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

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 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! 14-3

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  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 14-4

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  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 14-5

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  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 14-6

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  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 future  They 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 14-7

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

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  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 14-9

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  12 Key Ratios  Liquidity 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 14-10

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  12 Key Ratios  Liquidity 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 14-11

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  12 Key Ratios  Liquidity ratios  Leverage 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 14-12

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  12 Key Ratios  Liquidity ratios  Leverage 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 14-13

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 5.Times interest earned ratio: a measure of a small company’s ability to make the interest payments on its debt 14-14

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  12 Key Ratios  Liquidity ratios  Leverage ratios  Operating 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 14-15

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 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 14-16

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 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 14-17

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 9.Net sales to total assets: measures a firm's ability to generate sales given its asset base 14-18

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  12 Key Ratios  Liquidity ratios  Leverage ratios  Operating ratios  Profitability 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 14-19

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 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 14-20

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  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 14-21

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  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? 14-22

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  What Do All These Numbers Mean?  Goal: achieve ratios that are better than the industry average  Where necessary, understand why figures are out of line  Analyze figures over time  Ratios are snapshots of the situation in a single instance 14-23

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Breakeven point: the level of operation (sales dollars or production quantity) at which it neither earns a profit nor incurs a loss  The single most important financial figure to understand  It is a useful planning tool because it shows entrepreneurs the minimum level of activity required to stay in business  With one change in the breakeven calculation, an entrepreneur can also determine the sales volume required to reach a particular profit target 14-24

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Calculating the Breakeven Point Step 1: Determine the expenses the business can expect to incur Step 2: Categorize the expenses in step 1 into fixed expenses and variable expenses Step 3: Calculate the ratio of variable expenses to net sales Step 4: Compute the break-even point by inserting this information into this formula: 14-25

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Adding a Profit  The breakeven formula can be modified to include a profit  Profit is treated as a fixed cost 14-26

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Breakeven Point in Units  Breakeven point can also be expressed in units produced or sold  To compute breakeven point in units use this formula: 14-27

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Constructing a Breakeven Chart Step 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 14-28

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. Step 4: Draw a total expense line that slopes upward beginning at the point at which the fixed cost line intersects the vertical axis Step 5: Beginning at the graph’s origin, draw a 45- degree revenue line showing where total sales volume equals total income Step 6: Locate the break-even point by finding the intersection of the total expense line and the revenue line 14-29

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

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Using Breakeven Analysis  Breakeven 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 14-31

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