978-1259912191 Chapter 8 Lecture Notes Part 2

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Chapter Eight: Financial Analysis

D. Leverage ratios

i Ratios that are used to examine the relative level of indebtedness of

the entrepreneurial business

ii. Three ratios evaluate the level of indebtedness of a business

1. Debt-to-Equity

a. Ratio provides data about the portion of the

business owned by lenders versus the portion of

business owned by the owner or founder of the

business

i. Total liabilities divided by total assets minus

total liabilities

2. Debt-to-Assets

a. Measures the percentage of the assets of the firm

that are actually owned by creditors

b. Total liabilities divided by total assets

3. Times Interest Earned

a. Figure estimates the number of times that the firm

could repay the current interest owed on its debts.

b. Higher number indicates the firm is more capable

of servicing its debt load

c. Operating income divided by the interest

iii. Calculating leverage ratios

1. Refer to the balance sheet illustrated in Figure 8.1 on page

145 of the text to provide example about how to calculate

the leverage ratios

2. Refer to the income statement illustrated in Figure 8.2 on

page 146 of the text to provide example about how to

calculate the times interest earned ratio

3. Significant changes in the debt-to-equity ratio and the

times interest earned ratio are of particular interest to the

business owner

a. The owner compares this data with industry

averages to reveal if there are changes in the

particular industry

E. Profitability ratios

i. Ratios that examine the performance of the firm and its ability to

make economic rents over and above its costs

1. Gross profit margin

a. Gross profit divided by net sales

b. Used to determine the overall profit obtained from

sales during a specific period of time

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Chapter Eight: Financial Analysis

c. Calculated by taking the total net sales of the firm

and subtracting the returned merchandise as well

as the direct cost of the goods sold

2. Operating profit margin

a. Operating income divided by net sales

b. Gross profit minus all operating expenses

c. Also known as Earning Before Interest and Taxes

(EBIT)

i. Represents the operating efficiency of the

organization

3. Net profit margin

a. Net profit divided by net sales

i. Bottom line calculation from the income

statement

ii. Figure represents a view of the relative margin

earned after all obligations and expenses are

considered

4. Return on assets (ROA)

a. Net profit divided by total assets

i. An industry standard calculation

ii. Examines the ability of the firm to return an

overall profit compared to the amount of assets

that the firm has invested

5. Return on equity (ROE)

a. Net profit divided by equity

i. Provides investors with an evaluation of how

much each dollar of their investment generates

a profit

i. Calculating profitability ratios

i. Review the income statement on page 146 of the text, figure

8.2

F. Summary of Ratios

i. Ratios are valuable assets to a firm

ii. Statements are standard with a variety of accounting packages

iii. Accounting packages may calculate ratios

iv. Small business owners understand the ratios and they only use

one or two few ratios in each category to assure conciseness

1. Liquidity

2. Activity

3. Leverage

4. Performance

5. Profitability

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Chapter Eight: Financial Analysis

v. Small business owners compare the ratios with other firms in

their industry over a specific time period in order to interpret the

outcome of the ratio analysis

6. Deviation Analysis (text page 153)



Learning Objective 8-5: Explain Deviation Analysis.

A Deviation analysis

i. Analysis of the differences between the predicted and the actual

performance.

ii. Deviation analysis is the second method used to evaluate the firm,

its activities, and its performance

iii. The time period associated with deviation analysis is typically

month to month or year to year

iv. A Deviation chart has two additional columns that ensure all

important metrics are maintained

1. Column to show the actual change

2. Colum to show a percentage of change

v. Ratios reveal data based on perception analysis

1. A drop in the current ratio from one year to the next can be a

negative indicator

2. At the same time, a drop in the amount of complaints can be

a positive indicator

vi. Entrepreneurs can easily evaluate the performance of the

organization based on the items considered important for the

success of the business

vii. Consider the frequency of ratio analysis when interpreting results

1. The frequency at shorter intervals can produce insights into

the business

2. Develop charts using shorter intervals so patterns and

deviations can be observed

3. Maintain the chart to complete the analysis on a monthly

basis

a. Reveal seasonal trends

i. Results of analysis enhance ordering, staffing,

and advertising at the business

b. In addition to this, keeping an Annual chart allows

comparing the company over years as the firm

reaches maturity

viii. Measuring the performance of a business goes beyond the basic

financial ratios of the business

ix. An analysis of how well the firm pursues its strategy over a stated

period of time documents the company’s success

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Chapter Eight: Financial Analysis

7. Sensitivity Analysis (text pages 154 and 155)



Learning Objective 8-6: Explain sensitivity analysis

A. Sensitivity analysis (text page 149)

i. A chart utilizing current cash flow statement, income

statement, or balance sheet to create a pro forma projection

based upon a dramatic increase in sales, a dramatic

decrease in sales, or the complication of a major change in

the business

B. The data required to complete a sensitivity analysis

i. Current cash flow statement

ii. Income statement or balance sheet

C. The projections are based on a variety of circumstances

i. Dramatic increase in sales

ii. Dramatic decrease in sales

iii. A major change in the business

D. The advantage is a visualization of how sensitive the business is to

various factors

E. The cash flow statement is used to evaluate the impact of a

dramatic increase or decrease in sales

i. Identifies what the impact is on the organization as a whole if

the firm experiences a sudden 50 percent increase or

decrease in sales

1. If the result is an increase, the outcome to consider

is how much staff is needed to accommodate the

sales

2. Another consideration is the impact on travel or

insurance

F. Steps used in evaluation

i. List the projected cash flow statement for the firm

ii. Provide another cash flow statement that indicates a 50

percent increase

iii. Provide another cash flow statement that indicates a 50

percent decrease in sales

G. A firm that experiences a rapid increase in sales could be hurt

during the first two years of operation

i. The business could experience a recovery period in the third

year

1. Result of this analysis indicates a need for additional

funding

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Chapter Eight: Financial Analysis

2. It is very important for a business owner to gain

experience in order to diversify plans to accommodate

and handle a variety of changes in the business

ii. Projections missed by a significant amount predict that the

future of the business is not good

H. Sensitivity analysis provides advantages to the business person

i. Sensitivity analysis provides the opportunity to test

assumptions

ii. The businessperson views the potential impact of these

assumptions prior to committing additional resources

8. Use of Short Surveys in Business (text pages 155 and 158)



Learning objective 8–7:Describe the use of short surveys in business

A. Surveys are the fourth method used by a businessperson to analyze the

business

i. Surveys are a nonfinancial method of analysis

1. By comparison, Ratio analysis, deviation analysis, and

sensitivity analysis focus on the financial data associated

with the business

ii. Surveys are used to evaluate the contextual information that is not

easily categorized or interpreted by the business owner

1. Customers

2. Suppliers

3. Employees

iii. Surveys are used to gather data to enhance the financial success

of a business

iv. Random sampling is an effective measure of a large customer base

1. Survey every third customer

a. The subset of total customers reflect all customers

taking into consideration a small margin of error

v. Data obtained in a survey contains bias

1. Use judgment to interpret the results of survey

vi. Survey questions are designed to answer direct questions related

to the organization’s mission and strategy

vii. Questions in the survey are designed to provide specific data about

an organizations goals or objectives

viii. Results of survey data and interpretation

1. Data in the survey is tabulated and examined with statistical

techniques, such as percentages

2. Increase the level of sophistication of data contained in a

survey in order to learn more from the data

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Chapter Eight: Financial Analysis

3. Strategic implementation of key competitive advantage to

reveal trouble in goals or objectives of the business

4. Cross tabulation of related items and simple regressions

form a visualization of the organization beyond its

competitors

a. Cross tabulations and simple regressions are

available in most spreadsheet or software packages

b. Cross tabulation displays the distribution of two or

more variables in columns

i. For example, how the drinks match entrees in a

restaurant

c. Regression analysis is a more complex analysis

i. Reveals how different variables explain the

impact of a given measure (i.e. profits)

difference in the measurement of profits

9. Importance of Having a Measurement Focus (text pages 158 and 159)

Learning Objective 8-8: Analyze the importance of having a measurement focus

A. Use a simplistic approach to measure the standard components

of the business

B. Assure that the performance of the firm is equivalent to other

firms in the industry

C. Do not analyze areas that do not create value to the business

D. Focus efforts on areas of the firm that enhance organizational

efficiency

E. Focus efforts on areas that provide a competitive advantage to

the firm

F. Concentrate analysis efforts on the areas that are extraordinary

efforts to create differentiation in the business

9. For Review (text page 154)

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