9 – Financial Considerations

Introduction

The steps for creating a small business enterprise were covered in the preceding unit. This class will teach you how to read financial statements and calculate company ratios. This unit’s sections and sub-sections will also explain financial sources and cash flow management. When an idea for a new initiative or business arises, the first thought that comes to mind is how to raise the necessary funds for the proposed venture or business. A company’s or an organization’s finances are its lifeblood. Financial planning also plays a significant role in the success or failure of a new enterprise. As a result, every entrepreneur must create a financial plan when establishing a new firm or initiative. A well-defined plan will aid in assessing the requirement for financing at various phases of the organisation.

9.1 Financial Statements

For a wide range of users, financial statements are essential sources of information about organisations. Company management teams, investors, creditors, governmental oversight bodies, and the Internal Revenue Service use financial statement information. To use the information in essential financial statements, users do not need to know everything there is to know about accounting. However, knowing a few fundamental principles and being familiar with some essential aspects of basic financial statements will help you use financial statement information more effectively.

The four primary accounting statements are as follows:

9.1.1 Balance Sheet 

A balance sheet shows what a firm has (assets) and what it owes (liabilities and owners’ equity) at a particular time. Some experts view the balance sheet as a company’s financial health snapshot. It’s helpful to remember the “left-right” accounting equation orientation while thinking about assets and claims — assets on the left, claims on the right. A few other balance sheet features are worth noting, such as balancing, order of listing, item valuation, and item definitions.

The balance sheet must balance, which is why it is called a balance sheet in the first place. In other words, the assets must be equal to the claims on the assets.

Each of the three balance sheet segments will include accounts documenting its value. Accounts such as cash, inventory, and property are on the asset side of the balance sheet, while accounts payable and long-term debt are on the liability side.

Pro Forma Balance Sheet	As of [Future Date]
Assets
Current Assets
Cash	$50,000
Accounts Receivable	$80,000
Inventory	$120,000
Total Current Assets	$250,000
Fixed Assets
Property, Plant, Equipment	$500,000
Less: Accumulated Depreciation	($150,000)
Net Fixed Assets	$350,000
Other Assets
Intangible Assets	$100,000
Investments	$75,000
Total Other Assets	$175,000
Total Assets	$775,000
Liabilities and Equity
Current Liabilities
Accounts Payable	$70,000
Short-term Loans	$30,000
Accrued Expenses	$20,000
Total Current Liabilities	$120,000
Long-term Liabilities
Long-term Loans	$200,000
Bonds Payable	$100,000
Total Long-term Liabilities	$300,000
Total Liabilities	$420,000
Equity
Common Stock	$100,000
Retained Earnings	$200,000
Additional Paid-in Capital	$55,000
Total Equity	$355,000
Total Liabilities and Equity	$775,000

9.1.2 Income Statement

For a given financial period, the Income Statement shows a company’s revenues, expenses, and taxes associated with those expenses. The income statement is thought of in “top-down” terms, whereas the balance sheet is in terms of the previously stated ” left-right ” orientation.

The following is a general summary of items a manufacturing company might use to construct an income statement. Other companies’ income statements may look slightly different, but the structure is generally the same.

Earnings Per Share (EPS) are crucial in interpreting the income statement (EPS). A corporation’s EPS is calculated by dividing net income by the number of outstanding shares of common stock. It represents a company’s bottom line.

Companies regularly judge how their bottom line will be influenced because shareholders worry about how management decisions affect individual shareholders.

Pro Forma Income Statement	For the Year Ending [Future Date]
Revenue
Sales Revenue	$1,200,000
Less: Returns and Allowances	($50,000)
Net Sales	$1,150,000
Cost of Goods Sold (COGS)
Beginning Inventory	$150,000
Add: Purchases	$700,000
Less: Ending Inventory	($120,000)
Total COGS	$730,000
Gross Profit	$420,000
Operating Expenses
Selling Expenses	$100,000
General and Administrative Expenses	$150,000
Depreciation	$30,000
Total Operating Expenses	$280,000
Operating Income	$140,000
Other Income/Expenses
Interest Income	$5,000
Interest Expense	($10,000)
Total Other Income/Expenses	($5,000)
Income Before Taxes	$135,000
Income Tax Expense (30%)	$40,500
Net Income	$94,500

9.1.3 Cash Flow Statement

Cash flow analysis can benefit short-term planning. A cash flow analysis of the past provides insight into preparing realistic cash flow estimates for the near future and making appropriate plans. The difference between inflow—cash sources (i.e., positive cash flow) and outflow—cash uses (i.e., negative cash flows) throughout the time is referred to as ‘Net Cash Flow.’ This statement examines changes in non-current and current accounts (other than cash) to evaluate the cash flow.

The cash position statement only records cash inflows and outflows, reflecting the net change over time. The cash balance after a period is the sum of cash received minus cash paid during that period. Non-cash items should be adjusted if the net change in cash position is to be determined from the profit and loss account and comparative balance sheets.

The Different Types of Cash Flow

The actual flow of cash and the notional flow of cash are two different types.

Actual Cash Flow

Under the following conditions, there may be an actual or direct movement of cash ‘in’ and ‘out’ of the business:

1. Actual Inflow of Cash: This transaction results in the actual input of cash into the business. When debentures are issued for money, loans are raised in cash, fixed assets are sold for money, dividends are received in cash, and so on, there is a cash inflow.

Example: Issue of shares for cash:

Cash a/c                 Dr.

To Share Capital a/c

2. Actual Outflow of Cash: This transaction results in an actual cash outflow from the company. Similarly, cash outflows occur when loans are repaid, preference shares or debentures are redeemed, taxes are paid, dividends are paid, and so on.

Example: Purchase of Machinery for cash.

Machinery a/c                Dr.

To Cash

Notional Cash Flow

The ‘notional flow of cash’ refers to the indirect movement of cash ‘in’ and ‘out’ of the business, which might occur under the following conditions:

1. Notional inflow of cash: When a transaction increases current liabilities or decreases current assets, it is referred to as a notional inflow of money. As a result of this transaction, the number of creditors grows in proportion to the amount of credit purchased. Even though there is no actual cash inflow, products purchased on credit can be turned into cash. As a result, there is a fictitious financial inflow.

Example: Purchase of goods on credit.

Purchases A/c                  Dr.

To Creditors A/c

2. Notional outflow of cash: When a transaction decreases current liabilities or increases current assets, it is called a notional outflow of money.

Example: Sale of goods on credits:

Debtors A/c                      Dr.

To Credit Sales A/c

As a result of this transaction, book debts/Bills Receivable increase to the extent of the credit sale. Despite a cash outflow, commodities sold on credit would have been sold for cash and would have cost the company materials, labour, and overheads. As a result, a hypothetical outflow of money may be regarded as a loan to customers. Similarly, a reduction in current obligations could be owing to partial payment of these debts. As a result, a decrease in a current liability is viewed as a notional cash outflow.

Pro Forma Cash Flow Statement	For the Year Ending [Future Date]
Cash Flows from Operating Activities
Net Income	$94,500
Adjustments for Non-Cash Items:
Depreciation	$30,000
Changes in Working Capital:
Increase in Accounts Receivable	($10,000)
Decrease in Inventory	$30,000
Increase in Accounts Payable	$15,000
Net Cash Provided by Operating Activities	$159,500
Cash Flows from Investing Activities
Purchase of Property, Plant, and Equipment	($50,000)
Sale of Investments	$25,000
Net Cash Used in Investing Activities	($25,000)
Cash Flows from Financing Activities
Proceeds from Long-term Debt	$100,000
Repayment of Short-term Loans	($30,000)
Dividends Paid	($20,000)
Net Cash Provided by Financing Activities	$50,000
Net Increase in Cash	$184,500
Cash at the Beginning of the Year	$50,000
Cash at the End of the Year	$234,500

9.1.4  Profit and Loss Account 

The profit and loss statement indicates how much money the company makes. The “Trading, Profit and Loss Account” is another name for this account. It consists of the following elements:

• Sales
• Direct Costs
• Gross Profit
• Indirect Costs
• Net Profit
• Taxation
• Director’s Drawings
• Investment in Business

The gross profit (on the credit side) or gross loss (on the debit side) is entered into the profit and loss account (debit side). In addition to direct expenses, a businessman must spend many more expenses to make a net profit. When those costs are subtracted from profit (or added to gross loss), the result is net profit or loss. Indirect expenses are those that are recorded in the profit and loss account.

Preparation of Financial Statements Projected

Whether it’s an annual or quarterly estimate, projected financial statements reveal predictions about a company’s financial status in the future. Preparing projected financial statements is a time-consuming process that necessitates examining the company’s finances, reading previous budgets and income statements, and examining the company’s current financial situation to make assumptions about the company’s financial potential. Smaller, sole-proprietor firms and well-established organisations follow the same procedure.

There are a few frequent traps to avoid when producing the forecasted financial statements:

• Don’t make a projection that is too ambitious or unreasonable. Preparing a conservative prediction and being able to exceed your plan is preferable to preparing an ambitious projection and having to explain to investors why you were unable to meet predicted results.
• Please don’t get too imaginative when it comes to presenting your projections. Use Generally Accepted Accounting Principles-compliant industry standard forms.
• Be aware of the quantity of information provided and avoid using technical terms. Give the reader enough info to make an informed conclusion.
• Facts and significant investigation should support all projection assumptions. This improves the credibility of your forecasts.
• Completely disclose all contract, ownership, offering price, stock options, warrants, related party issues, risks, and uncertainties information. Don’t lead the reader astray.

Pro Forma Profit and Loss Account	For the Year Ending [Future Date]
Revenue
Sales Revenue	$1,200,000
Less: Returns and Allowances	($50,000)
Net Sales	$1,150,000
Cost of Goods Sold (COGS)
Beginning Inventory	$150,000
Add: Purchases	$700,000
Less: Ending Inventory	($120,000)
Total COGS	$730,000
Gross Profit	$420,000
Operating Expenses
Selling Expenses	$100,000
General and Administrative Expenses	$150,000
Depreciation	$30,000
Total Operating Expenses	$280,000
Operating Profit	$140,000
Other Income/Expenses
Interest Income	$5,000
Interest Expense	($10,000)
Net Other Income/Expenses	($5,000)
Profit Before Tax	$135,000
Income Tax Expense (30%)	$40,500
Net Profit	$94,500

9.2 Cash Flow Management

Maintaining a solid cash flow is one of the most crucial components of running a small business. Controlling inflows and outflows, which can be monitored using financial software, is critical to success in this sector.

9.2.1 Analyzing Cash Flow

Before improving your cash flow management, you must understand how your firm handles money. Examine accounts payable, accounts receivable, credit terms, and inventories.

If you notice a disparity between money coming in and money going out – for example, if you have more outstanding purchases than sales due – this could cause a cash flow problem the next month.

You can start looking for strategies to improve cash flow management once you’ve examined your cash flow. In the most basic terms, your goal is to maximise inflows while minimising outflows while still fulfilling your financial responsibilities.

9.2.2 Improving Accounts Receivable

Accounts receivable account for a big amount of a small business’s cash flow, therefore keeping a careful check on them is critical for improving cash flow. Although collecting money isn’t always straightforward, there are actions you can do to guarantee you don’t end up in a cash flow crisis as a result of late payments.

1. Keep track of your bills: It’s critical to be aware of when clients’ payments are due, and you can utilise your financial software to help you remain on top of things.
2. Ensure it is simple for them to pay: In the same way, ensure you’ve been prompt in sending out bills. Customers who get their invoices regularly are more likely to receive payment swiftly. Ensure clients understand when payment is due by explicitly stating it on the invoice. Provide customers with simple and quick payment choices, such as fax and online ways. Many business owners have effectively increased accounts receivable collections by giving early payment discounts.
3. Establish a credit policy: When and how do you decide whether or not to extend credit to your customers? The sooner you do so, the sooner you’ll be able to bill them — and get paid. Before customers ask for financing, try to anticipate their demands. You should probably need a credit check and multiple references from new clients, a procedure that can be started before their first order to expedite matters. You might even request a small deposit on new orders to ensure you have enough cash.
4. Create a policy for collection: When you start trying to collect on a payment, your policy should say so. Many business owners use a formal reminder system that escalates in severity as lateness grows, eventually including an attorney and, finally, a collection agency. However, depending on the consumer or the magnitude of the payment due, you may want to adjust your strategy. A repeat late payer may require different treatment than someone who has made a single mistake.

9.2.3 Improving Accounts Payable

It is in your best interest to maintain cash on hand for as long as possible, including closely monitoring your financial outflows.

1. Organize your deadlines: Pay an invoice on the due date to maintain a continuous cash flow. Paying early can leave you cash-strapped at a critical juncture. You can organise withdrawals using your banking software to set up electronic fund transfers.
2. Extend the time it takes to pay: Speak with your vendors to see if you can agree to spread out payments and stretch payment times as much as feasible. Consider measures to strengthen your vendor connections if you need to postpone payment. Remember that those with the lowest pricing aren’t always the most flexible; remember this while deciding who to deal with.

9.2.4 Improving Inventory Management 

Inventory management entails keeping track of your daily sales and ensuring that your on-hand inventory reflects these trends. You may use your retail management software to estimate how demand will fluctuate over the future months. According to a classic adage, 20% of your inventory generates 80% of your revenue. You’ll be able to make informed judgments about how much of a given item to order – and when – once you figure out which of your items this applies to. Inventory that isn’t converted into cash is worthless. The most excellent plan for out-of-date inventory is to sell it for the highest possible price. Many experts feel that having a good cash flow is the key to success for small businesses. You may discover that you agree after understanding how to balance your inputs and outflows.

9.3 Applications of Business Ratios

Individuals use this tool to quantitatively examine data in a company’s financial statements. To measure a company’s success, ratios are generated from current year figures and compared to past years, other firms, the industry, or even the economy. Fundamental analysis proponents frequently employ ratio analysis.

Financial documents can determine many ratios relating to a company’s performance, activity, funding, and liquidity. Common ratios include the price-earnings ratio, debt-equity ratio, earnings per share, asset turnover, and working capital.

9.3.1 Business Ratios’ Importance

Business ratios are used to evaluate a company’s performance in the following areas:

1. Analyse the trends
2. Firm-to-firm comparison
3. An examination of operating efficiency
4. Financial viability in the long run
5. Identifies the business’s strengths and weaknesses
6. The company’s overall profitability

9.3.2 Financial Ratios

Financial ratios are tools used to evaluate a company’s financial health and performance. They help stakeholders, such as investors, managers, and analysts, assess various aspects of a company’s operations, liquidity, profitability, and leverage. Here’s a detailed explanation of key financial ratios, including their formulas:

1. Liquidity Ratios

Liquidity ratios measure a company’s ability to meet its short-term obligations using its current assets.

a. Current Ratio

• Formula: $$text{Current Ratio} = frac{text{Current Assets}}{text{Current Liabilities}}$$
• Explanation:
  The current ratio assesses a company’s ability to pay off its short-term liabilities with its short-term assets. A ratio above 1 indicates that the company has more current assets than current liabilities.

2. Quick Ratio (Acid-Test Ratio)

The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets, excluding inventory.

• Formula: $$text{Quick Ratio} = frac{text{Current Assets} – text{Inventory}}{text{Current Liabilities}}$$
• Explanation:
  This ratio is more stringent than the current ratio because it excludes inventory, which may not be as easily converted to cash. A higher quick ratio indicates better liquidity.

3. Cash Ratio

The cash ratio measures a company’s ability to pay off its short-term liabilities using only its cash and cash equivalents.

• Formula: $$text{Cash Ratio} = frac{text{Cash and Cash Equivalents}}{text{Current Liabilities}}$$
• Explanation:
  The cash ratio is the most conservative liquidity ratio, showing how well a company can meet its short-term obligations using only its most liquid assets.

4. Profitability Ratios

Profitability ratios measure a company’s ability to generate profit relative to its revenue, assets, equity, and other financial metrics.

a. Gross Profit Margin

• Formula: $$text{Gross Profit Margin} = frac{text{Gross Profit}}{text{Net Sales}} times 100$$
• Explanation:
  This ratio indicates the percentage of revenue that exceeds the cost of goods sold (COGS). A higher margin suggests better efficiency in production or sales processes.

b. Net Profit Margin

• Formula: $$text{Net Profit Margin} = frac{text{Net Profit}}{text{Net Sales}} times 100$$
• Explanation:
  The net profit margin measures the percentage of revenue left after all expenses have been deducted. It reflects the overall profitability of the company.

c. Return on Assets (ROA)

• Formula: $$text{Return on Assets (ROA)} = frac{text{Net Income}}{text{Total Assets}} times 100$$
• Explanation:
  ROA measures how efficiently a company uses its assets to generate profit. A higher ROA indicates better asset utilization.

d. Return on Equity (ROE)

• Formula: $$text{Return on Equity (ROE)} = frac{text{Net Income}}{text{Shareholders’ Equity}} times 100$$
• Explanation:
  ROE measures the return generated on shareholders’ equity, indicating how effectively management is using equity financing to increase profits.

5. Operations Ratios

Operations ratios, or efficiency or activity ratios, measure how effectively a company uses its assets to generate revenue.

a. Inventory Turnover Ratio

• Formula: $$text{Inventory Turnover Ratio} = frac{text{Cost of Goods Sold (COGS)}}{text{Average Inventory}}$$
• Explanation:
  This ratio shows how often inventory is sold and replaced over a period. A higher turnover rate indicates efficient inventory management.

b. Accounts Receivable Turnover Ratio

• Formula: $$text{Accounts Receivable Turnover Ratio} = frac{text{Net Credit Sales}}{text{Average Accounts Receivable}}$$
• Explanation:
  This ratio measures how effectively a company collects its receivables. A higher ratio suggests efficient credit and collection processes.

c. Asset Turnover Ratio

• Formula: $$text{Asset Turnover Ratio} = frac{text{Net Sales}}{text{Total Assets}}$$
• Explanation:
  The asset turnover ratio indicates how efficiently a company uses its assets to generate sales. A higher ratio suggests better utilization of assets.

6. Leverage Ratios

Leverage ratios assess the extent of a company’s financing through debt relative to its equity.

a. Debt-to-Equity Ratio

• Formula: $$text{Debt-to-Equity Ratio} = frac{text{Total Liabilities}}{text{Shareholders’ Equity}}$$
• Explanation:
  This ratio compares the total debt of a company to its equity. A higher ratio indicates more leverage, meaning the company is financing more of its operations through debt.

b. Debt Ratio

• Formula: $$text{Debt Ratio} = frac{text{Total Liabilities}}{text{Total Assets}}$$
• Explanation:
  The debt ratio measures the proportion of a company’s assets that are financed by debt. A higher ratio suggests greater financial risk.

c. Interest Coverage Ratio

• Formula: $$text{Interest Coverage Ratio} = frac{text{Earnings Before Interest and Taxes (EBIT)}}{text{Interest Expense}}$$
• Explanation:
  This ratio shows how easily a company can pay interest on its outstanding debt. A higher ratio indicates a stronger ability to meet interest obligations.

These ratios are fundamental tools for analyzing a company’s financial health, helping stakeholders make informed decisions based on various aspects of performance and risk.

9.4 Debt and Equity as Financing Sources

Various expenses, such as promotion and formation charges, spending on purchasing fixed assets, company expansion expenses, current assets, and the cost of obtaining capital, should all be included when preparing a capital demand estimate.

1. Internal resource creation: Despite widespread use in major corporations, small businesses rarely use this resource. It includes tax provisions, depreciation provisions, and a reserve fund, and it is inaccessible to newly established businesses.
2. Taking deposits from the general public: Large corporations take term deposits from the public to obtain intermediate-term capital. A deposit certificate is issued to the general public. Though it is one of the most important sources of funding for existing businesses, new businesses can’t take advantage of this opportunity.
3. Commercial bank financing: Commercial banks now provide short-term funding to businesses to meet their short-term financial needs. Commercial banks have provided short-term capital through bill discounting, cash credit, and advance payment.
4. Financial institution financing: Examples include IFC, IDBI, ICICI, SFC, SIDBI, and others.
5. Financing from other investment organisations: A variety of investment institutions, both public and private, have been established to provide funding to new businesses, including LIC, GIC, Tata Investment Trust, and others.
6. Personal finance: When launching a new business, the entrepreneur invests his or her own or family’s savings to provide funding. Examples are cash and personal assets that can be converted into cash. Most small-scale and family enterprises are started using the entrepreneur’s money. An entrepreneur may have set himself up for these months or years and must have made financial preparations. However, no large-scale business can be built only by using an entrepreneur’s funds.
7. Government grants: A particular section provides grants to fund new businesses. The government typically provides appropriate funding through grants and subsidies to cases identified as priority industries. Thus, capital is provided to entrepreneurs through government grants and subsidies.
8. Others: Besides the sources above, local moneylenders or bankers provide conditional funding to fledgling entrepreneurs. This can also be obtained through a venture capital firm. Lease financing may also be used to supply capital.

9.4.1 Equity Financing

If the new business is organized as a company, it can issue shares to the general public, subject to the permission of the Company Law Board, and raise essential funds. A share represents ownership and is worth a small amount of money.

As a result, anybody who wants to own a business can buy it in their name. The share capital is the amount of money raised via the sale of shares.

When an entrepreneur has to raise money from the market, equity financing is a popular option. Equity is capital that the owner or owners permanently invest in a business, and it is a risky investment. Equity or ownership capital refers to the funds the owner provides in a single-ownership business or the partners in a partnership business. The owners of private companies, their families, and friends provide the capital, whereas public corporations raise money by selling shares to the general public. Equity stockholders provide this capital, often known as ownership capital. The following are several types of equity financing: • Personal savings and assets of the entrepreneur.

• Relatives and friends have lent money to you.
• A personal loan from a local money lender.
• Shares are sold to fund the project.
• Ordinary shares are often known as equity shares.

9.4.2 Debt Financing

The company raises funds by selling debentures to expand its capital base. A debenture is a debt acknowledgement stamped with an organization’s seal. The people who buy debentures are known as debenture-holders. Debenture holders cannot become company owners but can be recognised as creditors.

Debt finance is a type of financing that involves the issuance of bonds, debentures, and mortgages to raise funds. Debt finance can be obtained in various ways, including selling bonds, debentures, and commercial papers. Small businesses have fewer options for debt funding than significant corporations. The size of these businesses is a constraint. They are small businesses with limited inventories or marketplaces with little assets to use as security for loans. Small entrepreneurial initiatives intended to grow are still in the early stages of growth and are, therefore, risky. Due to a lack of performance or asset strength, they haven’t proven their ability to underwrite significant debt.