Essentials of Entrepreneurship and Small Business Management, 9e (Scarborough)
Chapter 12 Creating a Successful Financial Plan
1) To reach profit objectives, entrepreneurs must be aware of their firms’ ________.
A) current ratio and liabilities
B) fixed assets and owner’s equity
C) assets and liabilities
D) overall financial position and any changes in the financial status
2) The ________ shows what assets the business owns and what claims creditors and owners
have against those assets, and is built on the basic accounting equation:
Assets = Liabilities + Owner’s Equity.
A) income statement
B) sources and uses of funds statement
C) balance sheet
D) cash budget
3) The ________ represents a “snapshot” of a business, showing an estimate of its value on a
given date, while the ________ is a “moving picture” of the firm’s profitability over time.
A) balance sheet; income statement
B) income statement; balance sheet
C) statement of cash flows; income statement
D) balance sheet; statement of cash flows
4) Which of the following associations is correct?
A) Balance sheet – cost of goods sold
B) Income statement – owner’s equity
C) Current assets – inventory
D) Long-term liabilities – accounts payable
5) The first section of a balance sheet lists ________.
A) assets
B) liabilities
C) claims creditors have against the firm’s assets payable within one year
D) the owner’s equity in terms of initial capital invested and retained earnings
6) Which of the following items would not be listed as a current asset in a company’s financial
reports?
A) Cash
B) Accounts receivable
C) Fixtures
D) Inventory
7) ________ are those items of value the business owns; ________ are those things the business
owes.
A) Assets; liabilities
B) Liabilities; assets
C) Ratios; equities
D) Equities; liabilities
8) Cost of goods sold is located on which financial statement?
A) Income statement
B) Balance sheet
C) Statement of cash flows
D) All of the above
9) Which of the following is not true regarding the components of the income statement?
A) Cost of goods sold represents the total cost, excluding shipping, of the merchandise sold
during the accounting period.
B) Gross profit margin is calculated by dividing gross profit by net sales revenue.
C) Operating expenses include those costs that contribute directly to the manufacture and
distribution of goods.
D) A and B above
10) The statement of cash flows ________.
A) compares costs and expenses against a firm’s net profits
B) is built on the basic accounting equation: Assets = Liabilities + Capital
C) shows what assets the business owns and what claims creditors and owners have against those
assets
D) shows changes in working capital by listing sources and uses of funds
11) On a company’s statement of cash flows, depreciation is ________.
A) the difference between the total sources available to the owner and the total uses of those
assets
B) listed as a source of funds because it is a noncash expense, already deducted as a cost of doing
business
C) the owner’s total investment at the company’s inception plus retained earnings
D) creditors’ total claims against the firm’s assets
12) On a projected income statement, a business owner’s target income is ________.
A) the sum of a reasonable salary for the time spent running the business and a normal return on
the amount invested in it
B) the income at which the company’s total revenues and its total expenses are equal
C) the income that will produce a 10 percent return on the owner’s financial investment in the
business
D) the income that the owner could earn working for someone else
13) According to one study, 23 percent of small business owners lack financial literacy to
identify the cost that has the greatest impact on their companies.
14) The balance sheet provides owners with an estimate of the firm’s worth for a specific
moment in time, while the income statement presents a “moving picture” of its profitability over
a period of time.
15) Assets represent what a business owns, while liabilities represent the claims creditors have
against a company’s assets.
16) The income statement is based on the fundamental accounting equation:
Assets = Liabilities + Owner’s Equity.
17) On the income statement, the cost of goods sold represents the total cost, excluding shipping,
of the merchandise sold during the year.
18) To determine net profit, the owner records sales revenue for the year and subtracts liabilities.
19) Service companies spend the greatest percentage of their sales revenue on cost of goods sold.
20) Comparing a company’s current income statement to those of prior accounting periods rarely
reveals valuable information about key trends.
21) The difference between the total sources of funds and the total uses of funds represents the
increase or decrease in a firm’s working capital.
22) Explain the three basic financial reports that a small business uses in building a financial
plan: the balance sheet, the income statement, and the statement of cash flows. What information
is contained in each, and of what value is it to the small business owner?
Mini-Case 12-7: Sharps and Flats
Anthony Gray has been interested in music since he was old enough to sit at the piano. He
literally grew up with music, and he used his talent to earn his way through college. Anthony has
grown tired of his job at a large music house in Houston and is seriously considering moving
back to his hometown in Massachusetts to open his own small music shop. In researching this
venture, Anthony notices that he must include a projected income statement in his loan
application. Use the following statistics from Robert Morris Associates’ Annual Statement
Studies to answer the following question(s).
Net Sales 100.0 percent
Cost of Sales 59.9 percent
Gross Profit 40.1 percent
Operating Expenses 31.2 percent
Net Profit (Before Taxes) 8.9 percent
23) Suppose that a market survey indicates that Anthony’s proposed business is likely to generate
only $190,000 in sales. What net profit should Anthony expect to earn?
24) Creating projected (pro forma) financial statements would allow a business owner to answer
which of the following questions?
A) What profit can my business expect to achieve?
B) What sales level must my business reach if our targeted profit is X dollars?
C) What fixed and variable expenses can my business expect to incur at our targeted sales level?
D) All of the above
25) You are to prepare a projected income statement for a proposed business venture. Your
desired income is $28,000 and you have the following published statistics:
Costs of Goods Sold = 56.9 percent of net sales
Operating Expenses = 37.1 percent of net sales
Gross Profit Margin = 43.1 percent of net sales
This information indicates the net sales on your pro forma “P & L” (income statement) would be
________.
A) $466,667
B) $491,228
C) $500,000
D) none of the above
26) Gaither Mack is preparing projected financial statements to include in the business plan he is
preparing for the launch of a specialty retail store. Using published financial statistics, Mack
finds that the typical net profit margin for a store like his is 7.3 percent. If Mack’s target income
for his first year of operation is $32,000, what level of sales must he achieve to reach it?
A) $233,600
B) $438,356
C) $2,966,400
D) Cannot be determined from the information provided
27) Michelle Becker’s target income in her business for the upcoming year is $78,500. The
company’s gross profit margin averages 32.6 percent of sales, and its total operating expenses
run 24.7 percent of sales. To achieve her target income, sales of Michelle’s company should be
________.
A) $148,773
B) $993,671
C) $317,814
D) $1,271,348
Refer to the following information to answer the question(s) regarding Anita Lupino’s toy and
game shop:
Anita Lupino is planning to open her own toy and game shop. She has conducted a great deal of
research at the local library, contacted the industry trade association, and has set up a meeting
with a consultant at the SBDC next week. Before she goes to the SBDC, she wants to sketch out
an estimated income statement. She reviews the following data from RMA’s Annual Statement
Studies:
Cost of Goods Sold 57.3 percent of net sales
Operating Expenses 32.9 percent of net sales
Gross Profit 42.7 percent of net sales
28) If Anita’s research suggests that she can expect net sales of $475,000, what net profit could
she expect?
A) $202,825
B) $46,550
C) $69,350
D) $156,275
29) If Anita’s net profit target is $32,000, what level of net sales must she achieve?
A) $74,941
B) $97,264
C) $326,531
D) $219,178
30) Cash requirements can be determined by dividing cash expenses by ________.
A) liabilities
B) accounts receivables
C) total assets
D) the average inventory turnover
31) The most common mistake entrepreneurs make when preparing pro forma (projected)
financial statements for their companies is being overly pessimistic in their financial plans.
32) Pro forma financial statements show a company’s most recent financial position.
33) On a projected income statement, a business owner’s target income is the sum of a reasonable
salary for the time spent running the business and a normal return on the amount the owner has
invested in it.
34) In start-up firms, one guideline is for the owner to draw a salary 25-30 percent below the
market rate for a similar position.
35) Concerning how much cash to have at startup, one rule of thumb is to have enough to cover
operating expenses (less depreciation) for two inventory turnover periods.
36) Define what a pro forma financial statement is. What are the two types a small business
owner uses, and how are they created?
Mini-Case 12-7: Sharps and Flats
Anthony Gray has been interested in music since he was old enough to sit at the piano. He
literally grew up with music, and he used his talent to earn his way through college. Anthony has
grown tired of his job at a large music house in Houston and is seriously considering moving
back to his hometown in Massachusetts to open his own small music shop. In researching this
venture, Anthony notices that he must include a projected income statement in his loan
application. Use the following statistics from Robert Morris Associates’ Annual Statement
Studies to answer the following question(s).
Net Sales 100.0 percent
Cost of Sales 59.9 percent
Gross Profit 40.1 percent
Operating Expenses 31.2 percent
Net Profit (Before Taxes) 8.9 percent
37) Using Anthony’s target income of $23,000, construct a pro forma income statement for
Anthony’s proposed music shop.
Net Sales $258,427
Cost of Goods Sold 254,798
Gross Profit 103,629
Operating Expenses 80,629
Net Profit (Before Taxes) $23,000
38) A technique that allows the small business owner to perform financial analysis by
understanding the relationship between two accounting elements is called ________.
A) creating the pro forma
B) budgeting
C) break-even analysis
D) ratio analysis
39) Analyzing financial ratios could alert a business owner to which of these problems?
A) Excessive inventory
B) Overextending credit
C) Too much debt
D) All of the above
40) Which of the following is not a liquidity ratio?
A) Current ratio
B) Total asset turnover ratio
C) Quick ratio
D) None of the above
41) The ________ ratio is a measure of the small company’s ability to pay current debts from
current assets and is the liquidity ratio most commonly used as a measure of short-term solvency.
A) quick
B) debt-to-net worth
C) current
D) debt-to-assets
42) ________ ratios tell whether or not the small company will be able to meet its short-term
obligations.
A) Leverage
B) Profitability
C) Liquidity
D) Operating
43) Financial analysts suggest that a small business should maintain a current ratio of at least
________.
A) 1:1
B) 2:1
C) 3:1
D) 4:1
44) The ________ ratio is a conservative measure of a firm’s liquidity and shows the extent to
which a firm’s most liquid assets cover its current liabilities.
A) current
B) quick
C) turnover
D) net profit
45) Bettina has just calculated her company’s current ratio. To calculate the quick ratio, she
should ________.
A) subtract current liabilities from current assets before dividing by total liabilities
B) subtract total liabilities from current assets before dividing by current liabilities
C) subtract inventory from current assets before dividing by current liabilities
D) subtract depreciation expense from current assets before dividing by current liabilities
46) When a company is forced into liquidation, owners are most likely to incur a loss when
selling ________.
A) accounts receivable
B) inventory
C) marketable securities
D) real estate
47) ________ ratios measure the extent to which an entrepreneur relies on debt capital rather
than equity capital to finance a business.
A) Liquidity
B) Leverage
C) Operating
D) Profitability
48) Which of the following combinations of ratios would indicate that a company is financially
mismanaged and is not a good credit risk?
A) High liquidity; high leverage
B) Low liquidity; high leverage
C) High liquidity; low leverage
D) Low liquidity; low leverage
49) The ________ ratio measures the percentage of total assets financed by a small company’s
creditors compared to its owners.
A) debt
B) times-interest-earned
C) net sales to total assets
D) total asset turnover
50) A high debt ratio ________.
A) means that creditors provide a large percentage of the company’s total financing
B) gives a small business more borrowing capacity
C) decreases the chances that creditors will lose money if the business is liquidated
D) represents a lower risk to potential lenders and creditors
51) Which ratio would best give an owner an indication that the business is undercapitalized?
A) Debt-to-net worth
B) Net sales to total assets
C) Average inventory turnover
D) Quick
52) The higher the ________ ratio, the lower the degree of protection afforded creditors, and the
closer creditors’ interest approaches the owner’s interest.
A) debt-to-net worth
B) quick
C) asset turnover
D) current
53) ________ is one indication that a small business may be undercapitalized.
A) A current ratio below 1:1
B) A quick ratio above 2:1
C) A debt-to-net worth ratio above 1:1
D) A net sales-to-working capital ratio equal to 3:1
54) The ________ ratio tells how many times the company’s earnings cover the interest
payments on the debt it is carrying.
A) debt
B) debt-to-net worth
C) times-interest-earned
D) net sales-to-working capital
55) ________ ratios help a business owner evaluate the company’s performance and indicate
how effectively the business employs its resources.
A) Liquidity
B) Leverage
C) Operating
D) Profitability
56) The average inventory turnover ratio ________.
A) measures the number of times a company’s inventory is sold out during the accounting period
B) tells a business owner whether (s)he is managing the company’s inventory properly
C) tells a business owner how fast the merchandise is moving through the business
D) All of the above
57) Sarah’s Smart Shop has an inventory turnover ratio of 3 times per year and an average
inventory of $156,000. If Sarah could manage her inventory better and increase the number of
turnovers to the industry average of 6 times per year, what average inventory would she need to
generate the same level of sales?
A) $78,000
B) $52,000
C) $468,000
D) $312,000
58) A business that turns over its receivables 5.9 times a year would have an average collection
period of about ________.
A) 30 days
B) 2/10, net 30
C) 71 days
D) 62 days
59) If the accounting period is one year with credit sales totaling $2,500,000 and accounts
receivable totaling $200,000, the average collection period ratio is ________.
A) 29.2 days
B) 365 days
C) 119.3 days
D) Cannot be determined from the information provided
60) For the most meaningful interpretation, the small business owner should compare her/his
firm’s average collection period to ________.
A) other businesses in the same geographic area
B) a direct competitor
C) the universal standard of 25 days
D) the average for the industry and the firm’s credit terms
61) A business with a payables turnover ratio of 10.4 times a year would have an average
payable period of about ________ days.
A) 3
B) 30
C) 35
D) 62
62) An excessively high average payable period ratio ________.
A) suggests that the company is making the best use of its available cash balance
B) indicates that the company is doing a poor job of collecting its accounts receivable
C) indicates the presence of a significant amount of past-due accounts payable
D) suggests that the company is highly liquid
63) The ________ ratio measures a company’s ability to generate sales in relation to its assets.
A) net sales-to-working capital
B) net sales to total assets
C) average collection period
D) average inventory turnover
64) ________ ratios indicate how efficiently the small firm is being managed.
A) Liquidity
B) Profitability
C) Leverage
D) Operating
65) Which ratio would be most helpful to a business owner to measure the profit per dollar of
sales?
A) Net sales to total assets
B) Net sales to working capital
C) Net profit on sales
D) Net profit to equity
66) The ________ ratio shows the portion of each sales dollar remaining after deducting all
expenses.
A) net profit on sales
B) net profit to equity
C) net sales to total assets
D) net sales to working capital
Refer to the following information to answer the question(s) regarding Port Royal:
Net Sales $927,641
Gross Profit $301,483
Net Profit $48,457
Total Assets $203,869
Total Liabilities $74,325
67) Port Royal’s debt-to-net worth ratio is ________.
A) 0.36:1
B) 0.08:1
C) 1.57:1
D) 0.57:1
68) Port Royal’s profit margin on sales is ________ percent.
A) 5.2
B) 32.5
C) 16.1
D) 8.0
69) Port Royal’s net profit-to-equity ratio is ________ percent.
A) 23.8
B) 37.4
C) 16.1
D) 232.7
70) A business should provide the owner with a reasonable rate of return based upon ________.
A) the time and money invested in the business
B) industry averages
C) the capital borrowed from the bank
D) an acceptable annual salary