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Learn about financial planning, sources of funds, debt, equity finance, and project cost analysis for small enterprises.
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CHAPTER 13 FINANCIAL MANAGEMENT FOR SMALL AND MEDIUM ENTERPRISES
Objectives The objectives of this chapter are to: identify the necessary steps to be taken in order to prepare a simple project costs schedule suggest potential sources to fund a new project identify inputs to prepare pro forma financial statement conduct simple financial ratio analysis for business
Learning Outcomes At the end of this chapter, students should be able to: list various types of common sources of financing for SMEs identify important elements required in preparing a financial plan identify necessary financial statements to be prepared in managing a small business
The Importance of Finance for SMEs The need for finance in SMEs might arise on four occasions. The first, and most common is the need for start-up capital to help in the establishment of a new business. The requirement to finance business expansion, i.e. for purchase of new buildings, plant, or machinery; to finance working capital by holding more stocks/work in progress and trade debtors. Finance might also be needed for taking over other existing businesses as an expansion strategy.
The need for finance in SMEs might arise on four occasions. The third occasion is when ‘venture capital' is required, particularly to finance an innovation. This type of capital, also known as 'risk capital‘. The last occasion is to adjust the existing financial structure of the business, e.g. changes in the proportion of equity to debt or the proportion of long to short-term debt. The Importance of Finance for SMEs (cont.)
Types of Finance for SMEs The main types of finance for SMEs can be categorized into debt and equity finance. Debt Finance Debt financing is a financing method which typically involves an interest-bearing instrument, normally a term loan. This type of financing requires the entrepreneur to pay back the funds borrowed plus an interest. Equity Finance Equity financing offers some form of the ownership in the business to the investor. Equity finance requires the entrepreneur to give up some degree of control and ownership of the business.
Internal or External Funds (cont.) Financing can also be considered from the perspective of internal versus external funds. The most frequently used funds are internally generated funds. The internal funds can come from various sources within the business, such as personal savings of the entrepreneur, profits retained in the business, sales of fixed assets, reduction of working capital, and account receivable. The external source of finance can be generated from outside the business and the most frequently used sources of external finance are banking and developmental financial institutions (DFIs).
Financial Plan A financial plan is also known as a financial budget. Determines whether or not a business proposal is viable. The process of estimating future income, expenses and assets of the business. In business, a financial plan or a financial forecast consists of three primary pro forma (projected) financial statements, cash flow statement, income statement, and the balance sheet prepared within a business plan.
The Importance of Financial Plan To Determine Total Project Implementation Cost. To Determine Amount of Funding Required and Identify Proposed Sources of Funds. To Ensure Sufficient Initial Investment . To Analyse the Viability of the Project . To Guide Project Implementation .
The process of preparing a financial plan involves: determining total project implementation costs determining amount of funding required and identifying proposed sources of funds calculating amount of depreciation on fixed assets calculating amount of loan and hire purchase repayments required estimating amount cash inflow and outflow during the planned period estimating amount of profit generated during the planned period estimating financial position at the end of the planned period performing financial analysis to determine financial viability of the proposed business The Importance of Financial Plan (cont.)
Steps in Developing a Financial Plan To develop a workable and meaningful financial plan, the entrepreneur has to follow these seven steps: Gathering relevant financial inputs Preparing project implementation cost schedule Identifying sources of financing Preparing pro forma cash flow statement Preparing pro forma income statements Preparing pro forma balance sheet Performing financial analysis based on the above pro forma statements
Step4: Preparing the Pro Forma Cash Flow Statement The pro forma cash flow statement is another important part of the financial plan. Pro forma cash flow statement refers to the projected statement of cash inflow and outflow throughout the planned period. The pro forma cash flow statement must be able to show the following information: cash inflows—the projected amount of cash flowing into the company cash outflows—the projected amount of cash flowing out of the company cash deficit or surplus—the difference between cash inflows and cash outflows cash position—the beginning and ending cash balances for a particular period Steps in Developing a Financial Plan (cont.)
Step 4: Prepare Pro Forma Cash Flow Statement (contd.) Elements of cash inflows: Equity contribution (cash) Term loan Cash sales Collection of receivables Others Steps in Developing a Financial Plan (cont.)
Step 4: Prepare Pro Forma Cash Flow Statement (cont.) Elements of cash outflows: Marketing expenditure Operations expenditure Administrative expenditure Term loan repayment Hire purchase repayment Purchase of fixed assets Pre-operating expenditure Payments for deposits Miscellaneous expenditure Steps in Developing a Financial Plan (cont.)
Step 5 Preparing the Pro Forma Income Statement [B] The next step in developing a financial plan is to prepare the pro forma income statement which shows the expected profit or loss for the planned period, usually for three consecutive years. Elements in the Pro Forma Income Statement Generally, the pro forma manufacturing account consists of the following elements: cost of goods manufactured gross profit net profit For manufacturing companies, the cost of goods manufactured must be calculated first, while for trading companies; it is the gross profit. Service companies can straight away calculate the net profit. Steps in Developing a Financial Plan (cont.)
Step 6 Preparing the Pro Forma Balance Sheets Elements of the Pro Forma Balance Sheet The general elements of the pro forma balance sheet include: assets owner’s equity liabilities Steps in Developing a Financial Plan (cont.)
Assets Non-current assets Fixed assets are used and depreciated by a company for more than a year, and thus, they are considered non-current assets. Current assets Current assets are short-term assets that can be converted into cash within a year. Examples of these assets are cash, stock (raw materials, work-in-process and/or finished goods), account receivables and other short-term investments. Steps in Developing a Financial Plan (cont.)
Owners’ Equity Owners’ equity refers to the original capital contributions from the owners or shareholders in terms of cash or assets plus the accumulated amount of net profit. However, if the company suffers a loss, the amount of loss will be deducted from the original equity contribution. Liabilities Liabilities are the amounts owed by the company to outsiders. They are categorized as current liabilities and non-current liabilities (long-term liabilities).The most common forms of current liabilities are accounts payable and accrued payments. Non-current liabilities or Long-term liabilities refer to the long-term obligations of the company that mature in a period of more than one year. They usually include long-term loans as well as hire purchase. Steps in Developing a Financial Plan (cont.)
Analysing Financial Statements Financial Ratio Analysis Liquidity Ratios Efficiency Ratios Profitability Ratios Solvency Ratios Steps in Developing a Financial Plan (cont.)
