Written by Bill Petty

A NOTE ON FORECASTING FINANCIAL REQUIREMENTS If we were to ask owners of small businesses to identify their most pressing problem, the answers would be varied. Responses might include finding and retaining qualified employees, meeting the increasing cost of employee health care, and managing change. lso, any time this question is asked, the difficulty of acquiring the needed financing is invariably cited as a critical problem. s noted by one entrepreneur, !"he biggest problem facing small business, as I see it, is money# where to get it, how to get it, and where to get enough when you need it.!$ Regardless of whether we consider financing to be the most pressing problem, most would agree that it is an issue that we can ill afford to ignore or even slight. "he problem is most pressing for new company startups and those firms that are e%periencing growth. FINANCING THE VENTURE: THE BASIC QUESTIONS While the acquisition of financing may seem intimidating, it need not be. It does require us to think carefully about the cash outflows needed to undertake a venture and where we might find the money to fund these cash e%penditures. &ffectiveness in such an analysis is largely dependent on developing a good understanding of the business, complemented with some common sense. In raising capital, there are some basic questions or issues that must be addressed prior to actually soliciting the funds. "he three issues which we will look at here are as follows' $. +. -. (orecasting a new company)s profits, and for a new firm, determining when it will achieve a break*even point in terms of profits.+ ,nderstanding the nature of the asset and financing requirements for a new firm. &stimating the amount and basic type of the assets needed and financing required for the new venture.

!What is the .ost Pressing /oncern for 0mall Business "oday1! Small Business Forum, 2ol. $3, 4o. $ 50pring $66+7, p. 89. 5"he article provides the answers given by ten business owners to this question.7 nother question that we do not address at this time is the pro:ection of the firm)s cash flows. While pro:ecting profits and financial requirements is important, understanding the firm)s cash flows is vital to our success. In fact, failure to analysis the firm)s cash flows would be a great oversight.. ;raft' <anuary $=, $66-

Written by Bill Petty

PROFITABILITY AND FINANCING A NEW VENTURE key question for anyone starting a new business should be, !>ow profitable is the opportunity1! We have two concerns in this regard' $. +. >ow do we pro:ect the firm)s future profits1 t what sales volume will we achieve a ?ero operating profit, where sales revenues e%actly cover the firm)s operating costs and e%penses, which is the firm)s operating profit break*even point1

Both of these questions are of significance to the company)s potential investors, whether they be our lenders or our partners. Forecast !" Pro# ts company)s profit is a primary source for financing future growth. "he more profitable a company, all else being constant, the more funds it will have for growing the firm.- "hus, we need a basic awareness of the factors that drive profits, so that we may make the needed profit pro:ections. In this regard, a company)s net income or net profits are dependent on five variables' $. +. A$o%!t o# sa&es .uch that we pro:ect about a company)s financial future is driven by the assumptions we make regarding future sales. O'erat !" e('e!ses @perating e%penses include such e%penses as the cost of acquiring our product or the e%penses related to marketing and distributing the product. We will want, as best we can, to classify these e%penses according to those that do not vary as sales increase or decrease 5fixed operating e%penses7 versus those that change proportionally with sales 5variable operating e%penses7. I!terest e('e!se When we borrow money, we agree to pay a fi%ed interest rate on the loan principal. (or instance, if we borrow A+=,333 for a full year and commit to pay $+*percent interest, our interest e%pense would be A-,333 for the year 5$+B C A+=,3337. Ta(es "he firm)s ta%es are, for the most part, a percentage of ta%able income, where the rate increases as the amount of income increases.

-.

D.

"his statement is not totally accurate. s we shall see more clearly in /hapter +3, a firm may be highly profitable, but be cash poor. 0o we ought to be very careful about thinking that profits and cash are one and the same. "hey are not# however, we will reserve this issue for later. + ;raft' $EDE+3$D

Written by Bill Petty

Fet)s consider an e%ample to demonstrate how we would estimate a new venture)s profits in future years. E(a$'&e We are contemplating a new business, @akcrest Products, Inc., to make stair parts for more e%pensive home. newly developed lathe will permit the new firm to be more responsive to different design specifications, while doing so more cheaply than heretofore possible. In studying the market and the economics of the venture, we have made the following estimates for the ne%t three years' $. @akcrest Product)s forecasted sales for the ne%t three years are as follows' Pro:ected Pro:ected ,nit 0ales ;ollar 0ales Gear $ Gear + Gear +,333 -,+33 D,833 A+=3,333 AD33,333 A933,333

"he dollar sales pro:ections assume that the average unit sales price for each part will be A$+=. +. "he fi%ed production costs are e%pected to be A$33,333 per year, while the fi%ed operating e%penses 5marketing e%penses, and administrative e%penses7 should be about A=3,333. "hus, the total fi%ed operating costs will be A$=3,333. "he variable costs of producing the stair parts will be around +3 percent of dollar revenues 5sales7# and the variable operating e%penses will be appro%imately -3 percent of dollar sales. In other words, given an e%pected A$+= sales price, the combined variable costs per unit, both for producing the stair parts and for marketing the products will be A9+.=3 H5+3B I -3B 7 % A$+=J. "he bank has agreed to loan the firm an increasing amount over the ne%t three years at an interest rate of $+ percent. "he bank would loan A$33,333 in the first year, another A=3,333 in the second year, and an additional A=3,333 in the third year. "hus, the loan balance each year would be as follows'

-.

D.

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Written by Bill Petty

Gear $ Gear + Gear =.

A$33,333 A$=3,333 A+33,333

ssume the income ta% rate will be += percent# that is, ta%es will be += percent of earnings before ta% 5ta%able income7.

Kiven the foregoing assumptions, we may forecast @akcrest)s profits, as shown in &%hibit $. &%hibit $ @akcrest Product, Inc. Pro:ected Income 0tatements 0ales /ost of goods sold (i%ed costs 2ariable costs 5+3B of sales7 "otal cost of goods sold Kross profits @perating e%penses (i%ed e%penses 2ariable e%penses 5-3B of sales7 "otal operating e%penses @perating profits Interest e%penses 5interest rate $+B7 &arnings before ta% "a%es 5+=B of earnings before ta%7 4et income Gear $ A+=3,333 A$33,333 =3,333 A$=3,333 A$33,333 A=3,333 L=,333 A$+=,333 *A+=,333 $+,333 *A-L,333 3 *A-L,333 Gear + AD33,333 A$33,333 83,333 A$83,333 A++3,333 A=3,333 $+3,333 A$L3,333 A=3,333 $8,333 A-+,333 8,333 A+D,333 Gear A933,333 Line 1 A$33,333 $+3,333 A++3,333 A-83,333 A=3,333 $83,333 A+-3,333 A$=3,333 +D,333 A$+9,333 -$,=33 A6D,=33 Line 2 Line 3 Line 4 Line 5 Line 6 Line 7 Line Line ! Line 1" Line 11 Line 12 Line 13

In pro:ecting the firm)s net income for the ne%t three years, the following steps were taken' $. We first compute the e%pected cost of goods sold 5line D7 and the operating e%penses 5line 87 for the given level of sales. 0ubtracting these costs and e%penses from the firm)s sales gives us the company)s o'erat !" 'ro# ts, or ear! !"s )e#ore !terest a!* ta(es 5line 67.

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Written by Bill Petty

+.

We ne%t calculate the interest e%pense for each year line $37, which in this case, was determined as follows' Gear $' Gear +' Gear -' $+B C A$33,333 $+B C A$=3,333 $+B C AA+33,333 M A$+,333 M A$8,333 M A+D,333

-.

"he final computation involves estimating income ta%es, where the ta%es are += percent of earnings before ta%. >owever, we have a small complication resulting from the A-L,333 loss in year $. "ypically, when a company has a loss from its operations, the ta% laws allow us to use the loss against any income in other years. "o keep things from becoming too complicated, we shall assume that we simply do not have to pay ta%es when we have a loss.D

"he result of all our computations suggests that the firm will lose money in year $ in the amount of A-L,333, followed by positive net income in years + and - of A+D,333 and A6D,.=33, respectively. We have completed our first task, that of pro:ecting the firm)s future profits. Fet)s now turn to the second issue' determining the firm)s break*even point, an issue of concern to any investor in our company. Brea+,E-e! A!a&.s s= If we were investing in a startup company, would we not want to know how long it would take for the firm to become profitable1 "he answer is an unequivocal !yes.! 0o it is with anyone investing in a new business &ven the least sophisticated investor will want an answer to this question. "hey might, however, ask the question in a slightly different way by wanting to know, !>ow many units of the firm)s product must be sold before it becomes profitable1! Kiven the number of break*even units, along with our sales forecast, we may easily draw a conclusion about the time required to reach profitability.

"he ta% laws actually allow a firm to apply losses in one year against income in other years. "his provision is e%plained more fully in the ne%t chapter. >owever, for now, we will ignore this option. We will also look at break*even analysis in /hapter $- when we are studying about product pricing. ;raft' <anuary $=, $66-

Written by Bill Petty

"o measure a company)s break*even point, we can use an equation that is an adaptation of the income statement. Recalling an income statement, such as the one presented in &%hibit $, we know that operating profits, or earnings before interest and ta%es, is measured as follows'
#otal dollar * sales

cos t of $oods * sold

operatin$ e%p enses

operatin$ M profits

5&q. $7

,sing the above equation, we simply want to find the number of units sold, and the corresponding dollar sales where operatin$ profits are equal to ?ero. In other words, we want to calculate the sales level where'
#otal dollar * sales

cos t operatin$ of * e%p enses M 3 $oods sold

5&q. +7

We could use the foregoing equation, and by trial and error, find the break* even sales level. >owever, an alternative and better approach is to restate the above equation where we are finding the sales level that e%actly covers the firm)s total variable and fi%ed costs.9 "hat is, where'
#otal dollar * sales
total variable cos ts

* fixed M 3

total

cos ts

5&q. -7

lso, since a firm)s total dollar sales equals' 5selling price per unit7 % 5the number of units sold,7 and total variable costs equals' 5variable costs per unit7 % 5the number of units sold7, then our break*even equation may be restated as'

units ( sellin$ price * sold ) * (

6

unit var iable cos t

total ) * fixed M 3 * units sold cos ts

5&q. D7

Remember that variable costs are those costs and e%penses that vary directly with the number of units sold. If the variable cost per unit is A= and we sell +=,333 units, then the variable costs will be A$+=,333 5A= % +=,3337. variable cost would include such things as the raw material used in producing our product. (i%ed costs, on the other hand, do not vary with the sales level. "hey are the same regardless of how much we sell, at least up to a point. (i%ed costs would be something like the rent on a building. 9 ;raft' $EDE+3$D

Written by Bill Petty

0olving for the numbers of units sold that produce a ?ero operating profit, we have

break even M units sold

total fi%ed costs selling price * unit variable costs

5&q. =a7

"hus, we see that the break*even point is a function 5$7 the firm)s total fi%ed operating costs 5numerator7, and 5+7 the unit selling price less the unit variable cost 5denominator7. "he higher the fi%ed costs, the more units we must sell to break even# and the greater the difference between the unit selling price and the unit variable cost, the fewer units we must sell to break even. "he difference between the unit selling price and the unit variable cost is the co!tr )%t o! $ar" !# that is, for each unit sold, a contribution is made toward covering the company)s fi%ed costs. (inally, let)s shorten equation 5=7 by using the following notations' Fet NB M ( P 2 M M M the number of units sold to break even. the total fi%ed operating costs 5includes all operating costs that are constant at various levels of productionEsales7. the unit selling price. the variable cost per unit 5includes all costs that vary directly with the volume producedEsold7.

&quation 5=7 may now be represented more efficiently as' NB M

( P*2

5&q. =b7

E(a$'&e We can return to the @akcrest Products, Inc. e%ample used earlier, where we forecast the firm)s profits. s was shown in &%hibit $, the firm achieved profitability in the second year. What we now want to know is e%actly how many units must be sold, and the corresponding sales dollars, to achieve a break*even point in operatin$ profits.L "he information needed from the e%ample is as follows' (
7

the total fi%ed operating costs M A$=3,333

We should note that we are calculating the break*even point for operatin$ profits, and not the break*even point for earnings before ta%es or net income. We can easily see that if we only break even in operating profits, but have interest e%penses, we will have both a negative earnings before ta% and a negative net income. >ence, we are looking only at the required sales level to break even before considering how the firm is financed, whether it be debt or equity. ;raft' <anuary $=, $66-

Written by Bill Petty

P M 2 M

the unit selling price M A$+=. the variable cost per unit M A9+.=3

"hus, given the information, the break*even point in number of units, NB, is determined as follows' NB M
A$=3,333 ( M M +,D33 units A$+= * A9+.=3 P*2

lso, we can know that the break*even in sales dollars is

&ollar sales M break*even units C sales price per unit brea%even

M M

+,D33 units % A$+= A-33,333

We now have an understanding of how to forecast profits and to measure the break*even point in terms of profits. We shall ne%t begin our inquiry into the actual financing of the firm, first by looking at the nature of the financial requirements we must satisfy, and then e%amining how we may estimate the amount of these requirements. DETERMINING THE NATURE OF FINANCIAL REQUIREMENTS "he specific needs of a proposed business venture govern the nature of its initial financial requirements. If the firm is a food store, financial planning must provide for the store building, cash registers, shopping carts, inventory, office equipment, and other items required in this type of operation. n analysis of capital requirements for this or any other type of business must consider how to finance 5$7 the needed investments and e%penses incurred to start and grow the company, and 5+7 any personal e%penses if the owner does not have other income for living purposes. Fet)s consider these two needs. Start%' I!-est$e!t a!* F !a!c !" Re/% re$e!ts "o understand the financing requirements for a new company, visuali?e a balance sheet, as pictured in &%hibit +. "he left*hand side of the balance sheet represents the assets owned by the company, such as cash, accounts receivable, and equipment. "he right*hand side comprises the firm)s sources of financing# that is, it tells us who has provided the needed capital for the business and how much. We shall focus first on the left*hand or asset side of the balance sheet, and then we will discuss the left*hand side 5the sources of financing7
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Written by Bill Petty

E0HIBIT 1 BALANCE SHEET ASSETS LIABILITIES (DEBT) AND EQUITY

CURRENT DEBT: Accounts payable Accrued expenses Short-term notes

CURRENT ASSETS: Cash Accounts receivable Inventories Prepaid expenses

+
FIXED ASSETS: Machinary & equipment Buildings Land

+
LONG-TERM DEBT: Long-term notes Mortgage

+
EQUITY: Owner net worth
or Partnership equity or Common stock equity

+
OTHER ASSETS: Investments Patents

=
TOTAL ASSETS

=
TOTAL DEBT & EQUITY

"he "ypes of ssets 4eeded to 0tart the Business firm)s assets are generally classified into one of three categories or types' 5$7 current assets, 5+7 fi%ed assets, and 5-7 other assets. "hese assets types, and the specific assets included in each category, are highlighted in &%hibit +. brief description of each of the asset categories is helpful in understanding the assets needed in starting a new business. /urrent ssets /urrent assets comprise the assets that are relatively liquid# that is, within the firm)s operating cycle, these assets will be converted into cash. "he current asset items mainly include cash, accounts receivable, inventories, and prepaid e%penses.
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Written by Bill Petty

/urrent assets represent the company)s 2or+ !" ca' ta&.$ lso, the term c rc%&at !" ca' ta& is sometimes applied to these three items, emphasi?ing the constant cycle from cash to inventory to receivables to cash, and so on. /areful planning is needed to provide adequate current asset capital for the new business. Cas3 &very firm must have the cash essential for current business operations. lso, a reservoir of cash is needed because of the uneven flow of funds into the business 5cash receipts7 and out of the business 5cash e%penditures7. "he si?e of this reservoir is determined not only by the volume of sales, but also by the regularity of cash receipts and cash payments. ,ncertainties e%ist because of unpredictable decisions by customers as to when they will pay their bills and because of emergencies that require substantial cash outlays. If an adequate cash balance is maintained, the firm can take such une%pected developments in stride. >owever, a firm could have too much cash. While we certainly need adequate cash to cope with business uncertainties, we also want to make a good return on our investment. 0ince cash is a non*income producing asset, there is a limit as to how much cash we want to keep on hand. Acco%!ts Rece -a)&e "he firmOs accounts receivable consist of payments due from its customers. If the firm e%pects to sell on a credit basis ** and in many lines of business this is necessary ** provision must be made for financing receivables. "he firm cannot afford to wait until its customers pay their bills before restocking its shelves. I!-e!tor es lthough the relative importance of inventories differs considerably from one type of business to another, they often constitute a ma:or part of the working capital. 0easonality of sales and production affects the si?e of the minimum inventory. Retail stores, for e%ample, may find it desirable to carry a larger*than*normal inventory during the /hristmas season. Pre'a * E('e!ses When starting a company, we may need to prepay some of the e%penses. (or e%ample, insurance premiums may be due before the business actually opens, or utility deposits may be demanded before the electricity at the business can be turned on. (or accounting purposes, these e%penses are recorded as current assets, and then e%pensed during the year as used. &ach of these e%penses may be small individually, but together they can be quite substantial.

$3

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Written by Bill Petty

(i%ed ssets (i%ed assets are the more permanent type assets that are intended for use in the business, rather than for sale. s shown in &%hibit $, the fi%ed assets needed in a new business might include machinery and equipment, buildings, and land. (or e%ample, a delivery truck used by a grocer to deliver merchandise to customers is a fi%ed asset. In the case of an automobile dealer, however, a delivery truck to be sold in the ordinary course of business would be part of the inventory and thus a current asset. "he nature and si?e of the fi%ed*asset investment are determined by the type of business operation. modern beauty shop, for e%ample, might be equipped for around A83,333, whereas a motel sometimes requires =3 or more times that amount. In any given kind of business, moreover, there is a minimum quantity or assortment of facilities needed for efficient operation. It would seldom be profitable, for e%ample, to operate a motel with only one or two rooms. It is this principle, of course, that e%cludes small business from automobile manufacturing and other types of heavy industry. firmOs fle%ibility is inversely related to its investment in fi%ed assets. Investments in land, buildings, and equipment involve long*term commitments. "he infle%ibility inherent in fi%ed*asset investment underscores the importance of a realistic evaluation of fi%ed*asset needs. @ther ssets "he third category of assets is classified as ot3er assets, and includes such items as intangible assets, these being patents, copyrights, and goodwill. (or the startup company, this category of other assets could also include organi?ational costs ** costs incurred in organi?ing and promoting the business. 0uch startup costs are shown as an ot'er asset and e%pensed in future years. (inally, other assets comprise investments made, but not actually used in operating the business. (or instance, the company might acquire some long*term investments in stocks or some land that is being held for speculative motives. >owever, most new companies seldom have any long*term investments, nor do they often have intangible assets. F%!*s #or Perso!a& L - !" E('e!ses In many startup businesses, we cannot limit planning to the business investments described in the previous discussions. (requently, financial provision must also be made for the owner)s personal living e%penses during the initial period of operation. Whether or not these e%penses are recogni?ed as part of the business capitali?ation, they must be considered in the business financial plan. Inadequate provision for personal e%penses will inevitably lead to a diversion of business assets and a departure from the financial plan. "hus, failure to incorporate these e%penses into the plan raises a red flag to any prospective lender or investor in the firm.
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Written by Bill Petty

>aving studied the nature of the assets essential in starting and operating a company, we now shift our attention to the financing of these assets. We shall begin by describing the basic types of capital available for financing the new firm. TYPES OF FINANCING SOURCES (inancing comes from two basic sources' debt 5liabilities7 and ownership equity. ;ebt is money that we borrow and must be repaid at some pre*determined date in the future. &quity, on the other hand, represents the owners) investment in the company ** money they have personally put into the firm without any specific date for repayment. s owners, they recover their investment by withdrawing money from the company or by selling their interest in the firm. "hese basic categories were shown in &%hibit +. De)t Ca' ta& s presented earlier in &%hibit +, debt capital is divided into short term and long term. S3ort,ter$ & a) & t es 5debt7 include money borrowed that must be repaid within the ne%t $+ months# &o!",ter$ *e)t comes due and payable some time after $+ months, depending on the terms of the loan. "he short*term sources of debt consist largely of accounts payable, accrued e%penses, and short*term notes. "hese short*term sources of money may be defined as follows' $. Acco%!ts 'a.a)&e ccounts payable represents credit e%tended to our company by suppliers. firm that purchase inventory for eventual resale either must pay cash, or the supplier e%tends credit# for instance, if credit is provided, the purchaser may have -3 or 93 days before paying for the inventory. "his form of credit e%tension or loan is called accounts payable. Accr%e* e('e!ses ccrued e%penses are those e%penses that have been incurred, but not paid. (or instance, employees may perform work, but payday may not come until ne%t month. S3ort,ter$ !otes 0hort*term notes consist of amounts we have borrowed from a banker or other lending sources ** for e%ample, a 63*day note at the bank.

+.

-.

It should be noted here that short*term credit represents one of the primary sources of financing for smaller companies. 0mall businesses have access to fewer sources of capital than their larger counterparts# thus, they must rely more on short*term debt capital. Fong*term debt includes loans from banks or other sources of capital that loan on a long*term. If you borrow money for five years to buy equipment, you will sign an agreement 5called a !ote7 promising to repay the money in five years.
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Written by Bill Petty

lternatively, you may borrow money to purchase real estate, such as a warehouse or office building. >ere the loan may be for -3 years, and the lender uses the real estate as collateral for the loan. If the borrower is unable to repay the loan, the lender can take the real estate in settlement for the loan. "his type of long*term loan is a called a $ort"a"e. O2!er4s E/% t. Ca' ta& "he owner)s equity is simply the money the owners invest in the business. "hey are the residual owners, in that they receive money only if there is something left over after repaying the debt holders. "hus, if the company is liquidated, the creditors are paid first, and only then are the owners paid. lso, in each year, the creditors must be paid the interest on the debt before the owners can participate in the income from the business. "he amount of equity in a business is determined by 5$7 the amount of the owner)s initial investment, as well as any later investments, in the business# and 5+7 the income retained within the business from its beginning to the present, less any withdrawals by the owners. "hus, the owner)s equity consists of the following'
@wner) s investment in the firm

Profits retained within the business

@wner) s withdrawals ifrom the firm

In summary, financing a new business entails raising debt capital and equity financing. >owever, knowing the basic types of capital is not enough. We must also estimate the amount of our asset requirements and decide how we will go about financing these needs. .ore specifically, we have to answer the question, !>ow much will we need in inventories, equipment, and other assets and where will the money come from to pay for these assets1! "he ne%t section helps us begin to answer these questions. ESTIMATING THE AMOUNT OF FUNDS REQUIRED When estimating the magnitude of capital requirements for a small business, the entrepreneur quickly feels the need for a Pcrystal ball.Q "he uncertainties surrounding an entirely new venture make estimation difficult. But even for established businesses, forecasting is never e%act. 4evertheless, when seeking initial capital, the entrepreneur must be ready to answer the question P>ow much1Q "he amount of capital needed by various types of new businesses varies considerably. >igh*technology companies, such as computer manufacturers, designers of semiconductor chips, and gene*splicing companies, often require several million dollars in initial financing. 0tephen . ;u?an, president of Immune% /orp. of 0eattle, W , estimates that is takes A93 million to bring a new biotech company from development stages to the market.
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Written by Bill Petty

.ost service businesses, on the other hand, require smaller amounts of initial capital. (or e%ample, ;ebora "sakoumakis started her business, >B Bakery /onnection, in Boulder, /@, with A$,333. (or a fee, "sakoumakis will arrange delivery of a personali?ed cake for clients who call her on the telephone. 0he has developed a network of D33 bakeries in almost every state that bake and deliver cakes. In her first year of operation, she filled over -=3 orders. "he e%planations that follow will show how a prospective entrepreneur may use a Pdouble*barreledQ approach to estimating capital requirements by 5$7 applying industry standard ratios to estimate dollar amounts, and 5+7 cross* checking the dollar amounts by break*even analysis and empirical investigation. Robert .orris ssociates, ;un R Bradstreet, Inc., banks, trade associations, and other organi?ations compile industry standard ratios for numerous types of businesses. If no standard data can be located, then estimating capital requirements inevitably involves common sense and educated guesswork. Est $at !" Asset Re/% re$e!ts While estimating asset requirements involves some guesswork, the key to our effectively forecasting asset needs depends on an understanding of the relationship between pro:ected sales and needed assets. firm)s sales are the primary driving force of future asset needs. "hat is, as sales increase, there will be an increase in a firm)s asset needs, which in turn results in a need for more financing. "hese relationships are depicted graphically in &%hibit -.

$D

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Written by Bill Petty

E0HIBIT 5 SALES,ASSET,FINANCING RELATIONSHIPS

Increases in sales

result in

increases in asset requirements

result in

increases in financing requirements

0tated differently, asset needs tend to follow sales increases. /onsequently, a company)s asset needs may be estimated as some percentage of sales increases. "hat is, given that we have estimated our future sales, a ratio of assets to sales may be used to estimate asset requirements
ssets as a percentage of sales

(ssets Sales

5&q. 97

Restating the equation, ssets M 0ales C

ssets as a percentage of sales

5&q. L7

(or e%ample, if we believe that sales will be A$ million, and we know that within our industry, assets tend to run about =3 percent of sales, we could reasonably e%pect that the firm)s asset requirements will be A=33,333 5=3B % A$,333,3337. While the asset*to*sales percentage will vary over time and with individual firms to some e%tent, the relationship tends to be relatively constant. (or e%ample, the asset*to*sales relationship for grocery stores is on average around +3 percent, compared to about 9= percent for an oil and gas company. We may also use this method, which we shall call the 'erce!ta"e,o#,sa&es tec3! /%e, to pro:ect the individual asset investments. (or instance, we can e%pect there to be a relationship between the amount of accounts receivable and sales. "o
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Written by Bill Petty

illustrate how we could use the percentage*of*sales technique for forecasting purposes, consider the following e%ample. E(a$'&e Satie ;alton is planning to start a new business, "railer /raft, Inc., to produce small trailers to be pulled behind motorcycles. fter studying a similar company in a different state, she believes the business could generate sales of appro%imately A+=3,333 in the first year, and have significant growth potential in future years. Based on her investigation of the opportunity, she has also made the following pro:ections' $. &arnings after ta%es will be about $+ percent of sales# that is, A+=3,333 of sales should result in after*ta% profits of A-3,333 5$+B % A+=3,3337 "he requirements for cash, accounts receivable, and inventories have been estimated as a percentage of sales for the first year and are as follows'8 ssets /ash ccounts receivable Inventories -. Percentage of nnual 0ales =B $3B +=B

+.

;alton has searched for a manufacturing facility, and has found a building suitable for the needs of the business that is currently available at a reduced price, owing to a recent real estate downturn. "he building, along with the necessary equipment, will cost about A=3,333.

Instead of representing the assets as a percentage of sales, we frequently e%press the asset*sales relationship as a turnover ratio. "he turnover ratio is measured as 5sales T asset7 instead of 5asset T sales7. (or e%ample, instead of saying that inventories will be about += percent of sales, we could say that the inventories will !turn over! four times per year. "hat is,
Sales M D. )nventories

In our e%ample,
A+=3,333 M DD. )nventories

and therefore, Inventories M

A+=3,333 M A9+,=33, D

which provides the same answer as before. "hus, inventories would equal A9+,=33# the same answer as before, but :ust calculated a bit differently. $9 ;raft' $EDE+3$D

Written by Bill Petty

Kiven the anticipated sales of A+=3,333 and the above asset*to*sales relationships, the forecasted asset requirements for "railer /raft, Inc. are as follows' /ash ccounts receivable Inventories "otal current assets (i%ed assets 5machinery7 "otal assets A$+,=33 +=,333 9+,=33 A$33,333 =3,333 A$=3,333 5=B of sales7 5$3B of sales7 5+=B of sales7 5&stimated market price7

"hus, we could e%pect to need A$=3,333 in assets, some immediately and the rest as the firm continues in its first year of operation. While these amounts are only rough appro%imations, the estimates should be relatively close if we have identified the asset*to*sales relationships correctly and if sales materiali?e as e%pected. Est $at !" F !a!c !" Re/% re$e!ts By relying on the relationship between assets and sales, we have provided a way to estimate the firm)s asset requirements. 0omeone, however, must provide the money to purchase these assets. In other words, for every dollar of assets, there must be a dollar of financing. s our accountant would say, !"he debits must equal the credits, or for every use of cash, there must be a source of cash.! We now want to focus on the issue of the sources of financing, or what we call the firm)s financial requirements. /orrectly forecasting a company)s financial requirements requires an understanding of certain guidelines or principles of finance. (ive such guidelines may be stated as follows' $. T3e $ore assets !ee*e* ). a # r$6 t3e "reater t3e # !a!c a& re/% re$e!ts7 s already noted in &%hibit -, the asset requirements drive a firm)s financial requirements. "hus, the faster a firm is growing in sales, the greater will be its asset requirements, and, consequently, the greater the pressure to find the needed financing. A co$'a!. s3o%&* # !a!ce ts "ro2t3 ! a 2a. t3at a&&o2s t to $a !ta ! a certa ! a$o%!t o# & /% * t.. In business, & /% * t. is the ability to meet maturing financial obligations as they come due. conventional measurement of a company)s liquidity is its current ratio, which merely compares the firm)s current assets 5mainly cash, accounts receivable, and inventories7 to its current or short*term debt 5short*term liabilities7. "he current ratio is measured as follows' /urrent ratio M
current assets current liabilities

+.

5&q. 87
;raft' <anuary $=, $66-

Written by Bill Petty

(or instance, to insure that we have the ability to pay short*term debts as they come due, we might want to maintain a current ratio of two# that is, current assets are twice as much as current liabilities. -. T3ere s a & $ t as to 3o2 $%c3 *e)t a # r$ ca! %se ! # !a!c !" t3e )%s !ess7 "he amount of total debt, both long term and short term, is limited by the amount of equity provided by the owners. We cannot e%pect the bank to loan all the money needed to finance the company. @wners must put some of their own money into the venture. "hus, we may decide that at least half of the firm)s financing should come from equity and the remaining half be financed with debt. 5Bear in mind that if we do not make a decision in this matter, the banker will make the decision for us.7 So$e s3ort,ter$ *e)t )eco$es a-a &a)&e s'o!ta!eo%s&. as t3e # r$ "ro2s7 /ertain types of short*term debt are spontaneous in nature# thus the name s'o!ta!eo%s # !a!c !". "hat is, these sources will increase as a natural consequence of the firm)s sales increasing. (or instance, as sales increase, we will purchase more in inventories and accounts payable will increase. "he supplier is essentially satisfying some of the firm)s financing needs in the form of accounts payable. "he same thing is true for accruals, such as accrued wages. "ypically, these spontaneous sources of financing follow a certain percentage of sales. (or e%ample, spontaneous sources of financing might average $3 percent of sales. T3ere are t2o so%rces o# e/% t. ca' ta&: e(ter!a& a!* !ter!a&7 "he equity ownership of a company comes initially from the owners making an investment in the firm. We think of these funds as e(ter!a& e/% t.# that is, they come form outside the business itself. fter the company has been started and is in operation, additional equity may then come either from 5$7 the owners investing more in the business 5e%ternal equity again7, or 5+7 profits for the year, in whole or part, being retained within the company for future investments, rather than being distributed to the owners. "his latter source, the retention of profits within the company for investment purposes, is called !ter!a& e/% t.. "hese funds come not from going to investors and raising capital, but from reinvesting the company)s profits into the business ** money that could have been distributed to the owners, but instead was reinvested for them.6 (or the small firm, internal equity, which is merely the retention of profits for financing company growth, is t'e primary source of equity.

D.

=.

We should be careful not to think of retained earnings as a big bucket of cash. s already noted, a company can have a large amount of earnings, and no cash to reinvest. .ore about this problem later in /hapters +3 and +$. $8 ;raft' $EDE+3$D

Written by Bill Petty

In summary, a firm)s financing requirements, the money needed for operating and growing the company, comes from several sources, these being 5$7 e%ternal financing, either from borrowing money 5debt capital7 or from the owner)s investment 5equity capital7, 5+7 sources of spontaneous financing, such as accounts payable, and 5-7 internal financing, which comes from the profits retained within the business, rather than being distributed to the owners. &%pressed in equation form, we can say that' "otal asset requirements M total sources of financing and that 5&q. 67

( )( ) ( )
total sources e%ternal sources of financing of financing
M I

spontaneous sources of financing

profits retained in business

5&q. $37

"he foregoing equations capture the essence of forecasting financial requirements. If we understand these relationships, we will be prepared to forecast our firm)s financial requirements. n e%ample can best illustrate this process. E(a$'&e Fet)s return to the "railer /raft, Inc. e%ample, where we pro:ected the asset requirements for the firm during its first year of operations. ssuming sales, as forecasted, of A+=3,333, we estimated the following asset requirements' /ash ccounts receivable Inventories "otal current assets (i%ed assets 5machinery7 "otal assets A$+,=33 +=,333 9+,=33 A$33,333 =3,333 A$=3,333

We should also recall that profits for the year are estimated to be A-3,333, based on earning after ta%es per sales dollar of $+ percent 5i.e., $+B % A+=3,333 sales M A-3,333 profits7. In addition, Satie ;alton, as the prospective owner of the new company, has made the following observations' $. "railer /raft has negotiated with a supplier to e%tend credit on inventory purchases# as a result, it is e%pected that accounts payable will average about eight percent of sales.
;raft' <anuary $=, $66-

Written by Bill Petty

+. -. D.

ccruals should run appro%imately D percent of annual sales. ;alton plans to invest AD3,333 of her personal savings in the venture in return for +3,333 shares of common stock.$3 "he bank has agreed to provide a short*term line of credit to "railer /raft of A+3,333, which means the firm can borrow up to this amount as the need arises. >owever, as the firm has e%cess cash, it may choose to pay down the line of credit. (or instance, during the spring and summer, business is particularly active. In these months, "railer /raft may need to borrow the entire A+3,333 for buying inventory and e%tending credit to customers. >owever, during the winter months, a slack time, less money will be needed, so the loan balance could possibly be reduced. "he bank has also agreed to help finance the purchase of the building to be used in manufacturing and warehousing the firm)s product. @f the A=3,333 cost for the facilities and equipment, the bank will loan the company A-=,333, with the building serving as collateral for the loan. "he loan will be a +=*year mortgage. s conditions for the bank agreeing to loan the money to "railer /raft, Inc., the banker would impose two loan restrictions' 5$7 the firm)s current ratio 5current assets T current liabilities7, should not fall below $.L=, and 5+7 no more than 93 percent of the firm)s financing should come from debt, including both short term and long term# that is, total debt relative to total assets should not be greater than 93 percent. (ailure to comply with either of these terms would result in the bank loans coming due immediately.

=.

9.

(rom the foregoing information, we may estimate the financial sources for "railer /raft, Inc. as follows' $. +. -. ccounts payable' ccruals' /redit line' 58B % A+=3,333 sales7 5DB % A+=3,333 sales7 M M A-3,333 A$3,333

Per the agreement with the bank, "railer /raft, Inc. may borrow up to A+3,333. ny additional financing must come from other sources.

"he choice of a legal form of business is discussed in the ne%t chapter. (or now, we need only be aware that ;alton could have chosen between operating as a sole proprietorship or a corporation. (or reasons to be e%plained later, she chose to form a corporation. lso, there is no economic rationale for $3,333 shares# it could have :ust as easily been +3,333 shares. In either case, the total value of the equity ownership would be the same# only the value per share would be different +3 ;raft' $EDE+3$D
10

Written by Bill Petty

D. =.

Fong*term debt' &quity

"he bank has agreed to loan "railer /raft A-=,333 for the purchase of the real estate. By year end the firm)s equity should be around AL3,333, consisting of AD3,333 of the original investment in the company made by the owners, plus the pro:ected A-3,333 in profits after ta%es for the year that is to be retained within the company and not distributed to the owners H5$+B net income*to*sales7 % 5A+=3,333 sales7 M A-3,333J

Based on the foregoing information, we may now formulate the pro:ected debt and equity section of the balance sheet for "railer /raft, Inc., which also reflects the financial requirements for the firm for the first year of business. "hese financial requirements are shown in the bottom portion of &%hibit D, which contains "railer /raft)s complete pro:ected balance sheet. "wo comments need to be made about the final pro:ected balance sheet in &%hibit D.. (irst, as we have noted earlier, sources must al*ays e+ual uses, and assets must e+ual debt plus e+uity. (or "railer /raft, Inc., asset requirements were estimated to be A$=3,333 by year*end# thus, debt and equity must likewise equal A$=3,333. s a result, only A$=,333 of the A+3,333 credit line will be needed to bring the total debt and equity to

;raft' <anuary $=, $66-

Written by Bill Petty

E(3 ) t 8 Tra &er Cra#t6 I!c7 Pro9ecte* Ba&a!ce S3eet at Year E!* Assets /ash ccounts receivable Inventories "otal current assets (i%ed assets 5machinery7 "otal assets De)t a!* E/% t. ccounts payable' ccruals /redit line "otal current liabilities Fong*term debt "otal debt &quity' /ommon stock Retained earnings "otal equity "otal debt and equity A$+,=33 +=,333 9+,=33 A$33,333 =3,333 A$=3,333 A+3,333 $3,333 $=,333 AD=,333 -=,333 A83,333 AD3,333 -3,333 AL3,333 A$=3,333

A$=3,333. 0econd, if all goes as planned, "railer /raft would be able to satisfy the banker)s loan restrictions, both in terms of the current ratio and the debt*to*total asset relationship. (rom the balance sheet, we can compute these ratios as follows' /urrent ratio M
current assets current liabilities

M A$33,333 T AD3,3337 M +.++ and ;ebt ratio M

total debt M A83,333 T A$=3,333 M =-.-B total assets

>ence, the current ratio would be +.++, compared to a minimum requirement of $.L=, and the debt ratio would be =-.-B, compared to the ma%imum limit of 93 percent. Both outcomes would more than meet the bank)s requirements.
++ ;raft' $EDE+3$D

Written by Bill Petty

SUMMARY We have now completed our instructions on forecasting profits, and pro:ecting asset needs and financing requirements for the firm. We have covered a considerable amount of information regarding financial planning for the new company. "hus, before continuing on, it would be helpful to review the ma:or ideas we have developed. "hey are as follows' $. +. company)s operatin$ profitability is determined by the dollar sales level achieved and the mi% of fi%ed and variable operating e%penses. firm)s operating break*even point is a function of 5$7 the amount of fi%ed operating costs to be incurred, and 5+7 the firm)s contribution margin, that being the unit sales price less the variable unit cost. "here are two basic types of capital used in financing a company' debt financing and equity ownership. ;ebt financing is classified either as short term or long term, depending upon when it matures. lso, some short*term debt is spontaneous in nature# that is, it increases as a natural consequence of the firm)s growth in sales. &quity either comes from new investments in the firm by the owners or by retaining the firm)s profits and reinvesting these funds in the company. "here is a direct relationship between sales growth and asset needs. s sales increase, more assets are required. s assets increase, more financing is required. We may use the 'erce!ta"e,o#,sa&es tec3! /%e to forecast asset needs and then to forecast financial requirements. We must blend equity with debt in financing. s we increase the amount of debt, there must be a corresponding increase in the amount of equity, either through new investments in the firm by the owners or through retaining the profits in the business, which is a form of equity.

-.

D.

=.

;raft' <anuary $=, $66-