Entrepreneurial Finance for Small Business (Third Edition) Review and Discussion Questions
chapter 2
Planning is a systematic process that takes us from some current state to some future desired state. Strategic planning is the development of long term plans for a business whereas functional plans use strategic plans to map out specific areas in a business
Goal setting is the precursor to a plan by which a measurable objective that can be reached in a specific time frame is set.
Planning, organizing, staffing, directing, and controlling operations
1. Establishing a standard if measurement; 2. measuring actual performance; 3. Taking corrective action when actual performance differs from established standards
Sole proprietorship – a business run solely by one person.
Partnership – an association of two or more persons who carry out business as co-owners for a profit
Corporations – a legal entity according to US law that ma may accomplish the same tasks as an individual
That a person is solely responsible for all claims held against them
In a general, each partner is personally liable for the acts of the partnership whereas in the limited only the general partners are liable but there can be investors in the business who are only liable for their share of the investment
You are not your own boss and there is usually a heft up front investment cost
Strength, weakness, opportunity, threats - strengths and weaknesses pertain to the internal working of the company whereas opportunity and threats are more related to external factors outside the company.
Cover sheet, statement of purpose, Financial data, supporting documentation, executive summary
Chapter 3
Returns and allowances = things that get returned to the company
Variable expenses are those expense over which you have some control and which change from month to month. Fixed expenses are those that a person has little control over and do not change that often.
An income statement shows what happened in a given accounting period with regards to revenues and expenses. It is broken into gross revenues minus returns and allowances which equals net sales; gross profit minus operating expenses which equals total operating income; and operating income minus interest which equals earnings before interest.
A corporation is subject to double taxation but can obtain leverage more easily.
A statement which indicates all items that are owned by the individual
I think that an income statement is done at least on a yearly basses whereas a balance sheet is ongoing and updated constantly.
Liquidity is the a measure of how fast an asset can be converted to cash, therefore, if all of your assets are tied up you do not have much liquidity and cannot scrounge up cash in a hurry
Current assets, fixed assets, liabilities and equity, owners or stockholders equity
Owners equity=total assets-total liabilities
A current asset can be converted into cash in a counting year, whereas fixed assets cannot, they have an expected life of more than one year, and tend to depreciate in accordance with tax laws.
A cash flow is a statement of working capital
Cash flows from operating expenses, Payments, Cash flows from investing activities, "" "" from financing activities, net increase in cash, cash balances
Because even though depreciation is shown, the item is always placed there at the value paid (book value)
Chapter 4
Vertical analysis – the process of using a single variable on a financial statement as a constant and determining how all other variable relate as a percentage of the single variable. It is very useful as a tool for the business owner as a monitoring tool because it is a rapid method of finding fluctuations in income statements or balance sheets and as a means of determining the financial health of the business.
Horizontal analysis – the process of determining the percentage increase or decrease in an account over a given time period. It is useful as a control tool to compare actual fluctuations with and established goal.
Ratio analysis – A relationship between variables, it is used to identify trends in the firms liquidity, leverage activity, profitability, and marketability. It is used to determine the health of a business especially business that are in the same industry
Lending, the business itself
Liquidity – determine how mush or a firms assets are available to meet short term claims
Current ratio =Current assets/current liabilities
Quick (acid test) = (current assets-inventory
Activity – indicate how efficiently a business is using its assets
Inventory turnover=COGS / (((beginning inventory) + (ending inventory)) /2 )
Indicates how efficiently a firm is moving its inventory
Accounts receivable turnover=Credit sales / accounts receivable
Allows someone to determine how fast their company is turning its credit sales into cash
Average collection period = days per year/accounts receivable turnover
Fixed asset turnover =net sales / fixed assets
Indicates how efficiently fixed assets are being used to generate revenue for a firm
Total asset turnover = net sales / total assets
Indicates how efficiently a firm uses its resources to generate revenue for the firm
Leverage – indicate what percentage of the business's assets is financed with credit
Debt-to-equity ratio=total liabilities / owners equity
Indicates what percentage of the owners equity is dept or for every dollar of equity, how many dollars of dept the firm owes
Dept to total assets ratio= total liabilities / total assets
indicates what percentage of a business's assets are owned by creditors
Times interest-earned = operating income / interest
Shows the relationship between operating income and the amount of interest in dollars the company has to pay to its creditors on an annual basis.
Profitability – are used by potential investors and creditors to determine how much of an investment will returned from either earnings on revenues or appreciation of assets. They are also used internally by managers to gauge how well their firms are performing
Gross profit margin = gross profit / net sales
Used to determine how much gross profit is generated by each dollar in net sales
Operating profit margin = operating income / net sales
Used to determine how mush each dollar of sales generates in operating income
Net profit margin = net profit / net sales
Tells how much a firm earned on each dollar in sales after paying all obligations, including interest and taxes
Operating return on assets = operating income / total assets
determines how much we are actually earning on each dollar assets before paying interest and taxes
net return on assets (ROA) = net profit / total assets
tells how much a firm earns on each dollar in assets after paying both interest and taxes
return on equity (ROE) = (net profit) / (total assets – total liabilities)
tells the stockholder or individual what each dollar of his or her investment is generated in net income
Market – used to compare firms within the same industry. They are primarily used by investors to determine if the should invest capital in a company in exchange for ownership
Earnings per share = (net income – preferred dividends) / (number of common shares)
Price earnings ratio = market price of stock / earnings per share
A magnification of earnings per share in terms of market price f the stock
Chapter 5 –
Efficiency – obtaining the highest possible return with the minimum use of resources
Effectiveness – accomplishing a specific task or reaching a goal
Profit – an absolute number earned on an investment
Accounting profit – what a business has left from its revenues after paying all expenses
Entrepreneurial profit – the amount earned above and beyond what the entrepreneur would have earned if you had had chosen to invest their time and money in a different enterprise.
Profitability – return on investments (calculated using net return on assets)
Earnings power – the product of the company's ability to generate income on the amount or revenue it receives (net profit margin) and it's ability to maximize sales revenue from proper assets employment (asset turnover) (= net profit * total asset turnover)
Financial leverage – financing a company using other peoples money the higher your liabilities, the greater your leverage and the lower your equity
Bankruptcy – occurs when the liabilities of the firm exceed the assets and the business lacks sufficient cash flow to make payment to creditors.
Chapter 11 – when a business seeks court protection while it develops a plan to pay off its creditors
Chapter 7 – requires liquidation of all assets of the business and payment to the creditors
Break even analysis is a process of determining how many unites of production must be sold or how much revenue must be obtained before someone breaks even.
Break even quantity = (fixed costs) / (price charged per unit – variable cost of producing)
Contribution margin = Price – variable cost
Break even dollars = (fixed costs + desired profit) / (1 – (variable cost/ price))
Chapter 6
A pro forma statement is used to project estimated financial information
1. determine the type; 2. determine the forecast horizon; 3. select one or more forecasting models; 4. evaluate the models; 5. apply the chosen model; 6. monitor the model to make sure it is still appropriate
Determines the effectiveness of a certain forecasting model
Judgmental uses only qualitative analysis and expert opinion where as time series uses only quantitative analysis to examine hard data. Causal models combine both in a cause and effect method.
Moving average model assumes that the actual sales for some recent time periods are the best predictors of future sales
Weighted moving average models assume that the closest time period is a more accurate predictor of future sales than previous time periods.
Exponential smoothing models use a smoothing constant as an adjustment in determining the forecast. A smoothing constant is a value assigned by the forecaster to adjust the forecast based on their assumptions of the relationship between sales in differing time periods.
Linear regression models use a set percentage of increase based on a fixed set beginning cost. This model is used for intermediate to long term forcasting.
By using previous data
Chapter 7
1. Compare gross working capital and net working capital.
Working capital consists of the current assets and the current liabilities of a business. Gross working capital is current assets and consists of cash, marketable securities, accounts receivable, and inventory. Net working capital is the different between a business's total current assets and its total current liabilities.
2. For most businesses, what does cash consist of?
Petty cash which is normally used to pay for small daily items much as postage or minor supplies; Cash on hand normally consists of daily sales and the amount of cash required for transactions (ex. cash in cash register); cash in back for checking; Cash in bank for savings;
3. In current asset management, what is the float? How would paying by check allow a business to take advantage of the float?
The float is the fact that paying for things by check allows you to continue to earn interest while the check is mailed and processed. The more time it takes to process, the more you earn interest on that payment.
4. List and describe at least three methods a business can use to speed receipt time from its debtors.
; Use of a lockbox so that checks can be immediately deposited into the agent's account; use of electronic funds transfer, which enables a business to immediately transfer from one fund to another; and making arrangements for banks to accept to the firm when banking customers make deposits in the bank.
5. What role do marketable securities play in current asset management?
Marketable securities are those investment vehicles that include U.S. treasury bills, government, government and corporate bonds, stock, and for a larger business, repurchase agreements, commercial paper, and banker's acceptances. This is a good way to earn more interest on extra cash than you could by just keeping the money in the bank.
6. What methods can be used by small businesses to speed the collection of money that is owed by them?
Use of factoring to receive immediate cash although slightly less of it
7. What are the three C's of credit? How do the serve as yard sticks for the credit evaluation?
Character, Capacity, Collateral. A customer's character is favorable if that customer has paid bills on time in the past and has good credit references from other creditors. Capacity to pay refers to whether the customer has enough cash flow or disposable income to pay back a loan or bill. Collateral is the ability to satisfy a dept or pay creditor by selling assets for cash. It is evaluated by determining if a market exits for the asset.
8. What corrective actions can be taken for customers whose outstanding balances do not adhere to the credit terms?
Usually monthly interest can be charged if the outstanding amount is not paid, the way that corrective actions are put in place is usually determined by the industry.
9. What is the ABC analysis with regard to inventory?
"A" items are raw materials or inventory items, "B" items are items that are the top 10-15% highest costing, and the remaining 75-80% stock numbers account for only 10-15% of the total costs ("C" items). The method of determining A, B, and C item costs is to take the total quantity purchased and multiply it by the unit cost. You then plug this into the following formula: (Total unit cost)/(total overall cost)*100=unit percentage.
10. List and describe three types of inventory.
Raw materials are the items that a company uses to create a product, Work-in-progress inventories consist of those items that are in the midst of the being created, Finished goods inventories consist of items that are actually sold by the business, Maintenance repair and operating (MRO) inventories consist of those items that are used by a company in normal operations, but are not then manufactured or sold.
11. How is a line of credit issued by a bank similar to a credit card?
With a line of credit, a credit limit is obtained, but obligations to make payments are not issued unless money is actually borrowed.
12. What is the difference between line of credit and short term loan?
With a loan, the entire sum of money is borrowed at one time and obligations are set to make monthly payments. A short term loan is usually used is a business has a very short term season.
13. If a firm does not provide for accrued liabilities, what problems may the firm face?
1-5 days late paying: 2%
6-15 days late 5%
16 or more days late 10%
14. Compare standard quantity discounts to cumulative quantity discounts.
Quality discounts are offered by vendors to increase their own flow when the offer discounts to customers who purchase items in large quantities whereas cumulative discounts normally are offered on total purchases of an item during the vender's fiscal year.
Chapter 9
1. What distinguishes a capital investment from other investments?
A capital investment is an investment in long term assets that cannot be easily converted (it takes over 1 year) whereas other investments do not have that same time restriction
2. List and briefly explain the five step capital budgeting process.
1. Formulate a proposal which serves as the purpose of identifying the various costs incurred and benefits received in after-tax cash flow;
2. Evaluate the data generated with respect to the benefits and costs to see whether the investment will be profitable
3. Make a decision about the data. Chose the course of action that will provide the greatest future benefits while minimizing the cost
4. Follow up on the capital budgeting decisions through a post-audit to see if the benefits received in reality exceed the additional costs incurred
5. Take corrective action if the post audit indicates that the benefits received are not meeting the expectations
3. What are the various costs that must be evaluated in evaluated in a capital budgeting decision?
Start-up costs are the total dollars spent to get a project under way.
Working capital commitment costs involve maintaining specific levels of working capital that are required by lending institutions.
Tax factor costs will result from additional taxes that have to be paid.
4. What are some tax-factor benefits of capital budgeting?
Those items that current tax law will allow you to deduct or write off once the new investment is made. Theses items include annual depreciation, interest on loans and/or investment tax credits.
5. List the advantages and disadvantages of the payback method.
Payback deals with the number of ears that it will take a business to get back the money that it has invested in a project or asset. The formula is:
Payback=(cost of the project [C])/(annual after-tax benefit of the project [ATB])
The advantages of payback are that it is easy to compute and simple to explain The disadvantages are that is does not consider the time value of money and it tends to lead to concentration on investment that satisfy immediate goals or those with a fast payback.
6. How does a company determine the interest rate it will use in making a NPV decision?
The Net Present Value method of capital budgeting uses the time value of money by discounting future benefits and costs back to the present. The calculations are made using an interest rate that matches the cost of capital for the investment. The two interest rates that must be considered are:
1. the interest rate charged by the supplier of funds or the lender
2. the interest rate that the borrower could receive by investing in some other enterprise.
7. What are three components used by a lender in determining the interest rate charged for a loan
Lenders use the following three components to determine an interest rate:
1. the real rate of return (the return that will be received after factoring out inflation
2. the inflation premium (the expected average inflation rate for the term of the investment)
3. the risk premium (the rate added to the interest rate to take into account the risk of the investment)
8. What is the actual cost of capital borrowed?
The cost of capital to the borrower consists of the opportunity cost on the amount of equity invested in the business. Therefore, both the lender's interest rate, and the borrower's opportunity, must be used to determine the interest rate for the net present value method of capital budgeting. These two rates are combined into a weighted average cost of capital (WACC)
9. Describe the process of calculating Net present value.
First the present value of the benefits is determined, including the benefits and costs. Then subtract present value of the costs to determine if there is a positive NPV.
NPV = PVB[present value of the benefits]-PVC[present value of the cost of the investment]
PVB=annuity[annual cash flow]*PVAF[present value annuity factor]
Weighted average cost of capital [WACC] = (equity cost)(equity %)+(Debt cost)(dept %)
10. List two advantages of using NPV
1. Future cash flows that would be paid and received can be discounted back to the present so that a decision on the investment can be made now. 2. Interest rates are determined by and based on the weighted average cost of capital that takes risk into account.
11. What is the relationship between NPV and profitability index?
The profitability index [PI] is the ratio of the present value of the benefits to the present value of the costs, calculated as: PI=PVB/PVC
A positive NPV result in a PI which is greater than one which is a good thing while a negative will result in a PI that is less than one.
12. What are the advantages of the profitability index method of index method budgeting?
It is easy to calculate once you have determined the PVB and PVC, it is easy to explain, and it provides a clear picture of cost-benefit analysis. The disadvantages are that it may give a false sense of security for a project if interest rate estimates are too low or cash flow estimates are too high.
13. How does the accounting rate of return differ from the internal rate of return?
The internal rate of return (IRR) is the actual rate of return of an investment and it uses the time value of money in its calculations. The IRR is the interest rate that mates the present value of the cost of the investment directly against the present value of the future benefits received.
IRR factor = (present value of the cost of the investment)/(period of cash flow)
The accounting rate of return is the average annual income from a project divided by the average cost of the project. This method basses it's rate of return on income and does not incorporate the time value of money or the present value of future cash flows.
ARR=(average annual income)/(average cost of investment over its life)
14. Um, yeah, I'm not going to answer that one
15. What are the differences between mutually exclusive, not-mutually exclusive, and capital rationing decisions?
Some investments are mutually exclusive because one is chosen and others are automatically sacrificed or excluded.
Investments that are not mutually exclusive are chosen because the have positive NPV's. A business can only invest in things that are not mutually exclusive if it has enough money.
Capital rationing is a constraint placed on the amount of funds that can be invested in a given time period.
16. What is the three step process of controlling?
1. establish standards for measuring a project
2. measure actual performance against the standards established
3. take corrective actions if required
The lowest total cost (LTC) method of capital budgeting is similar to the net present value method because it uses the time value of money by discounting future costs and benefits back to the present. The method used to determine the lowest present value of total cost is:
Include all costs associated with two or more competing investments
Calculate the present value of these costs.
Add the present value of an residual benefits (salvage value) that may be obtained on the investment
Select the investment with the lowest overall total cost