chapter 11 financial plan

Copyright 2008 Prentice Hall Publishing 1CHapter 11: Financial Plan

Creating a Successful

Financial Plan


Financial ReportingFinancial Reporting Common mistake among business owners: Common mistake among business owners:

Failing to collect and analyze basic financial Failing to collect and analyze basic financial data.data.

One-third of entrepreneurs run their companies One-third of entrepreneurs run their companies without any kind of financial plan.without any kind of financial plan.

Only 11 percent of business owners analyze their Only 11 percent of business owners analyze their companies’ financial statements as part of the companies’ financial statements as part of the managerial planning process. managerial planning process.

Financial planning is essential to running a Financial planning is essential to running a successful business and is not that difficult!successful business and is not that difficult!


Basic Financial Basic Financial ReportsReports

Balance SheetBalance Sheet – “Snapshot.” Estimates the firm’s worth – “Snapshot.” Estimates the firm’s worth on a given date; built on the accounting equation: on a given date; built on the accounting equation: Assets = Liabilities + Owner’s Equity Assets = Liabilities + Owner’s Equity

Income StatementIncome Statement – “Moving picture.” Compares the – “Moving picture.” Compares the firm’s expenses against its revenue over a period of time to firm’s expenses against its revenue over a period of time to show its net income (or loss):show its net income (or loss): Net Income = Sales Revenue - Expenses Net Income = Sales Revenue - Expenses

Statement of Cash FlowsStatement of Cash Flows – shows the change in the firm's – shows the change in the firm's working capital over a period of time by listing the working capital over a period of time by listing the sourcessources of funds and the of funds and the usesuses of these funds. of these funds.


Ratio AnalysisRatio Analysis A method of expressing the relationships A method of expressing the relationships

between any two elements on financial between any two elements on financial statements.statements.

Important barometers of a company’s financial Important barometers of a company’s financial position.position.

Study: Only 27 percent of small business owners Study: Only 27 percent of small business owners compute financial ratios and use them to manage compute financial ratios and use them to manage their businesses. their businesses.


Twelve Key RatiosTwelve Key RatiosLiquidity RatiosLiquidity Ratios - Tell whether or not a small - Tell whether or not a small business will be able to meet its maturing business will be able to meet its maturing obligations as they come due.obligations as they come due.

1. 1. Current RatioCurrent Ratio - Measures solvency by - Measures solvency by showing the firm's ability to pay current showing the firm's ability to pay current liabilities out of current assets.liabilities out of current assets.

Current Ratio = Current Ratio = Current Assets Current Assets = = $686,985$686,985 = = 1.87:1 1.87:1

Current Liabilities $367,850Current Liabilities $367,850


Twelve Key RatiosTwelve Key RatiosLiquidity RatiosLiquidity Ratios - Tell whether or not a - Tell whether or not a small business will be able to meet its small business will be able to meet its maturing obligations as they come due.maturing obligations as they come due.

2. 2. Quick RatioQuick Ratio - Shows the extent to which a - Shows the extent to which a firm’s most liquid assets cover its current firm’s most liquid assets cover its current liabilities.liabilities.

Quick Ratio = Quick Ratio = Quick Assets Quick Assets = = $231,530 $231,530 = = .63:1.63:1

Current Liabilities $367,850Current Liabilities $367,850


Twelve Key RatiosTwelve Key Ratios Leverage RatiosLeverage Ratios - Measure the financing - Measure the financing

provided by the firm's owners against that provided by the firm's owners against that supplied by its creditors; a gauge of the depth supplied by its creditors; a gauge of the depth of the company's debt.of the company's debt.

Careful!! Debt is a powerful tool, but, like Careful!! Debt is a powerful tool, but, like dynamite, you must handle it carefully!dynamite, you must handle it carefully!


Twelve Key RatiosTwelve Key RatiosLeverage RatiosLeverage Ratios - Measure the financing - Measure the financing provided by a firm’s owners against that provided by a firm’s owners against that supplied by its creditors; a gauge of the supplied by its creditors; a gauge of the depth of the company’s debt.depth of the company’s debt.

3. 3. Debt RatioDebt Ratio - Measures the percentage of - Measures the percentage of total assets financed by creditors rather total assets financed by creditors rather than owners.than owners.

Debt Ratio = Debt Ratio = Total Debt Total Debt = = $580,000 $580,000 = .68:1= .68:1 Total Assets $847,655 Total Assets $847,655


Twelve Key RatiosTwelve Key RatiosLeverage RatiosLeverage Ratios - Measure the financing - Measure the financing provided by a firm’s owners against that provided by a firm’s owners against that supplied by its creditors; a gauge of the supplied by its creditors; a gauge of the depth of the company's debt.depth of the company's debt.

4. 4. Debt to Net Worth RatioDebt to Net Worth Ratio - Compares what a - Compares what a business “owes” to “what it is worth.” business “owes” to “what it is worth.”

Debt to Net = Debt to Net = Total Debt Total Debt = = $580,000$580,000 = 2.20:1 = 2.20:1Worth Ratio Tangible Net Worth $264,155Worth Ratio Tangible Net Worth $264,155


Twelve Key RatiosTwelve Key RatiosLeverage RatiosLeverage Ratios - Measure the financing provided - Measure the financing provided by a firm’s owners against that supplied by its by a firm’s owners against that supplied by its creditors; a gauge of the depth of the company's creditors; a gauge of the depth of the company's debt.debt.

5. 5. Times Interest EarnedTimes Interest Earned - Measures the firm's - Measures the firm's ability to make the interest payments on its debt.ability to make the interest payments on its debt.

Times Interest = Times Interest = EBIT* EBIT* = = $100,479 $100,479 = 2.52:1= 2.52:1EarnedEarned Total Interest Expense $39,850 Total Interest Expense $39,850

*Earnings Before Interest and Taxes*Earnings Before Interest and Taxes

Low HighDegree of Leverage

Optimal Zone

Ben

efits

of L

ever

age

The Right Amount of Debt is a Balancing Act.The Right Amount of Debt is a Balancing Act.

How Lenders View Liquidity and Leverage

Liquidity Leverage

Low If chronic, this is often evidence of mismanagement. It is a sign that the owner has not planned for the company's working capital needs. In most businesses characterized by low liquidity, there is usually no financial plan. This situation is often associated with last minute or "Friday night" financing.

This is a very conservative position. With this kind of leverage, lenders are likely to lend money to satisfy a company's capital needs. Owners in this position should have no trouble borrowing money.

Average This is an indication of good management. The company is using its current assets wisely and productively. Although they may not be impressed, lenders feel comfortable making loans to companies with adequate liquidity.

If a company's leverage is comparable to that of other businesses of similar size in the same industry, lenders are comfortable making loans. The company is not overburdened with debt and is demonstrating its ability to use its resources to grow.

High Some lenders look for this because it indicates a most conservative company. However, companies that constantly operate this way usually are forgoing growth opportunities because they are not making the most of their assets.

Businesses that carry excessive levels of debt scare most lenders off. Companies in this position normally will have a difficult time borrowing money unless they can show lenders good reasons for making loans. Owners of these companies must be prepared to sell lenders on their ability to repay.

Source: Adapted from David H. Bangs, Jr., Financial Troubleshooting, Upstart Publishing Company, (Dover, New Hampshire, 1992), p. 124.


Twelve Key RatiosTwelve Key RatiosOperating RatiosOperating Ratios - Evaluate a firm’s overall performance - Evaluate a firm’s overall performance and show how effectively it is putting its resources to and show how effectively it is putting its resources to work.work.

6. 6. Average Inventory Turnover RatioAverage Inventory Turnover Ratio - Tells the average - Tells the average number of times a firm's inventory is “turned over” or number of times a firm's inventory is “turned over” or sold out during the accounting period.sold out during the accounting period.

Average Inventory = Average Inventory = Cost of Goods Sold Cost of Goods Sold = = $1,290,117 $1,290,117 = 2.05 times = 2.05 times Turnover RatioTurnover Ratio Average Inventory* $630,600 a year Average Inventory* $630,600 a year

*Average Inventory = *Average Inventory = Beginning Inventory + Ending InventoryBeginning Inventory + Ending Inventory 2 2


Twelve Key RatiosTwelve Key RatiosOperating RatiosOperating Ratios - Evaluate a firm’s overall - Evaluate a firm’s overall performance and show how effectively it is putting performance and show how effectively it is putting its resources to work.its resources to work.

7. 7. Average Collection Period Ratio (days sales Average Collection Period Ratio (days sales outstanding, DSO)outstanding, DSO) - Tells the average number of - Tells the average number of days required to collect accounts receivable.days required to collect accounts receivable.Two Steps:Two Steps:

Receivables Turnover = Receivables Turnover = Credit Sales Credit Sales = = $1,309,589 $1,309,589 = 7.31 times Ratio= 7.31 times Ratio Accounts Receivable Accounts Receivable $179,225 times a $179,225 times a year year

Average Collection = Average Collection = Days in Accounting Period Days in Accounting Period = = 365365 = = 50.0 Period Ratio 50.0 Period Ratio Receivables Turnover Ratio Receivables Turnover Ratio 7.31 days7.31 days


Twelve Key RatiosTwelve Key RatiosOperating RatiosOperating Ratios - Evaluate a firm’s overall - Evaluate a firm’s overall performance and show how effectively it is putting its performance and show how effectively it is putting its resources to work.resources to work.

8. 8. Average Payable Period RatioAverage Payable Period Ratio - Tells the average - Tells the average number of days required to pay accounts payable.number of days required to pay accounts payable.Two Steps:Two Steps:

Payables Turnover= Payables Turnover= Purchases Purchases = = $939,827 $939,827 = 6.16 = 6.16 times times RatioRatio Accounts Payable $152,580 a yearAccounts Payable $152,580 a year

Average Payable = Average Payable = Days in Accounting Period Days in Accounting Period = = 365365 = = 59.3 59.3 Period Ratio Period Ratio Payables Turnover Ratio 6.16 days Payables Turnover Ratio 6.16 days


Twelve Key RatiosTwelve Key RatiosOperating RatiosOperating Ratios - Evaluate a firm’s overall - Evaluate a firm’s overall performance and show how effectively it is performance and show how effectively it is putting its resources to work.putting its resources to work.

9. 9. Net Sales to Total Assets RatioNet Sales to Total Assets Ratio - Measures a - Measures a firm’s ability to generate sales given its asset firm’s ability to generate sales given its asset base. base.

Net Sales to = Net Sales to = Net Sales Net Sales = = $1,870,841$1,870,841 = = 2.21:1 2.21:1 Total Assets Total Assets Total Assets Total Assets $847,655$847,655


Twelve Key RatiosTwelve Key RatiosProfitability RatiosProfitability Ratios - Measure how - Measure how efficiently a firm is operating; offer efficiently a firm is operating; offer information about a firm’s “bottom line.”information about a firm’s “bottom line.”

10. 10. Net Profit on Sales RatioNet Profit on Sales Ratio - Measures a - Measures a firm’s profit per dollar of sales revenue.firm’s profit per dollar of sales revenue.

Net Profit on = Net Profit on = Net Income Net Income = = $60,629 $60,629 = 3.24% = 3.24% Sales Sales Net Sales $1,870,841 Net Sales $1,870,841


Twelve Key RatiosTwelve Key RatiosProfitability RatiosProfitability Ratios - Measure how efficiently a - Measure how efficiently a firm is operating; offer information about a firm is operating; offer information about a firm’s “bottom line.”firm’s “bottom line.”

11. 11. Net Profit to Assets (Return on Assets) RatioNet Profit to Assets (Return on Assets) Ratio – tells how much profit a company generates – tells how much profit a company generates for each dollar of assets that it owns.for each dollar of assets that it owns.

Net Profit to = Net Profit to = Net Income Net Income = = $60,629 $60,629 = = 7.15% 7.15% Assets Assets Total Assets Total Assets $847,655 $847,655


Twelve Key RatiosTwelve Key RatiosProfitability RatiosProfitability Ratios - Measure how efficiently a - Measure how efficiently a firm is operating; offer information about a firm is operating; offer information about a firm’s “bottom line.”firm’s “bottom line.”

12. 12. Net Profit to Equity RatioNet Profit to Equity Ratio - Measures an - Measures an owner's rate of return on the investment owner's rate of return on the investment (ROI) in the business.(ROI) in the business.

Net Profit to = Net Profit to = Net Income Net Income = = $60,629 $60,629 = = 22.65% 22.65% Equity Equity Owner’s Equity* $267,655 Owner’s Equity* $267,655

* Also called net worth* Also called net worth


Interpreting RatiosInterpreting Ratios Ratios – useful yardsticks of comparison.Ratios – useful yardsticks of comparison. Standards vary from one industry to another; Standards vary from one industry to another;

key is to watch for “red flags.”key is to watch for “red flags.” Critical numbersCritical numbers – measure key financial and – measure key financial and

operational aspects of a company’s performance. operational aspects of a company’s performance. Examples:Examples: Sales per labor hour at a supermarketSales per labor hour at a supermarket Food costs as a percentage of sales at a Food costs as a percentage of sales at a

restaurantrestaurant Load factor (percentage of seats filled with Load factor (percentage of seats filled with

passengers) at an airline passengers) at an airline


Putting Your Ratios to the Test

When comparing your company’s ratios to your industry’s standards, ask the following questions:

1. Is there a significant difference in my company’s ratio and the industry average?2. If so, is this a meaningful difference?

3. Is the difference good or bad?

4. What are the possible causes of this difference? What is the most likely cause?5. Does this cause require that I take action?

6. If so, what action should I take to correct the problem?

Source: Adapted from George M. Dawson, “Divided We Stand,” Business Start-Ups, May 2000, p. 34.


Interpreting RatiosInterpreting Ratios

Sam’s Appliance ShopSam’s Appliance ShopCurrent ratio = Current ratio =

1.87:11.87:1

Industry MedianIndustry MedianCurrent ratio = Current ratio = 1.50:11.50:1

Although Sam’s falls short of the rule of Although Sam’s falls short of the rule of thumb of 2:1, its current ratio is above the thumb of 2:1, its current ratio is above the industry median by a significant amount. industry median by a significant amount. Sam’s should have no problem meeting short-Sam’s should have no problem meeting short-term debts as they come due.term debts as they come due.


Interpreting RatiosInterpreting RatiosSam’s Appliance Sam’s Appliance ShopShopQuick ratio = Quick ratio = 0.63:10.63:1

Industry MedianIndustry MedianQuick ratio = Quick ratio = 0.50:10.50:1

Again, Sam is below the rule of thumb of 1:1, Again, Sam is below the rule of thumb of 1:1, but the company passes this test of liquidity but the company passes this test of liquidity when measured against industry standards. when measured against industry standards. Sam relies on selling inventory to satisfy short-Sam relies on selling inventory to satisfy short-term debt (as do most appliance shops). If sales term debt (as do most appliance shops). If sales slump, the result could be liquidity problems slump, the result could be liquidity problems for Sam’s. What steps should Sam take to deal for Sam’s. What steps should Sam take to deal with this threat?with this threat?


Interpreting RatiosInterpreting RatiosSam’s Appliance Sam’s Appliance ShopShopDebt ratio = 0.68:1Debt ratio = 0.68:1

Industry MedianIndustry MedianDebt ratio = Debt ratio = 0.64:10.64:1

Creditors provide 68 percent of Sam’s total Creditors provide 68 percent of Sam’s total assets, very close to the industry median of assets, very close to the industry median of 64 percent. Although the company does not 64 percent. Although the company does not appear to be overburdened with debt, Sam’s appear to be overburdened with debt, Sam’s might have difficulty borrowing, especially might have difficulty borrowing, especially from conservative lenders.from conservative lenders.


Interpreting RatiosInterpreting RatiosSam’s Appliance ShopSam’s Appliance ShopDebt to net worth Debt to net worth ratio = 2.20:1ratio = 2.20:1

Industry MedianIndustry MedianDebt to net worth Debt to net worth ratio = 1.90:1ratio = 1.90:1

Sam’s owes $2.20 to creditors for every $1.00 Sam’s owes $2.20 to creditors for every $1.00 the owner has invested in the business the owner has invested in the business (compared to $1.90 to every $1.00 in equity for (compared to $1.90 to every $1.00 in equity for the typical business. Many lenders will see the typical business. Many lenders will see Sam’s as “borrowed up,” having reached its Sam’s as “borrowed up,” having reached its borrowing capacity. Creditor’s claims are borrowing capacity. Creditor’s claims are more than twice those of the owners.more than twice those of the owners.


Interpreting RatiosInterpreting RatiosSam’s Appliance ShopSam’s Appliance ShopTimes interest earned Times interest earned ratio = 2.52:1ratio = 2.52:1

Industry MedianIndustry MedianTimes interest Times interest earned ratio = 2.0:1earned ratio = 2.0:1

Sam’s earnings are high enough to cover Sam’s earnings are high enough to cover the interest payments on its debt by a the interest payments on its debt by a factor of 2.52:1, slightly better than the factor of 2.52:1, slightly better than the typical firm in the industry. Sam’s has a typical firm in the industry. Sam’s has a cushion (although a small one) in meeting cushion (although a small one) in meeting its interest payments. its interest payments.


Interpreting RatiosInterpreting RatiosSam’s Appliance ShopSam’s Appliance ShopAverage inventory Average inventory turnover ratio = 2.05 turnover ratio = 2.05 times per yeartimes per year

Industry MedianIndustry MedianAverage inventory Average inventory turnover ratio = turnover ratio = 4.0 times per year4.0 times per year

Inventory is moving through Sam’s at a Inventory is moving through Sam’s at a very slow pace. What could be causing very slow pace. What could be causing this low inventory turnover in Sam’s this low inventory turnover in Sam’s business?business?


Interpreting RatiosInterpreting RatiosSam’s Appliance ShopSam’s Appliance ShopAverage collection Average collection period ratio = 50.0 daysperiod ratio = 50.0 days

Industry MedianIndustry MedianAverage collection Average collection period ratio = 19.3 period ratio = 19.3 daysdays

Sam’s collects the average account Sam’s collects the average account receivable after 50 days compared to the receivable after 50 days compared to the industry median of 19 days - more than 2.5 industry median of 19 days - more than 2.5 times longer. What is a more meaningful times longer. What is a more meaningful comparison for this ratio? What steps can comparison for this ratio? What steps can Sam take to improve this ratio?Sam take to improve this ratio?


Interpreting RatiosInterpreting RatiosSam’s Appliance ShopSam’s Appliance ShopAverage payable period Average payable period ratio = 59.3 daysratio = 59.3 days

Industry MedianIndustry MedianAverage payable Average payable period ratio = 43 daysperiod ratio = 43 days

Sam’s payables are nearly 40 percent Sam’s payables are nearly 40 percent slower than those of the typical firm in slower than those of the typical firm in the industry. Stretching payables too far the industry. Stretching payables too far could seriously damage the company’s could seriously damage the company’s credit rating. What are the possible credit rating. What are the possible causes of this discrepancy?causes of this discrepancy?


Interpreting RatiosInterpreting RatiosSam’s Appliance ShopSam’s Appliance ShopNet sales to total Net sales to total assets ratio = 2.21:1assets ratio = 2.21:1

Industry MedianIndustry MedianNet Sales to total Net Sales to total assets ratio = 2.7:1assets ratio = 2.7:1

Sam’s Appliance Shop is not generating Sam’s Appliance Shop is not generating enough sales, given the size of its asset enough sales, given the size of its asset base. What factors could cause this?base. What factors could cause this?


Interpreting RatiosInterpreting RatiosSam’s Appliance ShopSam’s Appliance ShopNet profit on sales Net profit on sales ratio = 3.24%ratio = 3.24%

Industry MedianIndustry MedianNet profit on sales Net profit on sales ratio = 7.6%ratio = 7.6%

After deducting all expenses, Sam’s has After deducting all expenses, Sam’s has just 3.24 cents of every sales dollar left as just 3.24 cents of every sales dollar left as profit - less than half the industry profit - less than half the industry average. Sam may discover that some of average. Sam may discover that some of his operating expenses are out of balance. his operating expenses are out of balance.


Interpreting RatiosInterpreting RatiosSam’s Appliance ShopSam’s Appliance ShopNet profit to assetsNet profit to assets ratio = 7.15% ratio = 7.15%

Industry MedianIndustry MedianNet profit to assetsNet profit to assets ratio = 7.15% ratio = 7.15%

Sam’s generates a return of 7.15 percent for Sam’s generates a return of 7.15 percent for every $1 in assets, which is 30 percent above the every $1 in assets, which is 30 percent above the industry average. Given his asset base, Sam is industry average. Given his asset base, Sam is squeezing an above-average return out of his squeezing an above-average return out of his company. Is this likely to be the result of company. Is this likely to be the result of exceptional profitability, or is there another exceptional profitability, or is there another explanation?explanation?


Interpreting RatiosInterpreting RatiosSam’s Appliance ShopSam’s Appliance ShopNet profit on equity Net profit on equity ratio = 22.65%ratio = 22.65%

Industry MedianIndustry MedianNet profit on equity Net profit on equity ratio = 12.6% ratio = 12.6%

Sam’s return on his investment in the Sam’s return on his investment in the business is an impressive 22.65 percent, business is an impressive 22.65 percent, compared to an industry median of just compared to an industry median of just 12.6 percent. Is this the result of high 12.6 percent. Is this the result of high profitability or is there another profitability or is there another explanation?explanation?


Breakeven AnalysisBreakeven Analysis The breakeven point is the level of The breakeven point is the level of

operation at which a business neither operation at which a business neither earns a profit nor incurs a loss. earns a profit nor incurs a loss.

It is a useful planning tool because it It is a useful planning tool because it shows entrepreneurs minimum level of shows entrepreneurs minimum level of activity required to stay in business.activity required to stay in business.

With one change in the breakeven With one change in the breakeven calculation, an entrepreneur can also calculation, an entrepreneur can also determine the sales volume required determine the sales volume required to reach a particular profit target.to reach a particular profit target.


Calculating the Calculating the Breakeven PointBreakeven Point

Step 1Step 1. Determine the expenses the business can . Determine the expenses the business can expect to incur.expect to incur.

Step 2Step 2. Categorize the expenses in step 1 into fixed . Categorize the expenses in step 1 into fixed expenses and variable expenses.expenses and variable expenses.

Step 3Step 3. Calculate the ratio of variable expenses to . Calculate the ratio of variable expenses to net sales. Then compute the contribution margin:net sales. Then compute the contribution margin:

Contribution Margin = Contribution Margin = 1 - 1 - Variable ExpensesVariable ExpensesNet Sales EstimateNet Sales Estimate

Step 4. Compute the breakeven Step 4. Compute the breakeven point:point:Breakeven PointBreakeven Point

$$=

Total Fixed Costs Total Fixed Costs Contribution MarginContribution Margin


Calculating the Calculating the Breakeven Point:Breakeven Point:The Magic ShopThe Magic Shop

Step 1Step 1. Net Sales estimate is $950,000 with . Net Sales estimate is $950,000 with Cost of Goods Sold of $646,000 and Total Cost of Goods Sold of $646,000 and Total Expenses of $236,500. Expenses of $236,500.

Step 2Step 2. Variable Expenses of $705,125; Fixed . Variable Expenses of $705,125; Fixed Expenses of $177,375.Expenses of $177,375.

Step 3Step 3. Contribution margin:. Contribution margin:Contribution Margin = Contribution Margin = 1 - 1 - $705,125$705,125

$950,000$950,000StepStep 4. Breakeven point:

Breakeven PointBreakeven Point$$

= $177,375$177,375

.26.26

= .26

= = $682,212$682,212

Breakeven ChartBreakeven Chart

Sales VolumeSales Volume

Total ExpenseTotal ExpenseLineLine

RevenueRevenueLineLine

Fixed ExpenseFixed ExpenseLineLine

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Ex p

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Breakeven PointBreakeven PointSales = $682,212Sales = $682,212

$682,212$682,212

$682,212$682,212

Profit Area

Profit Area

Loss Area

Loss Area

00

chapter 11 financial plan

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