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TITLE Financial Analysis. Unit 18. Level 3. InstructorGuide. PACE: Program for Acquiring Competence inEntrepreneurship. Third Edition. Research &Development Series No. 303-18.
INSTITUTION Ohio State Univ., Columbus. Center on Education andTraining for Employment.
PUB DATE 94
NOTE 38p.; For the complete set, i.e., 21 units, each doneat three levels, see Cr OCi 029-092. Supported by theInternational Consortium for EntrepreneurshipEducation, the Coleman Foundation, and the Center forEntrepreneurial Leadership Inc.
AVAILABLE FROM Center on Education and Training for Employment, 1900Kenny Road, Columbus, OH 43210-1090 (order no.RD303-18 IG, instructor guide $4.50; RD303-18 M,student module, $3; student module sets, level1--RD301M, level 2--RD302M, level 3--RD303M, $45each; instructor guide sets, level 1--RD30IG, level2--RD302G, level 3--RD303G, $75 each; 3 levels andresource guide, RD300G, $175).
PUB TYPE Guides Classroom Use Teaching Guides (For-.acher) (052) Guides Classroom UseInstructional Materials (For Learner) (051)
EDRS PRICE MFOI/PCO2 Plus Postage.DESCRIPTORS Behavioral Objectives; Business Administration;
*Business Education; Civil Law; *Competency BasedEducation; Compliance (Legal); *Entrepreneurship;Learning Activities; *Legal Responsibility;Legislation; Postsecondary Education; SecondaryEducation; *Small Businesses; Teaching Guides
IDENTIFIERS *Financial Analysis; *Program for AcquiringCompetence Entrepreneurship
ABSTRACTThis instructor guide for a unit on financial
analysis in the PACE (Program for Acquiring Competence inEntrepreneurship) curriculum includes the full text of the studentmodule and lesson plans, instructional suggestions, and other teacherresources. The competencies that are incorporated into this moduleare at Level 3 of learning--starting and managing one's own business.Included in the instructor's guide are the following: unitobjectives, guidelines for using PACE, lists of teaching suggestionsfor each unit objective/subobjective, model assessment responses, andoverview of the three levels of the PACE program. The followingmaterials are contained in the student's guide: activities be
completed in preparation for the unit, unit objectives, studentreading materials, individual and group learning activities, casestudy, discussion questions, assessment questions, and references.Among the topics discussed in the unit are the following:responsibilities in managing finances, financial advisors, cashflowmanagement, financial control procedures, cashflow patterns, troublespots, owner's equity financial statement, analysis of financialstatements, financial management ratios, break-even point, andcomputer applications for financial management. (KC)
UNIT 18LEVEL 3
THIRD EDITION
CENTER ON EDUCATIONAND MARRO FOR EMPLOYMENT
COLLEGE OF EDUCATIONIli ONO STATE (AVVERSITY
Research le Ilnelopmenl Series No. X13.18
O
C./
Objectives:
Discuss the responsibilities of the entrepreneur in man-aging the finances.Select appropriate advisors to assist in your financialanalysis.
Explain the importance of cashflow management.
Identify financial control procedures.
Describe how to find cashflow patterns.
Analyze trouble spots in financial management.
Describe how to prepare an owner's equity financialstatement.
Analyze your financial statements.
Analyze financial management ratios applicable to asmall business.
Compute and analyze break-even point.
Review computer applications for financial manage-ment.
BEST COPY AVAILABLE2
INSTRUCTOR GUIDE
Unit 18
Financial AnalysisLevel 3
HOW TO USE PACE
Use the objectives as a pretest. If a studentis able to meet the objectives, ask him orher to read and respond to the assessmentquestions in the back of the module.
Duplicate the glossary from the ResourceGuide to use as a handout.
Use the teaching outlines provided in theInstructor Guide for a .stance in focusingyour teaching delivt;.y. The left side ofeach outline page lists objectives with thecorresponding headings (margin questions)from the unit. Space is provided for you toadd your own suggestions. Try to increasestudent involvement in as many ways aspossible to foster an interactive learningprocess.
When your students are ready to do theActivities, assist them in selecting thosethat you Cc'el would be the most beneficialto their growth in entrepreneurship.
Assess your students on the unit contentwhen they indicate they are ready. Youmay choose written or verbal assessmentsaccording to the situation. Model re-sponses are provided for each module ofeach unit. While these are suggestedresponses, others may be equally valid.
u mosiermiiee or f PuCAhON"PERMISSION TO REPRODUCE THISMATERIAL HAS SEEN GRANTED IT
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Objectives
1. DISCUSS THERESPONSIBILITIES OF THEENTREPRENEUR INMANAGING THE FINANCES
What are the responsibilities ofthe entrepreneur in managing thefinances?
2. SELECT APPROPRIATEADVISORS TO ASSIST INYOUR FINANCIAL ANALYSIS
What advisors should be utilizedwhen considering financial anal-ysis?
3. EXPLAIN THE IMPORTANCEOF CASHFLOWMANAGEMENT
Why is cashflow managementimportant?
4. IDENTIFY FINANCIALCONTROL PROCEDURES
What are some financial controlprocedures?
Teaching Suggestions
Use an overhead or chalkboard to list the entrepreneur's respon-sibilities in successfully managing business fiances. Ask stu-dents to show how these responsibilities apply to various busi-nesses with which they are familiar with.
Ask students to offer their opinions on the importance of usik;outside financial expertise. Explain how SBDC, SBA, andSCORE can help the entrepreneur in the area of financial man-agement. Refer to the PACE Resource Guide for additionalinformation.
Ask students to explain the mechanics of a cashflow statementas they understand it. It is critical for students to understand themeaning of this vital financial statement and how it should becorrectly developed. Highlight the concepts of undercapitalizedbusiness and identify its implication for business growth.
Invite a local entrepreneur or accountant to speak about financialcontrol procedures used to monitor operations in small business.Ask students to compare the procedures mentioned by the speak-er with the ones listed in the unit, as well as other proceduresthey are acquainted with.
Objectives
5. DESCRIBE HOW TO FINDCASHFLOW PATTERNS
How can a cashflow pattern bedetermined?
6. ANALYZE TROUBLE SPOTSIN FINANCIALMANAGEMENT
What are signs of trouble in fi-nancial management?
How can long-range financialneeds ba managed?
7. DESCRIBE HOW TO PREPAREAN OWNER'S EQUITYFINANCIAL STATEMENT
What is an owner's equity finan-cial statement?
Teaching Suggestions
Use Figure 1 to explain how to develop and understand a cash-flow statement. Ask students to try to discover patterns in cashreceipts and cash disbursements from one month to another. Ex-plain the arithmetics of obtaining end-of-month cashflow (i.e.,adding cash income for the previous month to the next month'scashflow and subtract cash paid out).
Ask the guest entrepreneur or accountant to explain methods of"shooting financial management troubles." Encourage studentsto record these methods on note cards and to compare themagainst the ones presented in the text, as well against othermethods with which they are familiar.
Provide a list of items that are usually considered long-termfinancial needs for a small business (e.g., equipment and machin-ery, expansion needs, such as new construction, etc.). Defineand explain how the concept of working capital relates to expan-sion and growth needs.
Define the owner's equity financial statement and explain whatentries affect this statement (i.e., net worth, withdrawals ofowner's salary, additional owner's investments, etc.). Securesuch a statement from a local business or use one presented in atextbook.
4
Objectives
8. ANALYZE YOUR FINANCIALSTATEMENTS
How are financial statementsanalyzed?
9. ANALYZE FINANCIALMANAGEMENT RATIOSAPPLICABLE TO A SMALLBUSINESS
What are operating expenseratios?
What is an inventory ratio?
Why are financial ratios useful?
What are key business ratios?
What is the current ratio?
What is an acid-test ratio?
Teaching Suggestions
Explain how entrepreneurs analyze balance sheets, income state-ments, and cashflow statements by using financial ratio analysis.Emphasize the importance of using spreadsheet software (such asExcel, Lotus, and Quatro Pro) for ratio analysis and financialprojections. If such software is available, demonstrate its utility.
Write the general formula of operating expense ratio on thechalkboard or transparency (i.e., Operating expense ratio =Operating expense/Net sales). Ask students to compute variousoperating rations using the income statement presented in thetext (e.g., advertising expense ratio).
Refer to the above suggestion. Explain why inventory turnoverratios vary across industries (for example, why grocery storeshave a higher inventory turnover ratio than home appliancestores).
Use a chart to show reasons for using financial ratios.
Use an overhead or chalkboard to summarize the four categoriesof financial ratios (i.e., liquidity, solvency, fund managementefficiency, and profitability).
Define current ratio and working capital. Help students under-stand and interpret these formulas. Encourage students tomemorize formulas only after thoroughly understanding theconcepts and being able to apply numerical examples.
Refer to the above suggestion.
Objectives
What is a debt-to-tangible-net-worth ratio?
What is net incometo net salesratio?
10. COMPUTE AND ANALYZEBREAK-EVEN POINT?
What are break-even analysiscomponents?
Hew is a break-even point com-puted?
What information is obtainedfrom break-even analysis?
11. REVIEW COMPUTERAPPLICATIONS FORFINANCIAL MANAGEMENT
How can computer applicationsassist in financial analysis andmanagement?
Teaching Suggestions
Introduce the concept of solvency. Use simple examples toemphasize how solvency ratios measure the relationship betweenfunds borrowed by the business (debt), and funds owned by thebusiness. Define the debt-to-tangible-net-worth ratio and helpstudents work out computations on their own.
Refer to the above suggestion.
Define the concept of break-even point, fixed and variableexpenses. Also, define and give examples of semivariableexpenses.
Use several numerical examples to apply the break-even pointformula.
Create a chart to show the type of information reflected in thebreak-^-en analysis.
Ask students to explain how computer systems generate costssavings. Emphasize the types of costs incurred by businesseswhen computer systems are introduced in daily operations.Demonstrate any financial software that's available.
6
MODEL ASSESSMENT RESPONSES
1. The key responsibilities of the entrepreneurs inc.ide: (1) properly balance investments in assets, (2) accu-rately determine cashflow needs, (3) manage short-term and long-term debt, (4) secure sound credit termsand use sound practices for selling on credit, (5) evaluate the return on investment, etc. All of theseresponsibilities are important for small business success. Failure to efficiently manage any of the abovementioned areas could surely lead to business failure.
2. When starting a business, entrepreneurs may use advice offered by SBDC, SCORE, or local law and ac-counting firms which specialize in the financial management. In the first years of operations, entrepreneursneed to develop a close relationship with their accountants in order to refine the financial procedures ofbusiness. In addition, entrepreneurs should get involved in activities organized by the local chamber ofcommerce, SBDC, and other local small business organizations. As the business matures and grows, moresophisticated financial advisors from law and accounting firms may be needed.
3. Improper cash management may create problems in securing work capital for growth and expansion, ,'elaypayment of bills to creditors, delay the process of receiving payments, and may even result in bankruptcyif creditors are not paid in time.
4. Financial control procedures include: (1) handling cash as though it belonged to somebody else, (2) keep-ing personal cash separate from business cash, (3) recording all cash receipts and disbursements, (4) usinga bank account to deposit all cash receipts, (5) never making cash disbursements out of daily cash receipts,(6) depositing cash receipts daily, (7) paying all bills by checks, (8) making disbursements correctly, and(9) revising financial statements periodically.
5. Patterns to look for in a monthly cashflow include cash receipt and disbursement patterns (such as abruptdecreases, cyclical patterns), as well as end-of-month trends.
6. Signs of financial management troubles include: (1) expenses increasing at a faster rate than gross profit,(2) inadequate cash at the beginning of the month, (3) overexpansion of business with inadequate capitaliza-tion, (4) excessively high accounts receivable at the end of the month, and (5) cash shortage due to capitalexpenditures.
7. An owner's equity financial statement is prepared by recording changes in the owner's net worth (i.e., fundsinvested by the owner, withdrawal of owner's salary, depreciation of fixed assets, etc.).
8. Financial management ratio analysis provides information on the business performance from liquidity, sol-
vency, funds management and profitability standpoint. These ratios help entrepreneurs assess the currentcondition of their business and make sound management decisions.
9. To compute the break-even point, one divides the total fixed costs by the difference between the unit totalsales price and the unit variable cost.
8
ttiriii
RA-"Ox4-44,*.k2:400.7- -024
Incorporates the needed competencies for creating and operating a small business at three levels of learning, with experiences andoutcomes becoming progressively more advanced.
Level I Understanding the creation and operation of a business.Level 2 Planning for a business in your future.Level 3 Starting and managing your own business.
Self-contained Student Modules include: specific objectives, questions supporting the objectives, complete content in form of answersto the questions, case studies, individual activities, group activities, module assessment references. Instructor Guides include the full textof each student module and lesson plans, instructional suggestions, and other resources. PACE,Third Edition, Resource Guide includesteaching strategies, references, glossary of terms, and a directory of entrepreneurship assistance organizations.
For information on PACE or to order, contact the Publications Department at theCenter on Education and Training for Employment, 1900 Kenny Road, Columbus, Ohio 43210-1090
(614) 292-4353, (800) 848-4815.
Support for PACE, Third Edition provided in whole or in part by:
International Consortium for Entrepreneurship Educationand
International Enterprise AcademyCenter on Education and Training for Employment
The Ohio State University9
The Coleman Foundation
Center for Entrepreneurial Leadership Inc.Ewing Marion Kauffman Foundation
FinancialAnalysis
UNIT 18LEVEL 3
Your Potentialas an
Entrepreneur
Help forthe
Entrepreneur
LegalIssues
Nature ofri) Small Business
Types ofOwnership
BusinessOroortunities
Global MarketsThe
Business Plan
Marketing Location Pricing FinancingAnalysis Strategy the Business
BusinessManagement
HumanResources
Promotion Selling
AILRecord Customer
Keeping Credit
RiskManagement /N.. Operations
Program for: AcquiringCompetence inEntrepreneurshipi
CENTER ON EDUCATIONAND TRAINING FOR EMPLOYMENT
COLLEGE OF EDUCATIONTHE OHIO STATE UNIVERSITY 1 0
Research & Development Series No. 303-18
FINANCIAL ANALYSIS
BEFORE YOU BEGIN . . .
1. Consult the Resource Guide for instructions if this is your first PACE unit.
2. Read What are the Objectives for this Unit on the following page. If you thinkyou can meet these objectives now, consult your instructor.
3. These objectives were met at Level 1 and Level 2:
Level 1
Discuss the importance of financial management.
Define accounting terms.
Describe the tools for financial analysis.
Identify ways to analyze your business finances.
Level 2
Discuss the entrepreneur's role in managing finances.
Explain how to prepare a balance sheet.
Explain how to prepare an income statement.
Explain how to develop a cashflow projection.
Explain how to determine the break-even point.
Identify the use of advisors in the financial analysis decisions.
Discuss the use of computers in financial analysis.
4. Look for these business terms as you read this unit. If you need help with themeanings, ask your instructor for a copy of the PACE Glossary contained in theResource Guide.
Net income to net sales ratioNet sales to working capitalOperating expense ratioOwner's equity financial statementPaid-out voucher
Copyright © 1994. Center on Education and Training for Employment,The Ohio State University. All rights reserved.
Petty-cash fundSemivariable costsSolvencyUndercapitalized businessVariable costs
FINANCIAL ANALYSIS
WHAT ARE THE OBJECTIVES FOR THIS UNIT?
Upon completEm of this unit you will he able to
discuss the responsibilities of the entrepreneur in managing the finances,
analyze your financial statements,
select appropriate advisors to assist in your financial analysis,
explain the importance of cashflow management,
identify financial control procedures,
describe how to find cash flow patterns,
analyze trouble spots in financial management,
describe how to prepare an owner's equity financial statement,
analyze financial management ratios applicable to a small business,
compute and analyze break-even point, and
review computer applications for financial management.
WHAT IS THIS UNIT ABOUT?
To operate your business successfully, youwill have to be able to use financial man-agement techniques. Two key concepts offinancial management are planning and con-trol. A command of the tools and tech-niques of financial management will helpyou exercise these crucial tasks.
2
3
WHAT ARE THERESPONSIBILITIES OFTHE ENTREPRENEUR INMANAGING THE FINANCES?
The requirements for success in financialmanagement include the following:
Proper balance of investments in assetssuch as a building, fixtures, and otherequipment
4
Accurate determination of cash flowneeds
Sound management of both short-termand long-term debts
Sound credit terms and practices forselling on credit
A reasonable appraisal of whether or notyou are realizing an adequate rate ofreturn on your investment, based on theamount invested in your business and thetime you devote to it
This unit assumes that you have an under-standing of the basic components of andrelationship between the items in a balancesheet, income statement, .nd cashflow fore-cast. A balance sheet is a periodic reportthat identifies various assets and liabilities.The net worth or equity of the owner orstockholders is determined from the balancesheet formula: assets minus liabilities equalsnet worth (equity). The income statementidentifies revenues and expenses to deter-mine a profit or loss. Detailed explanationsof both statements are available in Levels 1and 2 of this unit. Ask your instructor foradditional information.
WHAT ADVISORS SHOULDBE UTILIZED WHENCONSIDERING FINANCIALANALYSIS DECISIONS?
Advisors may be employed at several stagesof the business growth and development.
In the pre-start-up stage, you need an objec-tive outside party to help you structure themethods you use to finance your businessand to assess the quality of the financialassumptions upon which you are basing yourfirst years forecasts.
Good prospects for this type of advise in-clude the local SBDC (Small BusinessDevelopment Center), SCORE (Service Coreof Retired Executives), or a local accountantexperienced in the industry you will beentering.
During the first several years of the businessoperations, an accountant to refine your fi-nancial management procedures and to learnto spot specific trends within your financialstatements. You may also want to partici-pate in local "roundtables" sponsored byyour local chamber of commerce for the pur-pose of acquiring insights from other busi-ness owners. The SBDC office can alsogive you a "second opinion" or help youmonitor your progress in maintaining controlover your working capital accounts.
As the business matures, you will want toutilize more specialized advisors from bothlaw and accounting to plan for succession,and to refine your strategic plan. Duringthis stage you will probably begin to rely on"in-house" staff to provide significant adviceon financial management. You may alsofind that having a qualified board of direc-tors will improve your business performance.
WHY IS CASH FLOWMANAGEMENTIMPORTANT?
Cash is a problem for many small busi-nesses. Comments, such as "I never seem tohave enough cash. Often I have to slightone creditor to pay another" are not uncom-mon for owners of small businesses.
The secret of controlling cash can he statedin one wordbalance. A firm should aim tohave just the right amount of cash onhandnever too little and never too muchfor its needs.
When a business has permanent pressure oncash, it may be undercapitalized. A businesswould be undercapitalized if it does not haveenough funds to pay cuient operating ex-penses or to purchase needed inventory orequipment. Such a chronic shortage of cashcan lead to disaster because the owner can'tpay the firm's bills when they are due. Orthe firm may go broke because its ownerlacks the financial resources to meet thesudden demands of new competition.
Often more capital is needed because thepresent investment does not generate enoughcash to keep the business financially healthy.
Many businesses that grow rapidly experi-ence critical (often fatal) cash shortagesbrought about because their collections ofreceivables do not grow as fast as paymentsdemanded by creditors.
Control of cash involves two elements. Thefirst is planning for your cash needs in ad-vance. Bankers are going to look more fav-orably on a request for a line of credit up to
5
12 months prior to your need than such arequest 3 days before you have to meet pay-roll in a given month. The second involvesdeveloping effective controls regarding howto use the cash that flows through your busi-ness. Financial controls must he developedto govern the day-to-day and month-by-month accounting of your funds. An ac-counting system tells you how much moneyyou have available, how much you need topay your bills, and whether there is either adeficit to be made up or a surplus to beinvested.
WHAT ARE SOMEFINANCIAL CONTROLPROCEDURES?
Keeping track of the cash received by yourbusiness requires two things:
Procedures and records that will helpsafeguard the funds
Attention to the details necessary to keepthose procedures working
These controls should be written and eachemployee should he rigorously trained intheir use.
The following guidelines may be helpful asyou assess your situation. Your goal shouldhe to keep good records and to control yourcash.
Handle business cash as though it be-longed to someone else. This is vital tothe success of your business, especiallywhen your cash is limited.
6
Keep personal cash separate from cashgenerated by you business. One way todo this is by paying yourself a weekly ormonthly salary.
Keep a record of all incoming cash. Therecord can he simple, showing (1) theamount of cash, (2) the date received,and (3) the source.
Use a hank account for your businessfunds.
Deposit all cash receipts in your firm'sbank account.
Never make a disbursement out of yourdaily cash receipts.
Deposit each day's cash receipts on adaily basis.
Pay all bills, if possible, with checks.Checks provide a record and serve as acontrol.
Use a petty cash fund if you need to paysome small bills in coin and currency.This fund should he a fixed amount andbalanced regularly. Get a properly sign-ed receipt when making a payment fromthe petty cash fund. Reimburse yourpetty cash fund with a check that notes,for example, "to cover cash used in pay-ing receipts numbered 21, 22, and 23."
Make disbursements only if you have(1) a supplier's invoice or (2) a receiptedpaid-out voucher that is dated and signedby the person to whom you give the
check (or cash if it's a petty cash ex-pense). Keep your records simple. In abusy schedule, you will be more apt torefer to your records if they are easy touse. Regularly have your procedures andcontrols checked by your accountant oran employee to see that they are workingeffectively.
Establish a regular time to review yourfinancial documents, reports, and state-ments. This will be daily for somerecords and weekly or monthly forothers. Develop a checklist of questionsto use as you review each record.
HOW CAN A CASHFLOWPATTERN BE DETERMINED?
Financial control can provide you withimportant information. Your concern iskeeping your business healthy by (1) avoid-ing a "cash-out" situation where you cannotmeet your obligations, (2) obtaining fundswhen there are anticipated cash deficits and(3) managing cash surpluses wisely. Thesedynamic situations change from month tomonth.
Before you can use your cash balances effi-ciently, you must know your firm's cashflowpattern. In addition to the basic questions:How much cash comes into your businesseach month?, How much goes out?, Is thereany left at the end of the month?, and If so,how much?, you need to develop a sensitiv-ity to patterns such as seasonal trends,expense creep, changing collection patterns,unexplained inventory growth, and so forth.
You can get answers to these questions bylooking at present and past records that giveyou "book control" of cash. See what theytell you about your past cashflow pattern.You'll need to use a budgeting techniquethat compares planned with actual levels foreach item. You may want to ask your ac-countant or bookkeeper to work out the de-tails for you and you should have these pro-cedures reviewed by an independent outsideadvisor.
One simple budget technique involves:
(1) adding estimates of income expectedduring the next month to the cash balance atthe beginning of the present month, and(2) subtracting estimates of expenses for thenext month. When this is done for twelvemonths, you know expected cash balancesfor each month.
This information will help you to forecastthe future. Review your cash records forlast year to find, on a monthly basis
the origin of your cash,
where it went, and
how much was left at the end of eachmonth.
Figure 1 describes a typical -example with.the accounting year starting with January.Add the beginning cash balance on hand inJanuary (0) to the following income items:
All payments from customers bothagainst accounts receivable and ascash sales
6
7
Any money received as a loan from abank or other source
Additional capital invested in the
business
All payments received from sale of fixedassets
The January income items amounted to atotal of $44,000.
The next step is to subtract January expenseitems from the $44,000. Subtract the fol-lowing:
All payments made against accountspayable
All expenses paid (not merely accrued)
All cash withdrawals by the owner
All repayment of loans
All payments for fixed assets
Suppose that these expenses totaled $47,956.Thus, your cash balance at the end of lastJanuary was ($3,956) (i.e., $44,000 minus$47,956).
This $3,956 was your negative cash balanceat the start of last February. You need toplan for a target amount that you would liketo have on hand at the end of each month tocover unanticipated changes in your collec-tions or expenses.
'CA
SH B
UD
GE
TN
ovA
ctua
lD
ecA
ctua
lJa
nF-
cast
Feb
F-ca
stM
arF-
cast
Apr
F-ca
stM
ayF-
cast
Jun
F-ca
stJu
lF-
cast
Aug
F-ca
stSe
ptF-
cast
Oct
F-ca
stN
ovF-
cast
Dec
F-ca
st
Sale
s40
,000
48,0
0057
,600
69,1
2082
,944
99,5
3311
9,43
914
3,32
717
1,99
320
6,39
124
7,66
929
7,20
335
6,64
442
7,97
3
Cas
h re
ceip
ts:
30 d
ays
afte
r sa
le (
50%
)24
,000
28,8
0034
,560
41,4
7249
,766
59,7
2071
,664
85,9
9610
3,19
612
3,83
514
8,60
217
8,32
2
60 d
ays
afte
r sa
le (
50%
)20
,000
24,0
0028
,800
34,5
6041
,472
49,7
6659
,720
71,6
6485
,996
103,
196
123,
835
148,
602
Tot
al c
ash
rece
ipts
44,0
0052
,800
63,3
6076
,032
91,2
3810
9,48
613
1,38
315
7,66
018
9,19
222
7,03
027
2,43
632
6,92
4
Cas
h di
sbur
sem
ents
:
Purc
hase
s (6
5%)
37,4
4044
,928
53,9
1464
,696
77,6
3693
,163
111,
795
134,
154
160,
985
193,
182
231,
819
278,
182
Selli
ng a
nd A
dmin
istr
a-
tive
expe
nses
(fi
xed
10,0
0010
,000
10,0
0010
,000
10,0
0010
,000
10,0
0010
,000
10,0
0010
,000
10,0
0010
,000
at S
l',,0
00)
516
505
534
476
457
476
407
374
376
287
230
204
Inte
rest
00
5,00
00
05,
000
00
5,00
00
05,
000
Tax
es0
00
00
00
00
20,0
000
0
00
00
00
00
00
00
Cap
ital e
xpen
ditu
res
Div
iden
ds
Tot
al c
ash
disb
urse
men
ts
47,9
5655
,433
69,4
4875
,172
88,0
9310
8,63
912
2,20
214
4,52
817
6,36
222
3,46
924
2,04
929
3,38
6
Cas
h in
crea
se o
r
(dec
reas
e)
Beg
inni
ng c
ash
bala
nce
lo,O
oo
(3,9
56)
(2,6
33)
(6,0
88)
860
3,14
684
79,
181
13,1
3212
,830
3,56
130
,388
33,5
37
End
ing
cash
bal
ance
(if
no f
inan
cing
)(3
,956
)(2
,633
)'6
,088
)86
03,
146
847
9,18
113
,132
12,8
303,
561
30,3
8833
,537
Des
ired
min
imum
cas
h
leve
l10
,000
10,0
0010
,000
10,0
0010
,000
10,0
0010
,000
10,0
0010
,000
10,0
0010
,000
10,0
00
Shor
t ter
m lo
an
(or
surp
lus
avai
labl
e fo
r
inve
stm
ent)
13,9
5612
,633
16,0
889,
140
6,85
49,
153
819
(3,1
32)
(2,8
30)
6,43
9(2
0,38
8)(2
3,53
7)
Figu
re 7
. Cas
h fo
reca
st
Follow the example to understand the pro-
cess of adding cash income for the next 2months and subtracting cash paid out inorder to get your cash balance at the end of
each month.
Notice the cash deficit that develops inMarch. This is caused by the fact that thiscompany's accounts receivable from creditsales is growing rapidly as sales increase,but the company still must pay for inventoryand selling expenses in the month they are
incurred.
Do the same for each of the 12 months in
that year. In addition, fill in your ownestimate of a desirable cash balance and any
short-term loans needed to maintain thisbalance. Do you anticipate having any funds
to invest?
As a final step, (1) underestimate cashreceipts by 5 percent and (2) overestimatecash payments by 5 percent. This provides
a 10 percent margin for unforeseen deficits.
WHAT ARE TROUBLESIGNS IN FINANCIALMANAGEMENT?
Determining last year's cash balances bymonths should give you an idea of the cashflow pattern for your business. However,before trying to predict your cash balancesfor each month of next year, look again at
your records.
This review is to check for trouble spots in
last year's operation. For example, werethere months when-
19
9
expenses were greater than the grossprofits you made from sales?
cash was inadequate at the start of the
month?
the business overexpanded without new
capital being made available?
excessively high accounts receivable
were not discounted at the bank?
cash was reduced below an adequate
balance because you had to buy fixedassetssuch as new equipmentthat arerecoverable only through depreciation?
Some of these conditions can be caused by
seasonal fluctuations. One way to avoidthem is through short-term borrowing. It is
crucial to discuss your anticipated cashneeds with your banker as you develop and/
or revise your annual financial plan.
HOW CAN LONG-RANGEFINANCIAL NEEDS BEMANAGED?
Before you start to plan how you will
improve your control of future cash, taketime to list the long-range needs of yourfirm. List items such as
equipment, tools, and other fixed ordepreciating assets that will need to be
replaced,
10
additional equipment or other fixedassets that you may need in order tocompete successfully,
remodeling or expansion of your facili-ties thy. .ay be needed to increase sales,and
increased working capital nGeds broughtabout by planned growth and the need tofinance inventory and related costs.
You need to have an idea of these long-range requirements so you can provide forthem without depleting your cash. Some re-tailers fail, for example, to depreciate theirfixed assets and set up financial reserves fortheir replacement. Thus, they must use theircash balancesfunds for paying the firm'sday-to-day billsto pay for the replacementof worn-out equipment.
Such a situation can be avoided by plan-ningthat is, by trying to chart the courseof the business for the next 1-5 years. Inaddition to budgeting for the short-rangeneeds, as will be discussed in the nextsection, you should plan tentative forhandling your firm's long-range needs.
WHAT IS AN OWNER'SFINANCIAL STATEMENT?
An important financial statement related tocashflow and financial management ischange in the owner's equity schedule. Thechange in the owner's equity statementreflects those items that change the owner'snet worth (the amount of capital or funds
invested by the owner of the business). Itincludes the owner's withdrawal (salary).
Other adjustments indicated on this financialstatement are additional investments by theowner of the business or possibly an adjust-ment for the depreciation value of equipmentand building. It is important to rememberthat additional capital may be needed tokeep the business in operation. Thesechanges will be reflected in the change inowner's equity financial statements. Theyshould also be considered as an integral partof the firm's operating records.
HOW ARE FINANCIALSTATEMENTS ANALYZED?
Vatic, is financial reports can be helpful infinancki management. The principal onesare the balance sheet, income statement, andcashflow statement. They are the basis forfinancial analyses of your firm. Financialstatement analysis is a control method inwhich information from both the balancesheet and income statements are examinedand relationships among items are estab-lished and compared.
Information from current and projectedstatements can he analyzed in the same way.These comparative measures (stated asratios) answer questions such as Can thebusiness pay its bills on time?, and Is themoney invested in the firm bringing you asmuch profit as alternative investments could?Careful financial analyses not only help youin assessing the firm's financial condition,but also help you in making sound manage-ment decisions.
As you continue working with financialinformation in this unit, keep in mind thefact that today many small business ownersuse microcomputers to help them manage fi-nances. A section on microcomputers inbusiness is included at the end of this unitand each of the worksheets presented in yourcase study are available from your instructorin the form of "electronic" spreadsheets aswell.
WHAT ARE OPERATINGEXPENSE RATIOS?
An operating expense ratio helps businessowners gain valuable management informa-tion by dividing each operating expenseseparately, such as s2laries or wages, by netsales. From the resulting information, own-ers can evaluate the relationship of variousexpenses to net sales. Trends of specificexpenses to net sales can be analyzed in
terms of monthly or seasonal changes.
Another name for this technique is the Com-mon Size Statement, examples of which areprovided in Figures 2 and 3. Note that fora balance sheet, the common size line itemsfor each asset and liability are divided by thetotal assets.
OperatingExpense Ratio
= Any Operating ExpenseNet Sales
Figure 2. Operating expense ratio formula
11
WHAT IS ANINVENTORY RATIO?
The inventory ratio compares costs of goodssold to average inventory. The average in-ventory is the amount of inventory a busi-ness normally has in stock at a certain time.It is often computed by averaging the begin-ning and ending inventory (see Figure 5).An inventory turn is how many times the av-erage inventory on hand is sold in a givenperiod of time. This ratio indicates how fastmerchandise is being sold. The formulashowing inventory turnover is:
Average=Inventory
Beginning inventory + Ending inventory2
Figure 5. Average inventory formula
InventocyTurnover
Total RevenueAverage Inventory
Figure 6. Inventory turnover formula
A study of turnover rates in similar business-es will help you determine the appropriaterate for your business. Usually, a fairly highratio indicates that your inventory is currentand saleable and that your firm has goodpricing policies. An extremely high ratiomay indicate that your inventory turns overtoo oftenthis may lead to shortages andcustomer dissatisfaction. Note that inventoryturnover is sometimes calculated as cost ofgoods sold divided by average inventory.
1
12
Jones Gift ShopProjected Balance Sheet(In thousands as of ...)
ASSETSYear I Opening
Common Size DayEnd ofYear 1
End ofYear 2
End ofYear 3
Cash 16.53 3,000 2,000 2,000 4,900Inventory 41.32 4,000 5,000 6,000 7,000Accounts Receivable 21.49 0 2,600 2,900 3,000
Total Current Assets 79.34 7,000 9,600 10,900 14,900
Equipment 12.40 2,000 1,500 1,000 500Building 0.00Other (Franchise Fee) 8.26 1,000 1,000 1,000 1,000
Total Fixed and Other 20.66 3,000 2,500 2,000 1,500
Total Assets 100.00 10,000 12,100 12,900 16,400
LIABILITIES
Accounts Payable 30.58 3,000 3,700 4,000 4,500Other Debts Due within
1 year 0.00 0 0 0 0
Total Current Liabilities 30.58 3,000 3,700 4,000 4,500
Long-Term Debt 0.00 0 0 0 0Notes Payable to Others 4.13 1,000 500 0 0
Total Long-Term Debt 4.13 1,000 500 0 0
Total Liabilities 34.71 4,000 4,200 4,000 4,500
Owner's Equity 57.02 6,000 6,900 8,900 11,900
Total Liabilities &Owners Equity 91.74 10,000 11,100 12,900 16,400
RATIOS Industry Average ActualCurrent Ratio 2.59 2.72 3.31Acid-Test Ratio 1.24 1.22 1.75Debt to Tangible Net Worth 0.71 0.51 0.41
Figure Balance sheet and common-sizing
13
Jones Gift ShopProjected Income Statement
(In thousands for the period . . .)
CommonSize First Year Second Year Third Year
Gross Sales 107.14 22,500 30,000 34,000
Less: Returns-Allowances 7.14 1,500 2,000 2,500
Net Sales 100.00 21,000 28,000 31,500
Cost of Goods SoldBeginning Inventory 19.05 4,000 5,000 6,000
Plus Purchases-Freight 47.62 10,000 14,000 16,000
Minus Ending Inventory 23.81 5,000 6,000 7,000
Total Cost of Goods Sold 42.86 9,000 13,000 15,000
GROSS PROFIT 57.14 12,000 15,000 16,500
EXPENSES
Selling Expenses:Sales Force Payroll 11.90 2,500 . 3,500 4,000
Commissions 0.0 0 500 750
Advertising 14.29 3,000 2,500 2,000
Operating Expenses:Utilities 4.29 900 1,400 1,650
Rent 17.14 3,600 4,000 4,250
Other 2.86 600 600 600
Total Expenses 50.48 10,600 12,500 13,250
NET PROFIT BEFORE TAXES 6.67 1,400 2,500 3,250
Income Taxes 0.00 0 0 250
6.67 1,400 2,500 3,000NET PROFIT Al- lER TAXES
RATIOS IndustryAverage
Inventory TurnoverReturn on Investment 5.00 5.45 5.23
0.20 0.28 0.25
Figure 4. Income statement and common-sizing
14
WHY ARE FINANCIALRATIOS USEFUL?
Financial ratios make it possible for you tocompare your firm's performance with theaverage performance of similar businesses aswell as your own performance trends overtime. However, there are certain things youshould rememter
All businesses are not exactly compar-able. There are different ways of com-puting and recording financial data onfinancial statements. Therefore, theremay not be exact points of comparison;that is, figures for you business may notexactly compare to those for a businesswhose figures are computed or recordedin a different manner.
Ratios are computed for specific dates.Unless your financial statements are pre-pared .often, the most recent data foryour firm may be wasted by not beingused for ratio analysis.
Financial statements show what has hap-pened in the past. One of the best usesof a ratio is to give you clues aboutfuture problems and opportunities. Sinceratios are based on past performance,you will need your management skills topredict the future.
WHAT ARE THE KEYBUSINESS RATIOS?
A number of ratios are compiled for thevarious types of industry and size categoriesfor businesses and are readily avdlable atpublic libraries. Sources include Dun and
Bradstreet and Robert Morris Statementstudies. Ratios are usually divided intocategories to facilitate analysis, (e.g.,solvency, efficiency, and profitability).
Several "key" business ratios discussedbelow include the following:
Liquidity
Current ratio
Acid-test ratio
Solvency
Total liabilities to tangible net worth
Efficiency Funds Management
Inventory ratio
Sales to working capital
Profitability
Return on sales
Return on investment
WHAT IS THECURRENT RATIO?
The current ratio is one of the most com-monly used measures of a firm's financialstrength. The question it answers is Doesyour firm have enough current assets to meetits current debts with a margin of safety for
15
possible losses (such as inventory pilferage spreadsheet to predict its impact on youror uncollectible accounts)? operations and performance.
The current ratio is current assets divided bycurrent liabilities. The ratio should be atleast two to one, assets to liabilities. Thisgives an ample margin for eventual paymentof current debts. Compute the current ratioby using this formula:
Current Ratio Current AssetsCurrent Liabilities
and is expressed as "times"
Figure 7. Current ratio formula
There is a difference between current ratioand working capital. Working capital repre-sents the amount of current assets minus theamount of current liabilities; in other words,the cash that is available for discretionaryuse. When computing working capital, re-member that your inventory may he highlyseasonal, thus making it easy to overstateyour working capital. Usually your liabili-ties are items due within 1 year. Paymentcannot be postponed. It is your current as-sets that are subject to analysis. Examinethem carefully before computing the finalfigure.
If a substantial amount of your working cap-ital is tied up in accounts receivable, youmay want to consider accepting national andbank credit card purchases if you are notdoing so. This would partially reduce youraccounts receivable. However, there isusually a 3 to 5 percent charge when youuse a national bank credit card systems.
This type of policy change on your part iseasily incorporated into an computerized
WHAT IS AN ACID-TEST RATIO?
A more accurate ratio to measure the debt-paying ability of a business is the acid-testratio. The acid-test ratio (quick ratio) usesonly cash, accounts receivable, and "near"cash marketable securities as current assets.In other words, inventory has been removedfrom the current assets and the ratio calcu-lated is the adjusted current ratio. This ratioshould be one to one or better. When abusiness has 1.0 or higher acid-test ratio it issaid to be "liquid" (this is a liquiditymeasure).
The acid-test ratio is computed using thisformula:
Acid-TestRatio
(Cash + Receivables += Government Securities)
Current Liabilities
and is expressed as "times"
Figure 8. Acid-test ratio formula
This ratio will show if you have enough incash and accounts receivable to pay all yourcurrent liabilities at any one time. Itanswers the question If all cash income fromsales were to stop, could the firm meet itscurrent debts with readily available funds?
16
WHAT IS A DEBT -TO-TANGIBLE- NET -WORTHRATIO?
The debt-to-tangible-net-worth ratio is a
measure of the business's solvency. Sol-vency describes the firm's ability to meet itsdebt obligations. In fact, the debt-to-tangible-net-worth ratio shows the relation-ship between borrowed funds and fundsowned by the entrepreneur. Debt, of course,means all debts, current and long-term.Tangible net worth is the worth of a busi-ness minus any intangible assets such asgoodwill, trademarks, patents, copyrights, orfranchise fees that have an indeterminablevalue. Goodwill, for example, i3 the valueof earning power acquired over a period oftime. For a new business, its value is espe-cially vague; it should not be included in aratio that compares what the firm owes towhat it owns.
If the ratio of debt to tangible net worth isgreater than one to one, then the business isundercapitalized. Debt should be reduced oradditional capital should be invested. Alender, such as a bank, will usually think itunwise to lend money to a firm whose debtexceeds the net worth.
To determine the debt-to-tangible-net-worthratio, use this formula:
Debt-to-Tangible-Net-Worth
= LiabilitiesTangible Net Worth
and is expressed in terms of percent (%)
Figure 9. Debt-to-tangible-net-worth formula
WHAT IS A NET-SALES-TO-WORKING-CAPITALRATIO?
A net-sales-to-working-capital ratio showshow many dollars of sales the businessmakes for every dollar in workiN, capitalowned. A low ratio may indicate that work-ing capital is not being used efficiently togenerate sales. On the other hand, an ex-tremely high ratio may signal that workingcapital is not sufficient for maintaining highsales volume. This ratio is subject to sea-sonal sales changes; evaluate it accordingly.Comparisons of similar sales periods in pastyears are helpful in analyzing this ratio.
To determine the net-sales-to-working-capitalratio, use this formula:
Net-Sales- =to- Working-Capital
Net SalesCurrent Assets - Current Liabilities
(Working Capital)
and is expresses as "time's'
Figure 10. Net-sales-to-working-capital formula
WHAT IS A NET-INCOME-TO-NET-SALES RATIO?
A measure of profitability, a net-income-to-net-sales ratio, shows how much net income,or net profit, comes from every dollar of netsales. It indicates the operating efficiency ofthe business. This ratio can signalincreasing expenses; thus it should bereviewed frequently. It is perhaps the mostimportant ratio for a new business owner toconsider.
To determine the net-income-to-net-salesratio, use the following formula:
Net-Income-to-Net-Sales
= Net IncomeNet Sales
and is expressed as percent (%)
Figure 11. Net-income-to-net-sales formula
WHAT ARE COMPONENTSOF THE BREAK-EVENANALYSIS?
Break-even analysis describes the level ofsales where total costs equal total revenue.The first two items to be calculated are thefixed and variable costs. Fixed costs do notvary with the level of business activity (overthe short run). Examples include administra-tive salaries, property insurance, depreciationof equipment, and rent.
Variable costs vary directly with the volumeof activity. Direct labor and materials areexamples. They double if production dou-bles, and drop to zero if production is zero.
Semivariable costs change with the level ofbusiness activity, but not in direct propor-tion. Office equipment or supervisors' sala-ries might be examples of semivariablecosts. Such costs are usually about the sameregardless of the level of output.
17
HOW IS A BREAK-EVENPOINT COMPUTED?
Computing the break-even point is onetechnique to determine when your businessbegins to make a profit. The break-evenpoint tells how much business a firm needsto break even, that is, to operate with neithera profit nor a loss.
To find the break-even point, first determinethe fixed costs and variable costs. Oncethese have been calculated, the followingformula can be used to find the break-evenpoint or volume of business:
The difference between selling price per unitand variable cost per unit is known as theunit contribution margin.
Break -EvenPoint
Total Fixed CostSelling Price - Variable Cost
(Per Unit)
Figure 12. Break-even point formula
For example, assume that your total fixedcosts are $15,000. You are selling a productfor $100 a unit. The variable cost per unitis $25. In order to break even, you need tosell 200 units.
Break-Even = $15,000 = 200 UnitsPoint $100 $25
Figure 13. Break-even point computation
The break-even point in terms of total salesis found by multiplying 200 by the salesprice per unit.
18
Thus, if you sell less than 200 units at thesecosts, you will have a loss. Of course, youwill want to do better than break even. Ifyou want to make a profit, you will have tosell more than 200 units at these costs.
WHAT INFORMATION ISOBTAINED FROM BREAK-EVEN ANALYSIS?
Break-even analysis helps compare cost toprofits at different volumes of sales. Youcan use break-even analysis to see how prof-itable different items are in a line of pro-ducts that you sell. It can answer such ques-tions as Which items are most profitable?,Which are least profitable?, Have any itemspassed their popularity peaks (shown de-creasing profits)?, and How many units of anew product must be sold before it begins tobring in a profit?
A break-even chart shows visually the rela-tionship of costs to profits at different salesvolumes. Figure 14 is a break-even chartshowing the break-even point and also theprofits and losses for other volumes of sales.It is plotted for a manufacturing companywith these costs for one of its products:
Total fixed costs = $100,000
Variable costs = $50 per unit
Selling price = $100 per unit
Figure 2 showed that profits depend on thenumber of units sold only when the priceand cost patterns do not change. Each of thefactors that affect profit can be varied. If
you reduce fixed costs, you would be able tolower the break-even point. If you couldreduce variable costs, this would cause thetotal cost line to rise rapidly. You couldalso raise or lower prices. An increase inprice would lower the break-even point. Aninventor once said that if he could only sellone of his inventions for $500,000, he wouldmake a tidy profit.
HOW CAN COMPUTERAPPLICATIONS ASSISTIN FINANCIAL ANALYSISAND MANAGEMENT?
Modern computer-based accounting pack-ages have the capability to automaticallyproduce all the required ratio or commonsize statements useful for analysis. It alsoautomates several common managementchores such as accounts receivable, accountspayable, and inventory management. Inaddition, these systems can output data inthe forms required by the common financialspreadsheet programs for further analysis.
Financial spreadsheets allow you to preparemany different versions of your forecasts tosuit different initial conditions or changes inyour business environment. These programsare fairly elementary to use because they usethe traditional rows and columns format de-veloped to record and analyze accountinginformation.
A wide variety of computer software hasbeen designed specifically to assist you incarrying out the types of financial analysisdescribed in this unit. Once you havecomputerized your financial record keepingsystems by installing a computer based
Pa.tiv.$
20
accounting system, you will find it especiallyuseful to take the additional steps needed toanalyze and control your finances via thisadditional software.
Programs of this type are essentially elec-tronic versions of the traditional accoun-tants paper rows-and-columns spreadsheets.These rows and columns are displayed onthe computer viewing screen. You may in-sert any type of business data as well as for-mulas that relate these data items to oneanother into specific locations in the workarea.
For example, when transferring a profit andloss statement into a computer version, youwould record the income and expense itemsdirectly into the spreadsheet as written, whiletotals and subtotals would he entered as for-mulas instructing the computer to sum upspecified areas of the worksheet. When youchange a data item such as salary expense,all other totals and ratios that depend on thevalue of that item will automatically changeas well.
This fact gives you the opportunity to exam-ine many alternative scenarios in sales, oper-ating costs, accounts receivable collectionrates, interest rates, and so forth.
A basic example of how such software canhe used to record and analyze financial datais illustrated as follows:
Alice sells apple pies from her kitchen. Shesells them mostly to restaurants that buythem by the dozens each week. Alice wantsto forecast sales under a variety of circum-stances for the next few months.
To start, she enters some basic informationabout her pie-making businessessentially,
an income statement for 1 month. Sheknows that in a typical month she sells 650pies at an average price of $5 per pie. Shethen details on the computer the costs ofdoing business: flour, sugar, apples, butter;her two part-time assistants, who earn $3 anhour each; her delivery costs, and the adsshe places in several trade journals. On thebottom line is her net profit of $1.90 per pie.or $1,235 for the month.
So far, it has taken Alice about 5 minutes toplug in the various components and to de-scribe the formula for calculating net profit:the variables (the pie ingredients and deliv-ery costs), which change with the number ofpies sold, and the constants (the ads and herstaff), which she must pay whether or notshe sells any pies. In business, however,nothing is certain; prices fluctuate and busi-ness gets better or worse. For Alice, what ifa bad apple harvest raises the price of herfruit by 60 percent? What if the number ofpies sold were to double, but her staff weregiven raises to $3.75 an hour? What ifadvertising rate increased and the bottomdropped out of the apple-pie market?
To answer such "what if" questions, Alicemerely changes the related piece of datathe price of apples, for example, or thenumber of pies sold. In seconds, thesoftware program recalculates all the costsand computes a new net profit.
Whereas, none of this may seem revolution-ary for calculating a month's worth of applepies, but consider other "what if" scenariosfacing the typical modern business. Theapple-pie example included a dozen vari-ables and a half-dozen assumptions. Thebeauty of the spreadsheet program is that itcan work with dozens of variables and hun-dreds of assumptions. The results include a
10-year income-and-cashflow statement fora proposed shopping mall; a 3-year profitand loss statement for a retail store sellinghundreds of items; a cost-efficiency study ofa ten-person firm, or just about any otherprojections or analyses that you can dreamup.
One of the great productivity gains you canmake is to ensure that your data from othercomputerized components of your businesscan be directly captured by your "spread-sheet" program without having to re-enterthe data by hand. Many software packagesare equipped with several "templates" thatcontain predeveloped worksheets and formu-las to cut the training time and labor neces-sary to fully utilize the program in financialanalysis.
Other types of computer programs are avail-able for financial analysis and management.Programs pertaining to productivity, payroll,investments, inventory control, ratio analysis,and so forth, may be obtained from commer-cial sources. A potential user of such pro-grams should contact a reputable computersupplier; review computer periodicals andtexts; or consult with business owners usingcomputers in similar businesses.
There are four cost areas that you shouldconsider when planning the conversion to acomputerized operation:
1. Hardware includes the computer, videomonitors, printers, electronic cash-registers, bar-code scanners, etc.
2. Software includes general purpose pro-grams such as electronic spreadsheet,word processing, database management,and specialized programs that you pur-chase to perform one function for your
21
business such as general ledger, accountsreceivable, payroll. Software costs caneasily equal your hardware costs for thefirst year for a basic system includingword processing, spreadsheet, accountingpackage, inventory management, and costestimation.
3. The training and "downtime" required tolearn new skills required to operate theautomated systems. Plan to spend atleast as much as your software costs totrain your staff fully.
4. Costs associated with integrating thevarious separate hardware and softwareelements into a working system, custom-izing general purpose software to yourspecific needs should also be considered.Unless you are extremely skilled in thecomputer programming area, this willprobably be your biggest first year costarea.
The real cost savings in computer operationsoften occur when you find ways to speed upand improve such operational aspects ofyour business as customer service, produc-tion, and quality as well as to obtain theadditional financial analysis power.
22
ACTIVITIES
The following activities are designed to helpyou apply what you have learned in thisunit.
INDIVIDUAL ACTIVITY
The following cost structure of the "JohnsonBusiness" was obtained from last year'sprofit-and-loss statement:
Selling Price = $100 per unitVariable Costs = $60 per unit
SalesFixed CostsVariable CostsProfit
Using a piece of graph paper:
$100,000$ 20,000$ 60,000$ 20,000
(a) plot (and identify) the sales line.(b) plot (and identify) the "total cost" line.
By inspection of the break-even chart, andby calculation determine:
(c) Variable cost per dollarof sales:
(d) Break-even point (units): $(e) Profit (or loss) at $50,000
sales volume:(f) Profit at $80,000 sales
volume:Profit at $100,000 salesvolume:
(h) Pa, at $120,000 salesvolume:
(g)
GROUP ACTIVITIES
A.
In teams of four to six, prepare a list ofcommonly used business ratios. Ask yourinstructor to help you identify a successfulbusiness manager or accountant in yourcommunity who uses ratios. Interview thisperson to obtain information about whichratios are used. Also ask him or her thesequestions: What data is required to computethe ratios?, How are the ratios used in ana-lyzing the business operations?, What busi-ness planning or follow-up activities takeplace in the business as the result of ratioanalysis?, and Are such ratios prepared withcomputer assistance? Report on your find-ings to the rest of your class.
B.
Continue working in groups. Secure finan-cial statements from a local small business.Compute liquidity, solvency, funds manage-ment, and profitability ratios. Search indus-try average ratios at your local library andcompare your financial analysis against aver-age ratios. Assess the performance pictureof the business.
CASE STUDY
Read and analyze the following case study.On a separate piece of paper, number from1 to 6. Write each ratio on this paper as itis com7uted. Betty Jones is opening "JonesGift Shop." The shop, located in a NewJersey resort town, is a seasonal businessopen only in the summer. The store site isrented. Betty selected the site herself. Shethen became a part of a national franchiseorganization by paying the one-time mem-bership fee of $1,000 plus yearly dues of$100. The organization provides advertisingand other management assistance services.
Betty began her business venture with$10,000. She made several trips to see afriend experienced in business. On her firsttrip she presents her friend with the follow-ing information.
I. Owner's cash investment2. Credit from suppliers3. Note (payable to an individual
or to a bank)TOTAL
$ 6,0(X)$ 3,000
$ 1,000$10,000
Pretend that you are this friend, and that youmust compute the necessary ratios for Betty.Refer to the text of this unit for the ratiosyou need. Using this information, you de-velop the projected balance sheet as shownin Figure 2, which indicates that only $4,000of the original $10,000 is to go for inven-tory. The remaining $6,000 is earmarked forworking capital, equipment, and the fran-chise fee.
During this first meeting, Betty begins tothin picture of the shop as of a specific date.Before she leaves, you construct ratios basedon the opening day's figures. The currentratio is greater than two to one (which is the
3 4
23
commonly accepted minimum). You com-pute this ratio to be
The acid-test ratio, a ratio that reflects Jones'ability to pay current debts, is a favorableone . You also calculate a debt-to-tangible-net-worth ratio by measuring the$4,000 debt against a tangible net worth of$5,000 ($6,000 minus the $1,000 franchisefee). After allowing for intangible assets,you come up with a ratio. This,too, is a favorable ratio. It indicates thatJones has more invested in her business thanher creditors do.
During this first meeting, you also discussthe income Betty hopes to earn. Betty rec-ognizes the importance of establishing finan-cial goals. "To do this we should prepare aprofit and loss statement for the shop," youadvise. You explain that a projected profitand loss statement also does the following:
Sets goals and timetables for reachinggoals
Describes anticipated trends in profits orinventory turnover
Relates the profits of the business to theinvestment in the business
Becomes a base or benchmark which,when compared to actual figures, can beused to adjust projections
You complete the 3-year profit and loss pro-jection for the gift shop as shown in Figure3. Yor meet with Betty again and you dis-cuss the projection, referring at times to theprojected balance sheet (Figure 2) developedduring the first meeting.
You compute the current ratio at the end ofthe second year to he . The
24
quick ratio or ability to pay all current debtshas changed to, and the debt to net worthratio has moved to . Profits arebeing invested in inventory and the marginor average markup has continued to averageover 50 percent.
At the end of the third year, the businessappears to be prospering. The owner's origi-nal investment has now increased to $11,900from $6,000. This reflects the profits from3 years of operation. In Figure 3 note thatfirst-year sales are estimated to he $22,500,which increased to $30,000 in the secondyear and $34,000 in the third year. Thisprojected income statement is very impor-tant, because it serves as a plan againstwhich actual income and expenses can becompared.
Since the gift store business has a relativelyhigh markup (over 50 percent), it will prob-ably have a low inventory turnover rate.High-markup businesses are usually charac-terized by low turnover of inventory, as thehigher-priced merchandise usually sells at alow rate. Average inventory turnover iscomputed by using this formula:
Gross Sales $22,500Average Inventory $4,000 + $5,000/2
Since the average inventory for the year is$4,500, based on annual sales of $22,500,
DISCUSSION QUESTION
the inventory is turning over or being re-placed on the average of onlytimes a year. You prepared this projectionknowing that most businesses characterizedby low inventory turnover are often plaguedby inventory obsolescence due to style orfad changes. Since the business is a giftstore, you advise Betty to keep this in mindwhen planning inventory. "Stock thoseitems that may decline in value below thecost paid for them at a minimum. Since oneof your objectives in financial planning iscontrol over the amount of debt and its rela-tionship with the total assets of the busi-ness," you advise, "the importance of arriv-ing at both the current ratio and debt-to-net-worth ratios quickly cannot be under-emphasized."
Figure 2 showed that at the end of the sec-ond year the business had expanded some-what, since assets now total $12,900. Thecurrent ratio has improved because first-yearprofits of $1,400 have been put back into thebusiness.
Betty computes her net profit after taxes asa percentage of equity. By doing this, shelearns how much her investment is making.She decides that if this rate of return everdrops to a point where she questions herreasons for being in her business, she willask you to help her do another analysis ofthe profit and loss items.
Complete the ratios for the second and third years of Betty's business and compare them to pub-lished ratios for small gift shops found in Dun and Bradstreet or the Robert Morris statementstudies. What suggestions would you make based upon these findings?
25
ASSESSMENT
Read the following questions to check your knowledge of the topics presented in this unit.When you feel prepared, ask your instructor to assess your competency on them.
I. List the key responsibilities of the entrepreneur in financial management and defend yourselection of the most critical responsibility.
2. Identify which advisors you would select prior to opening your business and which you mightadd by the third year of operations.
3. Explain what can happen if cashflow is not managed properly.
4. Identify several financial control procedures that any business should employ.
5. Describe what patterns you would look for in a monthly cashflow statement extending overa year's operations?
6. Identify and describe several "trouble" spots in financial management that most business own-ers face.
7. Describe how to prepare an owner's equity financial statement.
8. Explain the utility of common financial management ratios applicable to a small business.
9. Describe how you would compute a break-even point from the information provided in anincome statement.
REFERENCES
Anthony, Robert N., and Reece, James S. Accounting: Text and Cases, 8th ed. Homewood, IL:Irwin, 1989.
Bow lin, 0. D., et al. Guide to Financial Analysis. New York, NY: McGraw-Hill BookCompany, 1980.
Business Financing. Small Business Reporter Series. San Francisco, CA: Bank of America,1988.
Siegal, J. G., and Shim, J. K. Acco-unting Handbook. New York, NY: Barron's EducationalSeries, Inc., 1987.
Tracy, John A. How to Read a Financial Report, 3rd ed. New York, NY: John Wiley & Sons,1989.
U.S. Small Business Administration'. Employees: How to Find and Pay Them. ManagementAid No. MA 5.002. Washington, DC: U.S Government Printing Office, 1988.
U. S. Small Business Administration. Simple Break-Even Analysis for Small Stores. FinancialManagement Publication FM11. Washington, DC: U.S. Government Printing Office,1988.
U.S. Small Business Administration. Understanding Cashflow. Financial ManagementPublication FM4. Washington, DC: U.S. Government Printing Office, 1988.
Level 3
PACE
Unit 1. Your Potential as An Entrepreneur
Unit 2. The Nature of the Small Business
Unit 3. Business Opportunities
Unit 4. Global Markets
Unit 5. The Business Plan
Unit 6. Help for the Entrepreneur
Unit 7. Types of Ownership
Unit 8. Marketing Analysis
Unit 9. Location
Unit 10. Pricing Strategy
Unit 11. Financing the Business
Unit 12. Legal Issues
Unit 13. Business Management
Unit 14. Human Resources
Unit 15. Promotion
Unit 16. Selling
Unit 17. Record Keeping
Unit 18. Financial Analysis
Unit 19. Customer Credit
Unit 20. Risk Management
E4> Unit 21. Operations
Resource Guide
Instructor's Guide
Units on the above entrepreneurship topics are available at the following levels:
Level 1 helps you understand the creation and operation of a businessLevel 2 prepares you to plan for a business in your futureLevel 3 guides you in starting and managing your own business
