Chapter 7 Financial Management PDF

Chapter 7 Financial Management Learning Objectives Describe the importance of financing for entrepreneurial success. Explain why most entrepreneurial ventures need to raise money during their early life. Identify and describe the three sources of personal financing available to entrepre...

Chapter 7 Financial Management Learning Objectives Describe the importance of financing for entrepreneurial success. Explain why most entrepreneurial ventures need to raise money during their early life. Identify and describe the three sources of personal financing available to entrepreneurs. Identify and explain the three steps involved in properly preparing to raise debt or equity financing. Explain the three most important sources of equity funding that are available to the entrepreneurial firm. Describe common sources of debt financing entrepreneurial firms use. Describe several creative sources of financing entrepreneurial firms may choose to use. Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved.  Financial Management Financial management deals with two things: Raising money and managing a company’s finances in a way that achieves the highest rate of return. Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved.  Why Most New Ventures Need Financing or Funding There are three reasons that most entrepreneurial ventures need to raise money during their early life: Figure 10.1 Three Reasons Start-Ups Need Funding Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Alternatives for Raising Money for a New Venture Personal Funds Debt Financing Equity Capital Creative Sources Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved.  Personal Funds Vast majority of founders contribute personal funds, along with sweat equity, to their ventures.  Sweat equity represents the value of the time and effort that a founder puts into a new venture. Friends and Family - second source of funds for many new ventures. Bootstrapping - finding ways to avoid the need for external financing or funding through creativity, ingenuity, thriftiness, cost cutting, or any means necessary. – E.g., Buy used instead of new equipment, Lease equipment rather than buying, Obtain payments in advance from customers, Hire interns Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Preparing to Raise Debt or Equity Financing Figure 10.3 Preparation for Debt or Equity Financing Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Preparing to Raise Debt or Equity Financing Two Most Common Alternatives Equity Funding Debt Financing Exchanging partial ownership Is getting a loan. in a firm, usually in the form of stock, for funding. Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Sources of Equity Funding The primary disadvantage of equity funding is that the firm’s owners relinquish part of their ownership interest and may lose some control. Next, we describe the three most common forms of equity funding. Business Angels Venture Capital Initial Public Offerings Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved.  Business Angels Individuals who invest their personal capital directly in start-ups. The prototypical business angel is about 50 years old, high income and wealth, well educated, has succeeded as an entrepreneur, and invests in companies that are in the region where he or she lives. Many angels are motivated by more than financial returns: they enjoy the process of mentoring a new start-up. Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Venture Capital Money that is invested by venture capital firms in start-ups and small businesses with exceptional growth potential. A distinct difference between angel investors and venture capital firms is that angels tend to invest earlier in the life of a company, whereas venture capitalists come in later. The majority of venture capital money goes to follow-on funding for businesses that were originally funding by angel investors, government programs, or by some other means. Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved.  Initial Public Offering A company’s first sale of stock to the public. When a company goes public, its stock is traded on one of the major stock exchanges. An IPO is an important milestone for a firm. Typically, a firm is not able to go public until it has demonstrated that it is viable and has a bright future. Many advantages to going public, it is a complicated and expensive process and subjects' firms to substantial costs related to SEC reporting requirements. Many of the costliest requirements were initiated by the Sarbanes-Oxley Act of 2002. Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Sources of Debt Financing Commercial Banks When it comes to start-ups, some banks are rethinking their lending standards and are beginning to focus on cash flow and the strength of the management team rather than on collateral and the strength of the balance sheet. Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Creative Sources of Financing or Funding Crowdfunding - the practice of funding a project or new venture by raising monetary contributions from a large number of people (the “crowd”) typically via the Internet. Leasing - a written agreement in which the owner of a piece of property allows an individual or business to use the property for a specified period of time in exchange for payments. Grant Programs – MATRADE, TEKUN Financing Products etc Strategic Partners - partnerships are formed to share the costs of product or service development, to gain access to particular resources, or to facilitate speed to market. Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Financial Objectives of a Firm Figure 8.1 Primary Financial Objectives of Entrepreneurial Firms Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. The Process of Financial Management Person Corporat ion How can we Assess the Health of a Business? Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Financial Statements What are financial statements? Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Financial Statements Historical Overview After the Stock Market Crash of 1929 ad in the middle of Great depression, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934 that created the Securities and Exchange Commission. This commission requires publicly listed companies to report financial information, including financial statements each quarter of the year. (www.sec.gov) Copyright © 2021 Pearson Education, Inc. All Rights Reserved The Process of Financial Management Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. The Income Statement What are in the Income (Profit or Loss) Statement? Copyright © 2021 Pearson Education, Inc. All Rights Reserved The Income Statement Earnings Calculations – Gross Profit  Revenues Net Sales  - Cost of Sales = Gross Profit – Operating Income  Gross Profit-Operating Expenses = Operating Income – Earnings Before Interest and Taxes (EBIT)  Operating Income +/-Other Income = Earnings Before Interest and Taxes – Pretax and Net Income  EBIT +/-Interest Income Expense  = Pretax Income  Pretax Income-Taxes = Net Income Copyright © 2021 Pearson Education, Inc. All Rights Reserved Global Corporation’s Income Statement Sheet for 2019 and 2018 Global Corporation Income Statement Year ended December 31 (in $ millions) 2019 2018 Net sales 186.7 176.1 Cost of sales Minus 153.4 Minus 147.3 Gross Profit 33.3 28.8 Selling, general, and administrative expenses Minus 13.5 Minus 13 Research and development Minus 8.2 Minus 7.6 Depreciation and amortization Minus 1.2 Minus 1.1 Operating Income 10.4 7.1 Other income Blank Blank Earnings Before Interest and Taxes (EBIT) 10.4 7.1 Interest income (expense) Minus 7.7 Minus 4.6 Pretax Income 2.7 2.5 Taxes Minus 0.7 Minus 0.6 Net Income 2.0 1.9 Copyright © 2021 Pearson Education, Inc. All Rights Reserved The Balance Sheet Also called “Statement of Financial Position” Lists the firm’s assets and liabilities Provides a snapshot of the firm’s financial position at a given point in time Copyright © 2021 Pearson Education, Inc. All Rights Reserved  2.3 The Balance Sheet Current Assets Cash and other marketable securities Short-term, low-risk investments Easily sold and converted to cash Accounts receivable Amounts owed to the firm by customers who have purchased on credit Inventories Raw materials, work-in-progress and finished goods Other current assets Catch all category that includes items such as prepaid expenses Copyright © 2021 Pearson Education, Inc. All Rights Reserved 2.3 The Balance Sheet Long-Term Assets – Assets that produce tangible benefits for more than one year – Recorded value reduced through a yearly deduction called depreciation according to a schedule that depends on an asset’s life span  Depreciation is not an actual cash expense, but a way of recognizing that fixed assets wear out and become less valuable as they get older Copyright © 2021 Pearson Education, Inc. All Rights Reserved 2.3 The Balance Sheet Liabilities – Current Liabilities  Accounts payable – The amounts owed to supplier's purchases made on credit  Notes payable and short-term debt – Loans to be repaid in the next year  Accrual items – Items such as salary or taxes that are owed but have not yet been paid. – Long-Term Liabilities  Long-term debt – A loan or debt obligation maturing in more than a year Copyright © 2021 Pearson Education, Inc. All Rights Reserved 2.3 The Balance Sheet Stockholders’ Equity Copyright © 2021 Pearson Education, Inc. All Rights Reserved Global Corporation Balance Sheet for 2019 and 2018 ($ millions) Table 2.1 Global Corporation Balance Sheet for 2019 and 2018 ($ millions) Assets 2019 2018 Liabilities and Stockholders’ Equity 2019 2018 Current Liabilities blank blank Current Assets blank Blank Accounts payable 29.2 26.5 Cash 23.2 20.5 Notes payable/short-term debt 5.5 3.2 Accounts receivable 18.5 13.2 Total current liabilities 34.7 29.7 Long-Term Liabilities blank blank Inventories 15.3 14.3 Long-term debt 113.2 78.0 Total current assets 57.0 48.0 Total long-term liabilities 113.2 78.0 Total Liabilities 147.9 107.7 Long-Term Assets blank blank Stockholders’ Equity Blank Blank Net property, plant, and Common stock and paid-in surplus 8.0 8.0 113.1 80.9 equipment Retained earnings 14.2 13.2 Total long-term assets 113.1 80.9 Total Stockholders’ Equity 22.2 21.2 Total Assets 170.1 128.9 Total Liabilities and Stockholders’ Equity 170.1 128.9 Assets = Liabilities + Stockholders’ Equity Copyright © 2021 Pearson Education, Inc. All Rights Reserved  2.4 The Statement of Cash Flows – How much cash the firm has generated – How that cash has been allocated Cash is important because it is needed to pay bills and maintain operations and is the source of any return of investment for investors The statement of cash flows is divided into three sections which roughly correspond to the three major jobs of the financial manager: 1. Operating activities 2. Investment activities 3. Financing activities Copyright © 2021 Pearson Education, Inc. All Rights Reserved Global Corporation’s Statement of Cash Flows for 2019 and 2018 Global Corporation’s Statement of Cash Flows for 2019 and 2018 Year ended December 31 (in $ millions) 2019 2018 Operating activities Net income 2.0 1.9 Depreciation and amortization 1.2 1.1 Accounts receivable (5.5) (0.3) Accounts payable 2.7 (0.5) Inventory (1.0) (1.0) Cash from operating activities (0.6) 1.2 Investment activities Capital expenditures (33.4) (4.0) Acquisitions and other investing activity Cash from investing activities (33.4) (4.0) Financing activities Dividends paid (1.0) (1.0) Sale or purchase of stock Increase in short-term borrowing 2.3 3.0 Increase in long-term borrowing 35.2 2.5 Cash from financing activities 36.5 4.5 Change in cash and cash equivalents 2.5 1.7 Copyright © 2021 Pearson Education, Inc. All Rights Reserved 2.4 The Statement of Cash Flows Operating Activity – Use the following guidelines to adjust for changes in working capital:  Accounts receivable: – Adjust the cash flows by deducting the increases in accounts receivable – This increase represents additional lending by the firm to its customers and it reduces the cash available to the firm  Accounts payable: – Similarly, we add increases in accounts payable – Accounts payable represents borrowing by the firm from its suppliers – This borrowing increases the cash available to the firm  Inventory: – Finally, we deduct increases to inventory – Increases to inventory are not recorded as an expense and do not contribute to net income – However, the cost of increasing inventory is a cash expense for the firm and must be deducted – We also add depreciation to net income, since it is not a cash outflow Copyright © 2021 Pearson Education, Inc. All Rights Reserved 2.4 The Statement of Cash Flows Investment Activity – Subtract the actual capital expenditure that the firm made – Also deduct other assets purchased or investments made by the firm, such as acquisitions Copyright © 2021 Pearson Education, Inc. All Rights Reserved 2.4 The Statement of Cash Flows Financing Activity – The last section of the statement of cash flows shows the cash flows from financing activities  Dividends paid  Cash received from sale of stock or spent repurchasing its own stock  Changes to short-term and long-term borrowing Copyright © 2021 Pearson Education, Inc. All Rights Reserved 2.4 The Statement of Cash Flows The last line of the Statement of Cash Flows combines the cash flows from these three activities to calculate the overall change in the firm’s cash balance over the time period of the statement Copyright © 2021 Pearson Education, Inc. All Rights Reserved  Ratio Analysis Ratio Analysis – The most practical way to interpret or make sense of a firm’s historical financial statements is through ratio analysis, as shown in the next slide. Comparing a Firm’s Financial Results to Industry Norms – Comparing a firm’s financial results to industry norms helps a firm determine how it stacks up against its competitors and if there are any financial “red flags” requiring attention. Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Historical Ratio Analysis (1 of 2) Table 8.4 Ratio Analysis for New Venture Fitness Drinks, Inc. Ratio Formula 2018 2017 2016 Profitability ratios: associate the amount of Blank Blank Blank Blank income earned with the resources used to generate it Return on assets ROA = net income/average 21.4% 18.7% 14.7% total assetsa Return on equity ROE = net income/average 35.0% 31.0% 24.9% shareholders’ equityb Profit margin Profit margin = net 22.3% 17.9% 13.6% income/net sales Liquidity ratios: measure the extent to which Blank Blank Blank Blank a company can quickly liquidate assets to cover short-term liabilities Current Current assets/current 3.06 2.26 2.35 liabilities Quick Quick assets/current 2.58 1.89 1.96 liabilities Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Pro Forma Financial Statements Pro Forma Financial Statements – A firm’s pro forma financial statements are similar to its historical financial statements except that they look forward rather than track the past. – The preparation of pro forma financial statements helps a firm rethink its strategies and make adjustments if necessary. – The preparation of pro forma financials is also necessary if a firm is seeking funding or financing. Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Pro Forma Income Statements Table 8.6 Pro Forma Income Statement for New Venture Fitness Drinks, Inc. blank 2018 Actual 2017 Projected 2016 Projected Net sales $586,600 $821,200 $1,026,500 Cost of sales 268,900 390,000 487,600 Gross profit 317,700 431,200 538,900 Operating expenses blank blank blank Selling, general, and 117,800 205,300 256,600 administrative expenses Depreciation 13,500 18,500 22,500 Operating income 186,400 207,400 259,800 Other income blank blank blank Interest income 1,900 2,000 2,000 Interest expense (15,000) (17,500) (17,000) Other income (expense), net 10,900 20,000 20,000 Income before income taxes 184,200 211,900 264,800 Income tax expense 53,200 63,600 79,400 Net income 131,000 148,300 185,400 Earnings per share 1.31 1.48 1.85 Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Pro Forma Balance Sheets (1 of 2) Assets Table 8.7 Pro Forma Balance Sheets for New Venture Fitness Drinks, Inc. Assets December 31, 2018 Projected 2019 Projected 2020 Current assets blank blank blank Cash and cash equivalents $63,800 $53,400 $80,200 Accounts receivable, less allowance 39,600 57,500 71,900 for doubtful accounts Inventories 19,200 32,900 41,000 Total current assets 122,600 143,800 193,100 Property, plant, and equipment blank blank blank Land 260,000 260,000 360,000 Buildings and equipment 412,000 512,000 687,000 Total property, plant, and equipment 672,000 772,000 1,047,000 Less: accumulated depreciation 65,000 83,500 106,000 Net property, plant, and equipment 607,000 688,500 941,000 Total assets 729,600 832,300 1,134,100 Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Pro Forma Balance Sheets (2 of 2) Table 8.7 (continued) Assets December 31, 2018 Projected 2019 Projected 2020 Liabilities and shareholders’ equity blank blank blank Current liabilities blank blank blank Accounts payable 30,200 57,500 71,900 Accrued expenses 9,900 12,000 14,000 Total current liabilities 40,100 69,500 85,900 Long-term liabilities blank blank blank Long-term debt 249,500 174,500 274,500 Total long-term liabilities 249,500 174,500 274,500 Total liabilities 289,600 244,000 360,400 Shareholders’ equity blank blank blank Common stock (100,000 shares) 10,000 10,000 10,000 Retained earnings 430,000 578,300 763,700 Total shareholders’ equity 440,000 588,300 773,700 Total liabilities and shareholders’ equity 729,600 832,300 1,134,100 Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Pro Forma Statement of Cash Flows (1 of 2) Operating Activities Table 8.8 Pro Forma Statement of Cash Flows for New Venture Fitness Drinks, Inc. blank December 31, 2018 Projected 2019 Projected 2020 Cash flows from operating activities blank blank blank Net income $131,000 $148,300 $185,400 Changes in working capital blank blank blank Depreciation 13,500 18,500 22,500 Increase (decrease) in accounts 9,300 (17,900) (14,400) receivable Increase (decrease) in accrued expenses 1,900 2,100 2,000 Increase (decrease) in inventory 1,200 (13,700) (8,100) Increase (decrease) in accounts payable (16,700) 27,300 14,400 Total adjustments 9,200 16,300 16,400 Net cash provided by operating activities 140,200 164,600 201,800 Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Pro Forma Statement of Cash Flows (2 of 2) Investing Activities and Financing Activities Table 8.8 (continued) blank December 31, 2018 Projected 2019 Projected 2020 Cash flows from investing activities blank blank blank Purchase of building and equipment (250,500) (100,000) (275,000) Net cash flows provided by investing (250,500) (100,000) (275,000) activities Cash flows from financing activities blank blank blank Proceeds from increase in long-term debt 119,500 – 100,000 Principle reduction in long-term debt blank (75,000) blank Net cash flows provided by financing blank blank blank activities Increase in cash 9,200 (10,400) 26,800 Cash and cash equivalents at the beginning 54,600 63,800 53,400 of the year Cash and cash equivalents at the end of the 63,800 53,400 80,200 year Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Ratio Analysis (2 of 2) Ratio Analysis – The same financial ratios used to evaluate a firm’s historical financial statements should be used to evaluate the pro forma financial statements. – This work is completed so the firm can get a sense of how its projected financial performance compares to its past performance and how its projected activities will affect its cash position and its overall financial soundness. Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved. Copyright Copyright © 2019, 2016, 2012 Pearson Education, Inc. All Rights Reserved.