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Lecture 6

Week 6-8 - Entrepreneurial Finance Part 2.docx

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Laura Allan

Week 6 - Entrepreneurial Finance (Part 2) Evaluating Financial Performance  Why evaluate financial performance?  Principle 1 of entrepreneurial finance: Real human, and financial capital must be ‘rented’ from owners.  Want return on their investment  Principle 5 of entrepreneurial finance: A venture’s financial objective is to increase value.  Different analytical measures are important to different users at different stages… Analytical Measures  Development and Startup Issues:  How quickly the venture uses cash  Need to know how fast using cash as will need more (Cash Burn Rate)  The venture’s ability to meet short-term financial obligations (pay bills)  How liquid you are shows how fast you can pay bills  The length of the operating/working capital cycle  Operating Cycle: How long does it take to convert inventory to recievables to cash, how quickly can stay liquid  Working Cycle: The capital we work with to operate business  Additional Survival Issues:  The venture’s potential to employ and repay debt  Leverage  When we can take on more risk to earn a bigger return (bigger fixed costs)  Borrow assets to make more profit, risky as need to make more to cover borrowing  Taking on debt to try and make a bigger return on equity, debt less expensive  The venture’s ability to provide a return on invested capital?  Return/Profitability and Efficiency  How quickly and effectively you are using given assets to make a return Cash Burn Rates and Liquidity  Burn and Build balance each other; Liquidity is balance  Cash Burn Rate  How quickly a venture ‘burns through’/uses cash  Determine weeks of cash remaining  Cash Build Rate  How quickly a venture builds cash balances through collections on sales  Liquidity  The ability of the venture to maintain a build rate high enough to meet its obligations as they come due Measuring Burn and Build Rates  Cash Burn = the cash a venture expends on its operating and financing expenses and its investments in assets  Cash Burn = Cash Operating Expenses + Interest + Taxes + increase in Inventories – changes in Payables and Accruals + Capital Expenditures Cash Burn Rate = 45,000 – (27,000+1,000) + 50,000 = $606,000 (380,000+65000+39,000+27000+20000+8000) +  Cash Build = what the venture receives on its sales  Cash Build = Net Sales – Increase in Receivables =$575,000 – 30,000 = 545,000  Net Cash Burn – when cash burn exceeds cash build  = 606,000 – 545,000 = $61,000  Monthly Burn Rate  Monthly cash burn rate = $606,000/12= 50,500  – Monthly cash build rate = 545,000/12 = $45,417 = Monthly net cash burn rate = $61,600/12 = $5083  Given that the company has $5,000 in cash at the end of 2010, it has <1 month until it runs out of cash  Burn and Build Rates can also be determined using the Cash Flow Statement  Cash flow from operating activities and investing activities  Cash flow from operating and investing activities is negative, therefore net cash burn  =$11,000 + $50000 = $61,000 Liquidity  Compares assets the can be quickly converted to cash with liabilities that represent near-term needs for cash  Addresses long-term trends  We only use year-end figures  Deals with working capital management issues  Stuff we deal with on a daily basis, money we invest  Make sure we don’t go bankrupt  Current Ratio = average current assets / average current liabilities =1.37  Average current assets/liabilities = average of current assets/liabilities over the two years from the statements  ‘Rule of thumb’ >2, <4  Acid Test / Quick Ratio = average current assets – average inventories average current liabilities = .62  Much better liquidity measure than current ration  This looks at things that come back to cash quicker  ‘Rule of thumb’ >1  A receivable that has similar time frame to the payable  NWC (net working capital) to Total Assets Ratio = average current assets – average current liabilities average total assets = 14.7%  What do we have sitting in NWC in relation to the size of our business  The higher the percentage the greater the liquidity Interpreting Cash-Related Trends  What does this information tell you about the company?  Burning more cash than last year, and at a faster rate  Building more than last year, but not as fast as cash is being burned  Ratios are decreasing, probably has a lot to do with burn rate  Why did it happen?  Current ratio higher than quick ratio  slow moving inventory Conversion Period Ratios  Measure the average time in days required for non-cash current assets and selected current liabilities to create or demand cash  The faster assets can be converted into cash, the greater the liquidity (other things being equal)  Operating Cycle  Measures the time it takes to purchase raw materials, assemble a product, book the sale, and collect on it Measuring Conversion Times  Inventory-to-Sale Conversion Period = average inventory cost of goods sold/365 = 112.9 days  Sale-to-Cash Conversion Period (days of sales outstanding or average collection period) = average receivables net sales/365 = 57.2 days  Inventory-to-Sale + Sale-to-Cash conversion period = Average Operating Cycle = 170 days  Purchase-to-Payment Conversion Period = average payables + average accrued liabilities cost of goods sold/365 = 76.8 days  Inventory-to-Sale + Sale-to-Cash – Purchase-to-Payment conversion period = Cash Conversion Cycle (C ) = 93.2 days  The number of days of operation that must be externally financed  Bills have to be paid but money is tied up in the cycle  need to externally finance  Should be as close to 0 as possible Interpreting Conversion Trends  What does this information tell you about the company?  Cash conversion cycle has gone up, this is because purchase and payment is quicker  Why did it happen?  Economy slowed, not buying right stuff, not using inventories quickly  Could be a manufacturing firm having a production issue  wasted material, etc  Something to do with manufacturing, ability to sell, stocking of it  How is this related to the net cash burn rate?  This says I`m using up cash faster than I am building cash through sales Leverage 3)  Considers how the firm acquired external financing (to support the longer C  Measures the extent to which the firm has used debt and its ability to meet its debt obligations  What is the benefit of using debt vs equity?  Interest vs. dividends`  Interest is cost of using debt vs. dividends is the cost of using equity  Interest is cheaper in dividends, so the overall return is higher  Tax deductibility of interest is what makes it cheaper  Risk/return tradeoff  Risk of using debt is that you must pay it back, whereas you don’t have to pay dividends  Control vs. legal recourse  By selling more stock, diluting interest, takes away control  Using debt doesn’t give up control, but debtors have a legal reason to pursue Statements for Calculating Ratios  Interest cost $100,000 - tax savings $50,000 = real interest $50,000 / $1,000,000 debt = 5%, not 10% -- lower cost of capital  If return on capital is 15%:  A 15% return - 5% cost = 10% overall  B 15% return - 10% cost = 5% overall  But what about B’s greater net profit? Summary:  Low degree of leverage:  lower risk but higher cost of capital = lower return  High degree of leverage:  higher risk but lower cost of capital = higher return Other Ratios  Total Debt-to-Total Assets = average total debt / average total assets = 61.34%  Equity Multiplier = average total assets / average owners’ equity = 2.59 OR 1 / (1- total debt-to-total assets) >1/2 of assets supported by debt vs. equity  Debt-to-Equity = average total debt / average owners’ equity OR TD-to-TA / (1 – TD-to-TA) = 1.59  Current Liabilities-to-Total Debt = average current liabilities / average total debt = 64.88%  Interest Coverage = EBITDA / interest = 3.2x Earnings available to cover this could drop to 1/3 and you would be fine  Fixed Charges Coverage
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