mastering business finance

MasteringBusinessFinance

ii / Business Management Daily

Authors: NeilGriffin,DonBattle,RaymondJ.Lipay Editor: KathyA.Shipp Editorial Director: PatrickDiDomenico Associate Publisher: AdamGoldstein Publisher: PhillipA.Ash

©2011,2005,1996,BusinessManagementDaily,adivisionofCapitolInformationGroup,Inc.,7600ALeesburgPike,WestBuilding, Suite 300, FallsChurch,VA22043-2004;www.BusinessManagementDaily.com;phone: (800)543-2055.Allrightsreserved.Nopartofthisreportmaybereproducedinanyformorbyanymeanswithoutwrittenpermissionfromthepublisher.PrintedinU.S.A.

ISBN:1-880024-09-8

“Thispublicationisdesignedtoprovideaccurateandauthoritativeinformationinregardtothesubjectmattercovered.It issoldwiththeunderstandingthatthepublisherisnotengagedinrenderinglegal,accountingorotherprofessionalservice.Iflegaladviceorotherexpertassistanceisrequired,theservicesofacompetentprofes-sionalpersonshouldbesought.”—From a Declaration of Principles jointly adopted by a committee of the American Bar Association and a committee of publishers and associations.

Mastering Business Finance / iii

ContentsWhat Every Manager Should Know 1 Are You Savvy About Finance? 2

1. Learning the Tools of the Trade 3 The Balance Sheet 3 Sample Corporate Balance Sheet 4 Assets 5 Liabilities and Equity 5 The Income Statement 5 Sample Income Statement 6 The Statement of Cash Flows 7 Sample Statement of Cash Flows 8

2. How the Financial Pros Use These Tools 10 Troubleshooting With Ratio Analysis 10 Ten Critical Ratios 10 Does your firm have enough cash to pay its bills? 12 To leverage or not to leverage? 12 How profitable is your firm? 12 Should you provide credit to a customer? 12

3. AnsweringSomeDifficultFinancialQuestions 14 AQuestionofProfitMargins 14 A Question of Working Capital 15 RMA’s Annual Statement Studies 15 A Question of Returns 16 A Question of Asset Management 17 A Question of Debt Strategy 18 A Question of Purchasing 19 A Question of Stability 20

4. ProfitFromYourBudget 22 The Budgeting Process 22 Developing a Budget System That’s Right for You 22 Organizing a Budget Team 23 The Budget Committee 24 The Budget Chairman 24 Team Budgeting 24 A Look at Zero-Base Budgeting 25 What Not to Expect From a Budget 27

5. ShouldYouUseaFixedorVariableBudget? 29 Limitations of a Fixed Budget 29 How Rising Sales Can Affect a Fixed Budget 29 How Falling Sales Can Affect a Fixed Budget 30 Comparing Changes 30

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Using a Variable Budget 30 The Need for Flexibility 30 Budgeting After the Fact 31 Getting What You Pay For 31

6. ProducinganEffectiveBudget,StepbyStep 32 Step 1: Develop a Sales Forecast 32 Step 2: Develop Measures of Activity 33 Step 3: Collect Historical Data 34 Step 4: Do Cost Analysis 34 Step 5: Determine Budget Allowances 35 Expense Budget, Year Ending Dec. 31: ABC Corporation 36 Step 6: Review Expense Budgets 37 Step7:EstimateProfits 37 Using Your Budget 38 Remember to Follow Up 38 Revising Your Budget 38

7. ManagingYourCash 40 Making Cash-Flow Decisions 40 Using Your Cash Budget 41 Where to Obtain the Right Cash-Flow Information 42 Expense Budget: ABC Publishing Company 42 Cash Budget: ABC Publishing Company 43 Receipts and Disbursements Analysis 43 Receipts and Disbursements Analysis: ABC Publishing Company 45 Flow of Funds Analysis 45 Flow of Funds Analysis: ABC Publishing Company 46 Forecasting Your Cash Flow 47 Preparing a Short-Term Cash-Flow Forecast 48 Role of Cash-Flow Assumptions 48 Using a Long-Term Cash-Flow Forecast 49 Adapt Flow-of-Funds Analysis 49 Long-Term Cash Forecast: ABC Publishing Company 50 Keeping Cash Flow Under Control 51 The Cash-Flow Statement 51 Liquidity Report 51 Flow-of-Funds Statement 52 Making Your Cash Count 53 Managing a Financial Emergency 53 Priority List 54

8. CapitalInvestmentBasics 56 How to Prepare a Capital Investment Proposal 56 Classifying Capital Spending Projects 56 Avoiding Common Pitfalls 57 Calculating Your True Capital Costs 58 Assessing the Cost of Debt 58 What Are Equity Costs? 58

Mastering Business Finance / v

Ways to Measure Your Expected Return 59 The Payback Method 59 Using Net Present Value to Measure Return 61 Understanding the Discounting Concept 61 Discounting to Find NPV 62 Table 1: Present Value Factors 63 Using Internal Rate of Return 63 Calculating Internal Rate of Return (IRR) 64 The Hurdle Point: Uses and Misuses 65 Determining Flexible Hurdle Rates 65 Analyzing Your Capital Investment Risks 66 Weighted-Risk Analysis 67 Adjusting for Probabilities 67 Alternate Scenarios Measure Risk 68 Probability Adjustment—ABC Company 68

9. HowtoRaiseMoney 69 Keep a Business Plan on Hand 69 Contents of a Business Plan 69 When a Shorter Proposal Will Do 70 Where to Look for Funds 71 Internal Financing 71 Customers Come First 71 Make Your Employees Owners 72 The ABCs of Bank Borrowing 72 Finding the Right Type of Loan 73 Score Your Loan Worthiness 75 The Loan Application 75 If Your Banker Turns You Down... 77 Loan Guarantees From the SBA 77 How PLP Works 78 Loans From Commercial Finance Companies 78 Using a Factor 79 Bond Financing 80 Raising Equity Capital 81 How to Attract a Venture Capitalist 81 Evaluating a Venture Capitalist 82 Dealing With an SBIC 82 The Role of the Private Investor 83 Regulation D Private Placement 84 Raising Capital Through a Public Stock Offering 85 Other Methods of Financing 86 A Look at Leasing 86 Don’t Forget Development Corporations 87

Glossary 88

1

What Every Manager Should Know

Nosubjectseemstopervadeourlivesasmuchasfinance.Whetherit’swres- tlingwithyourfamilybudgetorseeingifyourcompanyqualifiesfora bankloan,financeloomslargerthananyothertechnicalsubjectonadaily

basis.Withdownsizingofcompaniesandstaffs,managersateverylevelarehav-ingtofacefinancialmattersinever-greaterproportionstoday.Ifyouhaven’tyetbeenaskedtoscaledowninventoriesorsetupfinancingfordepartmentalprojects,chancesareyouwillbesoon.

Intoday’scorporateenvironment,nonfinancialmanagersareexpectedtomakefinancialdecisionsfast.Infact,yourdecisionoftenwasdue“yesterday.”Ifthat’snotenoughpressure,thearrivalofcomputersandcyberspacehasgivenyourcompeti-tionaccesstomorefinancialfacts,ingreaterdetailandmorepromptly,thaneverbefore.Theneedtomakefinancialdecisionsquicklyisvitaltoyoursuccess.There’snotimeforanin-depthstudyoffinancialconceptsandtheirmeaningwhenyourbossoryouremployeesareexpectingayesornoanswerrightaway.

Thisreportismeanttostripawaythefearandconfusionyoumayexperienceaboutfinance.Itexplainsexpenseandcapitalbudgets,financialanalysisandcashmanagement,andtellsyouhowtogoaboutraisingmoney—allinlanguagethat’seasytounderstand.Weexplain jargonwherewehavetouseit—andwherewethinkthatapicturewouldbeworthathousandwords,you’llfindanexampleoranillustration.Unlikemostpublicationsonfinance,wegiveyounotjustthehowbutalsothewhyofthefinancialprocess.Ourgoal:tobringyouuptospeedfastonthefinancialtoolsyouneedtosucceedinbusinesstoday.

2 / Business Management Daily

AreYouSavvyAboutFinance?

Beforereadingthisreport,youmightfinditinterestingtotestyourcurrentknowledgeoffinance.Takethefollowingtestandcheckyouranswersbelow.

True False

1. Small companies generally use “S-1” ❏ ❏ public stock registrations in their equity offerings.

2. Another name for “income statement” is ❏ ❏ “statementoffinancialchanges.”

3. “NPV” stands for “net percentage value.” ❏ ❏

4. Fixed costs are so named because they ❏ ❏ never change.

5. A current ratio gives you a good ❏ ❏ indicationofacompany’sprofitability.

6.Non‑notificationfactoringridsa ❏ ❏ company of the chore of handling bookkeeping and collection payments for its receivables.

7. “Hurdle rate” is just another name for ❏ ❏ “current loan rate.”

8. The payback method is a good way to ❏ ❏ measuretheprofitabilityofacapital project.

9.Acompany’sfirststepinthebudget ❏ ❏ process is to come up with a cash forecast.

10. “Working capital” is a fancy label for ❏ ❏ acompany’scashflow.

Answers: All 10 questions are false.

Mastering Business Finance / 3

Learning the Tools of the Trade

Togetthebigpictureoftherolefinancesplayinyourcompany,thinkaboutanymajordecision youorotherswithinyourcompanymake.Thedecisionstohire,fire,buy,sell,startuporclose

down—allarefinancialnature.Almostanyquestionthatmakesitswaytoyourdesk,andthatrequiresadecisionbyyou,canbeputintofinancialterms.

Inthestrictestsense,thefinancialproorofficerinyourcompanyisstilltheonechargedwithmakingsurethecompanyusesitsassetstobringthegreatestpossiblereturnonthemoneyin-vested.Toaccomplishthat,heorshemustmanagethoseassets,measuretheneedforadditionalassets,obtainfundstofinanceexpansionandrepayborrowedfundsfromprofitsthattheassetshavegenerated.Inshort,thefinancialofficerridesherdonincomingandoutgoingdollars.But,infact,everymanagerhasatleastpartofthatresponsibility.

Itshouldcomeasnosurprisetoyou,then,thatthebasictoolsofthetradeusedtocarryoutthesetasksbeginandendindollarsigns.Theyarecalledthebalance sheet,theincome statement andthestatement of cash flows.Thesefinancialstatementsarepreparedbyyouraccountingde-partmentoraccountantontheaccrualbasisofaccounting.Accordingtotheaccrualaccountingmethod,revenuesarerecordedwhenrealizedandexpenseswhenincurred,regardlessofthedatewhencashisactuallyreceivedordisbursed.

Formanynonfinancialmanagers,theaccrualconceptisconfusingbecausemostofusmanageourpersonalfinancesonacashbasis.Similarly,otherbusinessfinancialconceptscreatefrustra-tionandembarrassmentformanagerswho,oftenunknowingly,attemptto“simplify”thingsbyapplyingpersonalfinancialpractices.

Forinstance,mostofusregardourannualincomeonagrossbasis.Rarelydoweconsiderdepreciatingpersonalitems,suchasacarforwearandtear,oramortizinglesstangiblegoods.Anexaminationofthebalancesheet,incomestatementandstatementofcashflowswillrevealtheimportanceofunderstandingthedifferencebetweenbusinessandpersonalfinance.

TheBalanceSheetThebalancesheetisacomprehensivestatementofthefinancialpictureofyourcompanyonagivendate.Virtuallyeverybusinesspreparesabalancesheetatthecloseofitsfiscalortaxyear.Manyalsopreparesemiannualorquarterlybalancesheets,andmostshoulddoso.

Therearetwoprimarysectionsonthebalancesheet:Thefirstone(theleftside,ifthetwosectionsareshownsidebyside)listsyourcompany’sassets,orwhatitowns.Thesecondsection(right-handside)listsliabilities,ordebts,andtheowner’sequityinthecompany.Totalliabilitiesareclaimsagainsttotalassets.Thesumoftheseliabilitiesandequityalwaysequalstotalassets(assets=liabilities+equity):hence,thename“balancesheet.”Thesimplifiedbalancesheetthatappearsonpage4mightbepreparedbyanymanufacturingcompany.Othercompanieswouldhavesimilarstatements.

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Sample Corporate Balance Sheet

ASSETSCurrent assets

Cash and equivalents $ 30,000 Trade accounts receivable $80,000 Less allowance for doubtful accounts 9,000 71,000

Inventories Finished goods/products 65,000 Work in process 65,000 Raw materials 10,000 Supplies 5,000 145,000

Prepaid expenses 9,000

Total current assets $255,000

Fixed assets Furniture and fixtures $ 9,000 Less allowance for depreciation 4,000 5,000 Machinery and equipment 20,000 Less allowance for depreciation 6,000 14,000 Buildings 35,000 Less allowance for depreciation 8,000 27,000 Land 14,000 Total fixed assets 60,000

Other assets Investments 15,000 Goodwill, patents 8,000 Total 23,000

Total assets $338,000

LIABILITIES AND EQUITYCurrent liabilities

Accounts payable $ 30,000 Notes payable 70,000 $100,000

Accrued liabilities Wages and salaries payable $ 3,000 Interest payable 1,000 4,000

Allowance for taxes Income tax $14,000 State taxes 3,000 17,000

Total current liabilities $121,000

Long‑term debt 5,000

Equity

Capital stock $150,000 Surplus 62,000 Total equity 212,000

Total liabilities and equity $338,000


Followingisadescriptionofeachofthebasicbalance-sheetitemslisted,manyofwhichwillbeusedtoconstructthevariousfinancialratiosexplainedinSection2.

Assets

Current assets:Allcashheld(primarilyinbankbalancesormoneymarketfunds);assetsthatwillbeconvertedtocashinthenormalcourseofbusinesswithinonebusinessyear(tradeaccounts,notesreceivableandinventories);plusotherassetsthatcouldorwillbeconvertedwithinayear(marketableshort-termsecurities,nontradedebtsordebtinstallmentsowedtothecompanywithinayear).Otherthancashandequivalents,currentassetsincludeinventories(invariousstagesofcompletion)andprepaidexpenses(anyrent,interest,insuranceortaxespaidinadvance).

Althoughthetermdoesn’tappearinmostbalancesheets,thefollowingitemsmakeupnon-current assets.

Fixed assets: Allproperty,plantsandequipment(buildings,realestate,machines,transporta-tionequipment,officeequipment,furniture,etc.)usedinthebusiness.Theaccumulateddeprecia-tionontheseitemsisdeductedwhereapplicableinstandardaccountingpractice.

Other assets:Alllong-terminvestments,suchassecurities(stocks,bonds,mortgages),andintangible assets,suchasgoodwill,patents,trademarksandotherpaperassets,whichmaybeassignedavaluefordeterminingthetotalsalepriceofthebusiness.Intangibleassetscanhaveasignificantimpactonabusiness’sabilitytogenerateincome.However,unlikeaplantorequip-ment,theyareoftenconceptsorlegalentitlements.

Total assets: Thesumofthecurrent,fixedandotherassetslistedabove.

Liabilities and Equity

Current liabilities:Outstandingtradedebtsandobligations(tradeaccountspayable,short-termnotesandloanspayable,currentinstallmentsdueonlong-termdebts,etc.)thatwillfalldueinthecourseofnormalbusinesswithinoneyear,plusaccruedbusinessexpensespayableandaccruedfederalincometaxespayable.

Long-term liabilities or debt:Allbusinessdebtsandliabilities(long-termloans,bonds,mort-gages,etc.)payablemorethanoneyearbeyondthedateofthebalancesheet.

Total liabilities: Thesumoftheaboveitems.Shareholders’ equity (net worth):Theparvalueofthecorporation’scommonandpreferred

stock,plusanypaid-inoraccumulatedcapitalsurplusoverthisparvalue,plusanyretained earn-ings foruseinbusiness.Retainedearningsofthebusinessrepresentthetotalincomeearnedbythefirmoveritslifelessanydividendspaidouttotheowners.(Equity=bookvalueofoutstandingstock+capitalsurplus+retainedearnings)

Total liabilities and equity: Thesumoftheabovetwogroups,whichbydefinitionisalsoequaltothetotalassetsofthebusiness.

TheIncomeStatementTheincomestatement(alsocalledtheearningsreportorprofit-and-lossstatement)reflectstheresultsofoperationoveraperiodoftime,incontrasttothebalancesheet’ssnapshotviewofthecompany’sfinancialconditionatagiveninstant.Again,everybusinessmustprepareanannualincomestatementfortax,legalandotherpurposes;nevertheless,semiannual,quarterlyorevenmonthlystatementscanbeextremelyuseful.Theitemsincludedinthesimplifiedincomestatementonpage6willoftenbeneededtocreatethefinancialratiosusedinyouranalysisandcoveredinthenextsection.Briefly,hereisadescriptionoftheitemscontainedinacompany’sincomestatement:


Gross sales or revenues: Theactualtotaldollarsbilledforgoodssoldorservicesprovided,beforereturns,discountsandallowancesgranted.Salesincomeandaccountsreceivabledeterminethisfirstlineitem.

Net sales or revenues: Grosssalesminusreturns,discountsandallowances.Cost of goods sold:Theamountspaidforthepurchasedmaterials,componentsandfinished

products;directpayroll,operatingoverhead;andothercostsofacquiringorproducingtheprod-uctsorservicesandmakingthemavailableforsale.Thislineitemoftenappearsasless cost of goods sold.

Gross profit:Thedifferencebetweennetsalesorrevenuesandthecostoftheproductsorservicessold.Thisrepresentstheamountofmoneylefttoselltheproductandperformtheday-to-dayoperationsofthebusiness.

Selling and administrative costs:Sellingcostsincludesalespersons’salariesandcommissions,travelandentertainmentexpenses,salespromotionandadvertisingcosts.Administrativecostsincludeofficesalariesandexpenses,executivesalariesandothercurrentsupportexpensesthatcan’tbeallocatedtoproductionorsalesdepartments.

Depreciation: Thecostsofplantassets(orfixedassets:property,plantandequipment)arewrittenoffasexpensesover theiranticipateduseful life.Notallfixedassetsaredepreciated,however.Forinstance,thevalueoflandtendstoappreciateinvaluebecauseitdoesnottypicallywearout.Therearevariousdepreciationtechniquesanaccountantcanuse.ThesimplestandmostcommonlyusedmethodinU.S.businessesiscalledthestraight-line method of depreciation,whichallowsyoutodepreciatethesameamountofexpenseeachyearoftheestimatedusefullifeoftheasset.Forexample,anassetwithavalueof$10,000andausefullifeof10yearswillhaveanannual$1,000depreciationexpenseeachyear.

Net operating profit:Grossprofit,lesssellingcostsandadministrativeoverhead.Thislineitemrepresentstheprofitgeneratedbythenormaloperationsofthebusiness.

Nonoperating income: Interestanddividendsreceivedoninvestments,gainsonthedisposi-tionofcapitalassets,etc.

Nonoperating expenses:Interestpaidonlong-termdebts,lossesonsalesofcapitalassets,etc.

Sample Income Statement

Gross sales or revenues $ 605,000

Returns, discounts and allowances 30,000

Net sales or revenues 575,000

Cost of sales or goods sold 470,000

Gross margin or operating profit $ 105,000

Selling and administrative costs 60,000

Depreciation 5,000

Net operating profit $ 40,000

Interest income or nonoperating income 10,000

Interest expense or nonoperating expense 3,000

Net profit before taxes $ 47,000

Provision for federal income taxes 10,000

Net profit after taxes $ 37,000


Net profit before taxes:Netoperatingprofit,plusanynonoperatingincomeandminusanynonoperatingexpenses.

Provision for federal income taxes:Theestimatedamounttobepaidonoperatingearningsfortheperiod,nottheamountoftaxespaidduringtheperiod.

Net profit (or income) after taxes: Thefinal“bottomline”profitclearedbythebusinessfromallsourcesduringtheperiodcoveredbythestatement.Usingthisvitalfigure,stockholderscanevaluatemanagement,investorscandecideonwhethertopurchasethecompany’sstock,andcreditorscanmeasuretheriskinessofaloan.

The Statement of Cash FlowsThestatementofcashflows,whichshowsthemovementofcashthroughabusiness,presentsthecashreceiptsandcashpaymentsofacompanyoveraperiodoftime.Itcomplementstheincomestatementbyprovidinginformationonacompany’sliquidityandfinancialflexibility.Italsoex-plainsthechangeofcashandcashequivalentsduringaperiod.(Cashequivalentsareshort-term,highlyliquidinvestmentsthatarereadilyconvertibletocashamounts,suchasshort-termTreasurybills,commercialpaperandmoneymarketfunds.)Insimilarfashiontothebalancesheetandtheincomestatement,thestatementofcashflowsmustbepreparedannuallybyeverybusinessbutmayalsobedonesemiannuallyorquarterly.

Note: EffectiveforannualfinancialstatementsforfiscalyearsendingafterJuly15,1988,thestatementofcashflowssupersedesthestatementofchangesinfinancialposition,whichtheFi-nancialAccountingandStandardsBoard(FASB)formerlyrequired.Not-for-profits,however,arenotrequiredtomaketheswitch-over.

Byusingthestatementofcashflowsinconjunctionwithinformationprovidedbythebalancesheetandtheincomestatement,companyowners,creditorsandotherswhousefinancialstate-mentscanassessacompany’sabilitytogeneratefuturenetcashinflows,meetdebtobligationsandpaydividends.Thestatementshouldalsohelpinassessingacompany’sneedforfutureexternalfinancing,aswellastheeffectsofbothcashandnoncashinvestingandfinancingactivitiesonacompany’sfinancialposition.

Thestatementofcashflowsisclassifiedbyoperating,investingandfinancingactivities.(See sample statement on page 8.) Briefly,thesearetheitemscontainedinacompany’sstatementofcashflows:Operating Activities: Cash received from: ● Saleofgoodsorservices. ● Collectionsorsalesofreceivablesthat

arise fromthesalesofgoodsandser-vices.

● Interestonloansandbonds. ● Dividendsonequitysecurities. ● Insuranceandlawsuitsettlements. ● Refundsfromsuppliers.

Cash paid to: ● Acquisitionofmaterials for inventory

ormanufacturingproducts,orforgoodsforresale,includingpaymentsontradeaccountsandnotespayabletosuppliers.

● Creditorsforinterest.

● Employeesforcompensation. ● Governmentalagenciesfortaxes,duties,

fees,finesorpenalties. ● Customersforrefunds. ● Lawsuitsettlements. ● Charitiesforcontributions.

Investing Activities: Cash received from: ● Salesofproperty,plant,equipmentand

otherproductiveassets. ● Salesofabusinessunitsuchasabranch,

divisionorsubsidiary. ● Collectionsofprincipalondebtinstru-

mentsofothercompanies. ● Saleofloans.


Cash paid to: ● Acquireproperty,plant,equipmentand

otherproductiveassets. ● Acquireanotherbusiness. ● Make loans toand/orpurchase loans

fromanothercompany. ● Acquiredebtorequityinvestmentsin

othercompanies.

Financing Activities: Cash received from:

● Issuing equity instruments, such asstockinthecompany.

● Issuingbonds,mortgages, notes andotherformsofshort-termorlong-termborrowing.

Cash paid to: ● Ownersofthecompanyintheformof

dividendsorotherdistributions. ● Repayment of amounts borrowedon

short-termandlong-termdebt.

Sample Statement of Cash Flows

Cash flows from operating activities Cash received from customers $110,000 Cash paid to suppliers and employees ( 90,000) Interest received 8,000 Interest paid ( 6,000) Income taxes paid ( 9,000) Net cash provided by operating activities $13,000

Cash flows from investing activities Proceeds from sale of plant $70,000 Purchase of equipment ( 10,000) Net cash provided by investing activities $60,000

Cash flows from financing activities Principal payments on notes ($40,000) Dividends paid ( 15,000) Net cash used in financing activities ($55,000)

Net increase in cash and equivalents 18,000

Cash and equivalents at beginning of year 12,000

Cash and equivalents at end of year $30,000

Reconciliation of net profit to net cash provided by operating activities: Net profit after taxes $37,000

Adjustments to reconcile net profit after taxes to net cash provided by operating activities: Depreciation 2,000 Gain on sale of plant (11,000) Increase in trade accounts receivable ( 7,000) Increase in inventory (10,000) Decrease in accounts and notes payable 5,000 Increase in interest and taxes payable ( 3,000)

Net cash provided by operating activities $13,000


Themoststraightforwardwaytopresentoperatingactivitiesinastatementofcashflowsisthedirectmethod,whichreportsmajorclassesofoperatingcashreceiptsandpayments.Underthismethod,aseparatescheduleispresentedwiththestatementofcashflowsthatreconcilesnetprofitandnetcashflowfromoperatingactivities.Ineffect,thisreconciliation isaconversionofnetprofitfromtheaccrualtothecashbasisofaccounting.

➤ Observation: You’llfindthebalancesheet,theincomestatementandthestatementofcashflowsinacompany’sannualreport.Inmostannualreportsthesefinancialstatementsarepre-sentedonacomparativebasis:thatis,thecurrentyearalongwithoneormoreprioryears.Usethefiguresinthesestatementstoanalyzeyourowncompanyaswellasyourcompetition,toforecastthefinancialoutcomeforyourentirebusinessordepartmentproject,andtomakeavarietyofotheressentialbusinessdecisions.Inshort,thesereportsarethreeofthebusinessperson’smostimportanttools.


How the Financial Pros Use These Tools

Nowthatyouareawareofthemechanicsofabalancesheet,anincomestatementandastate- mentofcashflows,yourworkisnotoveryet.Keepinmindthatalthoughthefiguresin

thosereportsareimportant,theydon’t,inandofthemselves,tellyouhowyourcompanyisdoingcomparedwithothersinyourindustry,whetherithasstayingpowerinourhighlycompetitiveworldorwhatweaknessesitshouldbecorrectingfromwithin.Inshort,thosereportsalonedonottellyouwhetherthecompanyisfinanciallyhealthy.

Todeterminethefinancialstateofyourcompany,youhavetoturntothreemajorconditionswithinyourcompanythatyou,asamanager,canhelpcontrolorchange:● Liquidity,whichissimplytheabilitytogenerateenoughcashtopayyourbillsandexpenses

ontime.● Leverage,whichistherelationshipbetweenyourcompany’stotalliabilitiesandequity.Your

firmissaidtobehighlyleveragedwhenithasa lotofdebt inrelationtoequity.Insomeinstances,carryingalotofdebtcanbeadvantageous.Atothertimes,itcanbeinjurioustoacompany’shealth.Thoseprosandconswillbediscussedlaterinthissection.

● Profitability,whichissimplywhetheryourcompanyendsupwithanymoneyafterallyourexpenses, including taxes,havebeenpaid.Profitability, inotherwords, is reflected in the“bottomline”ofyourincomestatementanddetermineswhetheryoushouldbeinbusinessatall.

TroubleshootingWithRatioAnalysisFinancialanalystsexaminetheliquidity,leverage,profitabilityandothervitalaspectsofafirmbyusingthefiguresinthecompany’sfinancialstatementstoformspecialrelationshipsorratios.Theseratiosarethemostcommonsourceofinformationtheyusetoassesstheperformanceofabusiness.Theycanrelateanyaspectofyourbusinesstoanyotherarea,suchassalestoprofits,orprofitstoassets.Mostimportant,becausetheyaresowidelyusedandreported,itispossibletocompareratiosforyourownbusinesswiththeaverageforyour industry,orforgroupsofcompanieswithinyourindustry.

Sometimes,however,ratioanalysiscanleadyouastrayifyouarenotawareofitslimitations.First,ratioanalysisisgearedtowardgivingyouinsightsratherthanhardbusinessdata.Assuch,itcanpointthewaytopossibletroublespots,butyouwillneedfurtherverificationwhenyougetthere.Forinstance,adownturninyouroperatingprofitmarginmightpointoutanoperatingbottleneck,butyouwillneedtoinvestigatefurthertoisolatetheproblem.Moreover,ratiosdealwithhistoricaldata,whichmayormaynotberelevanttocurrenteconomictrendsorcompanyneeds.Forthisreason,itisalwayswisetoconfirmthatatrendindicatedbyaratioanalysisis,infact,applicabletocurrentoperatingconditions.

TenCriticalRatiosRatioscomeinallshapesandsizes,andareapplicabletoawiderangeofbusinessproblems.Morethan150financialratiosarecurrentlyinuse.Forourpurposes,wehavechosen10ratios,eachaddressingaspecificpotentialproblemareaandderivedfromthebalancesheetand/orincome

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statement.These10criticalratiosarebasicanalyticaltoolsformostbusinesses.Thefollowinglistdetailstheircomponentsandprincipalsignificance:

1. Current ratio:Totalcurrentassets,dividedbytotalcurrentliabilitiesatthesamepointintime.Thestandardtestmeasureoftherelativeadequacyofworkingcapital,oroftheliquidity ofthebusiness.Recommendation:Generally,healthyfirmsaimfora2to1currentratio,whichmeanstheyhave$2incurrentassetsforevery$1ofcurrentliabilities.

2. Debt/equity:Totalcurrentandlong-termliabilitiesdividedbyaverageshareholders’equity.Measurestheleverage,ortheextenttowhichthebusinessdependsonborrowedcapital,andwhethercreditorsortheownershavealargerinterestintheenterprise.Recommendation: Asageneralrule,thisratioshouldequalroughly.6.

3. Return on equity:Netprofitfortheperiod,dividedbyaverageshareholders’equityfortheperiod.Thisisthetruereturnonthenetinvestmentoftheowners’capitaltiedupinbusiness,andthemostbasicratiointhefamilyofreturn on investment (ROI) ratios.Thisratio,alongwithratioNo.4,measures the thirdconditionyou’re lookingat inanalyzingacompany:profitability.Recommendation:Thisfigureshouldbe.14orhigher,whichmeansacompanyshouldreturnatleast14percenttobeginsatisfyingitsinvestors.

4. Return on assets:Netoperatingprofitfortheperiod,dividedbyaveragetotaltangibleassetsfortheperiod.ThisisanotherratiousedtomeasuretheROIofthetotalcapitalbeingusedinthebusiness.

5. Net profit margin:Netprofitdividedbynetsalesforthesameperiod.Thiskeymeasurereflectsthesuccessfulorunsuccessfulinteractionofsalesefforts,pricesandcostsovertheperiod.Recommendation:Usethisratiotocompareyourfigureswiththoseofothercompaniesinyourindustry,ortocomparenetprofitonsalesforindividualproductsorproductlines.Asamanager,youcanthenrecommendwhichproductsshouldbepromotedordropped.Note:Ratios6through9aregenerallyreferredtoasoperating ratios.Theyaremostusefulwhenmakinghistoricalcomparisonswithinthecompanyorwithothersinyourindustry.

6. Receivables turnover:Creditsalesdividedbyaverageaccountsreceivablefortheentireperiod.Ameasureofrelativehealthofoutstandingreceivables,inthatthehighertheratio,thefasteraccountsarebeingpaidup.

7. Inventory turnover:Costofgoodssolddividedbyaverageinventoryfortheperiod.Thisisayardsticktomeasuretherelativeadequacyofinventories,orthespeedwithwhichinven-toriesareturnedover.Iftheratiokeepsdecreasing,yourcustomer’sinventoriesareprobablyexcessiveanddrainingneededcash.Iftheratiosuddenlyrises,inventoriesmaybetoolowandthusmayendangerproductionschedules.

8. Fixed-asset turnover:Netsalesdividedbygrossplantandequipment(beforedepreciationdeduction)fortheperiod.Thisisanindexoftheamountoffixedcapitalrequiredtoproduceeachsalesdollar.Itisusedtodeterminewhetheryou’reusingyourfixedassetsefficiently.

9. Total asset turnover:Netsalesdividedbyaveragetotaltangibleassetsfortheperiod.Amea-sureoftheeffectiveemploymentofthetotalassetsofthebusiness.

10. Equity turnover:Netsalesdividedbyaverageshareholders’equityfortheperiod.Thisisthebasicmeasureforcomparingsalesproducedbytheowners’netinvestmentwiththatofothercompanies,periodsorindustries.Theratioindicatestheturnoverofinvestmentcapital,orhowhardtheinvestedcapitalisworking.Thereisn’tanygeneralnormforthisratio;eachlineofbusinesssetsitsown.

Nowlet’stakealookatthepracticalapplicationsofsomeoftheseandotherratiosbyaskingthefollowingquestions:


Does your firm have enough cash to pay its bills?

Lackofcashcanbeamajorproblemsimplybecausecashinflowisuncertain,whiletherequiredcashoutflowisconstantandnecessarytomaintainregularbusinessoperations.Forthatreason,abusinessmusttrytomaintaincertainlevelsofcashtopayitsbillsbymaintainingasafecurrent ratio.Inotherwords,itkeepsaneyeonitsliquidity.

Example:Inoursamplebalancesheet(see page 4),thecurrentratiowouldbe:

Currentassets($255,000) Currentliabilities($121,000)

Oursamplecompanyseemstohaveadequateliquidity.

To leverage or not to leverage?

Ahighlyleveragedcompanyhasitsprosandcons.Manyentrepreneursseekoutaleveragedfirmbecausetheybelievetheycanearnenoughwithacompanybothtopaytheinterestondebtandmakeagoodreturn.Inotherwords,leveragecanincreaseprofits.

Inbadtimes,ahighlyleveragedfirmcanreactthesamewayasanindividualdrowningindebt.Interestpaymentsbecomehardtomeet,andcreditorsbeginclosinginforthekill.Forthatreason,bankersandmanagementpeoplepaycloseattentiontothedebt/equityratiotoseeifthere’sanyunduedrainonfunds.

Example:Againinoursamplebalancesheet:

Totalliabilities($126,000) Shareholders’equity($212,000)

Again,oursamplecompanyseemstobesittingpretty!

How profitable is your firm?

Dependingonhowmuchitwantstomake,everycompanyhasitsownnormforwhatthereturn on equityratioshouldbe.Weused14percentasaminimum.Others,however,saythatthereturnshouldatleastmatchthegoingrateforTreasurybills,orafirmmightbebetteroffusingthecapitalinvestedinthefirmforsomeotherpurpose.

Example:Forthisratio,weturnbothtoourbalancesheetfortheequityfigureandtotheincomestatement(see page 6) forthenetincomefigure:

Netincome($37,000) Equity($212,000)

Itlookslikeoursamplefinancialstatementsindicateaveryhealthycompany.

Should you provide credit to a customer?

Often,youwillneedinformationfromacustomertobeabletoanswerthisquestion.Whenthecustomerprovidesabalancesheetorincomestatement,youneedtoknowwhattolookfor.Practi-callyspeaking,theincomestatementislikelytobeoutofdateandwon’trepresentthecompany’scurrentfinancialaffairs.Mostcompaniesprepareincomestatementsonlyonceortwiceeachyear,butmonthlybalancesheetsarecommon.

=2.1

=.59

=17%


Ifyouobtainanup-to-dateincomestatement,itwillnotrequiremuchadditionalworktocomeupwithacompletepictureofthecompany’scurrentstateofaffairs.Luckily,evenwithoutacurrentincomestatement,youcanlearnmuchfromthebalancesheetbyusingratioanalysis.Asyoucansee,mostratioanalysisrequiresonlybasicmathskills.

Fromourlistof10criticalratios,usethecurrentratiotodeterminewhetherthecustomerisliquidenoughtopayoffdebts,andusethereturnonequityratiotoseewhetherthecustomerisprofitable.Usetheinventoryturnoverratiotodetermineifthecustomerwillbeabletomeetyourproductionschedules.Whenusingratiosthatrequiresalesfigures,thoseforthelatestyearavailablewillsuffice.Inaddition,thefollowingratiosareimportant:● Current liabilities to net worth:howmuchofthefundsinvestedbyyourcustomerswould

beneededtopayoffallshort-termobligations.Thelowertheratio,thebetter.Normally,youshouldshyawayfromafirmwitharatioof66percentorhigher.

● Short-term debt coverage: currentassetsdividedbyshort-termdebt.Thisratioisavariationofthecurrentratio,withtheemphasisonshort-termdebt(debtduewithinoneyear).Ifyourcustomerhas$2ofcurrentassetstocovereach$1ofdebt,youaresafe.A1:1ratiowillsufficeifthecurrentassetsareeasilyconvertedintocash.

● Average collection period: accountsreceivabledividedbycreditsalestimes365.Thisratiowillgiveyouagoodideaofhowfastyourcustomeriscollectingitsbills.Usually,35–45daysisconsiderednormal.Anythingover50daysmayindicatesizableuncollectibleaccountsandshouldgiveyoujustcauseforconcern.

Example: Ifacompanywith$20million increditsalesmaintainedaccountsreceivableof $2million,theaveragecollectionperiodwouldbe36days($2million÷$20millionx365=36.5).

➤ Observation:Onceyoudecidethatanewcustomerhasthewherewithaltopaybillsontime,youmustdeterminehowmuchcredittoextend.Ageneralruleofthumbistofillanyfirstorderupto10percentofthecustomer’snetworthand,afterthat,openaformallineofcredit.Onceapproved,thislineofcreditshouldbeexceededonlywithtopmanagement’sapproval.


AnsweringSomeDifficult FinancialQuestions

Ratioanalysiscanbeveryhelpful inpinpointingoperating inefficiencieswithinyourcom- pany.Buttounderstandhowyoucanuseratiostospotproblems,youmustfirstknowthe

rightquestionstoask.Inthissectionweaddresssomeoftheimportantfinancialquestionsthatallmanagersshouldbeasking.

AQuestionofProfitMarginsHas profit growth kept pace with sales growth in recent years? If not, have some markets been more responsible than others for the lag?

Manymanagerswronglybelievethatasacompanygrowsandmatures,profitsalwaysin-creaseataslowerratethansales,evenasbothcontinuetoexpand.Thisiscalledtheprincipleofdiminishingreturnsonaddedvolume.However,thisprincipleisoftenuntrue.Considerthefollowingexample.

Amanufacturerofsmallpartsandcomponentsforfinishedproductsfoundthateconomiesofscaleandothergrowthfactorswerenolongerbringingsatisfactoryprofitgrowth.Rather,itappearedthatincreasedsalesvolumehadcomepartlyfromitsentryintonewmarketsthatweremorecompetitive,moreexpensivetopromoteandserve,andgenerallylessprofitable.

Oneof thefirst analyticalfigures the topmanagers turned towas the familiarnet profit margin,onamarket-by-marketbasis.Tobegin,thefirm’ssalesanalystproducedreportsshowingnetprofitmarginsonsalesbymarketsforeachofthelastthreeyears.Thesereportsshowedallthecostsassociatedwithgettingthesaleandsubtractedthemoutofthegrosssalesfigure.Theseresultsservedasanimportantfactorindecisionsthatlaterledtomajorchangesinthecompany’soverallmarketingstrategy.

Afewoftheindustrygroups,forexample,hadgrowninbothsalesvolumeandprofitabilityoverthepastfewyears.Severalothersaccountedforalargershareofcompanysales,butrevealedshrinkingprofitmarginsinthisanalysisasaresultofsubstantialpricediscounting.Forthetimebeing,atleast,littlecouldbedoneaboutsomeoftheseindustrymarketsbecausethecompanyneededthevolumetheygenerated.

In someof themosthighly competitive industrymarkets,however, analysis showed thecompanywasforgoingprofitswithoutsubstantiallyimprovingitsmarketposition.Furthermore,thetopmarketingpeopleagreedthattherewaslittlelikelihoodofchangingthissituationforthebetterinthenearfuture.Managementdecidedtodeemphasizesaleseffortsinthesemarkets,ex-ceptatfull-profitpricing.Althoughsalesvolumefelloff,thesaleseffortswereretargetedtomoreprofitableindustrysectors.Itwasnotlongbeforethegrowthtrendforoverallnetprofitreverseditsdeclineandslowlybegantoimprove.

Sometimesacompany isunable tobreakdownall itssellingandadministrativecostsbymarketsegmentorsimilarcriteria.Onealternativeissimplytoallocatethesecostsinproportiontothesalesvolumeinthemarketsegmenttowhichtheyarerelated.This,ineffect,assumesthatsellingcostsaremoreorlessuniforminthevariousmarkets,whichmaynotbethecase.

Often,youcanmakeausefulanalysisbydividing grossprofit,insteadofnetoperatingprofit,bynetsales.Thisgross profit marginiswidelyusedinretailingandothernonmanufacturingindustries.

3

14


Stillanotheroption,whensellingandadministrativecostscannotbefullyallocated,istocal-culatetheratioofgross profit to cost of goods soldinadditionto,oreveninsteadof,theaboveratios.Thisratiocanbeparticularlyusefulinfieldswherebiddingpricesarecalculatedandquotedoncontractsonthebasisofproductioncostestimates.Comparisonsovertime—betweenmarketsorevenbetweencustomers—canrevealpreciselytowhatdegreeprofitsacrificesarebeingmade,intermsofthelowerprofitreturnonproductionoutlays,toobtainvolume.

➤ Observation:Inthisandotherinternalratioanalysesinvolvingprofits,theincomestate-mentitemtostartwithisthenetoperatingprofit,ratherthanthebroadernetprofitbefore(orafter)taxes.First,federalincometaxrateschangefromyeartoyearandwiththesizeofcompanyprofits,sousingafter-taxprofitsforinternalpurposeswouldmerelyintroduceacomplicatingfactor,nottomentiontheneedtoallocateonemoreitem.Second,becausethevariousinternalcomparisonsbeingmadearealwaysbetweenoperatingpartsofthebusiness,theinclusionofanynonoperatingincomeorexpensewoulddistorttheresults.Insomelinesofbusiness,accountantsandindustrygroupsusetheprofitconceptof“earningsbeforeinterestandtaxes”(EBIT),whichisroughlythesameasnetoperatingprofitplusdepreciation.Thisfigureeliminatesbothfederalincometaxesandinterestearnedorpaidonlong-terminvestmentsanddebts.

AQuestionofWorkingCapitalDo you have enough working capital to take advantage of investment opportunities? If not, are some of your departments more to blame and need more tightening up than others?

Thedollardifferencebetweenanybusiness’scurrentassetsanditscurrentliabilitiesisaptlycalledworking capital.Thisistheamountofreadycashandreadilyconvertibleassetsthatyoucanput toworkasneeded,without leaving thecompany inadangerouslyexposedfinancialposition.Workingcapitaliswhatenablesyourfirmtotakeadvantageofspecialdeals,earncashdiscounts,borrowshort-termfundsmoreadvantageouslyorcapitalizeonsimilarprofitoppor-tunities.Italsoenablesthecompanytomeetitstradeobligationsanddebtinstallmentsontime.Theratiomostcommonlyusedtomeasuretheadequacyofworkingcapitalisthecurrent ratio.

Retailoperationsregularlyapplythecurrent-ratioapproachfor internalanalyses,suchascomparing thecreditandfinancialperformancesof theprincipaldepartmentswithinvariousstores,aswellascomparingstoreswitheachother.

RMA’sAnnual Statement Studies

A good way to compare your company’s ratios with other companies’ is to obtain a copy of the Risk Management Association (RMA) Annual Statement Studies. These studies are culledfrommorethan86,000financialstatementsofbankborrowersreviewedbyRMA,anationalorganizationofbanklendingofficers,andtheyincludeinformationoncloselyheld companies and public corporations.

Thedataisclassifiedintotwomainsections:Thefirstcontainscompositebalancesheetandincomestatementcomparisonsforeachof355industriesforthepastfiveyears.Thesecond section contains 17 commonly used ratios, presented as medians and quartiles, for most of the industries. With that information, a manager can zero in very quickly on where a company stands. For further information, go to www.rmahq.org.


Toconstructthecurrent-assetscomponentofthesedepartmentalratios,itisarelativelysimplematter tocollectcurrentdataonaccountsreceivable (fromthedepartmentalcodingoncreditcustomers’billing)andoninventories(directlyfromdepartmentrecords).Thesetwocategoriesaccountforthelargestshareoftotalcurrentassetsfoundinthistypeofbusiness.

Forthecurrent-liabilitiescomponent,itisequallysimpleformanagerstobreakdowntradeaccountspayablebydepartmentsbyusingvendorcodesandmerchandisecategoryinformation.Someoftheremainingshort-termdebtsandexpensespayablecanalsobeallocateddirectlytodepartmentswithreasonableaccuracy.Anallocationofremainingcurrentliabilitiesinproportiontodepartmentalvolumedoesnotbiastheresultsinanysignificantway.

Onthecurrent-assetsside,retailoperationsgenerallyapplyanotherratio—receivables turn-over—tohelpanalyzetheirworkingcapitalpositions.

Theidealdepartmentinaretailoperationisonethatbothcontributestoworkingcapital,reflectedinahighcurrentratio,andhasanacceptablerateofreceivablesturnover,indicatedbyalowlevelofoutstandingreceivables.

AQuestionofReturnsWhich areas of the business will provide the best return on an increased investment of capital? How profitably is each area using the assets now assigned to it?

Whereshouldyourcompanyspenditsinvestmentdollars?Intechnology?Salesdevelopmentandtraining?Buildingawarehouse?Perhapsinproductdevelopment?Todetermineacompany’slong-termstrategy,youmustknowwhat thereturnswillbe.Wecan illustrate this importantconceptthroughthefollowingexample.

Adistributorofcleaning/maintenancetoolsandsuppliesoperatesthreedivisions,eachaimedatadifferentmarket:(1)contractandinstitutionalsales,whichsellstolargebuildingmanagementfirms,maintenancecontractors,majorhospitalsandsimilarpurchasers;(2)industrialproducts,whichsellstocommercialandindustrialcustomerslargelythroughagents;and(3)consumerproducts,whichmarketsbrandedandunbrandeditemsthroughretailstores.Themanagersofallthreedivisionshavedemonstratedthattheycouldimprovetheirvolumeandmarketshareswithinfusionsofcapitalforpackaging,warehousing,deliveryandotherequipment.Thecompanyhasdecidedtoaddtoitscapitalinvestmentbutmustdecidewhichdivisionshouldbeallocatedthelion’sshareofthefundinginordertomaximizethereturntoshareholders.

Return on shareholders’ equityiswhatthecorporation’stopmanagerswillbelookingatfirstinthiscase.It’sreasonableforthemtoassumethatthedivisionwiththehighestpresentrateofreturnwillcontinuetoearnthebestreturnasitgrows.Andtheyacceptthepropositionthat,withinpracticallimits,allthreedivisionswouldshowthesamerateofsalesgrowthinproportiontoaddedinvestment.

Allocating shareholders’ equitydirectly to the threeoperatingdivisionsmay seem likeadifficulttask.Fortunately,however,thereisapracticalalternativethatreducestheproblemtomanageableproportions.

Constructingthreedivisionalbalancesheets,onecanestimateshareholders’equityineachdivisionbysimplysubtractingliabilitiesfromassets.Thenyoucancalculatethethreereturn-on-equityratios,forbothactualandfutureoperations.

Return on assets (ROA) isanothercritical ratio that topmanagerswillwant toexamine.Somefinancialexpertsbelievethatreturnontotalassetsprovidesthebestmeasureofreturnforacompanybecauseitfocusesonshort-termfinancing.Especiallyintheshortrun,returnonassetshasseveralpracticaladvantagesoverthemorecomplexreturn on equity (ROE)ratio.First,ROAdirectlymeasuresthekeyfactorinvolvedinthedecision:aninvestmentintangibleassets,such


asstorage,packaging,distributionorotherequipment.Second,itavoidsthenecessityofcon-sideringandallocatingliabilities,whichinmanycompaniesmayinvolvemoreuncertaintyandpotentialerrorthanallocatingassets.Finally,itiseasierfornonfinancialmanagerstounderstandandappreciate—anelementthatcannotbeignoredinreachinganagreement.

Itwouldbewise,however,formanagementtouseboththereturnonassetsratioandthereturnonequityratioinitsanalysis,ratherthanusetheassetsratioasasubstitutefortheequityratio.Theequityratioisthetruemeasureoftheshareholders’returnontheirinvestmentinthecompany,andimprovingthisreturnoverthelongrunisthebasicaimofanymajormanagementdecisions.Moreover,theequityratiomayhighlightcertainimportantresultsofanactualdecisionthattheassetratiowouldnotpickupatall.

Oneelementtakenintoaccountintheequityratio,forexample,willbethedifferingeffectsofvariousassetinvestmentdecisionsonthecompany’sliabilitiesovertime.Ifonedivisionwoulduseitsaddedinvestmentforashort-liveddeliveryfleet,whileanotherwoulduseitforaddedwarehousingspace,theimmediateeffectsontheassetratiowouldbeverysimilar.Theeffectsoverafewyearsonbothassetsandliabilities,andthereforeontheequityratio,however,couldbeverydifferent.Thelatter,ofcourse,wouldbethemoreaccuratemeasureofprospectiveratesofreturnonthealternativeinvestmentproposals.

AQuestionofAssetManagementHave recent volume gains been achieved at the price of a disproportionate tie-up of available assets? For example, have the costs of expanding operations into new territories been worth it?

Inanybusiness—manufacturing,distributionorservices—ittakesaninvestmentoftheown-ers’capitalinthebusinessassetstoproducesalesorrevenues.Incapital-intensivemanufacturingindustriesespecially,theamountofassetsrequiredforeachsalesdollarcanbeoneofthemostcriticalelementsinthecompany’ssuccessorfailure.Knowingjustwherethecompany’sassetsarebeingusedmostandleasteffectivelytocreatesales,therefore,isofvitalconcerntomanagement.

Example:Aregionalmanufacturerofplumbingandheatingsystemsmadeabasicdecisiontosetupassemblyfacilitiesprogressivelyinnewlocations,ratherthanextenditsshippingrangefromitsoriginallocation.Themanagementbelievedthiswasthebestpathtogeographicalexpan-sionofitsmarketingarea.Todate,oneundesirableresulthasbeenasteadydeclineinthedollarsofsalesproducedbyeachdollarofcompanyassets,asthetotalinvestmentinplantandequip-menthasgrown.Topmanagershavethereforebegunacompletereviewoftheoriginaldecisiononterritorialexpansion.

Oneofthemostcriticalnumberstoanalyzeisthetotal asset turnover(netsalesdividedbytotaltangibleassets)andequity turnover(netsalesdividedbytotalshareholders’equity).Athirdratiothatwillbeparticularlyusefulintheanalysisisfixed-asset turnover (netsalesdividedbygrossplantandequipment),whichmeasureshowefficientlyfacilitiesareusedtoproducesales.

Thefigurescommontoallthreeoftheseturnoverratios,forthecompany’spurposes,arethesalesdollarsproducedbyeachofitsterritorialplants,aswellasbythehomeplant.Fortunately,itisasimplemattertoobtaintheneededdollarsalesvolumeinformationforeachplantfromshippingrecordscheckedagainstcustomerbillings.Theotherfiguresinvolvedinmakingupeachratioare,respectively,tangibleassets,shareholders’equity,andtheplantandequipment(p&e)foreachplant.Companyrecordswillproducethep&efigurewithlittle,ifany,adjustmentsrequired.Managementwillhavetoestimatethefirsttwoonaplant-by-plantbasisbyusingthemethodsandassumptionsdiscussedearlier.

Becausethecompanycarriedoutitsterritorialdispersionofproductionandassemblyfacilitiesoveraperiodofyears,managementwillwanttolookattheseveralterritorialratiosastheyhave


changedover,say,thelastthreeyears.Thiswillenableittoseejusthowthegeneraldeteriorationincompany-wideratioshasdeveloped,andtopinpointtheterritorialdifferencesineffectivenessthatitexpectstofind.

Considering that the company’s turnover ratioshavedefinitelybeen slipping—andhavecoincidedwiththedispersionprogram—itispossibletospeculateonwhattheanalysisislikelytoturnup.First,aseachnewassemblyplantisbuiltandbroughtonstream,ithasundoubtedlycreatedaninitialdrainontheeffectiveuseofcompanyassets.Becausetheadditionalplantshavebeenactivatedoveraperiodofyears,moreover,thisdrainhascontinuedtoaffectturnoverastheprogramhasdeveloped.Thisfindingalonewouldbereasonforchangingthepolicyoffacilitydispersion.

Managementwillalsoprobablyfind,however,thatwhiletheoperatingfiguresofsometerrito-rialplantshaveimprovedwithtimeastheyandtheirsalesterritorieshavebecomeestablished,othershavepersistentlylagged.Insomecases,thereasonmayturnouttobethatthesizeoftheplantisnotgreatenoughtopermitfullyefficientoperations.Inothers,itmaybethatnotenoughsalesvolumehasdevelopedintheterritorytopermiteffectiveutilizationofthenewfacilities.

Atthispoint,managementneedstobeaskingthesequestions:Willtheplant’sresultsimproveasitssalespotentialisachieved?Shouldtheplantbeenlargedtomakeitmoreefficient,orshoulditbecloseddown?Cantheplantbemademoreefficientbyshiftingorderstoitfromotherter-ritoriesorfromthehomeplant?

AQuestionofDebtStrategyAre we using too much—or too little—borrowed capital in our business? In either event, are we using debt financing and leasing in our various fields of operations to the extent that others do?

Thewords“thecorporationisfreeoflong-termdebt”certainlyhaveasolidringinacreditreport.Yetmanydebt-freecompanieshave,infact,givenupvaluablegrowthopportunitiestoachievethisposition.Andtoday,thosethathaveavoidedfinancingorleasingtoacquirecapitalequipmentandmaterialsmayhavenotonlyrestrictedtheiractivities,butneglectedvaluabletaxbenefitsaswell.

Example:Adiversifiedbusinessserviceorganizationusescopyingandduplicatingequip-ment,offsetprinters,addressingandmailingmachines,wordprocessorsandsmallcomputersinitsoperations.Asservicecompaniesgo,itisarelativelycapital-intensiveenterpriseandmustcontinuallydecidewhethertoownorleasenewitemsofequipment.Ifthedecisionistoown,thereisusuallythefurtherquestionoftherelativeadvantageofacashoutlayversuslong-termfinancing.Atthispoint,companymanagementisconcernedabouttheoverallbalancebetweenownedandleasedequipment,andthemorebasicbalancebetweendebtandcapitalinthebusi-ness.Itwouldliketodecideoneachfutureequipmentacquisitionwiththesebalancesinmindandperhapsevenchangethestatusofsomeofitspresentequipment.

Thedebt/equity ratioistheuniversallyacceptedmeasureoftherelationshipbetweenowner-suppliedcapitalandthatborrowedfromsuppliersandothercreditorsinanybusiness.Ahighratiocomparedwiththatofothersinthesameindustrymaybetakenasawarningsign,butitmayalsobean indication thatyours isanaggressivelygrowing (highly leveraged)companycomparedwiththeaverage.Conversely,alowratiomaymeanthatyou’reinahealthy,conserva-tivedebtposition,butyoualsohaven’tusedtheleverageofdebtfinancingaswellasyoucouldandhavemissedopportunities.

Becausethecompanycompeteswithmailingservices,contractprinters,computerservicebureausandotherspecializedserviceorganizations,itwillwanttocompareitsowndebt/equitypositionwiththoseofaveragecompaniesinasmanyofthesefieldsaspossible.Asastarting


point,ithascollectedinformationfromtheRiskManagementAssociationcollectionofratios,aswellasfromDun&Bradstreet,Inc.

Toconstructitsowndebt/equityratiosforcomparison,itwillbefollowingasomewhatdiffer-entcoursefromthatofthecompaniesintheearlierexamples.Insteadofassigningbothliabilities(debt)andassetsexclusivelytoonefieldoranother,itrecognizesthatitsoperationsfrequentlyoverlapseveralfields.Foreachfieldtowhichitwillbecomparingitself,itisaskingwhichofitsassetsandliabilitieswouldbeusedorwouldexistifitwereonlyinthatfield.Severalassetandliabilityitems,therefore,maybeincludedinmorethanonecomparisonandwillnotalwaysbeproportionallydividedamongthesefields.

Whenithascompletedthisexercise,managementhopestofindthatitsdebtburden,inrela-tiontoitsowners’equityinthebusiness,isnoheavierthanwhatisconsideredgenerallyadvis-ableinthemajorservicefieldsinwhichitoperates.Itwillalsoundoubtedlyfind,however,thatcomparedwithaveragecompaniesinsomeofthesefields,itdependssignificantlymore,orless,ondebtfinancing.Ifthereasonsforthesedifferencesseemunreasonableonanalysis,managementintendstoshiftitsbuy-versus-leasedecisionsforthetypesofequipmentinvolved.

AQuestionofPurchasingHave our inventories, compared with sales volume, gotten out of line with those of others in our industry? Which of our products, in these terms, are showing the best and worst records, and why?

Traditionally,managementhasbeenadvisedthat“20percentofyourproductsprobablyaccountfor80percentofyourinventory,”solooktomakethebiggestcutswheremostoftheinventoryoccurs.Inmanycases,thisapproachcanaccomplishmoreharmthangoodandcanhindersalesanddeliveriesofproductsthatareamongthemostprofitable.Atthesametime,itmayoverlookothersituationsthatcollectivelyaccountformuchoftheexcessinventory.

Example:Amanufacturerofalineofpackagedhousewaressawinventoryvaluesonsuc-cessivereportsclimbing,andsuspectedtheyhadgonetoohigh.Acheckofinventoryturnoverratiosinitsindustryconfirmedthissuspicion.Itbegananinvestigationtodiscoverwhyfinishedproductswerepilingup,andhowtocorrectthesituation.Thetaskwasassignedtothesalesman-agerbecausehewasresponsibleforprojectingsalesandrequisitioningoutputfromproduction.

Hisfirststepwastohavetheavailablesalesandinventorydataorganizedonadetailedprod-uctbasissothathecouldcalculateproduct-by-productinventoryturnoverratios.Itthenbecameapparentthatthesuspectedfinishedproductinventoriesaccountedforonlyaminorfractionoftherising inventoryvaluesreportedonthebalancesheet.Furthermore,becauseofdifferencesinproductioncycles,someproductsgeneratedmuchheavierin-processinventoriesthanothers.

Anotherless-expectedfindingwasthatpurchased-materialsstocksforcertainproductswereabigpartofthetotalinventoryproblem.Somespecializedmaterialswereingeneroussupply,althoughtheproductstheywereintendedforwerenolongersalesleadersorwereactuallybeingphasedoutoftheline.Theinventoryproblem,inotherwords,wasnotonlyaproduct-by-productproblem,butonethatneededtacklingonastage-by-stagebasis.

Thesalesmanager’sreportshowedinventoriesoftheappropriatematerialsforeachproduct,work-in-processandfinisheditemsatthecloseofallofthepastfourquarters.Herelatedeachofthesetoproductsalesforeachquarter,toproduceinventoryturnoverratiosineachcalendarquarter. Basedonhisspecificrecommendations,thecompanytookseveralactions:● Forcertainproducts,itsharplyreducedheavyandagingmaterialsstocks.Excessitemswere

designatedforpossibleuseinotherproducts,assubstitutesforspecifiedmaterials.Thosenot


absorbedinthiswayweresoldoff,sometimesatagain.Italsomadeadjustmentsinseasonalorderingandotherpurchasingpracticestominimizefuturebuildups.

● Wherein-processinventorieswerehigh,thecompanyreviewedproductionscheduling.Somepracticesthatithadonceadoptedforconvenience,andtoavoidmorecarefulscheduling,werefoundtobecausingasignificanttie-upofexpensiveinventories—partlyfinisheditemswerebeingtemporarilyshuntedaside.Thesales/in-process stockratioswereusedtozeroinonthese.Thenchangesweremadetoschedules,sizeofproductionrunsandotherpracticesthatwereaddingtotheinventoryload.

● Finally,inarelativelyfewcases,stocksofproductsawaitingshipmentwere,indeed,foundtobeexcessive.Bettercoordinationofshort-runsalesprojectionswithproductionordersreducedsomeofthese.Wheretherewerepile-upsinanticipationofseasonalneeds,specialpreseasonofferstodealersnotonlytrimmedstocksbutoftenresultedinanetincreaseinannualsales.

AQuestionofStabilityHow well could your company withstand adversity—a sudden drop in prices or sales, or an increase in costs?

Oneyardstickusedtoanswerthisquestionisthecompany’sbreak-even point.Expressedinsalesvolume,thisisthepointwhereincomefromsalescoverstotalcosts,bothfixedandvariable.Anotherfactorthatmostmanagerswatchforcontinuously,oncethebasicbreakdownhasbeenprepared,isanysignthatfixedcostsarerising.

Yourfirststep,then,istoseparateallcostsofthecompany’soperationsintothoserelativelyindependentoftherateofoperationsandthosethatvarydirectlywiththenumberofunitspro-duced.Touseanobviousillustrationofthefirstgroup,thecostofrentisfixed,regardlessofthenumberofunitsproduced.Ofcourse,eventheso-calledfixedexpensesmayvaryundercondi-tionsofextremechange(thecompanymaydisposeoforsubletpartoftheplantifvolumefallsenough).Forthepurposesofthisroughcalculation,however,wecansafelyignorethepossibleresultsofsuchextremechanges.Bycontrast,directmaterialscostsvaryalmostexactlyinpropor-tiontotherateofproduction.

Youwillrunintosomeproblemsindealingwiththemanycoststhatdonotclearlyfallintoeithercategory—or,morecorrectly,containbothfixedandvariablecosts.Anobviousexampleispowercosts.Thebasicconnectedloadchargemustbeborneregardlessoftheactualoperatingrate.Onceacompanypaystheminimum,itpaysfortheadditionalconsumptionbasedonactualuse.Inthiscase,thetwoelementsmaybeseparatedfairlyeasily;inothers,itwillbemoredifficult.

Toillustrate,herearesomeguidelinesforbreakingdownlaborcostsintofixedandvariablecategories.Ifsalesfalloff,youmaybeabletoreducethenumberofworkersinaspecificopera-tion,butatwhatpointcanyoualsoreducethenumberofsupervisors?Ifyouhaveonlyone,heorsheisarelativelyfixedexpenseaslongasyouhaveevenafewpersonnel.Inthecaseoflaborcosts,youmaybeabletodeterminetheminimumorganizationthatmustberetainedandclassifythisasafixedexpense.

Totakeanothercommonitem,yourwarehousingcostscontainsomefixedelements(theex-penseofspaceandequipment,andatleastsomesupervision)andsomethatarevariable(wagesofworkerswhomaybeshiftedtoanotherpartoftheoperationifthewarehouseworkloadfallsoff).

Tosegregatefixedandvariableelementsofyourcompany’smixedcosts,youwillundoubtedlywanttoconsultyourcompany’saccountant.Askhertotakeeachcostitemforthelastfullyearandroughlyestimatethepercentagethatisfixedorvariablewithinthenormalrangeofopera-tions.Thepercentagesforthreeorfourpreviousyearsandthecurrentyearcanbeestimatedthe


sameway,orthoseforthelatestfullyearcanbeusedafteradjustingforanymajordifferences(suchasmakingatransitionfrommanualworktotheuseofmachines).

Onceyouhavethisinformation,calculatethebreak-evenpointinthefollowingmannerforasingleyear:Let’ssayyoudeterminethatyourfixedcosts(FC)are$100,000,sincetheydon’tchangethatmuchfromyeartoyear.Becauseyou’retryingtoforecastyourbreak-evenpointforafuturetime,you’renotsureofyourvariablecosts.Historically,however,theyhaverepresentedapproximately80percentofsales(variablecostsdividedbysales).Whatkindofsalesdoyouneedtobreakeven?Yoursetupwouldlooklikethis:

VC=variablecosts(asapercentageofsales) S = total sales you’ll need to break evenFC=fixedcosts P = profit

Yourbreak-evenformulais: P = S – (FC + VC)Therefore,yourformulawouldbe: P = S – ($100,000 + .8 x S)Sinceprofit,orP,is0atthebreak-evenpoint: 0 = S – ($100,000 + .8S), or

S = $100,000 + .8S

SolvingforS: S – .8S = $100,000 .2S = $100,000 S = $500,000

Thismeansyouwouldhavetochalkup$500,000insalesjusttocoveryourtotalcosts.


ProfitFromYourBudget

Fewpeopleenjoybudgeting.Ittakestimeandrequiresself-restrainttosticktoit.Nonetheless, there’snobetterwaytokeepacompanyonfinancialtrackthanthroughaproperlymaintained

budgetprogram.Despitethealmostuniversaldistasteforbudgetaryrestraintswithindepartments,rarelyisthereacompanytodaythatoperateswithoutabudget.Thekeytosuccessfulbudgetingistoinvolvemanagersinalldepartmentsandatalllevelsfromthebeginningstages.

TheBudgetingProcessThebudgetingprocessisanattempttoestablishasetofrealisticstandardsfortheoperationofacompany.Initsfinalform,thebudgetwillbeasetofspecificobjectivesfortheyearahead.Al-thoughtheseobjectivesareidentifiedonlyaftercarefulstudy,theyaremerelyforecasts.Recognizethattheoriginalbudgetwillprobablyneedsomerevision.

Theprocessonlybeginswiththeformulationofthebudgetitself.Everybudgetingsystemmustcontainprovisionsnotonlyforactuallypreparingthebudget,butalsoforimplementingasystem,includingcoordination,control,follow-upandmaintenance.

Tobeeffective,abudgetmustbetailoredtothespecificneedsofyourcompany.Mostwell-designedbudgetprogramsshareanumberofcharacteristics,outlinedasfollows:● Clear lines of responsibility.Tosucceed,yourbudgetingteammustbeabletoassigndefinite

responsibilityfortheperformanceofeachunitmeasured.Thepersonassignedthisresponsi-bilitymusthavefullauthoritytoapplythestandardssetdowninthebudget.

● Management support.Anunsupportedbudgetwillalmostsurelyfail.Youroperatingdepart-mentsmustknowthatyouwillusethebudgetasatoolformeasuringtheirperformance.

● Clear-cut reporting procedures.Whenfinished,yourbudgetshouldbeaprojectionofwhatyourfinancialstandardswilllooklikeatsomepointinthefuture.Therefore,themorecloselyyourbudgetsystemfollowsyouraccountingandreportingclassification,thebetteritschancesforsuccess.

● Realistic standards.Don’texpectyourbudgetprogramtoworkmiraclesovernight.Themosteffectiveonessetthestageforachievableincomeandcostimprovementsduringtheyear.Theyaredesignedtofostercontinuousimprovementinoperatingperformance.Thebudgetisjustoneofmanytoolsinthisongoingeffort,butonethatiseffectiveinpointingouttheweakspots.

DevelopingaBudgetSystemThat’sRightforYouTherearethreebasicapproachestobudgeting,eachwithinnumerablevariations.Inthissectionweexaminethestrengthsandweaknessesofeachapproach.

1. Budgeting from the top down:Inasmallelectronicscomponentsmanufacturer,topman-agementwillgeneratetheprimarybudget.Thentheallocationsaresentdowntothevariousdepartmentmanagersfortheirestimatesofexpensesandprofits.

● Strengths:Thisisbyfarthesimplestapproachtobudgeting.Italsoensuresthatmanagement’sgoalsarealwaysreflected.

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● Weaknesses:Thistypeofbudgetingassumesthatmanagementhastheoperationalknowl-edgenecessarytobudgetforeverypartoftheorganization.Also,thelackofparticipationbyoperatingpersonnelcanleadtoalackofsupportfor,andcommitmentto,thebudget.

➤ Recommendation:Thisapproachisbestsuitedtothesmallerorganization,wherethereisaneasyfamiliaritybetweenstaffandlinefunctions.Inasmallercompany,managementismorelikelytobeawareofoperationalproblemsandcaneasilybringdepartmentheadsintothediscussions.

2. Budgeting from the bottom up:Budgetingbeginsat theoperatinglevelforadiversified,midsizeplasticsmanufacturer.Itgraduallyprogressesupthroughhighermanagementlevelsuntilitreachesthetopechelons.Ateverylevel,personnelwillreviewandreviseit,butonlywithintheconfinesofbroadcorporateobjectivesthataresetdownattheoutset.

● Strengths:This typeofbudgetprovideseveryoperating levelwithagreaterunderstand-ingofthebusiness.Italsoensuresactiveparticipationandgreatercommitmentfromlowermanagementlevels.Everymanagerknowswhatisexpectedintermsofperformanceduringaspecificbudgetaryperiod.

● Weaknesses:Itrequiresalotoftimetomovethroughtheprocessandcompletethenecessaryadministrativeprocedures.Operatingunitswilloftentendtobeveryconservativeinproject-ingrevenuesandoverlyliberalinallocatingcosts.Somemayevenholdbackonperformancetoprotectthemselves.

➤ Recommendation:Thisbudgetsystemisbestsuitedtoamultiproductcompany,wheremanydiverseoperationshavetobeincludedinasinglebudget.Itrequiresalargestaff,sotheapproachmightnotbeeffectiveinasmallcompany.

3. The two-pronged approach:Ahigh-techcompanybasedinNewEnglandusesacombina-tionofthetwomethodsdiscussedabove.Specificobjectivesforfinancialperformanceareestablishedatthecorporatelevel,andthenaresubmittedtooperatingmanagers,whopreparebudgetsbasedonoperating-levelobjectives.Theirbudgetsarethenapproved,disapprovedorrevisedbymanagementandsentbackdownforpossiblefurtheractionbythedepartments.Theprocesscontinuesuntilafinalbudgetisapproved.

● Strengths:Theformalbudgetrepresentsatruemeetingofthemindsbyallpartiesandrequiresparticipationatallmanagementlevels.Theoretically,thisresultsinacommitmenttoagreed-upongoals.

● Weaknesses:Theprocess canbevery time-consuming if topmanagementandoperatingdepartmentscan’tagreeonthebasicobjectives.It’salsobyfarthemostcomplicatedapproach.Schedulesandsurveysareusuallynecessarytosupportdeliberationsatvirtuallyallmanage-mentlevels.

➤ Recommendation:Thisapproachisbestsuitedtoacompanythathasdevelopedacertainamountofsophisticationinpreparingbudgets.Thesizeofthecompanyshouldnotbeanover-whelmingconsideration,butkeepinmindthatpreparingthedatanecessarytobackupthistypeofprogramwillconsumeasignificantnumberofperson-hours.

OrganizingaBudgetTeamOnceyourcompanydecidesonabudgetingsystem,youcanbegintoassembleateamtooverseetheprocess.Notethatwehavenotincludedapermanentbudgetstaffinourdescriptionoforga-nization(see next page),butprefertousethetalentsofmanagementpersonnelalreadyinplacein


variousdepartments.Ifyoudecidelaterthatthecompanyneedsapermanentbudgetstaff,youcouldaddoneundertheaegisofthebudgetdirector.

The Budget Committee

Thebudgetcommitteeatoneservicecompanyincludesthepresident,chiefoperatingofficerandseniormanagementfromeachdivision.Theirprincipaltasksaretoappointabudgetchairmanandtooverseetheentirebudgetingprocess.Specificfunctionsinclude:● Resolvingbudgetingconflictsthatmightarisebetweendepartmentsorbetweenthebudget

chairmanandoperatingdepartments.● Reviewingbudgetestimatesandrecommendingchanges,ifnecessary,toappropriatedepart-

mentordivisionheads.● Reviewingperformancereportsandrecommendingactionwhenneeded.● Approvingthebudgetmanual,whichdetailstheadministrativeprocedurestobefollowedin

compilingthebudgetandcontainstheformsandinstructionsnecessarytocompilethedata.

The Budget Chairman

Thebudgetchairmanisresponsibleforcoordinatingthebudgetestimatesdevelopedbythelinedepartments.Heprovidestechnicalassistancetotheoperatingdepartments,whenevernecessary.Otherfunctionsinclude:● Advisingonbudgetarymatterstoboththebudgetcommitteeandthosewhoareresponsible

foroperations.● Recommendingprocedurestobefollowedbythoseresponsibleforeachbudgetcomponent.● Developingtimetablesforeachstageofthebudget.● Compilingforms,schedulesortablesnecessarytocompletethebudget.● Supplyingsupportdata,suchasrevenueorcostanalysis,whichcouldassistoperatingunits.● Recommendingactiontomanagementbasedonbudgetresults.● Analyzingandinterpretingvariancesbetweenbudgetedperformancelevelsandactualresults.

TeamBudgetingAsbusinesshasgrownsteadilymorecomplex,team budgetinghasproventobeavaluabletoolfordrawingthemanagementgrouptogetheranddirectingitseffortstowardcommonobjectives.Usingtheteamapproach,eachmanageriscalledontoplanandbudget—andwillbejudgedonhisperformance—inhisareaofresponsibility.Toparticipateinthisprocess,eachmanagerisgivenaccountingdataaboutpastandcurrentoperations.

Whatarethebenefitsoftheteamapproach?Managersareencouragedtothinkaheadandbepreparedforchangingconditions.Whentheyanticipatedifficultiesorproblems,theycanmoreeasilyavoidorcorrectthem.Theskillsoftheentireorganizationcanbebroughttobearindeter-miningthemostprofitablecoursesofaction.Throughteambudgeting,performancegenerallyimprovesbecausethepeopleresponsibleforattainingcompanyobjectivesshareinsettingthem.Finally,theconversionofeachmanager’splansintodollar-and-centsbudgetsprovidesherwithafinancialblueprintofheroperationsfortheperiodahead.Thisservesasabenchmarkagainstwhichtomeasureamanager’sperformanceandtospottroubleearly.

A limitation of the team approach:InadequateorfaultyplanningistheNo.1reasonwhybudgetsfail.It’snotunusual,forexample,tohavethebudget(1)provideforacostreduction,withnomentionofwho’sgoingtoaccomplishitorhow;or(2)projectasharpboostinsales,withno


programspellingouthowthiswillbedoneoratwhatcost.Openingupabudgetprocesstokeymanagerscanincreasethepossibilityofthiskindofwishfulthinking.Itwillbeuptothetopexecu-tive,duringhisorherreviewoftheback-upbudgets,totestthesoundnessofunderlyingplans.

ALookatZero-BaseBudgetingAnothercurrentlypopularapproachtobudgetingiszero-basebudgeting.WhenPresidentCarterdecidedin1977thatthegovernmentwouldadoptzero-basebudgeting,theconceptmushroomedovernightfromasubjectprincipallyofconcerntofinancialexecutivesandorganizationalheadsintoamatterofinteresttoallmanagers.

Thenamezero-base budgeting (ZBB)forbusinessesismisleading.Manypeople,recallingthegovernment initiative,believe thatZBB is a tool forfindingandeliminatingunnecessaryfunctions.That’snotthecase.

Thefactis,inanyorganizationmost,ifnotall,ofthefunctionscurrentlyperformedarenec-essarytoitscontinuedoperation.ZBBisusuallyappliedtohelpmanagementdecidewhethereachofthesefunctionswillmakeitsmaximumcontributiontotheoveralleffectivenessoftheorganizationatitspresentlevelofexpenditure,aloweroneorahigherone.Intheprocess,somefunctionsmaybeeliminated,but thathappensunderanykindofbudgetaryreview. Inmanyinstances,ZBB results in theapprovalof sizable increases in funding foractivitieswhere theanticipatedpayoffwarrantsit.

ZBBisdesignedtohelpmanagementrelateexpenditurestotheresultsexpectedtobeachieved.Eachmanagerpresentsseparatebudgetproposalsforeachfunctionoftheunithemanages.Thus,itissimilartotheteambudgetingapproach.Theseparateproposals,calleddecisionpackages,arewhatdifferentiateZBBfromteambudgetingorthemoretraditionaltypeofbudgetingprocess.

Example:Underconventionalline-itembudgeting,apersonnelmanagerwouldspecifyde-partmentalexpendituresforsalaries,supplies,paymentstoemploymentagencies,etc.Topman-agementwouldthenreviewthetotalofthesecosts.UnderZBB,thepersonnelmanagerwouldpresentseparatesetsofdecisionpackagesforeachofthedepartment’sfunctionalactivities,suchasrecruitingandhiring,EEOcomplianceandbenefitsadministration.

IfyourcompanydecidestointroduceZBBandyou,asamanager,areincludedintheprocess,youwillreceiveinstructionsandformsfromhighermanagement.Althoughtheoddsarethatnotwoorganizationswillgoaboutitexactlythesameway,thepatterninmostorganizationswillfollowthesegeneralsteps:

1. Identifying your objectives:ThesecretoflivingsuccessfullywithZBBliesincarefullyandthoughtfullyestablishingobjectives.Yourbestbetistostartfromscratchbysittingdownandmakingtwolists:everythingyourunitmustaccomplish,asmandatedbylaworbyhighermanagement,andeverythingyouwouldliketodoorbelievewouldimprovetheperformanceofyourunit.Thiscouldincludeprojectsthathavebeenshotdowninthepast.Byallmeans,includeyourkeysubordinatesinthethinkingatthisstage.

2. Refining your objectives:Whenyouhavecompletedyourlists,youmayendupwith20,30ormoreitems.Thenextstepistoconsolidatethemundermoregeneralcategories.Example: Amedicalofficer’slistsmightincludeyearlyphysicalsforexecutives,employeehealtheduca-tion,voluntaryexerciseclasses,flushots.Allofthesemightfallintothecategoryofpreventivemedicine.

Ifyouwindupwithsixorfewercategories,you’rereadytogoontothenextstep.(Thenumberofdecisionpackagesamanagercanproposeisgenerallylimited,asapracticalmatter,tofiveorsix.)Ifyouhavemorethansix,you’llprobablyhavetodosomehardthinkingaboutyourpriorities.


3. Stating your objectives:Youarenowreadytowriteupyourobjectivesinfinalformforthedecisionpackages.Thisisacriticalstep.Youwanttostate,asclearlyaspossible,thepurposeofyouractivityandtheresultsyouplantoachieveinrelationtoorganizationalgoals.Example: Supposeyouarethemanagerofsecurityforamanufacturingplant.Agoodstatementofob-jectiveswouldbe:“Toprotect—atthelowestpossiblecost—againstlossesduetopilferage,burglary,robbery,vandalismandfire,thuscontributingtoprofit.”Bycontrast,apoorstate-mentwouldbe:“Topatrolthegroundswithguardsanddogs,andmaintainthesecurityofthefenceandguardpoststopreventunauthorizedactivities.”Thatismoreadescriptionofactivitythanastatementofgoals.

4. Supporting your objectives:Onceyouhavedeterminedtheobjectivesforeachpackage,thenextstepistoexplorealternativewaysofreachingthem.Forestablishedactivities,thecurrentmethodisalwaysonealternative.Othersmightbetocontractouttheactivity,eliminateitorcombineitwithanotherone.

Usually,managersareaskedtospecifytwoalternativesthathavebeenconsidered,andexplainbrieflywhytheyarenotrecommended.Sometimesthismayseemlikeameaninglessexercisebecausetheonebestwayisobvioustoyou.Butthepurposeistoensurethatyoudon’tblindyourselftootherpossibilities,andthiscanoftenbehelpful.

5. Allocating costs:Afteryou’veselectedyourpreferredalternativeforeachobjective,youhavetodecidehowmuchshouldbespenttoaccomplishit.Yourstartingpointwillgenerallybeyourcurrentbudgetandcontrollable-costreports.Onepracticalwaytobeginistosetupaworksheetshowinglineitemsdowntheleft-handsideandobjectivesacrossthetop.Thenal-locateyourlineitemsasbestyoucantoeachoftheobjectives.Thisshowsyourcurrentlevelofeffort(spending)andwillbespelledoutinadecisionpackage.

Dependingontherequirementsestablishedbyyourorganization,youwillalsobeexpectedtodefinetwoormorelevelsofeffortinrelationtoeachobjective.Ifthecurrentfundingdoesnotaccomplish100percentoftheobjectiveyouarerecommending,thenoneormoreoftheadditionallevelswillbehigherthanthepresentexpenditure.Youwillalsobeaskedtospelloutsomelevelsbelowthecurrentfundingthatwouldbefeasible,butnotnecessarilydesirable.Oneofthesemaybeaminimumlevel,belowwhichitisnotworthwhiletocontinuethefunction.Manyorganiza-tionssetfiguresinpercentagesforthelowestlevelofeffort.

6. Preparing your decision package:Nowyouarereadytofillouttheformsthatwillbecomeyourdecisionpackages foreachobjective.Mostorganizationsdesign theirown,buteachpackageshouldincludethefollowing:

● Adescriptionofgoalsorobjectivesforeachlevelofeffort(expenditure).● Abriefdescriptionoftheactivitytobeundertakenandthecostsinvolved.● Theexpectedbenefitthislevelofeffortwillprovide.● Theprobableunfavorableconsequencesifthefundingisnotapproved.

Usually,youwillalsobeaskedtonotethealternativesthatyouconsideredbutdidnotulti-matelyrecommend.

Next,youmustrankthecompletedpackagesinorderofimportance.Ifyouhavefiveobjec-tives,youwillhavefivesetsofdecisionpackages,eachofwhichmustberankedagainst theothers.Thenthepackagesaresentontoyoursuperiorortosomeotherdesignatedindividualintheorganization.


7. Evaluating decision packages: Evaluationproceduresdiffer amongorganizations. Somebusinessesuseagroupsystem.Managersonagivenlevel,workingasarankingcommittee,discussoneanother’sproposalsandrankthembeforesubmittingthemtotheofficerinchargeofZBB.Inothercases,alldecisionpackagesgodirectlytotopmanagement.

Oncemanagementhasdecidedwhichdecisionpackagestoacceptandatwhichlevelofeffort,themanagerisusuallynotifiedbyherimmediatesuperior.Theamountsapprovedthenbecomethelimitswithinwhichthemanagerpreparestheconventionalline-itembudget.Thisisused,asusual,foraccountingpurposesandtomonitorcurrentexpendituresduringtheyear.

WhatNottoExpectFromaBudgetTherearelimitstothebenefitsabudgethastooffer—limitsthatmanagementissometimesslowtorecognize.Herearesometrapstoavoidwhenimplementingorreorganizingyourownbudget,whetheritbeforadepartmentorawholecompany:

✔ No substitute for a cost-reduction program:Atone timemanagementviewed itsbudgetprimarilyasacost-reductiontool.Itprovidedmeaningfulreductionsincostsduringthefirstyearortwoafterinstallation.Afterthefathadbeentrimmed,however,costreductionsbecamemoredifficulttoachievesimplybecausetherewasalimittotheimprovementsanoperatingmanagercouldproducewithoutadditionalmanagementsupport.

Oncethislimithadbeenapproached,furthertighteningofbudgetstandardswasself-defeating.Operatingmanagers,realizingthatthenew,morestringentbudgetstandardscouldnotbemet,simplyignoredthem.Becausemanagementcouldn’tdischargeallthemanagers,varianceswereoverlookedandthebudgetbecameineffective.

➤ Observation:Cost-reductionsystemscostmoney.Whetheritbenewcapitalequipment,moresophisticatedcostaccounting,additionalengineeringsupportorawork-measurementpro-gram,aconcertedprogramtoreducecostsmustinvolvemuchmorethanabudget.Thebudgetingfunctioncanhelpidentifytheseneedsandcanspottheimprovementwhenitcomes.Itcannotdothejobalone,however.

✔ Not written in stone:Allbudgetsshouldbesubjecttoperiodicreviewandrevision.Budgetsshouldneverberegardedasthefinalwordonhowtorunanoperation.Yet,inmanyinstances,operatingmanagersattempttoadheretooutdatedbudgets,eventhoughtheyrecognizethatthebestinterestsofthecompanymightbebetterservedbyabudgetrevision.

Example:Adepartmentheadcomesupwithagoodideathatwillsavemoneyinthelongrunbutwillincreasecostsinthenextfewmonths.Ifyousidetracktheideabecauseofbudget-aryconstraints,yourcompanyneedstoreviseitsconceptofbudgeting.Bythesametoken,anoptimisticproductionplannotquicklyalteredinaneconomicdownturncanplayhavocwiththecompany’sfinances.

✔ No substitute for a long-range plan:Manycompanies,afterinstallingaformalbudget,be-lievetheyhavealsotakencareofanynecessaryplanning.Nothingcouldbefurtherfromthetruth.Corporateplanningisakintobudgetinginmanyrespects,butitisfarafieldinsomeall-importantareas.

First, there is thegoal-setting function.Abudgetusuallyassumes that theoperationsofthecompanywillremainmoreorlessintactforatime.Aplanmakesnosuchassumption.Onthecontrary,oneofthepurposesofplanningistosetnewgoalsformanagement.Second,there


aretiming considerations.Byit’sverynature,budgetingisconcernedsolelywithshort-rangedecisions.Budgetsusuallyhavearangeofoneyear,brokendownintoquartersandmonths.Bycontrast,planningplacesprimaryemphasisonthelong-termoutlook.Fiveyearsisusuallytheminimumperiodinvolvedinlong-termplanning.

➤ Observation:Intruth,budgetingandplanningcomplementeachother.Companiesthatfailtotakethetimeandefforttoworkoutlong-termgoalsoftenfindthattheirshort-termobjec-tivesareinconflictandarewastingcorporateassets.Thosewhofailtosetdefiniteshort-termplansmayoftenfindthatlong-rangegoalsareunattainablesimplybecausetheywerebasedonerroneousassumptions.


ShouldYouUseaFixed orVariableBudget?

Onceyouhavedeterminedyourbudgetingapproachandhaveassignedcertainfunctionsto yourstaff,youcanproceedtothenextstep:developingthebudgetitself.Therearetwo

formatsyoucanuse:fixedorvariable.Eachhasitsstrengthsandweaknesses.Yourdecisiononwhichformtousewill,inthefinalanalysis,dependonwhatyouwantyourbudgettoaccomplish.

Fixedbudgets areby far themost common,particularly in smaller companies.Theyarerelativelysimpletopreparebuthavedefinitelimitations.Variable,orflexible,budgetsrequireabitmoreworktoinstall.Theyare,however,mucheasiertoadjustforinflationandforchangesinthelevelofoperatingactivity.Theemergenceofinflationasarelativelypermanentfixtureonthebusinessscene—anditsconsequentimpactonbusinessactivity—hasinevitablyledtotheincreaseduseofvariable-budgettechniques.

LimitationsofaFixedBudgetInasmallmetalworkingfirmusingafixedbudget,preparationsbeginaboutmidwaythrougheachfiscalyear.Eachdepartment,withthehelpofaccounting,preparesanoperating-costbudget,whichisthensenttoseniormanagement,whomayreviseit.

Ifrevisionisnecessary,theywillholddiscussionsandironouttheirdifferences.Then,nearthebeginningofthenewfiscalyear,thenewbudgetiscirculated,completewithmonthlyactivitygoalsandcostallowancesfortheentireyear.Meanwhile,managementhasusedthebudgettoestablishoverallsalesandprofitprojectionsfortheyear,andhassetcapitalexpendituresaswell.

➤ Observation:Aslongassalesorrevenuestayreasonablyclosetobudgetedlevels,theearn-ingsestimateandcoststandardsshouldholdupfairlywell.However,shouldtheactivitylevelvarytoanysubstantialdegreefromtheoriginalforecast,costallowanceswillquicklygetoutofline.

How Rising Sales Can Affect a Fixed Budget

Youare themanagerofaproductiondepartment foramidsizemanufacturingcompany.Theoriginalbudgetcalledforyourdepartmenttoprocess50,000unitsinNovember.However,becausebusinessactivitypickedup,youactuallyprocessed60,000units.Asaresultoftheextravolume,yourdirectlaborcostsforthemonthrosefromabudgeted$10,000to$11,000.Also,insteadofconsuming$1,500inoperatingsuppliesduringthemonth,yourdepartmentusedup$1,700worthofsupplies.Asthemonthdrewtoaclose,yourbudgetreportwouldlooksomethinglikethis:

Budget Actual Variance

ProductionUnits 50,000 60,000 10,000 DirectLabor $10,000 $11,000 ($1,000) OperatingSupplies $1,500 $1,700 ($200)

Inotherwords,yourdepartmenthashandleda20percentincreaseinvolumewithonlya10percentincreaseintwoimportantexpenseareas—acommendableperformance,byanystandard.Yetthebudgetpersistsinassigningyourdepartmentanunfavorablevarianceof$1,200.Youare,ineffect,beingcensuredforyourefficiency.

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How Falling Sales Can Affect a Fixed Budget

Onceagain,assumethatyouarethemanagerofadepartmentforamidsizemanufacturer,withanactivitybudgetof50,000unitsforthemonthandcostallowancesof$10,000and$1,500fordirectlaborandoperatingsupplies,respectively.Thistime,however,youractualvolumeslowsto40,000units,whichresultsina$1,000declineindirectlaborcostsanda$200declineinthecostofoperatingsupplies.Nowyourbudgetwouldbecalculatedlikethis:

Budget Actual Variance

ProductionUnits 50,000 40,000 (10,000) DirectLabor $10,000 $9,000 $1,000 OperatingSupplies $1,500 $1,300 $200

Inthissituation,youroutputhasdeclinedby20percent,butyouhavebeenabletoslicecostsbyonly10percent—notaveryhappysituation.Yet,byusingafixed-budgetsystem,youarecreditedwithafavorablevarianceof$1,200.

Comparing Changes

Obviously,goodmanagersdonotfallvictimtoillogicalconclusionssuchasthosedescribedabove.Theseexamplesdopointout,however,theproblemofattemptingtocontrolcostswhenusingafixedbudget.Evenifthecost-controlmanagerrecognizesasmallerriseincoststhanvolumeincreaseswouldjustifyinyourdepartment,thereisnoattempttomeasureyourefficiency.

➤ Observation:Afixedbudgetprovidesnostandardstousewhenyouaremeasuringcosts.Asaresult,ananalystwindsupattemptingtorelatebudgetedcostsatbudgetedlevelsofactivitywithactualcostsatactuallevelsofactivity.Therelationshipbetweenthetwoistenuousatbest,andthereforeitcansometimesleadtomisinformation.

UsingaVariableBudgetAnintegratedpapermanufacturerwithseveralplantsusesavariablebudget.Itpreparesprospec-tivecostallowancesforarangeofactivitylevels,basedonobservedvariable-costrelationships.Eachplant’scostallowanceisdeterminedonthebasisoftheactuallevelofactivity.Budgetper-formancereportsincludebothactualmoneyspentandthebudgetallowanceforeachcostitem,allattheactualactivitylevel.Thus,managementcancomparebudgetedcostswithactualcosts,bothatactuallevelsofactivity.Moreover,becausecostsareadjustedeachmonth,profitprojec-tionscanbebroughtuptodateandrefined,whichallowsmanagementsufficienttimetotakeanyactionnecessarytokeepoperationsatoptimumlevels.

The Need for Flexibility

Onlyafewfirmsarestableenoughtoallowforaccuratemonthlypredictionsofoperatinglevels.Yearlyforecastsmaycomeclosetoactualsales,butanannualforecastisrarelysufficienttosatisfythemanagerwhomustplanday-to-dayproductionschedules.Tobeeffective,budgetingmustbedoneinmonthlyincrements.Becauseitisnotpossibletopredictexactlywhatdirectionopera-tionswilltakefrommonthtomonth,theonlylogicalansweristobuildsomeflexibilityintothebudgetprogram.


Budgeting After the Fact

Thekeytoflexiblebudgetingistoestablishbudgetallowancesafterthemonthends.Assoonasyouknowactualactivitylevelsforthemonth,calculateallowancesandsendreportstodepart-mentheads.Makeeveryefforttosendthemoutwithinaweekto10daysafterthemonthends.

Underafixedbudget,youcancirculate theallowance foragivenmonthwellbefore themonthbegins.Asaresult,thedelayinvolvedincirculatingbudgetreportsforavariablesystemhasunderstandablyledtosomeconfusionoveritseffectiveness.Somearguethatifdepartmentheadsarenotinformedoftheirbudgetallowancesbeforethemonthbegins,theycannotbeheldaccountableforkeepingwithinthoseallowances.Whilethisargumentunquestionablyhasmerit,itislessimposinginpracticethanintheory.

Practicallyspeaking,allgooddepartmentheadsareintimatelyfamiliarwiththepaceofac-tivityintheirdepartment.Theyareawareofchangesintheoperatingrateandcanusuallycomeupwithavalidestimateofproductionforthefullmonthafteraweekorsohaselapsed.Theymaybesurprisedbysuddenshiftsinproduction,butmanagementcanavoidproblemsbykeepingoperatingdepartmentsabreastofthelatestproductionforecasts.

Getting What You Pay For

Avariablebudgetwillcostmuchmoretoimplementthanafixedbudget.Costanalysisismoredetailed;theextratimeandeffortthatgointoitwilltakemoney.Onceyouhavegatheredtheinformation,however,thecostofadministeringavariablebudgetwillprobablynotdiffertoomuchfromthatofafixedbudget.Moreover,byusingaflexiblebudget,youwillsetupmoreeffectivebudgetstandards,resultingintightercontroloveroperatingcosts.Generallyspeaking,firmsinstallingavariablebudgetfindthat,onbalance,theysavemoneyunderthenewsystem.


ProducinganEffectiveBudget, StepbyStep

Whetheryoudecideon afixedorvariable budget, oruse a teamorbudget committee approach,therearegeneralstepsthatanycompanytakesonthewaytogettingoutthe

budgetdocument,aswewilloutlineinthissection.

Step1:DevelopaSalesForecastOnceyourbudgetorganizationisinplace,theonlyremainingtaskofanyconsequenceistofor-mulateasalesforecast.Thosewhointendtouseabudgetprimarilyasacost-controldevicemightquestiontheneedforafull-blownsalesforecast.Nonetheless,aforecastofsales,brokendownbymonths,canhelpmaintainasmoothproductionscheduleevenifyourcompanydoesnotseetheneedforaconcreteestimateofprofits.Itcanalsohaveabeneficialimpactoninventorycontrolandpurchasingactivities.

Ifyouintendtouseyoursalesforecastforprofitestimatesonly,ageneralforecastwillprobablysuffice.Bycontrast,ifyourcompanyisconsideringamajorcapitalexpansionprogram,orintendstoinvestinlong-termresearchanddevelopment,youmaywanttoadoptamoresophisticatedapproach.Thefollowingisarundownofseveralsalesforecastingmethods:● Sales force survey:Askeachsalespersontoestimate,byproductandcustomers,thesalesin

hisorherterritory.Sometimesestimatesfromthefieldareaugmentedbysupervisoryprojec-tions,andthetwoarethenreconciled.

➤ Observation:Theprimarybenefitsofthisapproachincludeobtainingthelow-cost,activeparticipationofthesalesforceandgettingverydetaileddata.Drawbacksincludepossibleunre-alisticgoalsbythesalesforce,theinabilitytoincludeforecastsforplannednewproducts,andthefactthattheforecastisnotcapableofpointingoutanyturningpointsinthemarket.● Product survey:Anindustrialproductscompanyfirstidentifiesasmanypotentialcustomers

aspossible.Afterthelistiscomplete,prospectsarepolledontheirbuyingplansfortheyear.Finally,resultsofthepollareusedtocompileanindustryforecast.Byapplyingthecompany’santicipatedmarketsharetoeachproduct,itcanderiveaforecastofsales.

➤ Observation:Theproductsurveyishelpfulinbroadeningacompany’slistofcustomersandpotentialcustomers.Inmanyinstances,however,responsestothepollarenotverythought-ful,particularlyfromprospectswhohavenorelationshipwiththeinquiringcompany.Moreover,thetechniqueisexpensiveandusuallyinappropriateforacompanythatservesalargenumberofindustries.● Consensus method:Themanagementofaconsumerproductsmanufacturerselectsanumber

ofexperts,fromboththecompanyandoutsidesources,toprovidesalesforecastsalongwiththeirreasonsfortheforecasts.Acoordinatorsummarizestheindividualforecasts,circulatesthemandschedulesa roundtablediscussionabout them.Sometimes,a second forecast issubmitted.

➤ Observation:Thismethodhasseveralnoteworthydrawbackseventhoughitsolicitsthehelpofoutsidesourcesandcanbeusedtodevelopaconsensusonnewproductsaswellascur-rentlymarketeditems.Itisentirelysubjectivebecausenoquantitativedataareused;itseldomcontainsdetailsonproductlinesorgeographicareas;anditcanbeextremelytime-consuming.

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● Technical forecasts:Manycompanieskeepmoundsofstatisticaldatagleanedfromrawsalesreports.Thesereportsareoftenusedtosupplement,orevensubstitutefor,theirannualsalesforecasts.Twoofthemorefrequentlyusedtechnicaltoolsaretrend projectionsandmoving averages.

Withtrendprojections,pastsaleshistoryisusedtoestablishatrendlinethroughtheleast-squaresmethod,whichtodayiscarriedoutbycomputers.Thistrendlineisthenextrapolatedandusedasthebasisforasalesforecast.Inthecaseofmovingaverages,anaverageofsalesforaspecificperiodiscompiled.Then,atpredeterminedintervals(usuallyeachmonth),theoldestperiodisdropped,thenewestaddedandanewmovingaveragecalculated.Themonthlyaverageisplottedonacharttoestablishatrend.● Computer-based techniques:Theincreasedavailabilityofcomputersforsmallandmidsize

companieshasspawnedanumberofsophisticatedforecastingtechniques,formerlybeyondthecapabilityofsmallercompanies.Althoughthesetechniquesstillcostmorethanthemeth-odsmentionedearlier,theyarenowwithinthegraspofmostcompanies.

Regression analysisinvolvesaseriesofteststodeterminewhichsocialandeconomicfactorscorrelatewithpastsales.Whenanindexormeasurementthatfitsthesalespatternisfound,itisusedasthebasisforprojection.With econometric modelsaseriesofrelevantregressionfactorsarecombined,andforecastsforthemserveasabasisforthesalesforecast.

Salesforecastsareextremelyimportantinthebudgetprocessbecauseallotheractivitiesaregearedtothesaleslevel.Ifthesalestargetissettoohigh,asurplusincapacity,personnelandinventoriesmayresult.Ifsalestargetsaresettoolow,salesandprofitsmaybelostthroughstock-outs,delayeddeliveriesorinadequatecustomerservice.

Step2:DevelopMeasuresofActivityBeforeattemptingtocategorizecosts,youneedtoworkoutameasureofactivityforeachoperation.Totranslatethesalesforecast(whichusesunitsofproductsold)intoinformationthatwillbeusableforthebudgetanddepartmentheads,findmeasuresofactivity(standardhours,tons,dozens,units,cubicyards,etc.)thatarebroadlyapplicabletoyourcompanyandtoeachdepartment.

Example:Amanufacturingdepartmentcouldmeasureactivityintermsofphysicaloutput(tons,pounds,bushels)ortime(person-hours,actualproductionhours).Aservicecompany,suchasarailroadoranairline,coulduseanumericalmeasurement(numberoftrips,passengermiles,tonmiles).

Justmakesurethatthemeasurementcanbeusedtoidentifysimilarcostsinotherdepart-ments,andthatthemeasureisinfluencedprimarilybyvolume.Themostwidelyusedmeasur-ingrodforcostsiscalledstandard hours produced.Inthiscase,youmultiplythetimestandardforaparticularoperationbythenumberofpiecesproduced.Usuallytheaccountantorfinancialmanagerwillhandletheconversionoftheunitsalesforecastintodollars,basedonguidelinespreviouslyestablishedwithrespecttoprice.

Ifthebudgetistobebasedon“nochangesinprice”or,say,a5percentpriceincreaseonallproductsfortheentireperiod,it’sasimplemathematicalcalculation.If,however,theguidelinescalledforvaryingpricechangesbyproducts—differentincreasesanddecreases—andthechangesareplannedtotakeplaceduringtheperiod,thecalculationswillbeslightlymorecomplex.Thefinancialmanagerwillhavetodeterminewhatpercentageofthesalesfortheperiodareexpectedtotakeplacepriorto,andsubsequentto,thepricechangeforeachproductaffected.Agoodstart-ingpointusuallyispasthistory.


Example:IfapriceincreaseisplannedforApril1(inanannualbudget),and25percentofthebusinessonaparticularproductisnormallysecuredinthefirstquarter,thefinancialmanagerwouldconvert25percentoftheunitsattheoldpriceand75percentatthenewprice.Beforetheconversionismade,however,thesalesmanagershouldcheckforanyanticipatedchangesfrompastpatterns.

Beforecomputinggrossmargins—saleslessproductcosts—thefinancialmanagermustbeadvisedoftheanticipatedchangesinproductcosts(materials,laborandfactoryoverhead).Becausethesewillbeeducatedguesses,thechangesareusuallyaveragedandexpressedasapercent-ageincreaseordecreaseincurrentproductcosts.Somefirmsgoastepfurtherandestimatethechangesbymajorelements—forexample,materialsup5percent,laborup7percentandfactoryoverheaddown10percent.

Aftergrossmarginsarecomputed,thefinancialmanagerwillhavethefirstthreeentriesforthepreliminaryprofit-and-lossprojection:sales,costofgoodssoldandgrossmargin.Hewillalsowanttoretainbackupsheetsshowinghowthefigureswereprepared.Insomefirms,thetopexecutivemaywanttoseethesameitemsbyproductlineforcomparativepurposes.

Step3:CollectHistoricalDataCollectinformationonwhatthecompanyhasspentinthepastforallcostaccounts,anddeter-minetowhichdepartmentthesecostshavebeenallocated.Nowisthetimetomakeanychangesinthoseallocations.

Realisticcostallocationisattheheartofanysoundbudget.Withavariablebudget,whichrequiresthesecoststobeidentifiedoverawiderangeofoperatinglevels,thetaskisfarmorecomplicatedandexpensivethanunderafixedbudget.Budgeting,however,isnottheonlyareainwhichmanagementcanusedetailedcostdata.Productpricing,long-rangeplanning,market-ingcampaignsandmanyothercorporateendeavorsdependonproperidentificationofcosts.

Step4:DoCostAnalysisAnalyzeeachcostandcategorizeitasfixed,variableormixed.Eachcategoryisdiscussedhere.● Allocating fixed costs:Essentially,fixedcostsareacompany’soverhead.Theterm“fixed”

doesnotimplythatthesecostsneverchange,merelythattheydonotchangeasthefirm’ssalesactivitymovesupanddown.

Perhapsbecauseoftheuseoftheterm“fixed,”managementisofteninclinedtoacceptfixedcostsasanecessarypartofbusinesslife.Infact,manyfixedcostscan,andshould,bealteredwithchangesintheproductlineorthepurchaseofcapitalequipment.Forinstance,acompanymayreducetheadministrativestaffaftertheadditionoflaborsavingdevices,suchaswordprocessors.Insurancepremiumsareoftenadjusteddownwardafteraninsuranceaudit.Evendepreciation,themostrecognizablefixedcost,changesovertime.

Inotherwords,so-calledfixedcostsarenotfixedatall.Theycangetoutofhandjustasvariablecostsoftendo.Thisisparticularlytrueafteralengthyperiodofhighactivity.Ifyourcost-analysisprogramdoesnothingmorethanpointoutthisfact,itwillbemorethanworththeeffort.

Onceyou’veproperlyidentifiedfixedcosts,however,theanalysisisfairlystraightforward.Essentially, two steps are involved: investigation andallocation. First, investigate thebasicreasonforincurringthecost,andwhatfactorscauseittoriseorfall.Whenyouhaveidentifiedthesetwoingredients,assignthecosttoaproductorproducts.Asanexample,youmightallocateadministrativecostsamongseveralproductlinesbyusingpercentageofsalesvolumeasaguide.


➤ Caution:Avoidthetemptationtoallocatefixedcostsarbitrarily.Inmanycompanies,fixedcostsarespreadindiscriminatelyamongallproducts.Thisresultsinoneproductbeingcarriedbyanother.Itisthiskindofcorporateinjusticethateffectivebudgetingalwaysseekstouncover.

Second,afteryouhaveinvestigatedafixedcostandcometoadecisionastohowitistobereallocated,bepreparedtodefendyourdecision.Thereassignmentoffixedcostscancauseafurorinmanagementcircles.Productionmanagers,forinstance,willseldomsitbyquietlywhiletheirdepartmentalcostsareraised.Similarly,marketingwillbereluctanttoseeproductcostsraisedtoapointwheretheymightrequirepricechanges.Keepinmind,however,thatabudgetisusefulonlyiftheinformationituncoversisproperlyused.● Controlling variable costs:Avariablecostdirectlydependsontheactivityinvolved.Asthe

activityrisesandfalls,thecostfollows.Iftheactivityceases,nocostisincurred.Examplesofvariableordirectcostswouldincludesalescommissions,directlaborandrawmaterialscosts.

Normally,purevariablecostsrepresentanimportantpartofthetotalcostsofoperatingacompany.Thus,theyarealsoimportanttoaneffectivebudget,eventhoughtheyareusuallyfewinnumber.Becausepurevariablecostsaresoeasilyspottedandaredirectlyrelatedtoaspecificactivity,thereisrarely,ifever,aprobleminproperallocation.Fromabudgetingstandpoint,theprimaryprobleminhandlingvariablecostsisthedevelopmentofaworkablecontrolsystem.

➤ Recommendation:Inmostareas,abudgetis,inandofitself,aneffectivedeviceforcontrol-lingcosts.Withvariablecosts,however,abudgetmustbesupplementedwithlaborandmaterialstandardstobetrulyeffective.Usually,youcandevelopthesestandardsfromhistoricaldataifyourcompanyhasnotsetproductionyardsticks.Pastperformancereportscanbecombinedwithcostinformationtogeneratereasonablebudgetstandards.Usethesestandardstodevelopfairbudgetallowances.● Classifying mixed costs:Relativelyfewcostscanbedescribedaspurelyvariableorfixed.

Mostcostsarecomposedofelementsofboth;someelementsarefixedandothersvarywiththeactivity.

Insomeinstances,companiesassignmixedcoststoeitherthefixedorvariablecategoryforsimplicity.However,whenamixedcostistreatedaspurelyvariable,thebudgetwilltendtoberestrictiveatlowerlevelsofactivityandlooseathigherlevels.Ifamixedcostisregardedasfixed,thereverseistrue:Thebudgetwillbelooseatlowproductionlevelsandtightathigherlevels.

Toresolvethisallocation-of-costproblem,companiesusescatterdiagramstoestimatemixedcosts.Whenalinear mixedcostisinvolved,forinstance,alinedrawnthroughthepointswillslopeupwardandtotheright;thisindicatesthatcostsstartatafixedlevel,thenrisewithactivity.Whenastep mixedcostisinvolved,thescatterdiagramwillindicateasortofstaircasepattern,involvingaseriesoflinesathigherandhigherlevels.Indrawingthelines,the“eyeball”approachistheonlypracticaloneforthestepcosts.Usetheleast-squaresmethodforlinearcosts.

Besidesshowingyoumixed-costrelationships,scatterdiagramsareusedtodemonstratetheimpactofanycost.Theyareparticularlyusefulinidentifyinganoperatingpracticethatneedsimprovement.Furthermore,thegraphicpresentationprovidedbythescatterdiagramishelpfulinbringingapointhometomanagement.

Step5:DetermineBudgetAllowancesForeachcost,determinebudgetallowances,withasetamountbudgetedforeachfixedcost,andactivityrangesestablishedforvariableandmixedcosts.Thisentailssettingupanoverallexpensebudgetforthecompany,aswellasindividualexpensebudgetsfordepartmentsorsectionsofthecompany(see page 36).


Expense Budget, Year Ending Dec. 31: ABC Corporation

Full Year 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.

Sales $420,000 $90,000 $120,000 $80,000 $130,000

Less: Fixed Costs Sales Depreciation‑Office $ 1,200 $ 300 $ 300 $ 300 $ 300 Rent‑Office 9,600 2,400 2,400 2,400 2,400 Administrative Salaries $ 20,000 $ 5,000 $ 5,000 $ 5,000 $ 5,000 Insurance 2,200 550 550 550 550 Manufacturing Property Taxes $ 2,600 $ 650 $ 650 $ 650 $ 650 Depreciation‑Plant 3,000 750 750 750 750 Rent‑Plant 5,000 1,250 1,250 1,250 1,250 Salary of Supt. 12,000 3,000 3,000 3,000 3,000 Total Fixed Costs $ 55,600 $ 13,900 $ 13,900 $ 13,900 $ 13,900

Variable Costs Sales Commissions $ 45,000 $ 8,850 $ 13,070 $ 9,125 $ 13,955 Administrative Supplies $ 4,000 $ 820 $ 1,150 $ 795 $ 1,235 Bad Debt Expense 4,200 900 1,200 800 1,300 Manufacturing Direct Material $ 63,000 $ 13,500 $ 18,000 $ 12,000 $ 19,500 Direct Labor 105,000 22,500 30,000 20,000 32,500 Total Variable Costs $ 221,200 $ 46,570 $ 63,420 $ 42,720 $ 68,490

Mixed Costs Sales Advertising $ 8,000 $ 1,500 $ 2,400 $ 1,500 $ 2,600 Telephone 4,000 850 1,100 800 1,250 Other Sales 12,000 2,500 3,200 2,500 3,800 Administrative Telephone $ 2,000 $ 400 $ 550 $ 400 $ 650 Other Admin. 3,800 900 950 900 1,050 Manufacturing Heat & Power $ 15,000 $ 3,000 $ 3,750 $ 3,500 $ 4,750 Factory Supplies 6,600 1,600 1,700 1,550 1,750 Total Mixed Costs $ 51,400 $ 10,750 $ 13,650 $ 11,150 $ 15,850

Net Income From Operations $ 91,800 $ 18,780 $ 29,030 $ 12,230 $ 31,760

Less: Interest Expense 600 300 300

Federal Income Taxes 41,952 8,639 13,216 5,626 14,471

Net Income $ 49,248 $ 10,141 $ 15,514 $ 6,604 $ 16,989


Allgeneralexpensesofthecompanymustbecovered.Thisisnotaprobleminmostfirmsbecausethemembersofthebudgetingteam,asagroup,areusuallyresponsibleforallexpenses.If,forsomereason,thisisnotthecase—thetopexecutivemaybelievethatoneormoreindividu-alsarenotyetreadytoparticipateinthebudgetingprocess—theexpensesofthatfunctioncanbebudgetedseparatelyorincludedinthetopexecutive’sbudget.

Beforeeachmanagerpreparesanexpensebudget,thecompanyshouldprovidecertainguidelines:● What expenses should be budgeted?Inthepast,itwascommonforcompaniespreparing

budgetstoallocatethefixedexpenses(rent,light,heat,power,etc.)tothevariousindividualunitsonsomebasis,usuallyfloorspaceoccupied.Morerecently,thetrendhasbeenforeachmanagertobudgetonlythoseexpensesoverwhichshehascontrol.Fixedexpensesarethencarriedinthegeneraladministrativebudgetofthetopexecutive.

● What will be the compensation policies?Thesepoliciesmaychangesignificantlyalongwiththegeneraleconomicclimate(inaprofitsqueeze,forexample),theconditionofthelabormarketorthecompany’sprofitoutlook.Itisimportant,therefore,forindividualmanagerstohaveguidelineswithrespecttothepossibilityofacross-the-boardcost-of-livingincreasesorindividualmeritraises,overtimeand,ifapplicable,raisesfornonunionemployeestoadjustforunion-negotiatedwagehikes.

● What will be the company’s general policy on expenses?Ifthecompanyexpectstohavelimitationsonhiring,newprojectsoroverallcost-cuttingprograms,itshouldcommunicatethesetothedepartmentmanagerschargedwithsubmittingexpensebudgets.Ifthetopexecu-tivethinksthatonedepartment’sexpendituresoronespecificexpenseiscurrentlyoutofline,heshouldalsoconveythispointtotheindividualsinvolved.

Step6:ReviewExpenseBudgetsUnlikeotherstepsinthebudgetprocess,thereviewofeachexpensebudgetgenerallytakesplaceinaconfidentialmeetingbetweenthetopexecutiveorbudgetcommitteechairmanandtheresponsiblemanager,ratherthaninafullmeetingofthebudgetingcommitteeorgroup.Itwillbeuptothetopexecutive,however,to(1)makecertainthatanyservicesorprojectsplannedthatimpingeonotherareasofthecompanyarecoordinatedwiththemanager(s)involved,and(2)judgewhetherthelevelofactivityplannedproperlysupportsthecompany’sobjectives.

Fewtopexecutivesneedanyadviceonhowtoproberecommendedexpenditures.Thereare,however, twosituationsthatoccuragainandagaininexpensebudgeting,andeitheronecansubstantiallyreducetheeffectivenessofthebudgetprocess.

Onedangeroussituationariseswhenthebudgetsofallmanagersarenotequally“tight.”Onemanagermayconscientiouslybudgetaprogramdifficulttoachieveattheprice,whiletheothergiveshimselfplentyofleeway.Thisinequitysoonbecomesknownandseriouslyaffectsperformance.Theseconddangerariseswhenthemanagerslearnthatnomatterhowtightthepreliminarybudgetis,cutswillbemade.Suchanautomaticbudget-cuttingpolicyisboundtoboomerangbecausemanagersmaymerelypadtheirbudgetstowindupwiththeamountstheyreallywant.

Step7:EstimateProfitsWithcostallowancesbudgetedforeachdepartment,youcanforecastmonthlyprofitsbysubtract-ingcostsfromrevenueanticipatedinthesalesforecast.Theresultwillbepreliminaryprofitorlossbeforefederaltaxesforthebudgetperiod.


Tofacilitateareviewofthepreliminaryprofit-and-lossbudget,thefinancialmanagershouldpreparecertaincomparativedollarfiguresandratios.Thespecificcomparisonschosenwillvaryamongcompanies,buthereareseveralthatareoftenused:● Profitindollarsandnetprofitasapercentageofsalesforthebudgetcomparedwithcurrent

andpriorperiods.(Profitdollarsmaybeupbutrepresentasmallerpartofsales.)● Budgetedexpensefigurescomparedwithactualfiguresforthecurrentandpriorperiods,

showingpercentageincreasesordecreases.Itmaybedesirabletoprovidethesecomparisonsbothbydepartments(sales,financial,etc.)andbyitemofexpense(totalsalaries,travel,tele-phone,etc.).

● Ratiosofbudgetedexpensestosalescomparedwithratiosofactualexpensestosales,forcur-rentandpriorperiods.(Dollarexpensesmaybeupbutdowninproportiontosales.)Again,itmaybedesirabletoprovidetheseratiosbothfordepartmentsandindividualproducts.

● Theincreaseinthetotalnumberofemployeescontemplatedbythebudget.Controlofthenumberofemployees isoftenconsideredthekeytoanycostcontrolbecauseallcostsaredirectlyorindirectlyrelatedtopeople.Thetrendsoveraperiodofyearsshownbytworatioscanbehelpfulinviewingtheoveralleffectivenessoftheorganization:salesperemployeeandprofitperemployee.Inbothcases,thetotalnumberofemployeesisused.

UsingYourBudgetEvenmoderatesuccessinpreparingthebasicprofit-and-lossbudgetwillencouragethebudgetteamorcommitteetobranchoutintootherareas.Theexpensebudget,illustratedinthissection,thenbecomesafirmfoundationonwhichtobuildacashbudget,usedtoestimatetheflowoffunds,andacapitalspendingbudget,usedtocontrolthecapitalspendingactivities.Bothofthesetopicswillbecoveredinlatersections.

RemembertoFollowUpThebudgetingfunctiononlybeginswhenaformalbudgetisinstalledandoperating.Thecompanyneedstofollowuptoensurethatbudgetsareproperlyusedandthatstepsaretakentoimproveefficiencyofoperationswhenthebudgetpointsoutareasforpossibleimprovement.

Theheartofanysoundbudgetfollow-upsystemisthemonthlyperformance report.Issuedforalloperatingdepartments,thisreportdetailsresultsofthemanager’sefforttokeepwithinbudgetallocation.Dataincludedinthereportsvaryfromcompanytocompany,butalmostallreportsincludebudgetallowancesforthemonth;actualmonthlyspending;variance(differencebetweenallowanceandspending)forthemonth,whetherfavorableorunfavorable;andcumula-tivefiguresfortheyearonallowances,expendituresandvariances.

Performancereportsforavariablebudgetarenotissueduntilthemonthisover.Consequently,itisimportanttosendthemtooperatingmanagersassoonaspossible.Otherwise,departmentheadswillregardthereportsasobsoleteandhavinglittlerelationshiptotheproblemsoftheday.Nobudgetperformancereportshouldreachtheoperatingdepartmentlaterthanthe10thofthenextmonth.

RevisingYourBudgetAnybudgetisanunfinisheddocumentbecausecircumstanceschange.Manytimes,thedataonwhichabudgetisbasedareincomplete—andevenwhentheyaresufficient,thehumanelement


canaffectthem.Whentheeconomyturnsdown,forexample,anoverlyoptimisticbudgetcanquicklydrainacompany’sfinancial resourcesandsometimes lead toacrisisbeforeremedialstepsaretaken.

Youcanimproveyourcompany’sperformancesignificantlybymovingfromastaticbudgettoarolling budgetsystem.Arollingbudgetisperiodicallyadjustedtotheforecast,onthebasisofthelatestdevelopments,ofwhatthescenarioislikelytobeinthefuture.

Mostrollingbudgetsaremadeonacontinuous12-monthbasis,withadjustmentsmadeeachquarter.Forexample,arollingbudgetpreparedinthesecondquarterof2010wouldrunfromJuly1,2010,toJune30,2011.AttheendofSeptember,anotheradjustmentwouldbemade,andthenewbudgetwouldcovertheperiodbeginningOct.1,2010,andendingSept.30,2011.

Therearetwodistinctadvantagestousingarollingbudget:Yourbudgetisareflectionofthemostrecentbusinessdataavailable,andittakesintoaccountthelatestinputfromyoursalesforceandoperatingstaff.


ManagingYourCash

Nothingismoreindicativeofthehealthofyourcompanythancashflow.Asthesayinggoes, “Profitsareanopinion,butcashisafact.”Allmanagersareawarethatprofitslendthem-

selvestobeing“managed”duringanyonespecificreportingperiodtoachievedesiredcorporateorshareholderresults.Bycontrast,yourcashflowisanundeniablereality.

Cashmanagementisaneasyconcepttoenvisionifyouthinkaboutyourownpersonalcheck-book.Youhavetoensurethatenoughmoneyhasbeendepositedinthebanktocoverthechecksyouneedtowrite.Youcountonbeingpaidwhatisowedyousothatyoucanpayyourdebts.Thesameistrueofyourcompany—thenumbersarejustbigger.

Therealaim,then,ofcashmanagementistoensurethattherightamountofcashisavailableatalltimestomeetyourcompany’sneedsandobjectives.Withaneffectivecash-managementprogram,yourcompanywillneitherbesurprisedbyadevelopingcashshortagenorfinditselfstuckwithexcesscashthatshouldbeputtowork.

Anegativecashflowisnotnecessarilybadifitisplannedasanopportunitycostdirectedtowardyieldinggreaterbenefitsinaforeseeableperiod.Acashsurplus,bycontrast,cancauseyourcompanyalmostasmanyproblemsasadeficit,eventhoughtheyarelessdire.Acashsurplusrepresentsassetsthataremakingnocontributionwhatsoevertoyourfirm.Eveniftheseassetsareinvestedwiselyinfinancialinvestments,theyieldinmanyinstanceswillfallshortofyourcompany’sreturnoninvestment.Unfortunately,thereislittlethatcanbedonewithshort-termcashsurpluses,excepttoseekoutthebestpossibleyieldsforthem.

Asanonfinancialmanager, your role indeterminingyour company’s cashflowmaybeminimal—butunderstandingitisvital.First,ifyoumanageassetsorhaveaneffectonsalesoroverhead,youprobablyaffectthecompany’scashflow.Ifso,youwilllikelyfacequestionsabout eitherwhatyouexpecttobringin(salesforecasts)orwhatyouexpecttospend(capitalexpen-dituresoroperatingexpenses).Yourunderstandingofcashflowwillenableyoutoanswerthesequestions.

Plus,ifyouintendtoaskforadditionalstaff,resourcesormoneyforaproposedproject,alookatyourcompany’scash-flowanalysiscouldgiveyouammunition.YoumightseethatcashistightinMarch,butasurplusisprojectedinSeptember.AskingformoneyinFebruarywouldnotbeassmartasaskingformoneyinAugust.

MakingCash-FlowDecisionsTounderstandcashmanagement,keepinmindthesetwobasicprinciples:(1)Cashshouldnotflowintoandoutofyourfirmindiscriminately;and(2)gettingahandleonyourcash-flowsitua-tionmustinvolvenotonlyasubtractionofpayablesfromreceivables,butaplanfordealingwiththetimelagbetweenthetwo.Let’slookatthemajordecisionsyouwillhavetomaketoadheretotheseprinciples.● Timing changes:Theeasiestwaytoraiseorloweryourcashflowistochangethetactical

patterninwhichcashnormallyflowsintoandoutofyourfirmoverrelativelyshortperiodsoftime—say,fourtosixmonths.Youcanspeedupcollectionsand/ordelaycashoutflowstoeaseacashdeficit.

Bear inmind,however, thatchanges intimingmerelyaltercash-flowpatternsfor limited

7

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periodswithoutchangingtheamount.Theyshouldhavenoimpactonthefutureperformanceofthefirm,oronthefirm’slong-terminvestment,marketingandgrowthgoals.● Policy changes:Changesinpolicyforthesakeofhandlingcash-flowimbalanceshavemuch

longer-termeffectsthantimingchanges.Suchchangesinvolveacommitmenttoalterprevi-ouslyplannedobjectives in costsofoperations;organizationor replacementofplantandequipment;marketingandsales;andinvestmentinnewproductsorservicedevelopment.

Fromanoperationalpointofview,suchpolicydecisionscouldincluderaisingorloweringinventorylevels,oranincreaseordecreaseinresearchanddevelopmentspending.Fromafinancialstandpoint,youcoulddecidetochangeyourpolicyondividendsorcapitalinvestmentprograms.Ofthetwo,dividendpolicyisthemoreflexible.

Policydecisionsthatalterthefuturecourseofyourbusinessshouldnotbemadelightly.Al-thoughreversible,suchdecisionscanproveverycostlyandthereforeshouldbelimitedtothoseareasmostsusceptibletoquickresponse.● Volume changes:Thesechangesarestrictlyoperationalinnatureandalwaysconsistofcut-

backstoreducecashdeficits.Inadditiontoplannedreductionsinsalesand/orproduction,youcouldreducerawmaterialsandwork-in-processinventories.

● Irreversible policy decisions:Inalllikelihood,yourmostdifficultcash-flowdecisionswillinvolvethisarea.Byitsverynature,thistypeofdecisionchangesyourfirminafundamentalway.Irreversibleoperationaldecisions, forexample,almostalwayscenteronthedisposalofassets.Conversely,youmightseektoputsurpluscashtousebyacquiringacompanyoranotherproductline.

Raisingnewcapitalisthemostfamiliarfinancialmethodofhandlingacashdeficit.Equityfinancingispreferredundersuchcircumstancesbecauseitdoesnotaddtoyourfirm’sobliga-tions.Itisnotalwayspossible,however,forafirmwithacashdeficittoselladditionalcommonorpreferredstock.Asaresult,manycompaniesareforcedtoraisenewcapitalviathedebtroute,whichmeansthatfuturecash-flowmanagementmusttakeintoaccounttheneedtomeetdebtobligations.

UsingYourCashBudgetBeforeyoucancometogripswithcash-managementproblems,youmustfirstknowhowmuchcashwillflowintoandoutofyourcompany.Second,youshouldhaveanideaofwhenthesecashinflowsandoutflowswilltakeplace.Aproperlypreparedcashbudgetcanhelpanticipatepossibleproblemsandevensuggestsolutions.

Thecashbudgetisusedprimarilytospotlightperiodsoftoolittleortoomuchcashratherthanforcontinuouscontrol.Theformerisusuallytheproblemforsmallercompanies,andacashbudgetcanbeinvaluable.Bypinpointingprobablecashneedsbyperiodandamount,thecompanyisaffordedthetimeneededtoobtainextrafunds.

Acashbudgetistaken,inlargemeasure,fromanexpensebudget.Itstartswithacashbalancefromtheoldyear.Then,byusingdataobtainedfromtheexpensebudget,itprojectstheactualebbandflowofcashtransactionsfortheperiod.Formostbusinesses,cashinflowswillcomefromthreesources:sales,cashpaymentsreceivedonaccountandloans.Becausesomecustomerswillpurchaseonaccount,thecashbudgetmustreflectthatpaymentwillbemadeatalaterdate.Thisisanimportantfactor:Accountsreceivable,whilevital,arenotcashinhandandcannotbetreatedassuchtorunthebusinesseffectively.

Illustration:Incondensedform,theexpenseandcashbudgetsforABCPublishingCompanyappearonpages42and43.Bothbudgetscontainannualandquarterlyestimates.Notethatthe


cashbudgetindicatesthatABCwillneedtoborrowatotalof$40,000inthefirstquarter(primar-ilytopayincometaxes)butwillbeabletopayitback,alongwithotherborrowings,inthethirdquarter.Moreover,ABCshouldbeabletopayahealthy$50,000dividendinthefourthquarterandstillcarryoverareasonablecashbalanceintothecomingyear.

➤ Observation:Forpurposesofillustration,wehaveusedthesamedataforboththeexpenseandcashbudgets.Inpractice,thetwoareusuallysimilarbutcan’tbeexactlyalikebecauseofthetimelagbetweensalesandcollections.Moreover,estimatesforoperatingexpensesinacashbudgetareusuallysomewhatmoreuptodatethanthoseusedforanexpensebudget.

WheretoObtaintheRightCash-FlowInformationAcashbudget cangiveyouvaluable informationonyourprobable cash-flow trendsover a12-monthperiod.However,tobeeffectiveinmanagingyourliquidassetswillrequiremorethanguesstimates.You’llneeddataonhistoricalcash-flowpatternstojudgewhetheryourcashbudgetisrealistic.And,ifyouaretotaketimelyactiontoavertpotentialcash-flowproblems,youmust

Expense Budget: ABC Publishing Company

Full Yr. 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.Sales: $600,000 $80,000 $300,000 $150,000 $70,000

Less: Fixed Costs Sales $ 15,000 $ 3,750 $ 3,750 $ 3,750 $ 3,750 Administrative 28,000 7,000 7,000 7,000 7,000 Manufacturing 35,000 8,750 8,750 8,750 8,750 Total Fixed Costs $ 78,000 $ 19,500 $ 19,500 $ 19,500 $ 19,500

Less: Variable Costs Sales $ 55,000 $ 7,150 $ 27,500 $ 13,750 $ 6,600 Administrative 12,000 1,560 6,000 3,000 1,440 Manufacturing 230,000 29,900 115,000 57,500 27,600 Total Variable Costs $ 297,000 $ 38,610 $ 148,500 $ 74,250 $ 35,640

Less: Mixed Costs Sales $ 34,000 $ 4,300 $ 17,000 $ 8,500 $ 4,200 Administrative 8,000 1,000 4,000 2,000 1,000 Manufacturing 70,000 9,700 35,000 17,500 7,800 Total Mixed Costs $ 112,000 $ 15,000 $ 56,000 $ 28,000 $ 13,000

Income From Operations $ 113,000 $ 6,890 $ 76,000 $ 28,250 $ 1,860

Less: Interest Expense 2,000 — 1,000 — 1,000 Federal Inc. Taxes $ 47,460 $ 6,170 $ 23,730 $ 11,865 $ 5,695

Net Income $ 63,540 $ 720 $ 51,270 $ 16,385 ($ 4,835)


Cash Budget: ABC Publishing Company

Full Year 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.

Beginning Cash Balance: $ 16,000 $ 16,000 $ 11,430 $ 86,430 $ 63,880 Collections 600,000 80,000 300,000 150,000 70,000 Total Available Cash $ 616,000 $ 96,000 $ 311,430 $ 236,430 $ 133,880

Less: Cash Payments Sales $ 104,000 $ 15,200 $ 48,250 $ 26,000 $ 14,550 Administration 48,000 9,560 17,000 12,000 9,440 Manufacturing 335,000 48,350 158,750 83,750 44,150 Total Operating Expense $ 487,000 $ 73,110 $ 224,000 $ 121,750 $ 68,140

Interest Expense 4,800 — 1,000 2,800 1,000

Federal Income Tax 47,460 47,460 — — — Dividends 50,000 — — — 50,000 Bank Loan Payment 52,000 4,000 — 48,000 —

Cash Balance (Deficit) (25,260 ) (28,570 ) 86,430 63,880 14,740

Bank Borrowing 40,000 40,000 — — —

Ending Cash Balance $ 14,740 $ 11,430 $ 86,430 $ 63,880 $ 14,740

haveinformationoncurrentcashmovements.Finally,youwillneedtotakealookatfuturecashflowtoestablishanappropriatepolicy.

Althoughcashflow is simple in concept, inpractice it canbedifficult tonaildown.Theprimaryproblemisthatnotwofirmshaveexactlythesamecash-flowpattern.Firmshavedif-ferentcriticalfactorsthatmustbemonitoredandcontrolled.Therefore,everyfirmhasdifferentinformationneeds,requiringthattheinformation-gatheringnetworkbespecificallytailoredtoitspreciseneeds.Thisdoesnotmeanyoumustinventamethodologyforgatheringandanalyzingcash-flowinformation.Themethodologyalreadyexists.Wewilldiscusstwobroadapproachesthatprovideyouwithinsightsforyourfirmfromtwopointsofview.

Receipts and Disbursements Analysis

Thisistheoldest,mostcommonmethodofmeasuringcashflow.Becauseitisbasedoninformationrecordedinthereceiptsanddisbursementslog—abasicbookkeepingledgercommontovirtuallyallfirms—theinformationitselfiseasytoobtainandorganize.

Mostfirmswillcomeupwithrelativelyfewgeneralheadingsfortheirreceiptsandpayments.Thoseheadingsusuallywillfallintothefollowingcategories:

Receipts:Thereareonlyalimitednumberofwaysfortheaveragecompanytoobtaincash.However,itisimportanttodifferentiateeachofthoseinthereceiptsectionofyouranalysis.Onlyifeachcategoryisproperlyidentifiedcanyouproperlymonitoryourcashreceipts:


● Collections. Thesearefundsreceivedfromyouraccountsreceivable.Normally,thiscategorywillrepresentthebulkofyourcashinflow.

● Cash sales,orsalesnotinvolvingcredit.Theseareusuallythenextlargestcategorybutstandfarbelowcollectionsinmostcompanies.

● Nonoperating income.Manycompaniesroutinelytakeinincomefromsourcesnotnecessar-ilyassociatedwiththeirprimarybusiness.Thistypeofincomeincludesdividendorinterestincomefrominvestments,rentalorleaseincome,royalties,etc.

● Special, nonrecurrent sources of income.Themostcommonitemsinthiscategoryarenewfinancings(eitherinvestmentsorsurplusfixedassets).However,youcouldincludeincomefromanyunusualsourceinthiscategory.

Disbursements:Thereareanumberofpaymentcategoriesthatafirmcanchoosetoidentifyinitsanalysisofcashflow.Herearesomecommonheadingsthatyoumightconsider:● Supplier paymentsusuallyheadthelistandcanconsistofcashpaymentsaswellasareduc-

tioninaccountspayable.● Wages and salariesaredifficulttocontrolovertheshorttermbutcanusuallybemanaged

overaperiodoftime.● Overhead items,suchasheat,power,telephoneandotherutilities,propertytaxesorrent,are

generallyfixedandbeyondmanagement’scontrol.Thus,youcanusuallybringtheseitemstogetherinonecategory.

● Federal income taxescanchangerapidlyandshouldbeclassifiedseparately.● Recurrent payments,suchasinterestonlong-termbondsordividendpayments,shouldbe

groupedtogetherunderaseparateheading.● Irregular or special financial obligations, suchas short-term loan repaymentsor special

dividends,shouldalsobeclassifiedinaseparatecategory.● Capital expenditures cansometimesbesignificantand,atother times,canamount tono

morethananominalinfluenceonyourcashpayments.However,theyshouldbeclassifiedseparatelywheneverpossible.

● A special miscellaneous categoryshouldbeincludedforextraordinaryitems(suchasthesettlementofalawsuitorapatentpurchase)oranyothersignificant,nonrecurringitem.

Illustration:Tocarryonwithourprevious illustrations,wehavecompiledananalysisofreceiptsanddisbursementsfortheABCPublishingCompanyforthefirstquarteroftheyearbyusingdatacontainedinthecashandexpensebudgetsforthatfirm.Notethatthefiguresfortheactualcashflowareconsistent,eventhoughtheclassificationsusedhavebeenrearrangedtosuittheformatforareceiptsanddisbursementsanalysis.

Wehaveconfinedouranalysistoasinglequarter,brokendownintomonths.Thereisnoneedforyou,however,tofocusonlyononequarteratatime.Iftheseasonalpatternsforyourcompanywarrant,youmightchoosetoconsolidatethedatasemiannually,orevenannually.

Buttokeepyouranalysisuptodate,youwillneedtocompileanewoneeachmonth.Astheanalysisonpage45shows,therewasawarningasearlyasJanuarythatcashflowwouldprobablynotbesufficienttocoverincometaxespayableattheendofMarch.

BytheendofFebruary,theevidencewasconclusive.However,withthewarning,ABCwasabletonegotiateashort-termloanthattookcareoftheincometaxpaymentandamodestdebtrepaymentaswell.


Receipts and Disbursements Analysis: ABC Publishing Company

1st Qtr. January February March

Receipts Collections $ 62,000 $ 17,000 $ 25,000 $ 20,000 Cash Sales 18,000 4,000 5,000 9,000 Miscellaneous — — — — Bank Loan 40,000 — — 40,000 Total Receipts $ 120,000 $ 21,000 $ 30,000 $ 69,000

Payments Suppliers $ 16,610 $ 3,305 $ 5,105 $ 8,200 Wage & Salaries 34,500 10,500 11,000 13,000 Overhead 22,000 7,000 8,000 7,000 Taxes 47,460 — — 47,460 Interest & Dividends — — — — Debt Repayment 4,000 — — 4,000 Special Items — — — — Total Payments $ 124,570 $ 20,805 $ 24,105 $ 79,660

Current Surplus (Deficit) ( 4,570) 195 5,895 ( 10,660)

Cash Bal.— Beginning of Period 16,000 16,000 16,195 22,090

Cash Bal.—End of Period $ 11,430 $ 16,195 $ 22,090 $ 11,430

Flow of Funds Analysis

Analyzingyour cashflowby theflow-of-fundsmethod ismarkedlydifferent fromusing thereceipts-and-disbursementsmethod.Inthelattermethod,informationisorganizedbyaccount,butinformationinaflow-of-fundsanalysisisorganizedalongthelinesofmanagementresponsibility.Asaresult,itwillpointtothemanagementdecisionareasthatwillbeinvolvedinresolvinganycash-flowproblemsthatmayoccur.

Cash inflows:Whenviewedalongthelinesofmanagementresponsibility,cashcanflowintoyourcompanyinoneofthreeways.First,youcanreceiveincomefromyouroperations.Next,youcanreceiveincomefromafinancing,whetheritbebankloans,yourcreditlinesorthesaleofstock.Finally,youcanconvertapartofyourassetsintocash.Thiscanbedonebytheactualsaleofafixedasset,suchasland,abuildingormachinery,orbyspeedingupcollectionofaccountsreceivableorsellingoffinventories.

Cash outflows:Aswithcashinflow,cashcanflowoutofyourfirminoneofthreewayswhenviewedalongamanagementresponsibilityline.First,therearenormallyrecurringpayments,suchasthosefortaxes,interestpaymentsanddividends.Second,financingobligationsmayincludealoanrepayment,bondredemptionorperhapsareductioninyourlineofcreditwithsuppliers.Finally,youmaydecidetoincreaseyourassets.Youcoulddothisbypurchasingafixedassetorbyallowingcurrentassets,suchasaccountsreceivableorinventories,torise.


Flow of Funds Analysis: ABC Publishing Company

1st Qtr. January February March

Cash Inflows Income From Operations $ 6,890 $ 195 $ 5,895 $ 800

Financing Bank Financing 40,000 — — 40,000 New Supplier Credit 10,000 — 10,000 —

Disposal of Assets Fixed Assets — — — — Current Assets — — — — Inventories 2,000 2,000 — — Accounts Receivable — — — — Total Cash Flow $ 58,890 $ 2,195 $ 15,895 $ 40,800

Cash Outflows Recurring Payments Taxes $ 47,460 — — 47,460 Dividends — — — — Interest — — — — Financing Loan Repayment 4,000 — — 4,000 Reduced Supplier Credit — — — — Acquisition of Assets Fixed Assets 10,000 — 10,000 — Current Assets — — — — Inventories — — — — Accounts Receivable 2,000 — 2,000 — Total Cash Outflows $ 63,460 $ 0 $ 12,000 $ 51,460

Current Surplus (Deficit) ( 4,570) 2,195 3,895 (10,660)

Cash Bal.—Beginning of Period 16,000 16,000 18,195 22,090

Cash Bal.—End of Period $ 11,430 $ 18,195 $ 22,090 $ 11,430

Illustration:Toturnonceagaintoourpreviousexample,youwillfindbelowaflow-of-fundsanalysiscoveringthefirstquarteroftheyearforABCPublishing.Fordemonstrationpurposes,wehaveassumedthatduringthequarter,ABCreduceditsinventoriesby$2,000,increaseditsaccountsreceivablebythesameamountandboughta$10,000book-bindingmachineoncredit.


Onceagain,notehowtheendresultjibeswithboththereceipts-and-disbursementsanalysisandthecashbudgetforABC,eventhoughtheinformationprovidedbythisanalysisisentirelydifferent.Thecashflowisthesame,nomatterhowitispresented,butthereareanumberofwaysoflookingatit.

Evenacursoryglanceattheflow-of-fundsanalysiswillshowthatadditionalfinancingwasnecessarytopaytheMarchtaxbill.Atthesametime,anumberofotherpointsbecomeapparentaswell.First,theseasonalpatternofABC’soperationdoesnothelpthecompany.Eventhoughcashoutlayswerekepttoanabsoluteminimuminthefirsttwomonths,themodestcashbuildupwasoverwhelmedbyout-of-pocketexpensesinMarch.Moreover,eventhoughtheslackFebruaryperiodwasthepropertimetopurchasenewequipment,ABCwouldhavebeenhard-pressedtocomeupwiththeextracashifcredithadnotbeenavailable.

Alsonotethattheflow-of-fundsanalysisdoesnotgivespecificsonwheretheactualcashisbeingspent,justasthereceipts-and-disbursementsanalysismakesnomentionofmanagementdecisionareas.Thus,whileeachmethodhasblindspots,togethertheycanprovideyouwiththeinformationyouneedtomaketimelydecisions.

ForecastingYourCashFlowEitherorbothmethodsofcash-flowanalysiswillgoalongwaytowardsatisfyingyourcash-flowinformationneeds.Becausebotharecompiledonamonthlybasis,youshouldbeabletotrackcur-rentcash-flowpatternsquiteeasily.Inaddition,thequarterlyconsolidationsshouldprovidethedatanecessarytodeterminewhethertheassumptionscontainedinyourcashbudgetwererealistic.

Thisleavesoneimportantareatobeaddressed:theformidabletaskofforecastingcashflow.Withcashflowbeingvital to thecontinuedexistenceofyourorganization, it isessential thatyouattempttopredictfuturecashpatterns,ifonlyasaprecautionagainstapossibleseverecashsqueezesomewheredowntheroad.However,thereareotherbenefitsaswell.

Frequently,acash-flowforecastwillhelpyouavoidacostlybusinessmistake,oritwillprovideanearlywarningsignindicatingthepathtoimprovedmanagementcontrol.Itcanalsorevealtheneedtoraisesignificantfundsbeforeacrisis,oritcanpointthewaytowardproperutilizationofanimpendingsurplus.Evenwiththeseadvantages,cash-flowforecastscancauseproblemsunlesstheyareviewedinthepropercontext.Herearesomekeypoints:● Completely accurate forecasts are impossible.Nomatterhowmuch timeandattention

youdevotetoyourcash-flowforecast,itwillprobablybewideofthemark.Nevertheless,ifproperlyprepared,aforecastcanstillyieldvaluableinformationbyindicatingwhattypeofactionyoushouldtaketoavoidcash-flowproblems.

● Forecasts must establish timing.Notonlymustyouattempttopredicthowmuchcashwillflowintoandoutofyourfirminthefuture,butalsoyoumustforecastwhentheseflowswilloccur.

● Multiple forecasts should be used.Obviously,itwouldbedifficulttodevelopaformatthatcouldmakerealisticforecastsoftheextentandtimingofcashflowsfrom,say,onemonthtofiveyearsinthefuture.Indeed,evenifsuchaforecastdidexist,youmightnotfinditallthatuseful.Inashort-termforecast,youwouldprobablywanttoemphasizethedetailsofcashflowsintoandoutofyourcompany.Thelonger-termforecastwouldplacetheemphasisonthefinancialaspectofyourstrategicplanningeffort.Forthisreason,yourcash-flowinforma-tionneedswillbebestsatisfiedbydividingyourforecastintoseparateareas,onedirectedattheshorttermandtheotheratidentifyinglong-termtrends.


PreparingaShort-TermCash-FlowForecastShort-termcash-flowforecastsaredesignedtopredictyourcompany’scashflowforperiodsuptoayear.Initsfinalform,yourforecastwill lookmuchlikeyourreceipts-and-disbursementsanalysis.Aswiththatearlierexercise,theamountofdetailyouincludeintheforecastsisuptoyouandwilllargelydependonyourindustryandyourowninformationrequirements.Undermostconditions,however,arelativelyshortlistofheadings,coveringprimarilythoseitemsthataresubjecttomanagementcontrol,willdo.

Thebestwaytoprepareshort-termcashforecastsisonarollingmonthlybasis—thatis,thefirstforecastoftheyearcoversJanuarytoDecember;thenext,FebruarytothefollowingJanu-ary;thenext,MarchthroughthefollowingFebruaryandsoon.Inthatway,youwillreceivetheearliestpossiblewarningofacashemergency.

Role of Cash-Flow Assumptions

Thefirststepinpreparingyourforecastistotakeacloselookatyourcash-flowperformancefortherecentpast.Areviewofthepastseveralmonthscanbemosthelpfulinprovidinginformationonitemssuchasinventorylevelsandaccountsreceivable.

Next,youmustmakeseveralbroadassumptionsaboutyourbusinessforthenextyear.Isitlikelytobeagoodyear,amediocreyearorabadone?Willcostsriseatafasterratethansales,orviceversa?Manytimesyourassumptionswillbewrong,andyourforecastwillsufferasaresult.However,ifyousetyourassumptionsdownandmonitorthemcontinually,youwillknowwhentheyhavefallenshortofthemark.Asaresult,youwillbepreparedtochangeyourforecastaseventsunfold.

Onceyouhavemadethenecessarypreparations,youcanbegintheactualforecastingproce-dure.Asanillustration,referbacktothereceipts-and-disbursementsanalysisforABCPublishing. Thelineitemsonashort-termcash-flowforecastforthiscompanywould,inalllikelihood,beunchangedfromthereceipts-and-disbursementsanalysis.Theprojectionperiodwould,however,extendforanentireyearonamonthlybasis,ratherthanoverthethreemonthsshownintheanalysis.Here,onaline-by-linebasis,ishowyoumakeyourshort-termcash-flowprojections:● Collections.Thisisbyfarthemostdifficultitemintheforecastandunquestionablyoneof

themostcritical.Keepinmindthatyourprojectionsfortheearliestoneortwomonthsoftheforecastarelikelytobethemostaccurate;youhaveyourrecentsalesresultsandcurrentaccounts-receivableinformationalreadyonhand.

Afterthefirstmonthortwo,yourcashbudgetandpastcollectionexperiencewillbeyourprimaryforecastingtools.Whateverthecase,ifyoubringyourforecastuptodateonamonthlybasis,youwillalwayshavetimetorefineyourearlyestimates.● Cash sales.Yoursalesforecastandpastexperienceareyourprimaryguideswiththiscategory.

Althoughcashsalesarenotmucheasiertopredictthancollections,theyareusuallynotaslargeand,therefore,notascriticaltotheforecast.

● Miscellaneous receipts.Recurringitems,suchasrents,interestanddividends,aresimplemattersoffact.Nonrecurringitems,suchasbankloans,arealmostalwaysknowntomanage-mentinadvance.

● Suppliers.Nexttocollections,thisitemwillprobablyrequirethemostinvestigation.Youwilluseprimarilyyoursalesforecastandinventorypolicytodeterminesupplierpayments,but


willalsofactorinproductionscheduling,purchasingandyouraccounts-payablepolicy.Yourforecastsforthefirstfewmonthswillbemorereliablethanthoseforthefuture.

● Wages and salaries.This itemisusuallypredictable.Thecostsofovertimeandpart-timeworkersofferthemostsurprises.

● Overhead.Mostoftheitemsarepayableonaregularbasis,sothereshouldbelittledifficultyinmakingaforecastforthiscategory,providedthatyouremembertotakepriceincreasesintoconsideration.

● Financial obligations.Theseincludeinterest,dividends,taxesanddebtrepayment.Again,recurringitemsareknowntomanagement,andnonrecurringitemsaremattersofmanage-mentdecision.

● Special items.Thiscategoryisreservedforone-timedecisions,suchasthesaleofanasset.Allsuchmattersinvolveamanagementdecisionandarethereforepredictable.

UsingaLong-TermCash-FlowForecastThereisafundamentaldifferencebetweenlong-termandshort-termforecasts.Short-termfore-castsare tacticalandconcernedwithmanagementcontrolofanexistingsituation.Long-termforecastsarestrategicanddesignedtoassistindevelopmentoflong-termfinancingplansthatwillmeetmanagementgoals.Asaresult,forecastingyourcash-flowneedsforthelongtermiscloselyrelatedtostrategicplanning.Justasitwouldbefoolishtoforecastfuturecashneedsintheabsenceofspecificgoals,itwouldbefruitlesstoplanacourseofactionwithoutprovidingenoughcashtogetthere.

Ingeneral,yourlong-termcashforecastshouldmirroryourcompany’splanninghorizon.Alwayskeepinmindthatthefartherouttheplanextends,thelessreliabletheforecastislikelytobe.Inouropinion,itisnotpossibletoproduceadetailedfinancialplanforaperiodlongerthanthreeyears.Financialmarketsaretoochangeabletoallowseriousplanningbeyondthat.

Adapt Flow-of-Funds Analysis

Just as the receipts-and-disbursementsanalysisprovideda framework for a short-termcashforecast,theflow-of-fundsanalysistechniquecanbeadaptedtolong-termforecasting.However,unliketheshort-termforecast,somechangesintheformatusedfortheflow-of-fundsanalysisarenecessarytoseparatetheimpactofoperationalandfinancialdecisions.

Illustration:Takealookatthetableonpage50,wherewehaveusedtheinformationcontainedinthecashbudgetforABCPublishingCompanyasthebasisforalong-termcashforecast.Wehavealsoassumedthat,asintheflow-of-fundsanalysis,ABCPublishingdecreasedinventoriesby$2,000andraisedaccountsreceivablebythesameamount.Inaddition,thecompanypurchasedabindingmachinefor$10,000oncredit.

Obviously,thisforecastisbehindthetimes.Intherealworld,theforecastcouldhavebeenmadewellbeforeacashbudgetwassubmittedandwouldextendoutforthreeyearsormore.Nevertheless, itdoesdemonstratehowcloselya long-term forecastparallels aflow-of-fundsanalysis,whileatthesametimeaddinginformationthatlong-termplannerswouldneedtomakeintelligentdecisions.

InABC’scase,nofinancialsurprisesareinstore.Operatingcashmakesupmorethanhalfofthecashneededtomeetobligations.Thebalanceoftheneededcashiseasilymetbyashort-termloanandnewcredit.


Normally, long-term cash fore-casts areupdatedannually asman-agementreviewsstrategicplansanddrawsup newbudgets. Therefore,eveniftheplanwereabitwideofthemark,ABCwouldhavetimetoreviseitinsubsequentyears.Rememberthatthefirstyearofalong-termplanmustalwaysconformtoforecastsmadeintheshort-termplan.Otherwise,man-agersmayfind themselves at crosspurposeswithoneanother.

Followingarethemajorcategoriesofinformationinalong-termforecast:● Cash flow from operations.This

category isusuallypart of yourstrategicplan.As cashflow, thisitemisbefore interest, taxesanddepreciation.

● Taxes.Thisisafairlystraightfor-ward item, but don’t overlookpossibletaxsavingsinthefuture.

● Fixed assets (land, buildings, plant and equipment).Paymentsdue for thepurchaseofnewas-setsareusuallyfoundinthecom-pany’scapitalbudget.Don’tforgetthevariouscostsassociatedwiththeseassets,suchasmaintenanceandroutineadministrativeactivi-ties.

● Noncash current assets. Theseincludeinventoriesandaccountsreceivable. Inventory and creditpoliciesdonotchangeoften,soyoucanusuallyapplypastexperiencetosalesprojections for futureyears toobtain reasonable estimates for changes in inventoryand/oraccountsreceivable.

● Financial obligations (interest, div idends, repayment of loans or bonds).Itshouldbesimpletoforecastpaymentsdueoncurrentobligations,butyoumayfinditdifficulttoprojectinter-estandprincipalpaymentsonfutureloans.Dividendsarenotmandatory,butforthesakeofclarity,youshouldincludethem.

● Net cash requirements.Ifthereistobeacashsurplusinyourfirm’sfuture,youwillfirstidentifyithere.Ratherthananetcashrequirement,youwillcomeupwithanetsurplus.Youcan,ofcourse,makeplanstoincreaseyourdividendsortoinvestthesurplusforawhile.

● Available cash.Thisreflectsdrawingsfrombothexistingcashbalancesandcashequivalents(U.S.Treasurybills,certificatesofdeposit,etc.).Asurplustobeinvestedwouldbetreatedasanegativeitemonthisline.

Long‑Term Cash Forecast: ABC Publishing Company

Cash Resources Cash From Operations $ 113,000 Less: Taxes 47,460 Internal Cash Flow $ 65,540

Decrease (Increase) in Assets Land & Buildings — Plant & Equipment (10,000 ) Inventories 2,000 Accounts Receivable ( 2,000 ) Net Asset Change (10,000 )

Net Operating Cash $ 55,540

Financial Obligations Interest $ 4,800 Dividends 50,000 Loan Repayment 52,000 Total Obligations $ 106,800

Net Cash Requirements $ 51,260

Planned Financing From Available Cash $ 1,260 New Credit 10,000 New Borrowing: Short‑Term 40,000 Long‑Term — New Equity Capital — Total Financing $ 51,260


● New credit.Plannedpurchases,suchasthe$10,000bindingmachinecitedintheillustration,arerathereasytoidentify.However,youmayhavetolookcloselytospotapossibleneedforadditionalextensionsofcreditwithsuppliers.

● New sources of capital.Thesefinalitemsarestrictlytheresultofmanagementdecisions.Theyarethe“balancingitems”butalsorepresenttheendresultofyourfirm’sfinancialstrategy.

KeepingCashFlowUnderControlAsyoucompileyourcashforecasts,betheyshortorlongterminnature,youareforcedtocometogripswithpossiblecash-flowproblems.Nosensibleforecastwouldleaveapotentiallyharmfulcash-flowproblemuntouched.Youranalysesofreceiptsanddisbursementsandoftheflowoffundswillallowyoutomakeanynecessaryadjustmentstobringtheforecastsinlinewithreality.

Thefinalinformationtoolinthesystemisamonthlyliquidityreport,whichiseasilypreparedfrommonthlystatementsandpreviousforecasts.Itgivesyoutheinformationnecessarytomakeday-to-dayworkingdecisionsconcerningyourcashflow.

Illustration:Preparingaliquidityreportismoreamatteroforganizingyourexistinginforma-tionratherthangatheringnewdata.Alltheinformationneededforthereportshouldbereadilyavailableshortlyaftertheendofeachmonth.Fordetailsonhowyourliquidityreportmightlook,seetheboxbelow.

The Cash-Flow Statement

Anotherwaytokeepyourcashflowundercontrolistomonitoritcorrectly.Butbesuretousetherightcash-flowyardsticks.Becauseitcanbedifficulttoderivecash-flowinformationfromtheusualfinancialstatements,manymanagersgaugetheircashfloweitherbyaddingdepreciationbackintonetincomeorbyusingworkingcapitalfromoperationsasasubstitute.Bothmeasures,however,areoftenatoddswithactualcash-flowperformanceandcangiveoffconfusing,orevenmisleading,signals.

Liquidity Report

Current Month Percent Forecast Balance—End of Month Forecast Actual Change Coming Month

Cash on Hand and in Bank _______ _______ _______ _________

Cash Equivalents

(Short‑Term Investments) _______ _______ _______ _________

Accounts Receivable _______ _______ _______ _________

Accounts Payable _______ _______ _______ _________

Inventories _______ _______ _______ _________

Unused Lines of Credit _______ _______ _______ _________


● Net income plus depreciation:Eventhoughmanyfinancialprosdousethisformula(cashflow=netincome+depreciation)todefinecashflow,it’snotentirelyaccurate.Theformularepresentsmoreameasurementofprofitability,orwhatsomebusinessresearcherscallgrosscashflow,thannetcashflow.Forexample,it’saparadoxofbusinessthatcompanieswithlittleornogrowthusuallyhavefewercashproblemsthanhigh-profit,rapid-growthfirms.

● Working capital from operations:Again,someusetheworkingcapitalformula(currentassets–currentliabilities=workingcapital)tomeasurecashflow.Eventhoughworkingcapitalisexpressedindollars,itcan’tbespentlikecash.Workingcapitalisaconceptthatdoesn’tpayday-to-daybills;onlycashdoes.

Flow-of-Funds Statement

Acash-basispresentationinyourflow-of-fundsstatementavoidsthepotentialproblemsofrelyingtooheavilyonworkingcapitaltrendswhile,atthesametime,quicklygivesyouaclearpictureofyourcompany’soverallliquidity.Theflow-of-fundsorcash-flowstatementcanbestructuredanumberofways—noneofthemcomplicated—toreflectchangesinyourcashposition.

Tobeuseful,yourflow-of-fundsstatementshouldtellyouwhetheryouroperationsaregen-eratingenoughcashtosupportexpenditures.Specifically,youwillwanttoknowhowmuchcashwasgeneratedfromoperations,howmuchcashwasused,andwhetheryournetcashpositionsimprovedordeterioratedduringtheyear.Incondensedform,yourstatementmightlooklikethis:

ABC Corporation: Flow of Funds (000s) Netcashprovidedbyoperations $37,000

Usesofcash: Dividends (20,000) Interest(netoftax) (5,000) Financingactivities 7,000 Increase(decrease)innetcash $19,000 Netcashbalance— beginningofyear $15,000 Netcashbalance—endofyear $34,000

Inthiscase,thenetcashgeneratedbyABCCorporation’soveralloperationswasmorethansufficienttotakecareofinterestchargesandaheftydividendpayment.Moreover,afinancingprovidedafurtherincrementtocashresources.Allinall,cashandcashequivalentsmorethandoubledduringtheyear—anadmirableperformance.

➤ Observation:Thedefinitionofnet cash provided by operationsisthekeytothestatement.Normally,thisfigureencompassescashraisedfromsales,lessout-of-pocketcostsofgoodssoldandotherout-of-pocketexpenses. Cash salesmeansjustthat.Notesandaccountsreceivabledonotqualifyandmustbedeductedfromsales.However,ifnotesoraccountsreceivabledecline,extracashiscomingintothecompanyandsalesshouldbeadjustedupward.Cash cost of goods soldconsistsoftheactualdollarsspentformanufacturingduringtheperiod.Anincreaseinin-ventorymeansthatextracashwasspent,sothecostofgoodssoldshouldbeadjustedupward.Adownturnininventorieslowersyourcostofgoodssold.Conversely,adecreaseinaccountsornotespayableindicatesadditionalcashpaymentsandraisesthecostofgoodssold,whileanincreaselowerstheitem.


Keepinmindthatyoumustalsoadjustotherexpensestoreflectcashtransactions.Ifaccruedliabilitiesdeclined,cashwasusedtopaythemoff,soaddthatamounttocashexpenses.Anin-creaseinaccruedliabilitiesshouldbedeductedfromcashexpenses.Ifprepaidexpensesrise,addtheamounttocashexpenses;iftheydecline,reducecashexpensescommensurately.

MakingYourCashCountBeawareoftheopportunitiesthatcanenhancethecashyouhaveonhandtomeetshort-termexpenses.Forexample:Participationinelectronicfundstransfer(EFT)programsgenerallyleadstoareductioninpaymentcosts,comparedwiththeuseofchecks.Moreover,byarrangingfordiscountsinreturnforfastpayment,youcanreducereceivablecarryingcosts.

Alsoconsiderkeepingyourmoneyinmoneymarketaccounts.Bycombiningyourpresentcheckingaccountwithamoneymarketdepositaccount,youcanputyourliquidassetstoworkandsaveyourselfmostactivityfeesinthebargain.Lookforotherwaysorprogramsthatbankshavetoimprovecashmanagement.

Managing a Financial EmergencyEvenifyoumakealltherightmovesinmanagingyourcashflow,includingreliableforecasts,accurateanalysisreportsandup-to-dateliquiditystudies,youmaystillwindupinthemidstofafinancialemergency.Thereasonissimple:Manysuchemergenciesarecausedbyeventsoutsidemanagement’scontrol,suchasaninternationalfinancialcrisisorasevererecession.

Allfinancialemergencieshaveonecommoncharacteristic:Ifnotdealtwithquickly,theresult-ingdilemmascreatemoreproblemsandbecomeadragoneveryfacetofoperationandplanning.Forthisreason,afinancialcontingencyplanshouldbepartandparcelofeverycash-managementprogram.Theobjectiveofyourfinancialcontingencyplanshouldbetoquickenyourresponsetimetounforeseenfinancialstrains.Notwofinancialcontingencyplanswillbethesamesimplybecausenotwocompaniesarealike.Nevertheless,everyplanshouldcontainbasicelements:● Develop an early warning system: Earlier,weobserved that earlywarning is thekey to

effectivecashmanagement.Nowhereisthismoretruethanindealingwithacashcrisis.

Thefirststepistodeterminewhichkeyvariableshavethegreatestimpactonthefinancialviabilityofyourfirm.Thesevariableswilldifferfromfirmtofirm.Forsome,inventorieswillbetheculprit.Stillothersmightfindloaninteresttobethechiefburden.

Also,keepclosewatchontheassumptionsthathavebeenbuiltintoyourcash-flowforecasts.Oftentimes,thefactthatoneormoreoftheassumptionshaveprovedinvalidistheearliestwarn-ingsignofimpendingdifficulty.Forinstance,ifyourforecastassumesthatinterestrateswilldriftlowerandtheygoupinstead,yourcompanycouldbeheadedfortrouble,particularlyifyouwillneedtodosomefinancing.

Further,youshouldtakeacloselookatyourcompany’shistorytofindthecauseandcureofpastfinancialcrises.Historymaynotrepeatitself;butevenifitdoesn’t,yourknowledgeofhowpastdifficultieshavebeenovercomeshouldyieldpositiveresultswhendealingwiththenextcrisis.● Set your priorities:Onceyouhaveidentifiedanemergingfinancialcrisis,youwillneedto

knowthefollowing:(1)whatcanbedone;(2)howlongwillittake;and(3)howmuchcashyoucanraise.Thebestwaytoobtainthisinformationistoestablishalistofpriorities,organizedaroundthefourtypesofmanagementdecisionsdiscussedinthebeginningofthissection.Tothat,youcouldaddpotentialfinancingsources,soyourprioritylistprobablywouldwinduplookingsomethinglikethesampleonpage54.


➤ Observation:Eachtypeofactionhasitsownstrengthsanddrawbacks.Forinstance,tim-ingchangesareeasytoimplementbutcangoonlysofarandwillmerelydelaytheinevitableinaprotractedcrisis.Volumechangescanchangecash-flowpatternsinahurrybutareeffectiveonlywhentheemergencyisrelatedtodecliningsales.Policyactionsofferthemostfertilefieldforcuttingexpenses,buttheytaketimeandcanalsodelayarecovery.Allthingsconsidered,thebestapproachusuallyinvolvesacombinationofdecisions,eachsupplementingtheother.● Establish an emergency reserve:Onceyouunderstandwhatkindofactionscanbetakenin

anemergencyandhowlongtheymighttake,youcansetupasortofinsurancepolicyintheformofanemergencyreserve.

Thesizeofthereserveisuptoyou.Itshoulddepend,however,onthelengthoftimeitwilltaketomobilizeyourothercashresources,andtheestimatedsizeofacashdrainduringanemer-gency.Forexample,ifyouestimatethatitwouldtakefourbusinessdaysforaninitialemergency

Priority List

Type of Action Estimated Cash Response Time

Timing Changes Speed Collections ____________ ____________ Delay Supplier Payments ____________ ____________ Delay Capital Expenditure ____________ ____________ Other ____________ ____________

Policy Changes Reduce Inventory ____________ ____________ Reduce Dividend ____________ ____________ Cut Capital Expenditure ____________ ____________ Reduce Expenses: Administration ____________ ____________ Production ____________ ____________ Sales ____________ ____________

Volume Changes Cut Part‑Time ____________ ____________ Cut Overtime ____________ ____________ Cut Shift ____________ ____________ Layoffs ____________ ____________

Irreversible Policy Changes Liquidate Assets ____________ ____________ Financing: Short‑Term ____________ ____________ Long‑Term ____________ ____________ Equity ____________ ____________


responsetoyieldcashandyourmaximumcashdraincouldbeashighas$5,000perdayinanemergency,youwouldneedareserveof$20,000forfullprotection.

Tobeeffective,thereservemustalwaysbeavailableatamoment’snotice.Therefore,mosttraditionalinvestments,suchasTreasurybills,areout,eventhoughtheymaybeperfectlysafe.Usually,suchreservesareheldinmoneymarketfundsorinaninterest-bearingaccount.However,anunusedlineofcreditwouldsufficeifthefundswerecommittedbythebank.

Summary:Thecashmanagementsystemsetforthinthissectioncanmakeaconsiderablecontributiontoyourfirm.Thoughtfullyused,itwillidentifycash-flowimbalancesbeforetheybecomemajorproblemsandpointthewaytowardtheirsolutions.Consequently,whenyourcashflowisonanevenkeel,youcandevotemuchmoretimetoanotherimportantmatter:buildingyourcompany’srevenuesinascopeandsequencethatcontributedirectlyandeffectivelytoanoverallprofitableoperation.


CapitalInvestmentBasics

Now thatyouhaveahandleonbudgetandcashflow, it’s time tomoveaheadwithnew projects.Butfirstyoumustanswerthesequestions:(1)Isthereenoughcapital?(2)What

projectswillgetpriority?Thebesttime—indeed,theonlypropertime—tomakecapitalinvestmentdecisionsiswell

beforetheactualfundsareneeded.Fartoooften,capitalspendingplansaremadeonacrisisbasis,withthe“squeakywheelgettingthemostgrease.”Aslickpresentationforsomeone’spetprojectisnotruebasisforcommittingpartofthefirm’sfinancialresources,nomatterhowwellintentionedthatprojectmaybe.Asamanagerwithdecision-makingauthority,youneedalong-termapproach—asystemthatwillenableyoutoanalyzeeachproposalandthencompareitwithotherpossibleprojects.

HowtoPrepareaCapitalInvestmentProposalSoonerorlater,allseriouscapitalspendingproposalsaresubmittedforinclusioninacapitalbudget.Theretheyareclassified,analyzedandevaluatedbeforemanagementmakesafinaldecisiononwhichproposalsaremostsuitedtothefirm’sneedsandobjectives.Keepinmind,however,thatasuccessfulcapitalinvestmentprogrammusttakeyourcompany’slong-rangegoalsandobjec-tivesintoaccount.Ideally,youandyourstaffshouldprovideinputingeneratinganddevelopingcapitalspendingproposals.Youshouldalwaysthinkintermsofcontributingtooverallbusinessstrategieswhenchoosingamongvariousspendingproposals.

Thislinkwithstrategicplanningcanbeaccomplishedinavarietyofways,dependingonyourcompany’ssizeandthecomplexityofitsoperations.Followingisabriefrundownofthestepstotakeinpreparingacapitalspendingproposal.Theymirrormanyofthestepsyourfirmusesinpreparingacompany-widecapitalbudget.● Establish objectives:Tosetyourdepartmentontherightgrowthplan,youmustfirstdecide

whereyouwantittogo.Youmustsetlong-termobjectivesandtakeintoaccounttopmanage-ment’sexpectationsforthefuture.

● Develop strategies:Oncebroadobjectiveshavebeenestablished,yourdepartmentcanstarttoconsidervariousstrategiesthatwouldhelpyourcompanyachieveitslong-termobjectives.

● Present proposals:Makeeachproposalasdetailedaspossibleandincludeestimatedcostsandpreliminaryprojectionsofpossiblesavings.

Allthesestepsareessentialbecauseyourplanswillbecompetingwiththoseofotherunitsinthecompany.Uppermanagementwillevaluateandcompareeachunit’sspendingplans.Thosenotfittingintostrategicgoals,orthatdonothaveagoodbalancebetweenfinancialstabilityandgrowthpotential,willenduponthechoppingblock.

ClassifyingCapitalSpendingProjectsMostfirmstendtotreatallcapitalspendingprojectsalike,anapproachthatcansometimesleadtoseriouserrorsin judgment.Thereareatleastfourbroadcategoriesofcapitalprojects,eachrequiringadifferentplanningapproachandcorporatestrategy.

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1. Mandated expenditures:Theseareexpendituresrequiredbylaw,suchasOSHAsafetyregula-tionsorEPArequirements.Inaddition,youcanincludespendingprojectstoprotectagainstproductliabilitylawsuitsorpossibleproductrecall.

2. Maintenance expenditures:Projectsinthiscategoryincludeallthosenecessarytomaintainproductionlevels.Existingfacilitiesorequipmentoftenrequirerepairsorreplacement.Be-causeyourcompany’soutputwillbeaffectediftheexpendituresarenotmade,youshouldgivecapitalspendingformaintenanceahighpriority.

3. Cost-saving expenditures:Thiscategoryincludesallprojectsdesignedtomakecurrentopera-tionsmoreefficientorproductive.Cost-savingproposalsusuallyinvolveachoicebetweentheexistingmethodandproposedexpenditure,sotheyshouldalwaysbesupplementedbycash-flowprojections.

4. Growth expenditures:Thisisatoncethemostimportantandthemostelusivecategoryofcapitalspending.Itincludesallexpendituresdesignedtostimulateyourcompany’sgrowth,whetherbyintroducingnewproducts,enteringnewmarkets,purchasingequipment,addingfacilitiesormakingacquisitions.

Althoughcapitalexpendituresmadeforgrowthcanexertaprofoundlong-terminfluenceonafirm,itisusuallypossibletodeferthemwithoutunduepenalties.Forthisreason,youshouldputgrowthinvestmentsatthelowendofyourcapitalbudgetpriorityscale.Seekfundingformandatedandmaintenanceprojectsfirstbecausetheyarenecessarytokeepthefirmfunctioning.Nextcomecost-savingprojects,primarilybecausetheycanhaveaninstantimpactonthebottomline.Onlyafterspendingplansforthefirstthreecategoriesarefinalshouldyouturnyouratten-tiontogrowthprojects.

Avoiding Common PitfallsNosystem forallocating capital resources is foolproof.Youcan,however, cutdownonyourchancesofmakingamistakebyexploringthefollowingalternativeswhenplanningyourcapitalinvestmentproposal:● Look for something better.Resistthetendencytoassumethattheproposalsthatbubbleup

fromyoursubordinatesarethebestavailable.Tostrengthenyourplanning,solicitideasfromthewidestpossiblerangeofdepartments.

● Be ready to branch out.Anothercommonfailingisthetendencytoconcentrateonthefamiliarwhenseekingfundallocations.Toooften,innovativeprogramsareequatedwithriskypro-grams,andthereforedisregarded.Alwaysbereadytoacceptchangeifasoundbusinesscasecanbemadeforit.

● Look to the longer term.Inmanyfirms,projectswithashortpaybackperiodgettheinsidetrack.Management tends to think in termsof current-year results andoverlooksprojectsthatpromiseonlylong-termprofitopportunities.However,theprimarypurposeofcapitalinvestmentistoensurethelong-termprofitabilityofyourfirm.Thus,whileshort-termprofitsareimportant,alwaysleaveroomforprojectsthatwillpayoffoverthelongerterm—andbepreparedtoargueforthem.

● Follow up on your capital program.Onceaprojecthasbeenapproved,makeanefforttoensurethatitmeetsstatedobjectives.Thiswillassistyouinspottingproblemsearlyonandenhancetheeffectivenessoftheprogram.


CalculatingYourTrueCapitalCostsBeforeyoucanmakean intelligentdecisiononacapital investmentproject,youwillneedtofindouthowmuchtheprojectwouldcost.Thenyoumustcomeupwithareasonableideaoftheexpectedrateofreturn.Knowingthesefactswilltellyouwhetheryou’reinastrongpositiontorequestanallocationofyourfirm’slimitedresources.

Assessing the Cost of Debt

Notethattheinterestrateonloansorbondsusedinfinancingaprojectisaffectedbythenatureofthefirm’sothercommitments.Ifafirmhascommitteditselftoseveralhigh-riskprojects,itwillusuallyberequiredtopayarelativelyhighinterestrateonanewundertaking,whetherornotthisventureisriskyinitself.Otherfactorsaffectingafirm’scostofdebtincludethecompany’sdebt/equitypositionandtheeconomicoutlookforitsindustry.

Forthesereasons,itisneversafetoassumethatthedebtcostsusedtojustifyoneprojectwillbeapplicabletoanother.Eachtimeyoustarttoreviewanewproject,takethetimetofindoutyourcompany’scurrentcostofdebtfromyourfirm’sfinancedepartment.Becauseinterestexpenseisadeductibleitem,thecostoflong-termdebtshouldalwaysbeexpressedasanafter-taxfigure.Apartfromthat,figuringyourcostofdebtisafairlystraightforwardprocess.Merelyusetherateofinterestthatyourbankwouldchargeforadditionalborrowing;applyyourcurrenttaxratetoobtaintheafter-taxcostofyourdebt.

Example:Ifyourcompanyistaxedat34percentandyourinterestrateonanewloanwouldbe12percent,yourafter-taxdebtcostcomesto7.9percent(12percentx66percent=7.9percent).

What Are Equity Costs?

Companymanagersgenerallyviewequitycapitalascostfree.Theoretically,youdonothavetopaythecapitalback,soit’sfree,particularlyifyourcompanydoesnotintendtopaydividendsthatyear.

Fromastockholder’sviewpoint,however,theoutlookisdifferent.Everydollarofearningsretainedinthefirmisadollardeniedtothestockholders.Inasense,itisa“hidden”costforstock-holders,almostakintoanewinvestmentinthefirm.Thereasonthatstockholdersmaintaintheirinvestmentisthepromiseoffuturedividendsand/orcapitalappreciation(thatis,anincreaseinshareprices).Sincebothdividendsandsharepriceimprovementdependonfutureearningspershare,itisthemostimportantfactorindeterminingyourequitycosts.

Theeasiestwaytocalculateyourequitycostsistousetheinverseofthewidelyusedprice/earningsratioasameasure.Ifyouhaveafirmideaofthevalueofyourcommonstock,youcaneasilyworkoutyourownprice/earningsratio.Ifnot,youcanusetheP/Emultipleofasimilarpublicly tradedcompanyasaguide.Onceyouhaveobtainedanappropriateprice/earningsmultipleforyourfirm,merelydividethenumeral1bythatmultipletofindyourcapitalcost.

Illustration:Youexpectyourfirmtoearn$1.75persharethisyear.Yourcompany’scommonstockiscurrentlysellingfor$20.Thus,yourprice/earningsmultipleis11.4($20÷$1.75).Inotherwords,youneed$1inearningstoraise$11.40incapital,acostrateof8.8percent(1÷11.4).

Alternatively,youfindthatsimilarpubliclytradedcompaniesaresellingatP/Emultiplesrangingfrom7.5to8.5.Takingthemedian,youdeterminethat,foreach$1ofearnings,youcanraise$8innewequitycapital.Thus,theequitycostratebecomes12.5percent(1÷8).

➤ Observation:Whendiscussingequitycapital,almosteveryonethinksstrictlyintermsofcommonstock.Technically,that’snottrue.Preferredstockisalsoequitycapitalbutwithadiffer-


ence.Itispermanentcapital,butitbearsafixeddividendrate,muchlikeabond.Ifyourcompanyhaspreferredstockoutstanding,youshouldbyallmeansdetermineitscost.Sincemoststraightpreferredissuessellonayield(orinterest-rate)basis,thebestwaytocalculateyourcostistofindapubliclytradedpreferredissuesimilartoyourown.

Illustration:Ifyourcompanyhasa5percentpreferredissueoutstandingwitha$100parvalue,youmightnotethatasimilarissue,GeneralMotorspreferred,payinga$5dividend,issellingatabout$48,providingayieldof10.4percent.Theyieldbecomesyourcapitalcostbecausethatistherateyouwouldhavetopaytoraiseadditionalfundsviathepreferred-stockroute.

WaystoMeasureYourExpectedReturnOnceyouhaveestablishedtheprobablecostofyouranticipatedcapitalinvestment,youwillneedameaningfulmeasureoftheproductivityofthatcapitalsothatyoucanrealisticallydecideontheproject’sworth.Formanyfirms,thecostofcapitalbecomes,ineffect,the hurdle rate—theratethatanynewprojectmustearntoqualifyforapproval.

Attheoutset,youshouldrecognizethatallmethodsofcalculatingtheanticipatedreturnofacapitalinvestmentrequireapeekintothefuture.Thus,nomatterhowsophisticatedtheymaybe,theyarecertaintobefaultytosomedegree.Becauseofthis,manycompaniesseektoimprovetheoddsintheirfavorbyusingmorethanonemethodofcalculatingtheexpectedreturn.Theniftheproposedprojectfailstomeasureuponmorethanonescale,managementcandiscardit.

Therearethreecommonlyusedmethodsofevaluatingcapitalinvestmentprojects,eachwithitsownstrengthsandweaknessesandanumberofvariations.Thereisnorightorwrongmethod.Thepropermethodforyouistheonethatbestfitsyourneeds.

The Payback Method

Thepaybackmethodistheoldest,mostcommontechniqueofevaluatingcapitalexpenditures.Today,however,itisalmostalwaysusedinconjunctionwithoneofthemoresophisticatedmeth-odsofcapitalinvestmentevaluation.

Thisstraightforwardcalculationis:

Original net investment ÷ Annual earnings after tax = Depreciation = Payback period

Thecalculationtechniqueusedinthepaybackmethodisamodelofsimplicity.Thecapitaltobeinvestedintheproject,pluscosts,ismeasuredagainstprobablecashflowfromtheinvest-ment.Fromthismeasurement,theamountoftimeneededtobreakeven,orthepayback period,iscalculated.

Illustration:Let’ssaytheABCCompanypurchasesanewmachinefor$70,000thatwillrequireanother$40,000ininstallationandtrainingcosts.Thus,itstotalcapitalinvestmentis$110,000.Thecompanyalsoexpectsthisnewmachinetoimproveitscashflowattherateof$25,000peryear.Youwouldcalculatethepaybackperiodasfollows:

Capitalinvestment $110,000 Additionalcashflowperyear $25,000

Unfortunately,itisararecapitalinvestmentthatthrowsoffequalamountsofcashfloweachyear.Normally,theamountswillvaryeachyear,asbusinessconditionschange.Morelikely,thecashflowfromtheinvestmentdescribedabovewilllooklikethis:

= =4.4years


Year 1 2 3 4 5

Annualcashflow($000) $30 $20 $25 $25 $30 Cumulativecashflow($000) $30 $50 $75 $100 $130

Becausethecapitalinvestmentwillhavegeneratedtotalcashflowof$100,000afterthefourthyear,and$130,000afterthefifth,weknowthatthepaybackperiodliessomewherebetweenfourandfiveyears.

Tofindoutexactlywhen,merelydividetheamountnotyetpaidbackattheendofthefourthyearbytheamountofcashflowprojectedforthefifthyear.Inthiscase,itis:

CapitalshortfallatendofYear4 $10,000 CashflowprojectedforYear5 $30,000

Thus,thetotalpaybackperiodforthisparticularinvestmentbecomes4.3years,somewhatshorterthanthepaybackperiodfortheprojectwhenequalcashflowisassumed.

Therearegoodandvalid reasons for the enduringpopularityof thepaybackevaluationmethod,eventhoughnowitisusuallyusedinconjunctionwithotherformsofmeasurement.Themostimportantreasonsare:● Simplicity.Thepaybackmethodiseasytocalculateandjustaseasytounderstand.● Good risk indication.Thepaybackmethodgivesyouasoundassessmentofyourrisk.The

longerthepaybackperiod,thegreatertherisk.

Therearedefinitedisadvantagestothepaybacksystem,which,insomecases,outweightheadvantages.Hereareafew:● No profit measurement.Thepaybackmethodmeasurestheabilityoftheprojecttorecoup

yourinvestment.Itsaysnothingaboutprofit.Thus,itisdifficulttostrikeacomparisonwithotherinvestments.

● No rate of return.Paybackanalysistakesyouonlytothedatewhenyourinvestmentisre-turned.Thus,notruerateofreturnisascertainablebecausearateofreturnwouldconsidertotalcashflowovertheproject’slife.

● No consideration of money’s time value.Thepaybackmethodgivesthesamevaluetocashflowtobereceived,say,fiveyearsfromnow,ascashreceivedtoday.Inaperiodofhighinter-estrates,thiscanbeaseriousdrawback.

Overtheyears,anumberofvariationsofthepaybackmethodhavecroppedup,primarilyasaresultofattemptstoadaptthepaybackmethodtotheneedformoreprecisedata.Althoughthesevariationscanhelp,theyseldomrepresentthewholeanswer.

Thediscounted payback methodisanattempttowedthepaybackmethodtothediscounted cash flowconcept(seebelow),whichgivesrecognitiontothetime value of money.Youapplyadiscountfactorthatwillallowthediscountedcashflowtoreachzero,orclosetoit,overasome-whatlongerperiodthanwouldnormallybeused.Thismethodisnotfullysatisfactorybecauseitusesanarbitrarydiscountrate.Ideally,thediscountrateshouldrepresentsomesortofcorporateobjective,suchascapitalcosts,rateofreturnandaverageindustryreturn.

Thereciprocal payback techniquemerelyreverses themethodofcalculating thepaybackperiodinordertogiveanapproximatereturnoninvestmentrate.Forinstance,theapproximatereturnoninvestmentforourpreviousexamplewouldlooklikethis:

$25,000 $110,000

= =0.3years

=22.7%


Keepinmind,however,thatthisis,atbest,anapproximation.Moreover,itshouldnotbeusedifcashflowsvaryfromyeartoyear.

UsingNetPresentValuetoMeasureReturnIfyourcompanyhasnotyetusedthenetpresentvalue(NPV)methodofmeasuringtherateofreturnonaproposedcapitalinvestmentproject,chancesaregoodthatitwilldosointhenearfuture.Duringthepastseveralyears,NPVhasbecomeoneofthemostcommonlyusedmethodsofcapitalinvestmentevaluation.

Foranumberofreasons,thepopularityoftheNPVmethodhasgrownrapidly.Mostimpor-tant,itrecognizestheimpactthatinflationorhighinterestratesarelikelytohaveontheworthofanewcapitalinvestment.However,evenwiththecoolingofinflationandanaccompanyingsoftnessininterestrates,theNPVmethodislikelytoretainmost,ifnotall,ofitspopularity.Herearethereasonswhy:● Recognition of the time value of money.Essentially,theconceptoftimevalueholdsthata

dollarreceivedtodayisworthmorethanadollartobereceivedlaterbecause(1)inflationerodespurchasingpower,and(2)adollarreceivedtodaycanbeinvestedtoearninterest.

● Allowance of comparison of projects.YoucanapplytheNPVtechniquetoalltypesofprojectsandtherebycancompareandrankyourvariousoptions.

● Applicability for the life of an investment.NPVcanbeusedtoevaluateaninvestmentoveritsentirelife.

AlthoughtheseadvantagesgiveNPVaconsiderableedgeoverthepaybackmethodinsomeareas,don’tmakethemistakeofthinkingtheNPVmethodwillsolveallyourcapitalevaluationproblems.NPVhassomebasicflawsthatcan,attimes,leadtounjustifiedconclusions.First,itisdifficulttoforecastcashflow.NPVrequiresthatcashflowfromaproposedcapitalinvestmentventurebeprojectedforatleastfiveyears,andsometimesmore.Obviously,suchforecastsmaybesubjecttoseriouserror,particularlyinavolatilebusinessclimate.Second,thereisanassump-tionofsteadyreinvestment.TheNPVmethodassumesthatallcashflowsfromtheprojectcanbereinvestedatachoseninterestrate.(Thisrateiscalledthediscount rateandisusuallyequivalenttothecompany’scostofcapital.)Thismaynotalwaysbepossible.Finally,NPVdoesnotmeasuretheprofitabilityofaparticularproject,onlythecashflow.Actualprofitsinfutureyearsmayturnouttobearlittleresemblancetocash-flowprojections.

EventhoughtheNPVmethodisnot,inandofitself,abasisforjudgingtheworthofcapitalspendingproposals,itcanbeausefultoolinyourdecision-makingprocess.Aswiththepaybackmethod,however,itusuallyworksbestwhenusedinconjunctionwithotherevaluationmethods.

UnderstandingtheDiscountingConceptBothNPVandtheinternal rate of return (IRR), thenextevaluationmethodwewilldiscuss,dependontheconceptofdiscounted cash flow (DCF).DCFisbasedonaprinciplethatmostbusinesspeopleinstinctivelyunderstand,butneverthelessfinddifficulttoconvey.Insimpleterms,DCFrecognizesthatmoneyhasacertaintimevalue.Adollarreceivedtodayisworthmorethanadollartobereceivednextyearbecausethedollarreceivedtodaycanbeinvestedtoearnmoremoney.Specifically,each$1thatyoureceivetodayisworthroughly$1.08thefollowingyearsimplybecauseyoucanreinvesttoday’sdollartoearnarisk-free8percentatpresent.

Inotherwords,adollarthatyouarescheduledtoreceivenextyearisactuallyworthonly$0.92intoday’sdollar.That’sadiscountof8percenttomakeupfortheinterestforgone.Simi-


larly,adollartobereceivedtwoyearsfromnowwouldbeworthapproximately$0.86,withthe8percentdiscountcompoundedoverthetwo-yearperiod.Overathree-yearperiod,your$1wouldbeworthonly$0.79,givenathree-year8percentdiscount.

Inanutshell,that’showthetechniqueofdiscountedcashflowworks.Theprojectedcashflowfromaparticularprojectisdiscountedyearbyyear.Intheory,thefinalfigurearrivedatrepresentsthemoneytobereceivedintermsofcurrentdollars.

DiscountingtoFindNPVOnceyou’vegraspedtheconceptofdiscountedcashflow,itisasimplemattertocalculatenetpresentvalue.First,selectanappropriatediscountrate,onethatrepresentstheminimumrateofreturnthatisacceptablefornewcapitalinvestments.Usually,theaveragecost-of-capitalrateisusedasahurdlerate,butyoucansubstituteotherrates.Thediscountrateshouldbeinkeepingwithyourcompany’slong-andshort-termobjectives.Afterselectingadiscountrate,applyittotheprojectedcashflowsfortheproject.Finally,totalthecashflows.Iftheresultsarepositive,theprojectwilltheoreticallyyieldaprofit.Ifnot,thereisgoodreasontoquestionwhetheryouwillbeabletorecoupyourinvestment.

Illustration:SaytheABCCompanyisnowconsideringa$50,000capitalinvestmentinanewpieceofequipment.After$10,000ininstallationcosts,thenewequipmentisexpectedtoyieldannualnetcashflowsasfollows:

Year 1 $15,000 Year 2 $15,000 Year 3 $15,000 Year 4 $17,500 Year 5 $20,000

BecausetheABCCompany’saveragecapitalcostrate(see page 58)is8.8percent,itsetsadis-countorhurdlerateof9percent.Eachpaymentisthendiscountedbyusingapresentvaluefactortable,suchastheoneonpage63.HereishowtheNPVcalculationswouldlook:

Year Net Cash Flow Discount Factor at 9% Present Value

0 ($60,000) — ($60,000)1 15,000 .917 13,7552 15,000 .842 12,6303 15,000 .772 11,5804 17,500 .708 12,3905 20,000 .650 13,000Total $22,500 NPV $3,355

Asyoucansee,the$22,500theoretical“profit”projectedfortheinvestmentbeforediscount-ingboilsdowntoamoremundane$3,355onanNPVbasis.Nevertheless,ABCshouldconsidertheinvestment:Thecompanywouldnotonlyrecouptheinvestmentbutalsoearnaprofitinthebargain.


Toillustrate,however,howevenamoderateshiftinthediscountratecanaffectNPVcalcula-tions,let’sassumeABCdecidesthatthecostofcapitalwasclimbingandthat,fromhereonin,itwoulduseahurdlerateof11percent.NowtheNPVcalculationswouldlooklikethis:

Year Net Cash Flow Discount Factor at 11% Present Value

0 ($60,000) — ($60,000)1 15,000 .901 13,5152 15,000 .812 12,1803 15,000 .731 10,9654 17,500 .659 11,5325 20,000 .593 11,860Total $22,500 NPV $ 52

Nowthe$22,500profithasbeentransformedintoaminusculegainofonly$52overthefive-yearspan.Theproject,therefore,isonlymarginallyacceptable.Asyoucansee,yourexperiencewiththeNPVevaluationmethodwillheavilydependonthehurdleratethatyou’vechosen.

UsingInternalRateofReturnThe internal rate of return (IRR)evaluationmethodisakintonetpresentvaluebecauseitisalsobasedonthediscountedcashflowprinciple.WhenusingNPV,however,youalwaysassignadis-countrate.IntheIRRmethod,youderiveadiscountratethroughtrial-and-errorcalculation.TheIRRmethodattemptstodeterminetheinternalrateofreturnofaproposedcapitalinvestmentbycalculatingthediscountrateneededtobringtheNPVtozero.Then,ifthecalculatedrateofreturnisgreaterthantheaveragecostofcapital,theprojectisacceptable.Ifnot,theprojectisrejected.

Byusingaderiveddiscountrateratherthananassignedrate,theIRRmethodeliminatesoneofthepossiblemisusesoftheNPVapproach:arbitrarilyusinganunjustifiedhurdlerate.Never-theless,theIRRmethodisstillvulnerabletothebasicflawsfoundinanyevaluationsystemtiedtodiscountedcashflow:namely,thewidemarginforerrorinforecastingcashflows.

Evenwiththesecaveatsinmind,however,theIRRcanbeausefultoolinmeasuringtherateofreturnofacapitalinvestmentproject.Oncedeveloped,aninternalrateofreturncanbecomparedtothatforotherprojectsandtoyourcompany’soverallobjectives,aswellasthecostofcapital.

Table 1: Present Value FactorsNo. of Discount RateYears 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 .952 .943 .935 .926 .917 .909 .901 .893 .885 .887 .870 .862 .855 .848 .840 .833 2 .907 .890 .873 .857 .842 .826 .812 .797 .783 .770 .756 .743 .731 .718 .706 .694 3 .864 .840 .816 .794 .772 .751 .731 .712 .693 .675 .658 .641 .624 .609 .593 .579 4 .823 .792 .763 .735 .708 .683 .659 .636 .613 .592 .572 .552 .534 .516 .499 .482 5 .784 .747 .713 .681 .650 .621 .593 .567 .543 .519 .497 .476 .456 .437 .419 .402 6 .746 .705 .666 .630 .596 .565 .535 .507 .480 .456 .432 .410 .390 .370 .352 .335 7 .711 .665 .663 .584 .547 .513 .419 .452 .425 .400 .376 .354 .333 .314 .296 .279 8 .677 .627 .582 .540 .502 .467 .434 .404 .376 .351 .327 .305 .285 .266 .249 .233 9 .645 .592 .544 .500 .460 .424 .391 .361 .333 .308 .284 .263 .243 .226 .209 .19410 .614 .558 .508 .463 .422 .386 .352 .322 .295 .270 .247 .227 .208 .191 .176 .16215 .481 .417 .362 .315 .275 .239 .209 .183 .160 .140 .123 .108 .095 .084 .074 .06520 .377 .312 .258 .215 .178 .149 .124 .104 .087 .073 .061 .051 .043 .037 .031 .026


Illustration:AssumethatABCCompanyisconsideringa$60,000capitalinvestmentinnewequipment.Expectedcashflowsarethesame,butthistimewewillbeusingtheIRRevaluationmethod.FrompriorNPVcalculations,weknowthattheinternalrateofreturnissomewherebetween11percent,whereanarrowprofitwasrecorded,and12percent,whichwouldcertainlyproducealoss.(See box for the IRR calculation.)

Tofindtheexactrate,weinterpolate.First,takethedifferencebetweentheNPVat11percentandtheNPVat12percent.Inthiscase,thedifferenceis$1,552.Next,dividethepositiveNPVof$52bythe$1,552difference.Thenaddthequotienttothelowerdiscountratetogettheinternalrateofreturn,whichequals11.03percent.

IntheIRRmethod,thehighertheinternalrateofreturn,thebetter.Therefore,withan11.03percentrateofreturnandaveragecapitalcostsofonly8.8percent,theABCCompanywouldbewelladvisedtogivethisprojectcloseconsideration.

➤ Observation:Thesearesoundreasonsforyoutouseallthreecapitalspendingevaluationmethodsdescribedpreviouslywhenpreparingacapitalbudget.Forinstance,apaybackanalysisoftheABCCompanyprojectwoulddisclose,attheoutset,thatthiswasamedium-riskproject,withpaybackcalculatedinalittlelessthanfouryears.Inaddition,theNPVanalysisindicatesthatthenewmachinerywillmorethanreturnitsinitialinvestmentinthenextfiveyears.Finally,theproject’sIRRstandswellabovethecompany’shurdlerate.Becausetheprojectmeasuresupfavorablyunderallthreeevaluationscales,ABCCompanymanagementcanbefairlyconfidentthatitwillcontributetoprofitsoverthenextseveralyears.

Inshort,thereisnoneedforyoutopickandchooseamongthethreeevaluationtechniques.Eachisdesignedtogiveyouadifferentinsight,andyoucanprofitfromusingallthree.Equallyimportant,bylookingattheinvestmentfromthreeangles,youavoidplacingtoomuchemphasisononenarrowfact.

Calculating Internal Rate of Return (IRR)

Net Discount Present Discount Present Cash Factor Value Factor Value Year Flow at 11% at 11% at 12% at 12%

0 ($60,000) — ($60,000) — ($60,000)

1 15,000 .901 13,515 .893 13,395

2 15,000 .812 12,180 .797 11,955

3 15,000 .731 10,965 .712 10,680

4 17,500 .659 11,532 .636 11,130

5 20,000 .593 11,860 .567 11,340

$22,500 $ 52 ($ 1,500)

IRR = 11% + ($52 ÷ $1,552) = 11.03%


TheHurdlePoint:UsesandMisusesAswehavepointedout,ahurdlerateistheminimumacceptablerateofreturnforacapitalspend-ingproject.Originally,theaveragecostofcapitalratewasconsideredthehurdleratebecausenofirmcanaffordtoearnlessthanitscapitalcostsforlong.Overtime,however,theconceptofhurdlerateshaschanged.All-inclusive,company-widehurdleratesaregivingwaytoamoreflexibleapproach.Somehurdleratesareclassifiedaccordingtorisk;othersareassignedaccordingtoinformalguidelines;stillothersarerelatedtothecompany’sstrategicgoals.

Asaresult,therearenohard-and-fastrulesforsettingahurdlerate.Itshoulddependonyourcompany’sobjectives,theriskfactorinherentinyourbusinessandthestrengthofyourcompany’sfinancialunderpinnings.Nevertheless,youshouldkeepsomebasicconsiderationsinmindwhendecidingonasuitablehurdlerateforaproposedproject.

1. It should be based on reality. Thismaysoundobvious,butinfartoomanyfirms,thehurdlepointistheresultofanarbitrarymanagementdecision.Insomecases,thehurdlepointistoohighandresultsinlostinvestmentopportunities.Inothers,itissettoolow,whichusuallyleadstoastrainonprofits.

Yourhurdlerateshouldalwaysbeclosetoyouraveragecostofcapital.Youshouldconsidertheoveralltrendofcapitalcosts.If,forinstance,inflationandrisinginterestratesarelikelytopushcapitalcostshigher,youmaywanttocompensatebyraisingyourhurdlerate.

2. It should bear some relationship to risk.Yourhurdlerateshouldbeadjustedtocompensatefortherisksinherentintheproject.Thehurdlerateforlow-riskprojectsneednotbeashighastherateforprojectswithabove-averagerisks.Thisincludesinternalrisks,suchasfamiliaritywiththeprocess,marketorfacility.Moreimportant,itincludesexternalrisks:thestateoftheeconomy,theoutlookforinterestrates,inflation,thebusinessclimateandsoforth.

3. It should be current.Nohurdlerateshouldeverbesetinstone.Asfinancialmarketschange,yourcostofcapitalwillchangewiththem.Reviewyourhurdlerateatleastonceayear,and involatile times, consider revising it every sixmonths.Asamatterof fact, it is commonpracticeamongmajorcompaniestocalculateaveragecapitalcostsonanannualbasis.Theinformationisthenusuallypassedalongtothevariousoperatingdivisionsordepartments,witheachdeterminingitsownhurdlerate.

Determining Flexible Hurdle Rates

Whenproperlyused,flexiblehurdleratescanprovidereasonableyardsticksforjudgingprospectivespendingproposals,andtheyalsoavoidthepitfallsassociatedwithusingasinglehurdlerate.Toapplyflexiblehurdleratestoyourcapitalspendingprogram,youwillneedtorateeachproposalaccordingtoitsdegreeofrisk.High-riskproposalsshouldrequirearelativelyhighrateofreturntobeacceptable;medium-risk,asomewhatlowerreturn;andlow-riskproposals,anevenlowerrate.Minimum-returnstandardsforeachriskcategoryarebasedonassumed-riskcapitalcosts.Thisapproachinvolvesthreebasic,relativelyeasysteps:● Find appropriate debt/equity ratiosforeachofthecategoriesofrisk.Ifyouweretofinance

ahigh-riskprojectintheopenmarket,youwouldprobablyhavetodosolargelybyrais-ingequitycapital.Thesedays,fewbanksarewillingtotakethechanceoflendingforriskyenterprises.Amedium-riskventurecouldprobablybefinancedwithacombinationofnewequityandabankloan.Inalow-riskventure,yourbankerwouldlendyoumost,ifnotall,oftheneededfunds.


Whiletheprecisedebt/equityratiousedforeachriskcategorywilldependonyourindustry,thesizeofyourcompanyandyourownfinancialunderpinnings,thereisageneralpattern.Thedebt/equityratioformostcompanieswillfallwithinthefollowingranges:

High-risk: debt= 0%–20% equity=80%–100% Medium-risk: debt=30%–40% equity=60%–70% Low-risk: debt=80%–100% equity=0%–20%● Calculate after-tax debt and equity costs.Next,establishareasonableafter-taxcostbasisfor

raisingnewdebtandequitycapital.Wecanreferbacktotheexampleusedinourdiscussionofcapitalcosts(see page 58).Wewillassumeaveragedebtcostsof7.9percentandequitycostsof12.5percent.

● Calculate hurdle rates by computing a weighted cost of capital for each category.First,determinewhatpercentagesofthetotalfinancingforagivenprojectwillbeaccountedforbydebtandequity,basedontheguidelinesthatwerementionedabove.Thenmultiplyeachpercentagebytheappropriatecostofcapitaltogettheweighted cost of capital.Thesumoftheweightedcostsisyourminimumreturn,adesirablerateforeachriskclassification.

Illustration:Usingearlierexamples,hereishowtocalculatetypicalhurdlerates:

➤ Observation:Thecrucialelementinusingflexiblehurdleratesisyourassessmentoftheriskinvolvedineachproject.Howdoyoudeterminethedifferencebetweenamedium-riskprojectandahigh-riskone?Thisleadsdirectlytotheareaofriskanalysis,whichwewilldiscussbelow.

AnalyzingYourCapitalInvestmentRisksNocapitalinvestmentprojectiseverwithoutriskbecausethereisnocompletelyreliablewaytoforecastfuturecashflow.Nevertheless,therearevariousdegreesofriskinvolvedindifferenttypesofcapitalprojects.Forinstance,themarketingofanewproduct,orentryintoanewmarket,carriesahigherriskthanothertypesofprojects.Thisisbecausemanagementhasnoexperiencetodrawoninthissituation,whichleadstoimprecisecash-flowforecasts.

Thus,youcanequatetheriskinanygivencapitalinvestmentprojectwiththeprobabilityofavarianceinyourprojectedcashflows.Forinstance,thereplacementofaworn-outmachinewithanewoneisusuallyalow-riskproject.Youhavepreciseknowledgeof(1)whatthenewmachinecando,(2)howmuchmoreefficientitisthantheoldmachine,and(3)thecostsavingsorproductivitybooststhatwillresultfromreplacement.Thus,theoddsofamajordeviationfromcash-flowprojectionsaresmall.

Debt 7.9%x.10 = 0.79 High-risk (10% debt, 90% equity) Equity 12.5%x.90 = 11.25 Capitalcost = 12.04%

Debt 7.9%x.35 = 2.77 Medium-risk (35% debt, 65% equity) Equity 12.5%x.65 = 8.12 Capitalcost = 10.89%

Debt 7.9%x.90 = 7.11 Low-risk (90% debt, 10% equity) Equity 12.5%x.10 = 1.25 Capitalcost = 8.36%


Ifyouweregivenachoicebetweentwoprojectswiththesamereturn,youalmostcertainlywouldchoosetheprojectwithlessrisk.Thehigher-riskprojectcouldbejustifiedonlybyahigherreturn.Thisisthewhyyoumustmakesomeprovisionforassessingtheriskinaproposedcapitalproject.Withoutknowingtherisk,youarenotinapositiontojudgewhethertheprojectissuitable.

Attheoutset,youshouldrecognizethatriskanalysis isadifficult job.Nomethodofriskanalysisisentirelysatisfactory,andeachrequiresagooddealofexpertiseandjudgmentonthepartofmanagement.Moreover,manyrisksaredifficulttoreducetonumbers.Forthisreason,youshouldregardtheriskanalysismethodsdiscussedbelowastools.Theyarenotsubstitutesforsoundbusinessjudgment.Theydo,however,forceyoutoviewthevariousprojectsinthesamelight,whichhighlightsriskandpermitsyoutocompareallofthem.

Weighted-Risk Analysis

Inthistypeofanalysis,youattemptto isolatethosefactorsthatwouldhavethemost impactoncashflowiftheywerealtered.Youcanidentifyanynumberofkeyvariables,suchasasalesdownturn,thetimeittakestoputtheprojectintoplace,increasedcosts,aneconomicslowdownandmarketingdifficulties.Aftereachkeyvariablehasbeenidentified,itischangedslightlyandNPVisrecalculatedonthebasisofthedifferentcash-flowassumptions.Thentheeffectofthechangeisnotedandranked.

Illustration:TheABCCompanyisconsideringintroductionofanewproductthathasanetpresentvalueof$40,000overfiveyears.ItdeterminesthatthemostcriticalvariablesinitsNPVcalculationsareanticipatedsales,pre-productioncostsanddistributioncosts.Thecompanythenassumesa10percentchangeineachofthesevariablesandrecalculatesNPVinallthreecases.AssumingthefollowingNPVfigures,itsweighted-riskanalysismightlooksomethinglikethis:

Change in Variable Change in NPVSales –10% –30%Distributioncosts +10% –25%Pre-productioncosts +10% –15%

Inthiscase,asalesslowdownproducesthegreatestriskandtrimsthecompany’sNPVby30percent,or$12,000ona10percentsalesdip.Also,ithadbetterkeepawatchfuleyeondistribu-tioncostsifthecompanydoesgoaheadwiththeproject.A10percentrisetherewillcuttheNPVby$10,000.Pre-productioncostsareimportantbutexertlessimpactthanthefirsttwovariables.

➤ Observation:Weighted-riskanalysiscanbeveryinformative,particularlyifyouareastuteenoughtoisolatethekeyvariables.However,thismethodalsohassomelimitations.First,thereisnoprovisionformeasuringtheprobabilityofchangesinthekeyfactors.Also,changesinacombinationoflessinfluentialfactorscouldresultinasubstantialchangeincashflows.

Adjusting for Probabilities

TurnbackonceagaintotheABCCompany’sillustration (pages 62–64).Wehavealreadydemon-stratedthattheprojectwouldbeprofitableatboth9percentand10percentdiscountrates,butwouldproduceonlyamarginalprofitat11percent.Yourcompany’sfinancedepartmenthaslikelydevelopedestimatesoftheprobabilityforeachcostofcapital,basedontheoutlookforyourindustryandeconomicprojections.Obtaintheseestimatesfromthedepartment.

Acompanyestimatestheprobabilityofeachdiscountrateforeachyearthattheprojectwillbeinforce.Then,NPVforeachyearisadjustedfortheprobability.Example:Refertothetable


below.InYear1,ABCestimatesonlya10percentchanceofa9percentdiscountrate.Therefore,the9percentNPVof$13,755becomes$1,375($13,755x.10).Similarly,the80percentprobabilityofa10percentdiscountratetranslatesinto$13,635x.80,or$10,908.Addtothatthe$1,351fromthe11percentcolumn($13,515x.10),andtheadjustedNPVforYear1becomes$13,634.Afteradjustingforallfiveyears,NPVisapositive$1,759fortheproject—anindicationthattheABCCompanyshouldproceed.

Theattempttomeasuretheprobabilityofdifferentscenariosaddsanewdimensiontoriskanalysisandcanbequitehelpful.Butrememberthatitisdifficulttoassignprobabilitylevelsfourorfiveyearsintothefuture.

Alternate Scenarios Measure Risk

Withthismethod,youdevelopthreeseparateNPVorIRRstudiesforeachproject.Youassumethat(1)everythingwillgoexactlyasplanned,(2)nothingwillgoright,and(3)thingswillgomoreorlessasexpected,withsomebugs.Thenyoucomparethevaryingdegreeofriskineachproject.Forinstance,youfindtwoprojectswiththesamemidpointNPV,butonewithmuchmoreriskifnothinggoesright.Inthatcase,youwouldprobablychoosetheprojectwiththelowerrisk.

Itisrelativelyeasytocomparedifferentprojectswiththismethod.However,itisalsounre-alisticinthattherearefewprojectslaunchedwhereeverythinggoesright,andjustasfewwhereeverythinggoeswrong.Moreover,thereisnoadjustmentforthevariousprobabilities.

Probability Adjustment—ABC Company

Probability for

Discount Rate Discount Rate Discount Rate Adjusted Year of 9% of 10% of 11% Present Value

1 10% 80% 10% $13,634

2 20 70 10 12,417

3 30 60 10 11,329

4 20 60 20 11,955

5 20 60 20 12,424

Total Cash Flow $61,759

Capital Cost 60,000

Adjusted NPV $ 1,759


HowtoRaiseMoney

Almosteveryhealthybusinesswilleventuallyreachapointwhenitmustengageincapital formation.Forsomebusinesses,thistimecomesrightatstart-up,whenfundsareneeded

topaytheoverheadcostsassociatedwithlaunchingabusiness.Otherfirmslookforsourcesoffinancingwhentheywanttoexpandormoveintonewserviceareas.

Allthatyou’velearnedinthepreviouspagesisputtothetruetestwhenyou’researchingforcapital.Noteveryinvestorisgoingtowanttotakeachanceonyourbusiness.Tomakeyoursearchforcapitalaproductiveone,youmustshoparoundforaninvestorwhosegoalsandinter-estsmatchyourcompany’s.

Ifyou’reamanagerinasmallercompany,there’sagoodchanceyoumayfindyourselfsittingintheofficeofyourlocalbankoraventurecapitalistwithyourbriefcasefullofratios,abalancesheet,forecasts,etc.Ouraimhereistohelpyougetthemoneyyouneed.

Ifyou’reanonfinancialmanagerinamidsizeorlargecompany,you’relikelytobeaskedtoparticipateinthefund-raisingroutine,especiallyifitinvolvesoneofyourprojects.YoumaynotgotothebankwithyourCFOandaskformoney,butyoushouldbefamiliarwiththeprocesssothatyouknowwhat’sinvolved.Moreover,whenyougobeforeaninternalboardorcommit-teetopresentplansforanewproject,youneedtotakeaprofessional,polishedapproach.Yourplanshouldlooklikeabusinessplan,withadescriptionoftheproject,thecompetitionandtheexpectedpayback.Usethissectionofourreportasachecklistoffactorstothinkaboutbeforeyoupresentyourplan.

KeepaBusinessPlanonHandUnfortunately,manyexecutivesregardbusinessplansasfinancingtoolsthatareprimarilyuse-fulforstart-upcompaniesorforthosejustemergingfromthestart-upphase.Intruth,therearesoundreasonsforyoutohaveanup-to-datebusinessplanonhandatalltimes,nomatterhowsuccessfulorprofitableyourcompany.Asolidbusinessplanisanimportantfinancingtoolatanystageofyourcompany’sdevelopment.

Forexample,yourchancesofraisingequitycapitalwithoutabusinessplanarevirtuallynil.Noinvestmentbanker,venturecapitalistorevenasmallbusinessinvestmentcompany(SBIC)(see page 82)wouldevenconsiderafundingrequestwithoutaformalbusinessplan.Moreover,businessplansareabsolutelyessentialtothesuccessofseriousmergeroracquisitionnegotiations.Eventhoughbanksandotherlendersdonotusuallyrequireabusinessplan(exceptforlong-termloanapplications),awell-structuredplancanmateriallyimproveyourchancesofgettingaloan.

Contents of a Business Plan

Atypicalbusinessplanconsistsofthreemainsections,eachcontainingspecificinformationaboutyourcompany’scurrentbusinessandfinancialposition.Thefollowingisabriefsummaryofeachelement.

Introductory section:Usuallyonlythreetofourpages,thefirstsectionisintendedtogivethereaderabriefoverviewoftheproposal.Itshouldconsistofthefollowing:(1)a title page identifyingthecompanyanditsprincipalofficers,withnames,addressesandphonenumbers;

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(2)atable of contents,listingthethreeprincipalsectionsandallmajorsubheadings;and(3)abrief statement of purpose(approximatelyone-halfpage),summarizingtheproposal,spellingouthowmuchmoneyisinvolved,howthefundsaretobeused,howthefirmwillbenefitandhowthefundswillberepaid(inthecaseofaloan).

Descriptive section:Thecommentsinthissectionshouldspelloutyourcompany’scurrentbusinesspositionanditsplansforthefuture.Becertaintoaddressatleastthesefiveareasbydescribing:● Your business. Assuccinctlyaspossible,tellwhatyourbusinessis,howyourunitandwhy

youaresuccessful.● Your market and your com pany’s market niche.Givesomeideaofyourmarket’ssizeand

potentialaswellasyourmarketingstrategy.● Your competition and how you handle it.Mincenowords.Ifcompetitionissevere,sayso.● Your management team. Emphasizethebusinessbackgroundandexperienceofeachmember.

Includesomepersonaldata,suchasage,specialinterestsandplaceofresidence.● How the new capital will be applied.Spelloutwhatprojectsthefundswillbeusedfor.You

shouldbeasspecificaspossible,whichmeansthatyouwillhavetoreachsomeharddecisionsbeforeseekingfunds.

Financial section:Your“financials,”astheyarecommonlytaggedbylendersandotherprovid-ersofcapital,shouldbetargetedatprovidingsupportforthestatementsmadeinthedescriptivesection.Youwillneedbothhistoricaldataandprojectionsforthefuture.StartoffwithaSourceandApplicationofFundingstatement,whichshowsindetailhowtheproceedsofthefinancingwillbeused(forexample,percentagesallocatedtoequipment,advertising,productdistribution).Youcanthenmoveontothemoretraditionalfinancialstatements:● Historical statementsshouldgobackaboutfiveyearsinmostcases.Ifyourbusinessiscycli-

calinnature,however,youshouldcoveracompletecycle,evenifitmeansdiggingfurtherintothepast.Thereportsshouldincludebalancesheets,incomestatementsandcash-flowstatements.

● Projectionsshouldalsoincludepro-formabalancesheets,incomestatementsandcash-flowstatements.Summaryreportsareacceptableinmostcases.Besuretoincludeprojectionsforatleasttheperiodduringwhichthefundswillbeusedandrepaid.

When a Shorter Proposal Will Do

Usually,youwillneedafull-blown12-pagebusinessplantoensurepropertreatmentonmostfinancingexpeditions.Buttherearetimeswhenalessthoroughtreatmentwillsuffice.Forin-stance,youmayalreadyhaveestablishedacloserelationshipwithyourbankandmerelyneedtopresentadocumentedproposaltotheloancommittee.Or,youmaybeattemptingtoarrangenewfinancingfromaprivateinvestorwhoisalreadyfamiliarwithyourcompany’soperation.Insuchcases,youcanusuallysubstituteasummaryfinancingproposalforaformalbusinessplan.

Asummaryfinancingproposalisaminibusinessplanconsistingofnomorethansixorsevenpages.Thefirstpagecontainstheproposalitself,detailingtheamountofcashneeded,repaymentschedule,collateralandanyotherpertinentdetails.Thesecondpagesummarizeshowthefundswillbeusedandhowyourfirmwillbenefit.Briefly,thissectionsetsforthyourargumentsonwhytheproposalwouldbeagoodloanorinvestment.Thisisfollowedbyatwo-tothree-pageoutlineonyourcompany’shistory,itsproductandmarketingposition,themanagementteamandasummaryofitsprospectsforthefuture.Inshort,thisisacapsuleversionofthedescriptivesectionofaformalbusinessplan.


Finally,youshouldincludeacondensedbalancesheetandincomestatement,plusayearortwoofprojections.Cash-flowstatementswouldgiveasubstantialboosttoyourargumenthere.

WheretoLookforFundsCompaniesraisemoneyforexpansioninthreeways.First,businessescanuseretainedearnings,whichisthemoneytheyearnthroughtheiroperationsanddonotdistributeasdividendstoshare-holders.Thissimplymeanspayingforanexpansionprojectwiththecashyougeneratethroughprofits,similartotheeverydaypersonalpurchasesyoumake.Thesecondmethodisborrowing,andthethirdisequityfinancing(thesellingofsharestoinvestors).

InternalFinancingYourtopsourceofcapital isyourcompany’sowncash. Itcomesfromsalesandshowsupinprofits.Yet,althoughinternalsourcesareobvious,manyfinancialplannersoverlookthemwhentheyaredevisingcapitalformationschemes.

Many internalfinancing schemesboildown to cashmanagement.Plus, attention to cashmanagementearlyinthefinancialplanningprocesshasvalueevenifyoucan’trelysolelyoninternalsources.Effectivecashmanagementwillhelpconvincelendersandinvestorsthatyoureallyknowhowtorunacompanyandthatyou’lltreattheirmoneywiththerespectitdeserves.

Capitalformationbeginswithyourcompany’scashbudgets.Asexplained,therealaimofcashmanagement is toensureyouhavetheamountofcashyouneed justwhenyouneedit.There’sanotheradvantageofcarefulcashmanagement.Oftentimes,comparingactualcashflowwithyourpredictionscansignalanearlywarningoftheneedtoimprovemanagementcontrols.Youcanavoidcostlymistakesbytakingstepstoheadoffaflowinthewrongdirectionbeforeitbecomesaflood.Somekeystoimprovingyourcashmanagement:● Keepyourmoneyinmoneymarketaccounts.Notonlywillyouearninterest,butyou’llbe

eligibleforbankservices,suchaschecking,atareducedrate.● Useelectronicfundstransferinsteadofcertifiedchecks.Doingsowillloweryourbankcosts

andkeepmoneyworkingaslongaspossible.● Offerdiscountsforcustomerswhopayofftheiraccountsearly.Thiswillreducethecostsyou

incurcarryingreceivablesandwillacceleratecashflow.

Carefullymanageinventory,accountsreceivable,accountspayableandsurpluscash,andthinkofwaystoincreasesales.Thenextthingyouknow,you’vegotthecapitaltomovetothenextstepinyourgrowthplan.Apenny-wiseapproachmaygivemoreobviousbenefitstolargecompanieswithlargeamountsofpennies,butproportionallyitwillworkforsmallercompaniesaswell.

Customers Come FirstMorecompaniesareturningtotheircustomersandvendorsaspotentialsourcesoffinancing.Newtechnologieshavemadesomanybusinessesinterdependentthatthelinesareoftenblurredastowhereonecompany’sfunctionendsandtheotherbegins.AccordingtoRickCanada,direc-torofchangemanagementservicesatMotorola:“Thebestdefinitionofapartnership...iswhenthebuyerandthesellertakeonthecharacteristicsofoneorganization,ratherthantwoseparate,distinctorganizations.”Whenthisoccurs,itoftenforgesatypeofbusinessmarriageorpartner-shipinwhichtwoormorecompaniessharethecosts,risksandprofitsofaparticularventure.


MakeYourEmployeesOwnersEmployeestockownershipplans(ESOPs)areemployeetrustfundstowhichanemployercon-tributesstockinthecompanyatnocosttotheemployee.Theyarestructured,however,sothattaxadvantagesallowthecompanytoborrowmoneyatanominalcost.

Untilrecently,ESOPshavebeenusedprimarilytoshoreupshakycompanies.Usually,thetroubledcompanyturnsoverownershiprights(andrisks)toemployeesinthehopeofmotivatingtheworkforceandsecuring“give-backs”onwagesorbenefits.Now,however,manysuccessfulcompaniesareusingESOPsasfundingvehiclesbecauseoftheirsignificanttaxbreaks.

Suppose,forinstance,yourfirmwantstobuyuppartofitsoutstandingstock,butitdoesn’thavethenecessarycashonhand.First,thecompanycreatesanESOP.Next,itborrowsthemoneytobuythesharesandplacesthosesharesintheESOP.Torepaytheloan,thefirmmakescashcon-tributionstotheESOP,andtheESOPpaysthebank.Inthatway,boththeprincipalandinterestontheloanarefullytaxdeductible.Astheloanisrepaid,theESOPstockiscreditedtoaccountsofemployeesparticipatingintheplan.

ESOPsarenotaone-shotdeal.Yearafteryear,acompanycancontributewhatwouldnormallybetaxableprofitstotheESOP,upto25percentofpayroll.However,thecontributionsaremadeinstock—thecompanykeepsthecash.

ESOPscanbevaluablefinancingtoolsformidsizecorporations,particularlycloselyheldfirmsthatmightfinditdifficulttoraisecashthroughnormalchannels.

TheABCsofBankBorrowingAskedwhyherobbedbanks,WillySutton,awilystick-upman,oncesaid,“Becausethat’swherethemoneyis.”Ifyou’reasmallcompany,youprobablydonearlyallyourfinancingthroughbankloans,whichmeansthatyou’llbetakingondebt.Therearesoundreasonsforfinancingthegrowthofyourcompanybyusingdebtratherthantheotherprincipalformoffinancing—sellingsharesinthecompany.

Debt-servicepaymentsareadeductiblebusinessexpense;dividendpaymentsarenot.Whenyou issuenewdebt,you leverageyour company to increaseearningspotential. Issuingnewcommonstockdilutesyourearnings.Mostimportant,newdebtdoesnotweakencontrolofthecompany,aswouldanequityfinancing.

Ifit’sabankyouneed,besuretoshoparoundandknowwhattolookfor.It’simportant,forinstance,tofindoutwhichbanksareinthebestpositiontolendmoney—andmayevenbeunderpressuretomakeloans.Inthisrespect,akeynumbertoknowisthebank’sloan-to-depositratio.Thiswilltellyouwhatpercentageofabank’sdepositsistiedupinloans.Historically,theloan-to-depositratiowasabout60percent.Today,it’smorelike73–75percent.Youcaneasilyobtainthisloananddepositinformationthroughyourstatesuperintendentofbanking.

Getting the most out of your banker:Eventhoughbankssupplywellover90percentofthecapitalneedsofsmallandmidsizefirms,fewbusinesspeopletakethetroubletodevelopasolidrelationshipwiththeirbankers.It’strueinbothyourpersonalfinancesandyourbusinessdealings:Thebesttimetogettoknowyourbankeriswhenyoudon’tneedaloan.Ifyouareinapositionwithinyourcompanytogettoknowthecompany’sbanker,takefulladvantageofthatopportunity.It’sagoodideatoinviteyourbankeronatourofyourfacilities,andkeephiminformedofyourcompany’sprogressbysendingquarterlystatementswithappropriatecommentstohisoffice.

Evenifyoudon’tintendtoborrowfromyourbankintheforeseeablefuture,agoodbankingrelationshipcanhelpyouinmanyotherways.Foronething,abankermakesanexcellentchar-


acterreference.Assuch,hisendorsementmighthelpinobtainingbettertermsfromsuppliers,equipmentmanufacturersandthelike.

Presenting your case:Byfar,themostfrequentmistakemanagersmakeinapplyingforabankloanistosubmitalaterequestforfunds.Toabanker,anemergencyloanisanathema.Itisanobvioussignofpoorplanning.Nocompetentmanagershouldeverallowaneedthatshouldhavebeenanticipatedtoturnintoafinancialcrisis.Thus,ifyouexpecttohaveanychanceofgettingabankloanapproved,youmustanticipateyourcashneedswellinadvance,toprovideenoughtimeforthebanktoprocessyourapplication.Ittakesatleastthreeweeks,andsometimesmore,toprocessaloan.

Alsomakesurethatyouprovidetheproperinformation,whichissimilartotheingredientsfoundinyourbusinessplan.Thisincludesthefinancial statements(goingbackthreeyearsisthenorm,butsomeinstitutionspreferfiveyears); personal statementsdescribingtheexperienceandcapabilitiesoftopmanagement;anda statement of purposedetailinghowthefundswillbeused,andhowtheywillberepaid.Acash-flowbudgetcoveringthelengthoftheloanishelpful,thoughnotalwaysrequired.

The loan interview:Ifyou’vedoneyourhomework,thebattlewillnearlybewonbythetimeyouappearfortheloaninterview.Inmanyrespects,yourbusinessplanoryoursupportingdocu-mentswilldothetalkingforyou.Nevertheless,youshouldtakethisinterviewseriouslyandbepreparedtoanswerthebanker’squestions,whichwillbesimilartothese:

1. How much?Tellyourbankerexactlyhowmuchmoneyyouneed.Don’tbevague.2. How long?Indicatehowlongthefundswillbeneeded.3. What purpose?Bespecificabouthowyouwillusethemoney.“Generalcorporatepurpose”

isnoanswer.4. How will you repay?Again,bespecific.Ifit’sfromcashflow,bepreparedwithacash-flow

projectionforthedurationoftheloan.5. What if something goes wrong?Prepareyouraceinthehole:anemergencyplantouseif

theloandoesn’tworkout.Youcouldplantosellanasset,borrowelsewhereorhaveanewinvestorontap.Asoundemergencystrategycanbemostconvincing.

Finding the Right Type of Loan

Despitetheintimidatingproceduresinvolvedinnegotiatingaloan,yourbankerwantstolendyoumoney.That’stheinstitution’sbusiness.Hehastobecertain,however,tokeepthebank’smoneyundercontrol.Onewaytoimpressyourbankeristospeakhislanguage;structureyourloanproposalsothatitfitsneatlyintooneofthemanyloancategoriesthatthebankuses.Thereisplentyofroomformaneuveringwithinthesecategories,buttokeepthebankcomfortable,yourloanrequestshouldfitintooneofthefollowinggroups:

Short-term loans:Short-termcreditisthebackboneofcommerce.Businesspeopleuseshort-termloans(definedasloansmaturinginoneyearorless)tofinanceeverythingfrominventorytoemergencies.Hereareafewofthemostcommonshort-termloanclassifications:● Time loans.Forcompanieswithgoodcreditratings,thetimeorcommercialloanisthechief

sourceoffinancing.Itkeepsbookkeepingtoaminimumandcanbeusedforanypurpose,includinginventoryandaccountsreceivable.Timeloansusuallymatureinthreetosixmonthsbutcanberefinancedforlongermaturities.

● Accounts receivable.Inthistypeofloan,thebanklendsyou70–80percentofthevalueofeligiblereceivables.Aschecksinpaymentforreceivablescomein,youforwardthemtothe


bank,whichdeductsitsportionanddepositstherestinyouraccount.Interestispaidonlyontheamountoftheloanoutstanding.Tobeeligibleforfinancing,receivablesusuallymustbelessthan60daysold,andyourcustomersmustbecreditworthy.

● Line of credit.Alineofcreditisbyfarthesimplestandmostflexibleshort-termfinancingavailableforabusiness,especiallyasmallone.There’sacatch,though:Creditlinesareusu-allygrantedonlytothemostcreditworthycustomers.

Medium-term loans: Theprincipaldifferencebetweenashort-termandmedium-termloanistheimportanceofcollateral.Medium-termloansareforuptofiveyearsandarenormallyusedtofinanceequipmentpurchasesorplantexpansion.Ingrantingsuchloans,thebankwillusuallyexpectyoutopledgeanassetthatwillgeneratetherevenuesneededtorepaytheloan.

Abankerregardscollateralasasafetyvalve.Althoughyourabilitytorepaytheloanoutofyourcashflowisthekeyfactoringettingtheloanapproved,yourbankwillalsorequestthattheloanbesupportedbycollateral,justincasesomethinggoeswrong.Hereisarundownonsomeofthemostcommonassettypesandhowyourbankislikelytoregardthemascollateral:● Liquid assets.Moneymarketaccounts,savingsdepositsandbankcertificatesofdeposit(CDs)

canbetakenatfacevalue,ascanshort-termU.S.governmentsecuritiessuchasTreasurybills.However,longer-termTreasuryormunicipalbondsaretakenatmarketvalue.Listedstocksandbondsareusuallydiscountedfrommarketvalue,withthediscountrunningasmuchas25percent.

● Accounts receivablecanbringasmuchas60–80percentof facevalue,providedtheyare“eligible.”Thismeansweedingoutolderaccounts,doubtfulaccountsandslowpayers.

● Inventoriesarelessvaluableascollateral,primarilybecausetheyaremoredifficulttosell.Figureonanaverageofapproximately30percentofthecostofrawmaterialsandfinishedgoods.

● Machinery and equipmentaremeasuredbyauctionvalue.Youcanusuallyuse50–70percentoftheauctionvalueofmachineryandequipmentascollateral.

Term loans:Mosttermloansarewrittentocoverthelifeofanassetorforafive-yearperiodwitharefinancingclause.Theyarewrittenfor80–90percentofanasset’stotalcost.Paymentsaremadequarterlyandconsistof equal amountsofprincipalwith interest computedon theoutstandingloanbalance.

Becausesmallcompaniesoftenfindquarterlypaymentsburdensome,manybankswillworkoutascheduleofmonthlypayments.Mostbanksalsowilltailorpaymentstomeetthecompany’sneeds,suchasacceptinglowerpaymentsintheearlyyearsoftheloanandhigherpaymentslater.

Long-term loans: Long-termloans(overfiveyears)havebeenvirtuallynonexistentforthepastseveralyears.Fromabusinessperson’sstandpoint,theinterestrateistoohigh,andthebankishesitanttocommititscapitalforalongtermwheninflationmighterodethevalueoftheassettobefinanced.Whenlong-termloansareused,theyalmostalwaysinvolverealproperty.● Business property mortgages.Inmorestabletimes,commercialandindustrialmortgages

werenotunlikeresidentialmortgages.Theyranforaslongas25yearsandwerepaidoffinmonthlyinstallments.

Nowadays,youmaynotbeable togetamortgage formore thanfive to10years.Thesemortgagesusuallyinvolveequalmonthlyinstallments,withaballoonpaymentattheend.Onlyrarelyisrefinancingguaranteed,althoughmostcompaniescannegotiateanewdealwhentheballoonpaymentisdue.● Real estate loans.Ifyouhavesubstantialequityinyourbuilding,itmaystillbepossibleto

arrangeasecondmortgage.Interestcostscouldbeveryhighinsomeareas,however.Awhole


newrefinancingpackagemightalsosatisfyyourcashneeds,butyou’llprobablybeswappingalow-costmortgageforahigherone.

Inshort,unlessyouarecertainthatthereturnonyourproposednewinvestmentwillbeveryhigh,youwouldbebetteroffleavingtheequityinyourplantuntapped.

Score Your Loan Worthiness

There’salimittotheamountofdebtanycompanycanhandle.Thus,nomatterhowsmoothyourpresentation,yourbank(oranyotherlender)willalwaysevaluatehowmuchdebtyoucanafford.Ifyouwanttogaugeyourchancesofreceivingafavorablereceptionatabank,thereareacoupleoftechniquesyoucanuse.Lenderstraditionallylookattworatiostotestyourabilitytorepay:

1. Interest coverage ratio:earningsbeforeinterestandtaxesdividedbyinterestcharges.Thisbasicratiodefinesyourabilitytomeetinterestpaymentsontime.Inflationhasledtoalteredstandardsformanyratios,butthisoneremainsunchanged.Youshouldhave$3ofoperatingearningsforeach$1ininterestcharges.

2. Debt-service ratio:Thisratioiscalculatedasfollows:

Earningsbeforeinterestandtaxes Principalpayments 1–taxrate

TheLoanApplication

Alenderwillmakeyoufilloutaloanapplication.Typically,theapplicationasksforagreat deal of information, some of which will be contained in the business plan:

● The loan amount requested.

● How, when and from where it will be repaid.

● Description of collateral.

● Names,personalfinancialstatementsand income tax returns for anyone who will personally guarantee the loan.

● General information about the business: name, addresses, phone numbers, tax ID numbers, year-end statements.

● Type of business and history of the busi-ness.

● Structure, management and ownership, including résumés.

● List of other businesses that the owners control.

● Completeauditedfinancialstatementsfor the last three years, including bal-ance sheets, income statements and projections through the end of the year.

● Cash‑flowprojectionsforthetermofthenote.

● Recent aging of accounts receivable.

● Referencesfromfinancialinstitutionswith which your business has any kind of relationship.

● Customer references.

● Reportonanysignificantdevelopmentsfor the business.

● Any additional material you want to include, such as brochures to help the lender understand the business.

Interestcharges+


Principalpaymentsareadjustedforafter-taxearningsbecausetheyarenottaxdeductible.Theinterestcoverageratiosaysnothingaboutyourabilitytomeetdebtrepayments.This

ratiocorrectsthatfailing.Aratioof1iscritical;anythinglessandyourcompanyisindangerofdefault.Tobesafe,aratioof2ormoreisdesirable.

Inadditiontotheseratios,there’satechniquecalledtheZeta scoring system.Thisisapropri-etarycomputermodelusedbybanksandotherinstitutionstomeasureacompany’svulnerabilitytofinancialdifficulties.EvenifyourbankdoesnotusetheZetasystemitself,yourZetascoreshouldgivesomeindicationofhowyoustandaccordingtotraditionalfinancingbenchmarks.Theheartofthesystemisagroupoffinancialratios,eachweightedaccordingtoitsimportanceasanindicatoroffinancialhealth.Aswithallnumericalratingsystems,themodelhasitsflaws.Nevertheless,theZetascoringsystemhasbecomeoneofthemorecommonmethodsofevaluat-ingacompany’sfinancialunderpinnings.

Youshouldencounterlittledifficultyincomputingyourcompany’sZetascoreonyourownbyusingdatafromyourmostrecentfinancialstatements.Herearethekeyelementsandahypo-theticalillustrationofhowtheywereusedbytheXYZMfg.Company:● Working capital.First,divideworkingcapital(currentassetsminuscurrentliabilities)bytotal

assets.Then,toobtaintheproperweight,multiplyby1.2.XYZ’sassetstotal$120million,andworkingcapitalstandsat$24million.Thus,$24milliondividedby$120million=.20.When.20ismultipliedby1.2,theZetafactoris0.24.

● Cumulative profitability.Here,youdivideretainedearningsbytotalassets.Thismeasure-mentisweightedalittlemoreheavily,somultiplytheanswerby1.4.RetainedearningsofXYZamountto$54.4million.TheZetacalculationforthiscomponentbecomes$54.4milliondividedby$120million=0.45x1.4=0.63.

● Return on assets.Thismeasureofprofitabilityisgiventheheaviestweight.Dividepretaxprofitsbytotalassets.Thenmultiplyyouranswerby3.3.Withpretaxprofitsof$28.4million,XYZ’sZetacalculationforreturnonassetsbecomes$28.4milliondividedby$120million=.24x3.3=0.79.

● Return on sales.Here,youmeasurehowmanysalesdollarsaregeneratedbyeachdollarofassets.Dividesalesbytotalassets.Theweightingisneutral,somultiplyby1.0.Salesof$145millionforXYZaredividedby$120million,producingafigureof1.2.Whenmultipliedby1.0,theZetafactorremains1.2.

● Leverage.Thisfinalratioisabitdifferentinthatitattemptstomeasurethevolatilityofyourcompany’scapitalstructure.Divideshareholders’equitybyyourtotaldebt.Thisfinalcom-ponentisnegativelyweighted,somultiplyby0.6.XYZ’sequityof$90.6millionisdividedbyatotaldebtof$33million,producingaratioof2.75.Thisismultipliedby0.6foraZetafactorof1.65.

Toarriveatyourcompany’sZetascore,merelyaddthescoresforeachindividualcomponent.Ifyourfinalscoreis3.0ormore,youareingoodfinancialshape,accordingtotheZetasystem.Ascoreoflessthan2.0indicatesthatsomeproblemsexist,andanythinglessthan1.8placesafirminthehigh-riskcategory.Anegativescoreissupposedtoforeshadowimminentbankruptcy. InXYZ’scase,thefivecomponents,addedtogether,yieldatotalZetascoreof4.51,ormorethanenoughtojustifyaloan.

➤ Observation:Zetascoresareseldomcrucial toabanker’sevaluationofyourcompany.Therearemanyotherfactorsofatleastequalimportance.Nevertheless,ifyoufindthatyourZetascoreisonthelowside,youcanprepareargumentstorefutetheimplications.IfyoufindthatyourZetascoreissatisfactory,youcanciteitasevidenceoffinancialhealth.


If Your Banker Turns You Down . . .

Mostbusinesspeoplehavebeenturneddownforabusinessloanatleastonceintheircareers,anditcanbeawrenchingexperience.Ifyourloanrequestisrefused,don’tpanic.Yourcompanywillprobablyprosper,evenwithouttheextracash.However,youhavesomeworktodo.

Thefirsttaskistofindoutwhyyouhavebeenturneddown.Askyourbankerdirectly.Askforspecifics;don’tsettleforavagueanswer,suchas“undercapitalization.”Youcan’tcorrectthesituationunlessyouknowwhatiswrong.Mostloanrequestsareturneddownforoneofthefollowingreasons:

1. Poor communication.Ifyouandthebankerdon’thititoff,thechancesforyourloandropprecipitously.Solution:Asktobeservicedbyanotherloanofficer.Youhavearighttoexpectthatthepersonservingyouwillbeempatheticaboutyourproblems.

2. Uncontrolled expansion. Banksshyawayfromacompanywitharevenuegrowthratethatsurpassesitsabilitytofinancenecessaryexpansion.Solution:Ifyouwanttofinanceanexpan-sionprogram,makecertainthatyourbusinessplanincludesafullexplanationofhowyourcompanyexpectstokeeppacewithsalesgrowth.

3. Overly optimistic business plan.Yourbankwillcheckyoursalesandearningsforecastsagainstindustrywideforecastsandmayalsomatchyourprojectionsagainstthoseofacompanyinasimilarbusiness.Ifyourforecastsappeartoooptimistic,yourloanwillprobablybeturneddown.Solution:Keepforecastsrealistic,evenconservative.

4. Past misuse of loan funds.Ifyouusefundsforaprojectnotinyourstatementofpurposeandthebankfindsout,yourchancesofreceivinganotherloanfromthatbankareslim.Solution:Ifcircumstancesbeyondyourcontrolmakeitimpossibletofulfillloanconditions,informyourbankatonce.

5. Rapid inventory buildup.Toabank,asuddensurgeininventoriesmeansoneoftwothings:poorplanningoranunanticipateddropinsales.Ineithercase,thereisreasontoholdoffnewcredit.Solution:Makesureyourinventoriesareinreasonableshapebeforeyouapplyforaloan.Don’texpectthebanktofinanceinventoriesabovetherangeyounormallycarry.

Nobankenjoysturningdownaloanrequest.Apartfromthefactthatthebankmakesmoneybylendingfunds,thebankunderstandablywantstobeviewedfavorablybyitscustomersandprospectivecustomers.Therefore,ifyouareturneddown,youprobablyhavethefullsympathyofyourbankeratthatmoment.Youmightbeabletousethatsympathyasabridgetoyournextmove,byaskingforyourbanker’shelpwithsuchquestionsas:“Whatwouldyoudoifyouwereme?”or“WhatsourceshouldItrynow?”

LoanGuaranteesFromtheSBAIfyouareturneddownforaloanbyyourbanker,youmayapplyforaloanguaranteebytheSmallBusinessAdministration(SBA).Providedyoumeetcertainriskrequirements,theSBAcanguaranteetheloan.(Incitieswithapopulationof200,000ormore,youmustbeturneddownbytwobanksbeforeapplyingforanSBAloan.)Ifyouhaveagoodrelationshipwithyourbank,itwillprocessyourloanthroughtheSBA.Thiswillrequireagreatdealofdocumentation,includingtheusualbusinessfinancialstatements,plusthefollowing:acurrent personal financial statementfromallholdersof20percentormoreofthecompany’scommonstock;a business plancoveringtheperiodoftheloan;andalist of all collateral,includingtheestimatedmarketvalueofeachitem.


Inthepast,theattractivenessofSBA-guaranteedloanshaddimmedbecauseoftheseeminglyinterminableamountofredtapeandthetimeittooktogettheloanapproved.TheSBAhasbecomemoreinnovativeinattemptingtoreducethatleadtime.Inparticular,anewprogram,dubbedthePreferredLendersProgram(PLP),cancutprocessingdelaysdramatically.PLPloansfrequentlycanbeprocessedintwotothreedays.

How PLP Works

OnereasonforthisfasterprocessingisthatthePreferredLendersProgramturnsovermostofthepaperworktothebanklender.WhereasinprioryearstheprincipalresponsibilityforapprovalrestedwiththeSBA,thePLPtransfersthatresponsibilitytothebankmakingtheloan.Participat-inglenderscandetermineeligibility,creditworthinessandloanstructuring,aswellasmakeotherdecisionsontheirown,withoutpriorrevieworconsentbytheSBA.

UnderthePreferredLendersProgram,theamountof loanguaranteedbytheSBAcannotexceed75percent.Thiscompareswithaguaranteerateof90percentonpreviousSBAprograms.

IfyourareaisnotservedbyparticipatingPLPlenders,keepinmindthattheSBAstillcontinuestooperateitsCertifiedLendersProgram(CLP).UndertheCLP,participatinglenderstrainedinhandlingSBAloanapplicationscanobtainadecisionandloandocumentpackagefromtheSBAwithinthreeworkingdays.Formoreinformationabouttheseandotherprograms,contactyourlocalSBAofficeorvisitwww.sba.gov.

LoansFromCommercialFinanceCompaniesIfyouhaverecentlybeenturneddownforaloanbyabank,youmightreceiveawarmerwelcomeatacommercialfinancecompany.Indeed,manybanks,inrejectingaloanproposal,willreferacustomertoacommercialfinancesubsidiary.

Commercialfinancecompaniesuseaportionofacompany’sassetsascollateralforbusinessloans.Theirlendingstandardsarenormallymoreliberalthanthoseofbanks.Rates,however,aregenerallyhigherandvarywiththetypeofcollateralandlengthoftheloan.Generally,ratesvaryfrom3percentto6percentaboveprimeonloansmaturingintwoto15years.Thetypesofloansinclude:● Inventory loans.Inthistypeofloan,youuseyourinventoryascollateral.Thelenderwill

advancefundsatacertainpercentageofyoureligibleinventories.Thereisnostandardper-centage,butbecauseinventoriesarevaluedatdistressor“knock-down”prices,thevaluationisalwaysconservative.Youcancountonfrom25percentto50percentofeligibleinventories.

Yousupplyaregularscheduleofinventoriestothelender,andthetotalamountoftheloanisadjustedasinventoriesfluctuate.Generally,freelytradedcommoditiesreceivethehighestadvancesinaninventoryloan,whiledifficult-to-sell,work-in-processinventoriesreceivethelowestadvances.● Equipment loans.With these,youfinancenewequipmentbyborrowingagainstexisting

equipment.Machinery,rollingstock(vehicles)andevencomputerscanbeusedascollateral.Theequipmentmusthaveafirmresalevalue.Obsolete,rareorunusualequipmentcannotbeusedascollateral.

Afterappraisalbyanindependentparty,thecompanybeginstoworkouttheloanterms,whichdependprincipallyontheexpectedusefullifeoftheequipmentandthefinancialcondi-tionoftheborrower.Frequently,acompanycanarrangealoantocoverevenadownpaymentonsomenewequipment.


● Receivable loans.Foratime,banksweretakingonagrowingportionofreceivablesfinanc-ing.With tighter credit conditions,more recent receivables-financing activity tends tobeconcentratedincommercialfinancecompanies.Relativelyyoungreceivablesaccountsfromcreditworthycustomersqualifyforloans.Youarechargedinterestonlyontheamountdue.

➤ Observation:Mostasset-basedfinancingcompanieshaveminimumloanprovisions,usuallyofabout$100,000.Themoreyouborrow,themorefavorabletherate.Bepreparedtoguaranteetheloanpersonally:Apersonalguaranteeisarequirementwithacommercialfinancecompany.

Using a FactorIfyourcompanyneedsfinancingtobuildupinventoriesinadvanceofheavyshippingdates,orhastroublehandlingswollenaccountsreceivableafterapeakseason,afactormightbeabletoputyourbusinessonamoreevenkeel.

Inafactoringarrangement,yourcompanyactuallysellsitsreceivablestothefactor,whichthenassumes all credit riskswithout recourse. Factoringhas longbeena commonbusinesspracticeinthetextileandapparelindustries,butithasbeenslowtospreadtootherindustries.Thisisbecausefactorshavehistoricallyadoptedaninsularattitude,andbecausecustomersintheindustrieswherefactoringisnotcommonaresometimesdisturbedathavingtheiraccountsassignedtothirdparties.However,competitionhasheatedupamongfactors,andmanyarenowseekingclientsoutsidetheirtraditionalindustries.

Alongwiththischangeinattitudehascomeavarietyofnewfactoringservicesthatcanbespeciallytailoredtoavarietyofneeds.Mostfactorscurrentlyprovidethefollowingservices:● Maturity factoring.Inthistraditionalformoffactoring,youselltheaccountsreceivabletothe

factorandyoureceiveyourmoneywhentheinvoicematures(usually30days).Thecustomerisnotifiedthatheorsheistoforwardpaymentdirectlytothefactor,whichhandlesallthecollectionandbookkeepingchores.

● Nonnotification factoring.Underthisarrangement,yourcompanyhandlesthebookkeepingandcollectspayments.Yougetabreakonthefees,andyourcustomerdoesn’thavetoknowaboutthefactoringarrangement.

Factoringhasabigadvantageoveraccounts-receivableloansinthatyoureceivethefullamountofyourreceivablesastheycomedue,ratherthanthe70–80percentthatyougetfromabankloan.Also,factorsoffercashadvancesonreceivablesnotyetdue.Theseareessentiallyloansthatthecompanyusestocoverpeakinventorybuildupsinanticipationofabulgeinreceivables.Rateschargedonadvancesusuallyvarybetween1percentand3percentoverprime.

Can you use a factor?Ifyoubelievethatthetime,talentandresourcesnowbeingdirectedtocreditoperationsmightbebetterspentonsalesorproduction,youcanprobablyusetheservicesofafactor.Thisisparticularlytrueifyouperiodicallyneedadditionalcashtoeaseseasonalorcyclicalfinancialobligations.Keepinmindthatfactoringfeesarerelativelyhighandtypicallyrunbetween1percentand2percentoftheamountfactored.Againstthis,however,youmaybeabletocutdown,oreveneliminate,yourcreditdepartment.

Itisunlikelythatnonfinancialmanagerswillgetinvolvedinmoresophisticatedfinancingmaneuvers,butthefollowingsectionbrieflyexploresotherfinancingtechniquesthatyoumayencounterinyourjob.


BondFinancingBondsareactuallyloansthatpeople,likeyouandme,maketocompanies.Inexchangefortheloanmoney,companies issuebonds.Thetermsoftheloanaresetout inawrittenagreementcalledthebond indenture.Thisstipulatestheinterestratethatwillbepaidtobondholdersandwhentheprincipalwillberepaid.Italsodesignatesatrustee,whoisresponsibleforseeingthatthetermsoftheagreementaremet.

Illustration:A$1,000bondmayguaranteetopay10percentinterest(oftenreferredtoasa 10percentcoupon rate)annuallyover10years.Theinterestispaidatspecifictimes,usuallyeverysixmonths.Attheendofthe10-yearperiod(thematurity date)thecompanyrepaystheinvestortheoriginal$1,000(theprincipal).

Althoughyourfirmmaydecidetoissuebondsonitsown,it’smorelikelythatmanagementwilluseanoutsideinvestmentbankertounderwritethebondoffering.Likestockofferings,thesellingorissuingofbondsisheavilyregulatedbytheSecuritiesandExchangeCommission,whichrequiresacompanytomeetanumberoflegalrequirements.Thus,it’softenmucheasierforacompanytoturnthe“floating”ofbondsovertoaprofessionalinvestmentbanker,especiallyifit’sthefirsttimeyourfirmisgoingintothebondmarket.

An investmentbankerbuys thecompany’sbond issueand thenresells it to thepublic; it absorbsthelossifthereareanybondsthatitcannotresell.Foritsservices,theinvestmentbankerreceivesafee.Keepinmindthatbondinterestispaidfrompretaxdollars,andthatbondholdersarecreditorsofyourfirm.

Thereareallsortsofbonds,buthereareafewofthemorecommontypes:● Mortgage bonds.Asthenameindicates,thecompanypledgesascollateralspecificfixedassets,

suchasabuilding.Generally,theassetisofgreatervaluethanthevalueofthebondsissued.Thisensuresthat,incaseofabonddefault,theinvestorshavesufficientfinancialprotectionthroughresaleoftheasset.

● Collateral trust bonds.Inthisvariationofmortgagebonds,theassetsusedascollateralarestocksandbondsofothercompaniesinwhichyourfirmholdsaninterest.

● Equipment trust certificates.Thistypeoffinancingisfavoredbyrailroadsandairlinestomakemajorequipmentpurchases.Thecompanysellsthecertificatestoinvestors,andtheproceedsareusedtopayfortheequipment,suchasrailroadcarsorairplanes.Thetrusteetakestitletotheequipment.Therailroadorairlinethenpaystheperiodicinterestandtheprincipaltotheinvestorsoveraperiodoftime,say15years.Whenallthecertificatesarefinallypaidoff,titlepassesfromthetrusteetotheairlineorrailroad.

● Debentures.Theseare,ineffect,unsecuredbonds.Asanissuingcompany,yousimplypromisetopayinterestonthedebentureandrepayitinthesamewayyouwouldabond,exceptthatyoudon’tpledgeanyassets.Becausethereisn’tanycollateral,investorsassumeagreaterriskandrequireahigherinterestratethantheywouldonasecuredbond.

Inanothervariation,yourcompanymaywanttoaddabitofincentivetoinvestorsbymakingyourbondsanddebenturesconvertible.Thismeansthepurchaserofyourconvertiblebondsordebentureshastheoptionofexchangingthemforaspecifiednumberofsharesofyourcommonstock.Theattractionhereisthatthepriceofyourstockmayincrease,soitpaystheinvestortoconverttostock.Ifthisoccurs,yourcompanynolongerhastopayinterestortheprincipal.

Yourcompanymayemployotherfactorsthatareattractivetotheprospectivebondholder,aswellasyourcompany.Forexample,thecompanymaydevelopasinking fund,whichmeans


thefirmsetsasidespecifiedamountstoprovideforthegradualretirement(repurchase)ofpartofthebondissue.Thisprovidesaddedprotectionforbondholdersbecausereducingtheamountofoutstandingbondslessenstheriskofadefault.

Acompanycanalsoincludeacall featureforgreaterfinancingflexibility.Thissimplymeansthatthecompanyreservestherighttobuybackthebondataspecifieddatebeforethebondfallsdue.Thecallpriceisgreaterthantheprincipalamountandgenerallydecreasesasthebondap-proachesitsmaturitydate.Companiescanexercisethecallfeature,forexample,whenmarketinterestratesdrop,allowingthefirmtorepaythebondholderandthenrefinanceatalowerin-terestrate.Althoughthecallfeatureisattractiveforthecompany,it’snotanadvantageforthebondholderbecauseheorsheisgivingupthehigherinterestpaymentsofthebond.Asapartialremedy,bondswithcallfeaturestypicallycarryahigherinterestrate.

RaisingEquityCapitalEquitycapitalenjoysonlyonesignificantadvantageoverborrowedcapital,butforsomethisadvantageoutweighsalltheotherdrawbacks:Equitycapitalispermanentcapital;itneednoteverberepaid.

However,wheneveryourcompanyacceptsthispermanentcapital,itwill,ineffect,alsobeacceptingapartnerwhowillshareinthefortunesofthefirmfromthereon.Therefore,beforemanagementdecidesthattheequitymarketisagoodidea,itshouldfirstanswerafundamentalquestion: Is thepermanentnatureof thenewcapital thatwillberaisedworththedilutionofcontrolthatmaygowithit?

Therearefourdistinctfinancingmethods.Managementcan(1)seekoutaventurecapitalist;(2)raisethemoneythroughprivateinvestors;(3)tryprivateplacementthroughaninstitutionorinvestmentbankers;or(4)planapublicoffering.Forthenonfinancialmanagerwhoisconsideringstartingabusinessofherown,thesecondsectionisparticularlyimportant:Privateinvestmentfundshavebeenthesourceofmoneyforhundredsofsuccessfulstart-ups.

How to Attract a Venture Capitalist

Thefirstwaytoraiseequitycapitalisthroughaventure capitalist,whoinvestsinnewcompanies.Thebestwaytoattractaventurecapitalististohavea“friendincourt.”Ifyouknowsomeonewhohashaddealingswithaventurecapitalist,hisintroductionwillhelp.Still,arecentsurveyindicatedthatwellover80percentofallventurecapitalfirmshavenoparticularpreferenceonhowtheyareapproached.

Holdingtheattentionofaventurecapitalistmightbeanothermatter,however.Venturecapi-talfirmsmaintainstrictinvestmentstandards.Theyrequirethesameinformationasabankerwould—andmore. Ifyouare interested in establishing sucha relationship,hereareways toimprovetheodds:

1. Growth.Bereadytodemonstratehowyoucanincreaseyourrevenuebyabout$15millionand/oryourprofitsby$1millionwithin thenext three tofiveyears.Otherwise,venturecapitalistsareunlikelytoshowmuchinterest.

2. Product line.Mostventurecapitalfirmsconcentrateonindustriesinwhichtheyhaveac-quiredacertainamountofexpertise,orthosethatpromiseunusualgrowth.Ifyoucanlocateaventurecapitalfirmthatknowsyourindustry,yourchanceswillsignificantlyimprove.

3. Your management team.Venture capitalists tend to avoida “one-man show,”nomatterhowexcitingtheprospectsmaybe.Firmsthatcandemonstratemanagementcapabilityina


numberofareas,suchasfinance,marketing,productionandadministration,generallyreceivepreferentialtreatment.

4. Long-term planning.It’sessentialthatyoudrawupasoundcorporateplanforatleastfiveyears,includingcash-flowandincomeassumptions,beforediscussionswithaventurecapital-istbegin.Givesomethoughttoeventualcorporategoals,suchaspublicownership,amergerorotherpossibilitiesthatwillenabletheventurecapitalisttowithdrawfromthefirminfivetosevenyears.

➤ Observation:Ifyourfirmdoesn’tmeetthestandardsdiscussedabove,youwillprobablybewastingyourtimetryingtocourtaventurecapitalist.Althoughfundinghasincreaseddra-maticallyinthepastseveralyears,venturecapitalistsstillacceptonlyabout5percentofthedealsofferedtothem.

Evaluating a Venture Capitalist

Youcanavoidanuncomfortable,time-wastingrelationshipwithaventurecapitalistbydoingalittleevaluatingonyourown.Aventurecapitalistmayaskforupto60percentofyourcompany,sotheassociationshouldhaveconcreterewardsforyou.Herearesomeguidelinestofollowinyourevaluation:● Checkouthowaventurecapitalist’sclientsfaredinthepast.● Determinewhethertheventurecapitalisthelpsherclientswithadditionalfinancingif it’s

necessary.Youwillprobablyneedadditionalfinancingforyourfirminthefutureifthefirstoneissuccessful.

● Agreeonwhatrole—activeparticipantorpassiveinvestor—theventurecapitalistwillplayinyourfirm.Youmightpreferthathemerelysitonthesidelinesafterthedealismade,oryoumightwantactiveinvolvementinmanagement.Whateveryourwishes,makesuretheycoincidewiththoseoftheventurecapitalist.

● Findoutwhatkindofreputationtheventurecapitalistenjoysinthebusinesscommunity.Youwillwanttoknowwhetherthereputationwillhelporhinderyouinattractingotherfinancingsources.

DealingWithanSBICSmallbusinessinvestmentcompanies(SBICs),aspecializedformofventurecapitalfirms,havebecomeanimportantsourceofcapital.SBICsarelicensedbythefederalgovernmenttofillafinanc-inggapforsmallbusiness.SBICscanborrowuptofourtimestheirprivatecapitalpositionfromtheU.S.governmentatfavorableborrowingrates.MostSBICsattempttocoveronlyoperatingexpensesonloans,withprofitscomingfromequityparticipation.Thus,theinterest-ratespreadisnarrow.Often,aborrowerfromanSBICpaysnomorethanone-fourthof1percentovertheSBIC’scostoffunds.Moreover,becauseanSBICdoescoveroperatingexpensesontheloanportionofitsportfolio,itcanaffordtoloweritssightsonexpectedreturnsfromequityparticipations.Forthisreason,thetermsofanequitydealwithanSBICareusuallymorefavorableforyouthanwouldbepossiblewithotherventurecapitalists.Hereareafewadditionaldetails:

Length of loan.Bylaw,thetermofallSBICloansmustbebetweenfiveand15years.Asapracticalmatter,however,fewSBICloansaremadeformorethan10years.MostSBICspreferloansthatmatureinaboutsevenyears.

Equity participation.Usually,anSBICmakesaconvertible loan,underwhichitreservestherighttoconverttheloantocommonstockatspecified,prenegotiatedtimes.Amountsofcommon


stockavailableforconversionandtheconversiontermswill,ofcourse,dependonthesizeoftheloanandtheinherentriskinyourcompany.Innocase,however,cantheSBICassumecontrolofacompany—it’sprohibitedbylawfromdoingso.Aswithventurecapitalcompanies,mostSBICswilloffermanagementassistance,shouldyouneedit.

Cashing in.Uponconversion,theSBICmightdisposeofthestockinanumberofways,in-cludingapublicoffering,aprivatesaleorpossiblyevensellingthestockbacktothecompany.Whateverthecase,youwillusuallyexplorethealternativesthoroughlyduringnegotiations.

➤ Observation:TogetstartedwithanSBICfinancing,youwillneedadetailedbusinessplan.Also,lookaroundforanSBICthathassomefamiliaritywithyourindustryanditsproblems.Finally,someSBICsprefertoconcentrateonlyonfast-growingcompanies,whileothersaresatis-fiedwithcompaniesgrowingatamoredeliberatepace.

VirtuallyallSBICsaremembersoftheSmallBusinessInvestorAlliance,formerlyknownastheNationalAssociationofSmallBusinessInvestmentCompanies.ThisorganizationcantellyouallyouwanttoknowaboutSBICs,includingthelocationofthosenearestyou.Formoreinforma-tion,visitwww.nasbic.org.

The Role of the Private Investor

Forsmall,closelyheldfirms,privateinvestorsarebyfartheirmostimportantsourceofequitycapital.Thisequitycantakeanumberofforms.Usually,equitycapitaldenotescommonstock,butmanyprivatefinancingdealsinvolvepreferredstock,debenturesorevenwarrantsthatareconvertibleintocommonstock.Thus,whileanownershipinterestisalmostalwaysinvolved,itneednotstartoutwithcommonstock.

Don’texpectaprivateinvestortoacceptapassiveroleinthefirm.Theyarealmostalwaysactiveinvestorslookingtocontributemorethancapital.Usually,aspartoftheinvestmentagree-ment,theyactasconsultantsorserveonyourboardofdirectors.Thus,inasearchforinvestors,managersshouldattempttoidentifythoseinvestorswithexperienceandskillsthatcancontributetothecompany’sprogress.

Asarule,investorsincloselyheldfirmsarewillingtoacceptagreaterdegreeofriskthaninvestorsinpubliccompanies.Inreturn,theyexpecttoreceivehigherrewards.Inasense,then,youarebuyingcapitalratherthansellingequity.Therewardsthatyouarewillingtograntto yourinvestorsare,ineffect,yourcostofcapital.Therefore,thehighertherisks,thegreaterthecapitalcosts.Obviously,therecanbenohard-and-fastrulesfordeterminingtheextentofthereturnsyoumustoffertoattractprivateinvestors,buttherearesomebroadguidelinesforestablishingpossibleranges.Forinstance,inastart-upsituation,investorsusuallyexpecttoearnabout10timestheirinvestmentinfiveyears,acompoundannualreturnof60percentperyear.

Privateinvestorsinfledglingfirmsusuallyexpecttoearnaboutsixtimestheirinvestmentinfiveyears,astill-highannualcompoundreturnof43percent.Arelativelyyoungfirmwouldhavetoofferprivateinvestorsthechancetoquadrupletheirmoneyinfiveyearstoattractcapital,andevenanestablishedfirmwouldneedtoofferthemtheopportunitytotripletheirmoneyinfiveyears.Thatworksouttocompoundannualreturnsof38percentand25percent,respectively.

➤ Observation:Expensiveastheyseem,expectationsforprivateinvestors,eveninhigh-risk,early-stagecompanies,aresignificantlylowerthanthoseforprofessionalventurecapitalfirms.Inpart,thisseemingdiscrepancystemsfromthe“not-for-profit-only”characteristicofmanyprivateinvestors.Inmostinstances,privateinvestorsbackcompaniespartlyfornoneconomicreasons,suchasachievingaworthwhilesocialbenefit,helpingafriendorfulfillingacommunityneed.

Privateinvestorstendtobemuchlessformalthantheirprofessionalcounterparts.Still,onaver-age,theyturndowntwooutofeverythreedealsofferedtothem.Youcanimproveyourchancesofmakingafavorableimpressiononprivateinvestorsbyfollowingtheseimportantguidelines:


● Be specific.Putyourproposalinwriting.Don’texpecttowingitsimplybecausethepotentialinvestorisanindividualorafriend,ratherthananinstitution.Mostprivateinvestorsrequireawell-definedbusinessplan.Evenwhereabusinessplanisnotnecessary,youshoulddrawupawell-thought-outfinancingproposal.

● Be realistic.Thisincludesanobjectiveappraisaloftheprospectsandproblemsfacingyourcompany,andtherisksandpotentialrewardsintheinvestmentitself.Anyattempttominimizerisksorproblemswillalmostcertainlycausetheinvestortobackoff.

● Discuss your management team.Inreviewingasmallcompany,nothingismoreimpressivetoapotentialinvestorthanadedicated,competentmanagementteam.Makesureyoudem-onstratethattopotentialinvestors.

Theprimaryreasonfortheincreasedriskincurredbyaprivateinvestoristhelackofliquidityintheinvestment.Inotherwords,itcanbedifficulttofindabuyerforthestockofacloselyheldfirm,particularlyforaminorityinterestinthatfirm.Therefore,youwillprobablyneedtoofferanexitformula.Usually,thisinvolvestherighttotenderthestocktothecompanyataspecifieddateandatapricerelatedtobookvalue,cashfloworearnings.Anothercommonexitformulasetsasideanagreed-onpercentageofearningstopurchaseasegmentofsecuritiesheldbytheinvestorataprearrangedprice.

➤ Observation:Whennegotiatinganexitformula,rememberthatprivateinvestorsnormallyhavemuchlongertimehorizonsthanthethreetofiveyearsfavoredbyventurecapitalists.Onerecentpolldisclosedthatnearly25percentofallprivateinvestorseitherhadnotimepreferenceorexpectedtoholdtheirinvestmentsformorethan10years.

Howdoyoufindasuitableprivateinvestor?Thiscanbeathornyproblem:Thereisn’texactlyareferralservicegearedtowardputtingpotentialprivateinvestorsintouchwithcompaniesseek-ingequitycapital.Tolocateprospectiveinvestors,youwillbeforcedtobuildyourownnetwork.

Yourmostfruitfulsourceofinformationwillprobablybeyourfriendsandbusinessassociates.Investmentbankersareanothercommonsource.Yourotherprofessionaladvisers, suchasac-countants,lawyersandbankers,maybehelpful.Finally,besuretoinvestigateanyventurecapitalclubsinyourarea,aswellasbusinessandcommunityassociations.(Note:Venturecapitalclubsaregroupsofindividualinvestors,andshouldnotbeconfusedwithventurecapitalfirms.)Commu-nityassociationscanbeparticularlyimportantbecauseprivateinvestorstendtoconcentrateoncompaniesintheirgeographicareassothattheycanmaintainclosecontactwiththeirinvestment.

Regulation D Private Placement

Smallandmidsizecompaniesareincreasinglyusingprivateplacementsasfund-raisingvehicles,thankstoa1982streamliningoftherulesknownasRegulationD.Inaprivateplacement,stocksorbondsaresolddirectlytoaninstitutionalinvestororasmallgroupofinstitutionalinvestors.

RegulationDisspecificallydirectedtowardopeningupthehugeprivateplacementmarket.Inseveralways,theregulationcanhelpasmallbusinessraisecapitalthroughaprivateplacement.First,RegulationDincreasestheamountofcapitalthatcanberaisedundervariouscategories.Underthesmallestclassification(Rule504),youcanraise$500,000in12monthsversus$100,000undertheformerrule.Amiddlecategory,dubbedRule505,allowsyoutoraise$5millionin12monthscomparedwithapreviouslimitof$2millioninsixmonths.Inaddition,thereisanun-limitedcategorydubbedRule506.

Second,paperworkhasbeencutdrastically.TherearenospecificdisclosurerequirementsunderRule504.Youneedtocomplyonlywithantifraudprovisions.Thisessentiallymeansthatyoumustgiveinvestorsanaccuratepictureofyourcompanywithnomaterialomissionsinyourofferingmemorandum.


Third,underRule504youcanchoosefromanunlimitednumberofinvestors.Previousregu-lationsplacedalimitof100investorsperoffering.

Finally,tostimulateactivity,RegulationDallowsbroker-dealerstochargeacommissionforhelpingarrangeprivateplacements.Evenwiththecommissionruling,expensesforRegulationDofferingsinthepasthaverunfrom1percentto5percent.That’swellbelowthe13percentcommonlyassociatedwithpublicstockofferings.

How much help will you need for private placements?Ifyou’reconsideringprivateplace-ment,talktoyourlawyerfirst.Hecanbringyouuptodateonyourstate’sfilingrequirements,whichmayormaynotbeasliberalastheSEC’srules.Ifyouhaveaccesstocapitalsourcesinyourarea,youcanprobablyarrangeyourprivateplacementwithoutengagingtheservicesofabroker-dealer.Byallindications,alargeportionofRule504offeringsarecompletedwithouttheservicesofabroker.Inmostcases,theofferingcompany’slawyeroraccountantactsasanintermediary.

Ifyou’reconsideringraisingfundsintheprivateplacementmarket,insurersareanexcel-lentsourceofcapital.Thesecompaniesareincreasinglyactiveinworkingwithsmallbusinesses.Regionalinsurerssometimesloanamountsaslowas$250,000.

Therearemanypotentialadvantagestoworkingwithinsurancecompanies:● Potential for lower rates. Insurersareinterestedprimarilyinlong-termarrangements.Almost

allspeakof“relationshipfinancing,”whichreferstorecurringdealsbetweenacompanyandtheinsurerovermanyyears,ratherthanaone-shotdeal.

Therefore,theyareinclinedtobelessconcernedwithshort-terminteresttrendsthanaremanybankers.Thismeansinsurancefirmswilloftengrantclientsmorefavorabletermsonshort-andmedium-termloansifthiswillhelpthemnaildownlong-termbusiness.● Flexibility.Insurancecompanieswillarrangestraightloans,equityfinancingorthehybrid

deals(debtplusequityfinancing)thathavebecomepopularrecently.Keepinmind,though,thatallinsurancecompaniesconducttheirowncreditchecks.Mostwillconsiderdealsonlyifthefinancesofthepotentialcustomerareregardedas“investmentgrade”(BBBorbetter)byaratingservice.Thismeansthatyourfinancesmustbeingoodshape.

➤ Observation:Ifthereisadisadvantagetoworkingwithaninsurancecompany,it’sfindingtherightfitbetweenyourcompany’sfinancingneedsandtheinsurancecompany’sinvestmentpolicy.Someinsurers,forexample,specializeincertainindustries.Somerequireanintroductionthroughanadviser,suchasaninvestmentbanker.Everyinsurancecompany’sinvestmentstrategyisuniquetosomedegree,soyoumayhavetodosomehunting.Yetthesearchcanbeworthwhile.Looktothemajorinsurancecompaniesforthistypeoffinancing,suchasNationwide,Prudential,AetnaLifeandCasualty,TransamericaandTravelers.

Raising Capital Through a Public Stock Offering

Apublicstockofferingisprobablythemostcomplicatedofthefourwaystoraiseequitycapital.UsingthismethodmeansgeneratingscadsofpaperworktosatisfySECrules.Withthatinmind,herearecapsuledescriptionsofthefourtypesofpublicstockregistrationopentoyourcompany:

S-1 offerings.ThisisthegeneralfilingregistrationrequiredbytheSECandisrarelysuitableforsmallercompanies.Itrequiresmaximumdisclosureforboththeofferingandlaterstatements.Thiscanbeextremelydemandingandcostly.

➤ Recommendation:S-1registrationsshouldbeusedonlybylargercompaniesthathavethefinancialresourcesandthestafftocompletetheformsinvolved.Thereasonisverysimple:S-1registrationscancostupwardsof$300,000,puttingthemoutofreachofmostsmallcompanies.


S-2 offerings.Inessence,thisisanS-1offeringdesignedforcompanieswithalimitedhistory:thatis,nosubstantialsalesandearningsforthepastfiveyears.Forsuchfirms,theSECrequirespublishingdetailedinformationontheuseoftheproceedsandissuingvoluminousreportsonthecredibilityandintegrityoftheprincipals.

S-18 offerings.TheS-18offeringisgearedtowardsmallbusinessesthatneedtoraisesubstantialamountsofmoney(upto$5million).ThekeyisthatS-18offeringsareprocessedbyregionalSECoffices,andthereisnoneedtofilewiththeSEC’sWashingtonheadquarters.Thiscutsdownthecostsignificantly.S-18scanbebroughttomarketfor$100,000orless.CriteriaforanS-18offeringinclude:(1)theofferingmustbeforcash;(2)thecompanymustbeincorporatedintheUnitedStatesorCanada;and(3)thefirmmaynotbeaninvestmentcompanyorlimitedpartnership.

Regulation A offerings.Thistypeisdesignedspecificallyforsmallcompaniesandisexemptfrommanyofthefilingrequirements.Toqualify,yourcompanycannothavemorethan$1millioninassetsor500shareholders.Nomorethan$1.5millioncanberaised.SometimesRegulationAofferingscanbebroughttomarketforaslittleas$50,000.

➤ Observation:Thefilingofaregistrationstatementforanewpubliccommonstockofferinginvolvesagreatdealofredtape,withthecostsbornebythecompany.Someoftheindividualcostsinvolvedareasfollows:thetimemanagersmustdevotetopreparingaprospectus;yourownlawyer’sandtheunderwriter’slawyer’sfees;printingcosts,includingtheprospectusandregistrationstatement;registrationcostsforeverystateinwhichthestockistobesold;accountingfees;SECfees;registrationandtransferfees;andfederalissueandtransfertaxes(ifany).

Addtotheseitemsthesellingcommission,andthetotalcostbecomessignificant.Arecentsurveyindicatesthatthecostoffloatingacommonstockissueamounted,onaverage,tonearly13percentoftheproceeds.Keepinmindthatthisisforanaverageoffering.Withouteconomiesofscale,costsforsmallerofferingsrunrelativelyhigher.

Other Methods of FinancingInadditiontothemoretraditionalwaysofraisingcapitalthroughbankloansorstockandbondofferings,thereareanumberoflesser-knownmethods,manyofwhicharesimplyvariationsofthetraditionalones.

A Look at Leasing

Bydefinition,youmaywonderhowleasingcouldbeincludedinadiscussiononsourcesoffi-nancing.Afterall,aleaseisanagreement(contract)conveyingtoabusiness(thelessee)therighttousespecifiedproperty,plantorequipmentownedbyanotherparty(thelessor)forastatedperiodoftime.

Althoughleasingmaynottechnicallybeasourceofcapital,itdoesmakeadditionalcapitalavailabletoacompanybypermittingthefirmtofinance100percentoftheacquisitioncostofanasset,whereasatypicalequipmentloanmayrequirea20percentto30percentdownpayment.Similarly,deliveryandinstallationcharges,certaintaxes, insurance, legalandclericalcostsofarrangingthelease,andmaintenanceexpensesareamongtheothercostelementsthatmaybeincorporatedintotherentalinstallmentsandthusfinancedovertheleaseterm.

EventhoughtheTaxReformActof1986increasedtheafter-taxcostofleasing,itisstilloneofthefewpotentialsourcesofno-money-down,fixed-ratefinancing.Itconservescashandon-the-bookborrowingcapacity(becauseleasesarenotrecordedasaliabilityonthebalancesheet),andittransferssomeoftherisksofequipmentobsolescencetothelessor.Companieswithheavydebtburdens—oftenfromleveragedbuyouts—areturningincreasinglytoleasingasawaytofinancenewequipment.


Althoughthetaxactmayhaveincreasedthecosts,therearetwokeyfactorsthatmanycom-paniesstillaren’tconsideringintheirbuy-versus-leasedecisionmaking:● The repeal of the investment tax creditandthelengtheningofdepreciationschedulesfor

someequipmenthaveincreasedthecostofbuyingmorethantheyhavethecostofleasinginmanycases.Leaseonacase-by-casebasis.

● The act established the alternative minimum tax (AMT),whichimposesa20percenttaxonmanycommontaxdeductionsdesignatedas“taxpreferenceitems.”Theideawastomakesurecompaniescouldn’thavesomanydeductionsthattheywouldenduppayingnotaxes.

Whatissignificantintheleasingarenaisthataccelerateddepreciation—abigreasoninthepastforbuyinganasset—isamongthosetaxpreferenceitems.However,ifyourcompanyissub-jecttoAMTanditleases,youcandeducttherentorleasepaymentsasexpensesforbothregulartaxandAMTpurposes.

Don’t Forget Development Corporations

WhataboutthoseLDCs,CDCsandBDOs?Ineachcase,theDinthemiddlestandsfor“develop-ment.”Originally,theseorganizationswereformedtoactasaclearinghouse,matchingacompanyinneedoffundswithapotentialinvestor.Somenowgoabitfurther,butcommunitydevelopmentremainstheirchiefaim.Here’sabrieflookateachone:

Local development corporations (LDCs).Usually, anLDC isaprivately sponsoredcom-munityagencythatbringstogetherbusinessesandsourcesofcapital.Generally,itisstaffedbyvolunteersandisanonprofitagency.SomeLDCsborrowfromtheSBAtorelendthemoneytoaqualifiedsmallbusiness.Insomestates,statefundingisavailable.

Community development corporations (CDCs).UnlikeLDCs,which function largelyonaninformalbasis,CDCsusuallyoperatewithapermanent,full-timestaff.Theyprovideventurecapitalorsecuredfinancingtoeligiblecompanieswillingtorelocatetotheirarea.MostCDCsarenonprofitandreceivefundingfromstateagenciesandprivatesources.

Business development organizations (BDOs).Thesewereconceivedasasortofpackagingcenterwhereabusiness(particularlyinaminorityneighborhood)couldbeputintouchwithlocalbanksorgovernmentofficials.Theyalsohelppreparebusinessplans,financialstatementsandloanapplications.

➤ Observation:Moststateshavesomesortofprogramdesignedtoattractandaidbusinesses,especiallysmallcompanies.Theseprogramsvarygreatlyfromstatetostate,andspaceprecludesdiscussionofthemall.YoucanobtainafreebookletdescribingthevariousstateprogramsbycontactingtheSBAofficenearestyou.


Glossary

Accounting equation:Assets=liabilities+stockholders’equity.Accounts payable:Moneythatacompanyowesitsvendorsandsuppliers.Accounts receivable:Moneythatcustomersoweacompany.Accrual accounting:Anaccountingmethodthatrecognizesrevenue/expensetransactionswhentheyoccur,notnecessarilywhencashisreceivedorpaidout.Amortization:Aprocessofwritingoffassetsoverafixedperiod.Assets:Resourcesthatacompanyowns.Audit:Alookatacompany’srecordsandfinancialstatementstoensuretheiraccuracy.

Balance:Thedollaramountofanaccountataspecificpointintime.Balance sheet:Astatementonafirm’sfinancialpositionataparticularpointintime;usestheingredientsoftheaccountingequation:assets,liabilitiesandequity.Bond:Adebtinstrumentsoldtoinvestorsandpromisingtoreturntheprincipalandpayastatedrateofinterestatspecifictimes.Book value:Thehistoricalcostofanasset,lessanyaccumulateddepreciation.Intermsofstock,bookvalueofacommonshareisthecompany’snetworthminusthevalueofpreferredstock,dividedbythenumberofcommonsharesoutstanding.Break-even:Thepointinabusinesswheresalesincomeorrevenueequalsexpenses.Budget:Acompany’swrittenplanoutliningitsspendinggoals.

Capital budget:Ananalysisoflong-termprojectsfortheirriskandprofitability.Capital expenditure:Apurchaseofamajorasset,oraninvestment.Cash:Bills,coinsanddemanddeposits,suchascheckingaccounts.Cash accounting:Anaccountingmethodinwhichatransactionisrecordedwhencashisactuallyreceivedorpaidout.Cash budget:Aplanforcashreceiptsandexpendituresduringagivenperiod.Cash flow:Thedifferencebetweencashreceiptsandcashdisbursements.Alsodefinedasnetincomeplusdepreciation.Collateral:Theassetsacompanyputsuporpledgesassecurityonaloan.Collateral trust bond:Abondinwhichtheissuerusesthestocksandbondsofothercompaniesascollateral.Commercial paper:Unsecuredpromissorynotesgenerallyfloatedby large companies tofillshort-termcashneeds.Common stock:Asecurityissuedbyacompanytoobtaincapital.Holdersofsuchsecuritiesarepartownersandmayormaynotreceivedividends.Convertible securities:Anytypeofbond,note,debentureorpreferredstockthatcanbeconvertedtocommonstock.Cost:Thevalueofsomethingthatwasgivenuptoacquireanitem.


Cost accounting:Theamassingofinformationforreportingthecostsincurredintheproductionofproductsorservices.Cost of capital:Therateofreturnacompanymustoffertoobtainborrowedorinvestedfunds.Cost of goods sold:Theamountspaidforthepurchasedmaterials,componentsandfinishedproducts;directpayroll;operatingoverhead;andothercostsofacquiringorproducingtheprod-uctsorservicessold.Cost per unit:Theaveragecostofproductionforaparticularvolumeofproduction.Credit (CR):Anaccountingentrythatincreasesaliabilityandrevenue;decreasesanassetandanexpense.Current assets:Allcashheld(primarilyinbankbalancesormoneymarketfunds);resourcesthatwillbeconvertedtocashinthenormalcourseofbusinesswithinonebusinessyear;plusotherresourcesthatcouldorwillbeconvertedwithinayear(marketablesecurities,etc.).Current liabilities:Outstandingtradedebtsandobligations(tradeaccountspayable,short-termnotespayable,currentinstallmentsdueonlong-termdebts,etc.)thatwillfalldueinthecourseofnormalbusinesswithinayear.Current ratio:Totalcurrentassets,dividedbytotalcurrentliabilitiesatthesamepointintime.Indicatestheliquidityofacompany.

Days sales outstanding (DSO):Thisrepresentstheaveragecollectionperiodforaccountsreceiv-able.It’scalculatedasreceivablesmultipliedby365,dividedbyannualcreditsales.Debenture: Anunsecuredbond,orabondforwhichacompanydoesn’tpledgeanyofitsassets.Debit (DR):Anaccountingentrythatincreasesanassetandexpense;decreasesaliabilityandrevenue.Debt/equity ratio:Totalcurrentandlong-termliabilitiesdividedbyaverageshareholders’equity.Deferred income taxes:Thatportionofacompany’scurrenttaxexpensethatwillbepaidatsomeunstatedtimeinthefuture.Depreciation:Theconversionofafixedassettoanexpenseoveraperiodofyears.Althoughchargedagainstincomefortaxcalculationpurposes,itinvolvesnoactualoutlayofcash.Discounted cash flow (DCF):Aprocesstodeterminewhatafuturecashflowisworthtoday.Usedincalculatingnetpresentvalueandinternalrateofreturn.Dividend:Moneyorstockperiodicallypaidtoshareholdersinreturnfortheirinvestmentinacompany.

Earnings per share:Earningsavailabletocommonshareholdersonaper-sharebasis.It’scalculatedasnetincomeminuspreferred-stockdividends,dividedbynumberofcommonsharesoutstanding.Equipment trust certificate:Adebt instrumentofferedto investorstofinancethepurchaseofequipment,suchasrailroadcarsorairplanes.Equity:Theamountofinvestmentthatownersorshareholdershaveinacompany.Alsocallednetworth.(Assets–Liabilities=Equity)Equity turnover:Netsalesdividedbyaverageshareholders’equityfortheperiod.

Factoring:Thesaleofacompany’sreceivablestoathirdparty,calledafactor,“withoutrecourse”(thatis,thefactoracceptsallbad-debtrisks).


Finished goods:Productsreadyforsale.Fiscal year:Theannualtimeperiodthatacompanypickstoreportonitsoperation.Thisisgener-allythecalendaryear.Fixed assets:Allproperty,plantsandequipment(buildings,realestate,machines,furniture,etc.)usedinabusiness.Fixed-asset turnover:Netsalesdividedbygrossplantandequipment(beforedepreciationde-duction)fortheperiod.Fixed costs:Thesearecompanycoststhatdon’tchangeassalesactivitymovesupordown.Es-sentially,they’reregardedasoverhead.

Goodwill:Amountpaidinexcessofthemarketvalueofacompany’sspecifictangibleassets.Gross profit:Thedifferencebetweennetsalesorrevenuesandthecostoftheproductsorservicessold.Gross sales/revenues:Theactualtotaldollarsbilledforgoodssoldorservicesprovided,beforereturns,discountsandallowancesgranted.

Historical cost:Theoriginalamountpaidtoacquireanasset.Hurdle rate:Theminimumacceptablerateofreturnonaninvestment.

Income statement:Thesummaryofacompany’srevenuesandexpensesforaparticularaccount-ingperiod,suchasamonth,quarteroryear.Indenture:Anagreementcontainingthetermsandconditionsofabondoffering.Intangible assets:Thoseresourcesofacompanythatdon’thavephysicalform.Internal rate of return (IRR):Amethodthatfindsthespecificpercentageofareturnbydiscount-ingcashflowsuntiltheyreachanetpresentvalueofzero.Inventory:Stocksofgoodsheldforuseinproduction,orforsaleorresalebyacompany.Investment banker:Acompanythatbuysafirm’ssecuritiesandresellsthemtothepublic.Theinvestmentbankerunderwritesabondorstockissue(thatis,absorbsthelossforanypartoftheissueitcannotreselltothepublic).Investment tax credit (ITC):Areductioninacompany’staxliabilityresultingfromtheacquisi-tionofcertainequipment.

Joint venture:Formationofapartnershiporcorporationtocarryoutaparticularproject.Journal:Arecordofacompany’sfinancialtransactionskeptinchronologicalsequence.

Ledger:Arecordofacompany’sfinancialtransactionsastheyaffecteachaccount.Leverage:Ameasureofacompany’sindebtedness.Ahighlyleveragedfirmisonethathasdonealargeamountofborrowingorcontainsagooddealofdebtinproportiontoitsequity.Liabilities:Thefinancialobligationsthatafirmhastooutsidecreditors.Line of credit: Themaximumnumberofdollarsacompanyorabankpermitsacustomerorfirmtooweatanyonetime.


Liquidity: Ameasureoftheamountofresourcesacompanyhasthatarecashorcanbeconvertedtocashintheneartermtopayitsbillsontime.Loan agreement: Awrittenstatementcontainingthetermsandconditionsofaloan.Long-term debt: Adebtthatisscheduledtomaturemorethanayearfromthepresenttime.

Marginal income: Theamountrealizedaftersubtractingthecostperunitfromthepriceperunit.Market price: Theamountofmoneyashareofstockisworthonastockexchange,theover-the-countermarketortoanindividualbuyer.Marketable securities: Securities,suchasstocksorbonds,thatcanbeeasilysold.Mortgage bond: Abondforwhichtheissuerpledgescertainfixedassets,suchasabuilding,ascollateral.

Net income (profit) after taxes: Thefinal“bottom-line”profitclearedbythebusinessfromallsources.Net operating profit: Grossprofit,lesssellingcostsandadministrativeoverhead.Net present value (NPV): Amethodofevaluatinganinvestmentbyconvertingfuturecashinflowsandoutflowstotheirpresentvaluethroughtheuseofpresentvaluetables.Nonoperating expenses: Interestpaidonlong-termdebts,lossesonsalesofcapitalassets,etc.Nonoperating income: Interestanddividendsreceivedoninvestments,gainsonthedispositionofcapitalassets,etc.

Operating budget:Abudgetthatincludesthesales,expenseandproductionbudgetsofacompany.Itprovidesalltheinformationnecessarytoproduceaproforma(projected)incomestatement.Operating margin: Thepercentagederivedwhenoperatingincomeisdividedbysales,givingyouaprofitabilityratio.Outstanding shares: Sharesissuedbyacompanyandownedbyshareholders.

Par value: Thenominalorfacevalueofstocksandbondsatthetimeofissuance.Partnership: Anunincorporatedbusinessownedbytwoormorepersonswhoarepersonallyresponsibleforallthebusiness’debts.Payback: Amethodthatestimatesthetimeitwilltaketoreceiveenoughcashfromaprojecttorecoverthecashinvestedinthatproject.Preferred stock: Ashareinacompanythatusuallycarriesafixeddividendandentitlesitsownertopaymentpriortothatofacommonshareholderintheeventofbankruptcy.Private placement: Thesaleofacompany’ssecurities toan institutional investororgroupofinstitutionalinvestors,ratherthanofferingthemtothepublic.Pro forma statement: Aprojectedorbudgetedfinancialstatement.Profit-and-loss (P&L) statement: See Income statement.Alsocalledearningsreport.Profit margin: Thepercentagederivedwhennetincomeisdividedbynetsales.Alsocalledreturnonsales(ROS).Proprietorship: Theunincorporatedbusinessofasingleowner.


Raw materials: Purchasedcomponentsthatgointomakingaproduct.Receivables turnover: Creditsalesdividedbyaverageaccountsreceivableforaperiod.Retained earnings: Theprofitsafirmearnedduringitsexistencethathavenotbeendistributedtothestockholdersasdividends,butkeptinthefirm.Return on assets (ROA): Netoperatingprofitfortheperioddividedbyaveragetotaltangibleassetsfortheperiod.Return on equity (ROE): Netprofitfortheperiod,dividedbyaverageshareholders’equityfortheperiod.Return on investment (ROI): Ageneraltermtodescribeagroupofratios(ROA,ROE,ROS)thatmeasureacompany’sprofitability.Return on sales (ROS): See Profit margin.

Shareholders’ (stockholders’) equity: Theparvalueofthecorporation’scommonandpreferredstock,plusanypaid-inoraccumulatedcapitalsurplusovertheparvalue,plusanyearnedsurplusorearningsretainedforuseinbusiness.(Equity=Assets–Liabilities)Sinking fund: Moneysetasidebyacompanytorepurchasepartofabondissue.Small business investment companies (SBICs): Specializedventurecapitalfirmslicensedandpartlyfinancedbythefederalgovernmenttofillafinancinggapforsmallfirms.Statement of cash flows: Thepresentationofacompany’scashreceiptsandpaymentsoveraperiodoftime.

Tangible assets: Thoseresourcesofacompanythathavephysicalform,suchasabuildingorplant.Treasury stock: Sharesacompanyownsthroughtherepurchaseofthestockfromshareholders.Trial balance: Acomparisonofthetotalsofdebitcolumnsforallaccountswiththecreditcolumnsforallaccounts.Theyshouldbalance.

Variable costs: Coststhatdirectlydependonsalesactivity.Variance: Thedifferencebetweenexpectedorbudgetedresultsandactualresults.Venture capital: Fundsthatapersonorcompanywillingtotakeariskinvestsinasmallbusiness.

Work-in-process: Goodsonwhichproductionhasbegun,butwhichhavenotyetbeenfinished.Working capital: Currentassetslesscurrentliabilities.

Zero-base budgeting (ZBB): Abudgetingprocessinwhichdepartmentheadsormanagersmustjustifyallexpenseplansandrankthembasedontheiroverallcontributiontothecompany.

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