How to Develop Financial Projections Presented by Larry Davidson & Anthony Mangiarelli in connection with the Rhode Island Business Plan Competition January 14, 2010

The Business Plan The Business Plan establishes credibility: of the plan of the entrepreneurs

The Business Plan Demonstrates the following: Business Overview Market Analysis Team Financial Projection

The Financial Projections The Financial Projections must be: Realistic Consistent: With the Business Plan Internally With Budgets With Assumptions

Balance Sheet The Four Main Financial Statements Shows the financial position at a certain point in time. It includes: Assets: What the company owns and has title to Liabilities: Obligations of the company Stockholders’ Equity: The “book value” of a company. Shows the net amount invested in a company Assets = Liabilities + Equity

The Four Main Financial Statements Income Statement Revenues Expenses Other income and expenses Statement of Stockholders’ Equity Shows changes in stockholder’s equity during year Shows distribution made by company Shows capital contributions made to company

Statement of Cash Flows The Four Main Financial Statements Statement of Cash Flows Very important to overall understanding of company’s operations Includes cash flows relating to: Operating Activities Investing Activities Financing Activities Reconciles cash at beginning of the year to cash at the end of the year Provides information for the burn rate

Understanding the Footnotes Roles of Footnotes in the Projected Financial Statements Explains the major assumptions used in developing the Projected Financial Statements Provide valuable insight and clarification into the amounts contained on the basic financial statements Provides useful information related to the Company’s accounting policies

How to use and calculate Important financial ratios Types of Ratios Liquidity Ratios – Measures the enterprise’s short run ability to pay its maturing obligations Activity Ratios – Measures how effectively the enterprise is using the assets employed Profitability Ratios – Measures the degree of success of failure of a given enterprise or division for a given period of time Coverage Ratios – Measures the degree of protection for long term creditors and investors

Translating the Balance Sheet Current Assets - Cash and other assets that are expected to be converted to cash or sold or used up usually within one year or less, through the normal operations of the business Property, Plant and Equipment - Equipment, machinery, buildings and land used to conduct business operations Current Liabilities - Obligations that will be due within a year that will be satisfied with current assets Long-Term Liabilities - Obligations that will become due more than one year from the balance sheet date Stockholders’ Equity - The stockholders’ right to the assets of the business

Analyzing Liquidity and Solvency After gaining an understanding of the balance sheet components, you can now combine that information with the following tools to analyze the Company’s Liquidity; and Solvency

Analyzing Liquidity and Solvency Liquidity: Measures the Company’s ability to: Pay obligations as they come due; and Handle unexpected cash needs Measured by a few common ratios: Working capital Current ratio Quick ratio

Working Capital Current Ratio Analyzing Liquidity The difference between the Company’s current assets and current liabilities The goal for any company is to maintain positive working capital Current Ratio Measures the ratio of current assets to current liabilities

Analyzing Liquidity An issue with using working capital and the current ratio as the sole measures of a Company’s liquidity is that it may be difficult to turn inventory into cash in order to fulfill current obligations as they come due It may be necessary to calculate the quick ratio for the Company’s short-term liquidity The quick ratio is also known as the acid test ratio

Quick Ratio Analyzing Liquidity Calculated similarly to current ratio, with the exception that only cash, marketable securities, and receivables are included in the numerator

Translating the Income Statement and Statement of Stockholder’s Equity What the Income Statement Shows: Revenue - Increases in assets or decreases in liabilities from selling goods or providing services that constitute the primary activities of an organization Cost of Goods Sold - Cost incurred by a Company to acquire or produce the inventory or the cost of services that was sold during a specific period Gross Profit (Loss) - Difference between the selling price of goods or services and the cost

What the Income Statement Shows Selling, General and Administrative Expenses - Expenses associated with the day to day operations of the business, but not attributable directly to the goods manufactured and sold Operating Income (Loss) - The difference between the Gross Profit and the selling, general and administrative expenses Other Income and Expenses - Income and expenses received or paid by the Company that is not part of their normal business operations Provision for Income Tax - The estimate for income taxes to be accrued or refunded based on the Company’s earnings Net Earnings - The total difference between revenues and expenses for the period being reported on

Income Statement Components in Detail: Gross Profit Commonly indicated as a percentage and used as a comparison to measure a Company’s ability to increase their sales prices and produce goods and services at lower costs For every dollar of sales, how much profit the Company earns to cover selling, general and administrative expenses and generate a net profit

The Statement of Stockholder’s Equity What the Statement of Stockholder’s Equity Shows: Common Stock Additional Paid in Capital Retained Earnings (Accumulated Deficit) Treasury Stock Accumulated Other Comprehensive Income

What exactly does a Cash Flow Statement Show? Provides a description of the events that resulted in the receipt or payment of cash during a fiscal period Provides information about the company’s operating, investing, and financing activities The statement reconciles the net change in cash and cash equivalents for the accounting period from the prior reporting period Cash burn rate - equal to the cash used in operations plus the cash used in investing

Usefulness of the Statement of Cash Flows The Statement of Cash Flows is one of the most important statements because it helps investors, creditors, and others to assess: The entity’s ability to generate future cash flows The entity’s ability to pay dividends and meet current and future obligations The reasons for the differences between net income and net cash flows The entity’s cash and non-cash investing and financing activities

Classifications of Cash Receipts and Cash Payments Operating Activities Involve the cash effects of transactions that enter into the determinations of net income, such as cash receipts from sales of goods and services and cash payments to suppliers and employees for acquisitions of inventory and expenses Also included in the operating section are certain items that affect net income, but are non-cash items (income/expense), and therefore need to be included in the reconciliation of net cash flows from operating activities. Non-cash items often include, but are not limited to, depreciation and amortization expense, gain/loss on sale of fixed assts, bad debt expense, etc.

Classifications of Cash Receipts and Cash Payments Investing Activities Generally involve long-term assets and include: Making and collecting loans (notes receivable) Purchase and sales of investments Acquiring and disposing of fixed assets and long-lived assets

Classifications of Cash Receipts and Cash Payments Financing Activities Involve liability and stockholders’ equity items and include Obtaining cash from lenders and repaying the amounts borrowed Obtaining capital from owners and providing them with a return on, and a return of, their investment

(ldavidson@kahnlitwin.com) 401-274-2001 Anthony Mangiarelli, CPA, MST Larry Davidson, CPA (ldavidson@kahnlitwin.com) 401-274-2001 Anthony Mangiarelli, CPA, MST (amangiarelli@kahnlitwin.com)

Appendix

How to use and calculate Important financial ratios Other Types of Analytical Analysis Trend Analysis (Fluctuation) – Using historical data and budgeted data to determine trends and compare expectations to the actual financial statements Budget Versus Actual – Comparing budgets to actual results and investigating statements Industry Comparison – Benchmarking against the performance of companies in the same industry

How to use and calculate Important financial ratios Continued… Historical Analysis – Comparing actual results to historical performance or interim results Reasonableness Analysis – Reviewing account balances for reasonableness Predictive Analysis – Comparing what the outcome should be based on information you know (12 months of a set expense)

Additional Balance Sheet Analysis Accounts Receivable (A/R) Inventory Notes Payable and Long-term debt Accounts Payable and Accruals

Additional Balance Sheet Analysis Typical ratios and analytical procedures used to analyze accounts receivable: Receivables turnover Net sales/Average accounts receivable Days sales in accounts receivable A/R / (Sales/365) Allowance for doubtful accounts as a % of A/R Bad debt expense as a % of net credit sales Aging analysis

Additional Balance Sheet Analysis Typical ratios and analytical procedures used to analyze inventory: Inventory turnover COGS/Average inventory Days inventory on hand Inventory/ (COGS/365) Gross profit margin

Additional Balance Sheet Analysis Typical ratios and analytical procedures used to analyze notes payable and long term debt: Time interest earned EBIT/Interest Expense Cash debt coverage ratio Cash from operations/Average total liabilities Interest expense as a % of debt

Additional Balance Sheet Analysis Typical ratios and analytical procedures used to analyze accounts payable and accruals Days payable outstanding A/P /(COGS/365) A/P Aging Analysis