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Financial Preparation for Week 10

Entrepreneurial Ventures

LEARNING OUTCOMES

At the end of the lesson, the students should be able to:

• Explain the principal financial statements needed for any

entrepreneurial venture
• Outline the process of preparing an operating budget
• Discuss the nature of cash flow and explain how to draw up such
a document
• Describe how the projections of a firm’s financial position during
a future period are prepared

RESOURCES NEEDED

For this lesson, you would need the following resources:

• ENT101-Lecture Materials-Week 10
• Links to videos
• Links to websites
• Reference materials

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The Importance of Financial Information for

Entrepreneurs

Today’s entrepreneur operates in a competitive environment characterized by the constraining forces of

governmental regulation, competition, and resources. Three kinds of resources are available to the
entrepreneur: human, material, and financial.
This module focused on financial resources in the entrepreneurial environment.
Financial information pulls together all the information presented in the other segments of the business:
marketing, distribution, manufacturing, and management.

Most important concepts:

• Working capital – the capital you have available to work with today. This is determined by subtracting
current liabilities from current assets.
• Revenue – know your sales on a monthly, quarterly, and year-to-date basis. Compare these to your financial
plan/budget to see if you are behind or ahead.
• Gross profit – your gross profit is your revenue less the direct costs of producing your product or service.
By completing a capacity calculation you will be able to assess your target gross profit and consider ways to
improve the margin.
• Expenses – know these numbers and be prepared to adjust them to the current business environment.
Watch for wastage and regularly check for better deals from suppliers.
• Net profit – subtract the total of your overhead expenses from your gross profit to get net profit. Look at
this as a percentage of sales. This number will tell you how profitable the business is. If the number is
negative, you are losing money.

UNDERSTANDING THE KEY FINANCIAL STATEMENTS:

Financial Statements are powerful tools that entrepreneurs can use to manage their ventures. The basic
financial statements an entrepreneur needs to be familiar with are the balance sheet, income statement,
and cash flow statement.

• The Balance Sheet. A financial statement that reports a business’s financial position at a specific
time.

Two Parts:
1. Financial resources owned by the firm
2. Claims against resources

The claims against the resources come from two groups :

o Creditors who have a claim to the firm’s assets and can sue the company if these obligations
are not paid
o Owners who have the rights to anything left over after the creditors’ claims have been paid

• ASSETS. The financial resources the firm owns; including cash, stock, equipment, money owed to
the business, goodwill

• LIABILITIES. The claims that creditors have against the company; including loans, credit card
debts, tax liabilities, money owed to suppliers

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• OWNERS’ EQUITY. The residual interest of the firm’s owners; the amount left after liabilities are
deducted from assets

Note:
When all three are placed on the balance sheet, the assets are listed on the left and the liabilities and
owners’ equity are on the right.
The balance sheet follows the traditional accounting equation:

Assets = Liabilities + Shareholders’ Equity

Or, put another way:
Assets - Liabilities = Shareholders’ Equity

An Asset is something of value the business owns. The owner/manager must do the following:

1. Identify the resource

2. Provide a monetary measurement of the resource’s value.
3. Establish the degree of ownership in the resource.

Most assets can be identified easily. They are tangible, such as CASH, Land, and Equipment. Intangible
assets also exist they are Copyright and patents for example.

Liabilities are the debts of the business. This is divided into two categories:
Short-term- called current liabilities. Those that must be paid during the coming 12 months.

Sample Assets, Liabilities

ASSETS
Current Assets
Cash 20,000
Accounts receivable 15,000
Inventory 150,000
Total Current Assets 185,000

Non-Current Assets
Plant and equipment 50,000
Business premises 650,000
Vehicles 70,000
Total Non-Current Assets 770,000

TOTAL ASSETS 955,000

Current Liabilities
Accounts payable 25,000
Bank overdraft 10,000
Credit card debt 5,000
Tax liability 30,000
Total Current Liabilities 70,000

Non-Current Liabilities

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Long term business loan 1 450,000

Long term business loan 2 50,000
Total Non-Current Liabilities 500,000

TOTAL LIABILITIES 570,000

NET ASSETS 385,000

OWNERS EQUITY 385,000

Long-term – those that are not due and payable within 12 months such as a Mortgage on a building or a five-
year bank loan.

Owners’ Equity remains after the firm’s liabilities are subtracted from its assets; it is the claims the owners
have against the firm’s assets. If the business loses money, its owner’s equity will decline.

PREPARING FINANCIAL BUDGETS

Budget is one of the most powerful tools the entrepreneur can use to plan financial operations.
Common types of Budget :
• The Operating Budget - is a financial statement of estimated income and expenses over a specified
period.
• The Cash Flow Budget- a statement of estimated cash receipts and expenditures over a specified
period.
• The Capital Budget- which is used to plan expenditures on assets whose returns are expected to
last beyond one year

The operating budget

The operating budget is made up of a variety of forecasts, including sales forecasts, expense
forecasts, production forecasts, and operating forecasts
• Sales Forecast- the first step in creating an operating budget.
• Expense forecasts- after a fi rm has forecast its sales for the budget period, expenses must be
estimated.

Here is how John Wheatman determines his store’s expected purchases and inventory requirements:

For determining his purchase requirements, John Wheatman believes his gross profit will represent 20 percent of his sales dollar.
This is based on an analysis of the past five years’ income statement.

Consequently, the cost of goods sold will represent 80 percent of the sales for the current month. In addition, John wants to have
approximately one week’s inventory on hand. Thus the ending inventory is estimated to be 25 percent of next month’s sales.

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Table 10.1

• Production forecasts- The production budget is management’s estimate of the number of units that
need to be produced to meet the sales forecast.
Ex.

Tom B. Good, president and founder of General Widgets, has decided to implement a budget to help plan for his company’s
growth. After receiving the unit sales forecast from his sales manager, Tom examined last year’s product movement reports and
determined that he would like to have 10 percent of the next month’s sales on hand as a buffer against possible fluctuations in
demand. He has also received a report from his production manager that his ending inventory this year is expected to be 12,000
widgets, which will also be the beginning inventory for the budget period.

Table 10.2

After the production budget has been calculated, the materials required for producing the specified number
of units can be determined from an analysis of the bill of materials for the product being manufactured. In
addition, by examining the amount of direct labor needed to produce each unit, management can determine
the amount of direct labor that will be needed during the forthcoming budget period

• Operating Expenses- the last step in preparing the operating budget is to estimate the operating
expenses for the period.
o A fixed cost does not change in response to changes in activity for a given period.
▪ Ex, rent, depreciation, and certain salaries
o A variable cost changes in the same direction as, and in direct proportion to, changes in
operating activity.
▪ Ex. Direct labor, direct materials, and sales commissions

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After the expenses have been budgeted, the sales, cost of goods and expense budget are combined to form
the operating budget.

Table 10.4 outlines Wheatman’s Market’s anticipated expenses for the budget year and the completed
operating budget for the period. Each month represents the pro forma, or projected, income and expenses
for that period

Table 10.4

To identify the behavior of the different expense accounts, John Wheatman decided to analyze the past five
years’ income statements. Following are the results of his analysis:
• Rent is a constant expense and is expected to remain the same over the next year.
• Payroll expense changes in proportion to sales, since the more sales the store has, the more people it must
hire to meet increased consumer demands.
• Utilities are expected to remain relatively constant over the budget period. This is because the food coolers
will be running at the same level even though the sales levels may vary.
• Taxes are based primarily on sales and payroll and are therefore considered a variable expense.
• Supplies will vary in proportion to sales. This is because most of the supplies (cash register tape, vegetable
trays, meat trays, and plastic meat and vegetable bags) will be used to support sales.
• Repairs are relatively stable and are a fixed expense. John has maintenance contracts on the equipment in
the store and the cost is not scheduled to rise during the budget period.

The cash-flow budget

After the operating budget has been prepared, the entrepreneur can proceed to the next phase of the budget
process, the cash-flow budget. This budget, which is often prepared with the assistance of an accountant,
provides an overview of the cash in-flows and out-flows during the period. By pinpointing cash problems in
advance, management can make the necessary financing arrangements.

The first step in the preparation of the cash-flow budget is the identification and timing of cash in-flows. For
the typical business, cash in-flows will come from three sources:
• cash sales
• cash payments received on account
• loan proceeds.

Example of how Wheatman’s Market prepared its cash-flow budget

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John Wheatman has completed his operating budget and is now ready to prepare his cash flow worksheet. After analyzing the
sales figures and the cash receipts, John has determined that 80 percent of monthly sales are in cash. Of the remaining 20 percent,
15 percent is collected in the next month and the final 5 percent is collected in the month following (see the cash receipts worksheet
in table 10.5). Wheatman’s purchases are typically paid during the week following the purchase.

Therefore, approximately one-fourth of the purchases are paid for in the following month. Rent expense is paid a month in
advance. However, since it is not expected to go up during the budget period, the monthly cash outlay for rent remains the same.
All the other expenses are paid in the month of consumption (see the cash disbursements worksheet in Table 10.5). Finally, the
cash-flow worksheet is constructed by taking the beginning cash balance, adding the cash receipts for that month, and deducting
the cash disbursements for the same month.

Table 10.5

HOW PRO PORMA STATEMENTS ARE PREPARED?

The final step in the budget process is the preparation of pro forma statements.
• projections of a firm’s financial position over a future period
• on a future date (pro forma balance sheet)

Pro forma comes from the Latin meaning ‘according to form’.

In the normal accounting cycle, the income statement is prepared first, and then the balance sheet. Similarly,
in the preparation of pro forma statements, the pro forma income statement is followed by the pro forma
balance sheet.

Figure 10.1 provides a summary of the changes that should be added to the appropriate accounts.

After preparing the pro forma balance sheet, the entrepreneur should verify the accuracy of their work with
the application of the traditional accounting equation:

Assets = Liabilities + Shareholders’ Equity

If the equation is not in balance, the work should be rechecked. Table 10.6 provides a brief account of the
process of preparing pro forma financial statements for Wheatman’s Market.

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Figure 10.1

Table 10.6

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At this point in the budget process, John Wheatman has the information necessary to prepare pro forma
financial statements.
The first set he has decided to prepare is the pro forma income statements.
To do this, John simply copies the information from the operating budget (see the comparative income
statements below and compare it with the operating budget). The next set of pro forma statements is the pro
forma balance sheets. To compile these, John uses the following information along with the operating budget
and the cash-flow worksheet he has prepared:
• cash – the ending cash balance for each month from the cash-flow worksheet
• accounts receivable – 20 percent of the current month’s sales plus 5 percent of the preceding month’s sales
• inventory – the current month’s ending inventory on the pro forma income statements
• prepaid rent – the $2000 is expected to remain constant throughout the budget period and is always paid
one month in advance
• building and equipment – no new acquisitions are expected in this area, so the amount will remain constant
• accumulated depreciation – since no new acquisitions are anticipated, this will stay the same; all buildings
and equipment are fully depreciated
• accounts payable – 25 percent of current purchases
• capital – prior month’s capital balance plus current month’s net income.

SUMMARY
Entrepreneurs must have an understanding of working capital, revenue, gross profit, expenses, and profit
margins. Three principal financial statements are important to entrepreneurs: the income statement, the balance
sheet, and the cash-flow statement. The budgeting process facilitates financial statement preparation. Some key
budget forecasts that entrepreneurs should prepare are the operating budget, the cash-flow budget, and the
capital budget.
The operating budget typically has various kinds of forecasts, such as sales expense, production, and operating
forecasts. A cash-flow budget provides an overview of the in-flows and out-flows of cash during a specific
period. Pro forma financial statements then are prepared as projections of the firm’s financial position over a
future period (pro forma income statement) or on a future date (pro forma balance sheet). The operating and
cash-flow budgets often are used to prepare these pro forma statements

REFERENCES
Kuratko D.F (2020). Entrepreneurship: Theory, Process, Practice (11th ed) Cengage Learning
Howard, F, Kuratko, D.F., & Hodgets, R.M. (2006) Entreprenuership: Theoru, Process, Practice, Asia Pacific Edition. Thomson
https://www.smallbusiness.wa.gov.au/finance/financial-planning-documents/example-balance-sheet

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