Designing a new business (4): Financial analysis

Prof. Antonio Renzi

Entrepreneurship and new ventures finance

Agenda

1. Financial dynamic: general framework

2. Financial need of new businesses

3. Net working capital

4. Cash flow analysis

1. Financial dynamic: general framework

2. Financial need of new businesses

3. Net working capital

4. Cash flow analysis

Financial dynamic: general framework

Financial stakeholders:Investors and lenders

Capital raising

Structural cash inflow:Equity investments;

Financial credits

Investments

Financial need:Investments plan

Structuralcash

outflowCapital raising Investments

Economicnet cash flow

CapitalRemuneration

Structuralcash

outflow

Revenuesand costs

Self-financing

Financial need of a new business

Financial need for expected revenues

)(need(FN)Financial 10 REVf 000 SFEFEFN

REV1 = expected revenuesEFN = external financial needSF = self-financing.

REV1

Capitalintensive

Commercialcredits

Managementof inventory

EFN0 +SF0

Financial Need = Fixed Investments + Current Assets

Financial need of new businesses

The estimation of durable financial need: Analytic approach

Financial need of new businesses

The estimation of durable financial need: Synthetic approach

(T0)jj(T1)sj(T0)

n

1i i

is

FI)(REVACAFN

nREV

FIACA

ACAs = Average capital intensive of cluster sFNj = Financial need of business jREVj(T1) = Expected j revenuesFij(T0) = Fixed investments

Financial need of new businesses

Synthetic approach: multi-period analysis

)FI(FI...)FI(FI

)REV(REV...)REV(REVACAFN

1)-j(TNj(TN)j(T0)j(T1)

1)-j(TNj(TN)j(T0)j(T1)sTN)j(T0,

Hypothesis: Each expected Euro of revenue requires a durable investment equal to threeEuros

Financial need of new businesses

Analytic approach /Synthetic approach

The synthetic approach is useful especially in the first stage of analysis, when the specificbusiness goods are not identified. From this point of view, the synthetic approach helps theestimation of the general capital amount necessary to finance the industrial structure of theproject.

Moreover the synthetic approach could be useful to analyze the causes about differencesbetween the capital intensive of a certain industry and capital intensive of a certainbusiness.

The synthetic approach is useful especially in the first stage of analysis, when the specificbusiness goods are not identified. From this point of view, the synthetic approach helps theestimation of the general capital amount necessary to finance the industrial structure of theproject.

Moreover the synthetic approach could be useful to analyze the causes about differencesbetween the capital intensive of a certain industry and capital intensive of a certainbusiness.

Financial need and risk

Project StartElevated operative and

financial risk

High durable financialneed

Project GrowthNegative cash flow

High temporary financialneed

Financial need of new businesses

FINANCIALNEED

HighProject Start

Elevated operative andfinancial risk

High durable financialneed

Idea creationHigh uncertainty

Low durable financialneed

Consolidation

Positive cashflow

RISK

FINANCIALNEED

High Low

Low

Networking capital (NWC)

Balance sheet equation: CLDFCAFI

NWC = CA – CL = DL - FI

Networking capital (NWC)

FI DF

CA CL

NWC > 0

FI DF

CA CL

NWC = 0

FI DF

CA CL

NWC < 0Disequilibrium:

Excess of liquidityEquilibrium:

Excess of liquidityDisequilibrium:Lack of liquidity

Excess of liquidity: Causes

• Combination between economic strength and a lack of opportunity growth(cash cow).

• Self-financing.

• Business crises causes (for a short time) liquidity that comes fromdisinvestments

Net working capital

• Combination between economic strength and a lack of opportunity growth(cash cow).

• Self-financing.

• Business crises causes (for a short time) liquidity that comes fromdisinvestments

Lack of liquidity: Causes

• Economic inefficiency

• Difficulty to get a return on commercial credit.

• Difficulty to obtain durable financing.

Net working capital

• Economic inefficiency

• Difficulty to get a return on commercial credit.

• Difficulty to obtain durable financing.

The right level of NWCThe optimum level of NWC requires: 1) A low waste of financial resources;2) A protection margin (m) than the volatility of current asset and currentliabilities.

0NWCmc)

0NWCmb)

0NWCma)

Inefficiency: waste of financialresources; covered risk

Net working capital

0NWCmc)

0NWCmb)

0NWCma)

Inefficiency: waste of financialresources; covered risk

Limited efficiency; riskcovered

Max efficiency; No coverrisk

Cash flow analysis

Net Income(- ) ∆ Net operative Working Capital(+) DepreciationA) Economic cash flow

(+) ∆ Equity - Net Income(+) Financial debts(+) Financial debts(-) New Fixed Investments(+) DisinvestmentsB) Structural cash flow

Total Cash flow = A +B

Cash flow analysis

- ∆ Net operative Working Capital=

Accounts payable – (∆ Accountsreceivable + ∆ Inventory)

Accounts payable = costs without cashout flow

Accounts receivable = revenueswithout cash inflow

- ∆ Net operative Working Capital=

Accounts payable – (∆ Accountsreceivable + ∆ Inventory)

Accounts payable = costs without cashout flow

Accounts receivable = revenueswithout cash inflow

Cash flow analysis

A) Economic cash flow

B) Structural cash flow

Goal: maximization

Goal: ?

A positive value of the structural cash flow indicates a surplus of financing

A negative value of structural cash flow could depend on self-financing processes

A null value of the structural cash flow arises when there is a perfect balance betweenthe acquisition of new equity (and/or new financial debts) and the dynamic of fixedinvestments

Cash flow analysis

Free cash flow

Free Cash FlowTo Firm

It comes just frominvestment decisions.

Free Cash FlowTo Equity

It comes from bothinvestment decisions and

financing choices

Equity

Debt

Assets

The free cash flow is a net cash flow usable to reward lenders and shareholders

Free Cash FlowTo Equity

It comes from bothinvestment decisions and

financing choicesDebt

The Free Cash Flowis correlated in negative way with the business dynamic:

Investments growth decreases dividends

Investment growthΔ Net Fixed Investments + Depreciation > 0

Cash flow analysis

Free Cash Flow To Firm

Net Income+ Debt service

+ Non-Cash Items (Depreciation)

– ΔNet Operative Working Capital

– New Fixed Investments+ Fixed Disinvestments

= FCFF

Net Income+ Debt service

+ Non-Cash Items (Depreciation)

– ΔNet Operative Working Capital

– New Fixed Investments+ Fixed Disinvestments

= FCFF

Cash flow analysis

Free Cash Flow To Equity

Net Income

+ Non-Cash Items (Depreciation)

– ΔNet Operative Working Capital

– New Fixed Investments+ Fixed Disinvestments

= FCFE = FCFF - Debt service

Net Income

+ Non-Cash Items (Depreciation)

– ΔNet Operative Working Capital

– New Fixed Investments+ Fixed Disinvestments

= FCFE = FCFF - Debt service

Cash flow analysis

Expected Free Cash Flow analysis and growth assumption

• No-Growth Assumption - Free Cash Flow stable• Constant Growth Assumption – Constant growth of Free

Cash Flow• Negative Growth Assumption• Variable Growth Assumption – Variable growth of Free

Cash Flow

In general the growth assumptions about expected free cashflow are inverse than the growth assumptions about

investment dynamic:Temporal mismatching between earning dynamic and

investment dynamic

• No-Growth Assumption - Free Cash Flow stable• Constant Growth Assumption – Constant growth of Free

Cash Flow• Negative Growth Assumption• Variable Growth Assumption – Variable growth of Free

Cash Flow

In general the growth assumptions about expected free cashflow are inverse than the growth assumptions about

investment dynamic:Temporal mismatching between earning dynamic and

investment dynamic