9.

Entrepreneurial Finance
❖ Understand the importance of start-up capital

Sources of finance in venture creation

Friends and Family

It's very common that new businesses receive startup capital from their friends and family. This
is a very easy way to receive funds, but there can be many drawbacks.
Personal savings
When starting a business, your first investor should be yourself either with your own cash or
with collateral on your assets. This proves to investors and bankers that you have a long-
term commitment to your project and that you are ready to take risks

Retained earnings
Profits that a company decides to keep and generate back to business

Share capital
Share capital refers to the funds that a company raises from selling shares to investors

Loan capital
Bank loans are the most commonly used source of funding for small and medium-
sized businesses. Consider the fact that all banks offer different advantages, whether it's
personalized service or customized repayment. It's a good idea to shop around and find the
bank that meets your specific needs.
Grants
Government grants and subsidies. Government agencies provide financing such as grants and
subsidies that may be available to your business

Venture capital
Venture capitalists pledge to invest in a company in exchange for equity, or a stake in the
business, and a portion of the profits down the line.

Business angels /Angel Investors

An angel investor is a high net worth individual who will invest in your company in exchange
for partial ownership

Angel Groups
This is a group of angel investors who pool their money to share deal flow. Angel groups can
do priced rounds, and if a high enough percentage of the group is interested in your business,
they can lead your deal.
Business incubators
Business incubators (or "accelerators") generally focus on the high-tech sector by providing
support for new businesses in various stages of development. However, there are also local
economic development incubators, which are focused on areas such as job creation,
revitalization and hosting and sharing services. Commonly, incubators will invite future
businesses and other fledgling companies to share their premises, as well as their
administrative, logistical and technical resources.

❖ Simple profit, mark up, margin calculation

Simple profit calculation for company ABC

Question
Cash sales 37500
Opening Inventory 1000
Purchases 10000
Closing Inventory 1400
Credit sales 2400
Rent 4600
Wages 7000
Depreciation 400
Utilities 350
Required:
Prepare the income statement

Solution:

Sales 39900
Less: Cost of goods sold
Opening inventory 1000
Add: purchases 10000
11000
Less: closing inventory 1400
9600
Gross profit 30300

Less: expenses
Rent 4600
Wages 7000
Depreciation 400
Utilities 350
12350
Net profit 17950
Company ABC made a profit of $17950

MARK-UP AND MARGIN

1. Introduction
Occasionally it is the case that all selling prices are calculated so as to give a fixed percentage
profit.
This information means that if we know the cost of sales we are able to calculate the sales (and
vice versa). Make sure that you can do the arithmetic, but that also you learn the terminology
and remember the difference between a mark-up and a gross profit margin.

2. Mark-up
A mark-up is the gross profit expressed as a percentage of the cost.
Example 1
(a) James has cost of goods sold of $20,000 and applies a mark-up of 20%.
What are the sales?
(b) John has sales of $50,000 and applies a mark-up of 25%.
What is his cost of goods sold?

Solution:
Mark up is profit as a percent of cost
(a) Sales = 20,000 + (20% × 20,000) = $24,000 (20000+4000)
(b) (For every 100 cost add a mark-up of 25 to give sales of 125 and for 125 sales the
cost will be 100)

Cost of goods sold = 100 × 50000 = $40000

125
Or
Cost of goods sold: 50,000 = x + (0.25 × x) = 1.25x)
x = 50,000 = $40,000
1.25

Example 2
A business made purchases during the year of $90,000, and sales during the year of
$120,000
The opening inventory was $30,000.
There had been a fire that had destroyed much of the inventory, and the inventory remaining at
the end of the year was $12,000.

If the business always has a mark-up of 20% of cost, then what was the cost of the
inventory that had been destroyed?

Solution:

Sales $120000
Less: Cost of Sales
Opening inventory $30000
+ Purchases $90000
$120000
Less Clossing inventory ($20000)
$100000
Gross Profit $20000
Lost in fire is $20000-$12000= $8000

3. Gross profit margin

The gross profit margin is the gross profit expressed as a percentage of the selling price.
Example 1
(a) Peter has sales of $120,000. His gross profit margin is 20%.
What is his cost of goods sold?
(b) Paul has a cost of goods sold of $45,000 and a gross profit margin of 25%.
What are his sales?

Solution:
Margin is profit as a percent of selling price
(a) Cost of goods sold = 120,000 – (20% × 120,000) = $96,000
(b) 45,000 = x – 0.25x = 0.75x

Sales: x = 45,000 = $60,000

0.75
 Or

For every 100 sales the cost will be (100-25=75) and for every 75 of cost the selling price
will be 100
100 × 45000 = $60000
75

❖ Cost Volume Profit analysis

MATHEMATICAL APPROACH OF CVP ANALYSIS

KEY FORMULARS
Net Profit
N.P = Total Revenue - Total Costs
N.P = TR - (Fixed Cost + Variable Costs)
N.P = Px – (a + bx)
Where
x = Number of units produced
p = price per unit
a = fixed costs
b = variable cost per unit

Variable cost

Variable costs are costs that change as the quantity of the good or service that a business
produces changes

Fixed Cost

A fixed cost is the other cost incurred by businesses and corporations. Unlike the variable cost,
a company's fixed cost does not vary with the volume of production. It remains the same even
if no goods or services are produced, and therefore, cannot be avoided.

CONTRIBUTION
Total Revenue - Total Variable Cost
 TR - TVC
Selling Price/Unit - Variable Cost/Unit
SP - VC
- It is the term used by management accounting that defines profits
- Is the net amount that each additional unit sold contributes towards a company’s
fixed costs and profit.

- It is the difference between the selling price and the variable costs.
- Fixed costs are not factored in when determining contribution

PROFIT VOLUME RATIO

Contribution/Sales

BREAK EVEN SALES VOLUME

Fixed Cost
Contribution per unit

BREAK EVEN SALES REVENUE or BE units x selling price

Fixed Costs
Profit Volume Ratio

MARGIN OF SAFETY
- Margin of safety is the excess of budgeted or actual sales over the breakeven
volume of sales.

- It states the quantity by which sales can drop or decline before losses can begin
to be incurred.

Margin of safety ratio

Sales – Breakeven Sales
Sales

Profit Ratio
Net Profit
Sales
EXAMPLE
The following information relates to an entity which produces and sells a single product.
Annual fixed cost = $120 000
 Selling price/unit = $ 40
Variable Cost/Unit = $ 20
Sales = 8 000 units

Required

(i) Calculate contribution per unit

(ii) Calculate the breakeven point in units and in value
(iii) Calculate the number of units to earn to a profit of $60 000
(iv) Determine the selling price to earn a profit of $60 000 from existing sales
(v) Calculate additional sales volume to meet $16 000 additional fixed costs.
(vi) Compute the profit volume ratio and interpret it
(vii) Determine margin of safety and interpret it
(viii) Determine margin of safety ratio and interpret it

Solution

(i) Contribution per unit = SP-VC

= 40-20
= $20
(ii) In units FC /Contribution =120000/20
= 6000 units

In value 6 000 x 40 = $240 000

(iii) fixed cost +targeted profit Contribution / unit

= (120 000+60 000)/20

= 9 000 units

(iv) N.P = Px – (a + bx)

60 000 = P8 000 – (120 000 + 8 000)
60 000 = 8 000 P – (120 000 + 160 000)
60 000 = 8 000P – 280 000
 60 000 + 280 000 = 8 000P
340 000 = 8 000P
P = $42.5/Unit

(iv) Breakeven sales volumes = Additional Fixed Cost

Contribution/Unit

= 16 000
Selling Price – Variable

Or Fixed Costs + Addition =

Contribution
= 120 000 + 16 000 = 16 000
20 20
= 6800 – 6000 = 800 Units
= 800 units

Contribution
(v) Profit Volume Ratio = Sales

= 0.5

Therefore for every $1 of sales, 50% is profit

(vi) Margin of safety

= Actual Sales - Breakeven
= 8 000 – 6 000
= 2 000 Units

Therefore sales can fall by 2 000 units from current level before losses start to be incurred.
 (vii) Margin of safety ratio
Sales - Breakeven sales
Sales

= 2 000/ 8 000
= 0.25

Therefore sales can decline by 25% from the current level before the firm start experiencing
losses.

Example 2

Falcon Enterprise operates in the manufacturing industry of Zimbabwe. The company is

examining the viability of its new product. The estimated fixed costs are RTGS$ 650 000 and
variable costs are estimated to be RTGS$200 per unit. The proposed selling price per unit
RTGS$300. The management of Falcon Enterprise has requested the following:

i. The contribution per unit (5 marks)

ii. The number of units that must be sold to breakeven (5 marks)

iii. How many units must be sold to earn RTGS$400 000 target profit (5 marks)

iv. What selling price would have to be charged to give a profit of RTGS$400 000
on sales of 80 000 units, fixed costs of RTGS$600 000 and variable costs of RTGS$100
per unit? (5 marks)

Solution:
(i) Contribution per unit = SP-VC
= 300-200
= $100
(ii) In units FC /Contribution =650000/100
= 6500 units

(iii) fixed cost +targeted profit

 Contribution / unit
= (650 000+400 000)/100
= 10500 units

(iv) N.P = Px – (a + bx)

400 000 = P80 000 – (600 000 + 100*80 000)
400 000 = 80 000 P – (600 000 + 8000 000)
400 000 = 80 000P – 8600 000
400 000 + 8600 000 = 80 000P
9000 000 = 80 000P
80 000 80 000
P = $112.5/Unit

❖ Payback period

Payback Period
The payback period is the number of years it takes to get back the original
investment in cash terms. The shorter the payback period, the more certain we are
that the project will actually pay for itself.

Example
A new project will cost $100,000 and will last for 5 years with no scrap value.
The project is expected to generate operating cash flows each year as follows:
Year 1 20,000
Year 2 30,000
Year 3 40,000
Year 4 50,000
Year 5 30,000
The cost of capital is 10% (a)
Calculate the payback period
Solution:

Cashinflow Cumulative Cashinflow

Year 1 20,000 20,000

Year 2 30,000 50,000

Year 3 40,000 90,000

Year 4 20,000 140,000

Year 5 30,000 170,000

Payback period = 3 + 10,000 = 3.2 years

50,000

❖ Depreciation

Depreciation definition
The term depreciation refers to an accounting method used to allocate the cost of a
tangible or physical asset over its useful life. Depreciation is the charging of the cost
of a non-current asset over its useful life. Depreciation is a decrease in an asset's
value over time, especially as a result of wear and tear.

Methods of calculating depreciation

The methods that you are expected to be aware of are the following:
✓ straight line method
✓ reducing balance method

These are the most common methods in practice.

Straight line method

Under this approach we charge an equal amount of depreciation each year.
The depreciation charge each year is calculated as:
Cost of the asset – residual value
Estimated useful life
Example 1
ABC has a year end of 31 December each year. On 1 April 2020 he purchases a car
for $12,000. The car is expected to last for 5 years and to have a scrap value at the
end of 5 years of $2,000.
You are required to calculate the depreciation charge.

Solution:
❖ Cost of the asset $12000
❖ Residual value $2000
❖ Useful life 5 years.

Cost of the asset – residual value

Estimated useful life

= $12000 – 2000
5

= $2000

Therefore, Company ABC would depreciate the car at the amount of $2,000
annually for 5 years.

Reducing balance method

Under this approach we charge more depreciation in the early years of an asset’s life,
with a progressively lower charge in each subsequent year.
The depreciation charge each year is a fixed percentage of the net book value (or
written down value) at the end of the previous year.

Example 1
ZEX LTD has a year end of 31 December each year. On 5 April 2020 he purchased a
machine for $15,000. His depreciation policy is to charge 20% reducing balance, with
a full year’s charge in the year of purchase.
You are required to calculate the depreciation charge for each of the first five
accounting periods.
Solution:
$
Cost 15,000
Yr 1 Depreciation (0.2*15000) (3,000)
12,000
Yr 2 Depreciation (0.2*12000) (2,400)
9,600
Yr 3 Depreciation (0.2*9600) (1,920)
7,680
Yr 4 Depreciation (0.2*7680) (1,536)
6,144
Yr 5 Depreciation (0.2*6144) (1,229)
4915

❖ Cash budget preparation

A cash budget is a company's estimation of cash inflows and outflows over a specific
period of time, which can be weekly, monthly, quarterly, or annually. A company will
use a cash budget to determine whether it has sufficient cash to continue operating
over the given time frame. A company needs to produce a cash budget in order to
ensure that there is enough cash within the business to achieve the operational levels
set by the functional budgets.

Cash budgets are probably the most important tool in practice for the management of
any company’s cash position. They are vital to identifying in advance a likely deficit or
surplus in order that appropriate action can be taken to avoid any problem or profit
from any opportunity.
Cash budget - PROFORMA

Example 1
You are presented with the following forecasted cash flow data for your organisation
for the period November 20X1 to June 20X2. It has been extracted from functional
cashflow forecasts that have already been prepared.
November 20X1 to June 20X2. It has been extracted from functional flow forecasts
that have already been prepared.
NovX1 DecX1 JanX2 FebX2 MarX2 AprX2 MayX2 JuneX2
$ $ $ $ $ $ $ $
Sales 80,000 100,000 110,000 130,000 140,000 150,000 160,000 180,000
Purchases 40,000 60,000 80,000 90,000 110,000 130,000 140,000 150,000
Wages 10,000 12,000 16,000 20,000 24,000 28,000 32,000 36,000
Overheads 10,000 10,000 15,000 15,000 15,000 20,000 20,000 20,000
Dividends - 20,000 - - - - - 40,000
Capital - - 30,000 - - 40,000 - -
expenditure
You are also told the following.
(a) Sales are 40% cash 60% credit. Credit sales are paid two months after the month
of sale.
(b) Purchases are paid the month following purchase.
(c) 75% of wages are paid in the current month and 25% the following month.
(d) Overheads are paid the month after they are incurred.
(e) Dividends are paid three months after they are declared.
(f) Capital expenditure is paid two months after it is incurred.
(g) The opening cash balance is $15,000.
The managing director is pleased with the above figures as they show sales will have
increased by more than 100% in the period under review. In order to achieve this he
has arranged a bank overdraft with a ceiling of $50,000 to accommodate the
increased inventory levels and wage bill for overtime worked.

Required
(a) Prepare a cash flow forecast for the six-month period January to June 20X2.
(b) Comment on your results in the light of the managing director’s comments and
offer advice.
Solution:

a) JanX2 FebX2 MarX2 AprX2 MayX2 JuneX2

$ $ $ $ $ $
Cash
receipts
Cash sales 44,000 52,000 56,000 60,000 64,000 72,000
Credit sales 48,000 60,000 66,000 78,000 84,000 90,000
92,000 112,000 122,000 138,000 148,000 162,000
Cash Payments
Purchases 60,000 80,000 90,000 110,000 130,000 140,000
Wages: 75% 12,000 15,000 18,000 21,000 24,000 27,000
Wages: 25% 3,000 4,000 5,000 6,000 7,000 8,000
Overheads 10,000 15,000 15,000 15,000 20,000 20,000

Dividends - - 20,000 - - -
Capital - - 30,000 - - 40,000
expenditure
85,000 114,000 178,000 152,000 181,000 235,000
Net cashflow 7000 (2000) (56,000) (14,000) (33,000) (73,000)
surplus/Deficit
Balance b/f 15000 22,000 20,000 (36,000) (50,000) (83,000)

Balance c/f 22,000 20,000 36,000 (50,000) (83,000) (156,000)

b) The following are possible courses of action.

(i) Activities could be curtailed.
(ii) Other sources of cash could be explored, for example a long-term loan
to finance the capital expenditure and a factoring arrangement to provide
cash due from accounts receivable more quickly.
(iii) Efforts to increase the speed of debt collection could be made.
(iv) Payments to accounts payable could be delayed.
(v) The dividend payments could be postponed (the figures indicate that
this is a small company, possibly owner-managed).
(vi) Staff might be persuaded to work at a lower rate in return for, say, an
annual bonus or a profit-sharing agreement.
(vii) Extra staff might be taken on to reduce the amount of overtime paid.
(viii) The stock holding policy should be reviewed; it may be possible
to meet demand from current production and minimise cash tied up in
inventories.
 ❖ Cash flow preparation

A Statement of Cash Flows is simply a summary of the cash receipts and payments. The
purpose is to provide users of the financial statements with more information than is provided
just by the Statement of Profit or Loss and Statement of Financial Position.
THE INDIRECT METHOD
Statement of Cash Flows - PROFORMA
❖ B plc Statement of Cash Flows for the year ended 31 December 2018

$ $
CASH FLOWS FROM OPERATING ACTIVITIES
Net profit before taxation x
Adjustments for non-cash items:
Depreciation x
Profit on sale of non-current assets (x)
Interest expense x
Op. Profit before working cap. Changes x
Increase in accounts receivable (x)
Increase in inventories (x)
Increase in accounts payable x
Cash generated from operations x
Interest paid (x)
Dividends paid (x)
Taxation paid (x)
Net cash from operating activities x

CASH FLOWS FROM INVESTING ACTIVITIES

Purchase of non-current assets (x)
Sale proceeds of non-current assets x
Interest received x
Dividends received x
Net cash from investing activities x
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issue of shares x
Repayment of debenture loan (x)
Net cash from financing activities x

Net increase in cash & cash equivalents x

Cash and cash equivalents b/f x
Cash and cash equivalents c/f x
 (3) Dividends paid during the year were $16,000
Produce a Statement of Cash Flows for the year ended 31 December 2018

Solution:

Statement pf cashflow
$ $
Cash flows from operating activities
Operating profit 101,000
Depreciation 40,000
Profit from sale of non-current asset (10,000)
(30000-20000)
131,000
Increase in inventories (9,000)
Increase in receivables (8,000)
Increase in payables 28,000
Cash generated from operations 142 000
Interest paid (1000)
Taxation paid (30000+39000-20000) (49,000)
Dividends paid (16,000)
Net cash from operating activities 76,000
Cash flows from investing activities
Purchase of non-current assets (195,000)
 Sale of non-current assets 30,000
Net cash outflow from investing activities (165,000)
Cash flows from financing activities
Proceeds from issue of shares 70,000
(50000+20000)
Net cash from financing activities 70,000

Net decrease in cash (19,000)

Cash and cash equivalents b/f 64,000
Cash and cash equivalents c/f 45,000

Working
Non-current asset
Balance b/f $410,000 Depreciation $40,000
Acquisitions $195,000 Disposals $20,000
(balancing figure) Balance c/f $545,000
$605,000 $605,000

The direct method

In the previous paragraph, where we used the indirect method, we established the
cash flow from operations by taking the profit from the Statement of Profit or Loss and
working backwards – eliminating non-cash items and adjusting for changes in working
capital.
The alternative approach is to calculate the cash flow from operations directly by taking
the cash receipts from customers and deducting the cash payments. This is known as
the direct method. (Note that the rest of the Statement of Cash Flows stays the same
as before.) The layout for arriving at the cash flow from operations is as follows:

Cash received from customers x

Cash payments to suppliers (x)
Cash paid to and on behalf of employees (x)
(x)
Other cash payments
Net cash inflow from operating activities x
Solution:
a) Indirect Method

$
Operating profit 240,000
Depreciation 36,000
Profit on sale (6,000)
270,000
Increase in Inventory (20,000)
Increase in Receivables (24,000)
Increase in Payables 30,000
$256,000
 b) Direct Method

$
Cash received from customers 1,162,000
(235,000 + 1,200,000 – 259,000 – 14,000)
Cash payments to suppliers (830,000)
(840,000 + 160,000 – 168,000 – 140,000 + 138,000)
Cash paid to and on behalf of employees (42,000)
Other cash payments
(120,000 – 36,000 – 42,000 + 6,000 – 14,000) (34,000)
Net cash inflow from operating activities
$256,000