Unit 1: Assessing a new venture financial strength

INTRODUCTION TO FINANCIAL MANAGEMENT

UNIT 5
FINANCE
 Financial Decisions
• Selection of the investment proposal, known as the
investment decision.
• Determination of working capital requirement,
known as the working capital decisions.
• Raising of funds to finance the assets, known as the
financing decision.
• Allocation of profit for dividend payment, known as
dividend decision.
Alternative sources of finance
 Sources of Finance
Owned Funds Borrowed Funds

• Equity Shares • Debentures

• Preference Shares • Public Deposits
• Retained Earnings • Financial Institutions
• Banks
Arranging seed money for new ventures
 Angel Investor / Seed Funding

• Provides ‘seed funding’

• Usually affluent individual providing capital for
business start-ups
• Different from venture capitalists
• Limitation on amount of money that can be raised
• Bear high risk
• Require very high return
• Investment holding period of less than 5 years
Obtaining equity funding from Venture
Capitalists
 Venture Capital
Venture capital is characterized by:
• Financing of new and potentially high growth companies
• Investments primarily in the form of equity participation
• Assistance in the early days of the enterprise
• Adding value to the company through active participation,
even joining the management on occasions
• Willingness to take on higher risk
• Expectation of higher rewards
• A long-term outlook regarding the investment

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 Roles in a Venture Fund
• General partner
• Investor
• Venture partner
• Entrepreneur-in-residence
• Others

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 Screening by VCs
• Get rid of scamsters
• Major broad concerns
• Growth and industry considerations
• Monetising value

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Arranging debt finance
 Disadvantages of Equity Finance
• Dilution of shareholding
• Increased 3rd party governance
• Increased external controls
• Increased commitment to stated strategy

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 Sources of Debt
• State Finance Corporations
• NBFC
• Banks

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 Securing Debt
• Drawing up the business plan.
• Identifying sources of debt finance.
• Presenting the proposal to the bank.
• If the manager is considering your proposal
favourably, you will have to go for further
talks
• Once the two parties have broadly agreed,
details have to be worked out.
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 Principles of Good Lending
• Purpose
• Safety
• Profitability
• Other considerations

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 Security
• Collateral
– Inside
– Outside
• Personal guarantee
• Maturity
• Covenants
• Menu pricing

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 Lending Strategies
• Financial statements
• Relationship lending
– Length of relationship
– Breadth of relationship
– Degree of trust
• Credit scoring

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Unit 1: Assessing a new venture financial strength

FINANCIAL STATEMENT AND FORECAST

• “You need to have enough
immediate profits that you can
finance the long-range growth
without diluting the stock”.
• - Paul Cook
 Functions of Financial Management

Financial management involves two types of functions:

(i) Managerial finance functions and

(ii) Routine finance functions.
 Managerial Finance Functions

• Estimating financial requirement

• Identifying sources of finance

• Raising of finance

• Proper use of finance

• Control of finance.
 Routine Finance Functions

Important routine finance functions are:

• Supervision of cash receipts and payments

• Safeguarding cash balances
• Record keeping (accounting)
• Custody and safeguarding of securities, insurance policies, and other
important documents
• Taking care of the mechanical details of outside finance
• Regular return of borrowed funds
 Financial Statements

A complete set of financial statements normally consists of:

• A balance sheet.

• A profit and loss account or income statement.

• A cash flow statement.

 Balance Sheet

• It is a significant financial statement of an enterprise and is

called a fundamental accounting report.
• A balance sheet shows the financial status of an enterprise at
any given moment in time.
• The balance sheet will always balance. The balance sheet
contains information in respect of assets, liabilities, and
shareholder’s equity.
 The Salient Features of a Balance Sheet
• Prepared as on a given date.
• Comparative position.
• Vertically drawn.
• Grouping and sub-grouping of assets and liabilities.
• Details in schedules and notes to the accounts.
• Matching of assets and liabilities.
• Signed by person who prepared it and auditors
 Profit and Loss Account
• This is also known as income statement, statement of earnings,
statement of operations, and profit and loss statement.
• The profit and loss account represents the scoreboard of the
performance of the enterprise in terms of the profitability of
operations.
• The main contents of a profit and loss account are: revenues, sales
income, and net income/profit/loss.
• The profit and loss account of an enterprise reports the results of
operations in terms of income/net profit in a year.
• The statement of profit and loss depicts the total income of the
company, the expenditure incurred in deriving that income, the
income tax payable to the government, the net profit earned, the
dividend paid to the shareholders, and the profit retained and
ploughed back into the company
 Profit and Loss Account
The salient features of a profit and loss account are:
• Prepared for a given period.
• Comparative position.
• Vertically drawn.
• Grouping on income and expenditure.
• Details in schedules and notes to the accounts.
• Appropriation of profit and transfer to the balance sheet.
• Signed by person who prepared it and the auditors.
 Cash Flow Statements

• Cash flow statement is derived from the balance sheet and

profit and loss account and cash equivalents of an enterprise
by classifying cash flows during the period from operating,
investing, and financing activities.
• Cash has been defined as comprising cash on hand and
demand deposits with banks. Cash equivalents are short term,
highly liquid investments that are readily convertible into
known amounts of cash and which are subject to an
insignificant risk of change in value.
• Cash flows refer to inflows and outflows of cash and cash
equivalents.
 Cash Flow Statements

The salient features of a cash flow statement are:

• Prepared for a given period.

• A derived statement.
• Comparative position.
• Vertically drawn.
• Cash flows from operating, investing and financing activities.
• Reconciliation with the opening and closing balances of cash
and cash equivalents.
• Indirect method for cash flows from operating activities.
• Signed by the person prepared it and the auditors
 Cash Flow Statements
A cash flow statement, when used in conjunction with other financial statements,
provides information that benefits its users in a number of ways as given below:
• It enables users to evaluate the changes in the net assets of an enterprise, its financial
structure including its liquidity and solvency, and its ability to affect the amount and
timing of cash flows in order to adapt to changing circumstances and opportunities.
• The information is useful in assessing the ability of an enterprise to generate cash
and cash equivalents and enables users to develop models to assess and compare the
present value of the future cash flows of different enterprises.
• It enhances the comparability of the reporting of operating performance by different
enterprises because it eliminates the effects of using different accounting treatments
for the same transactions.
• Historical cash flow information is often used as an indicator of the amount, timing,
and certainty of future cash flows.
• It is useful in checking the accuracy of past assessments of future cash flows.
• It helps in examining the relationship between profitability and net cash flow.
 
 Working Capital Management

• Working capital is the money needed to fund the normal, day to day
operations of the enterprise. It is needed for the smooth operation of an
enterprise.
• The working capital cycle is the length of time between the company’s
outflow on raw materials, wages and other expenditures and the inflow of
cash from the sale of goods.
• Working capital is defined as the excess of current assets over current
liabilities. Working capital requirements are financed by a combination of
long-term and short-term sources.
• Working capital = Current assets−Current liabilities
• The various ratios used for measuring the efficiency in managing working
capital are: the quick ratio, the debtor’s turnover ratio, the creditor’s
velocity ratio, the stock turnover ratio, the current ratio, and the stock-
working capital ratio.
Unit 1: Assessing a new venture financial strength

PRO FORMA OF FINANCIAL

STATEMENT
Definition of Pro Forma Financial Statement
• A pro forma financial statement is one based on certain
assumptions and projections (as opposed to the
typical financial statement based on actual past transactions).
What are the benefits of pro forma financial statements?
• Pro forma statements for each plan provide important
information about future expectations, including sales and
earnings forecasts, cash flows, balance sheets, proposed
capitalization, and income statements. Management also uses
this procedure in choosing among budget alternatives.
What should be included in a pro forma?
• An effective business plan has to include at least three
important "pro forma" statements (pro forma in this context
means projected). They're based on the three main accounting
statements: The profit or loss, also called income, statement
shows sales, cost of sales, operating expenses, interest and
taxes.
Consolidated Financial Statement Example
Balance Sheet
Pro forma Financial Statements Projections
Why Is It Important for Entrepreneurs to Develop
Financial Plans for Their Companies?
• Completing a financial plan is the last step in writing a
business plan.
• The plan includes a projected profit-and-loss statement for
the next three to five years and a cash flow statement.
• A balance sheet is sometimes included as well as a break-
even analysis. T
• he financial plan is important, because it establishes the
financial goals of the company.
• That is not the only reason it's important.
 1. Determine the Feasibility of the Company

• When you begin to contemplate starting a business, you assume it

will be successful, but many entrepreneurs find out after launching
the company that success can be elusive.
• Creating a business plan with the accompanying financial plan is
really a feasibility study of what it takes to be successful.
• If the resources are out of your reach, you don't have the
experience or the market is too unstable at the moment, the
financial plan will make that clear.
• You may find that the price you plan on charging for your products
or services is materially higher than what your competitors are
charging. Or perhaps the price is fine, but your manufacturing
costs are too high and it will be difficult to earn a profit.
 2. Variance Analysis

• Monitoring the actual results against the line-item budget

in the financial plan gives you the opportunity to take
whatever steps are necessary to get back on track.
• For example, if you're not reaching the projected revenue,
either the projections are wrong or the marketing
program is not as effective as you thought. Knowing the
assumptions behind the projections is important to find
out why the projections have been missed.
• In other words, you need to know what you did right and
what went wrong
A line item budget is a form of budget presentation that clusters proposed 
expenses by department or cost center. This method of aggregation more
easily shows which departments and cost centers are absorbing the bulk of
the entity's funds
 Forecast Financing Requirements

• Starting a business requires money. The forecast financial

plan demonstrates how much money is required and
when.
• If you don't have the required amount of funding to start
the business, you may have to begin on the smaller scale
your funding allows. The financial plan also shows you
where a shortfall will occur.
• Adjust the revenue and expense projections to avoid the
shortfall or make sure you have other funds available, such
as your own savings or a loan to cover any cash deficit.
 Obtain Funding

• Investors and lenders request to see the entrepreneur's

business plan, including the financial plan with projections and
assumptions behind the forecast.
• If the financial plan is unrealistic, a common mistake with
entrepreneurs, the loan or investment will not be forthcoming.
• Another reason the financial plan is important is because it
lets you know what type of financing would be more
appropriate.
• For example, if you need less than $1 million to get started,
then venture capital firms won't be interested. VCs invest
larger amounts of money.
Important Financial Ratios
• 1. Debt-to-Equity Ratio
• The debt-to-equity ratio, is a quantification of a
firm’s financial leverage estimated by dividing
the total liabilities by stockholders’ equity. This
ratio indicates the proportion of equity and
debt used by the company to finance its assets.
• The formula used to compute this ratio is
– Total Liabilities / Shareholders Equity
Financial leverage is the use of borrowed
money (debt) to finance the purchase of
assets.
• 2. Current Ratio
• The current ratio is a liquidity ratio which
estimates the ability of a company to pay back
short-term obligations. This ratio is also known
as cash asset ratio, cash ratio, and liquidity
ratio. A higher current ratio indicates the higher
capability of a company to pay back its debts.
The formula used for computing current ratio is:
– Current Assets / Current Liabilities
• 3. Quick Ratio
• The quick ratio, also referred as the “acid test ratio” or
the “quick assets ratio”, this ratio is a gauge of the
short term liquidity of a firm. The quick ratio is helpful
in measuring a company’s short term debts with its
most liquid assets.
• The formula used for computing quick ratio is:
– (Current Assets – Inventories)/ Current Liabilities
• A higher quick ratio indicates the better position of a
company.
 An asset is said to be liquid if it is easy to
sell or convert into cash without any loss in
its value. 
• 4. Return on Equity (ROE)
• The return on equity is the amount of net income
returned as a percentage of shareholders equity.
Moreover, the return on equity estimates the
profitability of a corporation by revealing the
amount of profit generated by a company with the
money invested by the shareholders. Also, the
return on equity ratio is expressed as a percentage
and is computed as:
– Net Income/Shareholder's Equity
• 5. Net Profit Margin
• The net profit margin is a number which indicates the
efficiency of a company at its cost control. A higher net
profit margin shows more efficiency of the company at
converting its revenue into actual profit. This ratio is a
good way of making comparisons between companies
in the same industry, for such companies are often
subject to similar business conditions.
• The formula for computing the Net Profit Margin is:
– Net Profit / Net Sales