The Financial Plan Part 1: Projecting Financial Requirements Part 3 Developing the New Venture Business Plan

Looking Ahead After studying this chapter, you should be able to: Describe the purpose and content of the income statement, the balance sheet, and the cash flow statement. Forecast a new venture’s profitability. Determine asset requirements, evaluate financial sources, and estimate cash flows for a new venture. Explain the importance of using good judgment when making projections. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Understanding Financial Statements Financial Statements (Accounting Statements) Reports of a firm’s financial performance and resources, including an income statement and a balance sheet Helps determine a startup’s financial requirements Assesses the financial implications of a business plan Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Understanding Financial Statements Income Statement A report showing the profit or loss from a firm’s operations over a given period of time. “How profitable is the business?” Sales – Expenses = Profits Revenue from product or service sales Costs of producing product or service (cost of goods sold) Operating expenses (marketing, selling, general and administrative expenses, and depreciation) Financing costs (interest paid) Tax payments Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Sections of the Income Statement Cost of goods sold The cost of producing or acquiring goods or services to be sold by a firm Gross profit Sales less the cost of goods sold Operating expenses Costs related to marketing and selling a firm’s product or service, general and administrative expenses, and depreciation Operating income Earnings before interest and taxes are paid Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Sections of the Income Statement Financing Costs The amount of interest owed to lenders on borrowed money Net income available to owners (Net income) Income that may be distributed to the owners or reinvested in the company Depreciation expense Costs related to a fixed asset, such as a building or equipment, distributed over its useful life Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

The Income Statement: An Overview Operating Activities Sales Revenue = Operating Income Earnings Before Taxes Net Income Available to Owners Cost of producing or acquiring product or service (cost of goods sold) Gross profit Marketing and selling expenses, general and administrative expenses and depreciation (operating expenses) , – Financing Activities Interest expense on debt (financing costs) Taxes Income taxes Exhibit 10.1 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Income Statement for Petri & Associates Leasing, Inc Income Statement for Petri & Associates Leasing, Inc., for the Year Ending December 31, 2005 Sales revenue $850,000 Cost of goods sold _550,000 Gross profit $300,000 Operating expenses: Marketing expenses $90,000 General and administrative expenses 80,000 Depreciation _30,000 Total operating expenses $200,000 Operating income $100,000 Interest expense __20,000 Earnings before taxes $ 80,000 Income tax (25%) 20,000 Net income $ 60,000 Dividends paid $_15,000 Change in retained earnings $ 45,000 Exhibit 10.2 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

The Balance Sheet Balance Sheet A report showing a firm’s assets, liabilities, and owners’ equity at a specific point in time Total Assets = Outstanding debt + Owner’s equity Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

The Balance Sheet: An Overview Current Assets Cash Accounts receivable Inventories Other Assets Long-term investments, patents + Total Assets = Fixed Assets Machinery and equipment Buildings and land Debt Capital Accounts payable Accrued expenses Short-term notes Long-term notes Mortgages Total Debt and Equity Owner's Equity Owner's net worth or Partnership equity Common stock equity Assets Debt (Liabilities) and Equity (Net Worth) Current Debt Long-term Debt The Balance Sheet: An Overview Exhibit 10.3 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Balance Sheet: Current Assets Current Assets (Working Capital) Assets that can be converted to cash within the firm’s operating cycle Cash: Currency and negotiable instruments Accounts receivable: the amount of credit extended to customers that is currently outstanding Inventory: raw materials and products held in anticipation of eventual sale Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Balance Sheet: Fixed Assets Relatively permanent resources intended for use in the business (not for resale) Depreciable assets Assets whose value declines (depreciates) over time Gross fixed assets Original cost of depreciable assets before any depreciation expense has been taken Accumulated depreciation Total depreciation expense taken over the assets’ life Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Balance Sheet: Fixed Assets (cont’d.) Net fixed assets Gross fixed assets less accumulated depreciation Other assets Assets other than current assets and fixed assets, such as patents, copyrights, and goodwill that have an estimated value Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

The Balance Sheet: Debt Business financing provided by a creditor Current (Short-term) debt Accounts payable: outstanding credit payable to suppliers Accrued expenses: short-term liabilities that have been incurred but not paid Short-term notes: Cash amounts borrowed from a bank or other lending sources that must be repaid within a short period of time Long-term debt Loans and mortgages from banks and other lenders with maturities greater than one year Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

The Balance Sheet: Debt Long-term debt Loans and mortgages from banks and other sources with repayment terms of more than 12 months Mortgage A long-term loan from a creditor for which real estate is pledged as collateral Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

The Balance Sheet: Types of Financing Owners’ equity Money that the owners invest in the business Owners are “residual owners” of the firm. Creditors have first claim on the assets of the firm. Retained earnings Profits less withdrawals (dividends) over the life of the business Owners’ equity = Owners’ investment – Cumulative dividends paid to owners Cumulative profits + Earnings retained within the business Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Balance Sheets for Petri & Associates Leasing, Inc Balance Sheets for Petri & Associates Leasing, Inc., for December 31, 2004 and 2005 Exhibit 10.4 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Profits Versus Cash Flows Accrual-Basis Accounting A method of accounting that matches revenues when they are earned against the expenses associated with those revenues Sales reflect both cash and credit (noncash) sales Inventory purchased on credit is a noncash expense Depreciation is a noncash expense Income tax is accrued and may not be entirely expensed Cash-Basis Accounting A method of accounting that reports transactions only when cash is received or a payment is made Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

The Fit of the Income Statement and the Balance Sheet Exhibit 10.5 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

The Cash Flow Statement A financial report showing a firm’s income (cash) when it is received and expenses when they are paid. Cash flows from normal operations (operating activities) Cash flows related to the investment in or sale of assets (investment activities) Cash flows related to financing the firm (financing activities) Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

The Cash Flow Statement (cont’d.) Cash Flows from Operations Net cash flows generated from operating a business Calculated by adding back to operating income depreciation, deducting income taxes, and factoring in any changes in net working capital Adjusted Income After-tax cash flow Net Working Capital Money invested in current assets less accounts payable and accruals Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

The Cash Flow Statement (cont’d.) Cash Flows from Investment Activities Cash inflows and outflows resulting from the sale or purchase of equipment or another depreciable asset Cash Flows from Financing Activities Cash inflows and outflows resulting from: Paying dividends and interest expense Increasing or decreasing short-term and long-term debt Issuing or repurchasing stock Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Computing Cash Flows from Assets After-Tax Cash Flows from Operations Cash Flows from Assets Changes in Operating Working Capital Changes in Long-Term Assets After-tax cash flows from operations Investments in operating working capital Investments in long-term assets Cash flows from assets = Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Computing Other Cash Flows After-Tax Cash Flows From Operations Net income Depreciation expense Interest Expense After-tax cash flows from operations = + Operating Working Capital Current assets Operating Working Capital = – Account payable and accruals Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Cash Flows from Financing Interest and Dividends Paid to Investors Increase in Debt (firm issues new debt) Increase in Equity (firm issues new stock) Decrease in Debt (firm repays debt) Decrease in Equity (firm repurchases outstanding stock) Increases in Cash Flows from Financing Decreases in Cash Flows from Financing Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Cash Flow Statement for Petri & Associates Leasing, Inc Cash Flow Statement for Petri & Associates Leasing, Inc., for the Year Ending December 31, 2005 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Exhibit 10.6

Cash Flow Patterns Pattern 1. This firm has positive cash flows from operations, negative investment cash flows, and positive cash flows from financing. It is using its cash flows from operations and new financing to expand the firm’s operations. Pattern 2. This firm is using cash flows from operations to expand the business, pay down debt, and/or pay its owners. Pattern 3. This firm is encountering negative cash flows from operations, which are being covered by selling assets and by borrowing or acquiring more equity financing. Pattern 4. This firm has negative cash flows from operations and is growing the company’s fixed assets through increased financing. This firm is a startup business that has yet to break even, is investing in assets to produce future cash flows, and is having to raise capital to make that happen. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Exhibit 10.7

Financial Forecasting Pro Forma Financial Statements Statements that project a firm’s financial performance and condition Purposes of pro forma statements: How profitable can the firm be expected to be, given the projected sales levels and the expected sales expense relationships? What will determine the amount and type of financing (debt or equity) to be used? Will the firm have adequate cash flows? If so, how will they be used; if not, where will the additional cash come from? Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Pro Forma Income Statements for Cameron Products, Inc. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Exhibit 10.8

Forecasting Profitability Net Income Depends On: Amount of sales Cost of goods sold and operating expenses Interest expense Taxes “If we’re doing so well, then why am I always so broke?” Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Forecasting Assets and Financing Requirements and Cash Flows Bootstrapping Minimizing a firm’s investments Estimating Asset Requirements Use industry ratios for assets-to-sales Use breakeven analysis and empirical data Percentage-of-Sales Technique Using a percentage of the total sales for a firm as the basis for forecasting the level of assets, accounts receivable, and inventories to be held by a firm Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Assets-to-Sales-Financing Relationships Exhibit 10.9 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Percentage-of-Sales Technique Example Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Determining Financing Requirements Liquidity The degree to which a firm has working capital available to meet maturing debt obligations Current Ratio The firm’s relative liquidity, determined by dividing current assets by current liabilities Debt Ratio Debt as a fraction of assets; total debt divided by total assets Spontaneous financing—debts such as accounts payable that increase as the firm grows Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Sources of Equity Capital External Equity The owners’ original investment Profit Retention The reinvestment of profits in a firm Internal Equity Capital from retaining profits within the firm Forecasting financial requirements (in total): Total sources of financing Spontaneous financing Profits retained within the business Total asset requirements = + External sources of financing Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Projected Balance Sheets for Cameron Products, Inc. Exhibit 10.10 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Good Forecasting Requires Good Judgment Practical Suggestions Develop realistic sales projections. Build projections from clear assumptions about marketing and pricing plans. Do not use unrealistic profit margins. Don’t limit your projections to an income statement. Provide monthly data for the upcoming year and annual data for succeeding years. Avoid providing too much financial information. Be certain that the numbers reconcile—and not by simply plugging in a figure. Follow the plan. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Key Terms financial statements (accounting statements) income statement (profit and loss statement) cost of goods sold gross profit operating expenses operating income financing costs net income available to owners (net income) depreciation expense balance sheet current assets (gross working capital) accounts receivable inventory fixed assets depreciable assets gross fixed assets accumulated depreciation net fixed assets other assets debt current debt (short-term liabilities) accounts payable (trade credit) accrued expenses short-term notes long-term debt mortgage ownership equity retained earnings cash flow statement accrual-basis accounting cash-basis accounting cash flows from operations net working capital pro forma financial statements bootstrapping percentage-of-sales technique liquidity current ratio debt ratio spontaneous financing external equity profit retention internal equity Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Computing Cash Flows for Petri & Associates, Inc. Part 3 Developing the New Venture Business Plan

Income Statement and Balance Sheet Changes for Petri & Associates, Inc Income Statement and Balance Sheet Changes for Petri & Associates, Inc., for the Year Ending December 31, 2005 Exhibit A10.1 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Cash Flow Statement for Petri & Associates, Inc Cash Flow Statement for Petri & Associates, Inc., for the Year Ending December 31, 2005 Exhibit A10.2 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Computing Cash Flows for Petri & Associates, Inc. Part 3 Developing the New Venture Business Plan

Cash Flow Statements For Cameron Products, Inc. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.