chapter 36 financing the business · explore the photo moodboard photography/veer. chapter 36 —...

756 UNIT 11 — ENTREPRENEURSHIP AND FINANCE

C H A P T E R 36

Chapter ObjectivesAfter reading this chapter, you should be able to:

• Explain the purpose of fi nancial documents

• Develop a personal fi nancial statement

• Determine start-up costs for a business

• Estimate business income and expenses

• Prepare an income statement

• Create a balance sheet

• Interpret a cash fl ow statement

Market Talk Starting a business requires

more than a good idea and a good market

analysis. Seed money is necessary for that

idea to grow. That money, the capital, often

has to be borrowed from commercial bankers,

investors, and other lenders. To convince the

lenders to lend you money, you need a good

fi nancial plan.

Quick Think What do you think it takes to

convince a lender to provide capital?

Financing the Business

EXPLORE THE PHOTO

moodboard Photography/Veer

Chapter 36 — Financing the Business 757

ROLE PLAY Check your understanding of DECA performance indicators with the DECA activity in this chapter’s review. For more information and DECA Prep practice, go to the Marketing Essentials OLC through glencoe.com.

DECA Events These acronyms represent DECA com-petitive events that involve concepts in this chapter:AAMACT*ADC*ASMBLMDM* BMDM

BSMEMDM*FMALFMDM* FMML*HLM*

HMDM*MMS*QSRM* RFSM*RMS SEM*

SMDM*TMDM*TSE*

Performance Indicators The performance indicators represent key skills and knowledge. Relating them to the concepts explained in this chapter is your key to success in DECA competitive events. Keep this in mind as you read, and write notes when you fi nd mate-rial that helps you master a key skill. In these DECA competitive events, you should follow these perfor-mance indicators:• Explain the nature of overhead/operating costs• Explain employee’s role in expense control• Explain the concept of accounting• Describe the nature of cash fl ow statements• Explain the nature of balance sheets• Describe the nature of profi t-and-loss statements• Describe the nature of budgets• Describe the nature of business recordsThe events with an asterisk also include:• Analyze cash-fl ow patterns• Calculate fi nancial ratios• Interpret fi nancial statements• Analyze operating results in relation to budget/

industry • Develop expense-control plans• Develop company’s/department’s budget

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Organized Financing

1. Prepare financial documents.

2.

3.


The Financial Part of a Business Plan Financial information is a major component of a business

plan. In your business plan, you will include financial docu-ments that describe your personal finances as well as the finan-cial needs of your business. By preparing financial statements, you will be able to determine the amount of money needed to operate the business as well as the amount that must be borrowed, if any.

THE MAIN IDEAA key reason for writing a business plan is to obtain financing to start your business. It is important to prepare and include financial documents.

GRAPHIC ORGANIZERDraw this chart to outline steps in the preparation of a financial statement.

Go to the OLC through glencoe.com for printable graphic organizers, Academic Vocabulary definitions, and more.

READING GUIDE

OBJECT IVES• Explain the purpose of

financial documents

• Develop a personal financial statement

• Determine start-up costs for a business

KEY TERMS• personal financial statement

• asset

• liability

• net worth

• start-up costs

ACADEMIC VOCABULARYYou will find these words in your reading and on your tests. Make sure you know their meanings.• assess

• purpose

Predict Why would financial documents be included in a new business plan?

SECTION 36.1

BEFORE YOU READ

Preparing Financial Documents

ACADEMIC STANDARDSEnglish Language ArtsNCTE 1 Read texts to acquire new information.

English Language ArtsNCTE 3 Apply strategies to interpret texts.

Predict Why do you

think it is necessary

to develop personal

and start-up financial

statements?



When you borrow money, the lender will want to see proof that you are able to repay a loan. The lender will examine your credit his-tory, collateral (items you own that can be sold to pay off the loan), and prospects for business success. The financial documents you include in your business plan will help show that you will be able to pay off your loan.

The five important financial documents in a business plan are the personal financial statement, the start-up cost estimate, the income statement, the balance sheet, and the cash flow statement. In this section, you will learn about the first two.

The Personal Financial Statement

The personal financial statement is a summary of your current personal financial condition—a snapshot of your finances. It is an important part of any loan application for a new business. It measures your finan-

cial progress to date and shows how well you have met your personal financial obligations. It compares your assets and liabilities at a par-ticular point in time. An asset is anything of monetary value that you own, such as cash, checking and savings accounts. There are three types of checking accounts: regular, activity, and interest-earning accounts. Assets also include real estate stocks. A liability is a debt that you owe to others, such as credit card debt, school loans, car payments, or taxes.

Assets To develop a personal financial statement,

you first list your assets. Be realistic about the current value of your assets. For example, if you have a car worth $11,700, do not round it up to $12,000. Be sure to list all your cash assets (checking and savings accounts), any investments (stocks, bonds, mutual funds, and retirement funds), and personal assets (furniture, cars, clothes, and home). Estimate

• THE LENDER’S POINT of VIEW This ad is for a national legal firm that handles high-level financial transactions. It facilitates deals and advises lenders and borrowers.

Why would an entrepreneur need such financial and legal guidance?

760 UNIT 11 — ENTREPRENEURSHIP AND FINANCE glencoe.com

the present value of each item. A lender will look for assets that you can sell to pay off the business loan if your business fails. Provide a total value for each asset and a grand total for all assets.

Debts Next, list your debts, including your charge

accounts, mortgage balance, and school and

automobile loans. Calculate a total for each type of debt and a grand total for all of your debts.

Net Worth Next, calculate your personal net worth.

Your net worth is the difference between your assets and your liabilities. To find a busi-ness’s net worth, subtract its debts from its assets. For corporations, net worth is called stockholders’ equity; for partnerships and sole proprietorships, it is called owner’s equity.

Your personal financial statement is one way to determine whether you and your busi-ness are good credit risks. A lender will require a copy of your personal tax returns to see how you have earned money in the past. A lender will also request a credit report to determine how well you have paid past debts. If you plan to continue working at another job, the lender will be interested in whether that income can cover your personal expenses until your new business becomes profitable.

P R A C T I C E 1

1. You have assets of $15,000 (car), $5,000 (savings), $1,000 (cash value of life insurance), $1,700 (cash), and personal property worth $2,500. What are your total assets?

2. You have liabilities of $10,000 (car loan), $5,000 (student loan), and $1,500 (credit card balances). What are your total liabilities?

3. What is your net worth?

Note: Answers to all the practice sets are at the Market ing Essentials OLC through glencoe.com.

Estimating Start-Up Costs Before starting your business, you will need

to know how much beginning your business will cost. Start-up costs are projections of how much money you will need for your first year of operation (see Figure 36.1). You also need an estimate of the long-term operating costs that you anticipate after the first year.

By assessing start-up costs before get-ting involved in a project, you are protecting

Serena, Frank, and Dominick are three friends who are going into business together. They plan to open a small sunglasses shop in a large mall. They have a clear business plan and are certain the shop will be a suc-cess if they can get the financing they need. In preparation for meeting with a bank loan officer, each of them has prepared a per-sonal financial statement. Being young, they do not have a lot of assets, and they are concerned the bank will not consider them good risks for a loan.

Inflating AssetsDominick asked his parents if they would add his name to the title of their house, just until the start-up financing comes in. They agreed, so Dominick has listed the family home as an asset. That has increased his net worth by $200,000. He feels the bank will look more favorably on the loan application as a result.

If you were one of his partners, what would you say to Dominick about this arrangement?

Go to the Marketing Essentials OLC through glencoe.com to find an activity on ethics and capital loans.




Column 3

2 times column 1

3 times column 1

3 times column 1

3 times column 1

3 times column 1

3 times column 1

3 times column 1

3 times column 1

Payment required by insurancecompany

4 times column 1

3 times column 1

3 times column 1

3 times column 1

3 times column 1

Leave column 2 blank

See separate worksheet

Talk it over with a contractor

Talk to suppliers from whom you buy these

Supplies will probably help you estimate this

Find out from utility companies

Lawyer, accountant, and so on

Find out from city offices what you need

Estimate what you’ll use for opening

What you need to buy more stock until credit customerspay

For unexpected expenses or losses,specialpurchases,etc.

Make a separate list and enter total

Add up all the numbers in column 2

ESTIMATED MONTHLY EXPENSES

Your estimateof monthly expenses basedon sales of$____________per year

Your estimateof how muchcash you needto start your business(See column 3)

What to put in column 2. (These figures are typicalfor one kind of business. You will have to decidehow many months to allow for your business.)

Item

Column 1 Column 2

Salary of owner $ $

All other salaries and wages

Rent

Advertising

Delivery expenses

Supplies

Telephone and Internet

Other utilities

Insurance

Taxes, including Social Security

Interest

Maintenance

Legal and other professional fees

Miscellaneous

STARTING COSTS YOU ONLY HAVE TO PAY ONCE

Fixtures and equipment

Decorating and remodeling

Installation of fixtures and equipment

Starting inventory

Deposits with public utilities

Legal and other professional fees

Licenses and permits

Advertising and promotion

Accounts receivable

Cash

Other

TOTAL ESTIMATED CASHYOU NEED TO START $ $

Chapter 36 — Financing the Business 761glencoe.com

36.1 Start-Up Cost Worksheet• Estimating Costs The SBA provides many forms and worksheets to help new business owners project monthly

expenses.

Why is a start-up worksheet helpful to a new entrepreneur?

Go to the Marketing Essentials OLC through glencoe.com to find a project on start-up costs.



Long-term financing

• P ersonal financing• F amily and friends• P rivate investors• Equity financing• Leasing• Credit unions• S BA LowDoc

Short-term financing

• P ersonal financing• F amily and friends• Credit cards• Credit unions• T rade credit• Banks• S BA M icroloans• S BA LowDoc

Long-term financing

• Business alliances• S BA regular 7(a) program• V enture capital• SBICs• State and local public

financing• F ranchising• Asset-based financing

Short-term financing

• S BA CAPLines• Consumer finance

companies• Commercial finance

companies• State and local

public financing

Primary Sources Secondary Sources


yourself and helping to ensure the viability of the business. You will need to spend money on goods and services ranging from furniture to advertising. The costs vary depending on the type of business.

Although start-up costs vary, they are based on factors such as:

• The nature of your proposed business Manufacturing, wholesale, and retail businesses all have different needs and requirements.

• The size of your business Small businesses usually do not require as much money to start as big ones.

• The amount and kind of inventory needed For example, it is much more costly to purchase inventory for a large supermarket than for a neighborhood convenience store.

• The estimated time between starting the busi-ness and earning income from the first sales.

• The operating expenses Expenses must be paid before cash is received from sales.

Business start-up costs may be one-time costs or continuing costs.

• One-time costs are expenses that will not be repeated after you begin the business. Examples of one-time costs are licenses

and permits; deposits for telephone installation; and charges for installation of equipment, fixtures, and machinery.

• Continuing costs are operating expenses you will pay throughout the life of the business. Examples of continuing costs are payroll, monthly rent, advertising, supplies, insurance, repairs, maintenance, and taxes. Most businesses are not profitable immediately, so include at least three months of continuing costs when estimating the amount of cash you will need to get started.

You can get information from several reliable sources to help you plan your financial needs (see Figure 36.2). The Small Business Admin-istration (SBA) provides information to people who want to start a new business. The SBA offers a wide variety of loan programs. These programs help small businesses borrow money at reason-able interest rates from traditional lenders. The SBA has developed a worksheet for estimating start-up costs and operating expenses for new businesses.

You can also get estimates of start-up costs from people who are already in a similar busi-ness or from a trade association. State and local government agencies, such as your state

36.2 Financing Sources

Go to the Marketing Essentials OLC through glencoe.com to find a project on financing a business.

• Finding Funding There are several funding sources for new businesses.

What is the difference between a primary and a secondary source of financing?



Problem Solving: Start-Up Costs Start-up costs include several different values. When determin-ing start-up costs, make a list of all the things that are included. 1. To solve this problem, total the

amounts for initial expenses, the money needed for reserve, and the value of the start-up inventory.

2. Add each of the values together to determine the total start-up cost.

For help, go to the Math Appendix located at the back of this book.


P R A C T I C E 2

1. Your business has one-time costs of $25,000 and average monthly costs of $3,600. What are your total costs for the first quarter of operation? Using the sam average monthly costs, what are your total costs for the year?

department of commerce and local cham-ber of commerce, are valuable sources of cost information.

and household cash needs for at least the first year of business. When starting a new busi-ness, you may be able to meet your personal expenses by working at another job or by rely-ing on income from your parents or a spouse.

You may choose not to work outside yourbusiness or seek any other income, but you must plan to have enough cash on hand to pay your personal expenses. Some experts suggest you have enough start-up capital to pay for up to six months of living expenses.

Set aside the money for living expenses in a savings account or another account from which you can withdraw money with-out penalty. Do not use the money for any other purpose. This fund will help you get through the start-up period. The amount should cover living expenses such as regu-lar monthly payments, household operating expenses, food expenses, personal expenses, and various tax expenses.

Personal Costs Unless you are starting your new business

while still working at another job, you will need money to live on during the start-up phase. Your personal costs are those expenses that are necessary for you to live. You will need to project your monthly living expenses

Check your answers at the Marketing Essentials OLC through glencoe.com.

Key Terms and Concepts 1. What is a personal financial statement? 2. Define asset, liability, and net worth. 3. How are one-time costs different from

continuing costs?

Academic SkillsMath

4. Calculate the total start-up costs for an online business by using the Starting Cost Calcula-tor on the U.S. Small Business Administration Web site and the following data:

• Initial expenses: legal: $500; office supplies: $300; office equipment: $1,500; design: $150; brochures: $150; Web site: $500; other: $700.

• Money needed for reserve for a total of six months: monthly payroll: $2,500; monthly rent: $750; and monthly expenses: $550.

• Start-up inventory: $2,000. What are the total start-up costs for a six-month period?

Social Studies/Economics

5. Do Internet or library research on factors considered by start-ups when locating in a particular state. Summarize research in a one-page paper.



Financial Documents

1. Prepare an income statement.

2.

3.


Estimating Business Income and Expenses After you estimate your start-up costs and personal living

expenses, the next step is to estimate the money you expect to earn and to spend while operating your business. Many small businesses fail because they do not bring in enough revenue to pay their costs and expenses. Estimating business income and expenses is a key part of your business plan. Lenders want to see your estimates to decide whether to lend you money.

THE MAIN IDEAFinancial institutions and investors want to know how a business will use their money and how it will be repaid. The financial section of a business plan provides this information.

GRAPHIC ORGANIZERDraw an outline that lists key financial documents.

Go to the OLC through glencoe.com for printable graphic organizers, Academic Vocabulary definitions, and more.

READING GUIDE

OBJECT IVES• Estimate business income and

expenses

• Prepare an income statement

• Create a balance sheet

• Interpret a cash flow statement

KEY TERMS• income statement

• gross sales

• net sales

• net income

• interest

• principal

• balance sheet

• cash flow statement

ACADEMIC VOCABULARYYou will find these words in your reading and on your tests. Make sure you know their meanings.• significant

• ratio

Predict Why do you think so many new businesses fail?

SECTION 36.2

BEFORE YOU READ

Financial Aspect of a Business Plan

ACADEMIC STANDARDSEnglish Language ArtsNCTE 1 Read texts to acquire new information.

MathNCTM Algebra Use mathematical models to represent and understand quantitative relationships.

Connect As you read,

list specific financial

needs you would have to

start a company.



If you are buying an existing business, you will have previous operating results to use as a guide. If you are starting a new business, you will need to estimate your potential revenue and the different costs and expenses of operat-ing the business.

The Income StatementThe financial document used to calculate

revenue, costs, and expenses is the income statement. The income statement is a summary of income and expenses during a specific period such as a month, a quarter, or a year. This statement is often called a profit and loss statement.

The income statement for an existing busi-ness shows the previous year’s income, costs, and expenses. The income statement for a new or planned business estimates earnings and expenses for the first few months (or the first year) of operation. Figure 36.3 on page 766 shows a sample projected quarterly income statement. Refer to this figure as you read about the parts of the income statement.

Income statements have several major parts: total and net sales, cost of goods sold, gross profit, expenses of operating the busi-ness, net income from operations, other income or expenses, net profit before income taxes, and net profit after income taxes. Each item on the income statement is added to or subtracted from total sales to find the amount of net profit or loss.

Total Sales� Returns and Allowances� Net Sales� Cost of Goods Sold� Gross Profit� Operating Expenses� Net Income from Operations� Other Expenses (Interest)� Net Profit (Loss) Before Taxes� Taxes� Net Profit (Loss) After Taxes

Now we will see how to calculate the dif-ferent amounts for each part of the income statement.

Estimating Total SalesThe income generated by a business

depends on the yearly volume of sales. Most new businesses grow slowly in the beginning, so you should be conservative in estimating your first-year sales.

Most people who start a new business have some idea about where they will sell their products. You may already have discussed your new product with potential buyers. You may even have a contract to produce a cer-tain number of items. Suppose you are start-ing a new T-shirt printing business. You have a contract for 2,000 shirts, which you will sell at $8 each wholesale. Your estimated total sales will be $16,000. You would estimate your total sales at $160,000 if you think you can produce and sell ten times that amount during your first year.

It is important to calculate a reasonable estimated sales volume. You must verify your estimated sales volume by comparing it with projected industry figures for your size of busi-ness and location. Trade associations, bankers, and industry publications can help you make sales and income estimates.

The accuracy of your sales estimates will also depend on the quality of your market analysis. Losses rather than profits are com-mon during the first year of business. In your business plan, you will need to show how you will cover any losses by investing more capital or reducing your operating expenses.

Calculating Net SalesThe total of all sales for any period of time

is called gross sales. Your gross sales will sim-ply be the total of all cash sales if your com-pany sells only on a cash basis. When your company accepts credit and charge cards, sells gift certificates, or offers merchandise on account, then all of these different types of sales transactions must be totaled to arrive at gross sales.

Most businesses have some customer returns and allowances (credit granted to cus-tomers for damaged or defective goods kept by the customer); therefore, the gross sales figure does not reflect the actual income from sales.


36.3 Projected Quarterly Income Statement• Financial Statement An income statement summarizes a business’s income and expenses for a specific period of

time. It gives a snapshot of the business’s health, showing profits or losses. This is often used to attract investors or

to show lenders. Because a new business does not have a business history, it develops a projected income statement

that estimates expected income and expenses for a period of time.

How might a new business gather the information needed to project income and expenses?

Go to the Marketing Essentials OLC through glencoe.com to find a project on personal finance.




The total of all sales returns, discounts, and allowances is subtracted from gross sales to get net sales. The net sales figure is the amount left after gross sales have been adjusted for returns and allowances. Look at Figure 36.3 to find the net sales for each month.

Cost of Goods SoldThe total amount spent to produce or to

purchase the goods that are sold is called the cost of goods sold. To calculate cost of goods sold, add goods purchased during the period to the beginning inventory value. Then sub-tract the amount of the ending inventory.

Beginning Inventory � Net Purchases, or Production Costs� Ending Inventory

� Cost of Goods Sold

As you learned in Chapter 24, you count the stock on hand and calculate its total value to determine beginning and ending inventory amounts.

Most service businesses do not provide goods to their customers. Therefore, they do not have to determine the cost of goods sold. Their gross profit is the same as net sales. Other businesses that produce or purchase products to sell must calculate the cost of goods sold.

Determining Gross ProfitGross profit or gross margin on sales is the

difference between the net sales and the cost of goods sold.

The formula for calculating gross profit is:

Net Sales� Cost of Goods Sold � Gross Profit

Once you know the cost of goods sold, you can calculate your gross profit by subtracting the cost of goods sold from net sales.

Suppose you are employed by Downhill Racers, a company that sold $115,765 worth of mountain bikes last year. The company books show a total of $3,220 in sales returns and allowances. When you subtract the sales

returns and allowances from total (gross) sales, you get net sales of $112,545. The cost of goods sold for last year totals $69,459; therefore, your gross profit is: $112,545 �

$69,459 � $43,086.

Projecting Business Expenses The next major part of the income state-

ment is the operating expenses—the costs of operating the business, including variable and fixed expenses.

Calculating Variable Expenses Variable expenses change from one month

to the next. Variable costs can fluctuate depending upon the sales volume of the busi-ness. Variable expenses include items such as advertising, office supplies, telephone bills, and utilities.

Variable expenses are often calculated as a percentage of some baseline amount. Adver-tising expenses, for example, may average 5 percent of total sales.

Calculating Fixed Expenses Fixed expenses are costs that remain the

same for a period of time. These types of expenses stay fixed for months regardless of sales volume. Depreciation, insurance, rent, salaries, and payroll taxes are examples of fixed expenses.

Depreciation is a complicated fixed ex -pense. Depreciation represents the amount by which an asset’s value has fallen because of age, wear, or deterioration in a given period of time. IRS laws and rules govern the time period over which you can depreciate assets. An accountant can help you determine the asset depreciation schedule and amounts to use in listing assets on your income tax return.

Projecting other fixed expenses usually is easier because you simply add all your fixed costs, such as rent or insurance. Employee wages may be a significant part of your busi-ness expenses. Let’s look at how to calculate payroll costs.

Calculating Payroll Expenses To calculate payroll expenses, you must

first estimate the number of employees you

FPO—C36-01SC


need to operate your business. Then, research typical salaries in your area for the work the employees will perform. You can get help on salary information by consulting your state employment security agency (SESA) office and by reviewing the help-wanted ads in the news-paper for similar jobs. You can also use the minimum wage as a starting point and decide how much more to pay for more skilled work-ers, recognizing that a skilled worker should have a higher salary than an unskilled one.

When setting up your business, you need to give careful attention to your payroll records. Payroll records are important to your employ-ees and to your company. They are also used to prepare income tax returns, so the federal and state governments are also concerned with their accuracy.

Your bank, your accountant, a bookkeep-ing service, or a computer software program can help you set up a system to calculate and record payroll and cut checks.

Two Men and a Truck

The sons of Mary Ellen Sheets started a local moving service when they were in high school. They used an old pickup to transport people’s belongings around Lansing, Michigan, after school. In 1985, the boys’ mother bought the company’s first truck to keep the business going while the boys were away in college. In 1988, Two Men and a Truck became the first local moving company in the United States to offer franchises. By 2006, there were 185 franchises worldwide, including those in 29 U.S. states, Canada, and Ireland with revenues of $181 million. Sheets’s sons, Brig and Jon Sorber, are still part of management.

Advice on Starting a Business

Sheets has advice for people starting a new business: Get your finances in order and keep accurate accounts. For years, she kept company receipts in a shoebox under her desk. As the company grew and annual audits were required, auditors would groan as they searched through boxes of paper receipts.

What stopped Sheets from getting accounting help was her idea that it was too expensive. When she finally hired an accountant, however, the errors he found in his first month on the job saved the company enough money to pay his first year’s salary. Her advice to new businesses is: Either learn about finance or hire financial professionals.

Why is it necessary for a business to keep good financial records?

Go to the Marketing Essentials OLC through glencoe.com to find an activity on financials and starting a business.




Your payroll records may be part of the cash disbursements journal where you keep records of all cash payments. You may pre-fer to keep your payroll records in a separate payroll journal. When using a separate jour-nal for payroll records, use a separate record for each employee. Each record will show one employee’s pay period, hours worked, earn-ings, deductions, and net pay.

The amount earned by an employee is that person’s gross pay. Net pay is what the employee receives after deductions for taxes and insurance, and voluntary deductions. Nancy Baker earns $11 an hour and worked 40 hours during the week; therefore, her gross pay is $440 ($11 � 40 hours).

Nancy’s deductions total $125.66, so you would calculate her net pay by subtracting the deductions from her gross pay:

$440 � $125.66 � $314.34 (net pay)

Tax tables are available for calculating the amount to be deducted from each employee’s pay for local, state, and federal income tax. The percentage of gross pay to be deducted for FICA (Social Security and Medicare taxes) changes frequently. Get the latest information from your local Social Security office.

Example: Find the net pay for Rosarita Romerez, who worked a total of 44 hours dur-ing a week at $13 per hour. She is paid time-and-a-half for overtime (hours worked beyond 40 hours in a week). Her deductions totaled $105.25 for the week.

STEP 1 Calculate the gross pay.

$520.00 ($13 � 40 hours)� 78.00 ($13 � 4 hours � 1.5)$598.00 (gross pay)

STEP 2 Subtract deductions.

$598.00 (gross pay)� 105.25 (total deductions) $492.75

In estimating your total payroll expenses, you will need to use current tax rates for local, state, and federal income taxes. Remember that as the employer, you will also pay FICA and unemployment payroll taxes on your employees’ earnings. You will need to include those tax amounts in your total payroll expense estimate.

Calculating Total Expenses Once you have calculated all your oper-

ating (variable and fixed) expenses, you are ready to total your expenses. To calculate total expenses, add the variable expenses to the fixed expenses.

Total Variable Expenses� Total Fixed Expenses

� Total Expenses

Net Income From OperationsAfter calculating your total expenses, the

next step is to calculate net income from busi-ness operations. Net income is the amount left after the total expenses are subtracted from gross profit.

The formula for calculating net income from operations is:

Gross Profit on Sales� Total Expenses � Net Income From Operations

Suppose you own the “I Can Do That” Home Remodeling Company, which had gross profit on sales of $153,156 during the year. Your total operating expenses for the year were $88,991, so your net income from operations was:

$153,156 � $88,991 � $64,165

During the first years of operation, a busi-ness may have a net loss from operations. A net loss results when total expenses are larger than the gross profit on sales. The financial plan should address how the business intends to pay its debts in the short term, especially if a loss is probable during the first months of operation.


Calculating Other Income In the Net Income From Operations sec-

tion of the income statement, list money earned from sources other than sales. You may earn dividends on stocks or interest on your savings or checking accounts. Interest is the money paid for the use of money borrowed or invested.

To estimate your interest earnings, check with local banks and find the current inter-est rate paid on similar accounts. It is likely that you will use some of this money during the year, so you need to calculate interest only on the amount that is actually on deposit. Unless the interest income that you expect to earn is significant, you may want to list this amount as zero in your business plan.

Calculating Other Expenses You will pay interest on any money that

you borrow to start your business. The amount you borrowed is called the principal. Inter-est is expressed as a percentage of the principal and is called the rate of interest.

For example, if you borrow $100 at 6 per-cent, the principal is $100 and the rate of interest is 6 percent. To find the amount of interest for one year, multiply the principal (p) times the rate of interest (r) times the length of time (t). This formula is stated as:

i � prt($100 � .06 � 1 � $6)

You would pay $6 in interest for the exam-ple above.

The units in the rate of interest and time must agree. That is, if the rate of interest is expressed in years, then the time must be expressed in years as well. Both may be expressed in months. Check this before you do your math so that your answers will be cor-rect. If the rate is given without reference to a time period, you can assume that it is for one year.

Suppose you are quoted a yearly rate and need to convert it to a monthly rate. There are 12 months in a year, so you would divide the yearly rate by 12 to get the monthly rate.

When you are quoted a monthly rate and want to convert it to a yearly rate, multiply the monthly rate by 12.

Once you decide how much money you will need to borrow and how long it will take you to repay the loan, you can calculate your total annual (or monthly) interest. This amount is listed on the financial statement as Other Expenses (Interest).

Net Profit or Loss Before TaxesNet profit or net loss before taxes is calcu-

lated by adding other income to net income from operations and then subtracting other expenses from the total.

Net Income From Operations� Other Income� Other Expenses

� Net Profit (or Loss) Before Taxes

Net Profit or Loss After TaxesNet profit (or loss) after taxes is the amount

of money left over after federal, state, and local taxes are subtracted. This amount represents the actual profit from operating the business for a certain period of time.

The projected income statement should be done on a monthly basis for new businesses. After the first year, projected income state-ments can be prepared on a quarterly basis.

The steps that follow are a summary of how to prepare a monthly projected income statement.

STEP 1 Estimate total sales.

STEP 2 Subtract sales discounts, returns, and allowances from total sales to calculate net sales.

STEP 3 List the estimated cost of goods sold.

STEP 4 Subtract the cost of goods sold from net sales to find gross profit on sales.

STEP 5 List each monthly operating expense, categorizing each as a variable or fixed expense.


STEP 6 Total the monthly operating expenses.

STEP 7 Subtract total operating expenses from gross profit on sales to find net income from operations. Put parentheses around any projected losses; for example, a projected loss of $1,000 would be identified as ($1,000).

STEP 8 Add other income such as interest on bank deposits and subtract other expenses, such as interest expense, from net income from operations. The result is net profit (or loss) before income taxes.

STEP 9 Estimate total taxes on the net income and subtract that amount from net profit. The result is net profit (or loss) after taxes.

P R A C T I C E 3

Using the income statement shown below, answer the following questions:1. How much did Mountain Air pay for the

bikes it sold? 2. How much was the gross profit for the

year?3. How much were total operating expenses?

4. Which operating expense was the most costly?

5. How much net income was earned during the year?

Mountain Air BikesIncome Statement for the Year Ended

December 31, 20- -

Net Sales $ 202,736Cost of Goods Sold $ 124,375Gross Profit $ ?Operating Expenses Salaries $ 28,022Rent $ 14,211Utilities $ 5,214Advertising $ 3,422Total Operating Expenses $ ?Net Income From Operations $ ?

Creating LoyaltyEncouraging customer loyalty has always

been a goal of marketers. Marketing technol-ogy has pioneered many ways of getting cus-tomers to come back again and again. “New marketing” targets individuals rather than groups, because the software behind it col-lects specific information about each person.

Targeted RewardsHarrah’s, an entertainment, resort, and

casino company, asks each customer to sign up for its Total Rewards loyalty program. Cus-tomers use their rewards cards whenever they make a purchase at the resort.

Harrah’s tracks the results and offers spe-cial deals and privileges to consumers who return often even if they do not spend a lot of money on their visits.

The rewards offered are related to what the consumer has purchased in the past—free concert tickets to music lovers, for example.

The company tracked an increase of 20 percent in customer loyalty after the pro-gram’s first year.

Go to the Marketing Essentials OLC through glencoe.com to find an activity on technology and starting a business.

Where would you list on an income statement the expenses for the software necessary to track customer purchasing?




The Balance Sheet A balance sheet is a summary of a busi-

ness’s assets, liabilities, and owner’s equity.

AssetsAssets are anything of monetary value

that you own. They are classified as current or fixed.

• Current assets are cash and anything of value that can be converted into cash in a year. Examples of current assets are cash in the bank, accounts receivable (money owed to you by your customers), and inventory.

• Fixed assets are used over a period of years to operate your business. Fixed assets cannot be changed into cash within a year. Examples of fixed assets include land, buildings, equipment, furniture, and fixtures. The assets of the business are needed to operate the busi-ness. When borrowing money to start a business, assets are also often used as collateral for the loan.

LiabilitiesLiabilities are listed in another section of

the balance sheet. Liabilities are the amounts that the business owes—for example, money owed for merchandise purchased. Liabilities are classified as either current or long-term.

• Current liabilities are the debts the business must pay during the upcoming business year. Examples of current liabilities are accounts payable (money owed to suppliers), notes payable (money owed to a bank), taxes payable, and money owed to employees for salaries.

• Long-term liabilities are debts that are due after 12 months. Some examples are mortgages and long-term loans.

Equity Equity, or net worth, is the third section of

the balance sheet. When you start a new busi-ness, you will most likely invest some savings in the business. The amount of the savings is your equity, or ownership interest, in the

business. The money invested will be used to buy assets and to operate the business. The assets owned by the business and the debts the business owes impact your equity. Remember, net worth is the difference between the assets of a business and its liabilities: Assets � Liabilities � Net Worth (Equity).

Analysis of Financial Statements Lenders use ratio analysis to determine

how a business is performing as compared to other businesses in the industry. Ratios indi-cate whether a business has too much debt, is carrying too much inventory, or is not making enough gross profit. Information on the bal-ance sheet and the income statement may be used to calculate these ratios. Lenders use ratio analysis to determine whether your business would be a good investment risk and whether it could repay a loan.

Figures on the balance sheet show you the amount of your ownership interest (owner’s or stockholders’ equity) and the financial strength of a business on a given date. The data on the income statement shows how well the business is operating over a period of time. You may need information from both statements to calculate ratios.

The following are some of the most basic operating ratios and how they may be used to analyze or interpret financial statements. A number of sources and directories exist to help you determine the common business ratios for your type of business. These include Financial Studies of Small Business published by the Financial Research Associates, Industry Norms and Key Business Ratios by Dun & Brad-street, and Almanac of Business and Industrial Financial Ratios by Leo Troy.

Liquidity Ratios Liquidity ratios are used to analyze the

ability of a firm to meet its current debts. One liquidity ratio is current ratio. Its formula is current assets divided by current liabilities. In this case, it is better to have a high ratio.

Explain Why do lenders use ratio analysis?


The acid test, or quick ratio, is used to see if the company can meet its short-term cash needs. Its formula is cash plus marketable securities plus accounts receivables divided by current liabilities.

Activity Ratios Activity ratios are used to determine how

quickly assets can be turned into cash. One such ratio is called accounts receivable turn-over, which indicates the number of days it takes to collect the money owed by custom-ers. To calculate this ratio, divide net sales by average trade receivables. In this case, it is bet-ter to have a lower ratio.

The stock turnover ratio measures how many days it takes to turn over, or sell, the inventory. Excessive inventory ties up cash that a company can use to grow its business. The basic formula for this ratio is cost of goods sold divided by average inventory.

Profitability Ratios Profitability ratios measure how well the

company has operated during the past year. One ratio is profit margin on sales, which shows the rate of profit in percentages. This information is found on the income state-ment. Its formula is net income divided by net sales. Another profitability ratio is the rate of return on assets, which shows how well you are doing when compared to other compa-nies. The formula for this ratio is net income divided by average total assets.

Cash Flow Statement A cash flow statement is a monthly

plan that tracks when you anticipate that cash will come into the business and when you expect to pay out cash. A cash flow statement helps you determine whether you will have enough money to pay your bills on time.

Businesses need cash to pay bills and their employees, and to use for unexpected expenses. The cash flow statement itemizes how much cash you started with, what your projected cash expenditures are, and how and when you plan to receive cash. It also

shows when you will need to find additional funds and when you will have cash remain-ing. Most lenders will require you to estimate the business’s cash flow for the first year of operation.

Cash PaymentsWhen operating a business, one of your

largest payments of cash will be for your mer-chandise. You will most likely have to pay for part of the merchandise in cash and part of it on credit.

When estimating sales for the income state-ment, you include both cash and credit sales. In contrast, the cash flow statement shows only the amount you expect to receive in cash (for cash sales and payments for credit sales) during the month.

P R A C T I C E 4

Using the balance sheet shown below, answer the following questions:

1. How much are the total assets for Mountain Air Bikes?

2. How much are the total liabilities? 3. What is Mountain Air’s net worth?

Mountain Air BikesBalance Sheet December 31, 20- -

Current AssetsCash $ 10,000Accounts Receivable 15,000Inventory 68,000

Fixed AssetsBuilding 120,000Equipment 80,000Vehicles 30,000Total Assets $ ?

Current LiabilitiesNotes Payable $ 3,000Accounts Payable 12,000Salaries Payable 5,000Taxes Payable 1,000

Long-Term LiabilitiesNotes Payable 90,000

Total Liabilities $ ?

Net Worth $ ?


You may receive payment for most of your credit sales 30 days after the sales. You will also need to calculate your monthly costs for oper-ating the business.

How to Prepare a Cash Flow Statement

Use the following steps to prepare a cash flow statement.

STEP 1 Add the total cash on hand (in bank accounts) and money received from any loans to find your total start-up money.

STEP 2 Subtract the start-up costs to determine the amount of cash left for operation.

STEP 3 Enter the estimated cash you expect to receive from cash sales and credit sales for each month during the first year. Enter the amount of any income from business investments or additional loans.

STEP 4 Add all sources of cash receipts to find the total cash income for the month.

STEP 5 List the cost of goods that you will buy for your inventory. This cost should be separated into purchases for which you will pay cash and purchases on credit, which you will pay for the next month.

For example, the cash flow statement shows goods bought on credit in Month 1.

This is a payment for items bought on credit prior to the opening of the business. Add the cash and credit purchases to find the total cost of inventory purchases.

STEP 6 List the expenses you expect to pay during the month. These amounts are the same as those listed on the income statement, except for the depreciation expense.

Depreciation is a means of spreading the cost of an asset over a period of years. The amount ofdepreciation is not an actual paymentmade by the business, so it is not listed on the cash flow statement.

STEP 7 Total all expenses for the month.

STEP 8 List amounts that will be paid out for capital expenditures. A capital expenditure is money paid for an asset used to operate the business. The purchase of a delivery truck would be a capital expenditure.

STEP 9 List any other payments that will be made, such as repayment of the principal and interest for the loan.

STEP 10 Add all the cash expenditures (cost of inventory purchased, expenses, capital expenditures, and other payments).

Subtract the total cash payments fromthe total cash received during the month to determine net cash flow.

The amount of any cash payments that are higher than cash receipts should be placed in parentheses to show a loss.

STEP 11 Add the beginning cash balance from the start-up column to the net cash flow for the month.

The result is the cash surplus for the month. When the costs of operating the business are higher than income added to the beginning of the cash balance, the business will have a deficit rather than a surplus.

In that case, the business will need additional cash for its operations. The amount is listed on the Cash Needs line.

The income statement does not take into account how long it may take a business to collect the cash from sales made on credit.

Number and Operations: Multi-Step Problems With multi-step problems, make a list of all the things you are looking for. Also, include how the values are related to one another when making the list. 1. To solve this problem, subtract the

value of the items returned from the total sales to calculate the net sales.

2. Subtract the cost of goods sold from the net sales to determine the gross profits.

3. Subtract the value of fixed costs and variable expenses from the gross profit to calculate the net income from operations.



LoansWhat can you do if your cash flow state-

ment indicates you will need additional money during the year? You should be able to borrow money if your business has potential and your balance sheet shows enough assets to serve as collateral.

A loan can help you keep the business going during the start-up period and duringslow sales months. When your cash flow projec-tions indicate that you need to borrow money to meet monthly expenses, you will want to include monthly payments on the loan as apart of your cash needs for the rest of the year.

P R A C T I C E 5

1. You have total cash of $23,000 to start your business and start-up costs of $12,000.What amount of cash is available for operating the business?

2. Suppose cash income for the first three months is $100, $750, and $980. Total expenses for these same months are $4,800, $3,400, and $2,700.What is the cash flow for each month?

3. What is the cumulative amount of cash available at the end of each month?

Check your answers at the Marketing Essentials OLC through glencoe.com.

Key Terms and Concepts 1. How is gross profit calculated on an income statement? 2. What is the difference between variable and fixed expenses on an

income statement? 3. What is a balance sheet?

Academic SkillsMath

4. Total first-quarter sales for the Bad Frog Beverage Company were $315,000. Goods returned by customers amounted to $6,100. The cost of goods sold to customers was $212,000. The company’s total fixed and variable expenses were $94,500. Calculate the following amounts: net sales, gross profit, net income from operations.

English Language Arts/Writing

5. Investigate the concept and the purpose of cash flow statements. Write a one-page paper on how a business owner could improve cash flow.




JAMES KAISERFINANCIAL MANAGERAMERICAN GREETINGS CORPORATION

What do you do at work?

I gather specifi c fi nancial information related to an investment (expected investment versus expected return) and develop fi nancial performance goals, then structure the terms of the relationship in a manner that is most benefi cial to American Greetings, while coaching

the executive management team in developing customer-oriented strategies.

What skills are most important to you?

The most valuable technical skill important to success is in-depth knowledge and understanding of corporate fi nance, including profi tability analysis (discounted cash fl ows, internal rate of return, net present value, return on net capital employed). The most valuable soft skill important to success is a broad knowledge of marketing, including product position/differentiation and product life cycle (what competitive advantages the product offers over competition, where the product is in its life cycle, and how these attributes affect product profi tability).

What is your key to success?

There are two keys to be successful as a fi nancial manager that recommends corporate profi tability strategies to executive management teams. The fi rst is fi nancial knowledge, the ability to correctly and accurately analyze fi nancial information. The second is presentation, the ability to market and defend your fi nding/results to a broad audience in a manner that achieves your objectives.

Courses marketing, general business, fi nance, business administration

Degrees BA, BS, MBA

Finance careers often begin with entry-level positions in accounting, bookkeeping or similar departments.

Growth about as fast as average for the next ten years

Source: Occupational Outlook Handbook

Knowledge of fi nance and marketing, attention to detail, and presentation and communication skills

Go to the Marketing Essentials OLC through glencoe.com to fi nd a career-related activity.

How important is a thorough understanding of the workings of corporate fi nance in this career?




C H A P T E R 36 R E V I E W

SECTION 36.1• Five important fi nancial documents are the personal fi nancial statement, the start-up cost

estimate, the income statement, the balance sheet, and the cash fl ow statement. The

personal fi nancial statement is a summary of your current personal fi nancial condition.

Start-up costs are a projection of how much initial money you will need for your fi rst and

continuing years of operation. You also need an estimate of your personal living expenses.

SECTION 36.2• The next step is to estimate the money you expect to earn and to spend operating your

business. The fi nancial document that is used to calculate a business’s revenue, costs,

and expenses is the income statement. A balance sheet is a summary of a business’s

assets, liabilities, and owner’s equity. A cash fl ow statement is a monthly plan that in-

dicates when you anticipate cash coming into the business and when you expect to pay out

cash. A cash fl ow statement shows whether you will have enough money to pay your bills.

Key Terms• personal fi nancial statement

(p.759)• asset (p.759)• liability (p.759)• net worth (p.760)• start-up costs (p.760)• income statement (p.765)

• gross sales (p.765)• net sales (p.767)• net income (p.769)• interest (p.770)• principal (p.770)• balance sheet (p.772)• cash fl ow statement (p.773)

Academic Vocabulary• assess (p. 760)• purpose (p. 763)• signifi cant (p.770)• ratio (p. 772)

1. On a sheet of paper, use each of these key terms and academic vocabulary words in a written sentence.

2. What fi nancial information should be

included as part of a business plan? (36.1)

3. What factors determine start-up costs for a

new business? (36.1)

4. How do start-up costs differ from personal

costs? (36.1)

5. What are the major categories that are

calculated on the income statement? (36.2)

6. How is a cash fl ow statement used? (36.2)

7. What is the purpose of a balance sheet? (36.2)

8. What is an asset? (36.2)

9. What does net worth tell a business owner?

(36.2)

10. What kinds of fi nancial information are

presented on an income statement, a balance

sheet, and a cash fl ow statement? (36.2)

11. What is the formula for calculating gross

profi t? (36.2)


12. Workplace Skills Human Relations After high school, a friend

has decided to open a landscaping business

for cottage owners who live around a small

inland lake. He believes that he will not need

extra capital for personal living costs because

the business will generate enough revenue to

cover this. Should your friend be concerned

about his personal living costs? If so, discuss

the reasons why your friend should be

concerned.

13. Technology ApplicationsCash Requirement Worksheets Perform

an Internet search for initial cash

requirements worksheets. Use one of

these templates to estimate expenses and

calculate the total amount of cash needed to

start a new business.

14. Math Practice Develop a Budget Suppose that you are

renting an apartment and earn a yearly

salary of $24,000. Develop a cost-of-living

budget. Be sure to include all regular monthly

payments, household operating costs, food,

and personal expenses. How might you help

pay for your expenses?

Problem Solving: Developing

a Budget Include expenses required by an

individual or company.


15. English Language Arts/Writing Accounting Information technology has

allowed for a number of different ways to

easily record a business’ fi nances. Go online

and research several different types of

software for managing business fi nances.

Write a paragraph about each. Include in the

paragraph such things as to what type of

business each product is marketed, and

the product’s pros and cons.

16. Business Ratios

Select an industry that interests you.

Research several companies and contact the

person in charge of fi nances at one or two

companies. Interview each person to fi nd out

about three business ratios that have proven

helpful to him or her in running the business.

Identify each ratio and write a one-paragraph

summary on why each ratio was important.

17. Investigating Start-Up Costs Select a business and investigate its start-up

costs for the fi nancial section of a bus iness

plan. Use these resources: people in business,

suppliers, trade associations, Service Corps of

Retired Executives (SCORE), Small Business

Administration, chambers of commerce, and

start-up guides and magazines.

Activity Develop a start-up worksheet for the

business and present your project in class.

Include variable and fi xed expenses, such as

rent and maintenance contracts.



Role PlaySporting Goods Store ManagerSituation Assume the role of manager of

a sporting goods store who is considering

starting your own sporting goods store.

You are completing your business plan and

investigating sources of fi nancing for your

proposed business. You are going to meet

with a friend (judge) who works for a fi nancial

services business and will discuss some of

the factors to consider when planning the

start-up costs.

Activity You are to make note of the factors

to consider when planning start-up costs for

a new business. Also identify one-time costs

and continuing costs. Discuss your start-up

cost plans with your friend (judge).

Evaluation You will be evaluated on how well

you meet the following performance indicators:

• Describe the nature of budgets.

• Explain the nature of overhead/operating costs.

• Develop company’s/department’s budget.

• Demonstrate orderly and systematic behavior.

• Make oral presentations.

For more information and DECA Prep practice, go to the Marketing Essentials

OLC through glencoe.com.

18. Research Franchise Opportunities

Locate the International Franchise Association

Web site on the Internet. Find an existing

franchise opportunity to investigate. Use a

word processing program to write a report

describing the franchise opportunity, including

the type of franchise, primary product or

service, potential for growth, and other

pertinent facts about it.

1. Directions Choose the letter of the best answer. Write the letter for the answer on a separate piece of paper.

What is the cost of a $12 CD offered with an 8 percent discount?

A $12.96 B $11.96 C $12.04 D $11.04

2. Directions Choose either True or False as the answer. Write the letter for the answer on a separate piece of paper.

A balance sheet is a summary of a business’s assets, liability, and the owner’s equity.

T

F

When taking a test, if you have time at the end, check you answers and solutions. Make sure you answered each part of every question and that your answers all seem reasonable.

Test-Taking Tip




Start a Bicycle Business BASIC BACKGROUND

Your firm has a new client, a cycling enthusi-ast, who wants to open a bicycle shop. As former vice president of marketing for a small manufac-turer, she took early retirement with a $200,000 severance package, which she is willing to invest

in this new venture.

Picking Up Speed Your client believes there’s a growing inter-est in cycling because of Lance Armstrong’s influence, and she says baby boomers are looking for exer-cise that is easier on the joints than running.

That, combined with the client’s passion for the sport of cycling, her business experience, and her capital resources, can mean potential suc-cess for your firm. Now all she needs is a good business plan to obtain the financing to begin her second career as a bicycle shop owner.

YOUR OBJECTIVE Your objective is to prepare a complete busi-

ness plan for a new cycling shop for our client. A detailed financial section is important because this plan will be used to secure a loan and/or to interest investors in this new business venture.

SKILLS NEEDED Preview the project and brainstorm a list of

skills you will need to. Describe how you might apply them. Some skills might include:

Academic Skills reading, writing, math, and social studies

Basic Skills speaking, listening, thinking, and interpersonal skills

Technology Skills word processing, presentation, telecommunications, and Internet skills

ASSIGNMENT AND STRATEGY

• Get the background Con-duct research on the sport of cycling, and dif ferent types of bicycles and acces-sories. Research suppliers. Conduct a SWOT analysis and an assessment of the competition in your area. Study geographic, demographic, and eco-nomic factors that influ-ence the store location. Consider economic, socio-cultural, and technologi-cal factors affecting this business. Find ways to differentiate the business.

780 UNIT 11 — ENTREPRENEURSHIP

A SIMULATED SPORTS AND ENTERTAINMENT MARKETING EVENT

Option 1 Internship Report Once you have completed your Marketing Internship project and presentation, include your written report and a few printouts of key slides from your oral presentation in your Marketing Portfolio.

Option 2 Start Your Own Independent or Franchised Business Assuming you had $100,000 to start a new business, what type of business would you open? Select a business (independent or franchise) you would like to open some day and write a complete business plan for it. Assume this plan will be used to obtain additional financing. Prepare your written report using a word processing program and use presentation software for your oral presentation. See a suggested outline and key evaluation points at the Marketing Essentials OLC through glencoe.com.

• Figure out startup costs Research the costs of opening the store, such as renovation of a local retail space that is available for lease or purchase, buying the initial inventory, and pro-motions, as well as fixed expenses for the first year. Investigate ways of obtaining financial resources.

• Develop the business plan Prepare a business plan that includes an introduction, an analysis of the business situation, proposed organization, proposed marketing mix decisions, and a com-plete financial analysis and plan.

• What your project should include Include a suggested store layout, sample promotional mate-rials, and detailed projected financial statements, such as a projected income statement, cash flow statement, and balance sheet.

YOUR REPORT Use a word processing program and presenta-

tion software to prepare a double-spaced report and an oral presentation for your client. See a suggested outline and key evaluation points at the Marketing Essentials OLC through glencoe.com.

Go to the Marketing Essentials OLC through glencoe.com to review entrepreneurship concepts that relate to DECA events.

glencoe.com Unit 11 Thematic Project — Marketing Internship 781



