating Expenses (excluding depreciation) = Cash flow from operations + Investment income - Acquisition of space, r&d, equipment, etc = Cash flow from investment + Equity investment + Loans - Repayments - Dividends / owner withdrawals = Cash flow from financing Cash on Hand – End of Period Planning: List one-time and recurring cash inflows and outflows. Juggle the timing to remain cash positive while growing. Analysis: Calculate the cash available for to finance investment, new initiatives, etc.

Balance sheet Balance Sheet Current Assets Long-term Assets = Total Assets Current Liabilities Long-term Liabilities = Total Liabilities Capital Investment Retained Earnings = Total Equity Balance Sheet Definition: Snapshot of a firm’s wealth – and how it has funded that wealth Use: Project & monitor the growth or decline of a firm’s value/ capital - and so potential

A = L + E Assets = Wealth = Use of Funds Cash, loans to customers (A/R), buildings, equipment, inventory, partnerships Platform for growth Liabilities = LeveragedSource of Funds Nervous claims on wealth secured by contracts & collateral such as loans from vendors, banks, other sources, bonds Expand possibilities while increasing risk Equity = Capital = Invested Source of Funds More patient claim on wealth secured by control, especially owners’ capital plus retained profits Assets platform for growth Liabilities & equity source of capital A = L + E

Balance sheet Current Assets Long-term Assets Current Assets = Total Assets Current Assets Cash & similar Accounts receivable Inventory Long-term Assets Equipment Leasehold Improvements Net of depreciation Depreciation Spread expense over time Virtual layaway/savings]

Uses of cash Payments Supporting customers by offering terms Inventory Investing in capacity: machinery, know-how, new products, partnerships Investing in financial instruments

Balance sheet Current Liabilities Long-term Liabilities = Total Liabilities Current Liabilities Accounts payable Deposits Line of credit Current portion of long-term debt Long-term Liabilities Loans Bonds

Balance sheet Equity Capital Investment Additional Paid-in Capital Retained Earnings Capital Investment Retained Earnings = Total Equity

Sources of cash Initial equity Other equity: Informal loans: owners, family, friends Other equity: angels, venture firms, partners, public markets Informal loans: terms from suppliers, customers, landlords, partners Traditional loans: credit cards, banks, leases, bonds Revenues Related business income Investment income

Matching sources & uses of funds Short-term sources of cash to fund short-term needs A/P <> A/R Deposits <> inventory Long-term sources of cash to fund long-term needs Loans for hard assets with collateral Mortgage <> building Lease <> equipment Investments for softer assets like r&d Angel <> r&d Strategic investor <> new product

Matching sources & uses of funds Farm Example Seasonal cash flow – revolving line of credit Equipment – leases Buildings - mortgages Software Application Example Personal & angel investment for proof of concept Stock options (personal investment) for building core staff Venture capital for commercialization and marketing roll out Short-term loans for equipment Mid-term loans for leasehold improvements

Balance sheet projections: Assets Identify uses of capital: What asset-based capabilities must be built? By when? Some -- equipment, initial space, r&d time -- might be necessary just to start Some -- inventory, accounts receivable, permanent working capital, expanded space -- might grow in proportion to sales Support with evidence Compare with others Interviews, Morris, S&P

Balance sheet projections: Liabilities & equity Identify sources of capital Initial Equity Loans Eligibility: Credit history, 30% down, collateral (co-sign), unencumbered cash flow. Availability: Eligibility, types of businesses. Terms, especially cost - interest and collateral - and covenants Other equity Availability Terms, especially control and cash out plans Profit Retained earnings vs dividends

Balance sheet projections Start with simple Balance Sheet for day 1 Assets = cash Liabilities & Equity = initial loans and investment Sketch changes to get a sense of the end of period balance sheet Investments reduce cash but increase fixed assets Inventory purchases reduce cash but increase inventory Sales increase cash but reduce inventory Loan repayments reduce cash and loan balance Profit increases retained earnings, losses reduce retained earnings

Balance sheet exercise Current Assets Long-term Assets = Total Assets Current Liabilities Long-term Liabilities = Total Liabilities Capital Investment Retained Earnings = Total Equity Planning: List necessary assets & timing. Brainstorm possible sources of funds and timing. Match them up. Analysis: Are sources and uses of funds well matched?

Tying the statements together Income Statement > Balance Sheet Net income less dividends = additional retained earnings on B/S Incomes Statement > Cash Flow Direct method: All income (adjusted for timing) - all expenses (adjusted for timing) + depreciation = operating cash flow (Remember other income/expense and taxes) Interest payments provide clues about the loan situation

Tying the statements together Cash Flow > Balance Sheet New capital, new loan principal, repaid capital, repaid loan principal, purchases or sales of equipment Dividends (which reduce net income’s contribution to retained earnings) Cash Flow > Income Statement Changes in loans should be reflected in changes in interest

Tying the statements together Balance Sheet > Income Statement Change in retained earnings = Net income less dividends Balance Sheet > Cash Flow Indirect method: Changes in balances (eg., Accounts receivable, accounts payable, etc) are used to calculate changes in cash Similarly with changes in investing (equipment, equity) and financing categories (loans)

Building financial statements Don’t Panic! Start with a clear picture of your model – of how your business will work in detail Collect relevant data: expenses, sources of income, possible investors Get help! This is confusing. Spreadsheet in lab Sample financials on website SBDC: 215-204-7282 and www.sbm.temple.edu/%7Esbdc/ Accountants, accounting students