abdm4223 lecture week 9 290612

Financial Feasibility,Financial Feasibility,Financial Planning,Financial Planning,

& Cashflow Management& Cashflow Management

Financial Feasibility,Financial Feasibility,Financial Planning,Financial Planning,

& Cashflow Management& Cashflow Management

ABDM4233 ENTREPRENEURSHIPABDM4233 ENTREPRENEURSHIP

byStephen OngStephen Ong

Principal Lecturer (Specialist)Principal Lecturer (Specialist)Visiting Professor, Shenzhen UniversityVisiting Professor, Shenzhen University

Who are the Best?Who are the Best?1.1. The way the world tells its story.The way the world tells its story.

2.2. Whatever it takes.Whatever it takes.

3.3. United for a more equitable world.United for a more equitable world.

4.4. Harnessing the past. Enriching the future.Harnessing the past. Enriching the future.

5.5. From harm to home.From harm to home.

6.6. Pioneering solutions, lifesaving results.Pioneering solutions, lifesaving results.

7.7. Defending dignity. Fighting poverty.Defending dignity. Fighting poverty.

8.8. Our doctors go to places photographers don’t.Our doctors go to places photographers don’t.

9.9. It’s about saving lives.It’s about saving lives.

10.10. Changes the way information flows in the world.Changes the way information flows in the world.

11.11. No good food should go to waste.No good food should go to waste.

Competitive Analysis Grid for Element Competitive Analysis Grid for Element BarsBars

5-3

PRODUCTPRODUCTATTRIBUTESATTRIBUTES

COMPETITORSCOMPETITORSYOUR YOUR PRODUCTPRODUCT

The 6 Ps of Marketing for New VenturesThe 6 Ps of Marketing for New Ventures

Marketing Mix

Product Price

Philantrophy

(Do GOOD)

People (or Customer Service)

11-4

Place (or distribution

channel)

Promotion

Product or ServiceProduct or Service FeasibilityFeasibility

Elements of a Feasibility AnalysisElements of a Feasibility Analysis

Industry and Industry and Market Market

FeasibilityFeasibility

FinancialFinancialFeasibilityFeasibility

FINANCIAL FINANCIAL

MILESTONEMILESTONESS

BUSINESBUSINESS MODELS MODEL

The 360° CUBE PitchThe 360° CUBE Pitch

Six Posters in a 6 minute Investor Pitch

SOCIAL SOCIAL PROBLEMPROBLEM

VISION & VISION & MISSIONMISSION

MARKETINMARKETING & SALESG & SALES

OPERATIONS OPERATIONS TEAM & KEY TEAM & KEY PARTNERSPARTNERS

360° Business CUBE360° Business CUBE1.1. The Problem : How BIG is the problem?The Problem : How BIG is the problem?2.2. The Solution : Our Social Enterprise’s The Solution : Our Social Enterprise’s

Vision & Mission Vision & Mission 3.3. The Business Model : Getting the JOB done The Business Model : Getting the JOB done

for the Customer Segmentsfor the Customer Segments

4.4. Marketing & Sales (and Fundraising)Marketing & Sales (and Fundraising)5.5. The Team & Key PartnersThe Team & Key Partners

6.6. The Financial Plan : Goals The Financial Plan : Goals and objectives, with a and objectives, with a timeline (Milestones)timeline (Milestones)

Assessing a New Venture’s Financial

Strength and Viability

8-9

Financial ManagementFinancial Management1 of 21 of 2

Financial ManagementFinancial Management Financial management deals with two things: raising Financial management deals with two things: raising

money and managing a company’s finances in a way money and managing a company’s finances in a way that achieves the highest rate of returnthat achieves the highest rate of return

Chapter 10 focuses on raising money. This chapter Chapter 10 focuses on raising money. This chapter focuses primarily on:focuses primarily on:

How a new venture tracks its financial progress through How a new venture tracks its financial progress through preparing, analyzing, and maintaining past financial preparing, analyzing, and maintaining past financial statements.statements.

How a new venture forecasts future income and expenses by How a new venture forecasts future income and expenses by preparing pro forma (or projected) financial statements.preparing pro forma (or projected) financial statements.

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Financial ManagementFinancial Management2 of 22 of 2

The financial management of a firm deals with such questions on an ongoing basis:

• How are we doing? Are we making or losing money?

• How much cash do we have on hand?

• Do we have enough cash to meet our short-term obligations?

• How efficiently are we utilizing our assets?

• How do our growth and net profits compare to those of our industry peers?

• Where will the funds we need for capital improvements come from?• Are there ways we can partner with other firms to share risk and reduce the amount of cash we need?

• Overall, are we in good shape financially?

Financial Objectives of a FirmFinancial Objectives of a Firm1 of 31 of 3


ProfitabilityProfitability Is the ability to earn a profit.Is the ability to earn a profit.

Many start-ups are Many start-ups are not profitable not profitable during their first 1 to 3 during their first 1 to 3 years while they are training employees and building their years while they are training employees and building their brands.brands.

However, a firm must become profitable to remain viable and However, a firm must become profitable to remain viable and provide a return to its owners.provide a return to its owners.

LiquidityLiquidity Is a company’s ability to meet its short-term financial Is a company’s ability to meet its short-term financial

obligations.obligations. Even if a firm is profitable, it is often a challenge to keep Even if a firm is profitable, it is often a challenge to keep

enough money in the bank enough money in the bank to meet its routine obligations to meet its routine obligations in a timely mannerin a timely manner..


EfficiencyEfficiency Is how productively a firm utilizes its assets relative to Is how productively a firm utilizes its assets relative to

its revenue and its profits.its revenue and its profits. Air Asia, for example, uses its assets very productively. Its Air Asia, for example, uses its assets very productively. Its

turnaround time, or the time its airplanes sit on the ground turnaround time, or the time its airplanes sit on the ground while they are being unloaded and reloaded, is the lowest in while they are being unloaded and reloaded, is the lowest in the airline industry.the airline industry.

StabilityStability Is the strength and vigor of the firm’s overall Is the strength and vigor of the firm’s overall

financial posture. financial posture. For a firm to be stable, it must not only earn a profit and For a firm to be stable, it must not only earn a profit and

remain liquid but also keep its debt in checkremain liquid but also keep its debt in check..

The Process of Financial ManagementThe Process of Financial Management1 of 41 of 4

Importance of Financial StatementsImportance of Financial Statements To assess whether its financial objectives are To assess whether its financial objectives are

being met, firms rely heavily on analysis of being met, firms rely heavily on analysis of financial statements.financial statements.

A financial statement is a written report that A financial statement is a written report that quantitatively describes a firm’s financial health. quantitatively describes a firm’s financial health.

The income statement, the balance sheet, and the The income statement, the balance sheet, and the statement of cash flows are the financial statements statement of cash flows are the financial statements entrepreneurs use most commonly.entrepreneurs use most commonly.

ForecastsForecasts Are an estimate of a firm’s future income and Are an estimate of a firm’s future income and

expenses, based on past performance, its expenses, based on past performance, its current circumstances, and its future plans.current circumstances, and its future plans.


Forecasts (continued)Forecasts (continued) New ventures typically base their forecasts on an New ventures typically base their forecasts on an

estimate of sales and then on industry averages or the estimate of sales and then on industry averages or the experiences of similar start-ups regarding the cost of experiences of similar start-ups regarding the cost of goods sold and other expenses.goods sold and other expenses.

BudgetsBudgets Are itemized forecasts of a company’s income, Are itemized forecasts of a company’s income,

expenses, and capital needs and are also an important expenses, and capital needs and are also an important tool for financial planning and control.tool for financial planning and control.


Financial RatiosFinancial Ratios Depict relationships between items on a firm’s Depict relationships between items on a firm’s

financial statements.financial statements. An analysis of its financial ratios helps a firm An analysis of its financial ratios helps a firm

determine whether it is meeting its financial determine whether it is meeting its financial objectives and how it stacks up against industry objectives and how it stacks up against industry peers.peers.

Importance of Financial ManagementImportance of Financial Management Many experienced entrepreneurs stress the Many experienced entrepreneurs stress the

importance of keeping on top of the financial importance of keeping on top of the financial management of the firm.management of the firm.

Financial StatementsFinancial Statements

Historical Financial StatementsHistorical Financial Statements Reflect past performance and are usually Reflect past performance and are usually

prepared on a quarterly and annual basis.prepared on a quarterly and annual basis. Publicly traded firms are required by the SEC to Publicly traded firms are required by the SEC to

prepare financial statements and make them available prepare financial statements and make them available to the public. to the public.

Pro Forma Financial StatementsPro Forma Financial Statements Are projections for future periods based on Are projections for future periods based on

forecasts and are typically completed for two to forecasts and are typically completed for two to three years in the future.three years in the future.

Pro forma financial statements are strictly planning Pro forma financial statements are strictly planning tools and are not required by the SEC.tools and are not required by the SEC.

Importance of Keeping Good RecordsImportance of Keeping Good Records

The first step toward prudent The first step toward prudent financial management is keeping financial management is keeping

good records.good records.

Example : New Venture Fitness DrinksExample : New Venture Fitness Drinks

New Venture Fitness DrinksNew Venture Fitness Drinks To illustrate how financial statements are prepared, To illustrate how financial statements are prepared,

we used New Venture Fitness Drinks, a fictitious we used New Venture Fitness Drinks, a fictitious sports drink company.sports drink company.

New Venture Fitness Drinks has been in business for five New Venture Fitness Drinks has been in business for five years.years.

Targeting sports enthusiasts, the company sells a line of Targeting sports enthusiasts, the company sells a line of nutritional fitness drinks.nutritional fitness drinks.

The company’s strategy is to place small restaurants, The company’s strategy is to place small restaurants, similar to smoothie restaurants, near large outdoor sports similar to smoothie restaurants, near large outdoor sports complexes.complexes.

The company is profitable and is growing at a rate of 25% The company is profitable and is growing at a rate of 25% per year.per year.

Historical Financial StatementsHistorical Financial Statements

Three types of historical financial statements

Financial Statement Purpose

Income Income StatementStatement

Balance SheetBalance Sheet

Statement of Statement of Cash FlowsCash Flows

Reflects the results of the operations of a firm over a specified period of time. It records all the revenues and

expenses for the given period and shows whether the firm is making a profit or is experiencing a loss.

Is a snapshot of a company’s assets, liabilities, and owner’s equity at a specific point in time.

Summarizes the changes in a firm’s cash position for a specified period of time and details why the

changes occurred.

Historical Income StatementsHistorical Income Statements

Historical Balance SheetsHistorical Balance Sheets1 of 21 of 2

Assets

Historical Balance SheetsHistorical Balance Sheets2 of 22 of 2

Liabilities and Shareholders’ Equity

Historical Statement of Cash FlowsHistorical Statement of Cash Flows

Ratio AnalysisRatio Analysis

Ratio AnalysisRatio Analysis The most practical way to interpret or make The most practical way to interpret or make

sense of a firm’s historical financial statements sense of a firm’s historical financial statements is through ratio analysis, as shown in the next is through ratio analysis, as shown in the next slide.slide.

Comparing a Firm’s Financial Results to Comparing a Firm’s Financial Results to Industry NormsIndustry Norms Comparing a firm’s financial results to industry Comparing a firm’s financial results to industry

norms helps a firm determine how it stacks up norms helps a firm determine how it stacks up

against its against its competitorscompetitors and if there are any and if there are any financial “red flags” requiring attention.financial “red flags” requiring attention.

Historical Ratio AnalysisHistorical Ratio Analysis

ForecastsForecasts1 of 41 of 4

ForecastsForecasts The analysis of a firm’s historical financial statements The analysis of a firm’s historical financial statements

are followed by the preparation of forecasts. are followed by the preparation of forecasts. Forecasts are predictions of a firm’s future sales, Forecasts are predictions of a firm’s future sales,

expenses, income, and capital expenditures.expenses, income, and capital expenditures. A firm’s forecasts provide the basis for its pro forma A firm’s forecasts provide the basis for its pro forma

financial statements.financial statements. A well-developed set of pro forma financial statements A well-developed set of pro forma financial statements

helps a firm create accurate budgets, build financial plans, helps a firm create accurate budgets, build financial plans, and manage its finances in a proactive rather than a and manage its finances in a proactive rather than a reactive manner.reactive manner.

8-29


Sales ForecastSales Forecast A sales forecast is a projection of a firm’s sales for a A sales forecast is a projection of a firm’s sales for a

specified period (such as a year).specified period (such as a year). It is the first forecast developed and is the basis for It is the first forecast developed and is the basis for

most of the other forecasts. most of the other forecasts. A sales forecast for a new firm is based on a good-faith A sales forecast for a new firm is based on a good-faith

estimate of sales and on industry averages or the experiences of estimate of sales and on industry averages or the experiences of similar start-ups.similar start-ups.

A sales forecast for an existing firm is based on (1) its record of A sales forecast for an existing firm is based on (1) its record of past sales, (2) its current production capacity and product past sales, (2) its current production capacity and product demand, and (3) any factors that will affect its future product demand, and (3) any factors that will affect its future product capacity and product demand.capacity and product demand.

8-30


Historical and Forecasted Annual Sales for New Venture Fitness Drinks

8-31


Forecast of Costs of Sales and Other ItemsForecast of Costs of Sales and Other Items Once a firm has completed its sales forecast, it must Once a firm has completed its sales forecast, it must

forecast its cost of sales (or cost of goods sold) and the forecast its cost of sales (or cost of goods sold) and the other items on its income statement.other items on its income statement.

The most common way to do this is to use the The most common way to do this is to use the percentage-of-sales method, which is a method for percentage-of-sales method, which is a method for expressing each expense item as a percentage of sales.expressing each expense item as a percentage of sales.

If a firm determines that it can use the percent-of-sales method If a firm determines that it can use the percent-of-sales method and it follows the procedures described in the textbook, then and it follows the procedures described in the textbook, then the net result is that each expense item on its income statement the net result is that each expense item on its income statement will grow at the same rate as sales (with the exception of items will grow at the same rate as sales (with the exception of items that can be individually forecast, such as depreciation).that can be individually forecast, such as depreciation).

8-32

Pro Forma Financial StatementsPro Forma Financial Statements

Pro Forma Financial StatementsPro Forma Financial Statements A firm’s pro forma financial statements are similar to A firm’s pro forma financial statements are similar to

its historical financial statements except that they look its historical financial statements except that they look forward rather than track the past.forward rather than track the past.

The preparation of pro form financial statements helps The preparation of pro form financial statements helps a firm rethink its strategies and make adjustments if a firm rethink its strategies and make adjustments if necessary.necessary.

The preparation of pro forma financials is also The preparation of pro forma financials is also necessary if a firm is seeking funding or financing. necessary if a firm is seeking funding or financing.

8-33

Types of Pro Forma Financial Types of Pro Forma Financial StatementsStatements

Financial Statement Purpose

Pro Forma Income Statement

Pro Forma Balance Sheet

Pro Forma Statement of Cash flows

Shows the projected results of the operations of a firm over a specific period.

Shows a projected snapshot of a company’s assets, liabilities, and owner’s equity at a specific

point in time.

Shows the projected flow of cash into and out of a company for a specific period.

8-34

Pro Forma Income StatementsPro Forma Income Statements

8-35

Pro Forma Balance SheetsPro Forma Balance Sheets1 of 21 of 2

Assets

8-36

Pro Forma Balance SheetsPro Forma Balance Sheets2 of 22 of 2

Liabilities and Shareholders’ Equity

8-37

Pro Forma Statement of Cash FlowsPro Forma Statement of Cash Flows1 of 21 of 2

Operating Activities

8-38

Pro Forma Statement of Cash FlowsPro Forma Statement of Cash Flows2 of 22 of 2

Investing Activities and Financing Activities

8-39

Ratio AnalysisRatio Analysis

Ratio AnalysisRatio Analysis The same financial ratios used to evaluate a firm’s The same financial ratios used to evaluate a firm’s

historical financial statements should be used to historical financial statements should be used to evaluate the pro forma financial statements.evaluate the pro forma financial statements.

This work is completed so the firm can get a sense of This work is completed so the firm can get a sense of how its projected financial performance compares to its how its projected financial performance compares to its past performance and how its projected activities will past performance and how its projected activities will affect its cash position and its overall financial affect its cash position and its overall financial soundness. soundness.

8-40

Ratio Analysis Based on Historical and Ratio Analysis Based on Historical and Pro-Forma Financial StatementsPro-Forma Financial Statements

CASH is KINGCASH is KING

Managing Cash FlowManaging Cash Flow

The Importance of CashThe Importance of Cash

““Everything is about cash – raising it, Everything is about cash – raising it, conserving it, collecting it.” conserving it, collecting it.”

Guy KawasakiGuy Kawasaki

Common cause of business failure: Common cause of business failure:

Cash crisis!Cash crisis!

Cash ManagementCash Management A business can be earning a profit and be A business can be earning a profit and be

forced to close because it runs out of cash! forced to close because it runs out of cash!

American Express OPEN Small Business American Express OPEN Small Business Monitor study: Monitor study: 59% of small business owners 59% of small business owners

experience problems with cash flow.experience problems with cash flow.

Their biggest cash flow concern is Their biggest cash flow concern is the ability to pay bills on time. the ability to pay bills on time.

FIGURE 12.1 Small Business Owners’ Strategies for Improving Cash Flow Source: American Express OPEN Small Business Monitor, 2008.

Cash ManagementCash Management

Cash management – forecasting, Cash management – forecasting, collecting, disbursing, investing, and collecting, disbursing, investing, and planning for the cash a company planning for the cash a company needs to operate smoothly. needs to operate smoothly.

Young and growing companies Young and growing companies are “cash sponges.”are “cash sponges.”

Know your company’s Know your company’s cash flow cycle.cash flow cycle.

The Cash Flow CycleThe Cash Flow Cycle

OrderOrderGoodsGoods

Day 11

ReceiveReceiveGoodsGoods

1515

PayPayInvoiceInvoice

4040

1414 2525

218218

178178

SellSellGoods*Goods*

DeliverDeliverGoodsGoods

221221

33

CustomerCustomerPays**Pays**

SendSendInvoiceInvoice

230230

99

280280

5050

Cash Flow Cycle = Cash Flow Cycle = 240 days240 days

**Based on Average Inventory TurnoverBased on Average Inventory Turnover::

365 days365 days 2.05 times/year2.05 times/year

**Based on Average Collection Period:**Based on Average Collection Period:

365 days365 days 7.31 times/year7.31 times/year

= 178 days= 178 days

FIGURE 12.2

= 50 days= 50 days

Five Cash Management Five Cash Management Roles of an EntrepreneurRoles of an Entrepreneur

1.1. Cash FinderCash Finder

2.2. Cash PlannerCash Planner

3.3. Cash DistributorCash Distributor

4.4. Cash CollectorCash Collector

5.5. Cash ConserverCash Conserver

Cash and Profits Cash ≠ profits.Cash ≠ profits. Profit is the difference between a Profit is the difference between a

company’s total revenue and total company’s total revenue and total expenses.expenses.

Cash is the money that is free and Cash is the money that is free and readily available to use.readily available to use.

Cash flow measure a company’s Cash flow measure a company’s liquidity and its ability to pay it bills.liquidity and its ability to pay it bills.

Cash FlowCash Flow

Cash

Accounts Payable

Decrease in CashDecrease in Cash

Production/Cash Purchases

Inventory

Accounts Receivable

Cash Sales

Increase in CashIncrease in Cash

LeakageLeakage

LeakageLeakageFIGURE 12.3

The Cash BudgetThe Cash Budget

A “cash map” that shows the amount and A “cash map” that shows the amount and the timing of a firm's cash receipts and the timing of a firm's cash receipts and cash disbursements over time.cash disbursements over time.

Predicts the amount of cash a company will Predicts the amount of cash a company will need to operate smoothly.need to operate smoothly.

Helps to visualize a company’s cash Helps to visualize a company’s cash receipts and cash disbursements and the receipts and cash disbursements and the resulting cash balance.resulting cash balance.

Preparing a Cash BudgetPreparing a Cash Budget

1.1. Determine a Minimum Cash BalanceDetermine a Minimum Cash Balance Not too much...Not too much... Not too little...Not too little... But a cash balance that's But a cash balance that's

just right ... for you!just right ... for you!


1.1. Determine a Minimum Cash BalanceDetermine a Minimum Cash Balance

2.2. Forecast SalesForecast Sales

(continued)

The The heartheart of the cash budget. of the cash budget.

Sales are ultimately transformed Sales are ultimately transformed into cash receipts and cash into cash receipts and cash disbursements.disbursements.

Cash forecast is only as accurate Cash forecast is only as accurate as the sales forecast from which as the sales forecast from which it is derived. it is derived.

Forecast SalesForecast Sales

““Lumpy” or seasonal sales patterns Lumpy” or seasonal sales patterns are common.are common.

15% to 18% of wine and spirits shops’ 15% to 18% of wine and spirits shops’ annual sales occur between annual sales occur between December 15 and 31.December 15 and 31.

40% of toy sales take place 40% of toy sales take place in last 6 weeks of the year.in last 6 weeks of the year.

Forecast SalesForecast Sales(continued)

Prepare three sales forecasts:Prepare three sales forecasts:

PessimisticPessimistic

OptimisticOptimistic

Most LikelyMost Likely

Forecast SalesForecast Sales

Sales Forecast for a Start-UpSales Forecast for a Start-Up

Example:Example:

Number of cars in trading zoneNumber of cars in trading zone 84,000 84,000 x Percent of importsx Percent of imports x 24%x 24% = Number of imported cars in trading zone= Number of imported cars in trading zone 20,160 20,160

Number of imports in trading zoneNumber of imports in trading zone 20,160 20,160 x Average expenditure on repairsx Average expenditure on repairs x $485x $485 = Total import repair sales potential= Total import repair sales potential $9,777,600 $9,777,600

Total import repair sales potentialTotal import repair sales potential $9,777,600 $9,777,600 x Estimated market sharex Estimated market share x 9.9%x 9.9%

= Sales estimate= Sales estimate $967,982$967,982




3.3. Forecast Cash ReceiptsForecast Cash Receipts

(continued)

Record all cash receipts when the Record all cash receipts when the cash is cash is actually received actually received (i.e. the (i.e. the cash method of accounting).cash method of accounting).

Determine the collection pattern for Determine the collection pattern for credit sales; then add cash sales.credit sales; then add cash sales.

Monitor closely: Monitor closely: Slow and non-payers.Slow and non-payers.

Forecast Cash ReceiptsForecast Cash Receipts

13.60%

23.60%

42.80%

57.80%

73.60%

85.20%

93.80%

0.0% 20.0% 40.0% 60.0% 80.0% 100.0%

24

12

9

6

3

2

1

Probability of Collection

Nu

mb

er o

f Mo

nth

s D

elin

qu

ent

Collecting Delinquent Collecting Delinquent AccountsAccounts





4.4. Forecast Cash DisbursementsForecast Cash Disbursements

(continued)

Record disbursements when you expect to Record disbursements when you expect to make them. make them.

Start with those disbursements that are Start with those disbursements that are fixed amounts due on certain dates.fixed amounts due on certain dates.

Review the business checkbook to ensure Review the business checkbook to ensure accurate estimates.accurate estimates.

Add a cushion to the estimate to account Add a cushion to the estimate to account for “Murphy’s Law.”for “Murphy’s Law.”

Don’t know where to begin? Try making a Don’t know where to begin? Try making a dailydaily list of the items that generate cash list of the items that generate cash and those that consume it.and those that consume it.

Forecast Cash DisbursementsForecast Cash Disbursements





4.4. Forecast Cash DisbursementsForecast Cash Disbursements

5.5. Estimate End-of-Month Cash Estimate End-of-Month Cash BalanceBalance

(continued)

Take Beginning Cash Balance ...Take Beginning Cash Balance ... Add Cash Receipts ...Add Cash Receipts ... Subtract Cash DisbursementsSubtract Cash Disbursements Result is Cash Surplus Result is Cash Surplus

or Cash Shortage or Cash Shortage (Repay or Borrow?)(Repay or Borrow?)

Estimate Estimate End-of-Month BalanceEnd-of-Month Balance

Benefits of Cash ManagementBenefits of Cash Management

Increase amount and speed of cash flowing Increase amount and speed of cash flowing into the companyinto the company

Reduce the amount and speed of cash Reduce the amount and speed of cash flowing outflowing out

Make the most efficient use of available cashMake the most efficient use of available cash Take advantage of money-saving Take advantage of money-saving

opportunities such as cash discountsopportunities such as cash discounts Finance seasonal business needsFinance seasonal business needs

Benefits of Cash ManagementBenefits of Cash Management

Develop a sound borrowing and Develop a sound borrowing and repayment programrepayment program

Impress lenders and investorsImpress lenders and investors Provide funds for expansionProvide funds for expansion Plan for investing surplus cashPlan for investing surplus cash

(continued)

The “Big Three” The “Big Three” of Cash Managementof Cash Management

1.1. Accounts ReceivableAccounts Receivable

2.2. Accounts PayableAccounts Payable

3.3. InventoryInventory

About 90% of industrial and wholesale About 90% of industrial and wholesale sales are on credit, and 40% of retail sales sales are on credit, and 40% of retail sales are on account.are on account.

Survey of small companies across a variety Survey of small companies across a variety of industries found that 77% extend credit of industries found that 77% extend credit to their customers.to their customers.

Remember: Remember: “A sale is not a sale until you “A sale is not a sale until you collect the money.”collect the money.”

Accounts receivable goal: Collect your Accounts receivable goal: Collect your company’s cash as fast as you can.company’s cash as fast as you can.

Accounts ReceivableAccounts Receivable

FIGURE 12.5 Cash Flow Concerns Source: Based on American Express Corporation, 2005.

Establish a firm credit-granting policy.Establish a firm credit-granting policy. Screen credit customers carefully.Screen credit customers carefully.

Develop a system of collecting accounts.Develop a system of collecting accounts.

Send invoices promptly.Send invoices promptly.

When an account becomes overdue, take When an account becomes overdue, take action action immediatelyimmediately..

Add finance charges to overdue accounts Add finance charges to overdue accounts (check the law first!).(check the law first!).

Accounts ReceivableAccounts Receivable

Beating the Cash CrisisBeating the Cash Crisis

Accelerating Accelerating Accounts ReceivableAccounts Receivable

Ensure that invoices are accurate and Ensure that invoices are accurate and timely.timely.

Include a description of the goods or Include a description of the goods or services purchased.services purchased.

Ensure that invoices match purchase Ensure that invoices match purchase orders or contracts.orders or contracts.

Highlight the balance dues and due date.Highlight the balance dues and due date. Include contact information in case Include contact information in case

customers have questions. customers have questions.

Stretch out payment times as long as Stretch out payment times as long as possible possible without damaging your credit without damaging your credit ratingrating..

Verify Verify allall invoices before paying them. invoices before paying them. Take advantage of cash discounts.Take advantage of cash discounts.

Accounts PayableAccounts Payable


The Cost of Foregoing a Cash DiscountThe Cost of Foregoing a Cash Discount$1,000 invoice 2/10, net 30$1,000 invoice 2/10, net 30

DayDay

AmountAmount

00 1010 3030

$1,000$1,000$980$980

2020 daysdays

$20$20

R = R = IIP x TP x T

= $20$20$980 x 20/365$980 x 20/365

= 37.25%= 37.25%

FIGURE 12.6

Negotiate the best possible terms with Negotiate the best possible terms with your suppliers.your suppliers.

Be honest with creditors; avoid the “the Be honest with creditors; avoid the “the check is in the mail” syndrome.check is in the mail” syndrome.

Schedule controllable cash disbursements Schedule controllable cash disbursements to come due at different times.to come due at different times.

Use credit cards wisely.Use credit cards wisely.

Accounts PayableAccounts Payable


Monitor it closely; inventory can drain a Monitor it closely; inventory can drain a company’s cash.company’s cash.

Avoid inventory “overbuying.” Avoid inventory “overbuying.” It ties up valuable cash at It ties up valuable cash at a zero rate of return.a zero rate of return.

Arrange for inventory deliveries Arrange for inventory deliveries at the latest possible date.at the latest possible date.

Negotiate quantity discounts with Negotiate quantity discounts with suppliers when possible.suppliers when possible.

InventoryInventoryBeating the Cash CrisisBeating the Cash Crisis

Avoiding the Cash CrunchAvoiding the Cash Crunch Consider bartering, exchanging goods and Consider bartering, exchanging goods and

services for other goods and services, to services for other goods and services, to conserve cash.conserve cash.

Trim overhead costs: Trim overhead costs: Ask for discounts and “freebies” Ask for discounts and “freebies” Periodically evaluate expensesPeriodically evaluate expenses Lease rather than buyLease rather than buy Avoid nonessential cash outlaysAvoid nonessential cash outlays Negotiate fixed loan payments Negotiate fixed loan payments

to coincide with your to coincide with your company’s cash flowcompany’s cash flow

Avoiding the Cash CrunchAvoiding the Cash Crunch

Trim overhead costs:Trim overhead costs: Buy used equipmentBuy used equipment Hire part-time employees and freelancersHire part-time employees and freelancers Outsource nonessential activitiesOutsource nonessential activities Control employee advances and loansControl employee advances and loans Establish an internal security and control Establish an internal security and control

systemsystem Develop a system to battle check fraudDevelop a system to battle check fraud Change shipping termsChange shipping terms

(continued)(continued)

Avoiding the Cash CrunchAvoiding the Cash Crunch Start selling gift cardsStart selling gift cards Switch to zero-based Switch to zero-based

budgetingbudgeting Be on the lookout for Be on the lookout for

employee theftemployee theft Keep your business plan Keep your business plan

currentcurrent Invest surplus cashInvest surplus cash

(continued)(continued)

ConclusionConclusion

““Cash is King”Cash is King” Cash and profits are not the same.Cash and profits are not the same. Entrepreneurial success means Entrepreneurial success means

operating a company “lean and mean.”operating a company “lean and mean.” Trim wasteful expenditures.Trim wasteful expenditures. Invest surplus funds.Invest surplus funds. Plan and manage cash flow.Plan and manage cash flow.

Appendix 1 :Appendix 1 :

Creating a Financial PlanCreating a Financial Plan

The Importance of a The Importance of a Financial PlanFinancial Plan

Common mistake among business Common mistake among business owners: Failing to collect and analyze owners: Failing to collect and analyze basic financial data.basic financial data.

Many entrepreneurs run their Many entrepreneurs run their companies without any kind of companies without any kind of financial plan.financial plan.

Only 11% of business owners analyze Only 11% of business owners analyze their companies’ financial statements their companies’ financial statements as part of the managerial planning as part of the managerial planning process. process.

Financial planning is essential to Financial planning is essential to running a successful business and is running a successful business and is not that difficult!not that difficult!

Basic Financial StatementsBasic Financial Statements Balance Sheet – “Snapshot.” Balance Sheet – “Snapshot.”

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

built on the accounting equation: built on the accounting equation: Assets = Liabilities + Owner’s Assets = Liabilities + Owner’s EquityEquity

Income Statement – “Moving picture.” Income Statement – “Moving picture.” Compares the firm’s expenses against Compares the firm’s expenses against

its its revenue over a period of time to revenue over a period of time to show its net show its net income (or loss):income (or loss): Net Income = Sales Revenue - Net Income = Sales Revenue - ExpensesExpenses

Statement of Cash Flows – Shows the Statement of Cash Flows – Shows the change in the firm's working capital change in the firm's working capital over a period of time by listing the over a period of time by listing the sourcessources and and usesuses of funds. of funds.

Creating Projected Creating Projected Financial StatementsFinancial Statements

Helps the entrepreneur transform Helps the entrepreneur transform business goals into realitybusiness goals into reality

Challenging for a business start-upChallenging for a business start-up Start-ups should focus on creating Start-ups should focus on creating

projections for two yearsprojections for two years Projected financial statements:Projected financial statements:

Income statementsIncome statements Balance sheetBalance sheet

Ratio AnalysisRatio Analysis ““How is my company How is my company doing?”doing?”

A method of expressing the A method of expressing the relationships between any two relationships between any two elements on financial statements.elements on financial statements.

Important barometers of a Important barometers of a company’s health.company’s health.

Studies indicate few small business Studies indicate few small business owners compute financial owners compute financial ratios and use them to ratios and use them to manage their businesses. manage their businesses.

Twelve Key RatiosTwelve Key Ratios

Liquidity Ratios - Tell whether or not a small Liquidity Ratios - Tell whether or not a small business will be able to meet its maturing business will be able to meet its maturing obligations as they come due.obligations as they come due.

1. 1. Current Ratio - Measures solvency by Current Ratio - Measures solvency by showing showing the firm's ability to pay current liabilities out the firm's ability to pay current liabilities out of current assets.of current assets.

Current Ratio = Current Ratio = Current Assets Current Assets = = $686,985$686,985 = = 1.87:11.87:1

Current Liabilities $367,850Current Liabilities $367,850


Liquidity Ratios - Tell whether or not a small Liquidity Ratios - Tell whether or not a small business will be able to meet its maturing business will be able to meet its maturing obligations as they come due.obligations as they come due.

2. 2. Quick Ratio - Shows the extent to which a Quick Ratio - Shows the extent to which a firm’s most liquid assets cover its current firm’s most liquid assets cover its current liabilities.liabilities.

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

Current Liabilities $367,850Current Liabilities $367,850

Twelve Key RatiosTwelve Key Ratios Leverage RatiosLeverage Ratios

Measure the financing Measure the financing provided by the firm's owners provided by the firm's owners against that supplied by its against that supplied by its creditorscreditors

A gauge of the depth of the A gauge of the depth of the company's debt.company's debt.

Careful! Debt is a powerful Careful! Debt is a powerful tool, but, like dynamite, you tool, but, like dynamite, you must handle it carefully! must handle it carefully!

Twelve Key RatiosTwelve Key RatiosLeverage Ratios - Measure the financing Leverage Ratios - Measure the financing provided by a firm’s owners against that provided by a firm’s owners against that supplied by its creditors; it is a gauge of the supplied by its creditors; it is a gauge of the depth of the company’s debt.depth of the company’s debt.

3.3. Debt Ratio - Measures the percentage of Debt Ratio - Measures the percentage of total assets financed by creditors rather than total assets financed by creditors rather than owners.owners.

Debt Ratio = Debt Ratio = Total Debt Total Debt = = $367,850 + $367,850 + 212,150212,150 = .68:1 = .68:1

Total Assets $847,655 Total Assets $847,655

Twelve Key RatiosTwelve Key RatiosLeverage Ratios - Measure the financing Leverage Ratios - Measure the financing provided by a firm’s owners against that provided by a firm’s owners against that supplied by its creditors; it is a gauge of the supplied by its creditors; it is a gauge of the depth of the company’s debt.depth of the company’s debt.

4. 4. Debt to Net Worth Ratio - Compares what a Debt to Net Worth Ratio - Compares what a business “owes” to “what it is worth.” business “owes” to “what it is worth.”

Debt to Net = Debt to Net = Total Debt Total Debt = = $580,000$580,000 = 2.20:1 = 2.20:1Worth Ratio Tangible Net Worth $264,155Worth Ratio Tangible Net Worth $264,155

Twelve Key RatiosTwelve Key RatiosLeverage Ratios - Measure the financing provided Leverage Ratios - Measure the financing provided by a firm’s owners against that supplied by its by a firm’s owners against that supplied by its creditors; creditors; it is a gauge of the depth of the company’s debt.it is a gauge of the depth of the company’s debt.

5. 5. Times Interest Earned - Measures the firm's Times Interest Earned - Measures the firm's ability to make the interest payments on its debt.ability to make the interest payments on its debt.

Times Interest = Times Interest = EBIT* EBIT* = = $60,629 + $60,629 + 39,85039,850 = = Earned Earned Total Interest Expense $39,850 Total Interest Expense $39,850

= = $100,479$100,479 = 2.52:1= 2.52:1 $39,850$39,850

**Earnings Before Interest and TaxesEarnings Before Interest and Taxes

Low High

Degree of Leverage

Optimal Zone

Ben

efi

ts o

f L

eve

rag

e

The Right Amount of Debt The Right Amount of Debt is a Balancing Actis a Balancing Act

FIGURE 11.6

11- 91Ch, 11: Creating a Successful Financial Plan

Table 11.1 How Lenders View Liquidity and Leverage

Liquidity Leverage

Low

If chronic, this is often evidence of mismanagement. It is a sign that the owner has not planned for the company's working capital needs. In most businesses characterized by low liquidity, there is usually no financial plan. This situation is often associated with last minute or "Friday night" financing.

This is a very conservative position. With this kind of leverage, lenders are likely to lend money to satisfy a company's capital needs. Owners in this position should have no trouble borrowing money.

Average

This is an indication of good management. The company is using its current assets wisely and productively. Although they may not be impressed, lenders feel comfortable making loans to companies with adequate liquidity.

If a company's leverage is comparable to that of other businesses of similar size in the same industry, lenders are comfortable making loans. The company is not overburdened with debt and is demonstrating its ability to use its resources to grow.

High

Some lenders look for this because it indicates a most conservative company. However, companies that constantly operate this way usually are forgoing growth opportunities because they are not making the most of their assets.

Businesses that carry excessive levels of debt scare most lenders off. Companies in this position normally will have a difficult time borrowing money unless they can show lenders good reasons for making loans. Owners of these companies must be prepared to sell lenders on their ability to repay.

Source: Adapted from David H. Bangs, Jr., Financial Troubleshooting, Upstart Publishing Company, (Dover, New Hampshire, 1992), p. 124.

11- 91

Twelve Key RatiosTwelve Key RatiosOperating Ratios - Evaluate a firm’s overall Operating Ratios - Evaluate a firm’s overall performance and show how effectively it is putting performance and show how effectively it is putting its resources to work.its resources to work.

6. 6. Average Inventory Turnover Ratio - Tells the average Average Inventory Turnover Ratio - Tells the average number of times a firm's inventory is “turned over” number of times a firm's inventory is “turned over” or sold out during the accounting period.or sold out during the accounting period.

Average Inventory = Average Inventory = Cost of Goods Sold Cost of Goods Sold = = $1,290,117 $1,290,117 = 2.05 = 2.05 times Turnover Ratiotimes Turnover Ratio Average Inventory* $630,600 Average Inventory* $630,600 a yeara year

*Average Inventory = *Average Inventory = Beginning Inventory + Ending InventoryBeginning Inventory + Ending Inventory 2 2


7. 7. Average Collection Period Ratio (days sales Average Collection Period Ratio (days sales outstanding, DSO) - Tells the average number of outstanding, DSO) - Tells the average number of days required to collect accounts receivable.days required to collect accounts receivable.

Two Steps:Two Steps:

Receivables Turnover = Receivables Turnover = Credit Sales Credit Sales = = $1,309,589 $1,309,589 = = 7.31 times Ratio7.31 times Ratio Accounts Receivable Accounts Receivable $179,225 a year$179,225 a year

Average Collection = Average Collection = Days in Accounting Period Days in Accounting Period = = 365365 = = 50.0 Period Ratio 50.0 Period Ratio Receivables Turnover Ratio 7.31 Receivables Turnover Ratio 7.31 days days


8. 8. Average Payable Period Ratio - Tells the average Average Payable Period Ratio - Tells the average number of days required to pay accounts payable.number of days required to pay accounts payable.

Two Steps:Two Steps:

Payables Turnover = Payables Turnover = Purchases Purchases = = $939,827 $939,827 = 6.16 = 6.16 times times Ratio Ratio Accounts Payable $152,580 a year Accounts Payable $152,580 a year

Average Payable = Average Payable = Days in Accounting Period Days in Accounting Period = = 365365 = 59.3 = 59.3 daysdaysPeriod Ratio Period Ratio Payables Turnover Ratio 6.16 Payables Turnover Ratio 6.16


Operating Ratios - Evaluate a firm’s overall Operating Ratios - Evaluate a firm’s overall performance and show how effectively it is performance and show how effectively it is putting putting its resources to work.its resources to work.

9. 9. Net Sales to Total Assets Ratio - Measures a Net Sales to Total Assets Ratio - Measures a firm’s ability to generate sales given its firm’s ability to generate sales given its asset base. asset base.

Net Sales to = Net Sales to = Net Sales Net Sales = = $1,870,841$1,870,841 = = 2.21:1 2.21:1 Total Assets Total Assets $847,655Total Assets Total Assets $847,655


Profitability Ratios - Measure how Profitability Ratios - Measure how efficiently a efficiently a firm is operating; offer information about a firm is operating; offer information about a firm’s “bottom line.”firm’s “bottom line.”

10. 10. Net Profit on Sales Ratio - Measures a Net Profit on Sales Ratio - Measures a firm’s profit per dollar of sales revenue.firm’s profit per dollar of sales revenue.

Net Profit on = Net Profit on = Net Income Net Income = = $60,629 $60,629 = 3.24% = 3.24% Sales Sales Net Sales $1,870,841 Net Sales $1,870,841


Profitability Ratios - Measure how efficiently a Profitability Ratios - Measure how efficiently a

firm is operating; offer information about a firm is operating; offer information about a firm’s “bottom line.”firm’s “bottom line.”

11. 11. Net Profit to Assets (Return on Assets) Ratio Net Profit to Assets (Return on Assets) Ratio – tells how much profit a company generates – tells how much profit a company generates for each dollar of assets that it owns.for each dollar of assets that it owns.

Net Profit to = Net Profit to = Net Income Net Income = = $60,629 $60,629 = = 7.15% 7.15% Assets Assets Total Assets Total Assets $847,655 $847,655

Twelve Key RatiosTwelve Key RatiosProfitability Ratios - Measure how efficiently a Profitability Ratios - Measure how efficiently a firm is operating; offer information about a firm is operating; offer information about a firm’s “bottom line.”firm’s “bottom line.”

12. 12. Net Profit to Equity* Ratio - Measures an Net Profit to Equity* Ratio - Measures an owner's rate of return on the investment (ROI) owner's rate of return on the investment (ROI) in the business.in the business.

Net Profit to = Net Profit to = Net Income Net Income = = $60,629 $60,629 = = 22.65% 22.65% Equity Equity Owner’s Equity* $267,655 Owner’s Equity* $267,655

* Also called Net Worth* Also called Net Worth

Interpreting RatiosInterpreting Ratios

Ratios – useful yardsticks of Ratios – useful yardsticks of comparison.comparison.

Standards vary from one industry to Standards vary from one industry to another; the key is to watch for “red another; the key is to watch for “red flags.”flags.”

Critical numbers Critical numbers – measure key – measure key financial and operational aspects of a financial and operational aspects of a company’s performance. Examples:company’s performance. Examples: Sales per labor hour at a supermarketSales per labor hour at a supermarket Food costs as a percentage of sales at a Food costs as a percentage of sales at a

restaurant.restaurant. Load factor (percentage of seats filled Load factor (percentage of seats filled

with passengers) at an airline. with passengers) at an airline.

FIGURE 11.7 Trend Analysis of Ratios

Putting Your Ratios to the TestPutting Your Ratios to the TestWhen comparing your company’s ratios to your industry’s standards, ask the following questions:

1. Is there a significant difference in my company’s ratio and the industry average?

2. If so, is this a meaningful difference?

3. Is the difference good or bad?

4. What are the possible causes of this difference? What is the most likely cause?

5. Does this cause require that I take action?

6. If so, what action should I take to correct the problem? Source: Adapted from George M. Dawson, “Divided We Stand,” Business Start-Ups, May 2000, p. 34.


Sam’s Appliance ShopSam’s Appliance Shop

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

Industry MedianIndustry Median

Current ratio = 1.50:1Current ratio = 1.50:1

Although Sam’s falls short of the Although Sam’s falls short of the rule of thumb of 2:1, its current rule of thumb of 2:1, its current ratio is above the industry median ratio is above the industry median by a significant amount. Sam’s by a significant amount. Sam’s should have no problem meeting should have no problem meeting short-term debts as they come due.short-term debts as they come due.



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


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

Again, Sam is below the rule of thumb Again, Sam is below the rule of thumb of 1:1, but the company passes this of 1:1, but the company passes this test of liquidity when measured test of liquidity when measured against industry standards. Sam against industry standards. Sam relies on selling inventory to satisfy relies on selling inventory to satisfy short-term debt (as do most appliance short-term debt (as do most appliance shops). If sales slump, the result shops). If sales slump, the result could be liquidity problems for Sam’s. could be liquidity problems for Sam’s. What steps should Sam take to deal What steps should Sam take to deal with this threat?with this threat?



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


Debt ratio = 0.64:1Debt ratio = 0.64:1

Creditors provide 68% of Sam’s Creditors provide 68% of Sam’s total assets, very close to the total assets, very close to the industry median of 64%. Although industry median of 64%. Although the company does not appear to the company does not appear to be overburdened with debt, Sam’s be overburdened with debt, Sam’s might have difficulty borrowing , might have difficulty borrowing , especially from conservative especially from conservative lenders.lenders.



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

Industry MedianIndustry MedianDebt to net worth Debt to net worth ratio = 1.90:1ratio = 1.90:1

Sam’s owes $2.20 to creditors for Sam’s owes $2.20 to creditors for every $1.00 the owner has invested in every $1.00 the owner has invested in the business (compared to $1.90 to the business (compared to $1.90 to every $1.00 in equity for the typical every $1.00 in equity for the typical business). Many lenders will see business). Many lenders will see Sam’s as “borrowed up,” having Sam’s as “borrowed up,” having reached its borrowing capacity. reached its borrowing capacity. Creditor’s claims are more than twice Creditor’s claims are more than twice those of the owners.those of the owners.



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


Times interest Times interest earned ratio = 2.0:1earned ratio = 2.0:1

Sam’s earnings are high enough Sam’s earnings are high enough to cover the interest payments on to cover the interest payments on its debt by a factor of 2.52:1, its debt by a factor of 2.52:1, slightly better than the typical slightly better than the typical firm in the industry. Sam’s has a firm in the industry. Sam’s has a cushion (although a small one) in cushion (although a small one) in meeting its interest payments. meeting its interest payments.


Sam’s Appliance ShopSam’s Appliance ShopAverage inventory Average inventory turnover ratio = 2.05 turnover ratio = 2.05 times per yeartimes per year

Industry MedianIndustry MedianAverage inventory Average inventory turnover ratio = 4.0 turnover ratio = 4.0 times per yeartimes per year

Inventory is moving through Inventory is moving through Sam’s at a very slow pace. Sam’s at a very slow pace. What could be causing this low What could be causing this low inventory turnover in Sam’s inventory turnover in Sam’s business?business?



Average collection Average collection period ratio = 50.0 daysperiod ratio = 50.0 days


Average collection Average collection period ratio = 19.3 daysperiod ratio = 19.3 days

Sam’s collects the average account Sam’s collects the average account receivable after 50 days compared receivable after 50 days compared to the industry median of 19 days - to the industry median of 19 days - more than 2.5 times longer. What more than 2.5 times longer. What is a more meaningful comparison is a more meaningful comparison for this ratio? What steps can Sam for this ratio? What steps can Sam take to improve this ratio?take to improve this ratio?



Average payable period Average payable period ratio = 59.3 daysratio = 59.3 days


Average payable Average payable period ratio = 43 daysperiod ratio = 43 days

Sam’s payables are nearly 40 Sam’s payables are nearly 40 percent slower than those of the percent slower than those of the typical firm in the industry. typical firm in the industry. Stretching payables too far could Stretching payables too far could seriously damage the company’s seriously damage the company’s credit rating. What are the credit rating. What are the possible causes of this possible causes of this discrepancy?discrepancy?



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


Net Sales to total Net Sales to total assets ratio = 2.7:1assets ratio = 2.7:1

Sam’s Appliance Shop is not Sam’s Appliance Shop is not generating enough sales, generating enough sales, given the size of its asset base. given the size of its asset base. What factors could cause What factors could cause this?this?



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


Net profit on sale Net profit on sale ratio = 7.6%ratio = 7.6%

After deducting all expenses, After deducting all expenses, Sam’s has just 3.24 cents of Sam’s has just 3.24 cents of every sales dollar left as profit - every sales dollar left as profit - less than half the industry less than half the industry average. Sam may discover that average. Sam may discover that some of his operating expenses some of his operating expenses are out of balance. are out of balance.



Net profit to assetsNet profit to assetsratio = 7.15%ratio = 7.15%


Net Sales to working Net Sales to working capital ratio = 5.5%capital ratio = 5.5%

Sam’s generates a return of 7.15% for Sam’s generates a return of 7.15% for every $1 in assets, which is 30% above every $1 in assets, which is 30% above the industry average. Given his asset the industry average. Given his asset base, Sam is squeezing an above-base, Sam is squeezing an above-average return out of his company. Is average return out of his company. Is this likely to be the result of this likely to be the result of exceptional profitability, or is there exceptional profitability, or is there another explanation?another explanation?



Net profit on equity Net profit on equity ratio = 22.65%ratio = 22.65%


Net profit on equity Net profit on equity ratio = 12.6%ratio = 12.6%

Sam’s return on his investment Sam’s return on his investment in the business is an impressive in the business is an impressive 22.65%, compared to an 22.65%, compared to an industry median of just 12.6% industry median of just 12.6% Is this the result of high Is this the result of high profitability, or is there another profitability, or is there another explanation?explanation?

Breakeven AnalysisBreakeven Analysis Breakeven point - the level of operation Breakeven point - the level of operation

at which a business neither earns a at which a business neither earns a profit nor incurs a loss. profit nor incurs a loss.

A useful planning tool because it shows A useful planning tool because it shows entrepreneurs minimum level of activity entrepreneurs minimum level of activity required to stay in business.required to stay in business.

With one change in the breakeven With one change in the breakeven calculation, an entrepreneur can also calculation, an entrepreneur can also determine the sales volume required to determine the sales volume required to reach a particular profit target.reach a particular profit target.

Calculating the Breakeven PointCalculating the Breakeven Point

Step 1.Step 1. Determine the expenses the business can Determine the expenses the business can expect to incur.expect to incur.

Step 2.Step 2. Categorize the expenses in step 1 into fixed Categorize the expenses in step 1 into fixed expenses and variable expenses.expenses and variable expenses.

Step 3.Step 3. Calculate the ratio of variable expenses to Calculate the ratio of variable expenses to net sales. Then compute the contribution net sales. Then compute the contribution margin:margin:

Contribution Margin = Contribution Margin = 1 - 1 - Variable ExpensesVariable ExpensesNet Sales EstimateNet Sales Estimate

Step 4.Step 4. Compute the breakeven Compute the breakeven point:point:

Breakeven Point Breakeven Point ($)($)

= = Total Fixed Costs Total Fixed Costs Contribution MarginContribution Margin

Calculating the Breakeven Point:Calculating the Breakeven Point:The Magic ShopThe Magic Shop

Step 1.Step 1. Net Sales estimate is $950,000 with Net Sales estimate is $950,000 with Cost of Goods Sold of $646,000 and total Cost of Goods Sold of $646,000 and total expenses expenses of $236,500. of $236,500.

Step 2.Step 2. Variable Expenses: $705,125 Variable Expenses: $705,125Fixed Expenses: $177,375Fixed Expenses: $177,375

Step 3.Step 3. Contribution margin: Contribution margin:

Contribution Margin = Contribution Margin = 1 - 1 - $705,125$705,125$950,000$950,000

StepStep 4. 4. Breakeven Point:Breakeven Point:

Breakeven PointBreakeven Point$$

= = $177,375$177,375

.26.26

= .26= .26

= $682,212= $682,212

FIGURE 11.8 Break-Even Chart for the Magic Shop

ConclusionConclusion

Preparing a financial plan is a Preparing a financial plan is a critical step critical step

Entrepreneurs can gain Entrepreneurs can gain valuable insight through: valuable insight through: Pro forma statements Pro forma statements Ratio analysisRatio analysis Breakeven analysisBreakeven analysis

Further ReadingFurther Reading Scarborough, Norman, M. 2011. Scarborough, Norman, M. 2011. Essentials of Essentials of

Entrepreneurship and Small Business Management.Entrepreneurship and Small Business Management. 66thth edition. Pearson. edition. Pearson.

Brooks, Arthur C. (2006) Social Entrepreneurship : A Brooks, Arthur C. (2006) Social Entrepreneurship : A Modern Approach to Social Value Creation. Pearson Modern Approach to Social Value Creation. Pearson

Barringer, Bruce R. & Ireland, R. Duane, 2011 Barringer, Bruce R. & Ireland, R. Duane, 2011 Entrepreneurship – Successfully launching new Entrepreneurship – Successfully launching new ventures ventures 44thth edition, Pearson. edition, Pearson.

Schaper, M., Volery, T., Weber, P. & Lewis, K. 2011. Schaper, M., Volery, T., Weber, P. & Lewis, K. 2011. Entrepreneurship and Small Business.Entrepreneurship and Small Business. 3 3rdrd Asia Asia Pacific edition. John Wiley.Pacific edition. John Wiley.

abdm4223 lecture week 9 290612

Economy & Finance

financial planning

financial ratios

financial progress

past financial statements

projected financial

firms financial health

financial objectives

firm deals