978-0134741086 Chapter 12 Part 1

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CHAPTER 12. CREATING A SUCCESSFUL FINANCIAL PLAN

Part 1: Learning Objectives

1. Describe how to prepare the basic financial statements and use them to manage a small

business.

2. Create projected (pro forma) financial statements.

3. Understand the basic financial statements through ratio analysis.

4. Explain how to interpret financial ratios.

5. Conduct a break-even analysis for a small company.

Part 2: Class Instruction

Introduction

Entrepreneurs who fail to develop workable strategies for earning a profit from the outset

eventually suffer business failure. Potential lenders and investors demand a realistic

financial plan. Financial management is a process that provides entrepreneurs with

relevant financial information in an easy–to-read format on a timely basis; it allows

entrepreneurs to know not only how their businesses are doing financially but also why

they are performing that way.

Failure to collect and analyze basic financial data is a common mistake among

entrepreneurs. Most accounting experts advise entrepreneurs to use one of the popular

computerized accounting programs such as Quickbooks, Xero, and others to manage

routine bookkeeping, as studies show that business owners who use them are more likely

to be financially literate.

Basic Financial Statements LO 1

Three important financial statements assist entrepreneurs to assess the financial status of

their business: the balance sheet, income statement, and statement of cash flows.

The Balance Sheet.

The balance sheet is a financial statement that provides a snapshot of a business’s

financial position, estimating its worth on a given date; it is built on the fundamental

accounting equation, Assets = Liabilities + Owner’s Equity. Refer to Figure 12.1, Sam’s

Appliance Shop, Balance Sheet.

The first section of the balance sheet lists the company’s assets (valued at cost, not actual

market value) and shows the total value of everything the business owns. It includes the

following:

 Current assets are assets such as cash and other items to be converted into

cash within one year or within the company’s normal operating cycle.

 Fixed assets are assets acquired for long-term use in a business.

The second section shows the business’s liabilities, which are creditors’ claims against a

company’s assets. This section includes the following:

 Current liabilities are those debts that must be paid within one year or within

the normal operating cycle of a company.

 Long-term liabilities are liabilities that come due after one year.

 Owner’s equity is the value of the owner’s investment in the business.

The Income Statement.

The income statement (also called the profit-and-loss statement) is a financial statement

that represents a moving picture of a business, comparing its expenses against its revenue

over a period of time to show its net income (or loss). Refer to Figure 12-2, Sam’s

Appliance Shop, Income Statement.

Income includes all income from sales of goods and services revenue, as well as income

from rent, investments, and interest. Other terms to understand include:

 Cost of goods sold is the total cost, including shipping, of the merchandise sold

during the accounting period.

 Gross profit margin is the gross profit divided by net sales revenue. Some

businesses incur losses as the result of an inadequate gross profit margin; to

repair this problem, firms must raise prices, cut costs, refuse orders with low

profit margins, “fire” unprofitable customers, or add new products with more

attractive profit margins. Refer to Figure 12.3, Customer Profitability Map.

 Operating expenses are those costs that contribute directly to the manufacture

and distribution of goods.

Comparing a company’s current income statement to those of prior accounting periods

often reveals valuation information about trends and progress toward its financial goals.

The Statement of Cash Flows.

Creating Projected Financial Statements LO 2

Entrepreneurs must determine the funds needed for starting and sustaining a business for

the initial growth period. Typically, the entrepreneur relies on data collection through

forecasts must be realistic and well researched. Entrepreneurs typically rely on published

statistics that summarize the operation of similar size companies in the same industry.

Projected Financial Statements for a Small Business.

The Projected Income Statement. A general guideline to assist with this process of

developing pro forma statements is to start with the sales forecast and work down. To

trading area).

 Contact industry trade associations to collect sales data.

 Use Risk Management Association and Dun & Bradstreet published useful

financial information.

 Do Internet searches and the resources of local libraries.

The net income a company generates should be at least as much as an entrepreneur could

earn by working for someone else. An adequate profit must also include a reasonable

return on the owner’s total investment in the business.

Calculations are demonstrated in the chapter.

The Projected Balance Sheet. This statement is valuable because many small companies

demonstrated in the chapter.

Liabilities. To complete the projected balance sheet the owner must record all of the

small firm’s liabilities, the claims against its assets. The final step is to compile all of these

Twelve Key Ratios.

Liquidity ratios indicate whether the business will be able to meet its short-term financial

obligations as they come due. The primary measures include:

1. Current ratio – Measures a small firm’s solvency by indicating its ability to pay

current liabilities out of current assets.

2. Quick ratio – a conservative measure of a firm’s liquidity, measuring the

3. Debt ratio – Measures the percentage of total assets financed by a company’s

creditors compared to its owners.

4. Debt-to-net-worth ratio – Expresses the relationship between the capital

5. Times interest earned ratio – Measures a small firm’s ability to make the interest

6. Average inventory-turnover ratio – Measures the number of times its average

inventory is sold out or turned over during an accounting period.

7. Average-collection-period ratio – Measures the average number of days it takes

8. Average-payable-period ratio – Measures the number of days it takes a company

9. Net-sale- to–total-assets ratio (also called the total-asset-turnover ratio) –

Chapter 12, Page 193

Measures a company’s ability to generate sales in relation to its asset base.

Profitability Ratios indicate how efficiently a small company is being managed and

provide information about a company’s ability to use its resources to improve its bottom

line.

10. Net profit on sales ratio – Measures a firm’s profit per dollar of sales.

11. Net-Profit-to-Assets Ratio – Tells how much profit a company generates for each

dollar of assets that it owns.

12. Net-profit-to-equity ratio – Measures the owner’s rate of return on investment.

Consider using You Be the Consultant: “The Challenges of Debt” at this point.

Interpreting Business Ratios LO 4

Ratios are useful yardsticks when measuring a small firm’s performance and can point out

potential problems before they develop into a crisis. A performance dashboard is the use

business owners develop ratios and measures that are unique to their own operations:

Critical numbers (or key performance indicators, KPIs), are indicators that measure key

financial and operational aspects of a company’s performance.

Financial benchmarking is used to compare your business to averages from many firms

of similar size in your industry to identify problem areas which your own history will not

 Risk Management Association

 Dun & Bradstreet, Inc.

 Bizminer

 Almanac of Business and Financial Ratios

 Standard & Poor’s Industry Surveys

 Government Agencies

What Do All of These Numbers Mean?

Analyzing ratio trends can offer invaluable insight for managing the business. Table 12.2:

Ratio Analysis: Sam’s Appliance Shop versus the Industry Median presents an example of

applying the 12 key ratios. Applying these ratios to Sam’s Appliance Shop illustrates the

1 and 2” at this point.

Break-even Analysis LO 5

The break-even point is the level of operation (sales dollars or production quantity) at

which a company neither earns a profit nor incurs a loss.

First, determine the fixed expenses and variable expenses. Fixed expenses are those that

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

Step 4: Compute the break-even point.

Refer to Figure 12.6, Break-Even Chart for the Magic Shop

Step 5: Beginning at the graph’s origin, draw a 45–degree revenue line showing

where total sales volume equals total income.

use as a final screening device because it ignores the importance of the cash flows, the

accuracy depends on the accuracy of the revenue and expense estimates, and the

assumptions pertaining to break-even analysis may not be realistic.

Consider using You Be the Consultant: “Where Do We Break– Even?” at this point.

Chapter 12, Page 195

Conclusion

Preparing a financial plan is a critical step for the entrepreneur. It can provide insight to

important financial aspects of the venture through proforma statements, ratio analysis, and

breakeven analysis. This information can be invaluable to have before the entrepreneur

begins to make commitments and incur expenses.

Part 3: Chapter Exercises

You Be the Consultant: “The Challenges of Debt”

1. What are the benefits to entrepreneurs who use debt capital (leverage) to finance

their companies’ growth? (LO 3) (AACSB: Reflective thinking)

2. What are the risks associated with debt financing? (LO 3) (AACSB: Reflective

thinking)

3. Why is using ratio analysis to keep track of their companies’ financial

performance over time so important for entrepreneurs? (LO 3) (AACSB:

Reflective thinking)

Entrepreneurs will benefit from tracking financial performance over time to determine the