Entrepreneurship (CC399) Chapter 6: Financing a New Venture Short Note

Balance Sheet / Capital Structure

Asset Liability
- Fixed Asset - Long term Liability
- Land and Building - Equity Shore
- Furniture - Preference Share
- Fixtures - De-ventures
- Motor Vehicles - Long term Loan
- Computer - Current Liability
- Current Asset - Bills Payable
- Cash - Salary
- Prepaid Expenses - Short Term loan
- Bills Receivable - Outstanding Payments
Balance sheet: a statement that shows the capital structure of an organization by segregating
the items as assets and liabilities. It shows a firm’s financial position at a specific data.
Asset: the wealth of an organization Liability: an obligation that a firm has to owe.
It is a best practice to keep Asset : Liability at 2:1 or else if:
1. Asset<Liability there will be liquidity shortage
2. Asset = Liability there will be financial equilibrium
Assets are classified as:
1. Fixed Asset: those that return their value in the long run. These are the relatively
permanent assets that are intended for use in the business rather than for sale.
• Tangible fixed assets: These include assets like building, machinery, equipment,
and land-including mineral rights, timber, and the like.
• Intangible fixed assets: including patents, copyrights, good will.
• Fixed security investments: These include stocks of subsidiaries, pension funds,
and contingency funds.
2. Current Asset: that are converted into liquid cash within a period of one year.
• Inventory: stock keeping items be it raw material, work in process/Semi-finished
goods, finished goods and maintenance, repair and operating supplies (MRO)
• Prepaid expenses: these are paid it advance for the next year
• Bills receivable: these are the outstanding income to be collected for debtors for the
item sold on a credit.
• Marketable securities: these are when the company makes an investment for a short
period of time. Eg: National Bank of Ethiopia saving in other Banks
Liabilities
1. Long term liabilities: those obligations that the company has to meet in the long run.
These includes:
• Equity capital/share: long term obligation that the firm has to meet by issuing a share
certificate to potential share holders.
The equity shareholders are the owners of the organization where they have agreed to
bare the lose and enjoy the profit. The main purpose is to maximize the wealth of its
equity shareholders.
Preference shareholders: have preference rights over the equity shareholders of the
time of dissolving the business.
• De-ventures: are creditors that supply materials to the organization.
• Long term loan: the money secured from financial institutions like IMF,
Development Bank or WB
Note: Share Certificate has vote capabilities therefore the higher your share the more your
voice matters.
Failing to pay full share requirement results in forfeiting (cancellation)
2. Current Liability: Short term obligation that the firm has to meet in a period of one
year.
• Bills payable: the amount of money that the company has to owe to its creditors.
• Bank overdraft: the amount of money the bank has to issue to its client over and
above the money that they have in their current account.
• Current account: the type of account that the bank provides to its customer which is
not an interest bearing account. (last as a treasure)
• Fixed account: the account that has been kept by a bank for a fixed time period with
the bank. The bank pays high percentage of interest if complied with the agreement.
• Saving account: an interest bearing account where the bank obliges to pay on the
outstanding amount.
Capital
Initial capital consists of owner capital and creditor capital.
Traditionally it is said that owner capital in a new firm should be at least two thirds of the
total initial capital.
Working Capital
The excess of current asset over current liability. There are 2 types:
1. Permanent working capital: that is required to meet fixed chart. Example: Salary.
2. Temporary working capital: that is required to meet the opportunity (peek demand).
Working capital includes: cash, receivables, inventories, and marketable securities.
• Accounts and Notes Receivable: occur when sale made on credit and it is payments
due from its customers.
• Inventories: Finished and stored goods to be sold.
Cost: It means the amount of money incurred or to be incurred.
Cost can be classified based upon their nature:
1. Direct cost (Prime Cost): those costs that have a direct relationship towards the
conversion of raw materials into finished goods.
Eg: Direct material cost, direct labor cost, direct expenses
2. Indirect cost (Overhead Cost): those costs that provides an auxiliary service that is
supporting service towards the conversion of raw materials into finished goods.
Eg:A. Carriage Outward: transportation cost bare by the company to deliver the
goods at the customer doorstep.
B. Carriage Inward: transportation cost bare by the company to bring goods to
the factory.
C. Return Inward (Sales Return): these are goods sold to customer and
returned back to the company being rejected.
D. Return Outward (Purchase return): these are goods returned by the buyer
being rejected.
Cost con be classified based on variability:
1. Fixed Cost: remain fixed irrespective of the level of output, however as the level of
output increased the fixed cost per unit decreases.
2. Variable Cost: those cost varies based on the level of output.
3. Semi-variable Cost: remain fixed up to certain level of output but varies there after.
Note: Bootstrapping is company financing using discounts.
Equity is less risky compared to a company.
Expense: this means the expired cost
Dividend: the interest to be paid for the shareholders for the share certificate which has been
acquired
Interest: is the money being paid by the bank for the amount deposited by a person.
Collateral: the timeble asset to be surrendered by the bank for the money loan to be granted
by it.
Source of Financing
- Own Saving - Family - Equity Financing - Crowd Funding - Leasing
- Venture Capitalist - Financial Institutions - Bootstrapping - Collateral
The following are other sources of funds for long term capital needs of the going business.
A. Retained Earnings
Realized profits that are plowed back into the business, or retained earnings,
constitute a major source of funds for financing small business expansion.
Financing through retained earnings provides a conservative approach to expansion.
The dangers of over expansion or expansion that is too rapid are largely avoided.
B. Sale of Capital Stock
A second source of expansion capital is available through the sale of capital stock to
outsiders.
Investment Valuation
Traditional Methods of Investment Valuation
- Payback Period Method
- Return-on-Investment Method: evaluates proposals by relating the expected annual
profit from an investment to the amount invested.
This method is expressed in the following equation:
ROI = Annual profit / Investment
Weaknesses of Traditional Methods
 Fail to recognize the time value of money -
 A simple rate of return method gives no indication of the length of time
Techniques of Financial Evaluation
Keeping Accounting Records: should provide information on;
Assets, including real estate, equipment, inventory, receivables, and cash.
Liabilities to banks, suppliers, employees, and others.
Owner’s equity in the firm.
Sales, expenses, and profit for the accounting period.
Objectives of an Accounting System
Methods of recording system in accounting
 In a cash system, the accounts are debited and credited as cash is received and paid out.
 In the accrual system, income earned and expenses incurred are recorded at the time the
sale made or the expense is incurred - this provide accurate and up-to-date statement of
profits.
Types of Accounting Records
 Accounts Receivable – implies effectiveness of the firm’s credit and collection policies.
 Accounts Payable - Records of liabilities show what the firm owes,
 Inventory Records – Ensure adequate stock levels, and computation of turnover ratios.
 Payroll Records – show the total payments to employees
 Cash Records - yield a knowledge of cash flow and balances on hand
 Other Records – insurance, other business investment