ENTR 386 - Exam 1

What are the primary financial statements a new business needs to prepare, and what are the purpose of each statement?

1. Income statement - Show whether a business earned a profit or incurred a loss over a period of time

2. Balance sheet - Show’s a business financial position at a specific date. What a business owes vs. what it owns

3. Cash flow statement - Shows how cash moves in and out of a business and the liquidity of the business

How do the 3 financial statements interrelate?

Income → balance

• Net income is transferred to the balance sheet through retained earnings/owner’s equity, either raising it or lowering it

Balance → cash flow

• Cash flow uses assets, liabilities, and equity to explain cash balance changes. Determines whether the company actually made money or not

Income → cash flow

• Cash flow begins with net income and adjusts for depreciation and changes in working capital, report actual cash received and paid

What is break-even point, and how do you calculate it?

Where the total revenue equal total cost, the business is neither making a profit nor incurring a loss. Determines how many sales they need before they can begin to earn a profit

BE = total fixed expenses / (revenue per unit / COGS per unit)

Why is break-even analysis important for entrepreneurs when planning their business?

Determines the minimum sales needed to cover all costs. Helps determine pricing, sales goals, costs, and funding.

What is depreciation, and how does it affect a company’s financial statement?

Depreciation - Allocating the cost of an asset over its useful life instead of recording the cost as an expense when it is purchased, the cost is spread over the years the asset is expected to be used.

Effect on income → Recorded as an expense

Effect on balance → reduces assets book value and lowers retained earnings through reduced net income

Effect on Cash flow → Added back to net income because it is a non-cash expense that does not involve an outflow of cash

How would a business decide between straight-line and accelerated depreciation?

Straight-line: Cost is spread evenly, produced predictable profits, financial statements are easier to compare, useful when the asset provides benefits evenly throughout its life

Accelerated: More in early years and less in later years, lowers taxable income initially, greater tax savings and cash flow in the short-term, better matches assets that lose value quickly or are used heavily when new

Accrual vs. cash basis accounting:

Accrual → Records income when it is earned and expenses when they are incurred. Income for work done in May is recorded in May, even if payment is received later

Cash basis → Transactions are only recorded when cash is received or paid. A client can pay in May for work done in April, but the income is recorded in May.

Is accrual or cash basis better for a startup business?

Cash basis → Because they are dealing with simple transactions and minimal inventory, it is also simpler, less time-consuming, and required minimal experience.

How do accounts receivable and payable affect a business’s working capital?

Receivable → Increase in this account means more sales on credit, which increases current assets and improves work capital if collected promptly

Payable → An increase in this account means you purchased more on credit, which increases liabilities and reduces working capital

*Working capital = current assets - current liabilities

How can a business manage its receivables to improve cash flow?

• Reduce late payments

• Send invoices as soon as goods or services are delivered

• Collect them as soon as possible

What is the FIFO inventory valuation?

Oldest inventory items are sold first, so the COGS reflects older costs, while ending inventory reflect newer costs

• Results in lower COGS and higher ending inventory values because the lowest-cost inventory is sold first, increasing gross profit, while the highest-cost inventory remains on the balance sheet

What is the LIFO inventory valuation?

Newest inventory items are sold first, so COGS reflects recent costs while ending inventory reflects older costs

• Results in higher COGS and lower ending inventory values, reducing taxable income but also lowers gross profit and higher ending inventory

What is the weighted average inventory valuation?

Calculates the average cost for all inventory items

• Suitable for large volumes of similar items where tracking individual costs is impractical

How does inventory valuation impact financial reporting and taxes?

Inventory valuation determines the value assigned to inventory sold and inventory still on hand

• FIFO → leads to higher taxable income and higher taxes

• LIFO → leads to lower taxable income and lower current tax payments

How do you calculate the cost of goods sold for a new business?

COGS = Beginning inventory + purchases - ending inventory

• Beginning inventory = the value of unsold goods from previous periods

• Purchases = the cost of all inventories bought during the period

• Ending inventory = the value of unsold goods at the end of the period

Why is COGS an important figure in understanding profitability?

COGS shows how much it costs a company to produce or purchase the goods that were sold during a period. By comparing COGS, you can determine the gross profit

• Gross profit = sales revenue - COGS

• COGS is also an expense, so it directly reduces profit

• Net income = revenue - expenses

Personal savings startup capital:

Advantages → Full ownership, no loan payments or interest costs

Disadvantages → Personal finance risk, may deplete emergency saving or retirement funds, limited amount of capital

Bank loans for startup capital?

Advantages → Business owners retain ownership, can provide substantial funding, build businesses credit

Disadvantages → Required payment regardless of business success, interest increases costs, may require collateral and a strong credit history

Crowdfunding for startup capital:

Raises money from many individuals through online platforms

• Advantages → Access to a broad audience can validate market demand, generate publicity and customer interest

• Disadvantages → Success is not guaranteed, requires significant marketing effort, platform fees may apply

Venture capital for startup capital:

Professional investment firms provide funding in exchange for ownership shares

• Advantages → Significant funding, access to professional guidance and network, can support rapid growth

• Disadvantages → Loss of ownership and control, high expectations for growth and profitability, competitive and difficult to obtain

What are the most important financial ratios that an entrepreneur should use to assess the financial health of their business?

• Liquidity ratios → ensures you can pay bills without distress

• Profitability ratios → Reveals if you are generating sustainable earnings

• Efficiency ratios → Highlight operational strengths and weaknesses

• Leverage ratios → Gauges financial risk and stability

• Market ratios → Reflects investor confidence and valuation

How would you calculate and interpret current ratios?

Current ratio = Current assets / current liabilities

• >1.0 → The company can cover short-term obligations

• <1.0 → Liabilities exceed the current assets

• About 2 → Strong liquidity and buffer for unexpected expenses

How do you calculate and interpret the quick ratio?

Quick ratio = current assets - inventory - prepaid expenses / current liabilities

Quick ratio = cash + accounts relievable + short-term investments / current liabilities

• Higher ratio = stronger ability to meet immediate obligations without selling inventory

• A large gap between current and quick ratios often indicates heavy reliance on inventory or prepaid assets

What is equity financing?

Raising money by selling ownership shares in the business to investors

• Advantages → No loan payments or interest charges, investors can provide expertise and networking services, lower financial risk because funds do not need to be repaid if the business fails

• Disadvantages → Give up partial ownership and control, profits must be shared with investors, investors may influence major decisions

What is debt financing?

Involves borrowing money that must be repaid over time, usually with interest

• Advantages → owners retain full control, once debt is paid the lender has no claim on future profits, interest payment may be tax-deductible

• Disadvantages → Payments are required regardless of performance, interest increases total cost of financing, failure to repay can damage credit and lead to bankruptcy

How should you choose between equity and debt financing?

Equity → Company has little or no revenue and cannot qualify for loans, required significant capital, wants strategic partners and mentorship, cash flow is uncertain, making loan payments is risky

Debt → Can support loan payments, owner wants full control, financing needs are smaller, business has assets or a strong credit history

How can a new business owner determine the appropriate level of debt to take on?

Should only take on the amount of debt that the business can comfortably repay through its expected cash flow while maintaining the ability to pay for unexpected expenses.

Why is cash flow important for the survival of a business, and what strategies can we use to manage cash flow effectivly?

Cash flow enables a company to pay expenses, handle unexpected challenges, and invest in growth opportunities

• Strong cash flow management increases long-term success

• You can forecast cash needs, monitor finances, speed up collections, controlling expenses, manage inventory, and use debt responsibly

What is the difference between profit and cash flow, and why can a profitable business still face cash flow problems?

Profit → the amount of money left after all the expenses are subtracted from revenue on the income statement (measures whether the business is earning money)

Cash flow → Actual movement of cash into and out of the business (measures if the company has enough cash to pay its bills)

What methods can be used to determine the valuation of a new business?

Cost-to-duplicate → Values the business on the cost of recreating it from scratch

Comparable company method → compares the startup to similar businesses that have recently been sold or funded

Discounted cash flow method → Estimates value based on projected future cash flows discounted back to their present value

Why is business valuation important when seeking investors or selling a business?

• It establishes the economic worth of a company

• It determines how much equity founder must give up and helps structure investment agreements

• When selling, it helps establish a fair sale price, supports negotiation, and build confidence in buyer

What is capital budgeting and how does it relate to the decision-making process when starting a business?

Process of evaluating long-term investment projects or capital expenditures to determine which will add the most value to a business (i.e. purchasing new equipment)

• Helps plan for major upfront costs ensuring they have enough capital to cover them

Explain NPV and IRR and how they can be applied to business investment decisions:

NPV - Net difference between the present value of future cash inflows and the present value of future cash outflows over a projects life

• Tell you if a project will add value

• Better for comparing projects of different sizes

IRR - The discount rate that make the NPV of a project’s cash flow equal to zero

• Tells you the expected return

• Useful for comparing similar-sized projects

Financial risk - Cash flow risk:

When a business does not have enough cash available to pay its expenses

• Mitigation: Maintain an emergency cash reserve, follow up on overdue payments, establish a line of credit for short-term needs

Financial risk - insufficient startup capital:

When you underestimate how much money is needed to launch and operate until you become profitable

• Mitigation: Develop realistic projections, secure adequate financing before launching, monitor spending carefully during startup

Financial risk - Excessive debt:

Borrowing too much can create large monthly repayment obligations

• Mitigations: Borrow only what you can repay, maintain a healthy balance between debt and owner’s equity

Financial risk - Economic and market risk:

External economic conditions can affect customer spending and business performance

• Mitigation: Maintain financial flexibility, diversify revenue streams, reduce unnecessary fixed costs

How do financial instruments such as insurance or hedging play a role in managing financial risk?

Insurance → Protects a business from unexpected events such as accidents, lawsuits, property damage, and operational disruptions

Hedging → Protects against financial uncertainties such as changes in exchange rates, interest rates, and commodity prices

How can a new business legally minimize its tax burden?

• Choose the appropriate business structure

• Deduct legitimate business expenses from revenue, reducing taxable income

• Separate business and personal expenses

• Using depreciations may allow the cost of assets to be deducted over time: this can lower taxable income in the years when the investment is made

What are some personal finance considerations an entrepreneur should keep in mind when starting a business?

• Maintain seperate personal and business finances

• Build a personal emergency fund

• Create a personal budget

• Monitor personal credit

• Avoid overinvesting personal assets

• Develop a backup plan

How can personal credit affect a business startup’s ability to secure financing?

Lenders and investors often use the owner’s personal credit as an indicator of financial responisbility and repayment ability

• Helps influence loan approval

• Strong credit can lower interest rates and give you higher borrowing limits

• Better personal credit generally means better business credit card options

Horizontal vs. vertical analysis

Horizontal → Compares periods, focus on time, finds growth trends, year-to-year changes

Vertical → Compares line items, focus on percentages, finds composition percentages, statement structure

What is the Return on Equity ratio financial ratio (ROE)?

Measures how effectively a company uses shareholders’ money

• ROE = Net income / Shareholders’ equity

• High ROE → Means management generates more profit from investor funds

What is the operating margin financial ratio?

Measures profit from normal business operations

• Operating income / Revenue

• High → company operations are efficient

What is the debt-to-equity ratio?

Measures how much debt finances the business

• Total liabilities / Shareholders’ equity

• High → more financial risk, greater dependance on borrowing

• Low → Less risk, stronger financial position

What is the interest coverage debt ratio?

Measure’s ability to make interest payments

• High → comfortable paying debt

• Low → risk of financial trouble

What is the inventory turnover efficiency ratio?

Measures how quickly inventory sells

• High → strong sales, efficient inventory management

• Low → excess inventory, slow sales

What is the price-to-earnings (P/E) valuation ratio?

Shows how much investors are willing to pay for each dollar of earnings

• Stock price / Earnings per share (EPS)

• High → Investors expect future growth or could also indicate overvaluation

• Low → May be undervalued or company growth expectations are lower

What is the dividend yield valuation ratio?

Measures income received from stock ownership

• Annual dividend / stock price

• High → management is committed to returning profits to shareholders or the company’s stock price may have fallen significantly (concern for future earnings)

What are pro forma financial statements?

Pro forma means projected or forecasted financial statements based on assumptions

• Think “What if”

Pro forma scenarios:

Best case → Sale much higher than expected

Expected case → most realistic estimate

Worst case → Sales lower than expected or costs increase sharply

What are the uses of pro forma statements?

Business loans → Banks want to know whether future profits can repay loans

Investors → Want to evaluate projected growth and profitability

Decision making → Used for: new products, new locations, mergers, expansions, new customer contracts