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publishing as Prentice Hall

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Chapter 14

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 Research shows:
A significant positive relationship exists between
formal planning in small companies and their
financial performances
But, significant numbers of entrepreneurs run their
companies without any kind of financial plan!

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 The Balance Sheet
 Snapshot of the business
 Estimates the firm's worth on a given date
 Assets = Liabilities + Owner's Equity
 Assets
 Current assets
 Fixed assets
 Intangible assets
 Liabilities
 Current liabilities
 Long-term liabilities
 Owner’s equity
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 The Income Statement
 The income statement compares the firm's
expenses against its revenue over a period of
time to show its net income (or loss)
 Net Income = Sales Revenue - Expenses
 Cost of goods sold
 Gross profit
 Gross profit margin
 Operating expenses
 Net income or loss

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 The Statement of Cash Flows
 Shows the change in the firm's working capital
over a period of time by listing the sources of
funds and the uses of these funds

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 Projected financial statements answer questions such as:
What profit can the business expect to earn?
If the founder’s profit objective is x dollars, what sales
level must the business achieve?
What fixed and variable expenses can the owner expect
at that level of sales?
 They estimate the profitability and the overall financial
condition of the business in the immediate future
They are an integral part of convincing potential lenders
and investors to provide the financing needed to get the
company off the ground or to expand

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Financial Forecasting Model

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 Ratio analysis: a method of expressing the
relationships between any two accounting elements,
provides a convenient technique for performing
financial analysis
Ratios serve as a barometer of the company’s
financial health

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 12 Key Ratios
Liquidity ratios
Tell whether a small business will be able to meet its
maturing obligations as they come due
1.Current ratio: measures a small company’s
solvency by showing its ability to pay current
liabilities from current assets

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 12 Key Ratios
Liquidity ratios
Tell whether a small business will be able to meet its
maturing obligations as they come due
1.Current ratio: measures a small company’s
solvency by showing its ability to pay current
liabilities from current assets
2.Quick ratio (or acid test ratio): shows the extent to
which its most liquid assets cover its current liabilities

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 12 Key Ratios
Liquidity ratios
Leverage ratios
Measure the financing supplied by a company’s
owners against that supplied by its creditors; they
show the relationship between the contributions of
investors and creditors to a company’s capital base
3.Debt ratio: measures the percentage of total assets
financed by its creditors

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 12 Key Ratios
Liquidity ratios
Leverage ratios
3. Debt ratio: measures the percentage of total
assets financed by its creditors
4. Debt to net worth ratio: a measure of a
company’s ability to meet both its creditor and its
owner obligations in case of liquidation

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5. Times interest earned ratio: a measure of a small
company’s ability to make the interest payments on its
debt

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 12 Key Ratios
Liquidity ratios
Leverage ratios
Operating ratios
Help entrepreneurs evaluate their companies’
performances and indicate how effectively their
businesses are using their resources
6.Average inventory turnover ratio: measures the
number of times its average inventory is sold out, or
turned over, during the accounting period

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6. Average inventory turnover ratio: measures the
number of times its average inventory is sold out,
or turned over, during the accounting period
7. Average collection period ratio: tells the average
number of days it takes to collect accounts
receivable

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6. Average inventory turnover ratio: measures the
number of times its average inventory is sold out,
or turned over, during the accounting period
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 required to collect accounts
receivable

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9. Net sales to total assets: measures a firm's
ability to generate sales given its asset base

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 12 Key Ratios
Liquidity ratios
Leverage ratios
Operating ratios
Profitability ratios
Measure how efficiently a firm is operating; offer
information about a firm's “bottom line”
10.Net profit on sales ratio: Measures a firm's profit
per dollar of sales revenue

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10. Net profit on sales ratio: measures a firm's profit
per dollar of sales revenue
11. Net profit on 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 the investment in the business

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 In addition to knowing how to calculate business
ratios, owners need to understand how to interpret
them and apply them to the business
 Key performance ratios vary across industries and
within different segments of the same industry
 Key performance indicators (KPIs): ratios that are
unique to their own operations

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 Ask:
Is there a significant difference in my company’s
ratio and the industry average?
If so, is this a meaningful difference?
Is the difference good or bad?
What are the possible causes of this difference?
What is the most likely cause?
Does this cause require that I take action?
What action should I take to correct the problem?

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 What Do All These Numbers Mean?
Goal: achieve ratios that are better than the
industry average
Where necessary, understand why figures are out
of line
Analyze figures over time
Ratios are snapshots of the situation in a single
instance

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 Breakeven point: the level of operation (sales
dollars or production quantity) at which it neither
earns a profit nor incurs a loss
The single most important financial figure to
understand
It is a useful planning tool because it shows
entrepreneurs the minimum level of activity
required to stay in business
With one change in the breakeven calculation,
an entrepreneur can also determine the sales
volume required to reach a particular profit target

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 Calculating the Breakeven Point
Step 1: Determine the expenses the business can
expect to incur
Step 2: Categorize the expenses 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 this formula:

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 Adding a Profit
The breakeven formula can be modified to include
a profit
Profit is treated as a fixed cost

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 Breakeven Point in Units
Breakeven point can also be expressed in units
produced or sold
To compute breakeven point in units use this
formula:

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 Constructing a Breakeven Chart
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

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Step 4: Draw a total expense line that slopes upward
beginning at the point at which the fixed cost line
intersects the vertical axis
Step 5: Beginning at the graph’s origin, draw a 45-
degree revenue 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

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Breakeven Chart

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 Using Breakeven Analysis
Breakeven analysis is a useful planning tool for
entrepreneurs, especially when approaching
potential lenders and investors for funds
It provides an opportunity for integrated analysis
of sales volume, expenses, income, and other
relevant factors.
With just a few calculations, an entrepreneur
can determine the minimum level of sales
needed to stay in business as well as the effects
of various financial strategies on the business

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