TIBURCIO TANCINCO MEMORIAL INSTITUTE

OF SCIENCE AND TECHNOLOGY

Calbayog City

GRADUATE SCHOOL AND TRAINING ACADEMY

Subject: Advance Cooperative Development and Entrepreneurship

Semester: 2nd Semester SY 2008 - 2009

Topic: How to Start a Business?

Business Risk and Insurance

Professor: Dr. Avelina N. Bergado

Reporter: Donald M. Patimo, MPM

STARTING A NEW BUSINESS

The advantages of starting a new business are as follows:

1. There is an option to select the location with the best economic and market potential.
2. If constructing a new building is included in the plan, the building may be designed according
to the requirements of the small business.
3. The type and size of the building may be designed according to current conditions.
4. The design can include a capacity for future additions to the building.
5. New businesses have no negative reputation.

The disadvantages of starting a new business are as follows:

1. Unproven operations; the business has no success history.
2. No knowledge of how competitors will react.
3. Higher cost of new equipment
4. No name recognition; the business will have to spend money to establish a name.

BUYING AN EXISTING BUSINESS

Buying an existing business offers the following advantages:

1. A successful existing business may be made to continue.
2. It may already have the best location.
3. Employees and suppliers are established.
4. Equipment is installed and productive capacity is known.
5. Inventories are in place and trade credit has been established.
6. The new owner can use the experience of the previous owner.
7. The business is already operating.
8. There is the possibility of buying the business at a bargain.

The possible disadvantages of buying an existing business are as follows:

1. Ill-will generated by the business may be inherited.
2. Incompetents in the workforce may also be inherited.
3. Bad precedents in policies, procedures, or customs also may be inherited.
4. Antiquated facilities which may entail higher maintenance and replacement costs may be
inherited.
5. Inventory may be obsolete.
6. The purchase price may be too high and may place a burden on future profits.

EVALUATING AN OPPORTUNITY TO BUY AN EXISTING BUSINESS

1. The Owner’s Reason for Selling

The following are some of the possible reasons why the owner is selling his or her
business:
a. The owner has reached the stage of boredom and burnout.
b. The owner is immigrating to another country.
 c. The owner would want to cash in and invest in other types of assets.
d. There is intense competition.
e. There is a change in the city ordinance affecting commercial establishments.
f. There are cash flow problems.
g. Lease agreements are expiring.
h. Customer base is declining.

2. The Physical Condition of the Business

Assets, whether tangible or intangible, must be evaluated using the following guide
questions whenever applicable:
a. Are they transferrable?
b. Are they reasonably priced?
c. Are they obsolete?
d. Are they working efficiently?
e. Do they need replacement?

To establish adjusted book value or real market value for the assets of a business
concern, the following steps are recommended:
a. determine the book value of the asset
b. add or subtract an adjusting factor

The mathematical formula for the real market value of an asset will appear as follows:
RMV = BV + AF (in case of a positive AF)
RMV = BV - AF (in case of a negative AF)
where:
RMV is for the real market value
BV is for the book value
AF is for the adjusting factor

The adjusting factors for the various assets are as follows:

a. Accounts receivable
Subtract an allowance (about 5%) for the failure of some credit customers to pay
their bills. If evidence shows a different percentage of bad debts, then it should be used.
b. Raw materials inventory
Add or subtract the difference of the acquisition cost and the current price.
c. Work-in-process inventory
If a general pay increase was given to employees, the value of the work-in-
process inventory must also be increased at the same rate. Otherwise, increase by one
percent to allow for random merit increase.
d. Finished goods inventory
The difference between cost of production and selling price must be added to the
book value.
e. Supplies
The one applied to raw materials inventory also applies.
f. Capital assets and facilities
From their depreciated book value, add a factor to indicate their appreciation due
to inflation. Items made obsolete by technological advancements must be considered
solely on their depreciated book value.
Example:
Suppose the following information is provided regarding the small business firm owned
by Mr. Alberto Dionisio, what is the real market value of its assets on December 31, 1996?
ALBERTO DIONISIO ENTERPRISES
Financial Data as of December 31, 1996
a. Accounts receivable
- Php 2,500,000
- Bad debts in 1993: Php 150,000
- Bad debts in 1994: Php 165,000
- Bad debts in 1995: Php 140,000
b. Raw materials inventory
- Php 1,000,000 (acquisition cost)
- Php 1,100,000 (current market price)
c. Work-in-process inventory
 - Php 1,000,000
- No general increase in salaries and wages
d. Finished goods inventory
- Php 1,100,000 (production cost)
- Php 1,500,000 (selling price)
e. Supplies
- Php 150,000 (acquisition cost)
- Php 140,000 (current market price)
f. Capital assets and facilities
- Php 5,000,000 (depreciated book value)
- 25% (appreciation due to inflation)
- 10% of total capital assets and facilities are obsolete
Solution:
ALBERTO DIONISIO ENTERPRISES
Real Market Value of Assets
December 31, 1996

Asset Book Value Adjusting Factor Real Market Value

Accounts Receivable Php 2,500,000 - Php 151,666 Php 2,348,334
(average of bad debts
for the past three
years)
Raw Materials Php 1,100,000 - Php 100,000 Php 1,000,000
Inventory (difference between
acquisition cost and
current market price)
Work-in-process Php 1,000,000 + Php 10,000 (1% Php 1,010,000
Inventory increase)
Finished goods Php 1,100,000 + Php 400,000 Php 1,500,000
(difference between
selling price and
production cost)
Supplies Php 150,000 - Php 10,000 Php 140,000
(difference between
current market price
and acquisition cost)
Capital Assets and Php 4,500,000 + Php 1,125,000 (25% Php 5,625,000
Facilities appreciation)
Php 500,000 none (due to Php 500,000
obsolescence)
Php 12,123,334

3. The Potential of the Company’s Products or Services

In preparation of a sales forecast, the following are necessary:
a. an analysis of existing and potential customers
The prospective buyer must have information about the characteristics of the
existing customers of the business. These will refer to age, sex, income, and so on.
b. an analysis of competitors
Relevant information about the competitors will reveal the chance of success for
the prospective business. This will consist of the number of competitors, product or
service offerings, marketing mix used, reactions to various activities of competitors, and
so on.

4. Legal Aspects to be Considered

The effective transfer of ownership of the assets of the business must be the concern of
the prospective buyer. As some creditors may have prior claims on specific assets, these must be
satisfied first before the sale or the buyer may assume responsibility for them.
The buyer must make sure that the following are undertaken:
a. The seller must give the buyer a sworn list of existing creditors.
b. The buyer and the seller must prepare a list of the property included in the sale.
 c. The buyer must keep the list of creditors and the list of property up to the period
prescribed by law.
d. The buyer must give notice of the sale to each creditor before he takes possession of the
goods or pays for them.

There are cases when the business has existing contracts with suppliers, lessors,
employees, customers, or others. The prospective buyer must know the rights and obligations he
will have to assume under such contracts. The following contracts must be evaluated by the
buyer:
a. fire insurance contract must be assigned to the buyer
b. copyrights, patents and trademarks
c. exclusive agent or distributor contracts
d. real estate leases
e. financing and loan agreements
f. union contracts

5. Financial Health of the Business

The prospective buyer must secure the financial statements of the firm and use these to
determine the financial health of the business. In determining the value of the business, three
practical methods are available. They are as follows:
a. Market method
The market method is arrived at by determining the real market value of the
assets and deducting the total liabilities of the firm. Thus, if the real market value of the
assets of a firm is Php 1,700,000 and the total liabilities are Php 285,519, the market
value of the business is Php 1,414,481.

b. Income method
In this method, the future earning potential of the business is taken into
consideration. The earnings are capitalized by a rate consisting of three components, as
follows:
- the current loan or mortgage interest rate to pay on any funds that need to
be borrowed for the purchase of the business
- the return on the equity put up by the buyer
- an additional rate to compensate for the risk factor which is translated as
the probability that the actual returns will deviate from expected returns
Example:
If 60% of the purchase price was borrowed at 16%, the balance of 40% financed
by equity requires a 25% return, and a risk factor of 2% is assigned to the investment,
the weighted capitalization rate will be:

60% debt x 16% = 9.6%

40% equity x 25% = 10.0%
Risk factor = 2.0%

TOTAL WEIGHTED
CAPITALIZATION RATE 21.6%

To determine the value of the firm, the average annual income after tax is divided
by the capitalization rate. For example, if the projected after tax earnings of a company
is as follows:

YEAR PROJECTED NET INCOME

(after tax)
1997 Php 402,608
1998 Php 422,738
1999 Php 443,874
2000 Php 466,067
2001 Php 489,370

Average Php 444,931

The value of the firm may then be derived as follows:

 Value of the firm = Average annual income / Capitalization rate
= Php 444,931 / 21.6%
= Php 2,059,866

c. Negotiation method
In this method, the firm’s value is arrived at by negotiating with the seller. Both
parties may use the value derived from either the market method or the income method,
plus or minus the perceived effects of nonfinancial factors like the following:
- Goodwill of the business
- The value of the employees who are experienced in the business and will
not leave
- The value of the operating and control systems already established

FRANCHISING DEFINED

Franchising is an arrangement whereby the manufacturer or sole distributor of a trademarked

product or service gives exclusive rights of local distribution to independent retailers in return for their
payment of royalties and conformance to standardized operating procedures.
The franchisor is the company that develops a product or service concept and sells others the
rights to make and sell the products or services.
The franchisee is the person who buys the franchise.

TYPES OF FRANCHISING
1. Trademark franchising
The franchisee buys the right to use the tradename of the franchisor without the
requirement of distributing particular products exclusively under the manufacturer’s name.

2. Product distribution franchising

This is also called as dealership that involves licensing the franchisee to sell specific
products under the manufacturer’s brand name and trademark through a selective, limited
distribution network.

3. Pure or business format franchising

This provides the franchise with a complete business format including name, image,
method of doing business, the products or services to be sold, the physical plant, a marketing
strategy plan, a quality control process, a two-way communication system, and the necessary
business services.

ADVANTAGES OF FRANCHISING

1. Management training and counseling is provided by the franchisor.

2. Brand name appeal of the products or services is offered for sale.
3. Quality of goods or services is standardized.
4. The benefit of a national advertising program is undertaken by the franchisor.
5. Lower capital requirements and financial assistance are given by the franchisor.
6. Products and business formats are proven.
7. Lower cost of procuring equipment and materials is enjoyed because of the franchisor’s
centralized buying power.
8. Exclusive rights to a specific territory are granted.
9. Greater chance of success is assured.

DISADVANTAGE OF FRANCHISING

1. Franchise fee have to be paid and profit is shared with the franchisor.
2. Restrictions regarding operations are imposed.
3. Product line is limited.
4. There is the possibility of unsatisfactory training programs provided by the franchisor.
5. Less freedom for the franchisee to make decisions.

EVALUATING A FRANCHISING OPPORTUNITY

 Among the factors that should be assessed pertains to the following:
1. the risk of dealing with an unproven franchisor
2. the financial stability of the industry
3. the potential market for the new franchise
4. the profit potential for the new franchise

FRANCHISE AGREEMENT DEFINED

The franchise agreement is the contract drawn between the franchisor and the franchisee. The
rights and obligations of each party are contained in the contract. The specific contents of the
agreement include the following:
1. the exclusive territorial rights granted to the franchisee
2. the number of years the control will be in force
3. the terms of renewal of the contract
4. the financial requirements including initial price for the franchise, schedule of payments,
royalties, profit sharing, etc.
5. the provisions in case of disability or death of the franchisee
6. the provision in case of selling the franchise to another party or the buyback arrangement with
the franchisor.

RISK DEFINED

Risks are a natural part of any activity. A venture may succeed or it may not. Profits are the
objectives of firms but the possibility of a loss trails operations from beginning to end. Risk may be
defined as “uncertainty as to economic loss”.

Business risks may be classified as:

1. Speculative risk is a type of risk involving a chance of either profit or loss.

Example:
building a new plant or opening a new branch

2. Pure risk is a type of risk involving a threat of loss with no chance of profit.
Example:
risk of fire, robbery, and injuries to the third parties

Business persons attempt to reduce speculative risk through careful planning while pure risks
are better confronted by the use of risk management techniques.

RISK MANAGEMENT DEFINED

Risk management may be defined as the process of effectively reducing the adverse effects of
risk. Risk management requires the following steps:

1. identification of pure risks confronting the firm

2. deciding on the methods of dealing with each risk

METHODS OF DEALING WITH RISK

1. Risk Avoidance is a method of dealing with risk in which the source of risk is eliminated.
Examples:
A person who wishes to avoid the risk of being in a sinking ship must avoid travelling
by ship.
If someone wants to avoid the risk of fire, renting a building instead of owning it avoids
the risk.

2. Risk Reduction refers to the steps undertaken to lessen the likelihood of a loss.
Examples:
Installation of nonskid stairways to minimize falls
Accident prevention programs
Truck drivers wearing seatbelts to minimize injuries from accidents
The use of water sprinklers to minimize fire loss
 Machine operators wearing safety glasses, gloves, and safety shoes to reduce the risk of
injury

3. Risk Assumption is a method of dealing with risk in which the company assumes the risk and
gets ready for whatever loss comes from the risks covered.
Example:
The practice of building a contingency fund which is also known as self-insurance

4. Risk Shifting is a method of dealing with risk in which the company shifts the risks to an
insurance company. This method is applied when the first three (3) methods of handling risks
cannot meet the requirements of the company or impractical.

TYPES OF INSURANCE COVERAGE

1. Life insurance policies are those that cover risks of losing one’s life, disability, or sickness.
According to Kapoor and others, life insurance is one of the few ways to provide
liquidity at the time of death.

Life insurance can be made in three (3) ways:

a. Group life insurance is provided to a well defined group of people who are associated
for some purpose other than purchasing life insurance. This covers loss due to death,
sickness and injury.

b. Industrial or debit life insurance is purchased in small amounts of coverage usually

10,000 pesos or less.

c. Individual life insurance policies are those policies purchased by individuals to fulfill
their life insurance plans.

2. Nonlife insurance policies cover risks of losses on properties owned by the firm due to fire,
robbery, theft, liability claims of third parties, etc.

TYPES OF LIFE INSURANCE POLICIES

1. Term life insurance is a kind of life policy providing protection for a specified period like one or
two years. Benefits are paid only if the insured peril happens during the period covered.
2. Whole life insurance policy provides the beneficiary of a stipulated sum when the assured dies.
Unlike term policies, whole life policies have cash value. Cash value refers to the amount
received by the assured if he gives up the insurance.
Whole life policies, also known as straight or ordinary life policies, may be further classified
into the following:
a. Limited payment policy requires that premiums be paid for a stipulated period, usually
20 to 30 years, or until a specified age such as 60 or 65 is reached.
b. Single premium policy is a type of contract where only one premium payment is made.
c. Modified life insurance contracts are those in which the premiums are arranged so that
they are smaller than average for the first 5 or 10 years of the policy and slightly larger
than average for the remaining years of the contract.
d. Variable life policy has a cash value that fluctuates according to the yields earned by a
separate fund. A minimum death benefit is guaranteed.
e. Adjustable life policy is one whose coverage can be increased or decreased by changing
either the premium payment or the period of coverage.
f. Universal life policy combines term insurance with investment. Premiums are paid at
any time in virtually any amount with the effect that the amount of insurance can be
changed easily.
3. Endowment life

BUSINESS USES OF LIFE INSURANCE

Business purchase life policies for any or all of the following reasons:
1. For use as a fringe benefit for employees
When group life insurance is purchased by the company as a benefit for employees, it
helps attract and retain employees.
 2. To protect the firm against the financial problems caused by the loss of a key person
When a key employee dies, financial losses may come as a result. The small firm may
purchase life insurance for protection against such losses. The business is the owner and the
beneficiary of the policy and the key employee is the subject of insurance.
3. To aid in transferring ownership rights
Life insurance proceeds also make the transfer of ownership interest easier because of
the availability of cast at the time of death. This may also help the family keep control of the
business.

TYPES OF NONLIFE INSURANCE POLICIES

1. Fire insurance
2. Motor car insurance
3. Marine insurance
4. General liability insurance
5. Bonds insurance
6. Miscellaneous insurance

FIRE INSURANCE DEFINED

 The subject of insurance may consist of buildings, machinery, furniture, stocks of merchandise,
raw materials, and work-in-process.
 This may also provide coverage on earthquake fire, earthquake shock, windstorm, typhoons,
flood, riot and strike damage, riot fire damage, and explosion.

MOTOR CAR INSURANCE DEFINED

Motor car insurance may cover the following losses:

 Own damage and theft insurance to cover losses on the vehicle itself
 Third party property damages
 Third party liability – body injury to third parties
 Passenger’s liability insurance

MARINE INSURANCE DEFINED

Marine insurance may be classified as follows:

1. Ocean Marine Insurance covers sea perils of ships and cargoes from the warehouse of the seller
to the warehouse of the buyer.
2. Inland Marine Insurance covers the land or over the land transportation perils of property
shipped by railroads, motor trucks, and other means of transport.

GENERAL LIABILITY INSURANCE DEFINED

There are times when business firms become the subject of liability suits arising from loss or
damage caused by various aspects of business operations. An example is the death of a customer as a
result of consuming the product of a food manufacturer.

Business liability forms of insurance consist of the following:

 Owner’s, Landlord’s, and Tenant’s Liability Policy
 Manufacturer’s and Contractor’s Form
 Comprehensive General Liability Form
 Contractual Liability Form
 Owner’s and Contractor’s Protective Liability Insurance
 Products and Completed-Operations Liability Form
 Products Recall Insurance
 Personal Inquiry Liability Policy
 Storekeeper Liability Policy
 Dramshop Liability Policy
BONDS INSURANCE DEFINED

Surety bonds guarantee the performance of certain obligations. This covers the following losses:
 Employee dishonesty (Fidelity Bond)
 A supplier’s failure to honor a supply contract (Supply Contract Bond)
 A contractor’s failure to complete a construction contract with the small business firm
(Performance Bond)

MISCELLANEOUS INSURANCE DEFINED

 Crime Insurance covers losses from crimes. Crime coverage includes possible losses from
burglary, robbery, larceny, theft, forgery, embezzlement, and other dishonest acts.
 Glass Insurance covers losses from glass used for light, displays, and ornamentation.
 Boiler and Machinery Insurance cover losses from machine breakdown.
 Credit Insurance covers insolvency of persons to whom the holder extends credit within the
term of insurance.

Reference:

Medina, Roberto G. Entrepreneurship and Small Business Management. Manila: Rex Book
Store, 2002.