INTRODUCTION TO ENTREPRENEURSHIP

1. INTRODUCTION TO ENTREPRENEURSHIP Finance in entrepreneurship Sirje Ustav 2014 / 2015

2. TOPICS • The aims of firms financial management • Financial sources • Incomes and expenses • Salary calculation • Self-cost and pricing • Break-even point • Income statement • Balance sheet • Cash flow statement • Financial ratios

3. Financialmanagement financial management deals with two things: • raising money and • managing a company’s finances in a way that achieves the highest return aim of financial management in entrepreneurship: • How a new venture tracks its financial progress through preparing, analysing, and maintaining past financial statements. • How a new venture forecasts future income and expenses by preparing pro forma (or projected) financial statements.

4. Financialquestions • How are we doing? Are we making or losing money? • How much cash do we have on hand? • Do we have enough cash to meet our short-term obligations? • How efficiently are we utilizing our assets? • How do our growth and net profits compare to those of our industry peers? • Where will the funds we need for capital improvements come from? • Are there ways we can partner with other firms to share risk and reduce theamount of cash we need? • Overall, are we in good shape financially?

5. Financialobjectivesof a Firm • Profitability • Is the ability to earn a profit. • Many start-ups are not profitable during their first one to three years while they are training employees and building their brands. • However, a firm must become profitable to remain viable and provide a return to its owners. • Liquidity • Is a company’s ability to meet its short-term financial obligations. • Even if a firm is profitable, it is often a challenge to keep enough money in the bank to meet its routine obligations in a timely manner.

6. Financialobjectivesof a Firm • Efficiency • Is how productively a firm utilizes its assets relative to its revenue and its profits. • Southwest Airlines, for example, uses its assets very productively. Its turnaround time, or the time its airplanes sit on the ground while they are being unloaded and reloaded, is the lowest in the airline industry. • Stability • Is the strength and vigor of the firm’s overall financial posture. • For a firm to be stable, it must not only earn a profit and remain liquid but also keep its debt in check.

7. The Process of Financial Management • Importance of Financial Statements • To assess whether its financial objectives are being met, firms rely heavily on analysis of financial statements. • A financial statement is a written report that quantitatively describes a firm’s financial health. • The income statement, the balance sheet, and the statement of cash flows are the financial statements entrepreneurs use most commonly. • Forecasts • Are an estimate of a firm’s future income and expenses, based on past performance, its current circumstances, and its future plans.

8. Income • Companies income = revenue streams from sales, services, rents, leasing, subscription fees, loan interests etc. • Think: Facebook – what are the companies revenue streams?

9. Expences • Periodiccosts General and Administrativecosts • Topmanagement, officepersonnel, otherstaffcosts • Office supplies • Office rent (ordepreciation), heating, electricity, water • Research and development Marketing costs • Othergeneral and administrative • Advertisingcosts • Market researchcosts • Salespersonnelstaffcosts • Intermediaries’ costs • Completedproducts’stockcosts • Salescosts

10. Expences • Otherbusinessexpences • Losses, fees, penalties • Member fees ofassociations, unionsetc • Environmentaldamagescompensations

11. Expencesof a company Dividedaccordingtoobjective • Directcosts • Indirectcosts According to dependence on production output volume costs are divided: • Variable costs - directly dependent on production output volume • Fixed costs- notdependant on production volume

12. Selfcost Exercise A company is producing T-shirts, 2 000 units a month. Total material costs are 1 200 EUR a month, direct staff costs are 500 EUR a month, company’s administration’s staff costs 1 500 EUR a month. The purchase price of the machinery was 8 980 EUR, transportation costs 20 EUR. The forcasted lifetime of the machinery is 10 years. Calculate the self-cost of one T-shirt

13. Break-even analysis • An analysis of cost behaviour, based on the relation of costs, sales volume (production volume) and profit. • REVENUE - COSTS = PROFIT • Break-even point is the sales (production) volume in case of which the company covers its costs and gets neither profit or loss.

14. Break-even analysis To make the analysis easier we make the following assumptions: • One type of product • Fixed costs remain constant, variable costs remain constant per unit • Prices do not change • All production that is produced is sold • Technology and production effectiveness do not change • Time value of money and risks are ignored

15. Break-evenpoint Revenue-expenses=profit At break-even point: Revenue-expenses=0 No of units of product=x Sales price per unit*x – variable costs per unit*x – fixed costs = 0 Find x to calculate the number of units at break-even point To get the break-even point revenue calculate sales price*the number of units at break-even point

16. Break-evencalculation Break-evenfixedcosts Point = inunitssalespriceperunit – variablecosts Break-evenvariablecostsperunit Pointof= 1 - Salesrevenuesalespriceperunit revenue break-even point profit area revenue costs variable costs loss area fixed costs Q3 Q2 Q1 Q

17. Break-even calculation Exercise A company produces computer desks. Variable costs are 24 EUR per a unit of product, fixed costs are 1 920 EUR a month. The company sells the desks for 40 EUR/a desk. The forecasted sales volume is 200 desks. How many desks does the company have to sell to cover the costs?

18. Margin of safety • Margin of safety is the amount of money by which the forcasted sales revenue exceeds the sales revenue at the break-even point. It can be also calculated in units of product. • The closer the forecasted sales revenue (sales volume) is to the break-even point, the bigger the risk that the company may fall into a loss.

19. Margin of safetycalculation The calculation of the margin of safety: Margin of safety (as sales revenue) = forecasted sales revenue – sales revenue at break-even point Margin of safety (in units of product)= forecasted sales volume – sales volume at break-even point Margin of safety can be also as % The margin of safety rate = margin of safety / forcasted sales revenue (volume)

20. Financialstatementsofthecompany Flow statements: • Cashflowstatement • Income statement Stock statement: • Balance sheet These financial statements are based on double entry bookkeeping on accounting documents - every entry to an account requires a corresponding and opposite entry to a different account

21. Incomestatement • Also called profit/loss statement • Reflects the results of the company’s economic activity during accounting period REVENUE – EXPENSES = PROFIT • The accounting period is one year, usually the calendar year • All numbers are without value-added-tax in income statement

22. Incomestatementformat According to the Estonian Accounting Act the companies are allowed to choose between two formats of the income statement: • FORMAT 1 divides the expenses into groups according to their character (staff costs, depreciation etc.) • FORMAT 2 divides the expenses into groups accordingtotheirfunctioninthecompany (costofsales, marketing expenses, administrative and general expenses)

23. Incomestatement(format 2) Sales revenue Cost of sold goods Gross profit (loss) Marketing expenses Administrative and general expenses Other operating revenue Other operating charges Operating profit (loss) Financial income and expenses Profit (loss) before income tax Income tax expense Net profit/loss for financial year

24. Balancesheet • Balance sheet is the statement of the company’s financial status at a certain moment (reflects company’s assets, liabilities and equity at a certain moment) ASSETS = LIABILITIES + EQUITY • Shows a balance between assets and their financial sources (liabilities and equity)

25. Balance sheet - assets Current assets: • Cash • Short-term investments • Receivables and prepayments • Inventories Total current assets Fixed assets: • Long-term investments • Investment properties • Tangible fixed assets • Intangible fixed assets Total fixed assets Total assets

26. Balance sheet - liabilities Liabilities Current liabilities: • Loan liabilities • Debts and prepayments • Total current liabilities • Long-term liabilities: • Long-term loan liabilities • Other long-term payables • Total long-term liabilities Total liabilities

27. Balance sheet - equity Equity: • Sharecapital (nominalvalue) • Retainedprofit/loss • Net profit/lossforfinancialyear Totalequity Totalliabilities and equity

28. Cash flow statement Thepurposeofthecashflowstatement: • togiveinformationaboutthechangeofcashbalanceofthecompany • toplan and checkcashinflow and outflow • Tohelptoevaluatecompany’sabilitytopaydividendstoshareholder and intereststodebitors

29. Cash flow statement Cashflow is the money that is moving in and out of the company during a given period Cash flows are divided into three groups: • cash flows from operations • cash flows from investments • cash flows from financing

30. Exersise Mr Jones decided to start his own company. He has 2000 euros and machinery (production machinery) worth 500 euros to pay in as share capital (the machinery’s remaining forcasted lifetime is 5 years). He needs to take a bank loan of 4000 EUR (annuity-loan, interest rate 8%, duration 4 years, yearly payments). Staff costs of the company are 1600 EUR a month, paid at the beginning of the next month (900 EUR of the staff cost is administrative staff cost and 700 EUR production staff cost). Monthly sales revenue is 3000 EUR (10% of it is received in the next month). Production costs are 1000 EUR a month (15% of the costs are paid out in the next month). Monthly rent is 300 EUR (paid in the same month). Please compile cash flow statement and income statement for the first two years. Please compile the incomestatement and balance sheet for the first two years

31. Cash flow statement The basic structure of cash flow statement: • Cash balance at the beginning of the period • Cash inflows • Cash outflows • Net cash flow • Cash balance at the end of the period

32. Cash flow statement Exercise A company is founded with 2500 EUR of share capital (all in cash). Machinery is bought for 2000 EUR. The rent of office and production space is 500 EUR a month, production costs are 1000 EUR a month. A loan of 2 000 EUR is taken with the duration of 2 years (interest rate 12%). Staff costs are 1500 EUR a month. Sales revenue is 3000 EUR a month. Compile the cash flow statement of the first year.

33. Financialratios Financial ratios are used for comparisons between different periods of one company, between different companies or between a company and the industry’s average.

34. Ratios • Liquidityratios • Activityratios

35. Ratios • Profitabilityratios

36. Ratios • Debtratios