scarb eesbm6e ppt_11

Copyright © 2011 Pearson Education, Inc. Publishing as Prentice Hall

Creating a Successful Creating a Successful

Financial PlanFinancial Plan

Creating a Successful Creating a Successful

Financial PlanFinancial Plan

CHAPTER CHAPTER 1111

Copyright © 2011 Pearson Education, Inc. Publishing as Prentice Hall 11 - 2Ch, 11: Creating a Successful Financial Plan

The Importance of a The Importance of a Financial PlanFinancial Plan

Common mistake among business owners: Common mistake among business owners: Failing to collect and analyze basic financial Failing to collect and analyze basic financial data.data.

Many entrepreneurs run their companies Many entrepreneurs run their companies without any kind of financial plan.without any kind of financial plan.

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

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

Copyright © 2011 Pearson Education, Inc. Publishing as Prentice HallCh, 11: Creating a Successful Financial Plan

Basic Financial StatementsBasic Financial Statements Balance Sheet – “Snapshot.” Balance Sheet – “Snapshot.”

Estimates the firm’s worth on a given date; Estimates the firm’s worth on a given date; built on the accounting equation: built on the accounting equation:

Assets = Liabilities + Owner’s EquityAssets = Liabilities + Owner’s Equity Income Statement – “Moving picture.” Income Statement – “Moving picture.”

Compares the firm’s expenses against its Compares the firm’s expenses against its revenue over a period of time to show its net revenue over a period of time to show its net income (or loss):income (or loss): Net Income = Sales Revenue - ExpensesNet Income = Sales Revenue - Expenses

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

11 - 3


Creating Projected Creating Projected Financial StatementsFinancial Statements

Helps the entrepreneur transform business Helps the entrepreneur transform business goals into realitygoals into reality

Challenging for a business start-upChallenging for a business start-up Start-ups should focus on creating Start-ups should focus on creating

projections for two yearsprojections for two years Projected financial statements:Projected financial statements:

Income statementsIncome statements Balance sheetBalance sheet

11 - 4


Ratio AnalysisRatio Analysis

““How is my company doing?”How is my company doing?” A method of expressing the A method of expressing the

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

Important barometers of a company’s Important barometers of a company’s health.health.

Studies indicate few small business Studies indicate few small business owners compute financial owners compute financial ratios and use them to ratios and use them to manage their businesses. manage their businesses.

11 - 5


Twelve Key RatiosTwelve Key Ratios

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

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

Current Ratio = Current Ratio = Current Assets Current Assets = = $686,985$686,985 = = 1.87:11.87:1

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

11 - 6



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

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

Quick Ratio = Quick Ratio = Quick Assets Quick Assets = = 686,985 – 455,455 686,985 – 455,455 = .63:1 = .63:1

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

11 - 7



Leverage RatiosLeverage Ratios Measure the financing provided by the Measure the financing provided by the

firm's owners against that supplied by its firm's owners against that supplied by its creditorscreditors

A gauge of the depth of the company's A gauge of the depth of the company's debt.debt.

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

11 - 8


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

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

Debt Ratio = Debt Ratio = Total Debt Total Debt = = $367,850 + $367,850 + 212,150212,150 = .68:1 = .68:1

Total Assets $847,655 Total Assets $847,655

11 - 9


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

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

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

11 - 10


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

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

Times Interest = Times Interest = EBIT* EBIT* = = $60,629 + $60,629 + 39,85039,850 = = Earned Earned Total Interest Expense $39,850 Total Interest Expense $39,850

= = $100,479$100,479 = 2.52:1= 2.52:1 $39,850$39,850

**Earnings Before Interest and TaxesEarnings Before Interest and Taxes

11 - 11


Low High

Degree of Leverage

Optimal Zone

Ben

efit

s o

f L

ever

age

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

FIGURE 11.6

11 - 12

Copyright © 2011 Pearson Education, Inc. Publishing as Prentice Hall 11- 13Ch, 11: Creating a Successful Financial Plan

Table 11.1 How Lenders View Liquidity and Leverage

Liquidity Leverage

Low

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

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

Average

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

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

High

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

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

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

11- 13


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

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

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

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

11 - 14



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

Two Steps:Two Steps:

Receivables Turnover = Receivables Turnover = Credit Sales Credit Sales = = $1,309,589 $1,309,589 = = 7.31 times Ratio7.31 times Ratio Accounts Receivable Accounts Receivable $179,225 a year$179,225 a year

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

11 - 15



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

Two Steps:Two Steps:

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

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

11 - 16



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

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

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

11 - 17



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

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

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

11 - 18



Profitability Ratios - Measure how efficiently a Profitability Ratios - Measure how efficiently a

firm is operating; offer information about a firm is operating; offer information about a firm’s “bottom line.”firm’s “bottom line.”

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

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

11 - 19


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

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

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

* Also called Net Worth* Also called Net Worth

11 - 20


Interpreting RatiosInterpreting Ratios

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

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

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

restaurant.restaurant. Load factor (percentage of seats filled with Load factor (percentage of seats filled with

passengers) at an airline. passengers) at an airline.

11 - 21

Copyright © 2011 Pearson Education, Inc. Publishing as Prentice HallCh. 6: Franchising and the Entrepreneur

FIGURE 11.7 Trend Analysis of Ratios

11 - 22


Putting Your Ratios to the TestPutting Your Ratios to the TestWhen comparing your company’s ratios to your industry’s standards, ask the following questions:

1. Is there a significant difference in my company’s ratio and the industry average?

2. If so, is this a meaningful difference?

3. Is the difference good or bad?

4. What are the possible causes of this difference? What is the most likely cause?

5. Does this cause require that I take action?

6. If so, what action should I take to correct the problem? Source: Adapted from George M. Dawson, “Divided We Stand,” Business Start-Ups, May 2000, p. 34.

11 - 23



Sam’s Appliance ShopSam’s Appliance Shop

Current ratio = 1.87:1Current ratio = 1.87:1

Industry MedianIndustry Median

Current ratio = 1.50:1Current ratio = 1.50:1

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

11 - 24




Quick ratio = 0.63:1Quick ratio = 0.63:1


Quick ratio = 0.50:1Quick ratio = 0.50:1

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

11 - 25




Debt ratio = 0.68:1Debt ratio = 0.68:1


Debt ratio = 0.64:1Debt ratio = 0.64:1

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

11 - 26




Debt to net worth Debt to net worth ratio = 2.20:1ratio = 2.20:1

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

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

11 - 27




Times interest earned Times interest earned ratio = 2.52:1ratio = 2.52:1


Times interest Times interest earned ratio = 2.0:1earned ratio = 2.0:1

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

11 - 28



Sam’s Appliance ShopSam’s Appliance ShopAverage inventory Average inventory turnover ratio = 2.05 turnover ratio = 2.05 times per yeartimes per year

Industry MedianIndustry MedianAverage inventory Average inventory turnover ratio = 4.0 turnover ratio = 4.0 times per yeartimes per year

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

11 - 29




Average collection Average collection period ratio = 50.0 daysperiod ratio = 50.0 days


Average collection Average collection period ratio = 19.3 daysperiod ratio = 19.3 days

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

11 - 30




Average payable period Average payable period ratio = 59.3 daysratio = 59.3 days


Average payable Average payable period ratio = 43 daysperiod ratio = 43 days

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

11 - 31




Net sales to total Net sales to total assets ratio = 2.21:1assets ratio = 2.21:1


Net Sales to total Net Sales to total assets ratio = 2.7:1assets ratio = 2.7:1

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

11 - 32




Net profit on sales Net profit on sales ratio = 3.24%ratio = 3.24%


Net profit on sale Net profit on sale ratio = 7.6%ratio = 7.6%

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

11 - 33




Net profit to assetsNet profit to assetsratio = 7.15%ratio = 7.15%


Net Sales to working Net Sales to working capital ratio = 5.5%capital ratio = 5.5%

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

11 - 34




Net profit on equity Net profit on equity ratio = 22.65%ratio = 22.65%


Net profit on equity Net profit on equity ratio = 12.6%ratio = 12.6%

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

11 - 35


Breakeven AnalysisBreakeven Analysis Breakeven point - the level of operation Breakeven point - the level of operation

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

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

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

11 - 36


Calculating the Breakeven PointCalculating the Breakeven Point

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

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

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

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

Step 4.Step 4. Compute the breakeven Compute the breakeven point:point:

Breakeven Point Breakeven Point ($)($)

= = Total Fixed Costs Total Fixed Costs Contribution MarginContribution Margin

11 - 37


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

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

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

Step 3.Step 3. Contribution margin: Contribution margin:

Contribution Margin = Contribution Margin = 1 - 1 - $705,125$705,125$950,000$950,000

StepStep 4. 4. Breakeven Point: Breakeven Point:

Breakeven PointBreakeven Point$$

= = $177,375$177,375

.26.26

= .26= .26

= $682,212= $682,212

11 - 38


ConclusionConclusion

Preparing a financial plan is a critical Preparing a financial plan is a critical step step

Entrepreneurs can gain valuable Entrepreneurs can gain valuable insight through: insight through: Pro forma statements Pro forma statements Ratio analysisRatio analysis Breakeven analysisBreakeven analysis

11 - 40


All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of

the publisher. Printed in the United States of America.

11 - 41

scarb eesbm6e ppt_11

Small Business & Entrepreneurship

pearson education

publishing ch

prentice hall11

kind of financial plan

debt ratio

financial planning

total debt

companys debt