UNDERSTANDING FINANCE AND MEMBER EQUITY MY EXPERIENCE AGENDA

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1 UNDERSTANDING FINANCE AND MEMBER EQUITY A Special Presentation for the Strengthening Cooperation Workshop February 21, 2006 by Brian Henehan Senior Extension Associate Cornell Cooperative Enterprise Program MY EXPERIENCE Program Leader of the Cornell Cooperative Enterprise Program since 1985 Past Experience in Management and Serving on Boards of Directors Researcher - Focusing on Cooperative Enterprise: Decision Making, Organizational Behavior, and Marketing Have Learned Much About Factors for Success (and Failure) Secretary of the Northeast Cooperative Council non-profit with 20 Ag. Cooperative Members AGENDA 1) Review Financial Issues for Start-ups 2) Look at the 2 major components of financial statements Income Statement Balance Sheet 3) Discuss Managing Member and Investor Equity Equity Plans Open Discussion

2 GROUND RULES Operate in an informal way Don t hesitate to stop me if you need clarification All questions are worth asking Definition of Terms Member = Owner and Primary Investor (in LLC. & Coop.) Member Equity = the Capital Invested in the Organization by Members Outside Investor = Non-member investor Equity Plan = Plan for Raising and Redeeming Equity (in LLC & Coop.) Financial Reporting = Means of Informing Members, Investors, and Decision-Makers About Financial Performance Financial Issues Establish Accurate and Understandable Financial Reporting System (Set up adequate accounting systems) Need to Develop Realistic Financial Projections that Later Become Performance Benchmarks Offer Stakeholder Access to Financial Information and Assure that Adequate Fiscal Controls are in Place

3 Questions About Financial Reporting Are You Collecting the Data You Need? How Conservative An Approach Is Being Used? (asset valuation, inventory, accounts) Are Grant Funds Counted as Extraordinary Income to Be Replaced by Cash Generated from the Business Over Time? Are Reports Delivered in a Format Understandable to Directors and Members? ECONOMICS IN THE START-UP STAGE $ s Sales Variable Costs Fixed Costs Profit Loss Time Start-up Risk, Returns & Investment Risk Returns Investment Pre- Startup Startup Post-Startup

4 Start-up Risks and Returns An Initial Infusion of Capital Will Be Required Start-up Capital is Typically Raised from Various Sources A Prospectus Type Proposal is Useful to Define Risks and Hoped for Returns There Will a Relatively High Level of Risk Early On with Postponed Returns Members and Investors Will Need to Be Patient THE INCOME STATEMENT Also called: Operating Statement Statement of Operations and Distributions THE INCOME STATEMENT + Revenues (sales) - Cost of Sales = Gross Profit - General, Selling, Administrative, & Interest Costs = Operating Income + Other Revenue = Proceeds before Patronage Refunds, dividends & taxes - Distribution to Members in Cash or Allocations (Paper) - Dividends on preferred stock (members and/or investors) = Taxable Net proceeds - Taxes = Tax Paid Retained Earnings (into Tax-paid reserve)

5 Points to Look for on the Income Statement Are sales (on average) increasing fast enough to reach break-even point when desired? Are expenses growing slower than sales? Will there be enough revenues generated to repay debt or reward investors? Related Tax Issues Both Cooperatives and LLC s Are Single Tax Pass Through Entities Either the Business Pays the Tax on Income or Members Pay the Tax on Income Distributed to Them Ag. Cooperative Members Declare that Income as Farm Income Taxes on Cooperative Retains Allocated to Members Are Due That Year. LLC s Members May Declare Income as Personal Income Economic Benefits to Members Better prices Patronage refunds (2 parts) Cash Paper (equity) Services (of value to members) Strategic Value (access to markets) Its Mere Existence (set tone for market) Return on equity (not the primary source of benefits)

6 Member Orientation vs. Investor Orientation Earnings Distributed to Members by Volume of Product Delivered Earnings Distributed to Investors by Level of Investment (stock shares) Can Be a ZERO SUM Game Increased Distributions to Investors May Mean Less Available for Members Increased Distributions to Members May Mean Less Available to Investors Should Net Proceeds Stay in the Business or Be Released to Members (or Investors)? Stay In Business: Grow business Reduce debt Support Innovation: R&D New Products Technology Redeem Equity Release to Members or Investors: Members Grow Own Business Member can reduce his/her debt Higher Prices More Services Larger Pat. Refund Stock Dividends Maintaining the Right Balance Stay In Business: Increasing Need to Support Innovation: R&D New Products Technology Build A Business That Can Compete in Today s & Tomorrow s Markets Release to Members: Tendency Can Be to Serve Short Term Needs of Members At the Expense of Maintaining Viable Cooperative Business Over the Long Pull

7 Determining Capital Needs How Much Operating Capital Needed? Producer Payments Payroll Rent/Lease Any Capital Expenditures? Equipment Assets How Long Before Bills Can Be Paid from Cashflow from Operations? THE BALANCE SHEET THE BALANCE SHEET Current Assets Cash Accounts Receivable Inventories Pre-paid Expenses Investments Fixed Assets Less Depreciation TOTAL ASSETS Current Liabilities Accounts Payable Notes Payable Accrued Expenses Long Term Liabilities (Debt) Members & Stockholders Equity: Allocations to Members Common Stock (voting rights) Preferred Stock Tax Paid Retained Earnings TOTAL LIAB. & EQUITY

8 Points to Look for on the Balance Sheet Provides the Primary Source of Growth Are Current Assets Adequate to Meet Current Liabilities? Cash stable Accounts receivable not increasing faster than sales Inventories increasing slower than sales Fixed assets (plant, property & equipment) increasing slower than sales Points to Look for on the Balance Sheet Current Assets: Adequate Level of Cash? Are Accounts Being Collected? How is Inventory Valued? Current Liabilities: Treatment of Current Obligations (accounts & notes payable) Fixed Assets Quality of fixed assets Value of Intangibles Points to Look for on the Balance Sheet Common stock usually increasing, as the number of members increases. Equity increasing Is There Adequate Equity? Typically 60% of Assets

9 Developing an Equity Plan Determine Amount of Total Capital Needed: Start-up Operating Capital (Until Sales Support Operations) Required Capital Expenditures (Assets) Arrive at Optimal Mix of Sources Member equity (typically at least 60%) Debt Grants (very short term solution) Determine Amount of Individual Member Equity Required Over Time Approaches to Raising Member Equity Voluntary vs. Mandatory Up Front (purchase delivery rights) Pay As You Go (per unit retains) Retain a Portion of Profits (allocated retained earnings) Delay Payments to Producers (pooling) Base Capital Plan is Commonly Used Calculate Production Base for Each Member Compute Amount of Equity Each Member Needs to Contribute (% of Total Production&% Equity) Member Contributes Until Base Amount Reached MEASURING PERFORMANCE More Challenging for a Member- Oriented firm vs. an Investor- Oriented firm Members Can Have More Complex and Harder to Measure Demands Stock holders have Clearly Defined Demands (stock value and yield) Many Stock Analysts Measuring Performance of IOF s

10 ACCESS TO CAPITAL Must Remain an Attractive Investment Opportunity or Borrower Explicit Lender Demands: Current Ratio Equity to Assets Ratio Lender Fixed Charge Coverage RESOURCES Financing Cooperatives - Understanding Cooperatives Series, USDA, RB-CS, CIR 45, sec. 7 Understanding Financial Reports The Merrill Lynch Guide ingfinancial.pdf Understanding Cooperative Bookkeeping and Financial Statements USDA, RB-CS CIR 57 RESOURCES Questions Cooperative Directors Should Be Asking Management. AEM Staff Paper Considering Cooperation: A Guide for New Cooperative Development. AEM Ext.Bul. Doing Business In New York State: Structures and Strategies AEM Ext.Bul. National Society of Accountants for Cooperatives,

11 SUMMARY A Good Financial Reporting System is Essential Financial Statements Provide Essential Insight into Financial Performance Forecast the Level of Sales Required to Sustain the Business and Reach It ASAP Understand the Financing Needs and Alternative Sources of Capital Finance & Member Equity are Less Complicated Than It Might Appear Use Common Sense UNDERSTANDING FINANCE AND MEMBER EQUITY Discussion USEFUL FINANCIAL RATIOS SOLVENCY: Debt Ratio = LT Debt to Total Capital = DEBT CAPACITY: Debt to Equity = ACCOUNTS REC. MANAGEMENT Days Sales in = Receivables Current Liab.+ LT Debt Total Assets Long-term Debt LT Debt + Equity Long-term Debt Equity Receivables (Sales/360)

12 USEFUL FINANCIAL RATIOS LIQUIDITY: Current Ratio = Quick Ratio = Net Working Capital = INVENTORY MANAGEMENT: Inventory turnover = Current Assets Current Liabilities Current assets-inventory Current liabilities Current assets current liabilities Cost of goods sold Inventory USEFUL FINANCIAL RATIOS PROFITABILITY: Gross margin on sales = Gross margin Sales Net margin on sales = Net income Sales RETURN ON EQUITY: ROE = (can be difficult to calculate in a cooperative) Net income Equity

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