Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 14-1.

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall14-1

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 14-2

Chapter 14

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.

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 futureThey 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


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 RatiosLiquidity 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 RatiosLiquidity 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 RatiosLiquidity ratiosLeverage 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 RatiosLiquidity ratiosLeverage 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 RatiosLiquidity ratiosLeverage ratiosOperating 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 RatiosLiquidity ratiosLeverage ratiosOperating ratiosProfitability 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 averageWhere necessary, understand why figures are out

of lineAnalyze 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 lossThe single most important financial figure to

understandIt is a useful planning tool because it shows

entrepreneurs the minimum level of activity required to stay in businessWith 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 PointStep 1: Determine the expenses the business can

expect to incurStep 2: Categorize the expenses in step 1 into fixed

expenses and variable expensesStep 3: Calculate the ratio of variable expenses to net

salesStep 4: Compute the break-even point by inserting

this information into this formula:

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Adding a ProfitThe breakeven formula can be modified to include

a profitProfit is treated as a fixed cost

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Breakeven Point in UnitsBreakeven point can also be expressed in units

produced or soldTo compute breakeven point in units use this

formula:

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Constructing a Breakeven ChartStep 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 axisStep 5: Beginning at the graph’s origin, draw a 45-degree revenue line showing where total sales volume equals total incomeStep 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


Using Breakeven AnalysisBreakeven 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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Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 14-1.

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