Chapter 8

Assessing a New
Venture’s Financial
Strength and
Viability
Bruce R. Barringer
R. Duane Ireland
Copyright © 2016 Pearson Education Ltd. 8-1
 Chapter Objectives
1 of 2

1. Learn about the importance of understanding the

financial management of an entrepreneurial firm.
2. Identify the four main financial objectives of
entrepreneurial firms.
3. Discuss the role of forecasts in projecting a firm’s
future income and expenses.
4. Explain the purpose of pro forma financial
statements.

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 Financial Management
• Financial Management
– Financial management deals with two things: raising money
and managing a company’s finances in a way that achieves the
highest rate of return
– This chapter focuses primarily on:
• How a new venture tracks its financial progress through
preparing, analyzing, and maintaining past financial
statements.
• How a new venture forecasts future income and expenses
by preparing pro forma (or projected) financial statements.
Pro forma financial statements, which include the pro forma
income statement, the pro forma balance sheet, and the pro
forma statement of cash flows, are extremely helpful to
firms in financial planning.
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 Financial Management
• Regardless of the quality of a product or service, a company
can’t be viable in the long run unless it is successful financially.
• Money either comes from external sources (such as investors or
lenders) or is internally generated through earnings. It is
important for a firm to have a solid grasp of how it is doing
financially.
• One of the most common mistakes young entrepreneurial firms
make is not emphasizing financial management and putting in
place appropriate forms of financial controls.
• Just because a firm is successful doesn’t mean that it doesn’t
face financial challenges, therefore entrepreneurs must be aware
of how much money they have in the bank and if that amount is
sufficient to satisfy their firm’s financial obligations

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 Financial Management

The financial management of a firm deals with questions

such as the following on an ongoing basis:

• How are we doing? Are we making or losing money?

• How much cash do we have on hand?
• Do we have enough cash to meet our short-term obligations?
• How efficiently are we utilizing our assets?
• How do our growth and net profits compare to those of our industry peers?
• Where will the funds we need for capital improvements come from?
• Are there ways we can partner with other firms to share risk and reduce the
amount of cash we need?
• Overall, are we in good shape financially?
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Financial Objectives of a Firm

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 Financial Objectives of a Firm

a) Profitability
– Is the ability to earn a profit.
• Many start-ups are not profitable during their first one to three
years while they are training employees and building their brands.
• However, a firm must become profitable to remain viable and
provide a return to its owners.
b) Liquidity
– Is a company’s ability to meet its short-term financial obligations.
• Even if a firm is profitable, it is often a challenge to keep enough
money in the bank to meet its routine obligations in a timely
manner.
• To do so, a firm must keep a close watch on accounts receivable
and inventories.
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 Financial Objectives of a Firm

c) Efficiency
– Is how productively a firm utilizes its assets relative to its revenue
and its profits.

• Southwest Airlines, for example, uses its assets very

productively. Its turnaround time, or the time its airplanes sit
on the ground while they are being unloaded and reloaded, is
the lowest in the airline industry.

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 Financial Objectives of a Firm

d) Stability
– Is the strength and vigor of the firm’s overall financial posture.
•For a firm to be stable, it must not only earn a profit and remain liquid
but also keep its debt in check.
•If a firm continues to borrow from its lenders and its debt-to-equity ratio,
which is calculated by dividing its long-term debt by its shareholders’
equity, gets too high, it may have trouble meeting its obligations and
securing the level of financing needed to fuel its growth.

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 The process of Financial Management

• To assess whether its financial objectives are being met, firms rely
heavily on analyses of financial statements, forecasts, and budgets. A
financial statement is a written report that quantitatively describes a
firm’s financial health. The income statement, the balance sheet, and the
statement of cash flows are the financial statements entrepreneurs use
most commonly.
• Forecasts are an estimate of a firm’s future income and expenses, based
on its past performance, its current circumstances, and its future plans.
New ventures typically base their forecasts on an estimate of sales and
then on industry averages or the experiences of similar start-ups
regarding the cost of goods sold (based on a percentage of sales) and on
other expenses.
• Budgets are itemized forecasts of a company’s income, expenses, and
capital needs and are also an important tool for financial planning and
control
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Copyright © 2016 Pearson Education Ltd. 8-11
 Forecasts
• Forecasts
– The analysis of a firm’s historical financial statements are followed
by the preparation of forecasts.
– Forecasts are predictions of a firm’s future sales, expenses,
income, and capital expenditures.

• A firm’s forecasts provide the basis for its pro forma financial
statements.
• A well-developed set of pro forma financial statements helps a
firm create accurate budgets, build financial plans, and manage
its finances in a proactive rather than a reactive manner.

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 Forecasts
• Forecasts
Completely new firms typically base their forecasts on a good-faith
estimate of sales and on industry averages (based on a percentage of
sales) or the experiences of similar start-ups for cost of goods sold and
other expenses. As a result, a completely new firm’s forecast should be
preceded in its business plan by an explanation of the sources of the
numbers for the forecast and the assumptions used to generate them.
This explanation is called an assumptions sheet

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 Forecasts

• Sales Forecast
• A sales forecast is a projection of a firm’s sales for a specified
period (such as a year). though most firms forecast their sales
for two to five years into the future.
– It is the first forecast developed and is the basis for most of
the other forecasts.
• A sales forecast for a new firm is based on a good-faith estimate of
sales and on industry averages or the experiences of similar start-ups.
• A sales forecast for an existing firm is based on (1) its record of past
sales, (2) its current production capacity and product demand, and (3)
any factors that will affect its future product capacity and product
demand.

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 Financial Statements
• Historical financial statements reflect past performance and are usually
prepared on a quarterly and annual basis.
• Historical financial statements include the income statement, the balance
sheet, and the statement of cash flows. The statements are usually prepared in
this order because information flows logically from one to the next. In start-
ups, financial statements are typically scrutinized closely to monitor the
financial progress of the firm. On the rare occasion when a company has not
used financial statements in planning, it should prepare and maintain them
anyway. If a firm goes to a banker or investor to raise funds, the banker or
investor will invariably ask for copies of past financial statements to analyze
the firm’s financial history. If a firm does not have these statements, it may be
precluded from serious consideration for an investment or a loan.
• Pro forma financial statements are projections for future periods based on
forecasts and are typically completed for two to three years in the future. Pro
forma financial statements are strictly planning tools. In fact, most companies
consider their pro forma statements to be confidential and reveal them to
outsiders, such as lenders and investors, only on a “need-to-know” basis.

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 Pro Forma Financial Statements

• Pro Forma Financial Statements

– A firm’s pro forma financial statements are similar to the
historical statements that an established firm prepares,
except they look forward rather than track the past.
– The preparation of pro forma financial statements helps a
firm rethink its strategies and adjust if necessary.*
­ A firm’s pro forma financial statements should not be prepared
in isolation. Instead, they should be created in conjunction with
the firm’s overall planning activities.**
– The preparation of pro forma financials is also necessary if a
firm is seeking funding or financing.
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 Pro Forma Financial Statements

• Pro forma financial statements include the pro forma

income statement, the pro forma balance sheet, and the
pro forma cash flow statement.
• They are usually prepared in this order because
information flows logically from one to the next.
• Most experts recommend three to five years of pro
forma statements. If the company you’re writing your
plan for already exists,
• Start-ups should also include three years of historical
financial statements.
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Types of Pro Forma Financial Statements

Financial Statement Purpose

Pro Forma Income Shows the projected financial results of the

Statement operations of a firm over a specific period.

Shows a projected snapshot of a company’s

Pro Forma Balance assets, liabilities, and owner’s equity at a specific
Sheet point in time.

Pro Forma Statement Shows the projected flow of cash into and out of a
of Cash flows company for a specific period.

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