DOCUMENT RESUME

ED 373 234 CE 067 068

TITLE Financial Analysis. Unit 18. Level 2. InstructorGuide. PACE: Program for Acquiring Competence inEntrepreneurship. Third Edition. Research &Development Series No. 302-18.

INSTITUTION Ohio State Univ., Columbus. Center on Education andTraining for Employment.

PUB DATE 94NOTE 35p.; For the complete set, i.e., 21 units, each done

at three levels, see CE 067 029-092. 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.RD302-18 IG, instructor guide $4.50; RD302-18 M,student module, $3; student module sets, level1--RD301M, level 2--RD302M, level 3--RD303M, $45each; instructor guide sets, level 1--RD301G, level2--RD302G, level 3--RD303G, $75 each; 3 levels andresource guide, RD300G, $175).

PUB TYPE Guides Classroom Use Teaching Guides (ForTeacher) (052) Guides Classroom UseInstructional Materials (For Learner) (051)

EDRS PRICE MF01/PCO2 Plus Postage.DESCRIPTORS *Accounting; Behavioral Objectives; *Business

Education; *Competency Based Education; ComputerOriented Programs; Decision Making;*Entrepreneurship; Learning Activities; MoneyManagement; Postsecondary Education; SecondaryEducation; *Small BuSinesses; Spreadsheets; StudentEvaluation; 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 th ..t are incorporated into this moduleare at Level 2 of learning--planning for a business in one's future.Included in the instructor's guide are the following: unitobjectives, guidelines for using PACE, lists of teaching suggestionsfor each unit objective/subobjective, modal assessment responses, andoverview of the three levels of the PACE program. The followingmaterials are contained in the student's guide: activities to becompletes:1).m preparation for the unit, unit objectives, studentreading materials, individual and group learning activities, case.,study, discussion questions, assessment questions, and references_Among the,topics discussed in the unit are the following: theentrepreneur's role in managing finances; balance sheet components '4: --(assets,'Iiabilities, and net worth); income statements and their ;

components; variations in income statements across businesses;methods of accounting for depreciation (straight-line, decliningbalance, and sum-of-the-year-digits depreciation); the purposes and.

--`preparati-O-ri7Of cash forecasts; break-even analysis; and roles of

advisers and computers in financial analysis decisions. Tenfigures/sample forms are included. (MN)

Objectives:

Discuss the role of the entrepreneur in managingfinances.

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 decisions.

Discuss the use of computers in financial analysis.U S DEPARTMENT OF EDUCATION PERMISSION TO REPRODUCE THIS

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TO THE EDUCATIONAL RESOURCEL',INFORMATION CENTER IERICI"

INSTRUCTOR GUIDE

Unit 18

Financial AnalysisLevel 2

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 assistance in focusingyour teaching delivery. 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 feel 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.

2BEST COPY AVAILABLE

Objectives Teaching Suggestions

1. DISCUSS THE ROLE OFTHE ENTREPRENEUR INMANAGING FINANCES

What is the entrepreneur's role inmanaging the finances?

2. EXPLAIN HOW TO PREPARE ABALANCE SHEET

What are the components of thebalance sheet?

What are assets?

What are liabilities?

What is net worth?

3. EXPLAIN HOW TO PREPAREAN INCOME, STATEMENT

What is an income statement?

Ask students to offer their understanding of the entrepreneur'srole in monitoring and managing business finances. Use achalkboard of an overhead to create a list with the issues raisedby your students. Complete this list with additional financialmanagement functions not mentioned by students.

Ask students to list the three main components of the balancesheet (i.e., assets, liabilities, and owner's equity) and explain thefundamental accounting equality underlying this statement (i.e.,Assets = Liabilities + Owner's Equity). Highlight the fact thatthe balance sheet is a "snapshot in time" of the company's per-formance. Use Figure 1 in this level to explain the meaning ofthe words "as of date."

Ask students to define the concept of assets in their own words.Classify assets in current and fixed, tangible and intangible, andother assets. Ask students to give examples of each category.Discuss the concept of goodwill and give examples.

Ask students to define the concept of liabilities and classify lia-bilities in current and long-term. Help students to provide exam-ples for each type of liability. Encourage students to use notecards to record definitions of newly introduced concepts.

Define the concept of net worth and show its importance to theentrepreneur. Highlight the double function of net worth (i.e.,(1) to show the business's performance in terms of return on in-vestment, and (2) to provide a "cushion" to investors for possiblelosses).

Use the income statement provided in the text to assist studentsin defining the concept of profit and loss statement. Emphasizethe difference between income statement and balance sheet. Ex-plain the meaning of the words "Income Statement for the period. . ." and "Balance Sheet as of date . . ."

3

Objectives

What are the components of an in-come statement?

How do income statements varyacross types of businesses?

What are some methods of ac-counting for depreciation?

How is straight-tine depreciationcomputed?

How is declining-balance deprecia-tion computed?

How is the sum-of-the-year-digitdepreciation computed?

4. EXPLAIN HOW TO DEVELOPA CASHFLOW PROJECTION

Why is a cash forecast necessary?

How is a cash forecast prepared?

Teaching Suggestions

Ask students to explain in their own words the mechanics ofdeveloping an income statement. Define the concepts of salesrevenue, cost of goods sold, net sales, gross billings, gross profitor gross margin, selling and operating expenses, depreciation,etc. Encourage students to use note cards to record thesedefinitions.

Explain the difference between accounting for cost of goods soldin retailing and manufacturing. Use an overhead or chalkboardto list additional costs that are included in the 'cost of goodssold' account for manufacturing businesses.

Invite an accountant to speak about various methods to accountfor depreciation. Ask the speaker to define the concept of depre-ciation followed by a brief outline of the three depreciationmethods (straight line, declining balance, and sum of the yeardigits). Also, ask the speaker to explain the double entry (debit-credit) system and how this system is translated in terms of de-preciation (depreciation expense and allowance for depreciationaccounts).

Refer to the above suggestion. Suggest the accountant explainthe straight-line depreciation formula and give an example.

Refer to the above suggestion. Ask the speaker to explain thetax regulations related to this depreciation method (i.e., salvagevalue is considered to have zero value).

Refer to the above suggestion. Ask the accountant to speakabout permissible changes in depreciation methods (i.e., theInternal Revenue Service (IRS) allows changes from double-declining depreciation method to straight-line method at all

times, but any other change requires permission from the IRS).

Explain how cashflow statements are developed. Define and ex-plain the concept of working capital. Assess the importance ofcash, accounts receivable, inventory, and accounts payable inconstructing accurate cash forecasts.

Use the cashflow forecast presented in this level to explain howcash projections should be made. Focus on assumptions under-lying these projections.

4

Objectives Teaching Suggestions

5. EXPLAIN HOW TODETERMINE THE BREAK-EVEN POINT

How is a break-even point com-puted?

What information is obtained frombreak-even analysis?

6. IDENTIFY THE USE OFADVISORS IN THE FINANCIALANALYSIS DECISIONS

What advisors should be utilizedwhen considering financial anal-ysis decisions?

7. DISCUSS THE USE OFCOMPUTERS IN FINANCIALANALYSIS

How can computers aid financialmanagement?

Explain the methods of computing the break-even points using asimple numerical example like the one presented in the unit.Use the formula Break-even point = (Total fixed costs)/(Unitselling price - Unit variable costs). Use as many numericalexamples as necessary to acquaint students with this method.Ask students to complete computations on their own.

Use a chalkboard or an overhead to list the types of informationthat can be obtained from break-even analysis (i.e., comparecosts to profits at different volumes of sales, profitability ofvarious products in the same product line, etc.). Draw a break-even chart like the one presented in Figure 6 and assist studentsin understanding its meaning.

List types of advisors available to enzepreneurs interested inobtaining outside financial assistance. Explain how each one ofthese advisors can assist the entrepreneur at various stages in thelife of the business.

Ask students why they believe computers are vital in saving theentrepreneur time and money. Also, pinpoint areas where entre-preneurs can use software to improve business management (i.e.,record keeping, payroll, taxes, accounts payable, accounts receiv-able, inventory, cost accounting in manufacturing, etc.). Use anoverhead or chalkboard to list the four cost areas entrepreneursshould consider when considering to introduce computers fordaily business operations. If a spreadsheet software (such asExcel, Quatro Pro, or Lotus) is available, demonstrate to studentssome basic operations that can be carried out (e.g., balancesheet, income statement, cashflow projections, common sizing,etc.). Emphasize the benefits of using spreadsheet from a timeand accuracy standpoint.

5

MODEL ASSESSMENT RESPONSES

1. The three financial responsibilities of the entrepreneur are (1) to assess the performance of the firm'soperations, (2) to monitor the assets, liabilities and owner's equity, and (3) to manage working capital foroperating and expanding the business.

2. Fixed assets are assets which are used over a long period of time, usually many years. Fixed assets, suchas land, machinery, equipment, and vehicles are used to help convert current assets (such as merchandiseand accounts receivable) into cash.

3. A more accurate valuation of a fixed asset than the book value (i.e., the value as shown on the balancesheet) is the market value. The market value is the value placed on the asset by buyers and sellers in themarket.

4. Three examples of intangible assets are goodwill, copyrights, and patents.

5. Short-term liabilities are those liabilities that are due within twelve months. They include accounts payableand the current portion of a debt. Long-term liabilities are liabilities due after 12 months, such asmortgages, long-term loans, debt owed to venture capitalists, etc.

6. Selling expenses are likely to be considered fixed expenses when computing a break-even analysis. Abusines.. ; likely to incur the same expense even if the sales volume increases. On the other hand, operat-ing expenses are likely to vary with the volume of manufactured products.

7. The introduction of a computerized system in a business might reduce cashflow because of costs incurredin purchasing the hardware, software, training employees, downtime, and costs associated with integratingthe computer system in daily business operations. Cash savings appear as a result of speeding up and in-creasing operating efficiencies in customer service, accounting, production, quality, processing data, etc.

8. When starting a business, entrepreneurs can seek advice from SBDC, SCORE, or local law and accountingfirms which specialize in the financial management. In the first years of operations, entrepreneurs need todevelop a close relationshi7 with their accountants to refine the business's financial procedures. In addition,entrepreneurs should be encouraged to get involved in activities organized by the local chamber of com-merce, SBDC, and other local small business organizations. As the business matures and grows, moresophisticated financial advisors from law and accounting firms might be needed.

c/X41112nNz.:, ,;0?...OVP:.5q89Ker4,`:"'

Incorporates the needed competencies for creating and operating a small business at three levels of learning, with experiences andoutcomes becoming progressively more advanced.

Level 1 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 Departmer i at theCenter on Education and Training for Employment, 1900 Kenny Road, Columbus, Cbio 43210-1090

(614) 292-4353, (800) 848-4815.

Support for PACE, Third Edition provided in whole or in part by:

International Cooriortium for Entrepreneurship Educationand

International Enterprise AcademyCenter on Education and Training lc Employment

The Ohio State University

The Coleman Foundation

Center for Entrepreneurial Leadership Inc.Ewing Marion Kauffman Foundation

Your Potentialas an

Entre7eneur

Nature ofSmall Business

Help forthe

Entrepreneur

Lep:Issues

ARILRecordKeeping

Types ofOwnership

FinancialAnalysis

BusinessOpportunities

MarketingAnalysis

BusinessManagement

HumanResources

CustomerCredit

CENTER ON EDUCATIONAND TRAINING FOR EMPLOYMENT

COLLEGE OF EDUCATIONTHE OHIO STATE UNIVERSITY

Global Markets

Location

UNIT 18LEVEL 2

TheBusiness Plan

PricingStrategy

Promotion

Financingthe Business

Selling

RiskManagement

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s'

r

Operations

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.16

Research and Developmmt Series No. 302-18

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:

Discuss the importance of financial management.

Define accounting terms.

Describe the tools for financial analysis.

Identify ways to analyze your business finances.

4. Look for these busine-s 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.

Accelerated depreciation Intangible assetsAllowance for depreciation Liability maturityAsset convertibility Market valueBonds MarkupBreak-even analysis Net salesCash forecast Operating expensesCash value of life insurance OverheadCopyright PatentDeclining balance Salvage valueDepreciation Selling expensesFixed/variable costs StocksFranchise fee Straight-line depreciationGoodwill Sum-of-the-year-digits depreciationGross billings Useful life of assetGross sales Working capital

Copyright © 1994, Center on Education and Training for Employment,The Ohio State University. All rights reserved.

FINANCIAL ANALYSIS

WHAT ARE THE OBJECTIVES FOR THIS UNIT?

Upci completion of this unit you will be able to

discuss the entrepreneur's role in managing finances,

explain how to prepare a balance sheet,

explain how to prepare an income statement,

explain how t

explain how t

o develop a cash flow projection,

o determine the break-even point,

identify the use of advisors in the financial analysis decisions, and

discuss the use of computers in financial analysis.

WHAT IS THLS UNIT ABOUT?

Most companies and firms of significantsize have sophisticated tools and techniquesand personnel to oversee the financial affairsof the business. This is not the case for thetypical owner of a small business. As theowner of a small business, you will need touse basic accounting statements that reflectthe results of the business operation. Evenif you have your financial statements pre-pared by an accountant, you should under-stand how they are put together, what theytell you, and some of the ways in which youcan use them.

3

WHAT IS THEENTRA'RENEUR'S ROLE INMANAGING THE FINANCES?

Your role in financial management is three-fold:

To assess the operational results of thefirms performance

To control the condition of the variousassets, liabilities, and owners equity in-volved in your business

4

To manage the companies working capi-tal effectively, especially with respect toplanning for the cash the company needsto keep operating

Specific activities that you will conduct anddevelop skills in during your work in thisunit include the following:

Planning for future financial require-ments as your company grows and fore-casting the cashflow needs of the firm

Analyzing the components of the balancesheet and profit-and-loss statements

Assigning and training staff to assist youin conducting the basic financial man-agement functions

Selecting and working with an account-ing service and other professionaladvisors

Some basic accounting too:s will help putyou in financial control of your business.The balance sheet and the profit-and-lossstatement are two financial statements youwill need to understand well enough to pre-pare and analyze. In this unit you will studycomponents of these statements in more de-tail. In addition, you will learn how todetermine cashflow needs and how to docomputations to determine the break-evenpoint.

WHAT ARE THECOMPONENTS OF THEBALANCE SHEET?

The balance sheet gives you a picture ofwhat your business owns and owes at a cer-tain time. It is a "photograph" of your com-pany's assets, liabilities, and net worth.Assets and liabilities are balance sheet itemsreported at their current value. Net worth(owners equity) reflects the owner's invest-ment in the business.

This financial statement must balance. Thatis, assets must equal liabilities plus networth, or the total of those items on the leftside under assets must exactly equal the totalof the right side under liabilities and networth.

Assc.N = Liabilities + Net Worth

Figure 1 illustrates a balance sheet suitablefor the entrepreneur just starting in business.This format can be used by sole proprietor-ships, partners, or corporations. Balancesheets are also presented in report formatswith all items arranged vertically on oneside.

WHAT ARE ASSETS?

Assets are balance sheet entries that showwhat your business owns. Assets can be cat-egorized as current, fixed, intangible, orother assets. These categories are based onthe availability (liquidity) of items; that is,

5

Assets

Current AssetsAccounts receivable (net)CashInventoryShort-term prepaymentsShort-term investments

BALANCE SHEETas of June 30, 1993

Total current assets

$114,30040,40093,900

5,000

$253,600

Fixed AssetsPlant, Property, and Equipment (PP & E)

Equipment 15,500Furniture and fixtures 6,000LandLeasehold improvements 4,000Office equipment 6,000Gross PP & E 31,500

Less accumulated depreciation 1,000Net PP & E 30,500DepositsOther

Total fixed assets 30,500

Total Assets $284,100

Liabilities and Stockholder's Equity

Current LiabilitiesAccounts payable 94,200Dividends payableIncome taxes payable 18,300Interest payable 900Other short-term debt 24,800

Total current liabilities $138,200

Noncurrent LiabilitiesLong-term debts

Total Liabilities

EquityCommon stockAdditional paid-in capitalRetained earnings

Total Equity (net worth)

Total Liabilities and Equity

83,200

$221,400

1,000

61,700

$62,100

$284,100

Figure 1. Balance sheet

6

the length of time it takes to convert them tocash. These categories which describe yourassets, can help you control your.business.

To guide management of the business, youshould analyze and compare each item in aconsistent, meaningful way. These c mpari-sons will reflect changes in the financialpicture of your business over a period oftime. You want your business to have an ef-fective inventory policy and maintain capitalinvestment that has a proper balance of fixedand current assets. Therefore, a realistic andaccurate picture of what your business ownsshould always be available.

Current assets are those assets that, in thenormal course of business, are expected tobe converted into cash within 12 months.The reason for the 12-month rule is twofold.First, most business managers consider 12months a normal cycle for their business.Second, state and local tax returns are filedon an annual basis.

When you are assigning assets to this cate-gory, ask yourself this question: What is thelikelihood that this asset will he convertedinto cash within 12 months? Cash, merchan-dise, and accounts receivable are normallydefined as current assets on a balance sheet.

However, using the 12-month rule, it is pos-sible that a portion of either one of thesecategories may not be considered a currentasset. Suppose a customer owes your busi-ness some money and you are carrying theamount due as part of your accounts receiv-able. To make the sale, you may haveagreed that payment will not he due for 18months. The sale will not be turned intocash within the 12-month period. Or, sup-pose your firm has some inventory that,because of its nature, is either seasonal or

currently out of style. If you estimate that itwill be more than 12 months before a salecan be made, then this item of merchandiseshould be treated as another type of assetand not as a current asset.

Fixed assets are assets that are used over aperiod of several years of normal operations.Generally, they are used to help convert cur-rent assets into cash. For example, a retaileroperates a business from a building he orshe owns. The building is an investmentthat houses the retailer's inventory. Becausethe building has a useful life of more than12 months, it is an asset of a more perma-nent nature than inventory or accountsreceivable.

When looking at a balance sheet that hasonly fixed assets, remember that the value ofthe fixed assets may he based on cost lessany depreciation. A more realistic estimateof worth may be the market value or thevalue that buyers in the market are willing topay for the asset. This is an area that youwill want to discuss with your accountant tobalance your needs to renew fixed asset withyour tax liability.

The examples listed in Figure 1 are probablythe three most common intangible assets thata small business can have. Goodwill is thevalue that a business gains from customers,image in the community, or reputation ofservicing the public. Determining a valuefor it is arbitrary. However, if you were topurchase an operating business, most likelya portion of the purchase price would be forthis intangible asset. Other common exam-ples of intangible assets are franchise fees,patents, and copyrights, which are tangibleonly in that a legal document says they exist.

Other assets is a miscellaneous category ofassets. If an asset is not current, fixed, orintangible, it should be included in the otherassets category. The asset most commonlyfound in this category is the cash value oflife insurance. This value is your "equity"in or "ownership" of an ordinary life insur-ance policy purchased for yourself. As youpay premiums over the life of the policy, acertain cash value builds and is available toyou as a loan from a bank or the insurancecompany.

Other assets may also include accountsreceivable (other debts due to you that arenot current) and investments such as stocksand bonds that you may have in othercompanies.

WHAT ARE LIABILITIES?

Business liabilities express the cash value ofwhat you owe to others. They are closelytied to business assets. Liabilities are debtsincurred by the business to acquire assets.Liabilities are classified either as currentliabilities or long-term liabilities.

A current liability is an obligation you oweto some individual or firm that will be paidby a current asset. Usually, a currentliability matures or comes due within 12months. These liabilities are debts that aredue within 1 year, to be paid with cashassets or assets that will be converted intocash within 90 days.

The most common type of current liability isaccounts payable. When you order and re-ceive merchandise or services, you incur adebt that usually will have to he paid within

7

1 year. This debt is considered an accountpayable in that it is due on account to yoursuppliers.

Other types of current liabilities are with-holding and social security taxes payable.These are liabilities that cause businessowners some problems. Money withheldfrom your salary and your employees' sala-ries in the form of payroll and income taxesmust be submitted to federal, state, and localgovernments within specified time periods,usually quarterly. Some businesses that areshort on funds will use this money for oper-ating expenses. This will inevitably placethem in difficulty with the Internal RevenueService or other taxing authorities.

Another common type of current liability isthe part of a long-term debt that is duewithin one year. Examples of this type ofcurrent liability include the preser: year'spayment due on mortgages Pnu long-termnotes.

Long-term liabilities are those debts that aredue after 12 months of maturity. They nor-mally consist of real estate mortgages, long-term loans, and similar obligations. Usuallythe funds obtained from incurring debts ofthis type are used to purchase buildings,equipment, and other fixed assets.

WHAT IS NET WORTH?

The net worth entry reflects the owner'sequity or investment in the business. Theseassets are acquired either by incurring a debtor with funds invested by the owner. Thenet worth entry on a balance sheet of a soleproprietorship states the owner's investment

8

in the business. The net worth entry for apartnership states each partner's investmentseparately.

The net worth entry allows you to track yourprogress in achieving your performancegoals in terms of return on your investmentin the business. The amount of money thebusiness earns needs to be viewed from theprospective of how much you have investedin it.

Another function of the ownership or networth entry is to describe the "cushion" forpossible losses. As far as creditors are con-cerned, the net worth is a protection in caseof nonpayment of debt. Businesses that failoften end up with a net worth that is nega-tive. This means that the creditors not onlyhave a claim on all the assets, but also thatafter all assets are converted to cash, notenough funds remain to pay off the debts.

WHAT IS AN INCOMESTATEMENT?

An income statement is the part of a finan-cial statement that reflects the income andexpenses of a business over a period of time.This contrasts with the balance sheet, whichgives the financial picture of a business as ofa given date. It contains a limited amount ofinformation and does not show how effi-ciently the assets of the business are beingused. The profit and loss statement, anothercomponent of the financial statement, is trulyan operating record which provides you withmeasures of your efficiency and ability tomake a profit. Figure 2 is an income state-ment suitable for the person who is juststarting a business.

WHAT ARE THECOMPONENTS OF ANINCOME STATEMENT?

The income statement is usually composedof the following:

Gross sales

Cost of goods sold

Gross profit on sales

Expenses

Net profit

Probably the most important component isgross sales. For a typical retail business,this component is the basic source of reve-nue. It consists of total revenues receivedfrom sales for the year. This item is ad-justed to arrive at a net sales figure bydeducting returned merchandise or allow-ances for spoiled or damaged merchandise.

If the business sells services rather thanmerchandise, net sales is labeled grossbillings.

The second component, the cost of goodssold, is the cost of the goods or services thatyour firm sells. It does not include otherexpenses of doing business. This is the totalprice paid for the products sold during theaccounting period plus transportation costs.

After you have found the net sales and thecost of goods sold, it is possible to calculatethe gross profit or gross margin. The grossmargin equals sales less the cost of the sales.This is really the dollar portion of your salesthat represents your markup on theinventory.

9

INCOME (PROFIT AND LOSS) STATEMENTfor the period June 30, 1992 June 30, 1993

Gross IncomeIncome from sale of goods

Cost or Goods Sold

Gross Margin

Operating ExpensesAdvertising and promotionBenefitsBuilding expense (rent, lease)DepreciationDues and subscriptionsEquipment rentalInsuranceInterest expenseMaintenanceOther expensesPayroll taxesPostageProfessional feesSalaries and wagesSuppliesTelephoneTravel and entertainment

Net income (profit) before taxes

Taxes

Net income (profit) after taxes

Total operating expenses

$1,277,000

952,700

$324,300

7,10010,00033,00011,200

1,00028,20014,00015,0002,100

4007,2002,5005,200

103,3008,1007,5008,600

$264,400

$59,900

$29,200

$30,700

Figure 2. Income statement

You may analyze your profit and loss state-ment and find that your profits are not asmuch as you'd like them to he. You caneither increase your margin (or markup) onyour existing sales volume, or try to increasethe sales volume on the same margin. In-creasing the markup may reduce volume, re-sulting in no net change. Increasing salesvolume on the same margin is difficult. Itmight add advertising or other costs that willuse up any profit realized. Gross margindoes not take selling or operating expensesinto account.

The fourth component includes two cate-gories of expenses: (1) selling, and (2) otheroperating expenses. These are importantexpenses in most businesses.

Selling expenses are those expenses foractivities performed to increase the salesvolume. They include

salaries or commissions of salespersons,

travel expenses for salespeople,

delivery expenses, and

lJ

10

advertising.

Operating expenses are those expenses madeto operate and administer the business. Theyinclude

office expenses,

salaries,

accounting expenses,

rent,

telephone expenses,

utilities expenses,

expenses for equipment repairs, and

depreciation of equipment and buildings.

In short, operating expenses include anyexpense that is not directly due to sales orservice activities and is considered an over-head expense. You may also have non oper-ating expenses associated with the cost offinancing your business such as interest onloans.

The last component of a profit and lossstatement is net profit. The net profit of thebusiness is what is left after all normal costsand expenses for the accounting period havebeen deducted. Net profit is the "bottomline" that summarizes the results of yourbusiness. For example, subtracting totalselling expenses from gross profit on salesgives the net profit on sales. Net profit onsales shows the profit from all buying andselling activities (before allowances aremade for the general overhead costs).

Net profit does not reflect any income taxesbecause income taxes am not considered anormal operating expense. If you are oper-ating a sole proprietorship, net profit from

your business is considered income on yourindividual federal income tax return.

HOW DO INCOMESTATEMENTS VARYACROSS BUSINESSES?

Because small manufacturers convert rawmaterials into finished goods, the method ofaccounting for cost of goods sold differsamong wholesalers, retailers, and servicefirms. In retailing and wholesaling, corn-luting the cost of goods sold during theaccounting period involves beginning andending inventories and purchases made dur-ing the accounting period. In manufacturing,it involves not only finished goods inven-tories, but also several other costs.

An income statement for a typical smallmanufacturing company includes the

following:

Raw materialsthe materials that be-come a part of the finished product

Direct laborlabor applied directly tothe actual process of converting rawmaterials into finished products

Manufacturing overheaddepreciation,utilities, insurance, real estate taxes, andthe wages of supervisors and others whodo not work directly on the product, andso on. This last term should include allmanufacturing costs other than raw mate-rials and direct labor. It does not includeselling expenses or general expensesassociated with officers and office work-

ers salaries, misc. office expense, ordepreciation on office equipment.

WHAT ARE SOME METHODSOF ACCOUNTINGFOR DEPRECIATION?

The purpose of depreciation accounts is torecognize that productive assets are con-sumed by use and an allowance must hemade to replenish the asset. Depreciationexpenses also have the effect of reducingyour net income (hut not your cash) and,therefore, your tax liability. It is importantto recognize that financial statements asprepared or reviewed by professional ac-counts must adhere to accepted accountingstandards and principles such as conserva-tism, consistency, and full disclosure.

The cost of certain tangible fixed assets isspread over their useful life through periodicdepreciation charges to an expense account.Corresponding credits to a valuation accountcommonly entitled Allowance for Deprecia-tion are also made. The total amountcharged to expense may not exceed the totalcost of the asset (purchase price) less anynet salvage value (sale or trade-in price) thatthe asset is expected to have at the end of itsuseful life. To determine the net salvagevalue, deduct estimated removal costs fromexpected sale proceeds.

Three methods of depreciation are describedbelow. Although other methods arc occa-sionally used in practice, these are the mostcommon.

11

HOW IS STRAIGHT-LINEDEPRECIATIONCOMPUTED?

The straight-line method of computingdepreciation is perhaps the most widelyused. The same amount of depreciation isrecorded for each year (or other accountingperiod) over the useful life of the asset. Toobtain the annual depreciation, the acquisi-tion cost less the expected net salvage valueis divided by the expected life in years.This may be expressed by the followingformula.

AnnualDepreciation

Acquisition Cost - Net Salvage Value

Useful Life in Years

Figure 3. Annual depreciation formula

Suppose that the office machine acquired byAshton & Barker at a total cost of $400 isexpected to be used for five years and tohave a trade-in or salvage value at the endof that time of $40. The result of substitut-ing these figures in the equation is asfollows:

Annual =Depreciation

$400 $40 = $725

Figure 4. Computation of annual depreciation.

12

HOW IS DECLININGBALANCE DEPRECIATIONCOMPUTED?

In the declining-balance method, an appro-priate percentage of the total value of theitem is applied to the net book value of theitem at the beginning of the year to obtainthe depreciation charge for that year. Themaximum percentage allowable for incometax purposes (and therefore widely used bybusiness firms) is twice the rate that thestraight-line method uses.

The straight-line method was applied to thepostage machine illustrated in Figure 5. Themachine had an expected useful life of 5years. The depreciation was 1/5 or 20 per-cent of the cost (minus salvage value) eachyear. The declining-balance rate allowable

on this same item is twice 20 percent, or 40percent. (The tax regulations are that sal-vage value is to be ignored.)

In the first year, the acquisition cost of $400would be multiplied by 40 percent to yield$160 depreciation expense for that year.The book value at the beginning of the sec-ond year would be $240 ($400 minus $160)and the depreciation for the second yearwould be $96 (40 percent of $240). In

tabular form, the depreciation under thedeclining-balance method for the 5 years isillustrated as follows:

Although no salvage value is used in figur-ing the annual depreciation, there remains atthe end of 5 years a net book value of$31.10only slightly less than the $40 esti-mated salvage value used in the straight-linemethod.

YearBeginning

Book Value RateDepreciation

for YearDepreciation

to Date

1 $400.00 40% $160.00 $160.00

2 240.00 40% 96.00 256.00

3 144.00 40% 57.60 313.60

4 86.40 40% 34.56 348.16

5 51.84 40% 20.74 368.90

Ending Book Value = $31.10

Figure 5. Declining-balance depreciation method

HOW IS THE SUM-OF-THE-YEAR-DIGITSDEPRECIATIONCOMPUTED?

Under the sum-of-the-year-digits method, afractional part of the cost of the asset ischarged to expense each year. Thedenominator of the fraction is always thesum-of-the-year-digits. This obtained byadding the numbers for each year of theasset's life. For example, the digits of theyears of life of a machine expected to last 5years are 1, 2, 3, 4, and 5. Thus, the sum-of-the-year-digits is 1 + 2 + 3 + 4 + 5, or15. The numerator for any year is thenumber of years of remaining life of theasset. Thus, for the first year the fraction is5/15; the second year it is 4/15; and so on.The fraction is applied t the acquisition costminus the salvage valuc in this case $400minus $40, or $360.

13

In Figure 6 the results of applying thismethod are listed and compared with boththe straight-line and the declining balancemethods described.

Note that the declining balance and sum-of-the-year-digit methods both give higherdepreciation charges in the earlier years ofthe asset life and lower charges in the lateryears. These two methods are sometimescalled accelerated methods. For income taxreporting purposes, a change may be madefrom the declining-balance method to thestraight-line method (for the remainingbalance) at any time; but any other changein depreciation method may not be madewithout the written permission of the taxauthorities. A business may use severaldifferent depreciation methods at the sametime for different assets or groups of assets.

It is also important to note that a businessmay use one method of depreciation for in-come tax purposes and another for preparingfinancial statements.

SUM-OF-THE-YEAR-DIGITS METHOD OF DEPRECIATION

Year FractionCost Minus

SalvageDepreciation

for YearDeclining

Balance MethodStraight-line

Method

1 5/15 $360.00 $h:.00 $160.00 $72.00

2 4/15 360.00 96.00 96.00 72.00

3 3/15 360.00 72.00 57.60 72.00

4 2/ t 5 360.00 48.00 34.56 72.00

5 1/15 360.00 24.00 20.74 72.00

Total Depreciation 5 years $360.00 $368.90 $360.00

Net Book Value - End of 5 years $40.00 $31.10 $40.00

Figure 6. Sum-of-the-year-digits depreciation method

14

WHY IS A CASH FORECASTNECESSARY?

In addition to preparing and analyzingbalance sheets, profit and loss statements,and depreciation schedules, it is necessary toprepare cash forecasts. Cash planning andforecasting the future cash needs of thebusiness are vital for survival. Unless cashneeds are foreseen and provided for there isa good chance the business will not be ableto meet its commitments.

Business growth is often associated withneeds for cash that grow faster than cashreceipts. This is because assets such asinventory are normally paid for faster thanaccounts receivable are collected.

Too much cash on hand shows that theowner is not alert to opportunities for wiseuse of surplus cash. Large amounts of cashwhich will not be used right away should beinvested where the cash will earn money forthe business.

Successful business growth will result onlyif working capital is managed (current assetsminus current liabilities) effectively. Youare going to learn cash forecasting tech-niques that will force you to make yourassumptions explicit regarding the inter-relationships among the key working capitalcomponents:

Cash

Accounts receivable

Inventory

Accounts payable

HOW IS A CASH FORECASTPREPARED?

Figures used in the cash forecast areexpected cash receipts and payments. Fore-casting is not mere guesswork, but is basedon past experience and knowledge of perfor-mance of similar businesses. For example,the expected cash sales figure for a certainmonth is arrived at by comparing thatmonth's sales figures for previous years, andconsidering price and market trends for theperiod.

Cash forecasts are normally prepared on amonthly basis for at least 3 months inadvance. Each month the figures are com-pared with actual results and revised accord-ingly. The cash forecast should always he 3months to 1 year ahead of current opera-tions. A new business will always heexpected to project monthly cash forecastsfor at least the first year of operations.

An example of a cash forecast is illustratedin Figure 7. The projected accountsreceivable receipt for each month wascomputed by what past experience hasshown will he paid by customers.

Although the firm's credit policy is that allcharge purchases are to be paid within 1

month, the history has been that 50 percentare paid during the month following the saleand 50 percent during the second month.

Other key assumptions are as follows:

Sales will increase dramatically by 20percent per month throughout the fore-cast period.

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Inventory purchases underlying the costof goods sold must he paid for duringthe month in which they are sold.

Cost of goods sold represents a constant65 percent of gross sales.

All sales are sold on credit.

A minimum cash balance of $5,000 atthe end of each month should bemaintained.

HOW IS A BREAK-EVENPOINT COMPUTED?

Comparing the break-even point is onetechnique to determine when your businesswill begin to make a profit. The break-evenpoint tells you how much business your firmwill need to do to break even, that is, tooperate with neither a profit nor a loss.

To find the break-even point, you must firstdetermine the fixed costs and variable costs.These costs are classified by preparing adetailed income statement and assigningeach of the expense categories into eitherfixed or variable costs. Once these havebeen calculated, the following formula canbe used to find the break-even point (volumeor business):

Break-EvenPoint

Total Fixed CostsSelling Price - Variable Cost

(Per Unit) (Per Unit)

Figure 8. Break-even 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 =Point

$15,000$100-25

= 200 Units

Figure 9. Break-even computation

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 can help you comparecost to profits at different volumes of sales.You can use break-even analysis to see howprofitable different items are in a line ofproducts that you sell. This analysis cananswer quesCons such as: Which items aremost profitable? Which are least profitable?Have any items passed their popularity peaks(shown decreasing profits)? How manyunits of a new product must be sold beforeit begins to bring in a profit?, etc.

A break-even chart shows visually the rela-tionship of costs to profits at different salesvolumes. Figure 11 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 company

with costs for one of its products figures asfollows:

Total fixed costs = $100,000

Variable costs = $50 per unit

Selling price = $100 per unit

Figure 10 shows 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. Ifyou could find a way to reduce fixed costs,you would be able to lower he break-evenpoint. In addition you need to consider thateven the most "fixed" costs can vary over along enough period of time (e.g., reduceyour rent by moving to a smaller facility.

If you could reduce variable costs, thiswould cause the total cost line to riserapidly. You could also raise or lowerprices. An increase in price would lower thebreak-even point. An inventor once said thatif he could only sell one of his inventionsfor $500,000, he would make a tidy profit.

Analysis of Figure 10 reveals these factsabout the break-even point:

The larger the loss area, the greater thedown-side risk

The larger the profit area, the greater theup-side potential

The larger the fixed costs, the higher therisk (increased loss area)

17

The large_ the proportion of variablecosts, the higher the risk (increased lossarea and decreased profit area).

WHAT ADVISORS CANHELP WITH FINANCIALANALYSIS DECISIONS?

Advisors may he productively employed atseveral stages of the business growth anddevelopment.

In the pre-start-up situation you may need anobjective outside party to help you structurethe methods you use to finance your busi-ness and to assess the quality of the financialassumptions upon which you are basing yourfirst years forecasts.

Good prospects for this type of advice in-clude your local SBDC (Small Business De-velopment Center), a SCORE (Service Corpof Retired Executives), or a local accountantexperiences in the industry you will beentering.

During the first several years of the businessoperations, you may require the assistance ofyour accountant to refine your financialmanagement procedures and to identify spe-cific trends within your financial statements.You may also want to participate in local"roundtables" sponsored by your local cham-ber of commerce to gain insights from otherbusiness owners. The SBDC office can alsogive you a "second opinion" or a financial"checkup" to help you monitor your progressin maintaining control over your workingcapital 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 hoard of direc-tors will improve your business performance.

HOW CAN COMPUTERS AIDFINANCIAL MANAGEMENT?

Many businesses find the best solution totheir information processing and financialanalysis requirements is a combination ofmanual and electronic methods. With theincreasing availability of low-cost, efficientcomputers, however many business ownersare converting manual information process-ing to computerized operations. Any tedi-ous, repetitive, and costly financial infor-mation recording task that involves process-ing of information in a predetermined way isa candidate for computerization.

If you elect to computerize yobr recordkeeping and accounting systems, you will heable to use the information captured by thesesystems to more efficiently control and man-age the financial aspects of your business.

Modem computer-based accounting packageshave the capability of automatically produc-ing all the required ratio or analysis state-ments useful for analysis as well as handlingaccounts receivable, accounts payable andinventory management tasks. In addition,these systems can output data in the formsrequired by the common financial spread-sheet programs for additional analysis.

19

Financial spreadsheets allow you to preparemany different versions of your forecasts tosuit different. initial conditions or changes inyour business environment. These programsare fairly "intuitive" to use because they usethe traditional rows-and-columns formatdeveloped to record and analyze accountinginformation.

The utility of these types of programs is thatthey can work with dozens of variables andhundreds of assumptions with such results asa 10-year income and cashflow statement fora proposed shopping mall, a 3-year incomestatement for a retail store selling hundredsof items; a cost-efficiency study of a 10-person firm, or just about any other projec-tions or analyses that you can dream up.

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 suchprograms should contact a reputable com-puter supplier review computer periodicals,and text; or consult with owners usingmicrocomputers in similar businesses.

There are four cost areas that you shouldconsider when planning the conversion to acomputerized operation:

Hardware includes computer, video-monitors, printers, electronic cash regis-ters, barcode scanners, and so forth.

Software includes general purpose pro-grams that you apply to your situation,e.g., electronic spreadsheet, word pro-cessing, database management and spe-cialized programs that you purchase to

0

20

perform one function for your business,etc. general ledger, accounts receivable,payroll. Software costs can easily equalyour hardware costs for the first year fora basic system including word process-ing, spreadsheet, accounting package,inventory management, and cost estima-tion.

Training and "downtime" required tolearn new skills to operate the automatedsystems should be considered.

Integrating costs associated with merg-ing hardware and software elements intoa working system. Also customizinggeneral purpose software to your specificneeds is a very important consideration.Unless you are extremely skilled in thecomputer programming areas, this willprobably be your biggest first-year costarea.

The real cost savings occurs when computeroperations are used to speed up and improvethe operational aspects of the business:customer service, production, financialanalysis. You should always he alert foropportunities to integrrte several aspects ofor business in new ways.

ACTIVITIES

The following activities are designed to helpyou apply what you have learned in thisunit.

INDIVIDUAL ACTIVITIES

A.

Prepare a profit-and-loss statement using thefollowing information. Compute the netprofit or loss for this business. Record theinformation on a profit-and-loss statementobtained from your instructor. Compute abreak-even point for this business. Whatassumptions must you make to compute thispoint of sales?

The following transactions occurred duringthe year:

Sales during the year were $260,000

21

Advertising expenses were $2,000.

Miscellaneous expenses were $1,500.

Rent expenses were $2,400.

The owner's salary was $15,000.

The annual insurance premium was$200.

Interest expenses were $10,800.

Depreciation expenses were $6,500.

B.

Prepare a balance sheet using the followinginformation. Record the information on abalance sheet obtain from your instructor.Compute the owner's equity in the businessas of December 31, 19_.

The following transactions occurred duringCustomers returned $10,000 of the the year:merchandise.

Cash on hand at the end of the year wasThe beginning inventory was $40,625. $14,475.

Purchases during the year amounted to$169,000.

The ending inventory was $50,000.

The ending inventory was $50,000.

Accounts receivable were $75,000.

Store fixtures and equipment were

Employees' wages and salaries paid dur- $60,000.

ing the year amounted to $19,600.

22

Depreciation on store fixtures and

equipment was $5,500.

A delivery truck was purchased for$7,000, and depreciation for the firstyear was $1,000.

Accounts payable totalled $169,000.

B.

Work in groups of or to six. Secure

financial statements Dm a local smallbusiness of your choice. Develop a ratioanalysis to assess the liquidity, fundsmanagement, and profitability performanceof the business you selected.

Accrued wages to employees were C.$2,600.

A note payable of $10,000 was out-standing.

GROUP ACTIVITIES

A.

In teams of two to three, develop a 1-monthprojected profit-and-loss statement for asmall business of your choice. Identify allthe possible expenses that you believe thisbusiness could have. Review referencematerials available from your instructor todetermine possible types of business ex-penses. Project estimated revenues, ex-penses, and profits for the 12-month period.Compare your projections with those ofother class members.

Continue working in teams. Refer toActivity B. Consult your local library tosecure information on average industryfinancial ratios. After you decide whatindustry is appropriate for the business youselected, compare the ratios computed in theprevious activity against industry data. Doesthe performance picture of the businesschange?

CASE STUDY

Bill Jones operates a small, two year old,wholesale toy business. He has asked youfor advice.

For each of the last six months, his saleshave been relatively constant at $10,000 permonth. The cost of goods sold averages 75percent of sales and operating expenses areat constant $2,500 per month. Bill wantedto expand his sales beyond the current breakeven level to generate positive net earnings.

DISCUSSION QUESTIONS

23

He is able to collect 70 percent of his ac-counts receivable during the month of saleand the remaining 30 percent during the fol-lowing month. He must pay for all hisgoods for resale within 30 days.

Bill developed a more effective method ofmarketing his products which resulted insales increases of $2,000, $3,000, and 4,000during each of the past three months. Be-fore he began to increase his sales he had$2,000 cash available.

1. What is the impact of these sales increases on his net earnings?

2. Bill has encountered a serious cash flow problem and would like your help in diagnosing itand suggesting ways to solve the problem.

3. In what month does his cash flow problem become serious?

4. What steps could Bill have taken to avoid the problem he now faces?

24

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.

1. Describe three financial responsibilities of the entrepreneur.

2. Distinguish fixed from current assets.

3. How would you place a value on fixed assets different than that found on the balance sheet?

4. List three examples of intangible assets.

5. Distinguish long-term from current liabilities.

6. Are selling expenses or operating expenses more likely to be classified as fixed expenseswhen computing a break-even analysis?

7. Where would you expect to reduce cash by using a computer system in your business?Where would you expect to increase cashflow by introducing a computer?

8. Describe how your use of business advisors would change as your business develops andgrows.

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 Book

Company, 1980.

Business Financing. Small Business Reporter Series. San Francisco, CA: Bank of America,

1988.

Siegal, J. G., and Shim, J. K. Accounting Handbook. New York, NY: Barron's Educational

Series, 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 2

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

14> Unit 18. Financial Analysis

Unit 19. Customer Credit

Unit 20. Risk Management

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 business* Level 2 prepares you to plan for a business in your future* Level 3 guides you in starting and managing your own business