Introduction to Entrepreneurship,

8e
Donald F. Kuratko
Chapter 11
Financial Statements in New Ventures

Chapter Objectives
1.

To explain the principal financial statements

needed for any entrepreneurial venture: the
balance sheet, income statement, and cashflow statement

2.

To outline the process of preparing an

operating budget

3.

To discuss the nature of cash flow and to

explain how to draw up such a document

4.

To describe how pro forma statements are

prepared

5.

To explain how capital budgeting can be used

in the decision-making process

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Chapter Objectives
6.

To illustrate how to use break-even analysis

7.

To describe ratio analysis and illustrate the

use of some of the important measures and
their meanings

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113

The Importance of Financial Information

for Entrepreneurs
Significant Information for Financial

Management

The importance of ratio analysis in planning

Techniques and uses of projected financial statements
Techniques and approaches for designing a cash-flow
schedule
Techniques and approaches for evaluating the capital
budget

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114

Understanding the Key Financial

Statements
Balance Sheet

Represents the financial condition of a company at a

certain date.
It details the items the company owns (assets) and the
amount the company owes (liabilities).
It also shows the net worth of the company and its liquidity.

Assets = Liabilities + Owners Equity

An asset is something of value the business owns.
Current and fixed assets
Liabilities are the claims creditors have against the company.
Short- and long-term debt
Owners equity is the residual interest of the firms owners in
the company.

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Table

11.2

Kendon Corporation Balance Sheet for the Year Ended

December 31, 2010

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Understanding the Key Financial

Statements (contd)
Income Statement

Commonly referred to as the P&L (profit and loss)

statement from activities of the firm.

Provides the results of the firms operations.

Income Statement Categories

Revenues: gross sales for the period

Expenses: Costs of producing goods or services

Net Income: The excess (deficit) of revenues over

expenses (profit or loss)

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Table

11.3

Kendon Corporation Income Statement for the Year Ended

December 31, 2010

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Understanding the Key Financial

Statements (contd)
Statement of Cash Flow

An analysis of the cash availability and cash needs of

the business that shows the effects of a companys
operating, investing, and financing activities on its
cash balance.

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 cash from operations sufficient to finance fixed asset
purchases?

The use of a cash budget may be the best approach

for an entrepreneur starting up a venture.

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Table

11.4

Format of Statement of Cash Flows

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Preparing Financial Budgets

Budget

One of the most powerful tools the entrepreneur can

use in planning financial operations.

Operating Budget
A statement of estimated income and expenses over a
specified period of time.
Cash Budget

A statement of estimated cash receipts and

expenditures over a specified period of time.

Capital Budget
The plan for expenditures on assets with returns
expected to last beyond one year.
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The Operating Budget

Sales Forecasting
Creating an operating budget through preparation of
the sales forecast.
Forecasting

Linear regression: a statistical forecasting technique.

Y = a + bx
Y is a dependent variableits value is dependent on the
values of a, b, and x.
x is an independent variable that is not dependent on any of
the other variables
a is a constant.
b is the slope of the line of correlation (the change in Y
divided by the change in x).

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Figure

11.1

Regression Analysis

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Table

11.5

North Central Scientific: Sales Forecast for 2010

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Table

North Central Scientific: Purchase Requirements

Budget for 2010
11.6

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Table

Dynamic Manufacturing: Production Budget

Worksheet for 2010
11.7

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The Cash-Flow Budget

Cash-Flow Budget
Provides an overview of the cash inflows and outflows
during the period. By pinpointing cash problems in
advance, management can make the necessary
financing arrangements.
Preparation of the cash-flow budget
Identification and timing of three cash inflows:

Cash sales
Cash payments received on account
Loan proceeds

Minimum cash balance

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Table

11.8

North Central Scientific: Expense and Operating

Budgets
In order to identify the behavior of the different expense accounts, John Wheatman
decided to analyze the past five years income statements. Following are the results of
his analysis:
Rent is a constant expense and is expected to remain the same during the next
year.
Payroll expense changes in proportion to sales, because the more sales the store
has, the more people it must hire to meet increased consumer demands.
Utilities are expected to remain relatively constant during the budget period.
Taxes are based primarily on sales and payroll and are therefore considered a
variable expense.
Supplies will vary in proportion to sales. This is because most of the supplies will be
used to support sales.
Repairs are relatively stable and are a fixed expense. John has maintenance
contracts on the equipment in the store, and the cost is not scheduled to rise during
the budget period.

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Table

North Central Scientific: Expense and Operating

Budgets (contd)
11.8

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Table

11.9

North Central Scientific: Cash-Flow Budget

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Pro Forma Statements

Pro Forma Statements
Are projections of a firms financial position over a
future period (pro forma income statement) or on a
future date (pro forma balance sheet).
Using beginning balance sheet balances, they depict
projected changes on the operating and cash-flow
budgets which are added to create projected balance
sheet totals.

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Table

11.10

North Central Scientific: Pro Forma Statements

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Table

11.10

North Central Scientific: Pro Forma Statements

(contd)

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Capital Budgeting
The Capital Budgeting Process
Identification of cash inflows or returns and their timing
The inflows are equal to net operating income before
deduction of payments to financing sources but after
deduction of applicable taxes and with depreciation added
back, as represented by the following formula:
Expected Returns = X(1 T) + Depreciation
X is equal to the net operating income
T is defined as the appropriate tax rate

Capital Budgeting Objectives

Which of several mutually exclusive projects should
be selected?
How many projects, in total, should be selected?
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Table

North Central Scientific: Expected Return

Worksheet
11.11

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Capital Budgeting (contd)

Payback Method
Considers the length of time required to pay back
(recapture) the original investment.
Any project that requires a longer period than the maximum
time frame will be rejected, and projects that fall within the
time frame will be accepted.
One of the problems with the payback method is that it
ignores cash flows beyond the payback period.

Why it is used?
Very simple to use compared to other methods.
Projects with a faster payback period normally have more
favorable short-term effects on earnings.
If a firm is short on cash, it may prefer to use the payback
method because it provides a faster return of funds.

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Capital Budgeting (contd)

Net Present Value (NPV) Method
The premise that a dollar today is worth more than a
dollar in the future.
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
flowscash value is determined by the present value of the
cash flow.

Internal Rate of Return (IRR method)

Similar to the net present value method, but future
cash flows are discounted a rate that makes the net
present value of the project equal to zero.
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Break-Even Analysis
Contribution Margin Approach
Uses the difference between the selling price and the
variable cost per unitthe amount per unit that is
contributed to covering all other costs.
Fixed cost assumption:
0 = (SPVC )S FC QC

Break-even point:
0 = [SP VC (QC/U )]S FC

where:

SP = Unit selling price

VC = Variable cost per unit
S = Sales in units
FC = Total fixed costs

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Break-Even Analysis (contd)

Graphic Approach

Graphing total revenue and total costs.

The intersection of these two lines (that is, where total
revenues are equal to the total costs) is the firms break-even
point.

Two additional costsvariable costs and fixed

costsalso may be plotted.

Handling Questionable Costs

Certain costs can behave as either fixed or variable

costs at different levels of output:
0=(SP-VC)S-FC-QC or
0=[SP-VC-(QC/U)]S-FC

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Figure

11.2

Dynamic Manufacturing: Fixed-Cost Assumption

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Figure

Dynamic Manufacturing: Variable-Cost

Assumption
11.3

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Ratio Analysis
Ratios are useful for:
Anticipating conditions and as a starting point for
planning actions.
Showing relationships among financial statement
accounts.
Vertical Analysis
The application of ratio analysis to identify financial
strengths and weaknesses.
Horizontal Analysis
Looks at financial statements and ratios over time for
positive and negative trends.
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Table

11.12

Financial Ratios

Source: Kenneth M. Macur and Lyal Gustafson, Financial Statements as a Management Tool, Small Business Forum (Fall 1992): 24.

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Table

11.12

Financial Ratios (contd)

Source: Kenneth M. Macur and Lyal Gustafson, Financial Statements as a Management Tool, Small Business Forum (Fall 1992): 24.

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Table

11.12

Financial Ratios (contd)

Source: Kenneth M. Macur and Lyal Gustafson, Financial Statements as a Management Tool, Small Business Forum (Fall 1992): 24.

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Key Terms and Concepts

accounts payable

expenses

accounts receivable

financial expense

administrative expenses

fixed assets

balance sheet

fixed cost

break-even analysis

horizontal analysis

budget

income statement

capital budgeting

internal rate of return

cash
cash-flow budget
cash-flow statement
contribution margin

approach

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(IRR) method
inventory
liabilities
loan payable
long-term liabilities

1136

Key Terms and Concepts (contd)

mixed cost

ratios

net income

retained earnings

net present value

revenues

(NPV) method
notes payable
operating budget
operating expenses
owners equity
payback method
prepaid expenses
pro forma statement
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sales forecast
short-term liabilities

(current liabilities)
simple linear
regression
taxes payable
variable cost
vertical analysis

1137