Measuring Financial Performance 1 ENTREPRENEURIAL FINANCE

Chapter 4Measuring Financial Performance

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ENTREPRENEURIAL FINANCE

Basic Accounting Concepts

Generally Accepted Accounting Principles (GAAP): guidelines that set out the manner and form for presenting accounting information

Accrual Accounting:the practice of recording economic activity when recognized rather than waiting until realized

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Basic Accounting Concepts

Depreciation:reduction in value of a fixed asset over its expected life intended to reflect the usage of wearing out of the asset

Accumulated Depreciation:sum of all previous depreciation amounts charged to fixed assets

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Basic Balance Sheet Terms & Concepts

Balance Sheet:financial statement that provides a snapshot of a venture’s financial position as of a specific date

Balance Sheet Equation:Total Assets = Total Liabilities + Owners’ Equity

Assets:financial, physical and intangible items owned or controlled by the business

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Basic Balance Sheet Terms & Concepts

Listing Order of Assets: assets are listed in declining order of liquidity, or how quickly the asset can be converted into cash

Liabilities:short-term liabilities are listed first followed by long-term debts owed by the venture

Owners’ Equity:equity capital contributed by the owners of the venture is shown after listing all liabilities

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Accounts In Balance Sheet Assets

Current Assets:cash & other assets that are expected to be converted into cash in less than one year

Fixed Assets:assets with expected lives of greater than one year

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Types of Current Assets

Cash:amount of coin, currency, and checking account balances

Receivables:credit sales made to customers

Inventories:raw materials, work-in-process, and finished products which the venture hopes to sell

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Types of Current Liabilities

Payables: short-term liabilities owed to suppliers for purchases made on credit

Accrued Wages:liabilities owned to employees for previously completed work

Bank Loan:interest-bearing loan of one year or less from a commercial bank

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Long-Term Liabilities

Long-Term Debts:loans that have maturities of longer than one year

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Basic Income Statement Terms and Concepts

Income Statement:financial statement that reports the revenues generated and expenses incurred over an accounting period

Sales or Revenues:funds earned from selling a product or providing a service

Gross Earnings:net sales (after deducting returns and allowances) minus the cost of production

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Basic Income Statement Terms & Concepts

Operating Income or Earnings Before Interest and Taxes (EBIT):indicates a firm’s profit after operating expenses, excluding financing costs, have been deducted from net sales

Net Income (or Profit): bottom line measure after all operating expenses, financing costs, and taxes have been deducted from net sales

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Internal Operating Schedules

Cost of Production Scheduleimportant for preparing the income statement

Cost of Goods Sold Scheduleimportant for preparing the income statement

Inventories Scheduleimportant for preparing the balance sheet

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Statement of Cash Flows: Definition and Use

Statement of Cash Flows:shows how cash, reflected in accrual accounting, flowed into and out of a firm during a specific period of operation

Net Cash Build exists when the sum of cash flows from operations and investing is positive

Net Cash Burn when the sum of cash flow is negative

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New Venture – Business Assumptions

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Initial Stage

In USDFounder capital 40,000Friend's borrowing - for 3 years 10,000Interest Rate for the loan 10% per yearEquipment Purchase 20,000Building Rental Expense 1,000 per monthPSA Initial Material Inventory 10,000 financed by Owner's Credit CardOwner's Credit Card Payable To Cover Inventory Purchase 10,000

Assumptions for the period of July - DecemberSelling Price 100 per unitSelling Unit 1,200Usage life of Equipment 10 years 120 monthsSales Credit - AR 50,000Accrued Wages 3,000

Balance Sheet

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Current Assets Current LiabilitiesCash and Marketable Securities 30,000 Payables 10,000Receivable 0 Accrued WagesInventories 10,000 Bank LoansTotal Current Assets 40,000 Other Current Liabilities

Total Current Liabilities 10,000Fixed AssetsGross Equipment 20,000 Long Term Debts 10,000Building 0 Capital LeaseLess: Accumulated Depreciation 0 Total Long Term Liabilities 10,000Net Equipment 20,000

Other Long Term Assets 0 Owner's Equity 40,000

Total Assets 60,000 Total Liabilities and Equity 60,000

ASSETS LIABILITIES AND EQUITY

PSA CORPORATIONINITIAL BALANCE SHEET

AS OF JUNE 30

Inventory Schedule

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Beginning Finished Goods 0 13,000 19,500 32,500 35,750 39,000Production Materials 10,000 10,000 15,000 15,000 15,000 15,000 Direct Labor 3,000 3,000 4,500 4,500 4,500 4,500Addition 13,000 13,000 19,500 19,500 19,500 19,500

Total (Beginning + Addition) 13,000 26,000 39,000 52,000 55,250 58,500-/- Cost of Goods Sold 0 6,500 6,500 16,250 16,250 32,500Ending Finished Goods 13,000 19,500 32,500 35,750 39,000 26,000

Dec

Inventories Schedule

July Aug Sept Oct Nov

Production Schedule

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Production (Units) 200 200 300 300 300 300 1,600Production Costs Electronic Parts 40 8,000 8,000 12,000 12,000 12,000 12,000 64,000 Plastic Materials 5 1,000 1,000 1,500 1,500 1,500 1,500 8,000 Connectors, etc 5 1,000 1,000 1,500 1,500 1,500 1,500 8,000 Direct Labor 15 3,000 3,000 4,500 4,500 4,500 4,500 24,000Total Costs 65 13,000 13,000 19,500 19,500 19,500 19,500 104,000

Dec TotalCost Per Unit Cost / Unit

Cost of Production Schedule

July Aug Sept Oct Nov

COGS Schedule

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Sales (Units) 0 100 100 250 250 500 1,200

Cost @ $65 / Unit 0 6,500 6,500 16,250 16,250 32,500 78,000

Total

Cost of Goods Sold Schedule

July Aug Sept Oct Nov Dec

Electronic Components 40 1,200 48,000Plastic Materials 5 1,200 6,000Connectors, Screws, etc 5 1,200 6,000Direct Labor 15 1,200 18,000

Total Costs 78,000

Cost Per Scanner (In USD) Total Units

Total costs (In USD)

PSA Corporation Cost of Goods Sold Report

Income Statement

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Description USD ExplanationsNet Sales 120,000 Sales of 1200 units @ USD 100 Cost Of Goods Sold 78,000 See COGS ScheduleGross Earning 42,000

Operating Expenses Marketing Expenses 12,500 Expense for 6 month period Administration Expenses 18,000 Expense for 6 month period (ie, USD 3000 per month) Building Rental 6,000 USD 1000 per month and for 6 month period Depreciation Expense 1,000 Accumulated depreciation for equipment depreciated for 10 yearsTotal Operating Expenses 37,500

Earning Before Interest and Taxes (EBIT) 4,500

Other Income / Expenses Interest 500 Interest Expense for 6 months period (10% of USD 10,000)Earning Before Taxes 4,000 Taxes (25%) 1,000Net Income 3,000

For The Six Month Period Ending December 31In USD

Account Payable – Repayment Schedule

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Beginning Accounts Payable 0 10,000 10,000 10,000 15,000 15,000 15,000 Material Purchased 10,000 10,000 10,000 15,000 15,000 15,000 15,000Accounts Paybable 10,000 20,000 20,000 25,000 30,000 30,000 30,000 Accounts Payable Repayment 0 10,000 10,000 10,000 15,000 15,000 15,000Ending Accounts Paybable 10,000 10,000 10,000 15,000 15,000 15,000 15,000

Nov Dec

Schedule of Accounts Payable

June July Aug Sept Oct

Balance Sheet – After 6 month

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Current Assets Current LiabilitiesCash and Marketable Securities 1,000 Payables 15,000Receivable 50,000 Accrued Wages 3,000Inventories 26,000 Bank LoansTotal Current Assets 77,000 Other Current Liabilities 25,000

Total Current Liabilities 43,000Fixed AssetsGross Equipment 20,000 Long Term Debts 10,000Building 0 Capital LeaseLess: Accumulated Depreciation 1,000 Total Long Term Liabilities 10,000Net Equipment 19,000

Owner's Equity 40,000Other Long Term Assets 0 Retained Earnings 3,000

Total Equity 43,000

Total Assets 96,000 Total Liabilities and Equity 96,000

PSA CORPORATIONBALANCE SHEET

AS OF JUNE 30


Statement of Cash Flow

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Sources Cash inflow – occurs when we “sell” something Decrease in asset account

▪ Accounts receivable, inventory, and net fixed assets Increase in liability or equity account

▪ Accounts payable, other current liabilities, and common stock

Uses Cash outflow – occurs when we “buy” something Increase in asset account

▪ Current Assets and other current assets Decrease in liability or equity account

▪ Notes payable and long-term debt

Balance Sheet – Comparison

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Proforma Jul - Dec Diff Proforma Jul - Dec DiffCurrent Assets Current LiabilitiesCash and Marketable Securities 30,000 1,000 -29,000 Payables 10,000 15,000 5,000Receivable 0 50,000 50,000 Accrued Wages 3,000 3,000Inventories 10,000 26,000 16,000 Bank Loans 0 0Total Current Assets 40,000 77,000 37,000 Other Current Liabilities 25,000 25,000

Total Current Liabilities 10,000 43,000 33,000Fixed AssetsGross Equipment 20,000 20,000 0 Long Term Debts 10,000 10,000 0Building 0 0 0 Capital LeaseLess: Accumulated Depreciation 0 -1,000 -1,000 Total Long Term Liabilities 10,000 10,000Net Equipment 20,000 19,000 -1,000

Other Long Term Assets 0 0 Owner's Equity 40,000 43,000 3,000

Total Assets 60,000 96,000 36,000 Total Liabilities and Equity 60,000 96,000 36,000


PSA CORPORATIONBALANCE SHEET COMPARISON

AS OF JUNE 30

Statement of Cash Flow

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Net Income 3,000+/+ :

Depreciation 1,000Increase in Payables 5,000Increase in Wages 3,000

-/-Increase in Receivables -50,000Increase in Inventories -16,000

Net Cash Flow From Operations -54,000

Cash Flow From Investing Activities-/-

Increase in Gross Equipment 0

Cash Flow From Financing Activities+/+

Increase in Other Short Term Liabilities 25,000

Net Change Excluding Cash Account -29,000

Beginning Cash and Marketable Securities 30,000

Ending Cash and Marketable Securities 1,000

STATEMENT OF CASHFLOWFOR PSA CORPORATION

FOR THE SIX MONTH PERIOD ENDED DECEMBER 31

Operating Breakeven Analysis

Variable Expenses:costs or expenses that vary directly with revenues

Fixed Expenses:costs that are expected to remain constant over a range of revenues for a specific time period

EBITDA:earnings before interest, taxes, and depreciation & amortization

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Operating Breakeven Analysis

EBDAT:earnings before depreciation, amortization, & taxes

EBDAT Breakeven:amount of revenues (survival) needed to cover cash operating expenses

Cash Flow Breakeven:cash flow at zero for a specific period (EBDAT = 0)

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Survival Breakeven Analysis

Basic Equation:EBDAT = Revenues (R) - Variable Costs (VC) – Cash Fixed Costs (CFC)

Where: CFC includes both fixed operating (e.g., general and administrative, and possibly marketing expenses) and fixed financing (interest) costs

When EBDAT is Zero: R = VC + CFC

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Breakeven Level of Survival Revenues

Starting Point:Ratio of variable costs (VC) to revenues (R) is a constant (VC/R) and is called the Variable Cost Revenue Ratio (VCRR)

Survival Revenues (SR) = VC + CFC

Rewriting, CFC = SR – VC By substitution, CFC = SR[1 –

(VCRR)] Solving for SR, SR = [CFC/(1 –

VCRR)]

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Survival Revenues Breakeven

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Year 1 Year 2 Year 3Number of Units Sold 5,000 15,000 25,000

Revenues 500,000 1,500,000 2,500,000-/- Cost of Goods Sold 325,000 975,000 1,625,000Gross Profit 175,000 525,000 875,000

Operating Expenses Administrative Expenses 200,000 200,000 200,000 Marketing Expenses 180,000 180,000 180,000Total Operating Expenses 380,000 380,000 380,000

EBITDA -205,000 145,000 495,000 Depreciation 25,000 25,000 25,000EBIT -230,000 120,000 470,000 Interest Expense 20,000 20,000 20,000Earning Before Taxes -250,000 100,000 450,000 Taxes 30,000 135,000

Net Income -250,000 70,000 315,000

AssumptionsSelling Price 100 USD per unitCOGS 65% of Total SalesTax Rates 30% of Earning Before Taxes

PSA CORPORATION'S FIRST THREE YEARS OF INCOME


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Business As UsualYear 1 Year 2 Year 3 BEP

Number of Units Sold 5,000 15,000 25,000 11,429

Revenues 500,000 1,500,000 2,500,000 1,142,857-/- Cost of Goods Sold 325,000 975,000 1,625,000 742,857Gross Profit 175,000 525,000 875,000 400,000-/- Administrative Expenses 200,000 200,000 200,000 200,000 Marketing Expenses 180,000 180,000 180,000 180,000 Interest Expense 20,000 20,000 20,000 20,000

EBDAT -225,000 125,000 475,000 0% to Revenue -45.0% 8.3% 19.0% 0.0%


SURVIVAL REVENUE (SR) Cash Fixed Costs (CFC) 400,000 Variable Cost Revenue Ratio 65%

Survival Revenue = CFC / (1 - VCRR)= 400,000 / (1 - 65%)

1,142,857Unit sales for this 11,429 Selling Units

PSA CORPORATION'S FIRST THREE YEARS OF INCOME

Graphically

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Reduce VCRR to be 60%Year 1 Year 2 Year 3 BEP


Revenues 500,000 1,500,000 2,500,000 1,000,000-/- Cost of Goods Sold 300,000 900,000 1,500,000 600,000Gross Profit 200,000 600,000 1,000,000 400,000-/- Administrative Expenses 200,000 200,000 200,000 200,000 Marketing Expenses 180,000 180,000 180,000 180,000 Interest Expense 20,000 20,000 20,000 20,000

EBDAT -200,000 200,000 600,000 0% to Revenue -40.0% 13.3% 24.0% 0.0%





PSA CORPORATION'S FIRST THREE YEARS OF INCOME STATEMENT

Variable Costs at 60% of Revenues

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Reduce CFC by USD 30,000Year 1 Year 2 Year 3 BEP


Revenues 500,000 1,500,000 2,500,000 1,057,143-/- Cost of Goods Sold 325,000 975,000 1,625,000 687,143Gross Profit 175,000 525,000 875,000 370,000-/- Administrative Expenses 200,000 200,000 200,000 170,000 Marketing Expenses 180,000 180,000 180,000 180,000 Interest Expense 20,000 20,000 20,000 20,000

EBDAT -225,000 125,000 475,000 0% to Revenue -45.0% 8.3% 19.0% 0.0%







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Increase Selling Price by 15%Year 1 Year 2 Year 3 BEP


Revenues 575,000 1,725,000 2,875,000 1,142,857-/- Cost of Goods Sold 373,750 1,121,250 1,868,750 742,857Gross Profit 201,250 603,750 1,006,250 400,000-/- Administrative Expenses 200,000 200,000 200,000 200,000 Marketing Expenses 180,000 180,000 180,000 180,000 Interest Expense 20,000 20,000 20,000 20,000

EBDAT -198,750 203,750 606,250 0% to Revenue -34.6% 11.8% 21.1% 0.0%







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COMPARISON - EBDAT


Revenues 1,142,857 1,000,000 1,057,143 1,142,857-/- Cost of Goods Sold 742,857 600,000 687,143 742,857Gross Profit 400,000 400,000 370,000 400,000-/- Administrative Expenses 200,000 200,000 170,000 200,000 Marketing Expenses 180,000 180,000 180,000 180,000 Interest Expense 20,000 20,000 20,000 20,000EBDAT 0 0 0 0% to Revenue 0.0% 0.0% 0.0% 0.0%


BAUScenario 1 - VCRR 60%

Scenario 2 - CFC $30K

Scenario 3 - SP Up 15%

NOPAT Breakeven

NOPAT:net operating profit after taxes or EBIT times one minus the firm’s tax rate

NOPAT Breakeven Revenues (NR):amount of revenues needed to cover a venture’s total operating costs

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NOPAT Breakeven: Terms & Concepts (continued)

Basic Equation:NR = TOFC/(1 – VCRR)

Where: TOFC is the total operating fixed costs which consist of cash operating fixed costs (excluding interest expenses) plus noncash fixed costs (e.g., depreciation)

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NOPAT Breakeven: An Example

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Year 1 Year 2 Year 3 BEPNumber of Units Sold 5,000 15,000 25,000 11,571

Revenues 500,000 1,500,000 2,500,000 1,157,143-/- Cost of Goods Sold 325,000 975,000 1,625,000 752,143Gross Profit 175,000 525,000 875,000 405,000

Operating Expenses Administrative Expenses 200,000 200,000 200,000 200,000 Marketing Expenses 180,000 180,000 180,000 180,000Total Operating Expenses 380,000 380,000 380,000 380,000

EBITDA -205,000 145,000 495,000 25,000 Depreciation 25,000 25,000 25,000 25,000EBIT -230,000 120,000 470,000 0 Interest ExpenseEarning Before Taxes -230,000 120,000 470,000 0 Taxes 36,000 141,000 0

NOPAT -230,000 84,000 329,000 0


NOPAT Breakeven Revenue (NR) Total Fixed Costs (TOFC) 405,000 Variable Cost Revenue Ratio 65%

NOPAT Breakeven Revenue (NR) = TOFC / (1 - VCRR)= 405,000 / (1 - 65%)



End

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Measuring Financial Performance 1 ENTREPRENEURIAL FINANCE