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Abdm4223 lecture week 9 290612
ABDM4233 ENTREPRENEURSHIP Financial Feasibility, Financial Planning,& Cashflow Management by Stephen Ong Principal Lecturer (Specialist) Visiting Professor, Shenzhen
Who are the Best?1. The way the world tells its story.2. Whatever it takes.3. United for a more equitable world.4. Harnessing the past. Enriching the future.5. From harm to home.6. Pioneering solutions, lifesaving results.7. Defending dignity. Fighting poverty.8. Our doctors go to places photographers don’t.9. It’s about saving lives.10. Changes the way information flows in the world.11. No good food should go to waste.
The 6 Ps of Marketing for New Ventures Product PricePromotion Place (or Marketing Mix distribution channel) Philantrophy People (or Customer (Do GOOD) Service) 11-4
Elements of a Feasibility Analysis Industry and Product or Service Market Feasibility Feasibility Financial Feasibility
The 360° CUBE Pitch Six Posters in a 6 minute Investor Pitch SOCIAL MARKETINGPROBLEM & SALESVISION & OPERATIONS TEAMMISSION & KEY PARTNERSBUSINESS FINANCIAL MODEL MILESTONES
360° Business CUBE1. The Problem : How BIG is the problem?2. The Solution : Our Social Enterprise’s Vision & Mission3. The Business Model : Getting the JOB done for the Customer Segments4. Marketing & Sales (and Fundraising)5. The Team & Key Partners6. The Financial Plan : Goals and objectives, with a timeline (Milestones)
Assessing a NewVenture’s Financial Strength and Viability
Financial Management 1 of 2 Financial Management Financial management deals with two things: raising money and managing a company’s finances in a way that achieves the highest rate of return Chapter 10 focuses on raising money. This chapter focuses primarily on: How a new venture tracks its financial progress through preparing, analyzing, and maintaining past financial statements. How a new venture forecasts future income and expenses by preparing pro forma (or projected) financial statements. 8-9
Financial Management 2 of 2 The financial management of a firm deals with such questions on an ongoing basis:• How are we doing? Are we making or losing money?• How much cash do we have on hand?• Do we have enough cash to meet our short-term obligations?• How efficiently are we utilizing our assets?• How do our growth and net profits compare to those of our industrypeers?• Where will the funds we need for capital improvements come from?• Arethere ways we can partner with other firms to share risk andreduce the amount of cash we need?• Overall, are we in good shape financially? 8-10
Financial Objectives of a Firm 2 of 3 Profitability Is the ability to earn a profit. Many start-ups are not profitable during their first 1 to 3 years while they are training employees and building their brands. However, a firm must become profitable to remain viable and provide a return to its owners. Liquidity Is a company’s ability to meet its short-term financial obligations. Even if a firm is profitable, it is often a challenge to keep enough money in the bank to meet its routine obligations in a timely manner.
Financial Objectives of a Firm 3 of 3 Efficiency Is how productively a firm utilizes its assets relative to its revenue and its profits. Air Asia, for example, uses its assets very productively. Its turnaround time, or the time its airplanes sit on the ground while they are being unloaded and reloaded, is the lowest in the airline industry. Stability Is the strength and vigor of the firm’s overall financial posture. For a firm to be stable, it must not only earn a profit and remain liquid but also keep its debt in check.
The Process of Financial Management 1 of 4 Importance of Financial Statements To assess whether its financial objectives are being met, firms rely heavily on analysis of financial statements. A financial statement is a written report that quantitatively describes a firm’s financial health. The income statement, the balance sheet, and the statement of cash flows are the financial statements entrepreneurs use most commonly. Forecasts Are an estimate of a firm’s future income and expenses, based on past performance, its current circumstances, and its future plans.
The Process of Financial Management 2 of 4 Forecasts (continued) New ventures typically base their forecasts on an estimate of sales and then on industry averages or the experiences of similar start-ups regarding the cost of goods sold and other expenses. Budgets Are itemized forecasts of a company’s income, expenses, and capital needs and are also an important tool for financial planning and control.
The Process of Financial Management 3 of 4 Financial Ratios Depict relationships between items on a firm’s financial statements. An analysis of its financial ratios helps a firm determine whether it is meeting its financial objectives and how it stacks up against industry peers. Importance of Financial Management Many experienced entrepreneurs stress the importance of keeping on top of the financial management of the firm.
Financial Statements Historical Financial Statements Reflect past performance and are usually prepared on a quarterly and annual basis. Publicly traded firms are required by the SEC to prepare financial statements and make them available to the public. Pro Forma Financial Statements Are projections for future periods based on forecasts and are typically completed for two to three years in the future. Pro forma financial statements are strictly planning tools and are not required by the SEC.
Importance of Keeping Good Records The first step toward prudent financial management is keeping good records.
Example : New Venture Fitness Drinks New Venture Fitness Drinks To illustrate how financial statements are prepared, we used New Venture Fitness Drinks, a fictitious sports drink company. New Venture Fitness Drinks has been in business for five years. Targeting sports enthusiasts, the company sells a line of nutritional fitness drinks. The company’s strategy is to place small restaurants, similar to smoothie restaurants, near large outdoor sports complexes. The company is profitable and is growing at a rate of 25% per year.
Historical Financial Statements Three types of historical financial statements Financial Statement Purpose Reflects the results of the operations of a firm over a Income specified period of time. It records all the revenues and expenses for the given period and shows whether the firm Statement is making a profit or is experiencing a loss.Balance Sheet Is a snapshot of a company’s assets, liabilities, and owner’s equity at a specific point in time. Summarizes the changes in a firm’s cash position forStatement of a specified period of time and details why the changes occurred.Cash Flows
Ratio Analysis Ratio Analysis The most practical way to interpret or make sense of a firm’s historical financial statements is through ratio analysis, as shown in the next slide. Comparing a Firm’s Financial Results to Industry Norms Comparing a firm’s financial results to industry norms helps a firm determine how it stacks up against its competitors and if there are any financial “red flags” requiring attention.
Forecasts 1 of 4 Forecasts The analysis of a firm’s historical financial statements are followed by the preparation of forecasts. Forecasts are predictions of a firm’s future sales, expenses, income, and capital expenditures. A firm’s forecasts provide the basis for its pro forma financial statements. A well-developed set of pro forma financial statements helps a firm create accurate budgets, build financial plans, and manage its finances in a proactive rather than a reactive manner.
Forecasts 2 of 4 Sales Forecast A sales forecast is a projection of a firm’s sales for a specified period (such as a year). It is the first forecast developed and is the basis for most of the other forecasts. A sales forecast for a new firm is based on a good-faith estimate of sales and on industry averages or the experiences of similar start-ups. A sales forecast for an existing firm is based on (1) its record of past sales, (2) its current production capacity and product demand, and (3) any factors that will affect its future product capacity and product demand. 8-29
Forecasts 3 of 4Historical and Forecasted Annual Sales for New Venture Fitness Drinks 8-30
Forecasts 4 of 4 Forecast of Costs of Sales and Other Items Once a firm has completed its sales forecast, it must forecast its cost of sales (or cost of goods sold) and the other items on its income statement. The most common way to do this is to use the percentage-of-sales method, which is a method for expressing each expense item as a percentage of sales. If a firm determines that it can use the percent-of-sales method and it follows the procedures described in the textbook, then the net result is that each expense item on its income statement will grow at the same rate as sales (with the exception of items that can be individually forecast, such as depreciation). 8-31
Pro Forma Financial Statements Pro Forma Financial Statements A firm’s pro forma financial statements are similar to its historical financial statements except that they look forward rather than track the past. The preparation of pro form financial statements helps a firm rethink its strategies and make adjustments if necessary. The preparation of pro forma financials is also necessary if a firm is seeking funding or financing. 8-32
Types of Pro Forma Financial StatementsFinancial Statement Purpose Pro Forma Income Shows the projected results of the operations of a Statement firm over a specific period. Shows a projected snapshot of a company’sPro Forma Balance assets, liabilities, and owner’s equity at a specific Sheet point in time.Pro Forma Statement Shows the projected flow of cash into and out of a of Cash flows company for a specific period. 8-33
Pro Forma Balance Sheets 2 of 2 Liabilities and Shareholders’ Equity 8-36
Pro Forma Statement of Cash Flows 1 of 2 Operating Activities 8-37
Pro Forma Statement of Cash Flows 2 of 2 Investing Activities and Financing Activities 8-38
Ratio Analysis Ratio Analysis The same financial ratios used to evaluate a firm’s historical financial statements should be used to evaluate the pro forma financial statements. This work is completed so the firm can get a sense of how its projected financial performance compares to its past performance and how its projected activities will affect its cash position and its overall financial soundness. 8-39
Ratio Analysis Based on Historical and Pro-Forma Financial Statements 8-40
The Importance of Cash“Everything is about cash – raising it,conserving it, collecting it.” Guy KawasakiCommon cause of business failure: Cash crisis!
Cash Management A business can be earning a profit and be forced to close because it runs out of cash! American Express OPEN Small Business Monitor study: 59% of small business owners experience problems with cash flow. Their biggest cash flow concern is the ability to pay bills on time.
FIGURE 12.1 Small Business Owners’ Strategies for Improving Cash Flow Source: American Express OPEN Small Business Monitor, 2008.
Cash Management Cash management – forecasting, collecting, disbursing, investing, and planning for the cash a company needs to operate smoothly. Young and growing companies are “cash sponges.” Know your company’s cash flow cycle.
The Cash Flow Cycle Deliver Goods Order Receive Pay Sell Send Customer Goods Goods Invoice Goods* Invoice Pays** Day 1 15 40 218 221 230 280 14 25 178 3 9 50 Cash Flow Cycle = 240 days*Based on Average Inventory Turnover: **Based on Average Collection Period: 365 days = 178 days 365 days = 50 days 2.05 times/year 7.31 times/year FIGURE 12.2
Five Cash ManagementRoles of an Entrepreneur1. Cash Finder2. Cash Planner3. Cash Distributor4. Cash Collector5. Cash Conserver
Cash and Profits Cash ≠ profits. Profit is the difference between a company’s total revenue and total expenses. Cash is the money that is free and readily available to use. Cash flow measure a company’s liquidity and its ability to pay it bills.
The Cash Budget A “cash map” that shows the amount and the timing of a firms cash receipts and cash disbursements over time. Predicts the amount of cash a company will need to operate smoothly. Helps to visualize a company’s cash receipts and cash disbursements and the resulting cash balance.
Preparing a Cash Budget1. Determine a Minimum Cash Balance Not too much... Not too little... But a cash balance thats just right ... for you!
Preparing a Cash Budget (continued)1. Determine a Minimum Cash Balance2. Forecast Sales
Forecast Sales The heart of the cash budget. Sales are ultimately transformed into cash receipts and cash disbursements. Cash forecast is only as accurate as the sales forecast from which it is derived.
Forecast Sales (continued)“Lumpy” or seasonal sales patternsare common. 15% to 18% of wine and spirits shops’ annual sales occur between December 15 and 31. 40% of toy sales take place in last 6 weeks of the year.
Forecast SalesPrepare three sales forecasts: Pessimistic Optimistic Most Likely
Sales Forecast for a Start-UpExample:Number of cars in trading zone 84,000 x Percent of imports x 24% = Number of imported cars in trading zone 20,160Number of imports in trading zone 20,160 x Average expenditure on repairs x $485 = Total import repair sales potential $9,777,600Total import repair sales potential $9,777,600 x Estimated market share x 9.9% = Sales estimate $967,982
Preparing a Cash Budget (continued)1. Determine a Minimum Cash Balance2. Forecast Sales3. Forecast Cash Receipts
Forecast Cash Receipts Record all cash receipts when the cash is actually received (i.e. the cash method of accounting). Determine the collection pattern for credit sales; then add cash sales. Monitor closely: Slow and non-payers.
Collecting Delinquent Accounts 1 93.80% 2 85.20% 3 73.60% 6 57.80% 9 42.80% D u q n e t i l 12 23.60%mMNhnobusertf 24 13.60% 0.0% 20.0% 40.0% 60.0% 80.0% 100.0% Probability of Collection
Preparing a Cash Budget (continued)1. Determine a Minimum Cash Balance2. Forecast Sales3. Forecast Cash Receipts4. Forecast Cash Disbursements
Forecast Cash Disbursements Record disbursements when you expect to make them. Start with those disbursements that are fixed amounts due on certain dates. Review the business checkbook to ensure accurate estimates. Add a cushion to the estimate to account for “Murphy’s Law.” Don’t know where to begin? Try making a daily list of the items that generate cash and those that consume it.
Estimate End-of-Month Balance Take Beginning Cash Balance ... Add Cash Receipts ... Subtract Cash Disbursements Result is Cash Surplus or Cash Shortage (Repay or Borrow?)
Benefits of Cash Management Increase amount and speed of cash flowing into the company Reduce the amount and speed of cash flowing out Make the most efficient use of available cash Take advantage of money-saving opportunities such as cash discounts Finance seasonal business needs
Benefits of Cash Management (continued) Develop a sound borrowing and repayment program Impress lenders and investors Provide funds for expansion Plan for investing surplus cash
The “Big Three” of Cash Management1. Accounts Receivable2. Accounts Payable3. Inventory
Accounts Receivable About 90% of industrial and wholesale sales are on credit, and 40% of retail sales are on account. Survey of small companies across a variety of industries found that 77% extend credit to their customers. Remember: “A sale is not a sale until you collect the money.” Accounts receivable goal: Collect your company’s cash as fast as you can.
FIGURE 12.5 Cash Flow Concerns Source: Based on American Express Corporation, 2005.
Beating the Cash Crisis Accounts Receivable Establish a firm credit-granting policy. Screen credit customers carefully. Develop a system of collecting accounts. Send invoices promptly. When an account becomes overdue, take action immediately. Add finance charges to overdue accounts (check the law first!).
Accelerating Accounts Receivable Ensure that invoices are accurate and timely. Include a description of the goods or services purchased. Ensure that invoices match purchase orders or contracts. Highlight the balance dues and due date. Include contact information in case customers have questions.
Beating the Cash Crisis Accounts Payable Stretch out payment times as long as possible without damaging your credit rating. Verify all invoices before paying them. Take advantage of cash discounts.
The Cost of Foregoing a Cash Discount $1,000 invoice 2/10, net 30 $20Amount $980 $1,000 Day 0 10 30 20 days I $20 R = = = 37.25% PxT $980 x 20/365 FIGURE 12.6
Beating the Cash Crisis Accounts Payable Negotiate the best possible terms with your suppliers. Be honest with creditors; avoid the “the check is in the mail” syndrome. Schedule controllable cash disbursements to come due at different times. Use credit cards wisely.
Beating the Cash Crisis Inventory Monitor it closely; inventory can drain a company’s cash. Avoid inventory “overbuying.” It ties up valuable cash at a zero rate of return. Arrange for inventory deliveries at the latest possible date. Negotiate quantity discounts with suppliers when possible.
Avoiding the Cash Crunch Consider bartering, exchanging goods and services for other goods and services, to conserve cash. Trim overhead costs: Ask for discounts and “freebies” Periodically evaluate expenses Lease rather than buy Avoid nonessential cash outlays Negotiate fixed loan payments to coincide with your company’s cash flow
Avoiding the Cash Crunch (continued) Trim overhead costs: Buy used equipment Hire part-time employees and freelancers Outsource nonessential activities Control employee advances and loans Establish an internal security and control system Develop a system to battle check fraud Change shipping terms
Avoiding the Cash Crunch (continued) Start selling gift cards Switch to zero-based budgeting Be on the lookout for employee theft Keep your business plan current Invest surplus cash
Conclusion“Cash is King” Cash and profits are not the same. Entrepreneurial success means operating a company “lean and mean.” Trim wasteful expenditures. Invest surplus funds. Plan and manage cash flow.
The Importance of a Financial Plan Common mistake among business owners: Failing to collect and analyze basic financial data. Many entrepreneurs run their companies without any kind of financial plan. Only 11% of business owners analyze their companies’ financial statements as part of the managerial planning process. Financial planning is essential to running a successful business and is not that difficult!
Basic Financial Statements Balance Sheet – “Snapshot.” Estimates the firm’s worth on a given date; built on the accounting equation: Assets = Liabilities + Owner’s Equity Income Statement – “Moving picture.” Compares the firm’s expenses against its revenue over a period of time to show its net income (or loss): Net Income = Sales Revenue - Expenses Statement of Cash Flows – Shows the change in the firms working capital over a period of time by listing the sources and uses of funds.
Creating Projected Financial Statements Helps the entrepreneur transform business goals into reality Challenging for a business start-up Start-ups should focus on creating projections for two years Projected financial statements: Income statements Balance sheet
Ratio Analysis “How is my company doing?” A method of expressing the relationships between any two elements on financial statements. Important barometers of a company’s health. Studies indicate few small business owners compute financial ratios and use them to manage their businesses.
Twelve Key Ratios Liquidity Ratios - Tell whether or not a small business will be able to meet its maturing obligations as they come due.1. Current Ratio - Measures solvency by showing the firms ability to pay current liabilities out of current assets. Current Ratio = Current Assets = $686,985 = 1.87:1 Current Liabilities $367,850
Twelve Key Ratios Liquidity Ratios - Tell whether or not a small business will be able to meet its maturing obligations as they come due.2. Quick Ratio - Shows the extent to which a firm’s most liquid assets cover its current liabilities.Quick Ratio = Quick Assets = 686,985 – 455,455 = .63:1 Current Liabilities $367,850
Twelve Key Ratios Leverage Ratios Measure the financing provided by the firms owners against that supplied by its creditors A gauge of the depth of the companys debt. Careful! Debt is a powerful tool, but, like dynamite, you must handle it carefully!
Twelve Key Ratios Leverage Ratios - Measure the financing provided by a firm’s owners against that supplied by its creditors; it is a gauge of the depth of the company’s debt.2. Debt Ratio - Measures the percentage of total assets financed by creditors rather than owners. Debt Ratio = Total Debt = $367,850 + 212,150 = .68:1 Total Assets $847,655
Twelve Key Ratios Leverage Ratios - Measure the financing provided by a firm’s owners against that supplied by its creditors; it is a gauge of the depth of the company’s debt.4. Debt to Net Worth Ratio - Compares what a business “owes” to “what it is worth.” Debt to Net = Total Debt = $580,000 = 2.20:1 Worth Ratio Tangible Net Worth $264,155
Twelve Key Ratios Leverage Ratios - Measure the financing provided by a firm’s owners against that supplied by its creditors; it is a gauge of the depth of the company’s debt.5. Times Interest Earned - Measures the firms ability to make the interest payments on its debt.Times Interest = EBIT* = $60,629 + 39,850 = Earned Total Interest Expense $39,850 = $100,479 = 2.52:1 $39,850 *Earnings Before Interest and Taxes
The Right Amount of Debt is a Balancing Act Optimal ZoneBenefits of Leverage Degree of Leverage Low FIGURE 11.6 High
Table 11.1 How Lenders View Liquidity and Leverage Liquidity Leverage If chronic, this is often evidence of This is a very conservative position. With mismanagement. It is a sign that the owner this kind of leverage, lenders are likely to Low has not planned for the companys working capital needs. In most businesses lend money to satisfy a companys capital needs. Owners in this position should characterized by low liquidity, there is have no trouble borrowing money. usually no financial plan. This situation is often associated with last minute or "Friday night" financing. This is an indication of good management. If a companys leverage is comparable to The company is using its current assets that of other businesses of similar size in Average wisely and productively. Although they may not be impressed, lenders feel comfortable the same industry, lenders are comfortable making loans. The company is not making loans to companies with adequate overburdened with debt and is liquidity. demonstrating its ability to use its resources to grow. Some lenders look for this because it Businesses that carry excessive levels of indicates a most conservative company. debt scare most lenders off. Companies in High However, companies that constantly operate this way usually are forgoing this position normally will have a difficult time borrowing money unless they can growth opportunities because they are not show lenders good reasons for making making the most of their assets. loans. Owners of these companies must be prepared to sell lenders on their ability to repay.Ch, 11: Creating a Successful Financial PlanSource: Adapted from David H. Bangs, Jr., Financial Troubleshooting, Upstart Publishing Company, (Dover, New Hampshire, 1992), p. 124. 11- 91 11- 91
Twelve Key Ratios Operating Ratios - Evaluate a firm’s overall performance and show how effectively it is putting its resources to work.6. Average Inventory Turnover Ratio - Tells the average number of times a firms inventory is “turned over” or sold out during the accounting period.Average Inventory = Cost of Goods Sold = $1,290,117 = 2.05 times Turnover Ratio Average Inventory* $630,600 a year*Average Inventory = Beginning Inventory + Ending Inventory 2
Twelve Key Ratios Operating Ratios - Evaluate a firm’s overall performance and show how effectively it is putting its resources to work.7. Average Collection Period Ratio (days sales outstanding, DSO) - Tells the average number of days required to collect accounts receivable. Two Steps:Receivables Turnover = Credit Sales = $1,309,589 = 7.31 times Ratio Accounts Receivable $179,225 a yearAverage Collection = Days in Accounting Period = 365 = 50.0 Period Ratio Receivables Turnover Ratio 7.31 days
Twelve Key Ratios Operating Ratios - Evaluate a firm’s overall performance and show how effectively it is putting its resources to work.8. Average Payable Period Ratio - Tells the average number of days required to pay accounts payable. Two Steps:Payables Turnover = Purchases = $939,827 = 6.16 times Ratio Accounts Payable $152,580 a yearAverage Payable = Days in Accounting Period = 365 = 59.3 days Period Ratio Payables Turnover Ratio 6.16
Twelve Key Ratios Operating Ratios - Evaluate a firm’s overall performance and show how effectively it is putting its resources to work.9. Net Sales to Total Assets Ratio - Measures a firm’s ability to generate sales given its asset base. Net Sales to = Net Sales = $1,870,841 = 2.21:1 Total Assets Total Assets $847,655
Twelve Key Ratios Profitability Ratios - Measure how efficiently a firm is operating; offer information about a firm’s “bottom line.”10. Net Profit on Sales Ratio - Measures a firm’s profit per dollar of sales revenue. Net Profit on = Net Income = $60,629 = 3.24% Sales Net Sales $1,870,841
Twelve Key Ratios Profitability Ratios - Measure how efficiently a firm is operating; offer information about a firm’s “bottom line.”11. Net Profit to Assets (Return on Assets) Ratio – tells how much profit a company generates for each dollar of assets that it owns. Net Profit to = Net Income = $60,629 = 7.15% Assets Total Assets $847,655
Twelve Key Ratios Profitability Ratios - Measure how efficiently a firm is operating; offer information about a firm’s “bottom line.”12. Net Profit to Equity* Ratio - Measures an owners rate of return on the investment (ROI) in the business. Net Profit to = Net Income = $60,629 = 22.65% Equity Owner’s Equity* $267,655 * Also called Net Worth
Interpreting Ratios Ratios – useful yardsticks of comparison. Standards vary from one industry to another; the key is to watch for “red flags.” Critical numbers – measure key financial and operational aspects of a company’s performance. Examples: Sales per labor hour at a supermarket Food costs as a percentage of sales at a restaurant. Load factor (percentage of seats filled with passengers) at an airline.
Putting 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.
Interpreting RatiosSam’s Appliance Shop Industry Median Current ratio = 1.87:1 Current ratio = 1.50:1 Although Sam’s falls short of the rule of thumb of 2:1, its current ratio is above the industry median by a significant amount. Sam’s should have no problem meeting short-term debts as they come due.
Interpreting RatiosSam’s Appliance Shop Industry MedianQuick ratio = 0.63:1 Quick ratio = 0.50:1Again, Sam is below the rule of thumb of 1:1, butthe company passes this test of liquidity whenmeasured against industry standards. Sam relieson selling inventory to satisfy short-term debt (asdo most appliance shops). If sales slump, the resultcould be liquidity problems for Sam’s. What stepsshould Sam take to deal with this threat?
Interpreting RatiosSam’s Appliance Shop Industry MedianDebt ratio = 0.68:1 Debt ratio = 0.64:1 Creditors provide 68% of Sam’s total assets, very close to the industry median of 64%. Although the company does not appear to be overburdened with debt, Sam’s might have difficulty borrowing , especially from conservative lenders.
Interpreting RatiosSam’s Appliance Shop Industry MedianDebt to net worth Debt to net worthratio = 2.20:1 ratio = 1.90:1Sam’s owes $2.20 to creditors for every $1.00 theowner has invested in the business (compared to$1.90 to every $1.00 in equity for the typicalbusiness). Many lenders will see Sam’s as“borrowed up,” having reached its borrowingcapacity. Creditor’s claims are more than twicethose of the owners.
Interpreting RatiosSam’s Appliance Shop Industry MedianTimes interest earned Times interestratio = 2.52:1 earned ratio = 2.0:1 Sam’s earnings are high enough to cover the interest payments on its debt by a factor of 2.52:1, slightly better than the typical firm in the industry. Sam’s has a cushion (although a small one) in meeting its interest payments.
Interpreting RatiosSam’s Appliance Shop Industry MedianAverage inventory Average inventoryturnover ratio = 2.05 turnover ratio = 4.0times per year times per year Inventory is moving through Sam’s at a very slow pace. What could be causing this low inventory turnover in Sam’s business?
Interpreting RatiosSam’s Appliance Shop Industry MedianAverage collection Average collectionperiod ratio = 50.0 days period ratio = 19.3 days Sam’s collects the average account receivable after 50 days compared to the industry median of 19 days - more than 2.5 times longer. What is a more meaningful comparison for this ratio? What steps can Sam take to improve this ratio?
Interpreting RatiosSam’s Appliance Shop Industry MedianAverage payable period Average payableratio = 59.3 days period ratio = 43 days Sam’s payables are nearly 40 percent slower than those of the typical firm in the industry. Stretching payables too far could seriously damage the company’s credit rating. What are the possible causes of this discrepancy?
Interpreting RatiosSam’s Appliance Shop Industry MedianNet sales to total Net Sales to totalassets ratio = 2.21:1 assets ratio = 2.7:1 Sam’s Appliance Shop is not generating enough sales, given the size of its asset base. What factors could cause this?
Interpreting RatiosSam’s Appliance Shop Industry MedianNet profit on sales Net profit on saleratio = 3.24% ratio = 7.6% After deducting all expenses, Sam’s has just 3.24 cents of every sales dollar left as profit - less than half the industry average. Sam may discover that some of his operating expenses are out of balance.
Interpreting RatiosSam’s Appliance Shop Industry MedianNet profit to assets Net Sales to workingratio = 7.15% capital ratio = 5.5%Sam’s generates a return of 7.15% for every $1 inassets, which is 30% above the industry average.Given his asset base, Sam is squeezing an above-average return out of his company. Is this likely tobe the result of exceptional profitability, or is thereanother explanation?
Interpreting RatiosSam’s Appliance Shop Industry MedianNet profit on equity Net profit on equityratio = 22.65% ratio = 12.6% Sam’s return on his investment in the business is an impressive 22.65%, compared to an industry median of just 12.6% Is this the result of high profitability, or is there another explanation?
Breakeven Analysis Breakeven point - the level of operation at which a business neither earns a profit nor incurs a loss. A useful planning tool because it shows entrepreneurs minimum level of activity required to stay in business. With one change in the breakeven calculation, an entrepreneur can also determine the sales volume required to reach a particular profit target.
Calculating the Breakeven PointStep 1. Determine the expenses the business can expect to incur.Step 2. Categorize the expenses in step 1 into fixed expenses and variable expenses.Step 3. Calculate the ratio of variable expenses to net sales. Then compute the contribution margin: 1 - Variable Expenses Contribution Margin = Net Sales EstimateStep 4. Compute the breakeven point: Total Fixed Costs Breakeven Point ($) = Contribution Margin
Calculating the Breakeven Point: The Magic ShopStep 1. Net Sales estimate is $950,000 with Cost of Goods Sold of $646,000 and total expenses of $236,500.Step 2. Variable Expenses: $705,125 Fixed Expenses: $177,375Step 3. Contribution margin: $705,125 Contribution Margin = 1 - = .26 $950,000Step 4. Breakeven Point: $177,375 Breakeven Point = = $682,212 .26 $
FIGURE 11.8 Break-Even Chart for the Magic Shop
Conclusion Preparing a financial plan is a critical step Entrepreneurs can gain valuable insight through: Pro forma statements Ratio analysis Breakeven analysis
Further Reading Scarborough, Norman, M. 2011. Essentials of Entrepreneurship and Small Business Management. 6th edition. Pearson. Brooks, Arthur C. (2006) Social Entrepreneurship : A Modern Approach to Social Value Creation. Pearson Barringer, Bruce R. & Ireland, R. Duane, 2011 Entrepreneurship – Successfully launching new ventures 4th edition, Pearson. Schaper, M., Volery, T., Weber, P. & Lewis, K. 2011. Entrepreneurship and Small Business. 3rd Asia Pacific edition. John Wiley.