Management of Technological Innovation

Andrew Maxwell

Entrepreneurial finance

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Why you need to start with financial forecasting

Establishes cash needs of business Allows entrepreneurs to compare

expected value of strategic alternatives Demonstrates value of company to

investors Helps identify appropriate benchmarks

for measuring company development

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Most importantly growing companies need cash

Understand why they need cash How much they are likely to need In the next lesson we will identify:

Ways of reducing the amount of cash required

Sources of cash, types of investment What entrepreneurs will have to give up to

get required cash and deal structures

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Three types of financial statements Balance sheet is a “snap shot” of a

company’s affairs; it shows companies’ assets and liabilities, shareholders’ equity and change from year to year

Income statement shows companies’ revenue and expenses, plus profit for a specific period

Cash flow shows how much cash the company generates or needs in a period

All three statements are important and linked together

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The importance of each

The income statement shows the health of the company and provides important guidance for entrepreneurs’ weekly/monthly decisions.

The cash flow statement and forecast provides guidance on daily tactics to preserve cash and ultimately on how much cash to borrow.

The balance sheet is used for valuation, comparison and progress assessment. It is more a consequence of the other two.

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Forecasting revenue

Use market research to identify market size and pricing strategy

Use the adoption curve to forecast number of units sold

Create a three to five year revenue forecast Use the unit numbers to forecast marginal cost Calculate the fixed costs Create a Profit and Loss account

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Typical P and L

2008 2009 2010

Sales $100,000 $400,000 $1,000,000

Cost of Sales $50,000 $180,000 $400,000

Gross Margin $50,000 $220,000 $600,000

Other costs $200,000 $300,000 $400,000

Profit ($150,000) $80,000 $200,000

What is included in other costs?

Salaries Rent Overheads Marketing Research and development (special

case)

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Calculating a simple initial balance sheet: Step 1 Investment in the business

Sylvia invests $20,000 in her new business, a clothing retailer,named Sylvia's Satins. The firm establishes an overdraftfacility with a bank for $20,000.

Sylvia's Satins Balance Sheet (Figures in 000's)Assets LiabilitiesCash $20 Overdraft $0

Shareholders EquityCurrent Assets $20 Common Shares 20Total Assets $20 Total Liabilities / Shareholders' Equity $20

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Step 2: Accounting for set up costs of business

Sylvia spends $5,000 to pay for legal feesfor setting up business

Sylvia's Satins Balance Sheet (Figures in 000's)AssetsCash Liabilities $15 Overdraft $0 Current Assets Shareholders EquityIntangibles $15 Common Shares 20Total Assets 5

$20 Total Liabilities / Shareholders Equity $20

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Step 3: Accounting for leasehold improvements

Sylvia enters into a lease and spends $5,000 on leasehold improvements

Sylvia's Satins Balance Sheet (Figures in 000's)Assets LiabilitiesCash $10 Overdraft $0 Shareholders Equity Current Assets $10 Common Shares 20Leasehold Improvement 5 Intangibles 5 Total Assets $20 Total Liabilities / Shareholders' Equity $20

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Step 4: Accounting for fixed asset purchase

Step 4: Accounting for fixed asset purchaseSylvia buys equipment for $10,000.

Sylvia's Satins Balance Sheet (Figures in 000's)

Assets LiabilitiesCash $0 Overdraft $0 Shareholders Equity Current Assets $0 Common Shares 20Equipment 10 Leasehold Improvement 5 Intangibles 5 Total Assets $20 Total Liabilities and Shareholders' Equity $20

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Step 5: Accounting of purchase for inventory

Step 5: Accounting for purchase of inventorySylvia's firm buys $60,000 of shirts from a supplier on credit

Sylvia's Satins Balance Sheet (Figures in 000's)

Assets LiabilitiesCash $0 Overdraft $0 Accounts Payable 60Inventory 60 Shareholders Equity Current Assets 60 Common Shares 20Equipment 10 Leasehold Improvement 5 Intangibles 5 Total Assets $80 Total Liabilities and Shareholders' Equity $80

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Step 6: Accounting for sales

Step 6: Accounting for salesSylvia's firm sells $30,000 of inventory for $40,000 on credit

Sylvia's Satins Balance Sheet (Figures in 000's)

Assets LiabilitiesCash $0 Overdraft $0Accounts Receivable 40 Accounts Payable 60Inventory 30 Shareholders Equity

Current Assets $70 Common Shares 20Equipment 10 Retained Earnings $10Leasehold Improvement 5 Intangibles 5

Total Assets $90 Total Liabilities and Shareholders' Equity $90

Income Statement of Sylvia's Satins

Revenue $40Cost of Goods Sold 30

Gross Margin $10

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A Step-By-Step Example:

Step 7: Accounting for payments to suppliersSylvia pays off $20,000 of payables

Sylvia's Satins Balance Sheet (INCOME STATEMENT UNCHANGED)

Assets LiabilitiesCash $0 Overdraft $20Accounts Receivable 40 Accounts Payable 40Inventory 30 Shareholders Equity

Current Assets $70 Common Shares 20Equipment 10 Retained Earnings 10Leasehold Improvement 5 Intangibles 5

Total Assets $90 Total Liabilities and Shareholders' Equity $90

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A Step-By-Step Example:

Step 8: Account for collection of accounts receivableSylvia receives $10,000 of cash from customers in collecting accounts receivable

Sylvia's Satins Balance Sheet (INCOME STATEMENT UNCHANGED)Assets LiabilitiesCash $0 Overdraft $10Accounts Receivable 30 Accounts Payable 40Inventory 30 Shareholders Equity Current Assets $60 Common Shares 20Equipment 10 Retained Earnings 10Leasehold Improvement 5 Intangibles 5 Total Assets $80 Total Liabilities and Shareholders' Equity $80

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A Step-By-Step Example: Step 9: Account for payment of interestCompany Is charged $1,000 of interest and bank charges related to overdraft.

Sylvia's Satins Balance Sheet (Figures in 000's)

Assets LiabilitiesCash $0 Overdraft $11.0Accounts Receivable 30 Accounts Payable 40Inventory 30 Shareholders Equity

Current Assets $60 Common Shares 20Equipment 10 Retained Earnings 9Leasehold Improvement 5 Intangibles 5

Total Assets $80.0 Total Liabilities and Shareholders' Equity $80.0

Sylvia Satin's Income Statement

Revenue $40.0Cost of Goods Sold 30.0

Gross Margin $10.0Interest 1.0

Net Income Before Tax $9.0

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Step 10: Accounting for depreciation & amortization Step 10: Account for depreciation and amortizationCompany depreciates equipment on straight-line basis over 5 years (useful life of equipment) and over 10 years (lease term) for leasehold improvements

Sylvia's Satins Balance Sheet (Figures in 000's)

Assets LiabilitiesCash $0 Overdraft $11Accounts Receivable 30 Accounts Payable 40Inventory 30

Current Assets $60 Shareholders Equity Equipment 8 Common Shares 20Leasehold Improvement 4.5 Retained Earnings 6.5Intangibles 5

Total Assets $77.5 Total Liabilities and Shareholders' Equity $77.5

Sylvia Satin's Income Statement

Revenue $40.0Cost of Goods Sold 30.0

Gross Margin $10.0Interest 1.0Depreciation 2.0Amortization 0.5

Net Income Before Tax $6.5

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Key Components of Cash Flows

Sales- Cost of Goods Sold- Selling, General and Administration Expenses Net Income- Interest- Income Taxes+Non-cash expenses e.g.depreciation= Cash Flows From Operating Activities- Increase in Accounts Receivable- Increase in Inventory Change in Net Working Capital+ Increase in Accounts Payable- Purchases of Fixed Assets Net Capital Expenditures + Sales of Fixed Assets- Payments to Owners of Business= Cash Generated (Used) By Business Available for Repayment of Debts

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Cash flows prior to sales

+ Initial investment from entrepreneur- Cost of setting up company- Acquisition of licenses- Labour/materials- Travel and general- Rent/utilities- Capital (even if leased)- Legal and professional services+ Bank or credit card loans+ SRED+ Government grants= Cash Flows From Research (cash hole)

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Key Components of Cash Flows

Components of Cash Flows for Sylvia’s Satins

Sales $40.0 - Cost of Goods Sold 30.0

= Gross Profit $10.0 - Selling, General and Administration Expenses 2.5 - Interest 1.0 - Income Taxes 2.6

=Net Income $3.9+ Non-cash Expenses (depreciation, amortization, deferred taxes) $3.7

=Cash Flows from Operating Activities $7.6- Increase in Accounts Receivable $30.0- Increase in Inventory 30.0+ Increase in Accounts Payable and other Payables 41.4- Purchases of Fixed Assets and other Capital Expenditures 20.0+ Sales of Fixed Assets 0.0- Payments to Owners of Business Other than Salary 0.0

Cash Generated (Used) By Business Available for Repayment of Debts -$31.0

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Financing Cash Flow Deficiencies

If Sylvia’s Satins used up $31,000 cash in its on-going operations, how was this financed?

Opening Cash Balance $20,000Less: Cash Used $31,000Cash Surplus (Deficiency) - $11,000

Deficiency was financed by overdraft

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Eleven Key Cash Flow Drivers Relationship with Cash Flow

1. Sales Growth usually negative2. Gross Margin % (Gross Profit/Sales) positive3. Selling, General and Administration

(SGA) as % of Sales negative 4. Interest Expense negative5. Non-cash Expenses positive6. Income Tax Rate negative7. Average Collection Period (ACP) negative 8. Inventory Conversion Period negative9. Accounts Payable Period positive10. Net Capital Expenditures negative11. Owner’s Withdrawals from Firm negative

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Impact of Doubling of Sales on Cash Flow of Firm

Sales $80.0 - Cost of Goods Sold 60.0

= Gross Profit $20.0 - Selling, General and Administration Expenses 2.5 - Interest 3.0 - Income Taxes 5.8

=Net Income $8.7+ Non-cash Expenses (depreciation, amortization, deferred taxes) $3.7

=Cash Flows from Operating Activities $12.4

- Increase in Accounts Receivable $60.0- Increase in Inventory 60.0+ Increase in Accounts Payable (includes Taxes Payables) 84.6- Purchases of Fixed Assets and other Capital Expenditures 20.0+ Sales of Fixed Assets 0.0- Payments to Owners of Business Other than Salary 0.0

Cash Generated (Used) By Business Available for Repayment of Debts -$43.0

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Relationship of sales growth to cash flow

With increased sales, Sylvia’s Satins would increase its profit from $3,900 to $8,700 but experience an increase in cash outflow from -$31,000 to -$43,000 and therefore end the year with a higher bank overdraft

Situation would be worse where firm experiences substantial growth and is capital intensive i.e. it needs more capital expenditures to facilitate expansion

These expenditures place greater pressure on the cash flow of the firm (a fact that is probably true for all the businesses for which you are developing business plans

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Preparing Comprehensive Pro Forma Financial StatementsSales Forecast Production Forecast

Cash Flow Forecast

Pro Forma Income Statement

Pro Forma Balance Sheet

Sales, production and cash flow forecasts - monthly pro forma income and balance sheets - annually