Question

1. What is the MEANING and the APPLICATION of the use of COMBINED LEVERAGE in a start-up business’ financial model?

2. What is the GOAL of the financial forecasting process for a start-up business? That it, what is the business “forecasting”, and why is the information derived from the forecast important?

3. Explain the fundamental assumption which underlies the Additional Funding Needed (AFN) formula approach to financial forecasting for a start-up. What are the limitations of rigid application of the AFN formula?

4. A new business has developed its preliminary business model.   It expects to incur BOTH fixed operating and financial costs; and the model projects Year 1 Sales of $650,000 (but team members think that Sales could be as low as $500,000 or as high as $900,000). The owners want to know what will happen to profits if the model Sales projection is incorrect. The primary concern is Sales less than $650,000 given the substantial fixed costs the model accepts. The Year 1 proforma Income Statement is as follows:

Sales                                        650,000                                                                                   

Variable Expense                      357,500

Gross Profit                              292,500

Fixed Expenses                          185,000

EBIT                                          107,500

Less: Fixed Financial Expenses   57,500

Income                                     50,000

Note: Ignore Depreciation and Taxes

- Given the company’s projected Sales and its expense structure, what Degree of Operating Leverage (DOL) is the company willing to accept? (2 points)

- Given the fixed financial costs in the company model, by what % will Income change for each 1% deviation in EBIT?

- If actual sales are $520,000, by what PERCENTAGE (%) will Income decrease under the company’s present financial model?

- What is the company’s Survival Breakeven Sales Volume?

Answer 1

1. The Combined Leverage means how the fixed cost for operations and the fixed cost for financing i.e. the interest part of the long term or short term debt will affect the earning of the equity stakeholders for start up business model.This involves the operating and the Fianncial risk of the business in totality. This will be calculated as a percentage change in EPS divided by the percentage change in Sales. The implied meaning that the change ratio of the Debt to equity. and the Fixed cost to variable cost ratio will have a significant impact of the Combined Leverage.

2. Goal of Financial forecasting for start up business will provide the growth path of the business and the amount of earning yield of the start ups will provide to stakeholders.

The forecasting in the Financial statement is the expected growth rate with which revenue, profit will show up in the books of accounts provided the constant and growing economic situation of the country of business origin, constant growth of demand of product /services pursued by the company with minimum effect to societal cause and the entity be taken as going concern aiming to maximize stakeholders wealth.

The information derived from forecasting is important to stakeholders which will provide some guidance for investing in start up business as they have  very little brand establishment and historical data.

3. Additional funds needed (AFN) is based on the need of increase in assets over the increase in liabilities and increase in retained earnings.

AFN= A₀ * ΔS/S_o -L₀ * ΔS/S_o - S₁ * PM *b

Where,
A_o = current level of assets
L_o = current level of liabilities
ΔS/S_o = percentage increase in sales i.e. change in sales divided by current sales
S₁ = new level of sales
PM = profit margin
b = retention rate = 1 – payout rate

Limitations of AFN are the spontanous increase in liabilities directly attributed to sales of that product only. If it is a poled resource specially for service product then it is difficult to estimate and same is the case for the asset class and also the time period of calculation is of the current year and not of the future prolinged average value, therefore making it difficult to calculate the actual AFN for entire lifetime of the product/service.

4. According to DOL formula,

DOL = EBIT/Sales= 107500/650000 = 0.165

For 1% cahnge in EBIT, the EBIT will become $ (107500-1075) = $106425

the new Income will be = $ ( 106425- 57500) = $ 48925,

% change in Income will be = $ (50000- 48925 )/ $ 50000 = 0.0215 = 2.1 % change.

Now, as the sales cahnges to $ 520000, the variable expense change to $ 286000 ( 0.55 * $ 520000)

All other Fixed cost remaining same,

EBIT = $ ( 520000- 286000- 185000) = $ 49000.

After Subtracting the Finance fixed cost, there will be loss of $ ( 49000 - 57500) = $ (8500)

Income will change to loss , on 100% basis.

We have to subtract the fixed cost ( operational + financial) = $ (185000 =57500) =$ 242500

The sales Volume need to be more than the $ ( 242500 + .55 per unit of sale) = Minimum is $ 548750