ENTREPRENEURIAL

FINANCE

SIMON HULME • CHRIS DREW

CONTENTS

Preface xvi
Acknowledgements xviii

Part 1 INTRODUCTION

1.1 THE PURPOSE OF ACCOUNTS AND FINANCIAL MANAGEMENT 3

Business Survival Rates 4
Reasons That Businesses Fail 5
Accounting and Finance: What Is It All About? 5

1.2 SETTING THE SCENE 8

The Concept of Double Entry 8
Types of Accounts 9
Financial Statements 9
The Accounting Equation 10
Cash Versus Accrual Accounting 11
The Basic Principles of Accounting 11

Part 2 PROFIT & LOSS

2.1 THE PROFIT & LOSS STATEMENT 17

The Vital Importance of the Profit & Loss Statement 17
The Profit & Loss Statement Is for a Period of Time 17
The Five Levels of Profit 19
Confusing Terminology 20
Taxation and the Profit & Loss Statement 20
Value Added Tax (VAT) 21
Level 1 – Gross Profit 22
Level 2 – EBITDA 24
Operating Expenses 25
Controversies and Weakness of EBITDA 26
Level 3 – Operating Profit 27
What Question Might You Now Want to Ask? 28
Introducing Return on Capital Employed 29
Level 4 – Profit Before Tax 30
Why Is It the Most Comprehensive Profit Definition? 30

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Level 5 – Profit After Tax 30

Corporation Tax 31
Examples of Profit & Loss Statements 32
Burberry Group Plc 32
Netflix, Inc. 33
The Five Levels of Profit Summary 35

2.2 THE IMPORTANCE OF GROSS PROFIT 38

Gross Profit and the Cost of Sales Calculation 38
Café Example 38
Service Businesses 39
Software as a Service (SaaS) Businesses 41
Allocating Some Fixed Costs to Cost of Sales 41
Calculating Cost of Sales for the Profit & Loss Statement 42
Valuation of Stock 43
Gross Profit by Product Line 44
Tracking Gross Margin 45
What Could Cause the Gross Margin to Decline? 45

2.3 PRODUCT PRICING STRUCTURES 48

Pricing Structures 48
Simple Margin Structure 48
More Complex Pricing Structure 49
Raising Prices to Customers 50
Margins and Mark-ups 50
Product Mark-up Definition 50

2.4 ACCRUAL ACCOUNTING 53

The Revenue Recognition Principle 53
Deferred Income 53
Accrued Income 54
The Matching Principle 55
Prepayments & Accruals 55

2.5 DEPRECIATION 57
Depreciation and the Profit & Loss Statement 57
How Depreciation Impacts the Different Financial Statements 57
Depreciation and Corporation Tax 58
Amortisation 58
Straight Line Depreciation 58
Reducing Balance Depreciation 59
Other Methods of Depreciation 61
Depreciation Is Only an Estimate 61

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Disposal of Assets 61
Effect of Extending Depreciation Periods Beyond Useful Life 62

2.6 BREAK-EVEN ANALYSIS 64

What Is the Break-Even Point? 64
Why Knowing the Break-Even Point Is Useful 64
The Different Types of Costs in a Business 64
Fixed Costs 65
Variable Costs 65
Drawing Break-Even Charts 65
Examples of Profit- and Loss-Making Businesses 67
Business Making a Profit 67
Business Making a Loss 68
Business with a High Gross Margin 68
Business with a Low Gross Margin 68
The Break-Even Point Formula 69
Break-Even Point in Terms of Number of Customers 70
Inclusion of Depreciation and Interest Costs in Fixed Costs 70
Variable Costs and the Break-Even Formula 71
Service Businesses with 100% Gross Margin 71
Corporation Tax and the Break-Even Formula 71
Break-Even Analysis Using Excel 72
Margin of Safety Concept 73
Businesses in Difficult Sales Environments 74
Experience of Cook Trading 75
What Can We Learn from Cook Trading’s Experience? 76
Limitations of Break-Even Theory 77
Relevance of Volume as a Measure 77
Fixed Costs Usually Rise in Jumps 77
The Total Cost Line May Be Curved 78

2.7 THE STOCK MARKET & PROFITABILITY 80

The Drivers of Share Prices 80
Earnings Per Share 80
P/E Ratio 81
Quality of Earnings 82

Part 3 THE BALANCE SHEET

3.1 THE BALANCE SHEET STATEMENT 85

The Balance Sheet Is on a Particular Day 86
The Balance Sheet Formula 86
Debits and Credits 88

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3.2 A TOUR OF THE BALANCE SHEET 91

Non-current Assets 92
How Non-current Assets from the Balance Sheet Impact
the Profit & Loss Statement 93
Treatment of Property in UK Accounts 94
How Non-current Assets from the Balance Sheet Impact
the Cash Flow Statement 95
Intangible Assets 95
Current Assets 96
Stock (Inventory) 96
How Stock from the Balance Sheet Impacts the Profit
& Loss Statement 97
How Stock from the Balance Sheet Impacts
the Cash Flow Statement 97
Debtors (Receivables) 97
Cash 98
Current and Long-Term Liabilities 99
Time Period Differentiation Between Current & Long-Term
Liabilities 100
Current Liabilities (Payables) 100
Future Interest Payments Are Not Included 101
Accruals 101
Deferred Income 102
Long-Term Liabilities 102
Capital and Reserves 103
Called Up Share Capital 103
Share Premium 104
Share Capital Can Be Tiny 104
Revaluation Reserve 104
Impairment Losses 105
Retained Earnings 106
Retained Earnings Are Cumulative 107
Conversion of Retained Earnings to Share Capital 107
Retained Earnings and Dividends 107
Further Examples of How Transactions Affect the Balance Sheet 108

3.3 ANALYSING THE BALANCE SHEET 110

Tulip Greeting Cards’ Profit & Loss Statement 110
Profitability and the Balance Sheet 111
Return on Equity 111
Return on Capital Employed 112
Cash and Capital Employed Calculation 113
Confusion Between Capital Employed and Net Assets 113
Significance of Return on Capital Employed 114
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Why Operating Profit is Used in Return on Capital Employed

Calculation 115
Liquidity Ratios 115
The Current Ratio 116
The Quick Ratio 116
Gearing Ratios 118
Debt to Equity Ratio 119
Debt to Capital Ratio 119
Interest Cover Ratio 120
Operational Gearing 120

3.4 BALANCE SHEET EXAMPLES 122

easyJet’s Balance Sheet 122
Vulpine Performance Limited 125
Profitability 126
Funding 127
Liquidity 127
Burn Rate and Runways 128

3.5 RETURNING TO THE BALANCE SHEET FORMULA 130

The Differing Balance Sheet Values 130
The Differing Perspectives 131

Part 4 CASH FLOW MANAGEMENT & FORECASTING

4.1 THE CASH FLOW STATEMENT 135

Presenting Cash Flow 135
The Direct Method 136
The Indirect Method 137
Debits & Credits 138

4.2 THE CASH CONVERSION CYCLE 141

The Stock Period 142
Measuring the Stock Period 142
The Debtor Period 143
Measuring the Debtor Period 144
Creditor Period 145
Measuring the Creditor Period 145
Calculating the Cash Conversion Cycle 146
The Cash Conversion Cycle Formula 146
Businesses with a Positive Cash Conversion Cycle 147
Free Cash Flow 148
Free Cash Flow and Capital Investment Appraisal 150
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4.3 IMPROVING CASH FLOW 151

Start with the Business Concept! 151
Our Top 10 Ways in Which You Can Improve Your Cash Flow 151
Moody Sewage Example 154

4.4 THE CASH FLOW FORECAST 156

The Importance of Cash Flow Planning 156
The Cash Flow Forecast 156
Timeframe for a Cash Flow Forecast 157
The Cash Flow Forecast Is the Product of a Financial Model 157

4.5 BUILDING A FINANCIAL MODEL 160

Your Starting Point 161
Carl’s Café 161
Davis Design 161
The Financial Modelling Process 162
General Principles of Financial Models 163
Rule 1: K.I.S.S. – Keep It Simple, Stupid! 163
Rule 2: Your Forecast Is Wrong 163
Rule 3: You’re Damned Either Way 164
Make Your Model Easy to Use 165
Treatment of Inflation 165
Assumptions in the Financial Model 166
Fixed and Variable Assumptions 166
More Complex Sales Assumptions for a Multi-product Business 167
More Complex Sales Assumptions for a Consultancy-Type
Business 168
The Profit & Loss Forecast 169
The Cash Flow Forecast 170
Cash Flow from Operations 170
Cash Flow from Investing Activities 171
Cash Flow from Financing Activities 172
Generating the Forecast Bank Balance 172
The Indirect Method as an Alternative 173
The Balance Sheet Forecast 173
The Difference Check Line 174
Summary and Graphs 176
Ratios 176
Graphs 177
Some Final Thoughts About Financial Modelling 178

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Part 5 FINANCIAL CAPITAL

5.1 SOURCES OF CAPITAL 181

Equity Versus Debt 181
Grants and Tax Credits 182
Are You Ready for Funding? 182
Advantage of Self-Funding 183

5.2 DEBT FUNDING 184

Term Loans 186
Typical Features of a Term Loan 186
Personal Guarantees 187
Overdrafts 188
Typical Features of an Overdraft Facility 188
Directors’ Loans 189

5.3 UNDERSTANDING SHARE CAPITAL 191

Different Types of Share Capital 191
Ordinary Shares 191
Preference Shares 192
The Different Equity Rounds 192
Issues of Share Dilution and Control 195
Up Rounds and Down Rounds 195
Convertible Notes 196
Enterprise Investment Scheme (EIS) 197
Convertible Notes and EIS/SEIS 199

5.4 SOURCES OF NEW EQUITY FUNDING 200

‘Friends, Family and Fools’ 200
Business Angels 202
Most Important Investment Criteria to Angels 203
Cost of Angel Funding 203
Double Dutch Case Study 204
Crowdfunding 205
Private Equity and Venture Capital 206
Venture Capital Funds 206
Corporate Venture Capital 207
Accelerator Programmes 207
Envio Case Study 208

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Other Venture Funding 209

Family Offices 209
Sovereign Wealth Funds 209
Stock Markets 209

5.5 THE EQUITY FUNDING PROCESS EXPLAINED 211

The Process in Outline 211
The Term Sheet 212
Economics of the Term Sheet 213
Price 213
Warrants 213
Liquidation Preference 213
Liquidation Preference with Multiples and Caps 216
Pay-to-Play 217
Vesting 217
Option Pool 218
Anti-dilution 218
Vungle Case Study 219
Control Terms in the Term Sheet 220
The Board of Directors 220
Shares 221
Management Reporting 221
Dividends 221
Confidentiality and Non-compete 221
Consent on Key Decisions/Events 221
Drag and Tag 222
Deal Exclusivity 222
Other Key Documents 223
The Cap Table 223
Articles of Association 223
The Shareholders’ Agreement 224
The Contractual Process 224
Due Diligence 224
Investor Agreement, or Sale and Purchase Agreement 225
Amendments to Articles of Association and Shareholders’
Agreement 225
Warranties and Indemnities 225

Part 6 CAPITAL INVESTMENT APPRAISAL

6.1 INTRODUCING CAPITAL INVESTMENT APPRAISAL 229

The Interrelationship Between Risk, Return and Time 229
Risk and Return 229

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Return and Time 230

Risk, Return and Time All Together 231
Overview of Appraisal Methods 231
Payback Method 232
Net Present Value (NPV) Method 232
Internal Rate of Return (IRR) Method 232
Choice of Metric to Use in Appraisal 232
Opportunity Cost Concept 233

6.2 THE PAYBACK METHOD 235

Example: Investment in Machinery 235

6.3 NET PRESENT VALUE 237

The Net Present Value Concept 237
The Net Present Value Calculation 238
Calculating the Net Present Value (NPV) 239
An Important Note About the Way Excel ‘Thinks’ 241
What If the NPV Is Zero? 242
Confusion Between Present Value and Net Present Value 242
An Enhanced Version of NPV 242

6.4 INTERNAL RATE OF RETURN 244

Calculating the IRR 244
The Hurdle Rate 245
Modified Internal Rate of Return 246

6.5 ESTABLISHING THE DISCOUNT RATE 248

Factors Which Will Influence the Discount (or Hurdle) Rate 248
The Cost of Debt Funding 249
The Cost of Equity Funding 249
Establishing the Discount Rate for Combination of
Debt and Equity Funding 250
Impact of Gearing on the Weighted Average Cost of Capital 251
When a Higher Discount Rate Leads to a Higher NPV 251

6.6 APPLICATIONS OF CAPITAL INVESTMENT APPRAISAL 253

Payback Method Limitations 253
IRR Method Limitations 253
Scale of Investment 253
Duration of Investments 254
Bias Towards Earlier Returns 254
Other Issues 254
NPV Method Is Most Reliable 255
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A Word About Inflation 255

Powerful Uses of Discounted Cash Flow Modelling 256
Company and Share Price Valuations 256
Evaluating an Angel Investment – Vulpine Performance Ltd 256
Vulpine’s History of Poor Performance 258
What Actually Happened to Vulpine 258
What Can We Learn from Vulpine? 259
Uses in Negotiation 259
Key Lessons from Frame Express 260

Part 7 RUNNING A FINANCIALLY INTELLIGENT BUSINESS

7.1 A FINANCIALLY INTELLIGENT BUSINESS 265

Good or Bad Performance? 266
Tesco’s Result in 2012 266
Setting the Benchmark 266
Benchmarking Beyond the Profit & Loss Statement 267

7.2 THE ANNUAL BUDGETING PROCESS 268

The Difference between Budgets and Targets 268
Love Taste Company Example 269
Fixing the Budget for the Year Ahead 269
The Rolling Forecast 270
What If the Budget for the Rest of the Year Looks Unrealistic? 271
The Cash Flow Forecast 271
Looking Beyond the Year-End 272
Circumstances When the Budget Can Be Changed 272
The Annual Budgeting Process Steps 273
Internal Management Process 274
Sales Revenue Plan 274
Cost Structure Responsibilities 274
The CEO Now Throws a ‘Wobbly’ 275
Avoid Creating an Excel Beast 276

7.3 MANAGEMENT ACCOUNTS 278

Accounts Unfit for Purpose 278
The Ideal Template for Management Accounts 280
Moody Sewage Example 281
Gartenart Swimming Ponds Example 283

7.4 TRAILING 12 MONTH GRAPHS 285

What Is a T12M Graph? 285
Your Business has Just Shrunk! 286
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T12Ms for Major Customers 286

T12Ms for Individual Product Lines 287
T12Ms and Departmental Costs 288
Looking at the Actual T12M Cost in Pounds 288
Looking at T12M Cost as a Percentage of Sales 288
Plotting Both Simultaneously 289
Dealing with Uneven Seasonality 289
Creating Your Own T12Ms 290
Creating Your Own Profitability Map 290
Using Profitability Mapping with T12Ms 291

7.5 LOOKING TO THE FUTURE 293

Housing Starts and Completions in the US 293
Tracking Your Forward Order Book 294
Five Star Financial Intelligence 294

Appendices 297
Glossary 321
Index 337

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