Essentials of Entrepreneurship and Small Business Management

Essentials of Entrepreneurship and Small

Business Management

Eighth Edition

Section 3: Launching the Business

Chapter 11

Creating a

Successful

Financial Plan

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Learning Objectives

11.1 Describe how to prepare the

basic financial statements and

use them to manage a small

business.

11.2 Create projected (pro forma)

financial statements.

11.3 Understand the basic financial

statements through ratio

analysis.

11.4 Explain how to interpret financial

ratios.

11.5 Conduct a break-even analysis

for a small company.

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Financial Management

• Financial management:

– A process that provides entrepreneurs with relevant

financial information in an easy-to-read format on a

timely basis.

– It allows entrepreneurs to know not only how their

businesses are doing financially but also why they are

performing that way.

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The Importance of a Financial Plan

• Common mistake among business owners: Failing to

collect and analyze basic financial data.

• Many entrepreneurs run their companies without any kind

of financial plan.

• About 75% of business owners do not understand or fail to

focus on the financial details of their companies.

• Financial planning is essential to running a successful

business and is not that difficult!

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Basic Financial Statements (1 of 3)

• Balance Sheet:

– “Snapshot”

– Estimates the firm’s worth on a given date;

built on the accounting equation:

Assets = Liabilities + Owner’s Equity

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Basic Financial Statements (2 of 2)

• Income Statement:

– “Moving picture”

– Compares the firm’s expenses against its revenue over

a period of time to show its net income (or loss):

Net Income = Sales Revenue – Expenses

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Customer Profitability Map

Figure 11.3 Customer Profitability Map

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Basic Financial Statements (3 of 3)

• Statement of Cash Flows:

– Shows the change in the firm’s working capital over a

period of time by listing the sources and uses of

funds.

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Creating Projected Financial

Statements

• Helps the entrepreneur transform business goals into

reality

• Challenging for a business start-up

– They should be realistic and well-researched!

• Start-ups should create two-year projections

• Projected financial statements:

– Income statement

– Balance sheet

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Ratio Analysis

• Ratio analysis:

– A method of expressing the relationships between any

two elements on financial statements.

– Important barometers of a company’s health.

• Studies indicate few small business owners compute

financial ratios and use them to manage their businesses.

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Twelve Key Ratios (1 of 4)

• Liquidity Ratios:

– Tell whether or not a small business will be able to

meet its maturing obligations as they come due.

▪ Current Ratio

▪ Quick ratio

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Current Ratio

Current Ratio:

• Measures solvency by showing the firm’s ability to pay

current liabilities out of current assets.

Current Assets $686,985 Current Ratio = = = 1.87 :1

Current Liabilities $367,850

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Quick Ratio

Quick Ratio:

• Shows the extent to which a firm’s most liquid assets cover

its current liabilities.

Quick Assets 686,985 – 455,455 Quick Ratio = = = .63 :1

Current Liabilities $367,850

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Twelve Key Ratios (2 of 4)

• Leverage Ratios:

– Measure the financing provided by the firm’s owners

against that supplied by its creditors

– A gauge of the depth of the company’s debt.

– Careful! Debt is a powerful tool, but, like dynamite, you

must handle it carefully!

▪ Debt ratio

▪ Debt to net worth ratio

▪ Times- interest- earned ratio

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Debt Ratio

Debt Ratio:

• Measures the percentage of total assets financed by

creditors rather than owners.

Total Debt $367,850 + 212,150 Debt Ratio = = = .68 :1

Total Assets $847,655

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Debt to Net Worth Ratio

Debt to Net Worth Ratio:

• Compares what a business “owes” to “what it is worth.”

Total Debt $580,000 Debt to Net Worth Ratio = = = 2.20 :1

Tangible Net Worth $264,155

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Times-Interest-Earned Ratio

Times Interest Earned:

• Measures the firm’s ability to make the interest payments

on its debt.

EBIT * $60,629 + 39,850 Times Interest Earned = = =

Total Interest Expense $39,850

$100,479 = = 2.52:1

$39,850

*Earnings Before Interest and Taxes

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Twelve Key Ratios (3 of 4)

• Operating Ratios:

– Evaluate a firm’s overall performance and show how

effectively it is putting its resources to work.

▪ Average Inventory Turnover Ratio

▪ Average Collection Period Ratio

▪ Average Payable Period Ratio

▪ Net Sales to Total Assets Ratio

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Average Inventory Turnover Ratio

Average Inventory Turnover Ratio:

• Tells the average number of times a firm’s inventory is

“turned over” or sold out during the accounting period.

Cost of Goods Sold $1,290,117 Average Inventory Turnover Ratio = = = 2.05 times a year

Average Inventory* $630,600

Beginning Inventory + Ending Inventory *Average Inventory =

2

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Average Collection Period Ratio

Average Collection Period Ratio:

– Tells the average number of days required to collect

accounts receivable (days sales outstanding, DSO).

• Two Steps:

Credit Sales $1,309,589 Receivables Turnover Ratio = = = 7.31 times a year

Accounts Receivable $179,225

Days in Accounting Period 365 Average Collection Ratio = = = 50.0 Period

Receivables Turnover Ratio 7.31 days

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How Lowering Your Average Collection

Period Can Save You money (1 of 2)

Too often, entrepreneurs fail to recognize the importance of collecting their

accounts receivable on time. After all, collecting accounts is not as glamorous or

as much fun as generating sales. Lowering a company’s average collection

period ratio, however, can produce tangible—and often significant—savings. The

following formula shows how to convert an improvement in a company’s average

collection period ratio into dollar savings:

Annual savings

(Credit sales Annual interest rate Number of days average collection period is lowered) =

365

 

Where

credit sales = company’s annual credit sales in dollars, annual interest rate = the

interest rate at which the company borrows money, and number of days average

collection period is lowered = the difference between the previous year’s

average collection period ratio and the current one.

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How Lowering Your Average Collection

Period Can Save You money (2 of 2)

Example

Sam’s Appliance Shop’s average collection period ratio is 50 days. Suppose that

the previous year’s average-collection-period ratio was 58 days, an eight-day

improvement. The company’s credit sales for the most recent year were

$1,309,589. If Sam borrows money at 8.75%, this six-day improvement has

generated savings for Sam’s Appliance Shop of

$1,309,589 8.75% 8 days Savings = = $2,512

365 days

  

By collecting his accounts receivable just eight days faster on average,

Sam has saved his business more than $2,512! Of course, if a

company’s average-collection-period ratio rises, the same calculation will

tell the owner how much that change costs.

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Average Payable Period Ratio

Average Payable Period Ratio:

– Tells the average number of days required to pay

accounts payable.

• Two Steps:

Purchases $939,827 Payables Turnover Ratio = = = 6.16 times a year

Accounts Payable $152,580

Days in Accounting Period 365 Average Payable Period Ratio = = = 59.3 days

Payables Turnover Ratio 6.16

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Net Sales to Total Assets Ratio

Net Sales to Total Assets Ratio:

• Measures a firm’s ability to generate sales given its asset

base.

Net Sales $1,870,841 Net Sales to Total Assets = = = 2.21:1

Total Assets $847,655

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Twelve Key Ratios (4 of 4)

• Profitability Ratios:

– Measure how efficiently a firm is operating; offer

information about a firm’s “bottom line.”

▪ Net Profit on Sales Ratio

▪ Net Profit to Assets Ratio

▪ Net Profit to Equity Ratio

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Net Profit on Sales Ratio

Net Profit on Sales Ratio:

• Measures a firm’s profit per dollar of sales revenue.

Net Profit $60,629 Net Profit on Sales = = = 3.24%

Net Sales $1,870,841

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Net Profit to Assets Ratio

Net Profit to Assets (Return on Assets) Ratio:

• Tells how much profit a company generates for each dollar

of assets that it owns.

Net Profit $60,629 Net Profit to Assets = = = 7.15%

Total Assets $847,655

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Net Profit to Equity Ratio

Net Profit to Equity* Ratio:

• Measures an owner’s rate of return on the investment

(ROI) in the business.

Net Income $60,629 Net Profit to Equity = = = 22.65%

Owner ‘s Equity* $267,655

* Also called Net Worth

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Interpreting Ratios

• Ratios – useful yardsticks of comparison.

• Standards vary from one industry to another; the key is to

watch for “red flags.”

• Critical numbers: measure key financial and operational

aspects of a company’s performance. Examples:

– Sales per labor hour at a supermarket

– Food costs as a percentage of sales at a restaurant.

– Load factor (percentage of seats filled with

passengers) at an airline.

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Financial Benchmarking

• When comparing critical numbers to the industry

standards, ask:

– Is there a significant difference in my company’s ratio

and the industry average?

– If so, what is the difference meaningful?

– Is the difference good or bad?

– What are the possible causes of this difference? What

is the most likely cause?

– Does this cause require that I take action?

– If so, what action should I take to correct the problem?

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Ratio Analysis: Sam’s Appliance

Shop (1 of 12)

Sam’s Appliance Shop Industry Median

Current ratio = 1.87:1 Current ratio = 1.60:1

Although Sam’s falls short of the rule of thumb of 2:1, its

current ratio is above the industry median by a significant

amount. Sam’s should have no problem meeting short-term

debts as they come due.

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Ratio Analysis: Sam’s Appliance

Shop (2 of 12)

Sam’s Appliance Shop Industry Median

Quick ratio = 0.63:1 Quick ratio = 0.50:1

Again, Sam is below the rule of thumb of 1:1, but the

company passes this test of liquidity when measured against

industry standards. Sam relies on selling inventory to satisfy

short-term debt (as do most appliance shops). If sales

slump, the result could be liquidity problems for Sam’s. What

steps should Sam take to deal with this threat?

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Ratio Analysis: Sam’s Appliance

Shop (3 of 12)

Sam’s Appliance Shop Industry Median

Debt ratio = 0.68:1 Debt ratio = 0.62:1

Creditors provide 68% of Sam’s total assets, very close to

the industry median of 62%. Although the company does not

appear to be overburdened with debt, Sam’s might have

difficulty borrowing, especially from conservative lenders.

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Ratio Analysis: Sam’s Appliance

Shop (4 of 12)

Sam’s Appliance Shop Industry Median

Debt to net worth ratio = 2.20:1 Debt to net worth ratio = 2.30:1

Sam’s owes $2.20 to creditors for every $1.00 the owner has

invested in the business (compared to $2.30 to every $1.00

in equity for the typical business). Many lenders will see

Sam’s as “borrowed up,” having reached its borrowing

capacity. Creditor’s claims are more than twice those of the

owners.

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Ratio Analysis: Sam’s Appliance

Shop (5 of 12)

Sam’s Appliance Shop Industry Median

Times interest earned ratio = 2.52:1 Times interest earned ratio = 2.10:1

Sam’s earnings are high enough to cover the interest payments

on its debt by a factor of 2.52:1, slightly better than the typical firm

in the industry. Sam’s has a cushion (although a small one) in

meeting its interest payments.

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Ratio Analysis: Sam’s Appliance

Shop (6 of 12)

Sam’s Appliance Shop Industry Median

Average inventory turnover ratio =

2.05 times per year

Average inventory turnover ratio = 4.4 times per year

Inventory is moving through Sam’s at a very slow pace. What

could be causing this low inventory turnover in Sam’s business?

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Ratio Analysis: Sam’s Appliance

Shop (7 of 12)

Sam’s Appliance Shop Industry Median

Average collection period ratio = 50.0

days

Average collection period ratio = 10.3 days

Sam’s collects the average account receivable after 50 days

compared to the industry median of 11 days – about five times

longer. What is a more meaningful comparison for this ratio? What

steps can Sam take to improve this ratio?

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Ratio Analysis: Sam’s Appliance

Shop (8 of 12)

Sam’s Appliance Shop Industry Median

Average collection period ratio = 50.0

days

Average collection period ratio = 10.3 days

Sam’s payables are significantly slower than those of the typical

firm in the industry. Stretching payables too far could seriously

damage the company’s credit rating. What are the possible

causes of this discrepancy?

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Ratio Analysis: Sam’s Appliance

Shop (9 of 12)

Sam’s Appliance Shop Industry Median

Net sales to total assets ratio = 2.21:1 Net sales to total assets ratio = 3.4:1

Sam’s Appliance Shop is not generating enough sales, given the

size of its asset base. What factors could cause this?

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Ratio Analysis: Sam’s Appliance

Shop (10 of 12)

Sam’s Appliance Shop Industry Median

Net profit on sales ratio = 3.24% Net profit on sales ratio = 4.3%

After deducting all expenses, Sam’s has just 3.24 cents of

every sales dollar left as profit – nearly 25% below the

industry median. Sam may discover that some of his

operating expenses are out of balance.

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Ratio Analysis: Sam’s Appliance

Shop (11 of 12)

Sam’s Appliance Shop Industry Median

Net profit to assets ratio = 7.15% Net profit to assets ratio = 4.0%

Sam’s generates a return of 7.15% for every $1 in assets, which is

nearly 79% above the industry average. Given his asset base,

Sam is squeezing an above-average return out of his company. Is

this likely to be the result of exceptional profitability, or is there

another explanation?

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Ratio Analysis: Sam’s Appliance

Shop (12 of 12)

Sam’s Appliance Shop Industry Median

Net profit to equity ratio = 22.65% Net profit to equity ratio = 16.0%

Sam’s return on his investment in the business is an

impressive 22.65%, compared to an industry median of just

16.0%. Is this the result of high profitability, or is there

another explanation?

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Trend Analysis of Ratio

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Break-Even Analysis

• Breakeven point:

– The level of operation at which a business neither

earns a profit nor incurs a loss.

• A useful planning tool because it shows entrepreneurs

minimum level of activity required to stay in business.

• With one change in the breakeven calculation, an

entrepreneur can also determine the sales volume

required to reach a particular profit target.

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Calculating the Breakeven Point

Step 1: Determine the expenses the business can expect to

incur.

Step 2: Categorize the expenses in step 1 into fixed

expenses and variable expenses.

Step 3: Calculate the ratio of variable expenses to net sales.

Step 4: Compute the breakeven point:

Total Fixed Costs Breakeven Point ($) =

Contribution Margin

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Calculating the Breakeven Point: The

Magic Shop

Step 1: Net Sales estimate: $950,000

Cost of Goods Sold: $646,000

Total expenses: $236,500.

Step 2: Variable Expenses: $705,125

Fixed Expenses: $177,375

Step 3: Contribution Margin = $705,125

1 .26 $950,000

 

Step 4: Breakeven Point = $177,375

$682,212 .26