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Entrepreneurship and Business Management

Financial feasibility study Module 4

Think about it What is meant by gross profit and net profit? What is the difference between a variable cost and a fixed cost? How do I calculate the break-even point?

Introduction

Introduction Every entrepreneur has to do a financial feasibility study to determine whether an idea is financially viable. A business may show a profit but have no cash flow. Therefore, a financial plan must be drawn up to ensure both a healthy cash flow and a profit.

The importance of financial feasibility concepts Unit 4.1

The importance of financial feasibility concepts Every entrepreneur must have a sound knowledge of the following financial concepts: Profit. Sales. Fixed costs. Operating costs. Break-even analysis.

Profit A distinction must be made between two kinds of profit, namely gross profit and net profit. Calculating gross and net profit Gross profit = Sales – Cost of sales Net profit = Gross profit + Other income – Expenses

Examples of operating expenses: • Salaries. • Electricity. • Wages. • Rent paid. • Advertisements. • Stationery. Figure 4.1: The enterprise needs to calculate its gross and net profit

Profit Calculating net income Net income = Income from services rendered (current income) – Operating expenses In the case of a trading concern, the enterprise buys merchandise (called ‘purchases’) at cost price and then resells it at the selling price.

Activity 4.1 Test your knowledge of this section by completing Activity 4.1 (page 60 of your Student’s Book)

Important point If the cost of sales is not given, it can be calculated as follows: Cost of sales = Opening stock + Purchases – Closing stock

VIDEO: VISION AND DRIVE MAKE ALL THE DIFFERENCE

Activity 4.2 Test your knowledge of this section by completing Activity 4.2 (page 61 of your Student’s Book)

Sales ‘Sales’ refers to the goods that are sold to generate profit. Sales equals the number of items (units) sold multiplied by the selling price per item. A trading concern makes a profit by buying merchandise/stock (purchases) and then reselling it at a higher price.

Calculating the selling price Figure 4.2: Calculating the selling price

Fixed costs Fixed costs are those costs that must be paid no matter how many units are produced or are bought for resale. Fixed costs therefore remain the same regardless of the volume sold. Examples of fixed costs include: Rent per month. Insurance. Salaries.

Operating costs Operating costs are also referred to as ‘total costs’. Operating costs are calculated as the fixed costs plus the variable costs. Figure 4.3: Variable and fixed costs affect the profit of the business

Break-even analysis The break-even point is the point where the income generated from sales equals the total costs. All sales below this point will result in a loss, while all sales above this point will result in a profit. The aim of any new business is to at least break even at the beginning of its operations.

Start-up costs Unit 4.2

Start-up costs Any business has to pay start-up costs before the business starts. These start-up costs can be divided into: Fixed assets (also called ‘non-current assets’). Pre-operating costs.

Fixed assets Fixed assets are assets bought with the purpose of using them in the enterprise and not for the purpose of reselling them. They have a long duration (life). Some of these assets will be subject to depreciation, as their value will decrease with time.

Examples of assets The following are some examples of fixed assets: Land and buildings. Equipment. Vehicles. Machinery. Furniture. Figure 4.4: Vehicles and buildings are examples of fixed assets

Purchase price and expenditure A number of decisions must be taken before purchasing fixed assets. These include aspects such as: Financing. The recording of assets in the asset register. The policy with regard to depreciation.

Financing Assets such as equipment may be purchased for cash. Other assets may require the business to take out a mortgage bond. If a business does not have cash to purchase fixed assets, short-term financing can also be obtained. Another possibility is to lease the asset. Leasing means that the business pays a monthly amount for the use of the asset.

Recording of assets in the asset register The asset register must indicate the following: The date of purchase. The cost price of the asset. Depreciation and accumulated depreciation. The book value of the asset.

Policy with regard to depreciation The value of assets, except land and buildings, will decrease with time. The enterprise needs to do a calculation to determine the amount by which a specific asset must be decreased (depreciated) per year.

Financing and finance charges Where does an entrepreneur get the finance to start a business? You have learnt a few accounting concepts so far, including the following: Fixed assets. Expenses. Income.

The accounting equation Assets = Owner’s equity + Liabilities Please note: The accounting equation is not for examination purposes, but serves as an explanation so that you have financial insight (understanding) into a business. All accounting principles are based on this equation.

Table 4.3: The accounting equation

An enterprise can make use of: Own funds. Borrowed funds. Buying on credit and paying back in instalments. Leasing. Figure 4.5: A business can use own or borrowed funds

Own funds This is money contributed by the owner of the business. ‘Owner’ refers to: Sole trader – one person. Partnership – the partners. Close corporation – the members. Company – the shareholders. ‘Own funds’ represents the capital in the accounting equation and is the amount belonging to the owner.

Borrowed funds (liabilities) Loans A loan is money obtained from outsiders. This represents a liability in the accounting equation. In addition to the compulsory repayment that must be made, interest is also added to the loan and has to be paid annually. Bank overdraft An entrepreneur can also make arrangements for an overdraft at a bank. Interest will, however, be charged for doing this and this will be an expense.

Instalment-sale transactions Where an entrepreneur needs to buy assets, like vehicles or equipment, this can be done by paying a deposit and then making further instalment payments. The business will only become the owner after the final payment. Interest is calculated and is added to the selling price of the item bought on instalment.

Leasing Leasing, in this context, applies to moveable property. The business has to pay an amount each month and must return the property when the lease agreement expires.

Pre-operating costs Pre-operating costs are the expenses that need to be paid to enable the business to start operating. Examples of these are the cost of: A trading licence. Purchases (merchandise, goods). Stationery. Packaging material. Advertisements. Electricity. Rent. Telephone installation.

VIDEO: YOU NEED TO SMOKE WHAT YOU SELL

Activity 4.3 Test your knowledge of this section by completing Activity 4.3 (page 65 of your Student’s Book)

Total costs Unit 4.3

Total costs Fixed costs Calculation of total costs Total costs = Fixed costs + Variable costs Fixed costs Fixed costs are costs that a business must pay regardless of how many items are bought and sold.

Graphically (in diagram or graph form) Figure 4.6: Fixed costs in a chair sales business

Variable costs Variable costs are costs such as the cost of electricity, packaging material, wages, fuel, and raw materials associated with manufacturing. In the case of a trading concern where goods are bought and resold at a profit, variable costs will also include the cost of the items sold.

Graphically represented Figure 4.7: Variable costs in a chair sales business

Total (operating) costs Calculation of total (operating) costs Total costs = Fixed costs + Variable costs

Total costs represented graphically Figure 4.8: Total costs in a chair sales business

Activity 4.4 – 4.5 Test your knowledge of this section by completing Activity 4.4 – 4.5 (page 69 of your Student’s Book)

Sales scenarios Unit 4.4

Sales scenarios A business has to do calculations to be prepared for a best-sales and a worst-sales scenario. Other factors that influence sales are: An increase in competitors. Substitute products. Suppliers increasing their prices.

Activity 4.6 – 4.7 Test your knowledge of this section by completing Activity 4.6 – 4.7 (page 71 of your Student’s Book)

Weighted average gross profit percentage (WAGPP) You will need the following information to calculate the WAGPP: The gross profit percentage of each product. The percentage that each product contributes to the total sales. Calculation of the WAGPP WAGPP = Percentage sales × Percentage gross profit

Turnover for a specific profit Think about it If you run a business that sells not only one product, but a number of products, you will want to know how much each product contributes to your profit.

The break-even point Figure 4.9: The business must know its break-even point

Graphically represented Figure 4.10: The break-even point in respect of the sale of chairs

Calculating the break-even point Table 4.6: Calculating the break-even point in units Step 1 Calculate the gross profit per unit. Selling price − Cost price Step 2 List all the fixed costs and add them to get the total fixed costs. Step 3 Calculate the break-even point in units.

Calculating the break-even point in rand Table 4.7: Calculating the break-even point in rand Step 1 Calculate the gross profit per unit. Selling price − Cost price Step 2 Calculate the gross profit % per unit. Step 3 Calculate the break-even point in rand.

Break-even calculation with profit motive The starting point for every business is to at least reach a point where the business breaks even. The main aim of most businesses is to make a profit. Therefore, another calculation must be done to determine how many units must be sold in order to do so. This can be calculated as follows:

Break-even calculation for more than one product

VIDEO: PLANS CHANGE

Activity 4.8 – 4.10 Test your knowledge of this section by completing Activity 4.8 – 4.10 (page 75 – 77 of your Student’s Book)

Summative assessment Test your knowledge of this section by completing the Summative assessment (page 79 of your Student’s Book)