COURSE CODE: ENT 101

COURSE DESCRIPTION: THE ENTREPRENEURIAL MIND

COURSE INTENDED 1. Understand the basic principle of entrepreneurship

LEARNING OUTCOMES:
2. Examine and practice critical tools, functions, concepts and skills that are
required for an entrepreneur in a small scale business.
3. Interpret the results of environmental scanning and conduct a feasibility
study.
4. Construct a comprehensive business plan in preparation for
entrepreneurial career.

LEARNING MATERIAL
FOR WEEK NUMBER:
10
I. TITLE: Financial Preparation for Entrepreneurial Ventures
II. OBJECTIVES: After this lesson, you are expected to:

1. To explain the principal financial statements needed for any

entrepreneurial venture: the balance sheet, income statement, and cash-
flow statement
2. To discuss and outline the process and nature of cash flow and preparing
an operating budget
3. To illustrate the break-even analysis
III. INTRODUCTION: This lesson will discuss the financial statements needed to monitor by an
entrepreneur. It will also explain how capital budgeting can be used in the decision
making process in the business.

IV. CONTENTS:

UNDERSTANDING THE KEY FINANCIAL STATEMENTS

Financial statements are powerful tools that entrepreneurs can use to manage their ventures.
The basic financial statements an entrepreneur needs to be familiar with are the balance sheet,
income statement, and cash-flow statement.

The Balance Sheet

A balance sheet is a financial statement that reports a business's financial position at a

specific time. Many accountants like to think of it as a picture taken at the close of business on a
particular day, such as December 31. The closing date is usually the one that marks the end of the
business year for the organization.

The balance sheet is divided into two parts: the financial resources owned by the firm and
the claims against these resources. Traditionally, these claims against the resources come from two
groups: creditors who have a claim to the firm's assets and can sue the company if these obligations
are not paid, and owners who have rights to anything left over after the creditors' claims have been
paid.

An asset is something of value the business owns. To determine the value of an asset, the
owner/manager must do the following:
1. Identify the resource.
2. Provide a monetary measurement of that resource's value.
3. Establish the degree of ownership in the resource.

Most assets can be identified easily. They are tangible, such as cash, land, and equipment.

Liabilities are the debts of the business. These may be incurred either through normal
operations or through the process of obtaining funds to finance operations. A common liability is a
short-term account payable in which the business orders some merchandise, receives it, and has not
yet paid for it. This often occurs when a company receives merchandise during the third week of the
month and does not pay for it until it pays all of its bills on the first day of the next month.

Liabilities are divided into two categories: short term and long term. Short-term liabilities
(also called current liabilities) are those that must be paid during the coming 12 months. Long-term
liabilities are those that are not due and payable within the next 12 months, such as a mortgage on
a building or a five-year bank loan.

Owners' equity is what remains after the firm's liabilities are subtracted from its assets-it is
the claim the owners have against the firm's assets. If the business loses money, its owners equity
will decline.

Understanding the Balance Sheet

Current assets consist of cash and other assets that are reasonably expected to be turned
into cash, sold, or used up during a normal operating cycle.

Cash refers to coins, currency, and checks on hand. It also includes money that the business
has in its checking and savings accounts.

Accounts receivable are claims of the business against its customers for unpaid balances
from the sale of merchandise or the performance of services.
 Inventory is merchandise held by the company for resale to customers.

Prepaid expenses are expenses the firm already has paid but that have not yet been used.

Fixed assets consist of land, building, equipment, and other assets expected to remain with
the firm for an extended period.

Land is property used in the operation of the firm.

Building consists of the structures that house the business.

Equipment is the machinery the business uses to produce goods.

Current Liabilities

Current liabilities are obligations that will become due and payable during the next year or
within the operating cycle.

Accounts payable are liabilities incurred when goods or supplies are purchased on credit.

A note payable is a promissory note given as tangible recognition of a supplier's claim or a

note given in connection with an acquisition of funds, such as for a bank loan.

Taxes payable are liabilities owed to the government-federal, state, and local.

A loan payable is the current installment on a long-term debt that must be paid this year.

Long-Term Liabilities. As we have said, long-term liabilities consist of obligations that will
not become due or payable for at least one year or not within the current operating cycle.

A bank loan is a long-term liability due to a loan from a lending institution.

Contributed Capital. The Kendon Corporation is owned by individuals who have purchased
stock in the business. Common stock is the most basic form of corporate ownership.

Retained earnings are the accumulated net income over the life of the business to date. In
Table 11.2, the retained earnings are shown as $750,000. Every year this amount increases by the
profit the firm makes and keeps within the company.

Why the Balance Sheet Always Balances

By definition, the balance sheet always balances. If something happens on one side of the
balance sheet, it is offset by something on the other side. Hence, the balance sheet remains in balance.
Before examining some illustrations, let us restate the balance-sheet equation:

Assets=Liabilities + Owners' Equity

The Income Statement

The income statements is a financial statement that shows the change that has occurred in
a firm's position as a result of its operations over a specific period. This is in contrast to the balance
sheet, which reflects the company's position at a particular point in time.

These revenues are the monies the small business has received from the sale of its goods and
services. The expenses are the costs of the resources used to obtain the revenues. These costs range
from the cost of materials used in the products the firm makes to the salaries it pays its employees.

Revenues are the gross sales the business made during the particular period under review.
Revenue often consists of the money actually received from sales, but this need not be the case.

Expenses are the costs associated with producing goods or services. For the furniture store
in the preceding paragraph, the expenses associated with the sale would include the costs of
acquiring, selling, and delivering the merchandise.

Net income is the excess of revenue over expenses during the particular period under
discussion. If revenues exceed expenses, the result is a net profit.

Understanding the Income Statement

To explain the income statement fully, it is necessary to examine one and determine what
each account is. Table 11.3 illustrates a typical income statement. It has five major sections: (1) sales
revenue, (2) cost of goods sold, (3) operating expenses, (4) financial expense, and (5) income taxes
estimated.

Revenue. Every time a business sells a product or performs a service, it obtains revenue. This
often is referred to as gross revenue or sales revenue.
 Cost of Goods Sold. As the name implies, the cost of goods sold section reports the cost of
merchandise sold during the accounting period.

Operating Expenses. The major expenses, exclusive of costs of goods sold, are classified as
operating expenses. These represent the resources expended, except for inventory purchases, to
generate the revenue for the period.

Administrative expenses. is a catchall term for operating expenses not directly related to
selling or borrowing. In broad terms, these expenses include the costs associated with running the
firm.

Financial Expense. The financial expense is the interest expense on long-term loans.

Estimated Income Taxes. As noted earlier, corporations pay estimated income taxes; then,
at some predetermined time (e.g., December 31), the books are closed, actual taxes are determined,
and any additional payments are made (or refunds claimed).

The Cash-flow Statement

The cash-flow statement (also known as the statement of cash flows) shows the effects of a
company's operating, investing, and financing activities on its cash balance. The principal purpose of
the statement of cash flows is to provide relevant information about a company's cash receipts and
cash payments during a particular accounting period. It is useful for answering such questions as the
following:

 How much cash did the firm generate from operations? How did the firm finance fixed capital
expenditures?
 How much new debt did the firm add?
 Was the cash from operations sufficient to finance fixed asset purchases?

Operating cash flows refer to cash generated from or used in the course of business operations
of the firm. The net operating cash flows will be positive for most firms because their operating
inflows (primarily from revenue collections) will exceed operating cash outflows (e.g., payment
for raw materials and wages).

Investing activities refer to cash-flow effects from long-term investing activities, such as
purchase or sale of plant and equipment. The net cash flow from investing activities can be either
positive or negative.

Financing activities refer to cash-flow effects of financing decisions of the firm, including sale of
new securities (such as stocks and bonds), repurchase of securities, and payment of dividends.
PREPARING FINANCIAL BUDGETS
One of the most powerful tools the entrepreneur can use in planning financial operations is a
budget. The operating budget is a statement of estimated income and expenses during a
specified period of time. Another common type of budget is the cash-flow budget, which is a
statement of estimated cash receipts and expenditures during a specified period of time. It is
typical for a firm to prepare both types of budgets by first computing an operating budget and
then constructing a cash budget based on the operating budget. A third common type of budget
is the capital budget, which is used to plan expenditures on assets whose returns are expected
to last beyond one year. This section examines all three of these budgets: operating, cash flow,
and capital.

The Operating Budget

Typically, the first step in creating an operating budget is the preparation of the sales forecast.
An entrepreneur can prepare the sales forecast in several ways. One way is to implement a statistical
forecasting technique such as simple linear regression. Simple linear regression is a technique in
which a linear equation states the relationship among three variables:

Y=a+bx

Y is a dependent variable (it is dependent on the values of a, b, and x), x is an independent

variable (it is not dependent on any of the other variables), a is a constant (in regression analysis, Y
is dependent on the variable x, all other things held constant), and b is the slope of the line (the change
in Y divided by the change in x).

The Cash-flow Budget

After the operating budget has been prepared, the entrepreneur can proceed to the next
phase of the budget process, the cash-flow budget. This budget, which often is prepared with the
assistance of an accountant, provides an overview of the cash inflows and outflows during the period.

The first step in the preparation of the cash-flow budget is the identification and timing of
cash inflows. For the typical business, cash inflows will come from three sources: (1) cash sales, (2)
cash payments received on account, and (3) loan proceeds. Not all of a firm's sales revenues are cash.
In an effort to increase sales, most businesses will allow some customers to purchase goods on
account.
Pro Forma Statements

The final step in the budget process is the preparation of pro forma statements, which are
projections of a firm's financial position during a future period (pro forma income statement) or on
a future date (pro forma balance sheet). In the normal accounting cycle, the income statement is
prepared first, followed by the balance sheet. Similarly, in the preparation of pro forma statements,
the pro forma income statement is followed by the pro forma balance sheet.

The process for preparing a pro forma balance sheet is more complex: The last balance sheet
prepared before the budget period began, the operating budget, and the cash-flow bud-get are
needed to prepare it. Starting with the beginning balance sheet balances, the projected changes as
depicted on the budgets are added to create the projected balance sheet totals.

After preparing the pro forma balance sheet, the entrepreneur should verify the accuracy of
her work with the application of the traditional accounting equation:

Assets=Liabilities + Owner's Equity

Capital Budgeting

Returns on other investments, however, are expected to extend beyond one year.
Investments that fit into this second category are commonly referred to as capital investments or
capital expenditures. A technique the entrepreneur can use to help plan for capital expenditures is
capital budgeting.

The first step in capital budgeting is to identify the cash flows and their timing. The inflows-
or returns, as they are commonly called-are equal to net operating income before deduction of
payments to the financing sources but after the deduction of applicable taxes and with depreciation
added back, as represented by the following formula:

Expected Returns=X(1-T) + Depreciation

The principal objective of capital budgeting is to maximize the value of the firm. It is designed
to answer two basic questions:
1. Which of several mutually exclusive projects should be selected? (Mutually exclusive projects are
alternative methods of doing the same job. If one method is chosen, the other methods will not be
required.)

2. How many projects, in total, should be selected?

Payback Method

One of the easiest capital-budgeting techniques to understand is the payback method or, as it
is sometimes called, the payback period, In this method, the length of time required to “pay back" the
original investment is the determining criterion. The entrepreneur will select a maximum time frame
for the payback period. Any project that requires a longer period will be rejected, and projects that
fall within the time frame will be accepted.

Net Present Value

The net present value (NPV) method is a technique that helps to minimize some of the
short-comings of the payback method by recognizing the future cash flows beyond the payback
period. The cost of capital is the rate used to adjust future cash flows to determine their value in
present period terms. This procedure is referred to as discounting the future cash flows, and the
discounted cash value is determined by the present value of the cash flow.

Internal Rate of Return

The internal rate of return (IRR) method is similar to the NPV method in that the future
cash flows are discounted. However, they are discounted at a rate that makes the NPV of the project
equal to zero. This rate is referred to as the internal rate of return of the project. The project with the
highest IRR is then selected.

One of the major drawbacks to the use of the IRR method is the difficulty that can be
encountered when using the technique. Using the NPV method, it is quite simple to look up the
appropriate discount factors in the present value tables. When using the IRR concept, however, the
entrepreneur must begin with a NPV of zero and work backward through the tables. sWhat this
means, essentially, is that the entrepreneur must estimate the approximate rate and eventually try
to track the actual IRR for the project.

BREAK-EVEN ANALYSIS
Break-even analysis is a technique commonly used to assess expected product profitability.
It helps determine how many units must be sold to break even at a particular selling price.

A common approach to break-even analysis is the contribution margin approach.

Contribution margin is the difference between the selling price and the variable cost per unit.

RATIO ANALYSIS
Financial statements report on both a firm's position at a point in time and its operations
during some past period. From an investor's standpoint, predicting the future is what financial
statement analysis is all about; from an entrepreneur's standpoint, financial statement analysis is
useful both as a way to anticipate conditions and, more important, as a starting point for planning
actions that will influence the course of events. An analysis of the firm's ratios is generally the key
step in a financial analysis. The ratios are designed to show relationships among financial statement
accounts.