Utilizing Chapter 6, prepare a two- to three-page paper that addresses the following points: Describe how the analysis of the financial statements and projections can be useful in determining the sources of financing available for a new venture. Describe the ratios that should be used to raise short-term and long-term financing. Explain the validity of the ratios.

CHAPTER 6 ANALYSIS OF THE FINANCIAL STATEMENTS AND PROJECTIONS: Who are the people who count the beans? For many years, financial people have been known as bean counters. Although the term is belittling, these people play an important role in the company. If the numbers are not correct, there is no way to manage the business. If the financial side is in the hands of incompetent people, the business is doomed to failure. The safety of your investment depends on these bean counters and how they keep the books of the company. The procedure in analyzing this area is the same as it was for the areas already discussed. You will need to analyze the financial people before you analyze the financial area. You need to know the individuals who will carry out the financial plan. You need to know who has computed the projections for the company. If you havent yet interviewed some of the financial people, you should do so now.

PERSONNEL: You should first concentrate on the background and experience of the people in the financial area. Obtain a short resume on each of the key financial people and look for experience in the small business area, specifically in helping small business companies grow and managing the financial function of small companies. These are key attributes of anyone in the small business area. You should analyze the financial people in depth, as you did with the personnel carrying out the marketing and production functions.

ANALYSIS OF THE NUMBERS :All of the qualitative analysis accomplished in the previous chapters now needs to be transferred into a financial analysis in this section. That is, all the qualitative data must be verified in its quantitative form. All the achievements of the marketing and production department must now be stated in terms of financial achievements. At this point of the analysis, you must turn all of your thoughts to numerical concerns. As most managers know, you have to live and the by the numbers. It is wise to start with the year-end numbers, then go to the interim financials. Usually, the year-end numbers will have been prepared by an auditor and should have been certified.

FINANCIAL ANALYSIS:The first place to begin the financial analysis is to study the historical financial statements of the company. One must first verify that these financial statements are accurate and current. Frequently, a small business will try to skimp on financial data by not preparing regular financial statements. This is a sure sign that the company is not being run by the numbers and should give you a clear indication that the company is not serious about using the financials to guide the management team. Before you begin investigating the financial section of a company with old historical financial statements, you may want to have the accountants come in and review the situation. Accountants call this an operational audit of the numbers. Ask accountants to review companies with old financial statements, and be wary if the accountants come back with horror stories. Frankly, you should be down on companies that cant keep current financial statements, and you should not invest in such companies. Old or sloppy financials usually mean business problems. Hundreds of books have been written about financial analysis, about how to walk through the balance sheet and profit and loss statement to determine whether the company is operating well or is in trouble. Anyone who is in the venture capital business should have been schooled in depth in financial analysis. Therefore, this book does not try to elaborate on the various areas of financial analysis. This kind of analysis is important, but you will also be concerned with the venture capital analysis, which should include the other items mentioned in this chapter. Before discussing these other items, lets consider some of the major items you should look for in the financial statements. Analyzing the Income Statement. Begin by looking at the companys sales and try to understand how the company recognizes revenues. So many companies recognize sales in so many different ways that you can no longer trust a mere number in the sales column. You need to understand what is behind it. For example, in the publishing business, a book is sold by a publisher to a bookstore, and the revenues are recognized by the publishing company. However, the book can be returned by the bookstore to the publisher for full credit, so that a sale does not occur for the publisher until the retail store has sold the book to a retail customer. Recognizing revenue in the book-publishing business can be difficult because a company may have several of its books take off and make sales look extremely good until the reviews come in, then those books may be sent back to the publisher. Verifying the way sales are recognized is critical. Nor can you rely on the accounting profession to give you everything. Recently, there was a public company that had contracts with companies that called for the services to be provided over several years. The accountants let the company recognize all the revenue from those contracts in a single quarter. This increased sales substantially and made the earnings look fantastic. Later, when the accounting trick was uncovered, the financials were restated, and the company was sued by it shareholders. Make sure you understand revenue recognition before you invest.

Percentage of Completion: In other companies, such as government contractors, large contracts are recognized on a percentage-of-completion basis. This means that the project can be half finished and the contractor can recognize half or maybe more than half of the contract as revenues, even though progress payments of cash to the business may fall behind the amount of the contract that has been completed. This is another way to front load sales of the contractor and make it look as though it is having a fantastic year when, in fact, it is experiencing a severe cash shortage. Loss Leaders. In other situations, a contractor may bid on the initial part of a contract, and the bid may be so low that the contract constitutes a loss to the company. According to accounting principles, it can then bury those losses as investments in future contracts. That is, they never show up on the income statement. They are booked on the balance sheet as an asset to substantiate the theory that the government, after an initial contract, usually comes back for a larger follow-on contract. The loss that was incurred on the initial contract can be amortized over the second long-term contract. It was the small companys loss leader. Several companies you encounter may show losses of this nature on the balance sheet as an asset. In analyzing the company, you should become familiar with the way it recognizes revenues. The revenues will tell you how the cash flows of the company will occur. Research and Development. Expensing research and development (R&D) can also give rise to assets on the balance sheet. The income statement may show no expense for R&D because the R&D expense is being capitalized. This new asset is then taken off the balance sheet and expensed through the income statement over a five- or ten-year period. The company has spent the money and run out of cash but the income statement may show that it had a profit!

Standard Cost:. How the company recognizes its costs of production can also be tricky. Some companies measure costs on the basis of standard costs. At the end of the year, they adjust the standard cost and bring in the real costs of production. However, standard costs do not recognize any reworking of the product. If the product doesnt meet the specifications of the client, more cost will be incurred in making the product right. This may mean that the company will produce an item, recognize a standard cost, show a profit on the product, then later in the year have to recognize either (a) an expense for reworking the product to make it sellable or (b) additional expenses to bring the standard cost in line with reality. Both of these can be extremely disconcerting to an analyst because it is not until the end of the year that things pop out. One small public company always showed good revenues in its first, second, and sometimes even in its third quarter, only to have all of those profits taken back by the audit at the end of the year, which took into account the real costs. The audit had such large adjustments that the year ended with a huge loss. If this happens to you, you will be left wondering whether this was a deliberate deception by management or just the result of a poor accounting system. In any case, it is directly indicative of the management.

CASH FLOW ANALYSIS :The first thing to do in cash flow analysis is to check the cash in the bank. How much cash does the company have and how does it flow in and out of the company? Make sure you understand how the company gets its cash. Critical questions to ask are: How many collection points does the company have for its cash? How many depository bank accounts does it maintain? What kind of cash balances does each account have? Of the cash that is collected, what amount cannot be used because it is in the financial float? What procedure does the company have for minimizing the transfer time for collecting cash balances? Also look at the number of disbursement points. Who authorizes payments from the companys funds and what amounts are they authorized to disburse? What procedures are used to ensure the proper disbursements by authorized people? What procedures are used to transfer funds and ensure the timely payment of bills? Does the company take advantage of discounts when they are available? How does it avoid missing discounts when payments are late? If the company is missing discounts, what does this cost the company per year? Quite often, companies come to VCs asking for financing to take care of discounts. Obviously, if this is the only reason someone comes to you for venture capital, it is a mistake to put your money in. You will not get the kind of return on investment that you are looking for if the cash is going to be used only for making timely payments of bills in order to take advantage of discounts.

ANALYSIS OF THE BALANCE SHEET: Cash flow analysis naturally leads you to the balance sheet. One source of cash is accounts receivable. You need to understand how receivables are recognized and how frequently receivables are not paid. That is, the company may have a receivable booked and income recognized, but the buyer of the product owing the money may not have recognized it as a payable and may not believe it owes anything to the company at all. Looking behind accounts payable is a must. You should determine what percentage of the companys sales is cash and what amount is credit that will be recognized as accounts receivable. What credit terms is the company giving its customers and how do those terms compare with those offered by the competition and the industry in general? What credit information is used to make the credit analysis and who in the company determines which customers will get credit? Is the procedure for extending credit coordinated with the sales activity? How frequently do the financial people update the customers credit information? The small business world is strewn with failures from small companies that extended credit to non-creditworthy customers who did not pay their bills. Like any other assets, an accounts receivable is no good unless it can be turned into cash. Inventory. What dollar amounts are tied up in inventory? How does management explain the money in inventory? How is this inventory coordinated with the management of production? What are the trade-offs between the flexibility of having a maximum inventory and the advantage of keeping a minimum inventory to reduce working capital? How is the responsibility for inventory control divided between the finance people and the production people? Inventory can be a perplexing number. One VC walked through a plant once and saw a big pile of goods with a large tarp over it. After asking what was under the tarp, he was told, spare parts. A look under the tarp revealed some rusty junk. When going over the inventory numbers, the VC found the spare parts sitting there at full value, just waiting for the auditor to write them off and lower earnings.

Fixed Assets. What capital budgeting procedure is used by the company, and who decides what production equipment and machinery to buy? What is the minimum acceptable return on investment used to determine which capital budget items to buy? Does the company consider leasing? Who does the analysis on lease versus purchase? What capital expenditures are budgeted for the coming years?

Liabilities. You must go through the liabilities in the same way that you walked through the asset side of the balance sheet. You need to determine the size of the accounts payable. Who are they owed to? How far back do they go? Accounts payable must be aged. You should determine whether the IRS is owed payroll taxes or whether any income tax bills have not been paid. Usually, this section of the analysis shows the loans from stockholders, banks, and others. Make a list of all debts and confirm each later.

BUDGETING AND CONTROL: Sound budgeting and effective controls of the company are one key to a successful operation. Although budgets may be based on a shorter time period than the projections you will analyze, you should investigate how the company budgets and funds its day-to-day activity. How does the company control its operations? The basic question you need to ask is, What are the companys budgeting procedures? That is, how often are the budgets put together and are they modified on an interim basis? How are the budgets used to manage the company? Some other key questions are as follows: How are the budget figures derived? What supporting schedules are available for these budgets? You need to understand how the corporation sets the budget objective. Does management set goals, then translate them into numerical budgets? How is the process carried out in the company? In your analysis of the budget, find out how well the company has met its budget in the past. What discrepancies, if any, show up in the past between its budget and its actual achievements? How often does the management measure performance in relation to budget figures? What kind of accountability is established for employees? Who is field responsible when there is a deviation from the budget, and what corrective procedures are followed to make sure that future budget numbers and performance are the same?

PAST FINANCINGS: During its lifetime, each company goes through a number of financings, from banks, insurance companies, VCs, individual investors, and so on. You should write down the past financings of the company chronologically and indicate how they came about and what value is placed on the company. You should establish the current status of these investments. That is, find out whether bank debts are being paid as agreed. Are individuals getting the dividends they were promised? Are past investors happy with the situation and willing to invest again? You should determine whether any personal guarantees were part of these earlier financings and what assets of the company were pledged. In other words, what outside assets belonging to individuals have been pledged for these financings? You may find that past financings from previous VCs often contain onerous terms with respect to the personal signatures of entrepreneurs. In some cases, houses or other assets outside the business have even been pledged. Entrepreneurs are extremely anxious to have these types of financings paid off, and its common for an entrepreneur to push hard for venture capital financing because the business is in trouble and he or she is trying to save his house by getting the bank loan paid off. You should keep an eye out for this type of financing. Also, keep in mind that if the entrepreneur has guaranteed the bank financing and if the business gets in trouble in the future, the entrepreneur will be working hard to pay off the bank without regard to your investment or what is best for the business. In a workout situation, the entrepreneur will want to make sure the bank is paid off so that the guarantee is not called. The entrepreneur will not care about your investment. You could lose money in this type of situation, so be careful.

PAST BANK FINANCINGS: In reviewing the companys past bank financings, you should go through all the pieces of information about each loan, including the legal documents. You should determine what collateral has been used for these loans, such as deeds of trust and life insurance, as well as specific assets on the balance sheet. Have there been personal or corporate guarantees? What are the requirements of the loan? That is, are there current ratios, working capitals, milestones, and the like? Determine what things the company must do to maintain the credit line with the bank. In one situation, a banks requirements had not been met, but the bank was still willing to work with the VC portfolio company so that it could go forward. The day after the venture capital financing agreement was reached and the money was deposited in the bank, the bank offset its loan amount against the money newly deposited into the account to pay down the debt immediately. The bank claimed a default on the loan and demanded that all future cash payments be made to the bank. Needless to say, this left the VC in a very unhappy situation. But, because it was a winery, the venture capitalist took some solace in his plight by drinking several cases of the wine. Each case cost about $65,000, and it wasnt very good wine. But, somehow, a bitter wine suited the moment.

ENTREPRENEURS INVESTMENT In reviewing past financings, you should determine how much money the entrepreneur has invested in this business and how much stock the entrepreneur received for it. Sometimes you will find that entrepreneurs have put very little in the company and have very little to lose if the company goes bust. This often makes us nervous because nothing keeps the entrepreneurs attention riveted on business like a substantial personal investment in the company. In one situation, an entrepreneur had invested $500,000, but he had made $12 million out of his past company. He had used the money to invest in other venture capital deals and put only $500,000 in this second business. When the company got into trouble, the individual worked very hard to save it. No one will ever know whether, had the entire $12 million had been invested, he would have had the incentive to save the business. As it was, he lost his $500,000, but he was still able to walk around with a smile because he had over $11.5 million in other situations. As a VC, you want to make sure that 100 percent of the entrepreneurs time is committed to the business you are investing in. A large and significant financial commitment is one of the strongest indicators of the entrepreneurs desire to make the business a success. When entrepreneurs dont have a great deal of money, it is best to get them to guarantee part of the venture capital investment to ensure that, if things turn sour, they wont walk away without a substantial personal loss. The fact that entrepreneurs will hock their houses by taking out second mortgages to buy stock in small businesses is one of the strongest signs of commitment that an entrepreneur can show a VC. You will hear all the other argumentsMy life and soul are wrapped up in this business or My reputation and prestige are on the line for this investmentbut none of these arguments carries any weight when compared with the words, Everything that I own is invested in this company.

ENTREPRENEURS OWNERSHIP Similarly, you should determine how much of the company the entrepreneur owns. No entrepreneur is going to work hard for the company if the entrepreneur owns little of it and has nothing to gain. At a small company in Atlanta, the entrepreneur had been diluted by individual outside investors to the point that the entrepreneur owned such a small part of the company that he was virtually a hired employee. Always make sure that the entrepreneur has a substantial stake in the company (so that the entrepreneur can make lots of money). Otherwise, the entrepreneur might give the company no more attention than a hired employee would. In the financings in which you invest, insist that the entrepreneur have an increased ownership, to the detriment of prior investors, in order to ensure that the entrepreneur would be motivated enough to make the company successful. Its the rare entrepreneur, indeed, who will work hard for less than approximately 20 percent of the small business. If it is a large business, 5 percent may be fine. With anything less, you probably wont have the entrepreneurs full time and attention. Most likely, the entrepreneur will be out looking for another company to jump into where he can own a substantial amount of the equity.

PARTICIPATION WITH OTHER INVESTORS :Investing with other venture capital companies or other individuals is always a benefit. However, those who have invested in the past and are now watching you invest your money have a vested interest in (a) not giving up much equity and (b) making sure you put your money in so that theirs will continue to be worth a great deal. The views, comments, and information gathered by a past investor who is now trying to induce you to make an investment are not nearly as valid as the analysis made by a current investor putting in new money for the first time, along with you. It is interesting to talk to these past investors, but one needs ask why they invested and what profit they expect to make in the future. However, it will be practically impossible to gain unbiased information from this type. In analyzing these past investments, you should determine who invested, how much they paid, and what valuation is placed on the company. This will give you a good idea of how much they are stepping up the investment from the time they invested to the time they are asking you to invest. If the new value is substantially increased from the last financing, you need to ask the question, What has happened to the business since the last financing that would make the value increase so much?

USE OF PROCEEDS :It is important to establish how past financings were used. If a company raised cash in the past, it is important to know where they spent it. This will give you a good indication of how well the company has been run and how far it will be able to run on the money that you are investing. You should review the companys use-of-proceeds statement in detail to determine why the company needs money for each of the items listed. Vague comments on the use of proceeds, such as working capital, should not be accepted. You need to know exactly where the money is going before you put it in. You need to determine whether the new money will make a difference in that companys future. If a fee is to be paid to a financial broker, make sure it is listed on the use of proceeds. These fees have a way of being overlooked until the day before closing.

PROJECTIONS Among the items that you and the entrepreneur will come back to many times are the entrepreneurs financial projections. These constitute the numerical forecast that you (as an investor) are buying. The entrepreneur is saying these projections are possible, and you are purchasing a part of the company on the basis of these projections. Your return on investmentthe cash that you will receive backdepends on the company making these projections. Your analysis of these projections is one of the key aspects of your investigation of any business opportunity. You will want to investigate the assumptions being made about the projections. How realistic are the margins being projected? How realistic are the financings? Go through all of the assumptions in detail with the management team to determine whether the projections are based on sound assumptions. One of the main assumptions that you should always have difficulty accepting from entrepreneurs is sales growth. Entrepreneurs are extremely bullish individuals whose sales projections tend to go through the ceiling. It is not uncommon to see unrealistic entrepreneurs thinking that they will double sales every year for 10 years. Sometimes sales projections are prepared in a haphazard manner. This is usually the case when a sales projection has a lot of zeros. For example, the first year might be $1 million, even; the second year $6 million; and the third year $15 million. These round figures are a sure tipoff that the entrepreneurs projections are being shot from the hip, rather than coming from hard analysis. With the aid of computer spreadsheets, it has become much easier to run sales and profits projections. However, computer spreadsheets can increase sales by whatever percentage per year the entrepreneur dictates. As a result, the computer programs cannot be taken as the strong evidence that the nonrounded financial projection is accurate, even though the computer carries out the projections with brutal numerical accuracy. For example, if sales are to increase 67 percent each year and sales in the first year have been $1,253,000, the computer will show sales for the following year at $2,092,510. This means that your tipoff is not zeros but numerical accuracy. You will have to do much more digging into the rationale of the projections because you will no longer have the many zeros to tip you off that the entrepreneur is shooting from the hip. With the aid of the computer program, the entrepreneur is giving you a different type of projection, but this time it is based on a flat rate that he has assumed will be constant. You need to make sure you know how the entrepreneur has arrived at the projections and what degree of work has gone into formulating the assumptions. In addition, you should be given projections of the balance sheet, cash flow, and the profit and loss statement. Without these three figures, you will be left out in the cold. You need all of them to make a valid judgment as to where the business is going and how it is going to get there. The projections should include a breakeven analysis with respect to profit and loss and cash flow. That is, the entrepreneur should show you monthly projections up to the point where the company expects to break even in terms of profit and loss, meaning it is no longer losing money. However, because of growth in accounts receivable and inventory, some companies may show a profitable financial statement even when they are having negative cash flow. This is the reason that the entrepreneur should show you a cash flow breakeven analysis. You want to determine at what point the company will stop having to raise capital and be able to finance itself on bank debt and other conventional borrowings. Until the entrepreneur shows you this breakeven analysis, you will not have a good handle on the company. Make sure you have a balance sheet before and after financing so you can see how the proposed financing will affect the company. It is necessary to trace the flow of funds into and out of the company, especially as company transactions. Without a transition balance sheet, you will not be able to follow the flow of funds. Quite often, the funds flow statement will not include the brokerage fee that the entrepreneur must pay as part of the financing. Make sure the fee has been subtracted from the cash available to the company. In addition, look for any consulting fees to be paid going forward and make sure that these consulting feesand of course your own feeshave been deducted from the cash flow statements. The projections should be based in part on assumptions about the stage of growth, when prototypes will be completed from the amount being spent for R&D, when the first model will be installed, when the beta test sites will be finished, and so on. You also need to know when branches in new cities will be opened with marketing staffs and when new locations will come on line. The cost of these items should be in the projections. Almost every VC has difficulty obtaining reliable projections. Quite frankly, most entrepreneurs know little about how to make projections and usually need help from an accounting firm.

BASIC INFORMATION

RATIO ANALYSIS OF THE FINANCIAL STATEMENT: There are numerous financial ratios to consider, each of which is significant. Generally speaking, the ratios in the financial area revolve around four areas: profitability, equity, leverage, and cash management. Each of these has its own slice of the financial numbers and can give you some indication of how well the company is doing.

PROFITABILITY RATIOS: Gross margin percentage can be calculated by dividing gross profit by sales. This will measure the margin that the company is achieving on sales. Over periods of time, it may reflect transit profitability. Profit margin percentage can be determined by dividing net income before taxes by net sales. This indicates the profitability of the company on each sales dollar. Over a period of time, it measures the profit trend of the company. Return on equity can be determined by dividing net income by total shareholders equity. This measures the return on invested capital and can show you how hard management is making the equity in the business work. Return on assets can be calculated by dividing net income by average total assets out during the year. This indicates the return on the average dollars of assets outstanding during the year.

LIQUIDITY RATIOS: The current ratio can be calculated by dividing current assets by current liabilities. This gives you some indication of the ability of the company to pay short-term obligations. Quick ratio can be calculated by dividing current assets minus inventories by current liabilities. This is also a measure of the ability of the company to pay its short-term obligations without selling off its inventory to generate cash. To calculate the working capital as a percentage of assets, divide working capital by total assets. This will indicate the due date of the assets, relative to the total assets of the company. Liquidity ratio can be calculated by dividing total assets by total liabilities to measure the overall liquidity of the company.

LEVERAGE RATIOS: Debt equity ratio can be computed by dividing total debts outstanding by total stockholders equity. This measures the degree to which the company has leveraged itself with debt. A similar ratio to debt equity ratio is total liabilities to stockholders equity. It can be computed by dividing net sales by working capital. This will measure how efficiently the company has been able to generate sales on the basis of working capital. Debt coverage ratio is something bankers always compute. It is calculated by dividing earnings before interest and taxes by total annual debt service. This measures the ability of the company to see its debt obligations. Cash flow debt coverage ratio is more difficult to compute. Here you must calculate earnings before interest and taxes plus depreciation, divided by interest and principal due on all of the companys debts. This will give you a more cash-oriented measurement of whether the company can meet its debt service. Percentage fixed charges of earnings is another good calculation. Here you divide the fixed charges by earnings before interest and taxes, plus fixed charges. This will give you a measure of how far the earnings could decline before you would be unable to meet the fixed cost.

CASH RATIOS :Cash flow cycle can be calculated by dividing receivables plus inventory by the cost of goods sold. This gives a general measure of the number of days it takes to convert inventory and receivables into cash. Calculate the receivables cycles by dividing net credit sales by average trade receivables. This will give you the time it takes to collect credit sales. A similar index is the past due index. This is calculated by dividing total receivables past due by total receivables. This will give you a trend in the collection activity over a time. Calculating the bad debt expense as a percentage of sales is a matter of dividing bad debt expenses by total credit sales. This calculation will give you a trend of the bad debts that the company is experiencing. Inventory turns can be calculated by dividing cost of goods sold by the average inventory outstanding in a year. This measures the number of times the inventory is sold and replenished during a given period of time. Another measure of cash flow is the percentage of cash flow to total assets, which can be calculated by dividing net cash flow by total assets. This will measure the cash-generating ability of the assets over a period of time.

FINANCIAL REPORTS: You need to determine which financial reports the financial management team uses in carrying out its tasks. The reports they use in day-to-day operations will give you a good indication of how they are managing the company. In addition, you should ask the financial people to give you copies of the reports that they provide to top management, and of course, you should find out how top management uses these reports to analyze the financial health of the company.

CONCLUSIONS ON THE FINANCIAL AREA: At the end of the financial analysis, it is important to evaluate this area as follows: What do you think the major problems will be over the next two or three years? Does this financial team have the wherewithal to tackle these problems? Can this team finance this company over the next two to three years? Can it manage the profitability and assets of the company in such a way that it will not have financial problems? Do you feel comfortable with this financial team negotiating bank debt and other credit lines? At the end of the day, you will have to ask yourself the question, Can they do the job?

Here is chapter 6 The question is in the beginning there is no business in particular it is about projections. The bolds are the questions