LESSON ELEVEN: FINANCIAL PLANNING / ACCOUNTING

BALANCE SHEET

The balance sheet where one can have a quick look at a business’ financial situation at one
point in time. It is a list (inventory) of assets (what the business has: equipment, supplies, cash, etc.),
and a listing of claims against those assets. The claims might be liabilities (what the business owes to
other people/institutions) or owner’s equity (what the owners have invested in the business).
Total assets always equal liabilities plus owner’s equity.

As you can see in the balance sheet example in this unit, the assets are shown at the top with
property, plant (factory) and equipment depreciated according to their original cost and how long they
are expected to last (original cost / number of years of anticipated use). Fixed assets are always
valued at purchase price, less accumulated depreciation. On the bottom half of the table, liabilities
and owner’s equity are listed. The total of these two items is exactly the same as the assets.
It can often be difficult to give a specific value to some assets. For example, raw material is
usually valued at its original price. But if it has deteriorated (worn down, aged), you will have to
value it at a level that is less than the original price. If inflation is high, the value of the raw material
stock will increase. Finished products would be valued at their cost of production, plus storage cost,
instead of their sale price.
To help you when you analyze, separate assets into two types: current assets and fixed assets.

• Current assets are cash and those things that can quickly and easily be turned into cash.
These include bank accounts (checking and savings), accounts receivable and
inventory.
• Fixed assets include plant equipment, office equipment, vehicles, buildings and land.

You can also separate liabilities into two types: current and non-current liabilities.

• Current liabilities are expenses which must be paid within the next 12 months. These
include accounts payable, wages payable, and short term loans.
• Non-current liabilities are loans and mortgages (long-term expenses).

What remains on your balance sheet is your working capital, the amount of money/capital you have to
work with (beyond your immediate expenses). That is, working capital is current assets, minus
current liabilities. This gives you a clear understanding of your financial situation at that moment.

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Analyzing balance sheets

You can analyze the balance sheets in two ways:

1. Look at the trends within the business

2. Compare the business with other businesses which produce a competing product or service

To look at the trends within the business, you would usually make a comparison on an annual
basis. For example, you might make a comparison at the end of each fiscal year, or each calendar
year. By looking at changes in the assets, liabilities and owner’s equity over time, you can get a good
idea about the growth of the enterprise.
For example, increases in property and equipment can indicate growth in the business (it
shows the business’ need to expand into a larger building, etc.). By comparing liabilities with
owner’s equity, you can see if the increase in assets is from additional debt (loans), or from an
increase in the owner’s equity (profit). An increase in owner’s equity is a good indicator of growth.
To compare your business with other businesses, you will need to make certain that your
balance sheets are in compatible terms. You do this by figuring out, or computing, a ratio. There are
many ways to do this, but we will look at three:

 Calculating the “current ratio”

The current ratio measures the proportion of current assets to current liabilities. It is an
indicator of how well a business is able to meet immediate obligations or expenses.

Current Ratio = Current Assets

Current Liabilities

The current ratio is also called the “working capital ratio.” There should be about twice as
many current assets as current liabilities. Therefore, the current ratio should be higher than
2. If the current ratio of the business you’re looking at is higher than that of other similar
businesses, then your business is probably doing quite well. If it is lower than that of other
businesses, there may be a problem which needs to be resolved; there might also be cash flow
problems.

 Calculating the “quick asset ratio”

The quick asset ratio measures whether or not the business can meet its financial obligations
over the next few months (i.e.- whether or not the business can pay its bills in the short run).

Quick Asset Ratio = Cash, bank balances, and accounts receivable

Current liabilities

The quick asset ratio should be at least 1. If it is lower, it may be difficult to meet current
financial obligations, especially if sales are slow for a while. If, on the other hand, the ratio is
higher than 1, this means a strong financial position. It means that the company could survive
a temporary slow-down in sales, without too much difficulty, unless there are accounts
receivable that are difficult to collect.

 Calculating the “long-term debt to equity ratio”

The long-term debt to equity ratio shows the amount of long-term investment in the business
by creditors, as it relates to the long-term investment by the owners. In other words, it shows
how much of the business is due to the owner’s investments, and how much of the business is
due to credit investments.

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 Long-Term Debt to Equity Ratio = Long-term debt
Owner’s equity

Owner’s equity was explained earlier; it is what the owner has put into a business. Long-term
debt is calculated by adding up (summing) all the loans, both interest and principal, and other
commitments due beyond the next six months.

What these ratios mean…

A new business might have to borrow a lot of money to get started. This means that, at first,
the long-term debt might be greater than the owner’s equity. This type of ratio would indicate a high
risk, from the lender’s/creditor’s point of view. Ideally, long-term debt should be less than 50% of
owner’s equity. After a major investment or expansion, the long-term debt would go up. On the
other hand, it may fall to less than 50% just before a major investment or expansion.

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Here is an example of some of the items commonly included on a balance sheet, with figures filled in
for a business, as of December 31.

THE BETTER MOUSETRAP COMPANY

BALANCE SHEET
Assets:
Current Assets:
Cash on hand $ 500
Savings account 2,500
Accounts receivable 1,800
Inventory:
Raw materials $ 1,500
Finished products 3,500
Property, Plant and Equipment
Office equipment $ 1,100
(less depreciation) (550) 550
Plant equipment 2,400
(less depreciation) (1,200) 1,200
Land and buildings 15,000
(less depreciation) (1,500) 13,500
_____________________
TOTAL ASSETS: $ 25,050

Liabilities:
Current liabilities:
Accounts payable $ 1,500
Wages payable 750
Non-current liabilities:
Loans payable 8,000
_____________________
TOTAL LIABILITIES: $ 10,250

Owners’ equity:
Reserves for bad debts $ 1,200
Owners’ capital 11,100
Retained earnings 2,500
_____________________
TOTAL OWNERS’ EQUITY: $ 14,800

TOTAL LIABILITIES AND OWNERS’ EQUITY: $ 25,050

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 BREAK-EVEN ANALYSIS

A break-even point is the price you need to charge, or the level of production you need to
maintain, in order to cover all your fixed and variable costs.
The break-even point is one good indicator of the risk at which a company is operating. If
products are being marketed at close to the break-even point, the business is operating at a higher
level of risk. If the products are being sold high above the break-even point, and the market continues
to expand, then the business is probably operating at a very low risk. If the break-even point is a low
fraction of the capacity of the business to produce, but this level of production is a large share of the
market demand, risk may also be high.
Risk analysis works best when the business has only a few products/services and/or where the
cost of each product or service can be calculated into a cost-per-item.
Risk may be reduced by diversifying into many products, some of which have joint
production costs. For example, a baker might make several kinds of cakes, breads and snacks, each
with different profit levels and demand. Since production costs (for equipment, ingredients, etc.) are
the same for all, the risk is reduced.

There are two types of break-even points:

 The break-even price: if prices are changing a lot, but production costs are
predictable/stable, then divide the cost of production by the number of units produced, and
you will know the break-even price. In this example, the business must sell each item for
more than $8.27 to cover the costs of production.

$34,305 (total cost of production) = $8.27 per unit

4,150 (units produced)

 The break-even production level: If prices are fixed, divide the costs by the price, and you
will have the break-even production level. In this example, the business must produce 3,430
units per month, in order to sell enough to turn/make a profit.

$34,305 (total costs of production) = 3,430 units

$10 (price per unit)

It is best to apply break-even analysis before a business is started. In this way, it can provide
good insight into its commercial feasibility (i.e.- you can make an educated guess about whether the
business will do well). The information can be used to determine at what level of production the
business will be able to cover all of its expenses. It can also help decide the minimum price needed
for the business to operate successfully at different levels of production.
Once a business is functioning, break-even analysis can be used again to test planning
assumptions against reality. An accurate idea of how long a business might require special funding
for a project can be determined in this way.

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 PROFIT-AND-LOSS STATEMENTS

A profit-and-loss statement provides the financial results of a business over a given period of
time. In other words, you can see if you have made or lost money, and how much. Profit is the
“bottom line” of the statement. It is an important indication of whether or not the business will
survive.

Income (revenue) - Expenses = Profits (net income)

This kind of statement is used to answer a number of questions…

1. Have profits increased over time?
2. Have sales increased since last year?
3. Have costs of production been reduced?
4. How does this business compare with other businesses?
5. How does this business compare with other industry averages?
6. How does this product compare with one in a different line of production?

THE BETTER MOUSETRAP COMPANY

Profit-and-Loss Statement
January 1 to 31, 1996

Income: cash: non-cash:

Sales (4120 units x $10 per unit) $ 41,200
Interest received 150
Value of products consumed (30 units x $10) $ 300
TOTAL INCOME: $ 41,350 $ 300

Expenses:
Raw materials purchased $ 14,800
Salaries and benefits 4,800
Wages and benefits 6,400
Family labor $ 2,300
Rent 1,500
Electricity 360
Office supplies 550
Transportation 500
Interest paid 1,340
Equipment and building repairs 130
Taxes 300
Depreciation 1,325
TOTAL EXPENSES: $ 29,180 $ 5,125

NET PROFIT (or NET LOSS): $ 7,345

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 CASH FLOW STATEMENTS

Cash flow statements are a summary of the money coming into, and going out of, a business.
They are usually done monthly and include actual receipts and disbursements.

All the figures in the cash flow chart are amounts actually paid out or received, not what is
owed. They also do not include depreciation. The net balance on the bottom line for each month is
carried forward to the following month and written in the line marked “amount brought forward.”
This amount is treated as cash received that month.
Analyzing the cash flow chart of a business is useful in identifying problems. If the net
balance at the end of a month is low, it might mean that production is being limited by a lack of
capital (money) to buy enough raw materials. For example, the stock of raw materials is so low that
the business has to wait for income from sales to purchase more materials. Or, it may mean that too
much has already been spent on an inventory of raw materials.
By developing and analyzing cash flow projections for businesses, the owner and creditors
can also get a clearer idea as to when and how much credit may be needed (during months when the
net balance is negative) or when it can be repaid (months when there is a positive net balance). This
is especially clear when examining monthly cash flow statements for a number of years and finding
trends.

Cash Flow Summary

January February March April May June July August

Cash Outlays
Investments
Business expenses
Interest paid
Savings
Owner share
TOTAL OUTLAYS
Cash received
Amount brought
forward
Sales
Other income
TOTAL RECEIVED
Surplus
Deficit
Loans received
Loans paid
NET BALANCE

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 U.S. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (US GAAP)
VS. INTERNATIONAL ACCOUNTING STANDARDS (IAS)

Especially since the corporate scandals in America from the last year or two, countries,
organizations and professions are debating which of the two global accounting standards to adopt for
their own use. Many blame the U.S. Generally Accepted Accounting Principles (US GAAP) for
allowing the large firms in America to hide their assets and their weaknesses, and essentially to lie to
their stockholders. On the other side, many Americans see the International Accounting Standards as
both confusing and incomplete.
In a recent article on this issue, the weekly American news magazine, Newsweek, wrote:

Europe sees America as a nation of lawyers, obsessed with rules, and is trying to convince the
United States that its voluminous accounting standards only multiply loophole opportunities
for crafty accountants. As London Stock Exchange chairman Don Cruickshank put it
recently, “Hard rules are hard-wired into the U.S. way of doing things.” The U.S. Generally
Accepted Accounting Principles fill a couple of thousand pages, compared with a couple of
hundred [pages] for international standards. Lately U.S. authorities have pledged to work
toward “global convergence,” implying a tilt toward the international approach.

According to PricewaterhouseCooper, Romania has, since December 2000, been working to fully
integrate itself into the International Accounting Standards system. According to a recent article, they
write that the Romanian government hopes to have the country using the IAS from 2005, with few
exceptions.

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Lesson Eleven vocabulary:

accountant person who figures and records your financial accounts

accounts payable collection of bills that need to be paid by you
accounts receivable collection of bills that need to be collected by you (paid to you)
assets positively-valued things the business has (including equipment, capital, etc.)
balance final number in accounting that is either positive or negative (tells how much
a person or business has or owes)
borrower person who borrows money from a creditor
break even to neither win, nor lose, money
calendar year the year from January through December
collateral something of value offered to a creditor as a promise that you will pay the
money you owe; security
creditor the lender; the person / organization that lends money to a borrower
debt money owed
depreciation the lowering in value of something (figured in accounting as original cost /
number of years of expected use)
disbursement payment, expenditure
figure number, amount
fiscal year An accounting period of 365 days (366 in leap years), but not necessarily
starting on January 1
in the red to have a negative balance; to be losing money
in the black to have a positive balance; to be making money
inflation an increase in the currency in circulation or a marked expansion of credit,
resulting in a fall in currency value and a sharp rise in prices
interest the money paid for the use of money
investment giving money to try to get money back
liability negative things one has, or what the business owes to others (i.e.- debt)
liquid (liquidity) easy to turn into cash (the measure of how easy something can be turned into
cash
mortgage the promise of property to a creditor as security for the repayment of a debt
outlay money spent
owner’s equity what the owner(s) has invested into the business
receipt a written acknowledgement that something has been received, the bill (the
piece of paper given to you with the cost, after you have bought
something)
security something of value offered to a creditor as a promise that you will pay the
money you owe; collateral
wages payable money owed to workers
working capital current assets – current liabilities = the amount of money you have to work
with at that moment, after you’ve paid your immediate bills

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