Financials

  • Businesses can either be financed by equity or debt.
  • Equity financing often means issuing additional shares of common stock to an investor. With more shares of common stock issued and outstanding, the previous stockholders’ percentage of ownership decreases.
  • There is no promise to repay the investment like in a loan arrangement, nor is there an interest component.
  • There is, however, a cost to equity capital. In order for investors to agree to invest in the company, they expect to earn an acceptable return that justifies the risk of the investment. That return varies over time and across industries as investors compare the potential upside, the potential risks, and the risk-reward profile of investment opportunities other than the given company. If the company fails to meet these return expectations, investors can share their ownership interest and move capital elsewhere, reducing the value of the company and hampering future efforts to raise capital.
  • Equity investors are owners of the company, which means they have significant upside should the company prosper in the future. The cost to their capital is a floor, not a ceiling. That higher upside is required to reward investors for the increased risk of equity financing, which excludes collateral and pays equity owners last in a bankruptcy situation.
  • Debt financing means borrowing money and not giving up ownership. Debt financing often comes with strict conditions or covenants in addition to having to pay interest and principal at specified dates.
  • Lenders have no claim to a company’s profits outside of the original financing agreement. The upside for lenders is capped from the onset of the transaction at the interest rate, but their downside is also mitigated through loan covenants, collateral requirements, and a senior position to be repaid should the company face bankruptcy.

 

Important financials:

  1. Forecast Sales
    1. Determine the quantity you will assume to sell for the next year
    2. Set the price for each month
    3. Calculate Sales Q*P
  2. Cost of Goods Sold (COGS)
    1. Estimate all costs related to production
    2. Deduct them from Sales to get profit margin
  3. Expenses
    1. Estimate other costs not related directly to production ( e.g. administrative costs, marketing, utilities, rent)
    2. Deduct them from Profit Margin to get Income before Tax
    3. Deduct Tax to get Net Income
    4. Net Income can be negative up till the first year, until you reach your break-even point, and then you start making profits.

How to overcome overstating profit?

  • Do not understate cost; take into account all costs, even indirect ones like office rent and supplies
  • Put realistic forecast for sales
  • Account for Depreciation Expense
  • Deduct organizational costs/initial investment
  • Do not forget to deduct taxes