EBD 481 – Fall, 09Craig S. GalbraithPresentation derived in part from original material developed by Craig Galbraith and various presentations from Alan Barefield, University of Tennessee

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Number one reason for small business failure is not understanding financial statements

Need to know financial statements in order to track and predict success

Need to develop pro-formas for business plans

Need to analyze financial performance for valuation

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Projection of future financial condition

3 to 5 year projection Why only 3 to 5 year?

Key issues in pro-forma are Consistency with underlying

business plan Consistency with accounting

formats Sources for line items Assumptions for line items

Underlying analysis is critical

Be reasonable

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Income or Profit & Loss Statement

Balance Sheet

Cash Flow Statement

Budget Forecast

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Provides a summary of the revenues and expenses associated with the period’s operating activities

Provide information to complete the business and personal income tax returns

Shows the profitability of the business for lenders and other interested parties

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The income or profit and loss statement summarizes the level of revenue and expenses for the business

Major components include: Revenues Expenses Taxes Extraordinary Items

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Business revenue can be divided into two categories Revenue from current operations – Cash

proceeds from the sale of inventory, noncash proceeds from sales, patronage dividends, insurance proceeds, noncash inventory adjustments

Expenses incurred in the production process should be deducted from revenues to yield a gross profit margin

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Capital gains and losses – Gain or loss realized from the sale of intermediate or long-term assets

Nonbusiness revenue – Income derived from nonbusiness employment, interest and dividend income from nonbusiness investments

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Cash operating expenses – Includes expenses paid in cash, expenses that have been incurred but not yet paid (accounts payable), interest expenses

Noncash expenses includes depreciation and any expenses paid from the last reporting period if the business is reporting on a cash basis

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This section includes the specific tax liabilities incurred during the reporting period. Only income and self-employment taxes are reported in this section. Payroll taxes, real estate and real property taxes, etc., are reported under the Expenses section of the income statement

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This section includes “once-in-a-lifetime” events that should not be included as a part of the firm’s regular financial activities

Includes insurance payments from a loss, agricultural disaster payments, etc.

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RevenuesBusiness Revenue

+ Gain from sale of intermediate or LT assets+ Non Business Revenues+ Noncash revenue adjustments= Total revenue

- Cost of goods sold

= Gross profit margin

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Gross profit margin- Cash operating expenses- Noncash operating expenses= Income from business operations+(-) Gain (loss) on depreciable assets= Net business income+ Nonbusiness revenue-Non business expenses= Income before taxes- Provisions for taxes= Net Income

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Summarizes the levels of cash that the business has available to meet current obligations

Generally divided into monthly or quarterly periods to show when excess cash is available or when borrowing needs to occur

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Highlights the financing arrangements necessary to cover cash requirements

Serves as a benchmark for budgeting activities

Analyzes the timing of financial borrowing activities

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Cash available Beginning cash balance Cash revenues from sales and accounts

receivable Other sources of cash

▪ Proceeds from sale of equipment and other assets

▪ Nonbusiness wages▪ Interest and dividend income

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Cash required Operating expenses Income tax payments Intermediate and long-term payments Capital expenditures Family living expenses Cash gifts and donations

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Borrowings New loans to finance production and

capital expendituresOther

Short term loan payments Savings – additions and withdrawals Ending cash balance for the period

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Many persons assert that the budget is simply a projection of the cash flow statement

However this is not correctThe budget must incorporate all key

financial statementsForecasting statements are also

called pro forma statements

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Details the financial position of a business at a particular point in time

Assets = Liabilities + Equity Tells the reader what the business

owns of monetary value and what the business owes to others.

Personal and business assets and liabilities are frequently reflected on the same statement

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The balance sheet indicates the degree to which the business is liquid and solvent

Liquidity – Can the business’ current liabilities be retired if the current assets are converted to cash?

Solvency – Can the total liabilities of the business be retired if all assets are converted to cash?

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Assets Represents the monetary value of what

the business owns Are normally grouped into three

categories denoting how soon they wear out or are sold▪ Current – Less than 1 year▪ Intermediate – 1 to 10 years▪ Long-term – Over 10 years

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Cash Checking accounts Savings accounts Accounts

receivable Inventories Supplies WIP investments

Equity in hedging accounts

Tax refunds Unused tax credits Prepaid expenses

Payroll Insurance Rent

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MachineryBusiness vehiclesRetirement accountsCash value of life insuranceHousehold goodsPersonal vehicles

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Land

Buildings and structures

Personal residences

Nonbusiness real estate

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Liabilities Represents the value of the debts owed

by the business Are normally grouped into three

categories denoting how soon they fall due▪ Current – Less than 1 year▪ Intermediate – 1 to 10 years▪ Long-term – Over 10 years

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Accounts payableShort term notes payableCurrent payments on intermediate or

long term notesAccrued expensesContingent tax on sale of current

assets

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Loans to finance intermediate assets less current payments

Contingent tax on sale of intermediate assets

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Business and nonbusiness mortgages less current payments

Other long-term notes

Contingent tax on sale of long term assets

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Net worth (also called net equity) Net worth represents the difference

between the total level of assets and the total level of liabilities

Net worth should be reported on an after-tax basis

If net worth is positive, the business is solvent (assets can be sold to retire liabilities). If net worth is negative, the business is insolvent

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Assets Current Assets Intermediate Assets Long-term Assets

Liabilities Current Liabilities Intermediate

Liabilities Long-term Liabilities

Net Worth

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Expected selling pricesExpected input pricesExpected input productivityPro forma operating budget

Production costs and sales objectivesPro forma financial budget

Cash receipts and disbursementsFamily living budgets

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Ratio analysis Alleviates the unit of measure problems

incurred when comparing raw numbers Four different types of ratios can be

examined▪ Liquidity ratios – can current debts be met▪ Solvency ratios – can all debts be met▪ Efficiency ratios – how efficient is the

operation▪ Profitability ratios – how profitable is the

operation

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Ratios don’t mean anything by themselves

They must be compared over time and with similar companies

Look at industry standards through trade magazines, Standard & Poore’s, RMA analysis, etc.

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Current assets divided by current liabilities

Interpretation Relatively high ratio values mean that

the business is liquid, but cash is not working

If the current ratio is greater than 1.0, the business is liquid

If the current ratio is less than 1.0, the business is illiquid

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sLiabilitie Current Total AssetsCurrent Total

Ratio Current

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Current assets minus inventories divided by current liabilities

Interpretation Relatively high ratio values mean that

the business is liquid, but cash is not working

If the current ratio is greater than 1.0, the business is liquid

If the current ratio is less than 1.0, the business is illiquid

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sLiabilitie Current TotalInventory - AssetsCurrent Total

Ratio Test Acid

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Total liabilities divided by total net worth

Interpretation The higher the value, the less solvent

the business is If less than 1.0, the business is solvent If greater than 1.0, the business is

insolvent

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WorthNet TotalsLiabilitie Total

Ratio Current

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Total assets divided by total liabilities

Interpretation The higher the value, the more solvent

the business If greater than 1.0, the business is

solvent If less than 1.0, the business is insolvent

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sLiabilitie Total AssetsTotal

Ratio Capital Net

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Value of production divided by total average productive assets

Interpretation The higher the value, the more efficient

the business The lower the value, the less efficient

the business

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AssetsProductive TotalProduction of Value

Ratio Capital Net

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Total business expenses divided by the value of production

Interpretation The lower the value, the more efficient

the business The higher the value, the less efficient

the business

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Production of ValueExpenses Business Total

Ratio Gross

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Net sales divided by net accounts receivables

Interpretation Measures the number of times

receivables turn over during the year The higher the turnover, the shorter the

time between the sale and cash collection

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sReceivable AccountsNetSales Net

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365 divided by the Sales/Receivables Ratio

Interpretation Dividing the sales/receivables ratio into

365 provides the number of days between sales and collections

The higher the number, the longer it takes the business to collect accounts receivable

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Ratio ivablesSales/Rece365

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Calculated by dividing cost of goods sold by the dollar level of inventory

Interpretation Measures the number of times inventory

is turned over during the year High inventory can indicate better

liquidity or superior merchandising

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Interpretation (continued) Conversely, high turnover can mean a

shortage of needed inventory for sales Low inventory turnover can indicate

poor liquidity, possible overstocking, obsolescence, or a planned inventory buildup

Closely examine the reasons behind the value of this ratio with regard to your business

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InventorySold Goods of Cost

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365 divided by the inventory turnover ratio

Interpretation Calculates the average number of days

that units are in inventory See explanations for high or low

numbers in the interpretation for the inventory turnover ratio

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Ratio TurnoverInventory 365

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Divide cost of goods sold by net accounts payable

Interpretation Measures the number of times payables

turn over during the year The higher the turnover, the lower the

time between purchase and payment

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Interpretation (continued) A low ratio can indicate:

▪ Cash shortage▪ Invoice disputes with suppliers▪ Extended terms of payment provided by

suppliers▪ Expansion of trade credits with suppliers

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Payable AccountsNetSold Goods of Cost

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365 divided by the payables turnover ratio

Interpretation Calculates the average number of days

that trade payables are outstanding For possible explanations of a relatively

large number of days, see the explanations for the payable turnover ratio

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Ratio Turnover Payables365

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Net sales divided by working capitalWorking capital is calculated by

subtracting current liabilities from current assets

Interpretation Measures how efficiently working capital

is employed

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Interpretation (continued) A relatively large ratio could mean that

working capital is efficiently employed Conversely, it could also mean that the

firm is undercapitalized and is in danger of becoming non-liquid

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Capital WorkingSales Net

where

Working capital = Current Assets – Current Liabilities

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Income + loan interest obligations – value of unpaid labor and management – business income taxes divided by total business assets

Interpretation The higher the value, the more profitable

the business

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AssetsBusiness TotalTaxes Business -

Labor Unpaid of Value

sObligation Interest Loan

Income

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Income – value of unpaid labor and management – business income taxes divided by total business net worth

Interpretation The higher the value, the more profitable

the business

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WorthNet Business TotalTaxes Business -

Labor Unpaid of Value

sObligation Interest Loan

Income