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©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Learning Objectives Learn the elements of the cash flow cycle. Understand the four critical determinants of a firms financial needs: minimum efficient scale, profitability, cash flow, and sales growth. Learn how to prepare a sales forecast for an established firm. Learn how to prepare a sales forecast for a new venture. Develop a financial model of a venture using pro forma analysis to integrate income statement, balance sheet, and cash flow. Identify publicly available data sources to provide an objective basis for underlying assumptions of the financial model.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Benefits of Financial Forecasting A disciplined means of evaluating the cash need of a venture. An aid to determining whether a proposed venture deserves the entrepreneur’s investment of capital and effort. A means of comparing the expected values of strategic alternatives. Demonstrate to potential investors the project merits and negotiate appropriate ownership. Provide a benchmark for assessing project development.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 The Firm as a Cash Conversion Process

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 The Cash Flow of a Business Venture

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 4 Key Determinants of Financial Needs Minimum efficient scale and capital intensity Profitability Cash flow Sales growth

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Manufacturer’s Long Run Per Unit Cost (LRAC)

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Factors That Increase a Firm’s Cash Needs Competition in markets where the minimum efficient scale (MES) is large. Low profit margins. High rates of sales growth. Increased reliance on depreciation of assets and less on expensing. Expectation of low cash flow levels. Increased trade credit offered (accounts receivable as a fraction of assets is high). Decreased trade credit used (accounts payable as a fraction of assets is high).

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Introduction to Pro Forma Analysis Assumptions for a simple asset-driven business model: Sales = 2 x Beginning Assets Net Income = Sales x 0.1 Retained Earnings = Beginning Assets x 0.06 Dividends = Net Income - Retained Earnings Ending Assets = Beginning Assets + Retained Earnings

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Asset-driven Pro Forma Model

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Five Year Pro Forma Analysis for a Simple Business Venture

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Integrating Pro Forma Financial Statements Basic Pro Forma Financial Statements (and some others) –Sales Forecast –Income Statement –Cash Flow Statement –Balance Sheet Net Income = Sales x 0.1

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Integrating Pro Forma Financial Statements The statements are interdependent Income Statement changes affect Balance Sheet and Cash Flow (e.g., higher profit may lead to increased cash balances). Balance Sheet changes affect Income Statement and Cash Flow (e.g., borrowing leads to interest expense and reduces taxes). An financial model should integrate the statements

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Key Questions to be Answered in a Sales Forecast When will the venture begin to generate revenue? How rapidly will revenue grow? Over what span of time (3 years, 5 years, 10 years, etc.) should the forecast be made? What is an appropriate forecasting interval (weekly, monthly, annually, etc.)?

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Forecasting the Sales of an Existing Business The forecast can be based on the existing track record of the business Some considerations Forecasting in levels or changes Forecasting in real or nominal terms Weighting of historical data Forecasting based on underlying factors for which forecasts exist

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Combining Growth Rates and Current Sales Levels to Forecast the Sales of an Existing Business

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Forecasting in Real Terms

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Using Weighting to Improve a Forecast

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Using Regression Analysis to Forecast

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Forecasting for a New Venture No track record to rely on Yardstick approach Comparable firms in relevant dimensions IPO prospectuses Other data sources

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Forecasting for a New Venture (Cont’d) Fundamental analysis Market and market share Engineering cost estimates Demand-side approach - How much customers would buy Supply-side approach - How fast the venture can grow Credibility and support for assumptions Mixed approach

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 Principles of Financial Forecasting Part 1 Build and support a schedule of assumptions. Begin with a forecast of sales. If sales growth is expected to track inflation, consider forecasting sales in real terms. When using historical data to forecast, consider a weighting scheme that focuses on the firm’s most recent experiences. For new ventures, choose several “yardstick” firms to use in developing underlying assumptions regarding expected performance. Integrate the pro forma balance sheet and income statement variables through a financial model.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 General Rules of Financial Forecasting Part 2 Consider time span. To assess financial need, project at least until the firm expects follow-on financing. To determine venture value, extrapolate to the point of harvest. Determine the planning horizon of the venture to establish forecasting intervals. Test the model’s rationality by tracing line items across financial statements. Apply sample scenarios and compare outcomes to estimates. Try a basic sensitivity analysis to ensure that the model yields reasonable results when magnitudes and growth rates of key variables change.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 New Company Assumptions Figure 6-5: 1)Development will require 18 months, during which no sales will be made. 2)Initial sales of $10,000 in the 19th month. 3)Sales will grow 8% per month in real terms for three years and at the inflation rate thereafter. 4)Cash operating expenses during the development period of $15,000 per month, plus inflation. 5)Inflation at 9 percent per year.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 New Company Assumptions Figure 6-5: (Continued) 6)A $200,000 production facility will come on line at the end of month 18. The facility is to be leased by the company for the first 5 years of operation, with monthly payments of $3,000. 7)Gross profit of 60% of sales revenue on materials costs with trade discounts. 8)Selling expenses of 15% of sales. 9)Administrative expenses of $2,000 per month beginning in month 19, growing at the inflation rate, plus 15 percent of sales (Included in development period operating expense total).

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 New Company Assumptions Figure 6-5 (Continued) 10)Entrepreneur’s salary of $3,000 per month through the first full year of sales. (included in initial operating expenses), increasing thereafter by $500 per month. 11)Corporate tax rate of 45%. No loss carry forward. 12)All sales are for credit. The average collection period is 45 days. No discount for prompt payment. 13)The inventory turnover rate is 5 times per year, measured against ending inventory.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6 New Company Assumptions Figure 6-5 (Continued) 14)The company desires to maintain the greater of 30 days’ sales in cash or $10, )All materials are purchased on credit, with terms of 2/10 net 30. The company anticipates paying in time to receive the discount. The payables period is 10 days. 16)The entrepreneur will borrow any funds necessary at a rate of 1% per month. 17)Initial investment by the entrepreneur of $200,000. Additional financing as needed by borrowing on a line of credit.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 6