Scarb Eesbm6e TB 11

Essentials of Entrepreneurship & Small Business Management, 6e (Scarborough)
Chapter 11 Creating a Successful Financial Plan
1) In order 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.
Answer: D
Diff: 2 Page Ref: 328
AACSB: Analytic Skills
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
Answer: C
Diff: 1 Page Ref: 329-330
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
Answer: A
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
Answer: C
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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.
Answer: A
Diff: 1 Page Ref: 329, Figure 11.1
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
Answer: C
Diff: 2 Page Ref: 329 Figure 11.1
7) 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
Answer: A
Diff: 2 Page Ref: 386, Figure 11.2
8) 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
Answer: A
9) ________ 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
Answer: A
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10) The statement of cash flows:
A) compares costs and expenses against 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.
Answer: D
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.
Answer: B
12) 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
Answer: D
13) 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.
Answer: A
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14) 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
Answer: A
15) 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
Answer: B
16) 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.
Answer: B
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Refer to the following information to answer questions 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:
Costs 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
17) 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
Answer: B
18) 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
Answer: C
19) Typically, in a start-up firm, salaries are not the best use of cash. A guideline is for the
owner to draw a salary that is about ________ below the market rate for a similar position.
A) 5-10 percent
B) 10-20 percent
C) 20-25 percent
D) 25-30 percent
Answer: D
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20) 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.
Answer: A
21) 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.
Answer: D
22) 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
Answer: D
23) Which of the following is not a liquidity ratio?

A) Current ratio
B) Total asset turnover ratio
C) Quick ratio
Answer: B
24) 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
Answer: C
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25) ________ 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
Answer: C
26) 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.
Answer: B
27) 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
Answer: B
28) 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.
Answer: C
AACSB: Reflective Thinking
29) 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.
Answer: B
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30) ________ 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
Answer: B
31) 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
Answer: B
Diff: 2 Page Ref: 343, Table 11.6
32) 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
Answer: A
33) 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.
Answer: A
34) 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
Answer: A
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35) 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
Answer: A
36) ________ 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
Answer: C
37) 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
Answer: C
38) ________ 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
Answer: C
39) 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 she 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
Answer: D
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40) 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
Answer: A
41) 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.
Answer: D
42) If the accounting period is one year with credit sales totaling $2,500,000 and accounts
receivable totaling $200,000, what is the average collection period ratio?
A) 29.2 days
B) 365 days
C) 119.3 days
D) Cannot be determined from the information provided
Answer: A
43) A business with a payables turnover ratio of 10.4 times a year would have an average
payable period of about:
A) 3 days.
B) 30 days.
C) 35 days.
D) 62 days.
Answer: C
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44) For the most meaningful interpretation, the small business owner should compare 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.
Answer: D
45) 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.
Answer: C
46) 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
Answer: B
47) ________ ratios indicate how efficiently the small firm is being managed.
A) Liquidity
B) Profitability
C) Leverage
D) Operating
Answer: B
48) 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
Answer: C
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49) 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
Answer: A
Refer to the following information to answer the questions regarding Port Royal:
Net sales $927,641

Gross profit $301,483
Net profit $48,457
Total assets $203,869
Total liabilities $74,325
50) 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.
Answer: D
51) Port Royal's profit margin on sales is:

A) 5.2 percent.
B) 32.5 percent.
C) 16.1 percent.
D) 8.0 percent.
Answer: A
52) Port Royal's net profit-to-equity ratio is:

A) 23.8 percent.
B) 37.4 percent.
C) 16.1 percent.
D) 232.7 percent.
Answer: B
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53) Ideally, a company reaches a point where increases in operating efficiency mean that
expenses as a percentage of sales revenue flatten or even decline. This is referred to as:
A) net profit to assets ratio.
B) profitability ratio.
C) net profit to equity.
D) operating leverage.
Answer: D
54) The ________ ratio measures the owner's rate of return on the investment in the business.
A) net profit to equity
B) net profit on sales
C) quick profit
D) net sales to working capital
Answer: A
55) The net profit to asset ratio measures:

A) the owner's rate of return on investment.
B) how much profit a company generates for each dollar of assets that it owns.
C) a company's profit per dollar of sales.
D) a company's ability to generate sales in relation to its asset base.
Answer: B
56) You are provided this information about a retail store called "BoardSports:"
BoardSports Industry Mean

Current Ratio 1.5 : 1 2: 1
Quick ratio .75 : 1 1:1
Debt ratio 0.87 : 1 0.75 : 1
Average collection ratio 46 days 33 days
Net profit on sales ratio 5.5% 8.2%
Net profit to equity ratio 7.7% 13.2%
What can you reasonably assess about the current financial status of this company?
A) The company is in excellent financial condition with no changes required.
B) The company is in respectable financial condition with no changes required.
C) The company is in questionable financial condition with minor changes required.
D) The company is in poor financial condition with significant changes required.
Answer: D
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57) The break-even point:
A) occurs where a company's total revenue equals its total expenses.
B) is the point at which a company neither earns a profit nor incurs a loss.
C) tells a business owner the minimum level of activity needed to keep her company in
operation.
D) All of the above
Answer: D
58) Which of the following is an assumption of break-even analysis?

A) Fixed expenses remain constant for all levels of sales volume.
B) Variable expenses change in direct proportion to changes in sales volume.
C) Changes in sales volume have no effect on unit sales price.
D) All of the above
Answer: D
59) Refer to the following information

Smith Office Supply Industry Mean
Current ratio 2.3 1.8
Quick ratio .4 .8
Average inventory turnover 2.0 3.9
Net sales-to-working capital 4.0 7.8
Debt-to-net worth ratio 3.0 1.7
Net profit to equity ratio 40.1 percent 22.2 percent
Which of the following statements is most likely false?

A) Smith relies heavily on inventory to meet its debt obligations.
B) Smith is sufficiently capitalized.
C) Smith's sales are inadequate.
D) Smith's prices may be too high and/or the inventory too "stale."
Answer: B
For Meters, Inc., refer to the following information to answer the questions below:
Meters, Inc., reported net sales of $874,916 and a net profit of $74,563 on its most recent
income statement. The company's balance sheet shows total assets of $342,742 and total
liabilities of $88,367.
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60) What is the net profit margin for Meters, Inc.?
A) 8.5 percent
B) 1.91:1
C) 21.8 percent
D) 29.3 percent
Answer: A
61) What is the return on net worth ratio for Meters, Inc.?
A) 8.5 percent
B) 1.91:1
C) 21.8 percent
D) 29.3 percent
Answer: D
Regarding Gunther's Emporium, refer to the following to answer the questions below :
Gunther's Emporium expects net sales of $2,396,919 for the upcoming year, with variable
expenses totaling $1,813,443 and fixed expenses of $412,190.
62) Using break-even analysis, what is Gunther's contribution margin?

A) 4 percent
B) 32 percent
C) 24 percent
D) 12 percent
Answer: C
63) Gunther's Emporium expects net sales of $2,396,919 for the upcoming year, with variable
expenses totaling $1,813,443 and fixed expenses of $412,190.
What is Gunther's break-even point?

A) $1,876,324
B) $1,693,276
C) $5,667,009
D) Insufficient information given to determine
Answer: B
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64) If Gunther's net profit target for the year is $190,000, what sales level must he achieve?
A) $2,473,796
B) $1,876,324
C) $5,667,009
Answer: A
Refer to the following break-even Chart to answer the questions below:
65) Line T is the ________ line, while Line S is the ________ line.
A) total revenue; total expense
B) total expense; total revenue
C) fixed cost; variable cost
D) variable cost; fixed cost
Answer: B
66) The area labeled ________ represents the firm's fixed expenses, while ________ represents
its variable expenses.
A) Z; W
B) X; Y
C) Y; X
D) W; Z
Answer: B
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67) The area labeled ________ is the "profit area."
A) W
B) X
C) Y
D) Z
Answer: D
68) The area labeled ________ is the "loss area."

A) W
B) X
C) Y
D) Z
Answer: A
69) According to one study, only 11 percent of small business owners analyzed their financial
statements as part of the managerial planning process, and another study found that one-third of
all entrepreneurs run their companies without any kind of financial plan.
Answer: TRUE
70) 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.
Answer: TRUE
71) Assets represent what a business owns, while liabilities represent the claims creditors have
against a company's assets.
Answer: TRUE
72) The income statement is based on the fundamental accounting equation:

Assets = Liabilities + Owner's Equity.
Answer: FALSE
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73) On the income statement, the cost of goods sold represents the total cost, excluding shipping,
of the merchandise sold during the year.
Answer: FALSE
74) To determine net profit, the owner records sales revenue for the year and subtracts liabilities.
Answer: FALSE
75) Service companies spend the greatest percentage of their sales revenue on cost of goods sold.
Answer: FALSE
76) Comparing a company's current income statement to those of prior accounting periods rarely
reveals valuable information about key trends.
Answer: FALSE
77) 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.
Answer: TRUE
78) The most common mistake entrepreneurs make when preparing pro forma (projected)
financial statements for their companies is being overly pessimistic in their financial plans.
Answer: FALSE
79) Pro forma financial statements show a company's most recent financial position.
Answer: FALSE
80) 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.
Answer: TRUE
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81) 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.
Answer: TRUE
82) 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.
Answer: FALSE
Diff: 2 Page Ref: 335, 337
83) Ratio analysis allows a business owner to identify potential problem areas in her business
before they become business-threatening crises.
Answer: TRUE
84) Ratio analysis is a useful managerial tool that can help business owners maintain financial
control over their businesses, but it is of no use to a business owner trying to obtain a bank loan.
Answer: FALSE
85) Liquidity ratios such as the current ratio and the quick ratio tell whether a small business will
be able to meet its short-term obligations as they come due.
Answer: TRUE
86) Liquidity ratios help a business owner evaluate a small company's performance and indicate
how effectively it employs its resources.
Answer: FALSE
87) A current ratio of 2.4:1 means that a small company has $2.40 in current liabilities for every
$1 has in current assets.
Answer: FALSE
88) A high current ratio guarantees that the small firm's assets are being used in the most
profitable manner.
Answer: FALSE
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89) Generally, the higher the current ratio, the stronger the small firm's financial position.
Answer: TRUE
90) Most firms calculate their quick assets by subtracting the value of their inventory from their
current asset total.
Answer: TRUE
91) A quick ratio of more than 1:1 suggests that a small company is overly dependent on
inventory and future sales to satisfy its short-term debt.
Answer: FALSE
92) Leverage ratios measure the financing supplied by the firm's owner against that supplied by
his creditors.
Answer: TRUE
93) Small businesses with high leverage ratios are more vulnerable to economic downturns, but
they have greater potential for large profits.
Answer: TRUE
94) Taking on debt destroys a business; therefore, small business owners should avoid it at all
costs.
Answer: FALSE
95) The small business with a high debt-to-net worth ratio has more borrowing capacity than a
firm with a low ratio.
Answer: FALSE
96) As a company's debt-to-net worth ratio approaches 1:1, its creditors' interest in that business
approaches that of the owners.
Answer: TRUE
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97) A company with a low debt-to-net worth ratio has less capacity to borrow than a company
with a high debt-to-net worth ratio.
Answer: FALSE
98) The times-interest-earned ratio tells how many times the company's earnings cover the
interest payments on the debt it is carrying.
Answer: TRUE
99) A company with a times-interest-earned ratio that is well above the industry average would
likely have difficulty making the interest payments on its loans, as creditors would see that it was
overextended in its debts.
Answer: FALSE
100) Creditors often look for a times-interest-earned ratio of at least 4:1 to 6:1 before
pronouncing a company a good credit risk.
Answer: TRUE
101) Operating ratios measure the extent to which an entrepreneur relies on debt capital rather
than equity capital to finance the business.
Answer: FALSE
102) The average inventory turnover ratio measures the number of times a company's inventory
is sold out during the accounting period.
Answer: TRUE
103) An inventory turnover ratio above the industry average suggests that a business is
overstocked with obsolete, stale, overpriced, or unpopular merchandise.
Answer: FALSE
104) A high inventory turnover ratio relative to the industry average could mean that a business
has too little inventory and is experiencing stockouts.
Answer: TRUE
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105) A company's average collection period ratio tells the average number of days it takes to
collect its accounts receivable.
Answer: TRUE
106) Generally, the higher the small firm's average collection period ratio, the greater the chance
of bad debt losses.
Answer: TRUE
107) Slow accounts receivable are a real danger to a small business because they often lead to
cash crises.
Answer: TRUE
108) If a company's average payable period ratio is significantly lower than the credit terms
vendors offer, it may be a sign that the company is not using its cash most effectively.
Answer: TRUE
109) An excessively high average payable period ratio indicates the possibility of the presence of
a significant amount of past-due accounts payable.
Answer: TRUE
110) Although sound cash management principles call for a business owner to keep her cash as
long as possible, slowing accounts payable too drastically can severely damage a company's
credit rating.
Answer: TRUE
111) The net profit on sales ratio measures the owner's rate of return on the investment in the
business.
Answer: FALSE
112) The net profit to equity ratio reports the percentage of the owners' investment in the
business that is being returned through profits annually.
Answer: TRUE
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113) Ratio analysis provides an owner with a "snapshot" of the company's financial picture at a
single instant; therefore, she should track these ratios over time, looking for trends that otherwise
might go undetected.
Answer: TRUE
114) The break-even point is the level of operation at which a business neither earns a profit nor
incurs a loss, and lets the business owner know the minimum level of activity required to keep
the firm in operation.
Answer: TRUE
115) Fixed expenses are those that do not vary with changes in the volume of sales, but do vary
with production.
Answer: FALSE
116) On a break-even chart, the break-even point occurs at the intersection of the fixed expense
line and the total revenue line.
Answer: FALSE
117) 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?
Answer: The balance sheet: This statement takes a "snapshot" of a business, providing owners
with an estimate of its worth on a given date. It is built on this fundamental accounting equation:
Assets = Liabilities + Owner's Equity. The balance sheet provides a baseline from which to
measure future changes in assets, liability, and equity.
Balance sheet components include assets (current and long term), liabilities (current and long
term), and owner's equity.
The income statement: This statement compares expenses against revenue over a certain period
of time to show the firm's net profit (or loss). It is a "moving picture" of the firm's profit over a
period of time and provides "the bottom line" figure for the small business owner. It is also
known as the profit and loss statement or P & L.
Income statement components include various categories of revenues and expenses.
Statement of cash flows: This statement shows the changes in the firm's working capital since
the beginning of the year by listing the sources of funds and the use of these funds. Although
many small business owners never create them, IRS, creditors, investors, and new owners may
require them when investigating the changes in a firm's working capital.
Statement of cash flow components include categories of sources and uses of funds.
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118) Define what a pro forma financial statement is. What are the two types a small business
owner uses, and how are they created?
Answer: Pro forma statements are vital elements in a small business financial plan. They
estimate the firm's future profitability and overall financial condition. These statements help the
owner determine the funds required to launch the business and sustain it. The basic pro forma
financial statements are:
The income statementMost entrepreneurs select a target income and build a pro forma income
statement from the bottom up. The target income includes a reasonable salary and a normal
return on the amount invested in the firm. The owner computes target sales from his target
income by:
T arget Income
Net Sales = Net profit margin (as a % of net sales)
Next, using published statistics, the owner computes the remaining entries by multiplying the
proper statistic by the net sales figure. After the owner determines that the targeted net sales
figure is reasonable, expenses are listed accordingly.
The balance sheetCreating a pro forma balance sheet begins with a statement of assets. One
rule of thumb suggests that the company's cash balance should cover its operating expenses (less
depreciation, a noncash expense) for one inventory turnover period.
The method of determining the firm's cash requirement is:
Cash expenses
Cash requirement = Average inventory turnover
The inventory level is computed from published statistics and the cost of goods sold figure from
the income statement:
Cost of good sold
Inventory level = Average inventory level
To complete the projected balance sheet, the owner must record the firm's other assets, and
liabilities, the claims against its assets. Using the accounting equation of Assets = Liabilities +
Owner Equity, he calculates the final componentowner's equity.
24
119) Explain what ratio analysis is. Name the four categories of ratios and describe the type of
information each group provides the small business owner.
Answer: Ratios help measure the small firm's performance and can point out potential problem
areas before they become business crises. They use accounts from both the balance sheet and
income statement and provide relevant information to the overall financial plan. One way to use
ratios is to compare those of the small business to other businesses in the same industry through
a number of published industry averages and standards. It is also helpful for the owner to
analyze the firm's financial ratios over time.
The four ratio categories are:
1. Liquidity ratiosTell whether a firm will be able to meet its short-term financial obligations
as they come due. These ratios can forewarn a business owner of impending cash flow
problems. A firm with a solid liquidity is able to pay bills on time and take advantage of
attractive opportunities as they arrive.
2. Leverage ratiosMeasure the financing supplied by the firm's owners against that supplied
by its creditors. The ratios are a gauge of the depth of a firm's debt. These ratios show the extent
to which a business relies on debt capital (rather than equity) to finance operating expenses,
capital expenditures, and expansion costs. In a sense, they measure the degree of financial risk
in a company. Generally, small businesses with low leverage ratios are affected less by
economic downturns, but the returns are lower during economic booms. Firms with higher
ratios are more vulnerable during economic downturns because of their debt loads, but have a
greater potential for large profits in economic booms.
3. Operating ratiosEvaluate a firm's overall performance and indicate how effectively the
business employs its resources. The more effectively its resources are used, the less capital a
small business will require.
4. Profitability ratiosIndicate how efficiently a small business is being managed. These
ratios provide information on the company's bottom line. Profitability ratios assess how
successfully the firm is using its available resources to generate a profit.
25
120) List the 12 key ratios outlined in the text and explain the type of information they provide
the small business owner.
Answer: Students should select from the following 12 Key Ratios:
1. Current ratioFirm's ability to pay current debts out of current assets. The rule of thumb for
the current ratio is 2:1.
2. Quick ratioExtent to which firm's most liquid assets cover its current liabilities. The rule
of thumb for the quick ratio is 1:1.
3. Debt ratioMeasure the financing supplied by business owners and that supplied by business
creditors.
4. Debt-to-net-worth ratioCompares what the business owes to what it "owns."
5. Times interest earnedA measure of the firm's ability to make the interest payments on its
debt.
6. Average inventory turnover ratioMeasures the average number of times its inventory is
"turned over" during the year.
7. Average collection period ratioTells the average number of days it takes to collect
accounts receivable.
8. Average payable period ratioTells the average number of days it takes a company to pay
its accounts payable.
9. Net sales to total assets ratioA general measure of firm's ability to generate sales in relation
to its assets.
10. Net profit on sales ratioMeasures firm's profit per dollar of sales.
11. Net profit to asset ratioMeasures how much profit a company generates for each dollar of
assets that it owns.
12. Net profit to equity ratioMeasures owner's rate of return on investment (ROI).
26
121) Why is it important for an entrepreneur, about to launch a business, to perform a break-even
analysis? Describe the steps in calculating it.
Answer: Break-even analysis is important because it helps the entrepreneur understand what
sales volume he/she must achieve to "break-even"neither earning a profit nor incurring a loss.
It shows the minimum level of sales required to stay in business and what minimum level of
sales is required to cover expenses. The formula can be adapted to figure the minimum level of
sales needed to support a certain profit margin or dollar amount.
The steps in calculating break-even include:

A. Determining variable and fixed expenses:
1.Fixed expensescosts that do not vary with changes in the volume of sales or production.
2.Variable expensescosts that vary directly with changes in the volume of sales or production.
B. Calculating the break-even point:
Step 1: Determine the expenses the business can expect to incur.
Step 2: Categorize the expenses estimated in step 1 into fixed expenses and variable expenses.
Step 3: Calculate the ratio of variable expenses to net sales.
Step 4: Compute the break-even point by inserting this information into the following formula:
total fixed costs

Break-even sales ($) = contribution margin expressed as a percentage of sales
C. Including desired net income in break-even analysis:
total fixed expenses + desired net income

Sales ($) = contribution margin expressed as a percentage of sales
D. Break-even point in units:
total fixed costs

break-even volume = sales price per unit - varaible cost per unit
27
122) Explain the procedure for constructing a graph that visually portrays the firm's break-even
point (the point where revenues equal expenses).
Answer:
• Step 1: On the horizontal axis, mark a scale measuring sales volume in dollars (or in units
sold or some other measure of volume).
• Step 2: On the vertical axis, mark a scale measuring income and expenses in dollars.
• Step 3: Draw a fixed expense line intersecting the vertical axis at the proper dollar level
parallel to the horizontal axis. The area between this line and the horizontal axis represents the
firm's fixed expenses.
• Step 4: Draw a total expense line that slopes upward beginning at the point where the fixed
cost line intersects the vertical axis. The precise location of the total expenses line is determined
by plotting the total cost incurred at a particular sales volume. The total cost for a given sales
level is determined by:
Total Expenses = (Fixed expenses + Variable expenses expressed as a percent of sales) x

Sales level
• Step 5: Beginning at the graph's origin, draw a 45-degree line showing where total sales
volume equals total income.
• Step 6: Locate the break-even point by finding the intersection of the total expense line and
the revenue line. If the company operates at a sales volume to the left of the break-even point, it
will incur a loss because the expense line is higher than the revenue line. On the other hand, if
the firm operates at a sales volume to the right of the break-even point, it will earn a profit
because the revenue line lies above the expense line.
123) What are the advantages and the disadvantages of using break-even analysis?
Answer: As a key component in a sound financial plan, the advantages of break-even analysis
include its ability to analyze costs and expenses so an entrepreneur can calculate the minimum
level of activity required to keep the firm in operation. These techniques can then be refined to
project the sales needed to generate the desired profit. Break-even analysis is a simple and
useful screening device. Business owners can also employ nonlinear break-even analysis using a
graphical approach.
Disadvantages of break-even analysis include limitations such as the analysis can be too simple
to use as a final screening device because it ignores the importance of cash flows. In addition,
the accuracy of the analysis depends on the accuracy of the revenue and expense estimates, and
the basic assumptions pertaining to break-even analysis may not be realistic for some businesses.
These assumptions include: that fixed expenses remain constant for all levels of sales volume;
variable expenses change in direct proportion to changes in sales volume; and changes in sales
volume have no effect on unit sales price. In addition, break-even analysis does not take into
consideration the time value of money.
28
Mini-Case 11-1: Bowden Brake Service (Part A)
Jim Bowden, owner of Bowden Brake Service, is planning to expand his six-year- old brake
service to include tune-ups and tire services. Based on budget estimates for the upcoming year,
Jim expects net sales to be $825,000 with a cost of goods sold of $530,000 and total operating
expenses of $210,000. From the budget he created, Jim computes fixed expenses to be $168,000,
while variable expenses (including cost of goods sold) are $572,000. Jim is concerned that the
new cost structure may damage his ability to produce a profit and he wants to perform a break-
even analysis for the upcoming year to gain insight.
124) Prepare an outline for Jim describing the components he should include in the business plan
when requesting a loan.
Answer: Jim's business plan should include: a cover letter, resumes of the owners, company
history, general business summary, business strategy, a description of the firm's products and
services, marketing strategy, a plan of operation, financial data, and a loan proposal.
Diff: 2 Page Ref: 100; Ch 4
125) If Jim were to reduce his fixed costs by 10 percent by reducing a middle management
position, what benefit would that be to him and the company? What would his new contribution
margin be?
Answer: By reducing his fixed costs, Jim improves his contribution margin.
If fixed costs are reduced by 10 percent
Then:
$572,000 x 90% = $514,800
To calculate the new contribution margin:
$514 ,000
$ 825 ,000 =.62
$825,800
1 - .62 = .38
or a contribution margin of 38%
Since middle managers are normally salaried employees that constitutes a fixed cost, it is easy to
appreciate why middle management positions have been significantly reduced in recent years.
29
126) Help Jim compute the break-even point for his brake service.
Answer: Contribution margin:
$ 572,000
1 - $ 825 ,000
1 - .6933 = .3067
break-even sales:
$ 547 ,767
3067 = $178,600
30
Mini-Case 11-2: Bowden Brake Service (Part B)
One day while you are in Bowden Brake Service getting your brakes repaired, Jim storms into
his office, slamming doors and shouting about the local financial institutions. After a few
minutes of building your courage, you approach Jim and ask him what the problem is. He
shouts, "It's the financial institutions in this town! Not one of them will lend me the money I
need to expand my business. They all said I needed to take a closer look at my financial position
before I consider expanding. One of them said something about ratio analysis. I know a lot about
cars and brakes, but what is ratio analysis?"
You tell Jim you will perform a ratio analysis for the business if he gives you a free brake job.
Jim provides you with the following financial statements.
Bowden Brake Service

Income Statement
Year Ending December 31, 2007
Net Sales $780,000

Costs of Goods Sold:
Beginning Inventory $104,000
Purchases 526,480
Goods Available for Sale $630,480
Ending Inventory 134,400
Costs of Goods Sold 496,080
Gross Margin $283,920
Operating Expenses:
Rent 24,000
Insurance 5,250
Advertising 6,000
Travel 2,500
Interest 72,750
Taxes (property, etc.) 2,500
Salaries & Admin. Expenses 97,000
Utilities 12,500
Supplies 1,360
Total Operating Expenses $223,860
Net Profit $60,060
31
Bowden Brake Service
Balance Sheet
December 31, 2007
Assets
Current Assets:
Cash $20,000
Accounts Receivable 10,000
Notes Receivable 5,000
Inventory 134,400
Total Current Assets $169,400
Fixed Assets:
Land 147,000
Machinery 73,000
Equipment 160,800
Less Accumulated Depreciation (30,200) 203,600
Total Fixed Assets 350,600
Total Assets $520,000
Liabilities & Owner's Equity
Current Liabilities:
Accounts Payable 40,500
Notes Payable 20,200
Accrued Salaries Payable 4,300
Total Current Liabilities: 65,000
Long-term Liabilities: Long-term Loan 325,000
Total Liabilities $390,000
Owner's Equity, Jim Bowden $130,000
Total Liabilities and Net Worth $520,000
32
127) Refer to the income statement and balance sheet. Prepare a ratio analysis for Bowden Brake
Service. In addition, use the following industry statistics for firms like Jim's to explain and
interpret what these ratios mean.
Answer: Current Ratio 1.4 : 1
Quick Ratio 0.7 : 1
Debt Ratio 1.8 : 1
Debt-to-Net Worth Ratio 1.9 : 1
Average Inventory Turnover N/A
Average Collection Period 21.22 days
Net Sales-to-Total Assets 2.8 percent
Net Sales-to-Working Capital 17.2 percent
Net Profit on Sales 9.0 percent
Net Profit to Equity 22.2 percent
$169,400
Current Ratio: $ 65 ,000 = 2.61
Bowden has $2.61 in current assets for every $1 in current liabilities. This surpasses both the 2:1
"rule of thumb" and the 1.4 industry median.
$169,000 - $134,400
Quick Ratio: $65 ,000 = .53
Bowden has .53 in quick assets for every $1 in current liabilities. This is below both the 1:1 rule
of thumb and the .7 industry median. Bowden apparently relies heavily on inventory to help
satisfy its short-term debt.
$ 65 ,000+$325,000
Debt Ratio: $520, 000 = .75
Compared to the industry median of 1.80, Bowden is not overburdened with debt.
$65 ,000+ $325,000

Debt-to-Net Worth Ratio: $130 ,000 = 3.0
Creditors have contributed three times as much to the business as Jim Bowden. Creditors are
likely to see Bowden as being "borrowed up," especially since the industry median is 1.90.
$ 496 , 080
Average Inventory: ($104,000 +$134,000 ) / 2 = 4.17 times per year
33
Bowden turns over its inventory about 4.17 times per year. A comparison is difficult since
industry figures are unavailable.
$ 780 , 000
Average Collection Period Ratio: $15 ,000 = 52
365 days
52 = 7.02
With credit sales of $780,000, Bowden's accounts and notes receivable are outstanding for an
average of 7.02 days, while the industry median is 21.22 days.
$ 780, 000
Net Sales to Total Assets Ratio: $ 520, 000 = 1.5
Bowden generates $1.5 in sales for every $1 in total assets. The industry median is 2.8. Bowden
is not producing enough sales in relation to its asset size.
$ 780 , 000
Net Sales to Working Capital Ratio: $169,900 - $69,000 = 7.47
Bowden is not using working capital efficiently to produce sales. With an industry median of
17.2, the implication is that Bowden must increase sales.
$60 ,060
Net Profit on Sales Ratio: $780 ,000 = .077
Each dollar of sales yields 7.7 cents in profit for Bowden, below the industry median of 9.0
cents.
$60 ,000
Net Profit to Equity Ratio: $ 130 ,000 = .462
Bowden's rate of return on his investments in the business is 46.2 percent, well above the
industry median of 22.2 percent. This reflects Bowden's low investment in the business.

34
128) Were the bankers correct? Do you think Jim should expand the business?
Answer: Bowden needs to increase sales, and expanding the business could help. However, Jim
may have a problem obtaining a loan since creditors have provided three times as much capital
as he has. In addition, Jim seems to rely on inventory to meet short-term debt. Still, with a
sound business plan explaining how the additional funds would be used, Jim could probably
obtain the financing he needs.
Mini-Case 11-3: Birmingham's Stereo Shop
Birmingham's Stereo Shop expects net sales of $280,000 in the upcoming year, with a cost of
goods sold of $173,600 and total expenses of $76,200. Birmingham expects variable expenses
(including cost of goods sold) to be $195,700 and fixed expenses to be $54,100.
129) What level of sales would Birmingham's have to achieve if it wanted to make a $25,000
profit?
Answer: Sales needed to generate a profit of $25,000. Therefore:
$ 25 ,000+ $54,100
Sales = . 3011 = $262,703
130) Construct a break-even chart for Birmingham's.

Answer:

35
131) Compute a break-even point in dollars.
$ 195 ,700
Answer: Contribution Margin = 1 - $280 ,000
1 - .6989 = .3011
$ 54 ,100
Break-even Point = 3011 = $179,675
Mini-Case 11-4: Calculating the Break-even Point
A small manufacturer plans to sell tents for $120 each. The variable cost for each tent is $90.
Fixed costs for the process are estimated to be $36,000. How many tents must the company sell
to break-even?
132) Suppose that the manufacturer desires a profit of $9,000 on this product. How many units
must be sold?
Answer: Price/unit $120
Variable cost/unit $90
Fixed cost $36,000
Sales required to earn a $9,000 profit:
Contribution Margin: $120 - $90 = $30
$ 36 ,000
Break-even Units: $ 30 = 1,200 Units
Use break-even formula and add desired profit:
$ 9 ,000+36,000
Break-even units plus desired profit: $120 - $90 = 1,500 Units
36
Mini-Case 11-5: A Projected Income Statement
You want to start your own retail furniture store, and you have already gathered a great deal of
information on location, layout, form of ownership, business failure rates, etc. In applying for a
loan, you notice that a projected income statement is required. Your problem is to complete this
projected "P&L," given a desired income of $23,000 and the following published statistics. Show
and clearly label all of your work!
Cost of Goods Sold 60.3 percent of net sales
Operating Expenses 36.4 percent of net sales
Gross Profit Margin 39.7 percent of net sales
133) If a market survey indicates that your firm's sales would be $620,000, what net profit would
you expect to earn?
Answer: First, find net profit margin percentage
Sales 100 percent
- CGS 60.3 percent
Gross Profit Margin 39.7 percent
- Operating Expenses 36.4 percent
Net Profit Margin 3.3 percent
Therefore, if net sales equals $696,970, then net profit is:

$696,970 x 3.3% = $23,000
Net profit can also be calculated by using dollar values:

Sales $696,970 100%
- CGS 420,273 60.3%
Gross Profit 276,697 39.7%
- Operating Expenses 253,697 36.4%
Net Profit $23,000 3.3%
37
Mini-Case 11-6: Crazy Harry's
The following is a pro forma income statement for Crazy Harry's.
Crazy Harry’s
Pro Forma Income Statement
Sales $96,000
Cost of Goods Sold 46,240
Gross Profit $49,760
Fixed Expenses
Rent $2,400
Insurance 3,000
Salaries 16,500
Taxes 1,100
Miscellaneous Fixed Expenses 900
Total Fixed Expenses $23,900
Variable expenses
Wages $11,200
Advertising 5,700
Benefits 2,800
Other Variable Expenses 1,120
Total Variable Expenses $20,080
Net Profit $5,040
134) Calculate Harry's break-even point.

Answer: Break-even Point:
Variable Costs: $46,240 + $20,080 = $66,320
$ 66,320
Contribution Margin: 1 - $ 96,000
1 - .6908 = .3092
$ 23 ,900
Break-even Sales Point: . 3092 = $77,296
38
135) Create a break-even chart for Harry.
Answer:

136) If Harry's profit target is $15,000, what level of sales must be achieved?
Answer: Sales required to earn a $15,000 profit:
$ 15 , 000+$23,9000
. 3092 = $125,808
39
Mini-Case 11-7: 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
137) 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?
Answer: If expected sales are $190,000, then Anthony's expected profit is:
$190,000 x .089 = $16,910

138) 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
Answer: To compute net sales:
$ 23 ,000
. 089 = $258,427
40

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Essentials of Entrepreneurship & Small Business Management, 6e (Scarborough)

Chapter 11 Creating a Successful Financial Plan

1) In order to reach profit objectives, entrepreneurs must be aware of their firms':

3) The ________ represents a "snapshot" of a business, showing an estimate of its value on a

4) Which of the following associations is correct?

7) Cost of goods sold is located on which financial statement?

11) On a company's statement of cash flows, depreciation is:

13) On a projected income statement, a business owner's target income is:

23) Which of the following is not a liquidity ratio?

33) A high debt ratio:

36) ________ is one indication that a small business may be undercapitalized.

39) The average inventory turnover ratio:

45) An excessively high average payable period ratio:

Net sales $927,641

50) Port Royal's debt-to-net worth ratio is:

51) Port Royal's profit margin on sales is:

52) Port Royal's net profit-to-equity ratio is:

55) The net profit to asset ratio measures:

BoardSports Industry Mean

58) Which of the following is an assumption of break-even analysis?

59) Refer to the following information

Which of the following statements is most likely false?

62) Using break-even analysis, what is Gunther's contribution margin?

What is Gunther's break-even point?

Refer to the following break-even Chart to answer the questions below:

68) The area labeled ________ is the "loss area."

72) The income statement is based on the fundamental accounting equation:

The steps in calculating break-even include:

total fixed costs

C. Including desired net income in break-even analysis:

total fixed expenses + desired net income

D. Break-even point in units:

total fixed costs

Total Expenses = (Fixed expenses + Variable expenses expressed as a percent of sales) x

To calculate the new contribution margin:

or a contribution margin of 38%

Bowden Brake Service

Net Sales $780,000

Net Profit $60,060

Total Assets $520,000

Liabilities & Owner's Equity

Long-term Liabilities: Long-term Loan 325,000

Total Liabilities $390,000

Owner's Equity, Jim Bowden $130,000

Total Liabilities and Net Worth $520,000

$65 ,000+ $325,000

Diff: 3 Page Ref: 329-354

Mini-Case 11-3: Birmingham's Stereo Shop

130) Construct a break-even chart for Birmingham's.

Diff: 3 Page Ref: 361-362

Mini-Case 11-4: Calculating the Break-even Point

Sales required to earn a $9,000 profit:

Contribution Margin: $120 - $90 = $30

Use break-even formula and add desired profit:

Therefore, if net sales equals $696,970, then net profit is:

Net profit can also be calculated by using dollar values:

The following is a pro forma income statement for Crazy Harry's.

Total Variable Expenses $20,080