Chapter 6 Private-Sector Reporting and Analysis C H A P T E R 6

Why Is Business Risky? Customers don’t always materialize. The costs of providing goods or services can be higher than predicted. Competition can interfere with your business plans. Investors might not always be available. Lenders may not want to loan you money.

Calculating Risks Before Starting a New Business Due diligence: Customer research Business environment and economic research Research of the competition Lender and investor research Pro forma budget modeling

Calculating Risks Before Investing in an Existing Business Reviewing the financial statements Performing ratio analysis on the financial statements Comparing the company’s performance with industry standards

Purposes of Budgeting To construct a financial model of how the business might perform over a given period To set benchmarks against which actual performance can be compared To articulate financial strategies for the fiscal year

Important Types of Budgets Operating budgets: The organizational plans for revenues and expenses on a departmental basis Sales budgets: Estimates of units to be sold and dollars to be received Production budgets: Estimates of the units and their costs required to meet sales quotas

The Art of Budgeting It’s a political process: Who gets what, when, and how. It’s incremental: This year’s budget is the basis for next year’s. It’s zero based: No assumptions are made.

Forecasting Revenues It begins with revenue from previous years. Macroeconomics plays a role in forecasting the next year’s revenue. Incrementalism also plays a role. Zero-based budgeting is one way of starting the budgeting process.

Demographics Is a Way of Forecasting Revenues Potential customers of a demographic group Potential customers × number of visits × revenue per visit = potential revenues of the company Profit = total potential revenues − the cost of goods sold

Budgeting as a Means of Predicting Profitability The sum of cost of goods sold, nonoperating expenses, and overhead costs are ways of predicting total expenses. Forecasting revenues is the essence of predicting profitability.

Making a Department or Company Profitable Make sure revenues exceed cost of goods sold. Make sure cost of goods sold is less than total revenues. Make sure that revenues minus cost of goods sold minus overhead is greater than total revenues.

Managing the Budget Make sure the budget is realistic. Understand that revenues are sometimes outside the control of financial managers. Understand that expenses are within the control of financial managers. Create financial reports that permit financial managers to make expense adjustments according to revenues.

The Purpose of Formulas Formulas provide benchmarks by which the financial performance of the company can be compared to that of other companies. Formulas provide benchmarks by which the financial performance of the company can be compared to that of the industry.

Liquidity Ratios Current ratio = current assets ÷ current liabilities Quick ratio = (cash and cash equivalents + short-term investments + accounts receivable) ÷ current liabilities

Ratios That Test the Financial Health of a Company Return on assets ratio: net income ÷ total assets Debt ratio: liabilities ÷ total assets

Summary Risk taking –Calculating risks –Managing risks Budgeting –Managing the budget –Forecasting revenues (continued)

Summary (continued) Ratio analysis: Measures of financial health –Liquidity ratios –Profitability ratios –Debt ratios