Chapter 8

Objectives
• The objectives of this chapter are to:

• identify the necessary steps to be taken in order
to prepare a simple project costs schedule
• suggest potential sources to fund a new project
• identify inputs to prepare pro forma financial
statement
• conduct simple financial ratio analysis for
business
Learning Outcomes
• At the end of this chapter, students should be
able to:
• list various types of common sources of
financing for SMEs
• identify important elements required in
preparing a financial plan
• identify necessary financial statements to be
prepared in managing a small business
The Importance of Finance for SMEs
• The need for finance in SMEs might arise on four
occasions.
• start-up capital to help in the establishment of a
new business.
• business expansion
• venture capital/risk capital -particularly to finance
an innovation
• to adjust the existing financial structure of the
business
Types of Finance for SMEs
• The main types of finance for SMEs :
• Debt Finance
• Debt financing is a financing method which typically
involves an interest-bearing instrument, normally a
term loan. This type of financing requires the
entrepreneur to pay back the funds borrowed plus an
interest.
• Equity Finance
• Equity financing offers some form of the ownership in
the business to the investor. Equity finance requires
the entrepreneur to give up some degree of control
and ownership of the business.
Internal or External Funds
• Internal - can come from various sources
within the business, such as personal savings
of the entrepreneur, profits retained in the
business, sales of fixed assets, reduction of
working capital, and account receivable.
• External - can be generated from outside the
business and the most frequently used
sources of external finance are banking and
developmental financial institutions (DFIs).
Financial Plan
• also known as a financial budget.
• Determines whether or not a business
proposal is viable.
• The process of estimating future income,
expenses and assets of the business. In
business, a financial plan or a financial
forecast consists of three primary pro forma
(projected) financial statements, cash flow
statement, income statement, and the
balance sheet prepared within a business
plan.
The Importance of Financial Plan
• to determine total project implementation
cost.
• to determine amount of funding required
and identify proposed sources of funds.
• to ensure sufficient initial investment .
• to analyse the viability of the project .
• to guide project implementation .
Objectives of Financial Plan
• The process of preparing a financial plan involves:
• determining total project implementation costs
• determining amount of funding required and identifying
proposed sources of funds
• calculating amount of depreciation on fixed assets
• calculating amount of loan and hire purchase repayments
required
• estimating amount cash inflow and outflow during the planned
period
• estimating amount of profit generated during the planned
period
• estimating financial position at the end of the planned period
• performing financial analysis to determine financial viability of
the proposed business
Steps in Developing a Financial Plan
• To develop a workable and meaningful financial
plan, the entrepreneur has to follow these seven
steps:
• STEP 1: Gathering relevant financial inputs
• STEP 2: Preparing project implementation cost
schedule
• STEP 3: Identifying sources of financing
• STEP 4: Preparing pro forma cash flow statement
• STEP 5: Preparing pro forma income statements
• STEP 6: Preparing pro forma balance sheet
• STEP 7: Performing financial analysis based on
the above pro forma statements
• STEP 1: Gathering Financial Inputs
Marketing budget
Administration budget
Operational budget
STEP 1: Gathering Financial Inputs
STEP 2: Preparing Project Implementation Cost
• STEP 3: SOURCES OF FINANCING
• Internal sources- equity contributions
(cash and/or assets)
• External sources- commercial banks,
finance companies, government
agencies (term loan, hire purchase,
business loan)
• Step 4: Preparing the Pro Forma Cash Flow
Statement
• Pro forma cash flow statement - projected statement of
cash inflow and outflow throughout the planned period.
The pro forma cash flow statement must be able to show
the following information:
• cash inflows—the projected amount of cash flowing into
the company
• cash outflows—the projected amount of cash flowing out
of the company
• cash deficit or surplus—the difference between cash
inflows and cash outflows
• cash position—the beginning and ending cash balances
for a particular period
• Step 4: Prepare Pro Forma Cash Flow
Statement
• Elements of cash inflows:
Equity contribution (cash)
Term loan
Cash sales
Collection of receivables
Others
Pro Forma Cash Flow Statement
Step 5: Preparing The Pro Forma Income Statement
• pro forma income statement - the expected profit or loss
for the planned period, usually for 3 consecutive years.
• Elements in the Pro Forma Income Statement
• pro forma manufacturing account consists:
– cost of goods manufactured
– gross profit
– net profit
• For manufacturing companies, the cost of goods
manufactured must be calculated first, while for trading
companies; it is the gross profit. Service companies can
straight away calculate the net profit.
• Step 6 Preparing the Pro Forma Balance
Sheets
• Elements of the Pro Forma Balance Sheet
• The general elements of the pro forma balance
sheet include:
• assets
• owner’s equity
• liabilities
• Assets
• Non-current assets
• Fixed assets are used and depreciated by a
company for more than a year
• Current assets
• Current assets are short-term assets that can be
converted into cash within a year.
• Examples of these assets are cash, stock (raw
materials, work-in-process and/or finished
goods), account receivables and other short-
term investments.
• Owners’ Equity - original capital contributions from
the owners or shareholders in terms of cash or
assets plus the accumulated amount of net profit.
However, if the company suffers a loss, the amount
of loss will be deducted from the original equity
contribution.
• Liabilities are the amounts owed by the company to
outsiders.
• current liabilities - accounts payable and accrued payments.
• Non-current liabilities or Long-term liabilities - the long-term
obligations of the company that mature in a period of more
than one year. They usually include long-term loans as well as
hire purchase.
STEP 7: Analysing Financial Statements
Financial Ratio Analysis
Liquidity Ratios – ability of the business to pay
its monthly commitment
 Current ratio - Current Asset / Current Liabilities
 CR=>1-2
 Quick ratio (Acid test ratio)- measures a
company’s ability to meet its short-term obligations
with its most liquid assets. The ratio excludes
inventories from current assets
 Quick ratio = (current assets – inventories) /
current liabilities
 QR= >1
Efficiency Ratios – how efficiently business
uses its assets to generate sales
 Inventory turnover -how many times a company's
inventory is sold and replaced over a period.
 Inventory Turnover = Sales / Inventory
 Inventory Turnover = Cost of Goods Sold /
Average Inventory
 Asset Turnover = Sales or Revenues / Total
Assets

Profitability Ratios –business financial
performance
 Gross profit margin = (Revenue-COGS) / Revenue
 Net profit margin=Net Profit / Revenue
 ROI (ROA)=Net profit / total assets
 ROE=Net Income/Shareholder's Equity

Solvency Ratios/ leverage ratios –measure the
degree of financial risk faces by business
 Debt to equity ratio = TL / TE
 Equity ratio = TE/ TA
 Debt ratio= TL/TA

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Objectives

• The objectives of this chapter are to:

Financial Ratio Analysis

Financial Ratio Analysis

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