1.0 INTRODUCTION
If we were to ask
owners of businesses to identify their most pressing problem, there would be
varied responses. This might include meeting the rising cost of health care of
their employees,
managing change, finding quality employees, reducing high
turnover rate of staff, etc. Finance poses a critical problem to businesses; it
is the most pressing for new company start-ups and those still growing. This note,
therefore, examines financing of business venture under the following:
profitability and financing a new venture, determining the nature of financial
requirement, sources of finance and estimating the amount of funds required.
2.0 OBJECTIVES
By the end of this note, you should be able to:
·
explain profitability as it relates to financing a new venture
·
discuss the nature of financial requirements
·
discuss sources of business finance
·
explain how to estimate the amount of funds required.
3.0 MAIN CONTENT
3.1 Profitability and Financing a New Venture
Acquisition of a new venture does require us to think carefully
about the cash outflow: how we might raise money the new venture. In raising capital,
some basic questions or issues that must be addressed prior to actual soliciting
the funds. Among these issues are:
1. Forecasting a new company’s profit and for a new firm, determining
when it will achieve a breakeven point in terms of profits.
2. Understanding the nature of the asset and financing
requirements for a new firm.
3. Estimating the amount and basic type of the assets needed and financing
required for the new venture.
A key question for anyone starting a new business should be “How profitable
is the opportunity?” There are two questions in this regard;
1. How do we project the firm’s future profits?
2. At what point or sales volume will the venture breakeven (zero operating
profit)?
Forecasting Profit: A company’s profit is a primary source for financing future
growth. The more profitable a company is, all things being equal, the more
funds it will have for financing its growth. In the light of this, it becomes
imperative to be aware of the factors that drive profits so that we may make
the needed profit projections. In this regard, a company’s net income or net
profits are dependent on five variables.
1. Amount of Sales: The
assumptions made from about five sales determine the protections about a
company’s future profit.
2. Operating Expenses: This includes expenses such as the cost of acquiring the product
or the expenses related to marketing and distributing the product. It is
classified into expenses that do not vary as sales increase or decrease (fixed
operating expenses) and those that change proportion with sales (variable
operating expenses).
3. Interest Expenses: This is the amount expressed as a percentage of the principal,
paid to the owner plus the principal borrowed.
4. Taxes: The firm’s taxes are, for the most part, a percentage of taxable
income, where the rate increases as the amount of income increases.
Breakeven Analysis: If an investor is
starting up a company, he would certainly want to know how long it would take
the firm to become profitable. So it is with anyone investing in a new
business. Of course, they might want to know how many notes of the firm’s
product must be sold before it becomes profitable. Based on the sales forecast,
an investor will or may easily draw a conclusion about the time required to reach
profitability.
To measure a company’s breakeven point, we can use this equation.
QB = F where QB = Number of notes sold to break
even
P – V
F = The total fixed operating costs
P = The note selling price
V = The variable cost per note
From the above equation, we can deduce that the value of breakeven
sales = QB x P. This is how to forecast profits and to measure the breakeven point
in terms of profits.
3.2 Determining the Nature of Financial Requirements
The specific need of a proposed business venture governs 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. An analysis of capital requirements for this or any other type
of business must consider how to finance the following:
1. The needed investments and expenses incurred to start and grow the
company;
2. Any personal expenses if the owner does not have other income for
living purposes.
3.2.1 Start-up
Investment and Financing Requirements
To understand the
financing requirements for a new company, visualise a balance sheet where the
left-hand side of the balance sheet represents the assets owned by the company,
such as cash, accounts receivable and equipment. The right hand side comprises
the firm’s sources of financing that is those that provided the needed capital
for the business and how much.
A firm’s assets are generally classified into one of these
categories or types:
(1) Current assets (2) Fixed assets, and (3) Other assets. A brief
description of each of the asset categories is helpful in understanding the assets
needed in starting a new business.
1. Current assets compose the assets that have relatively liquid nature;
that is, within the firm’s operating cycle, these assets can be converted into
the following:
Cash: This the cash needed because of the uneven flow of funds into
the business (revenue) and out of business (expenditure). Even though it is good,
there is a limit to how much cash we want to keep in order to enjoy returns.
Accounts receivable: This consists of payments due from its customers. If the firm
expects to sell on a credit basis, and in many lines of business, provision
must be made for financing receivables.
Inventories: They constitute a major part of working capital. Seasonality of
sales and production affects the size of the minimum inventory for instance,
Christmas period.
Prepaid Expenses: When starting a company, we may need to prepay some of the
expenses for instance, 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.
In conclusion, current assets represent the company’s working
capital or quite often circulating capital.
2. Fixed Assets are the more permanent types of assets that are intended
for use in the business. They include machinery, equipment, buildings and land.
Type of business operation determines the nature and size of fixed asset
investment.
3. Other assets include items such as intangible assets- patents, copyrights
and goodwill. For a startup company, they could also include Organizational
costs – cost incurred in organising and promoting the business.
3.2.2 Funds for Personal Living Expenses
In many startup
businesses, we cannot limit planning to the business investments described in
the previous discussions. Frequently, financial provision must also be made for
the owners personal living expenses during the initial period of operation.
Inadequate provision for personal expenses will inevitably lead to a diversion
of business assets and a departure from the financial plan.
3.4 Estimating Required
Amount The uncertainties surrounding an entirely new venture make
estimation difficult. Even for established businesses, forecasting is never
exact. Nevertheless, when seeking initial capital, the entrepreneur must determine
how much capital is needed. The amount varies depending on the type or nature
of business. High technology companies require higher capital while most
service businesses require smaller amount.
3.5 Estimating required Asset Understanding the relationship between
projected sales and needed assets is vital for effective forecasting of asset
requirement. As sales increases, there will be an increase in a firm’s asset
needs, which in turn results in a need for more financing. A company’s asset
needs may be estimated as some percentage of sales increases. Therefore,
assets/sales if we believe that sales will be N1 million and we know that
within our industry, assets tend to run about 50 per cent of sales, we could reasonably
expect that the firm’s asset requirements will be N500, 000 (50 per cent
multiplied by N1million).
3.6 Estimating required Finance
We earlier provided a way to estimate the firm’s asset
requirement, but someone must provide the money to purchase these assets.
Accurate forecasting of a company’s financial requirements requires an understanding
of certain guidelines or principles of finance. Five of such guidelines may be stated as
follows:
1. The more assets needed by a firm, the greater the financial requirements.
2. A company should finance its growth in a way that allows it to maintain
a certain amount of liquidity. Liquidity is the ability to meet maturing
financial obligations as they become due. A conventional measure of liquidity
is the currency ratio = Current Assets ÷ current liabilities.
3. There is a limit as to how much debt a firm can use in
financing the business. The amount of debt is limited by the amount of equity
provided by the owners. It can be 50 per cent each.
4. Some short-term debts become available spontaneously as the firm
grows. Those debts are referred to as spontaneous financing.
5. There are two sources of equity capital: external and internal.
External sources are initial investments in the firm by the owners while the
internal sources are as a result of retention of profit.
4.0 CONCLUSION
A prospective investor should estimate the profitability of a potential
business, determine the nature of financial requirements, examine the types of
financial sources available and estimate the amounts of funds required before
embarking on any business venture.
5.0 SUMMARY
In this note, we have examined a considerable amount of
information regarding financial planning for the new company, thus it is
helpful to review the major ideas we have developed. A company’s operating
profitability is determined by the sales achieved and the firms’ operating
breakeven is when sales or revenue levels and when revenue exactly equal cost. Again,
there are two basic types of capital used for a business: debt financing and
equity ownership.
Debt can be long-term or
short-term while equity comes from initial owners investments or retained
profits. Furthermore, there is a direct relationship between sales growth and asset
needs. As sales increases, more assets are required. Finally, we must blend
equity with debt financing. As we increase the amount of debt, there must be a
corresponding increase for equity.
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