FINANCIAL STATEMENTS Chapter 4 Managing Money in an Entrepreneurial Venture EBD-301 Dr. David P. Echevarria All Rights Reserved1

T HE S TRUCTURE OF F INANCIAL A CCOUNTS  Accounting is fundamentally the process of how we organize the way we think about the financial aspects of our business.  Two Important Financial Statements  Income Statement  Balance Sheet  Two additional financial statements  Statement of Cash Flows  Statement of changes in owner equity Dr. David P. Echevarria All Rights Reserved2

Dr. David P. EchevarriaAll Rights ReservedPage 3 Finance from a Personal Viewpoint A. All us own things and owe money B. If we own more than we owe – we are said to have a positive net worth. C. In Accounting & Finance:  What we own are called Assets.  What we owe are called Liabilities.  If our Assets exceed our Liabilities then we have [positive] Equity.  Accordingly: Assets = Liabilities + Equity  Savings are the difference between what we earn and what we consume: S = E – C

Dr. David P. EchevarriaAll Rights ReservedPage 4 Balance Sheet  The Balance Sheet answers two general questions:  How has the business invested its capital (money)?  Current Assets (cash, receivables, inventory)  Fixed Assets (plant, property, equipment)  How has the business financed its investment?  Personal Funds (owner’s capital)  Borrowing: short-term (current liabilities) and/or long-term (loan paid back over several years)  Trade Credit from suppliers  Later: Reinvesting a portion of profits in the business

The Asset Accounts  Current Assets (in order of liquidity)  Cash  Receivables  Inventory  Prepaid Expenses  Fixed or Long-Term Assets  Plant (buildings)  Property (land)  Equipment (computers to trucks) Dr. David P. Echevarria All Rights Reserved5

The Asset Accounts C. Fixed or Long-Term Assets (cont.) 4. Effects of Wear and Tear over time a. Depreciation Expense: a non-cash expense that in theory creates a “fund” which will be used later to replace the worn-out asset. b. In actuality: it is a “tax shelter”. It reduces our taxable income. c. Assets are depreciated over their expected economic life to zero. Book Value = 0 d. However, even worn out assets may have a market value. D. Asset accounts carry Debit Balances Dr. David P. Echevarria All Rights Reserved6

The Liability Accounts  Short-Term or Current Liabilities  Payables  Employees  Trade and other Creditors  Tax authorities  Current portion of Long-term debt  Long-term Liabilities  Mortgages  SBA loans (typ. 5 to 7 years max. with exceptions)  Liability accounts carry Credit Balances Dr. David P. Echevarria All Rights Reserved7

The Equity Accounts  Owner’s Capital  Owner’s Equity  Owner’s Draw  Retained Earnings  Equity accounts carry Credit Balances  The Accounting Equation Assets (Debits) = Liabilities + Equity (Credits) Dr. David P. Echevarria All Rights Reserved8

Balance Sheet Example Dr. David P. Echevarria All Rights Reserved9

Dr. David P. EchevarriaAll Rights ReservedPage 10 INCOME STATEMENT A. The income statement gives information relating to the firm’s Revenues and Expenses for the last accounting (fiscal) period. B. The I/S is frequently called the P&L (Profit and Loss). C. The most important use is for determining how profitably a business is operating. D. Revenues have Credit Balances and Expenses have Debit Balances.

Income Statement Example Dr. David P. Echevarria All Rights Reserved11

Income Statement (Sole Prop.) Revenues - Cost of Goods Sold Labor + Materials = Gross Profit - Overhead Expenses Utilities, rent, advertising, etc. = Operating Profits (= EBITDA) - Depreciation Expense (non-cash!) = Earnings before Interest & Taxes (EBIT) - Interest Expense = Net Income or Net Profit Dr. David P. Echevarria All Rights Reserved12

Dr. David P. EchevarriaAll Rights ReservedPage 13 STATEMENT OF CASH FLOWS  The statement of cash flows shows the financial analyst, stockholder, or other interested parties where the firm’s cash came from and how it was used.  The firm has 3 possible Sources & Uses of Cash:  Operating Activity (profits from sales)  Financing activity (borrowing)  Investing activity (buying/selling assets)

All Rights ReservedChapter 3Page 14 STATEMENT OF CASH FLOWS  Cash Flows from Operating Activities;  Net income; what's left after expenses and taxes.  Adjustments to determine operating cash flows;  + Depreciation expense; (a non-cash expense)  - Increases in current asset accounts.  + Decreases in current asset accounts.  + Increases in current liability accounts.  - Decreases in current liability accounts.  Net cash flows from operating activities. Dr. David P. Echevarria All Rights Reserved14

All Rights ReservedChapter 3Page 15 STATEMENT OF CASH FLOWS  Cash Flows from Investing Activities;  - Increases in investments (buying securities).  + Decreases in investments (selling securities).  + Interest/dividends received from investments.  - Increases in plant, property, and equipment  + Decreases in plant, property, and equipment.  = Net cash flows from investing activities. Dr. David P. Echevarria All Rights Reserved15

All Rights ReservedChapter 3Page 16 STATEMENT OF CASH FLOWS  Cash Flows from Financing Activities  - Payments of interest on debt  Net cash flows from financing activities.  Net change End of Year  Minus Owner’s Draw  Change in Cash Balance from last year Dr. David P. Echevarria All Rights Reserved16

F INANCIAL R ATIO A NALYSIS  The objective of financial ratio analysis (FRA) is to direct owner-manager attention to areas of concern in the financial performance of the business.  Five Areas of Owner/manager Focus  Liquidity Management  Asset Management  Debt Management  Profitability  Investment Performance Dr. David P. Echevarria All Rights Reserved17

Liquidity Management  Liquidity ratios measure the business's ability to pay their bills.  Current Ratio CR = Current Assets  Current Liabilities Rule of Thumb: best when greater than 2 times 2. Quick Ratio QR = (Current Assets – Inventory) ÷ Current Liab. Rule of Thumb: should be at least 1:1 3. Cash Ratio (the most critical measure) CR = Cash ÷ Current Liabilities Critical ratio for businesses with little access to borrowing. Must be able to pay suppliers! Dr. David P. Echevarria All Rights Reserved18

Asset Management  Asset utilization ratios measure the efficiency of asset management. We want just enough to support the current level of sales and maybe a little room to grow.  Days Sales Outstanding (DSO) DSO = A/R  average credit sales per day How many days does it take to collect money owed to the business? 2. Inventory Turnover (ITO) ITO = Cost of Goods Sold ÷ [Average] Inventory We want to turnover inventories as quickly as possible – increases profitability while minimizing the amount of capital tied up in inventory. Dr. David P. Echevarria All Rights Reserved19

Asset Management 3. Total Asset Turnover (TATO) TATO = net sales  total assets Are we the right size? Too little means growth is tough. Too much means capital is inefficiently invested. Should be close to 1:1 4. Fixed Asset Turnover (FATO) FATO = net sales  net fixed assets Net means after subtracting accumulated depreciation. Best estimate is 0.5 to 1. Dr. David P. Echevarria All Rights Reserved20

Debt Management  Debt Management or Leverage ratios are designed to measure the extent to which Debt is used to finance assets.  Debt Ratio (DR) DR = total debt  total assets The rule of thumb for small businesses has never been really set. However, unlike large businesses, it should be significantly less than 50%. Otherwise, a significant portion of your profits will go to the bank as interest. Dr. David P. Echevarria All Rights Reserved21

Debt Management 2. Times Interest Earned (TIE) TIE = Operating Income  Interest Expense Lenders are interested in this value since the ability to pay interest on borrowed funds is captured by this ratio. A high ratio is preferred to a low one. The general R of T is at least 3 to 4 times. 3. Fixed Charge Coverage (FCC) FCC = (Interest Expenses + Lease Expenses) ÷ EBIT Lease expenses, like interest expenses, must be paid if the leased assets are to continue in the possession of the lessee. You want this ratio to be greater than 3:1. Dr. David P. Echevarria All Rights Reserved22

P ROFITABILITY R ATIOS A. The ability of a business to generate profits is a function of two major factors. The first is sales revenues and the second is cost control. 1. Gross Profit Margin (GPM) GPM = Gross Profit  Net Sales The gross profit margin ratio measures how many cents of every sales dollar is consumed by labor and materials. 2. Operating Profit Margin (OPM) OPM = Operating Income  Net Sales The OPM ratio measures how much of each sales dollar remains after covering all the operating expenses of the business. Dr. David P. Echevarria All Rights Reserved23

P ROFITABILITY R ATIOS 3. Net Profit Margin (NPM) NPM = net income  net sales NPM is a direct measure of how much of every sales dollar results in [accounting method] profits Dr. David P. Echevarria All Rights Reserved24

I NVESTMENT P ERFORMANCE  The two concepts covered in this section, return on assets and return on equity, are really are measures of how well our business is generating a return on our investment.  Return on Investment (ROI) ROA = net income  total assets ROA is a measure of gross investment efficiency. If we consider the total investments in the assets of the business like money in the bank, ROA is akin to a rate of interest earned on that investment. Dr. David P. Echevarria All Rights Reserved25

I NVESTMENT P ERFORMANCE 2. Return on Owner’s Equity (ROE) ROE = net income  owner’s equity The reason for this ratio is that owner’s want to determine the return they are earning on their "equity" or the portion of the business they own, net of liabilities. 3. Basic Earning Power (BEP) BEP = EBIT  Total Assets The BEP ratio measures the effectiveness of the business in generating income from its asset investment. Dr. David P. Echevarria All Rights Reserved26

D U P ONT S YSTEM OF F INANCIAL A NALYSIS  The DuPont System was developed as a methodology to improve the usefulness of financial ratio analysis. It is a guide to the management options available to remedy poor financial performance.  The DuPont system divides the business into two focus areas; Cost Control and Capital Structure. Cost control is concerned with operating and non- operating expenses. Capital structure addresses the use of debt to finance assets. Dr. David P. Echevarria All Rights Reserved27

D U P ONT S YSTEM OF F INANCIAL A NALYSIS Dr. David P. Echevarria All Rights Reserved28

H OMEWORK Q UESTIONS Dr. David P. Echevarria All Rights Reserved29

H OMEWORK Q UESTIONS Dr. David P. Echevarria All Rights Reserved30

H OMEWORK Q UESTIONS Dr. David P. Echevarria All Rights Reserved31

H OMEWORK P ROBLEM Balance Sheet: Franco’s Pizzeria for FY ending Dr. David P. Echevarria All Rights Reserved32

H OMEWORK P ROBLEM Income Statement: Franco’s Pizzeria for FY ending Dr. David P. Echevarria All Rights Reserved33

H OMEWORK P ROBLEM  Compute the following ratios for Franco’s business:  Current ratio: ___________________________________  Quick ratio: _____________________________________  Days Sales Outstanding? (Assume a 365-day year) ________________________  Inventory Turnover: ___________________________  Total Asset Turnover: __________________________  Debt Ratio: _________________________________ Dr. David P. Echevarria All Rights Reserved34

H OMEWORK P ROBLEM 7. ROA: ______________________________________  ROE: _______________________________________  Gross Profit Margin: _______________________  Operating Profit margin: ________________________  Net Profit margin: _____________________________  The Equity Multiplier: _________________________ Dr. David P. Echevarria All Rights Reserved35