Chapter 6.pptx

Chapter 6
financing and financial evaluation
Monday, February 13, 2023 0
Entrepreneurship and Small Business Management

Acquisition and allocation of
funds
Sources of funds for venture
operation
Reasons why entrepreneurs will
require loan facilities
Financial Statements and
Forecasts
Analysis of Financial Statements
Contents

Acquisition and allocation of funds is central to the
success of any business venture.
 One of the main problems facing effective
management of small business enterprises is lack
of basic financial management skills needed to
guide the business venture. These skills include:
 The ability to keep appropriate records of financial
transactions,
 Financial control,
 Credit management,
 Risk management,
 Personal financial discipline of the entrepreneur and
inability to see the business as separate from the
6.1 Acquisition and allocation of
funds

 In addition, it is important that the entrepreneur avoid
under or over estimation of the capital requirements for
its operations, otherwise too large capital will lead to
unnecessary high costs and inadequate capital will
affect the growth of the business venture.
 The United States (US) Small Business Administration
(SBA) suggested the need for entrepreneur to answer
the following questions so as to realistically determine
the volume of capital needed for its operations:-
 Why do I need the capital?: -
 How much do I need?
 When do I need it?
 For how long will I need it?
 Where can I obtain it?
 How can I repay it?
6.1 Acquisition and allocation…

 Money is needed to operate and grow or expand a
business.
 Business may need money to purchase equipment,
inventory, create awareness, restructure or even
renovation to be properly positioned to handle
challenges.
 Financing is the use and manipulation of money.
Raising money for a business is one aspect of
financing.
 There are different forms of raising funds open to the
entrepreneurs. These sources vary in terms of the:
a) Volume of fund that can be accessed,
b) The cost of the funds and
6.2. Sources of funds for venture
operation

 The choice of the source of fund by the individual
entrepreneur will be determined by the following:
 Knowing the number of sources of funds available
 Risk involve
 The duration of financing whether it is short term or long
term.
 The cost of borrowing from each source
 The value and nature of assets as security or collateral
 The various sources of funds for business ventures are
classified under the following:
1. The Personal and family sources
2. The External sources
oper….

6.2.1 The Personal and family
 Personal savings: - This is necessary because
relying on borrowed funds may be too dangerous for
a new venture.
 Loan from family and friends: Family members
often want to support other family members
venturing into business, hence part of the venture
funds are contributed in form of loans or gifts. Also,
friends support through loans and sometimes gifts to
encourage their friend that is starting a business.
oper….

6.2.2 External Sources
 The external sources of funds are those that are
obtained outside the venture. The external sources
can be sub-divided into two namely; -
 Short- term finance
 Long term finance
a) A Short term finance: Short term financing involves
obligation debts that have maturity date of less than
one year.
 The typical example of short term finance includes
goods purchased on credits, outstanding short term
loans from banks/ accrued payment such as
deferred taxation, salaries and wages etc.
oper….

 Some of the methods of short term financing
are:
I. Open account or Trade credits/ Account payable: - It is a
form of financing in which the seller extends credits to
customers. The credit is reflected on the entrepreneur’s
balance sheet as accounts payable, and in most cases it must
be paid in 30 to 90 days.
II. Account receivable financing: - It is a short term financing
that involves either the pledge of receivables as collateral for a
loan or the sale of receivables (factoring). Accounts
receivables loans are made by banks, whereas factoring is
done primarily by finance companies and factoring concerns.
III. Bank overdraft facilities: An arrangement which allows a
person who keep a current account with a bank the opportunity
to draw above the balance in the account. The customers who
overdraws his/her account pays both the overdrawn account
plus the interest on the amount overdrawn.
oper….

IV. Notes payable: - These are payments to banks
(commercial), individuals or firms in which the
maker of such notes endorses them in favour of the
payee.
V. Specialized Institutions: - Some specialized
institutions were established to provide credit
facilities to the small and medium scale enterprises,
such institutions include microfinance banks,
Cooperative banks, Agricultural development banks
etc.
oper….

Long term finance: - As the name suggests this type of finance
require that funds will be at the disposal of the business
venture for a very long period of time. The sources of funds that
fall under this category include: -
1. Equity finance/ Shareholders fund: Since no repayment is
required equity capital can be much safer and cheaper for new
ventures than debt financing, although the entrepreneur must
be ready to give up part of his ownership rights to the willing
investors.
2. Bonds: A bond is typically a loan issued for a period of more
than one year with the purpose of raising capital by borrowing.
3. Mortgage financing: Mortgage institutions provides this type
of finance, such finance is usually provided for acquisition of
landed property; for example purchase of land, purchase of
already completed building, development of new building or
renovation of an existing structure.
oper….

Generally entrepreneurs will require credit facilities for the
following reasons:-
1. Normal operations: An entrepreneur/small business
owner may have to borrow part of the money to run the
business, especially when fund available is not sufficient
to profitably run the business venture.
2. Expansion purpose: If the business intends to expand
existing operation or acquire some highly sophisticated
equipment, such business may be required to look
outward to raise needed funds.
3. Financial difficulties: There may arise some financial
difficulties as a result of general economic depressions
which may require business venture to seek financial
assistance from any of the sources already discussed. In
addition, accumulation of high bad debts, temporary
losses from operations and some more fundamental
problems may cause a business to look outward for its
finance.
6.3. Reasons why entrepreneurs will
require Loan facilities

 Historical financial statements reflect past
performance and are usually prepared on a quarterly
and annual basis.
 Historical financial statements include the income
statement, the balance sheet, and the statement of
cash flows.
 Pro forma financial statements are projections for
future periods based on forecasts and are typically
completed for two to three years in the future.
 Pro forma financial statements are strictly planning
tools.
6.4 Financial Statements
And Forecasts

 Ratio Analysis
A smoothly functioning system of financial
controls is essential to achieving business
success.
These systems serve as an early warning
device for underlying problems that could
destroy a young business.
A company’s financial accounting and
reporting system will provide signals,
through comparative analysis, of impending
trouble, such as:
a) Decreasing sales and falling profit margins.
b) Increasing overhead.
c) Growing inventories and accounts receivable.
6.5 Analysis of Financial Statements

 Ratio Analy…
 Ratio analysis, a method of expressing the
relationships between any two accounting elements,
provides a convenient technique for performing
financial analysis.
 When analyzed properly, ratios serve as barometers
of a company’s financial health.
 Using ratios as benchmarks allows entrepreneurs to
determine, for example, whether their companies are:
 experiencing heavy operating expenses,
 carrying excessive inventory
 collecting payments from their customers slowly,
 managing to pay its debts on time, and
 to answer other questions relating to the efficient
operation of their businesses.
6.5 Analysis of Financial
Statements

Key Ratios
 We will group them into four categories:
liquidity ratios, leverage ratios, operating
ratios, and profitability ratios.
1. Liquidity Ratios: Liquidity ratios tell whether
a small business will be able to meet its
maturing obligations as they come due.
 Liquidity ratios measure a company’s ability to
convert its assets into cash quickly and
without a loss of value to pay its short-term
liabilities.
6.5 Analysis of Financial Statem…

 The two most common measures of liquidity are the
current ratio and the quick ratio.
a) Current ratio: The current ratio measures a small
company’s solvency by showing its ability to pay
current liabilities from current assets. It is calculated
In the following manner: we will use ahmed’s
electronics shop for illustration
Current ratio =Current assets
Current liabilities
= $686,985
$367,850
=1.87:1
Ahmed’s Shop has $1.87 in current assets for every $1 it
has in current liabilities.

b) Quick Ratio: This ratio includes only a
company’s “quick assets”—those assets that a
company can convert into cash immediately if
needed—and excludes the most illiquid asset
of all, inventory. It is calculated as follows:
Quick ratio = Quick assets(C.A-Inventory)
Current liabilities
= $686,985 - $455,455
$367,850
=0.63:1
Ahmed’s shop has 63 cents in quick assets for every
$1 of current liabilities.

2. Leverage Ratios: Leverage ratios measure
the financing supplied by a company’s
owners against that supplied by its
creditors;
 These ratios show the extent to which an
entrepreneur relies on debt capital (rather
than equity capital) to finance the business.
 Companies that end up declaring bankruptcy
most often take on more debt than the
business can handle.
 The following ratios help entrepreneurs keep
their debt levels manageable.

c) Debt Ratio: A small company’s debt ratio
measures the percentage of total assets
financed by its creditors. The debt ratio is
calculated as follows:
Debt ratio = Total debt (or liabilities)
Total assets
= $367,850 + $212,150
$847,655
= 0.68:1
Ahmed’s creditors have claims of 68 cents against
every $1 of assets that Sam’s Appliance Shop
owns, which means that creditors have
contributed twice as much to the company’s
asset base as the company’s owners have.

3. Operating Ratios: Operating ratios help entrepreneurs
evaluate their companies’ performances and indicate how
effectively their businesses are using their resources.
d) Average Inventory Turnover Ratio: A small company’s average
inventory turnover ratio measures the number of times its average
inventory is sold out, or turned over, during the accounting period.
This ratio tells owners how effectively and efficiently they are
managing their companies’ inventory. The average inventory
turnover ratio is calculated as follows:
Average inventory cost of goods sold
turnover ratio = average inventory (beg.inv+end.inv)/2
= $1,290,117
($805,745 + $455,455) ÷2
=
Ahmed’s shop turns its inventory about two times a year, or once every 178 days.
2.05 times/year

e) Average Collection Period Ratio: A small company’s
average collection period ratio (or days sales outstanding,
DSO) tells the average number of days it takes to collect
accounts receivable. the company’s receivables turnover
ratio is as follows:
Receivables turnover ratio = Credit sales (or net sales)
Accounts receivable
= $1,309,589
$179,225
= 7.31 times/year
Ahmed’s Shop turns its receivables 7.31 times per year.

 Entrepreneurs use the following formula to
calculate a company’s average collection period
ratio:
Average collection
period ratio = Days in accounting period
Receivables turnover ratio
= 365 days
7.31
= 50 days
Ahmed’s electronics Shop’s accounts receivable are
outstanding for an average of 50 days.

f) Average Payable Period Ratio: The converse of
the average collection period ratio, the average
payable period ratio (or days payables
outstanding, DPO), tells the average number of
days it takes a company to pay its accounts
payable. To compute this ratio, first calculate
the payables turnover ratio. Ahmed’s
payables turnover ratio is as follows:
Payables turnover ratio = Purchases
Accounts payable
= $939,827
$152,580
= 6.16 times/year

To find the average payable period, we use the following
computation:
Average payable period ratio = Days in accounting
period
Payables turnover ratio
= 365 days
6.16
= 59.3 days
 Ahmed’s electronics Shop takes an average of about
59 days to pay its accounts with vendors and
suppliers.

g) Net Sales to Total Assets: It describes how
productively a company employs its assets to
produce sales revenue.
Total assets turnover ratio = Net sales
Net total assets
= $1,870,841
$847,655
= 2.21:1
Ahmed’s electronics Shop generates $2.21 in sales
for every dollar of assets.

4. Profitability Ratios: provide the owner with
information about a company’s ability to generate
a profit. in other words, they describe how
successfully the business is using its resources
to generate a profit.
h. Net Profit on Sales Ratio: The net profit on sales
ratio (also called the profit margin on sales or the net profit
margin) measures a company’s profit per dollar of sales.
Net profit on sales ratio = Net income
Net sales x100%
= $60,629
$1,870,841 x100%
= 3.24%
Ahmed’s Electronics Shop keeps 3.24 cents in profit out of
every dollar of sales it generates.

i) Net Profit to Assets: The net profit to assets ratio
(also known as the return on assets, ROA) ratio tells
how much profit a company generates for each dollar
of assets that it owns.
Net profit on assets ratio = Net income
Total assets x 100%
= $60,629
$847,655 x100
= 7.15%
Ahmed’s Electronics shop earns a return of 7.15
percent on its asset base.

j. Net Profit to Equity:The net profit to equity ratio
(or the return on net worth ratio) measures the
owners’ rate of return on investment (ROI).
Net profit to equity ratio = Net income
Owner’s equity (or net worth) x 100%
= $60,629
$267,655 x 100%
= 22.65%
A business should produce a rate of return that exceeds its
cost of capital.

End of Chapter 6
Monday, February 13,
2023 29
Entrepreneurship and small business management

Chapter 6.pptx

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