CHAPTER – SIX

ORGANIZING AND FINANCING THE NEW

VENTURE
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6.1. Financial Requirements

• Finance is a key input of production. It is a pre requisite
for accelerating the process of industrial development.
• Financial resources are essential for business, but
particular requirements change as an enterprise grows.
• Obtaining those resources in the amount and at the time
they are needed can be difficult for entrepreneurial
ventures because they are generally considered more
risky than established enterprises.
• Depending upon the nature of the activity, the
entrepreneurs require three types of finances; i.e. short
term, medium term and long term finances.

Types of Finance
1. Short Term Finance:
 Refers to the funds required for a
period of less than one year.
 Short term finance is usually
required to meet variable, seasonal
or temporary working capital
requirements.
 Borrowing from banks,
 Trade credit,
 Installment credit, and
 Customer advances are sources of
short term finance.
2. Medium Term Finance:
 The period of one year to five years
may be regarded as a medium
term.
 Medium term finance is usually
required for permanent working
capital, small expansions,
replacements, modifications etc.
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 Medium term finance can be raised by:
1. Issue of shares
2. Issue of debentures
3. Borrowing from banks and
other financial institutions
4. Ploughing back of profits by
existing concerns
3.Long Term Finance:
 Period exceeding 5 years are usually
regarded as long term.
 Long term finance is required for
procuring fixed assets, for the
establishment of a new business, for
substantial expansion of existing
business, modernization etc.
 The important sources of long term
finance are:
• (a) Issue of shares, (b) Issue of debentures, (c)
Loans from financial institutions and (d)
Ploughing back of profits by existing
concerns.
 Sources of Finances 4

1. Equity Financing:
Equity is capital invested in a business by its owners, and it is ‘at risk’ on a
permanent basis.
Because it is permanent, equity capital creates no obligation by an
entrepreneur to repay investors, but raising equity requires sharing ownership.

2. Venture Capital:
Venture capital is an alternative form of equity financing for small
businesses.
Venture capitalists focus on high risk entrepreneurial businesses. They
provide:
start-up (seed money) capital to new ventures,
development funds to businesses in their early growth stages, and
expansion funds to rapidly growing ventures that have the potential to “go
public” or that need capital for acquisitions.

3. Personal Sources:
Entrepreneurs must look first to individual resources for startup capital.
These include cash and personal assets that can be converted to cash.
Family members and close friends become involved as informal
investors.
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4. Commercial Banks:
Most commercial loans are made to small businesses. Commercial banks
provide unsecured and secured loans.
 An unsecured loan is a personal or signature loan that requires no collateral; the
entrepreneur is granted the loan on the strength of his reputation.
 Secured loans are those with security pledged to the bank as assurance that the loan
will be repaid.

5. Finance Companies:
 There are three types of finance companies, and although all are asset-
based lenders, each serves a different clientele.
• Sales Finance Companies: focus on loans for specific purchases like
automobiles and farm machinery.
• Consumer Finance Companies: focus on short term loans secured by
personal assets, and most consumer loans are for small amounts at high
rates of interest. These loans are typically negotiated directly between finance
companies and consumers for purchases such as furniture, appliances,
vacation trips and home repairs.
• Commercial Finance Companies: are focused predominantly on small
business and agricultural lending. Their primary business is making loans on
commercial, industrial and agricultural equipment.
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6. Leasing:
 Leasing allows a small firm to obtain the use of equipment, machinery
or vehicles without owning them.
 Ownership is retained by the leasing company, although in many cases
there is a purchase option at the end of the lease period.

7. Hire Purchase:
 Hire purchase provides the immediate use of the asset and also
ownership of it, provided that payments according to the agreement are
made.

8. Factoring:
 Factoring is a specialist form of finance to provide working capital to
young, undercapitalized businesses.
 A small firm, which grants credit to its customers, can soon have
considerable sums of money tied up in unpaid invoices.
 Factoring is a method of releasing these funds; the factoring company
takes responsibility for collection of debts and pays a percentage
(Usually 80%) of the value of invoices of the issuing company.
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6.2. Control of Financial Resources
Financial problems Stage Likely Financial issues
 Fast growing small finance
businesses have sources
particular problems in
Conception Personal Under capitalization,
controlling their
finances. Growth brings
investment because of inability to
frequent changes to the raise finance.
internal structures and Introduction Bank loans, Control of costs and
external environment of overdrafts lack of information.
a small firm.
Development Hire „Over trading‟, liquidity
 It is often difficult to
purchase, crisis.
ensure that financial leasing
control systems keep Growth Venture „Equity gap‟ appropriate
pace with the changing capital information systems.
circumstances. The Maturity All sources Weakening return on
small business is likely
investment
to be confronted by a
variety of financial Decline Sale of Finance withdrawn. Tax
problems as it advances business/ issues of business are
through its life cycle. liquidation sold.
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The Financial Life Cycle of a Small Firm

Cash Flow-Debtors and Stock
• Financial management in a small firm starts with the management of
the cash flow. It is easy for cash resources of a small business to
become ‘locked up’ in unproductive areas such as debtors, work in
progress and finished stocks.
• Debtors can hurt small business in two major ways:-
1. They absorb cash and effectively increase the funding requirement
of a small firm.
2. The longer a debt is alive, the greater the risk of a bad debt.
• Stock represents a poor investment for a small firm’s financial
resources. Stock surpluses earn no money and the risk of deterioration
if not used quickly.
• Stock management is about balances, and the optimization of resources. Stocks
need controlling in three areas- raw material stock, work-in-progress, finished
stock.
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Costs and Profits

• Profits and losses are theoretical figures representing the difference
between total earnings and total expenditures, incurred by a small firm in
achieving those earnings.
• Profits or losses should be translated into cash surpluses or deficits.
Profitability can be improved by:-
j Reduction of costs
j Increase of prices
j Increase of sales volume
• Costs are classified as fixed or variable.
Fixed costs:
 remain unchanged in the short term and do vary in the long term
 will not vary with the volume of goods or services sold
 they are the overheads of a business.
Variable costs:
 are operational expenses that change according to the volume of
production.
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6.3. Financial Analysis
• Small firms differ greatly in their approach to the provision of accounting
information, and the use of forecasts and budgets for planning and
controlling of business.
• The three most widely used financial summaries are:-
Profit and loss account or income statement
Cash flow, and
The balance sheet.
The Profit and Loss Account:
o commonly called as income statement shows how a business is doing in
terms of sales and cost- and the difference between them of profit or
losses.
 The Cash Flow Summary:
o indicates the movement of cash into and out of the business.

 The Balance Sheet:

o represents a summary of what money has been spent by a business, and
what it has been spent on. It is usually an annual summary of the use and
source of funds in a company
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6.4. Financial Management

• Financial Record Keeping
Organizations are established to achieve certain objectives.
While trying to achieve these objectives, they perform
different activities, which are sources of different
transactions.
Once small and micro enterprises are established, they will
have:-
A) Different properties such as office chair, automobile
B) Money or goods borrowed from others and
C) Net capital of the business
The property owned by the company in accounting term is
known as equity.
 Equities can also be divided in to owners’ equity and creditor’s equity.
 The equity of the creditors is debts for the business organization and is called
liabilities and the equities of the owners are called capital.
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• Expansion of the equation to give recognition to the two types

of equities yields the following accounting equation.

 Asset = Liabilities + Capital

• An item to be called as asset it:-

. Should be the property of the organization

. Must be measured in terms of money

. The owner should exercise the right to possess, use, enjoy and
dispose of the asset.

j Balance sheet is one of the accounting statements that list

assets, liabilities and capital of a business entity at a specific
date, usually at the close of the last day of the month.
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• Preparing Financial Statements

 There are so many parties, which are interested about the financial
situation of a small business organization.
 Financial statements such as income statement, balance sheet, and
capital statements provide information about the financial condition of
the organization.
 Financial statement can be prepared on monthly, quarterly and yearly
basis as per the user’s requirement for decision making.
1) Income Statement:
 It is a summary of the revenue and the expense of a business entity

for the specific period of time such as a month or a year.

 Income statement has two major parts; the heading and the body.
In the heading, the name of the business, name of the
statement and the date of preparation are identified.
 In the body part, the revenue and the expense of the business
organization are listed.
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There are four steps that we should follow to prepare income

statement. These are:-
• Step 1. Write the heading of the statement- Write the name of the
business and the statement and date of preparation.

• Step 2. Prepare the revenue section- Write the word revenue at the left
side and write the income statement account sales in the second line by
moderately indenting.

• Step 3. Prepare the expense section-Like the revenue, the second part
of the income statement i.e. expense is written at the left side below
expenses account moderately indented from the left. The word total
expense is written on the line beneath the last expense account title.

• Step 4. Calculate the net income /net loss- Net income or loss is
calculated by subtracting total expense from the total revenue. The word
net income is written at the left margin.
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2) Capital Statements /Statements of Owners‟ Equity:

It is one of the financial statements that shows the increase or

decrease of the owner’s equity.

The owner’s equity might be changed due to additional

investment, income or loss and withdrawal by the owner.

Some information from income statement helps to prepare capital

statement. Therefore, capital statements should be prepared next
to income statements.

Capital statement like income statement has heading and body. In

the heading, the name of the statement, the name of the business
organization and the date on which it is prepared is specified.

The information on the capital statement helps to prepare the

balance sheet.
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3. Balance Sheet:
It is a list of assets, liabilities and capital of a business
entity as of a specific date usually at the close of the last
day of a month.

A beginning balance sheet can be prepared during the

establishment of the business organization and thereafter,
it can be prepared at different time when required.

While preparing balance sheet it is customary to begin

the asset section with cash which is followed by
receivables, supplies, and other assets such as prepaid
expenses that will be converted into cash or consumed in
the near future.

The assets of a relatively permanent nature such as

equipment, buildings and land follow in that order.

Steps To Prepare Balance Sheets
• Step 1- Write the Heading-
 write at the center the heading
specifying the name of the business
organization, the title of the
statement and date it is prepared
• Step 2- Prepare the Asset
Section-
 Identify the nature of the assets as
current assets/ fixed or permanent in
nature.
 write the heading current assets at
the left hand side and below it list
down current assets and below the
last current asset write total assets.
 the same applies for fixed assets.
After writing all current and fixed
assets write total assets indenting
moderately.
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• Step 3- Prepare the Liability
Section-
 Assess the nature of liability accounts and
identify current and long –term liabilities.
 Current liabilities are liabilities that will be
due within a short time (usually one year)
and that are to be paid off out of current
assets.
 Long – term liabilities are those, which will
be due comparatively after a long time
(usually more than one year)..
• Step 4- Prepare the Capital
Section-
 Capital is the word applied to the owner’s
equity in the business.
 It is the residual claim against the assets of
the business after the total liabilities are
reduced.
 If the business is profitable, it increase the
capital of the owner, if there is a loss, it will
decrease the capital.
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ANY LAST QUESTION