Assessing a New Venture’s Financial Strength and Viability

Profitability

• Many start-ups are not profitable during their first one to three years while they are training employees and building their brands.
• However, a firm must become profitable to remain viable and provide a return to its owners.

Liquidity

Even if a firm is profitable, it is often a challenge to keep enough money in the bank to meet its routine obligations in a timely manner.

Efficiency

Is how productively a firm utilizing its assets relative to its revenue and its profits.

Stability

Is the strength and vigor of the firm’s overall financial posture.

For a firm to be stable, it must not only earn a profit and remain liquid but also keep its debt in check.

Ratio Analysis

The most practical way to interpret or make sense of a firm’s historical financial statements is through ratio analysis, as shown in the next slide.

Comparing a Firm’s Financial Results to Industry Norms (benchmarking)

Comparing a firm’s financial results to industry norms helps a firm determine how it stacks up against its competitors and if there are any financial “red flags” requiring attention.

Forecasts

1. The analysis of a firm’s historical financial statements is followed by the preparation of forecasts.
2. Forecasts are predictions of a firm’s future sales, expenses, income, and capital expenditures.

• A firm’s forecasts provide the basis for its pro forma financial statements.
• A well-developed set of pro forma financial statements helps a firm create accurate budgets, build financial plans, and manage its finances in a proactive rather than a reactive manner.

Sales Forecast

• A sales forecast is a projection of a firm’s sales for a specified period (such as a year).
• It is the first forecast developed and is the basis for most of the other forecasts.
• A sales forecast for a new firm is based on a good-faith estimate of sales and on industry averages or the experiences of similar start-ups.
• A sales forecast for an existing firm is based on (1) its record of past sales, (2) its current production capacity and product demand, and (3) any factors that will affect its future production capacity and product demand.

Forecast of Costs of Sales and Other Items

1. Once a firm has completed its sales forecast, it must forecast its cost of sales (or cost of goods sold) and the other items on its income statement.
2. The most common way to do this is to use the percent-of sales method, which is a method for expressing each expense item as a percentage of sales.

• If a firm determines that it can use the percent-of-sales method and it follows the procedures described in the textbook, then the net result is that each expense item on its income statement will grow at the same rate as sales (with the exception of items that can be individually forecast, such as depreciation).

Pro Forma Financial Statements

• A firm’s pro forma financial statements are similar to its historical financial statements except that they look forward rather than track the past.
• The preparation of pro forma financial statements helps a firm rethink its strategies and make adjustments if necessary.
• The preparation of pro forma financials is also necessary if a firm is seeking funding or financing.

Ratio Analysis

• The same financial ratios used to evaluate a firm’s historical financial statements should be used to evaluate the pro forma financial statements.
• This work is completed so the firm can get a sense of how its projected financial performance compares to its past performance and how its projected activities will affect its cash position and its overall financial soundness.