1. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing Chapter 10 Accounting Statements and Financial Requirements In the Spotlight: Diamond Courier http://diamondcourier.com In the Spotlight: Diamond Courier http://diamondcourier.com 10-1

2. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing Learning Objectives: Chapter 10 1. Describe the purpose and content of financial statements. 2. Explain how to forecast a new venture’s profitability. 3. Estimate the assets needed and the financing required for a new venture. 10-2

3. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing Earnings before taxes Corporate taxes Operating Activities Sales revenue Cost of producing or acquiring product or service (cost of goods sold) Gross profit Marketing and selling expenses and general and administrative expenses (operating expenses) Financing Activities Operating income Interest expense on debt (financing costs) The Income Statement: An Overview 10-3 Earnings before interest and taxes (operating income) Earnings before taxes Net income available to owners = = = = Taxes

4. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing Bates & Associates’ Income Statement 10-4 Sales revenue$830,000 Cost of goods sold_540,000 Gross profit$290,000 Operating expenses: Marketing expenses $90,000 General and administrative expenses 72,000 Depreciation _28,000 Total operating expenses$190,000 Operating income$100,000Int erest expense__20,000 Earnings before taxes$ 80,000 Income tax (25%) 20,000 Net income $ 60,000 Dividends paid$_15,000 Change in retained earnings$ 45,000

5. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing The Balance Sheet: An Overview 10-5 Assets Debt (Liabilities) and Equity (Net Worth) + Total Assets Current Assets Cash Accounts receivable Inventories Prepaid expenses Fixed Assets Machinery and equipment Buildings Land + Other Assets Investments Patents Debt Capital Current Debt Accounts payable Other payables Accrued expenses Short-term notes Long-Term Debt Long-term notes Mortgages + Owner’s Equity Capital Owner’s net worth or Partnership equity or Common stock equity Total Debt and Equity = =

6. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing Assets 1998 1999 Changes Current assets: Cash$ 38,000 $ 43,000$ 5,000 Accounts receivable 70,00078,000 8,000 Inventories175,000 210,000 35,000 Prepaid expenses12,00014,000 2,000 Total current assets$295,000$345,000$ 50,000 Fixed assets: Gross plant and equipment$760,000 $838,000$ 78,000 Accumulated depreciation355,000383,000 28,000 Net plant and equipment$405,000 $455,000$ 50,000 Land 70,000 70,000 0 Total fixed assets$475,000$525,000$ 50,000 Goodwill and patents30,000 50,000 20,000 TOTAL ASSETS$800,000 $920,000$120,000 10- 6A Bates & Associates’ Manufacturing Balance Sheets

7. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing Debt (Liabilities) 1998 1999Changesand Equity Current debt: Accounts payable $ 61,000 $ 76,000$ 15,000 Income tax payable 12,000 15,000 3,000 Accrued wages and salaries4,000 5,000 1,000 Interest payable 2,000 4,000 2,000 Total current debt $ 79,000 $100,000$ 21,000 Long-term debt: Long-term notes payable 146,000 200,000 54,000 Total debt$225,000 $300,000$ 75,000 Common stock$300,000 $300,000 $0 Retained earnings275,000 320,000 45,000 Total stockholders’ equity$575,000 $620,000$ 45,000 TOTAL DEBT AND EQUITY $800,000 $920,000 $120,000 Bates & Associates’ Manufacturing Balance Sheets 10-6B

8. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing The Fit of the Income Statement and the Balance Sheet 10-7 Reports the profits from January 1, 1999 through December 31, 1999 Income Statement for 1999 Balance Sheet December 31, 1998 Reports the financial position as of December 31, 1998 Balance Sheet December 31, 1999 Reports the financial position as of December 31, 1999 Time

9. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing A Firm’s Cash Flows After-tax cash flows from operations Investments in net operating working capital Investments in fixed assets and other assets Firm’s cash flow = 10-8

10. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing Bates & Associates’ Measurement of Cash Flows Step 1: Compute after-tax cash flows from operations: Operating income (EBIT)$100,000 a Depreciation 28,000 a Earnings before interest, tax,$128,000 depreciation, and amortization (EBITDA) Tax expense $20,000 a Change in income tax payable 3,000 b Cash tax payments 17,000 After-tax cash flows from operation$111,000 10-9A a Figure from income statement b Figure from balance sheets

11. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing Bates & Associates’ Measurement of Cash Flows Step 2: Compute the change in net operating working capital: Change in cash$ 5,000 b Change in accounts receivable 8,000 b Change in inventories 35,000 b Change in prepaid expenses 2,000 b Changes in current assets $50,000 Change in accounts payable$15,000 b Change in accrued wages 1,000 b Change in non-interest-bearing current $16,000 operating liabilities Change in net operating working capital $34,000 10-9B a Figure from income statement b Figure from balance sheets

12. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing Bates & Associates’ Measurement of Cash Flows Step 3: Calculate the change in fixed assets and other assets: Gross purchase price of fixed assets $ 78,000 b Net cash used for investments in other assets 20,000 b Change in long-term assets98,000 Firm’s cash flows ($ 21,000) 10-9C a Figure from income statement b Figure from balance sheets

13. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing The Purpose of Pro Forma Financial Statements 1. How profitable can the firm be expected to be, given the projected sales levels and the expected sales expense relationships? 2. What will determine the amount and type of financing (debt or equity) to be used? 3. Will the firm have adequate cash flows? If so, how will they be used; if not, where will the additional cash come from? The purpose of pro forma financial statements is to answer three questions: 10-10

14. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing Oakcrest Products, Inc., Projected Income Statements 10-11 Year 1Year 2 Sales $250,000$400,000 Line 1 Cost of goods sold: Fixed costs$100,000$100,000 Line 2 Variable costs (20% of sales)__50,000 _ 80,000 Line 3 Total cost of goods sold$150,000$180,000Line 4 Gross profits$100,000$220,000Line 5 Operating expenses: Fixed expenses $ 50,000$ 50,000Line 6 Variable expenses (30% of sales)__75,000_120,000Line 7 Total operating expenses $125,000$170,000 Line 8 Operating profits ($ 25,000)$ 50,000Line 9 Interest expense (12% interest rate) 12,000 12,000 Line 10 Earnings before taxes ($ 37,000)$ 38,000Line 11 Taxes (25% of earnings before taxes) 0 9,500Line 12 Net income ($ 37,000)$ 28,500Line 13

15. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing Sales-Assets-Financing Relationships 10-12 Increases in sales Increases in asset requirements Increases in financing requirements

16. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing Practical Forecasting 1. Don’t stretch to reach your numbers; be factual and conservative. 2. Remember: Only the most astonishing changes in a business or a market can justify a sudden, rocket-like performance. 3. Build projections quantitatively from clear assumptions. 4. Document the reasoning behind each projection in a written list of assumptions. 5. Use industry-specific data to guide your projections of sales and expenses. 6. Remember: Projections are immediately suspect if sales or profit margins are significantly higher or lower than the industry average. 7. Check pro forma statements against actual results at least once a month. 10-13

17. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing BizPlanBuilder Spreadsheet Templates (p. 192) Using your spreadsheet processor, you edit the templates with your own financial data. There are two ways to generate financial statements: Integrated financials spreadsheet Basic spreadsheets Using your spreadsheet processor, you edit the templates with your own financial data. There are two ways to generate financial statements: Integrated financials spreadsheet Basic spreadsheets 10-14

18. Small Business Management, 11th edition Longenecker, Moore, and Petty © 2000 South-Western College Publishing BizPlanBuilder Recommendation for Making Financial Projections (p. 207) You may want to prepare not only one set of projections, but three. They should include a pessimistic (worst case) scenario and a realistic (most likely) scenario. In this way, you will have a true picture of your potential for gain and loss. While the best case is what you hope for, the worst case is what you need to be prepared for; in the meantime, the most likely case will be the basis for many of your decisions. You may want to prepare not only one set of projections, but three. They should include a pessimistic (worst case) scenario and a realistic (most likely) scenario. In this way, you will have a true picture of your potential for gain and loss. While the best case is what you hope for, the worst case is what you need to be prepared for; in the meantime, the most likely case will be the basis for many of your decisions. 10-15