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Designing a new business (4): Financial analysis
Prof. Antonio Renzi
Entrepreneurship and new ventures finance
Agenda
1. Financial dynamic: general framework
2. Financial need of new businesses
3. Net working capital
4. Cash flow analysis
1. Financial dynamic: general framework
2. Financial need of new businesses
3. Net working capital
4. Cash flow analysis
Financial dynamic: general framework
Financial stakeholders:Investors and lenders
Capital raising
Structural cash inflow:Equity investments;
Financial credits
Investments
Financial need:Investments plan
Structuralcash
outflowCapital raising Investments
Economicnet cash flow
CapitalRemuneration
Structuralcash
outflow
Revenuesand costs
Self-financing
Financial need of a new business
Financial need for expected revenues
)(need(FN)Financial 10 REVf 000 SFEFEFN
REV1 = expected revenuesEFN = external financial needSF = self-financing.
REV1
Capitalintensive
Commercialcredits
Managementof inventory
EFN0 +SF0
Financial Need = Fixed Investments + Current Assets
Financial need of new businesses
The estimation of durable financial need: Analytic approach
Financial need of new businesses
The estimation of durable financial need: Synthetic approach
(T0)jj(T1)sj(T0)
n
1i i
is
FI)(REVACAFN
nREV
FIACA
ACAs = Average capital intensive of cluster sFNj = Financial need of business jREVj(T1) = Expected j revenuesFij(T0) = Fixed investments
Financial need of new businesses
Synthetic approach: multi-period analysis
)FI(FI...)FI(FI
)REV(REV...)REV(REVACAFN
1)-j(TNj(TN)j(T0)j(T1)
1)-j(TNj(TN)j(T0)j(T1)sTN)j(T0,
Hypothesis: Each expected Euro of revenue requires a durable investment equal to threeEuros
Financial need of new businesses
Analytic approach /Synthetic approach
The synthetic approach is useful especially in the first stage of analysis, when the specificbusiness goods are not identified. From this point of view, the synthetic approach helps theestimation of the general capital amount necessary to finance the industrial structure of theproject.
Moreover the synthetic approach could be useful to analyze the causes about differencesbetween the capital intensive of a certain industry and capital intensive of a certainbusiness.
The synthetic approach is useful especially in the first stage of analysis, when the specificbusiness goods are not identified. From this point of view, the synthetic approach helps theestimation of the general capital amount necessary to finance the industrial structure of theproject.
Moreover the synthetic approach could be useful to analyze the causes about differencesbetween the capital intensive of a certain industry and capital intensive of a certainbusiness.
Financial need and risk
Project StartElevated operative and
financial risk
High durable financialneed
Project GrowthNegative cash flow
High temporary financialneed
Financial need of new businesses
FINANCIALNEED
HighProject Start
Elevated operative andfinancial risk
High durable financialneed
Idea creationHigh uncertainty
Low durable financialneed
Consolidation
Positive cashflow
RISK
FINANCIALNEED
High Low
Low
Networking capital (NWC)
Balance sheet equation: CLDFCAFI
NWC = CA – CL = DL - FI
Networking capital (NWC)
FI DF
CA CL
NWC > 0
FI DF
CA CL
NWC = 0
FI DF
CA CL
NWC < 0Disequilibrium:
Excess of liquidityEquilibrium:
Excess of liquidityDisequilibrium:Lack of liquidity
Excess of liquidity: Causes
• Combination between economic strength and a lack of opportunity growth(cash cow).
• Self-financing.
• Business crises causes (for a short time) liquidity that comes fromdisinvestments
Net working capital
• Combination between economic strength and a lack of opportunity growth(cash cow).
• Self-financing.
• Business crises causes (for a short time) liquidity that comes fromdisinvestments
Lack of liquidity: Causes
• Economic inefficiency
• Difficulty to get a return on commercial credit.
• Difficulty to obtain durable financing.
Net working capital
• Economic inefficiency
• Difficulty to get a return on commercial credit.
• Difficulty to obtain durable financing.
The right level of NWCThe optimum level of NWC requires: 1) A low waste of financial resources;2) A protection margin (m) than the volatility of current asset and currentliabilities.
0NWCmc)
0NWCmb)
0NWCma)
Inefficiency: waste of financialresources; covered risk
Net working capital
0NWCmc)
0NWCmb)
0NWCma)
Inefficiency: waste of financialresources; covered risk
Limited efficiency; riskcovered
Max efficiency; No coverrisk
Cash flow analysis
Net Income(- ) ∆ Net operative Working Capital(+) DepreciationA) Economic cash flow
(+) ∆ Equity - Net Income(+) Financial debts(+) Financial debts(-) New Fixed Investments(+) DisinvestmentsB) Structural cash flow
Total Cash flow = A +B
Cash flow analysis
- ∆ Net operative Working Capital=
Accounts payable – (∆ Accountsreceivable + ∆ Inventory)
Accounts payable = costs without cashout flow
Accounts receivable = revenueswithout cash inflow
- ∆ Net operative Working Capital=
Accounts payable – (∆ Accountsreceivable + ∆ Inventory)
Accounts payable = costs without cashout flow
Accounts receivable = revenueswithout cash inflow
Cash flow analysis
A) Economic cash flow
B) Structural cash flow
Goal: maximization
Goal: ?
A positive value of the structural cash flow indicates a surplus of financing
A negative value of structural cash flow could depend on self-financing processes
A null value of the structural cash flow arises when there is a perfect balance betweenthe acquisition of new equity (and/or new financial debts) and the dynamic of fixedinvestments
Cash flow analysis
Free cash flow
Free Cash FlowTo Firm
It comes just frominvestment decisions.
Free Cash FlowTo Equity
It comes from bothinvestment decisions and
financing choices
Equity
Debt
Assets
The free cash flow is a net cash flow usable to reward lenders and shareholders
Free Cash FlowTo Equity
It comes from bothinvestment decisions and
financing choicesDebt
The Free Cash Flowis correlated in negative way with the business dynamic:
Investments growth decreases dividends
Investment growthΔ Net Fixed Investments + Depreciation > 0
Cash flow analysis
Free Cash Flow To Firm
Net Income+ Debt service
+ Non-Cash Items (Depreciation)
– ΔNet Operative Working Capital
– New Fixed Investments+ Fixed Disinvestments
= FCFF
Net Income+ Debt service
+ Non-Cash Items (Depreciation)
– ΔNet Operative Working Capital
– New Fixed Investments+ Fixed Disinvestments
= FCFF
Cash flow analysis
Free Cash Flow To Equity
Net Income
+ Non-Cash Items (Depreciation)
– ΔNet Operative Working Capital
– New Fixed Investments+ Fixed Disinvestments
= FCFE = FCFF - Debt service
Net Income
+ Non-Cash Items (Depreciation)
– ΔNet Operative Working Capital
– New Fixed Investments+ Fixed Disinvestments
= FCFE = FCFF - Debt service
Cash flow analysis
Expected Free Cash Flow analysis and growth assumption
• No-Growth Assumption - Free Cash Flow stable• Constant Growth Assumption – Constant growth of Free
Cash Flow• Negative Growth Assumption• Variable Growth Assumption – Variable growth of Free
Cash Flow
In general the growth assumptions about expected free cashflow are inverse than the growth assumptions about
investment dynamic:Temporal mismatching between earning dynamic and
investment dynamic
• No-Growth Assumption - Free Cash Flow stable• Constant Growth Assumption – Constant growth of Free
Cash Flow• Negative Growth Assumption• Variable Growth Assumption – Variable growth of Free
Cash Flow
In general the growth assumptions about expected free cashflow are inverse than the growth assumptions about
investment dynamic:Temporal mismatching between earning dynamic and
investment dynamic