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# AST 205 Chapter 4 notes

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### AST 205 Chapter 4 notes

1. 1. Chapter 4- FBO Finance Contents: -Financial Statements Balance Sheet (balance sheet equation) Income Statement -Financial Ratios -Depreciation -Break-even analysis -Reasons new businesses fail -Increasing Cash Flows -Profit Centers -Profit -Overhead vs. direct costs -Cash Flows 1. Financial Statements Balance sheet
2. 2. Most Businesses/corporations will have a balance sheet (business plans for a start-up business will have a projected balance sheet). A balance sheet is a “snapshot” of the financial situation (assets, liabilities, and equity) of a business at any given point in time since it is constantly changing with the day-to day operations of a business similar to a picture of a moving car, you can’t tell where it’s been or where it’s going from just one picture. A balance sheet must “balance” following the “accounting equation” which is: Assets = Liabilities + Owners Equity In other words: Everything the business has (assets) is either owned by that business (owner’s equity) or they owe someone else for that asset (A liability such as making payments on your car). As an example: You buy a \$10,000 car with a \$2,000 down payment of your own money. You owe \$8,000 on that car to someone else such as a bank. That car (a \$10,000 asset) equals the \$8,000 you owe (liability) plus your \$2,000 down payment (Owner’s equity). In equation form it would look like this: Assets = Liabilities + Owner’s Equity \$10,000 = \$8,000 + \$2,000 That’s it! Each financial transaction of the business must balance (purchases, payments, etc.) Other Balance Sheet Notes: Assets and Liabilities are divided up into two basic types: 1. Current 2. Long Term (Total Assets = Current Assets + Long Term Assets). Current Assets are those that can be converted into cash (i.e. sold) within 90 days. These include items such as inventory on-hand (fuel etc.) and accounts due from customers etc. Current Liabilities are those that are due within 90 days. Items include bills and accounts that are payable, certain taxes etc. Long Term Assets include things like real estate (land) buildings etc. which may take longer to convert to cash.
3. 3. Long Term Liabilities would include long term bank loans (i.e. a 30 – year mortgage etc.) Other terms for owner’s equity include: retained earnings and shareholder’s equity Income Statement Revenues Net sales ____________________\$3,400,000 Rent revenue _________________ 40,000 Interest revenue _____________ 12,000 Total revenue _____________ 3,452,000 Expenses (usually sorted by amount) Cost of goods sold ___________ 2,000,000 Selling expenses _____________ 450,000 Administrative expenses ______ 350,000 Interest expense _____________ 45,000 Total expense _____________ 2,850,000 Income before taxes ____________ 602,000 Income taxes ___________________ 180,600 Net income _____________________ 421,400 For any given period of time, the income statement shows where money comes from, where it goes, and what’s left over (if any). Income Statement Notes: Total Revenue - Total Expenses = Net Income (loss) before taxes (\$602,000 in the above example) The terms “revenue” and “sales” are often used interchangeably. Operating income is equal to the sales revenue minus the expenses which are directly related to the sales of the products- the variable costs or those that change with volume. Financial Ratios With your knowledge of the above two financial statements you can now begin calculating financial ratios for your business. Financial ratios are simple calculations which allow you to measure the overall health of your business. Once you have calculated a ratio you need to measure it against a pre-determined standard for it to make sense. Ratio standards are published for given sectors of the economy (service, manufacturing, air transportation, etc. some of these are available at www.bizratios.com)
4. 4. As an example: 1. Current Ratio- A measure of a firm’s short-term ability to pay it’s current debts. A firm is likely to be in financial trouble of it can’t generate enough cash to pay its short- term financial obligations. The benchmark for this ratio is 1:1 (one asset to one liability) or greater. If there are more liabilities than assets (i.e. .5:1) then this is generally not good. The formula for the Current Ratio is: Current Assets divided by Current Liabilities or: Current Assets Current Liabilities In our example, the numbers will be taken from the above balance sheet: Current Assets = \$13,500,000 thus: Current Assets = 13,500,000 = 1.5:1 Current Liabilities = \$9,000,000 Current Liabilities = 9,000,000 Thus, this business has a positive current ratio having 1.5 current assets to each current liability. 2. Let’s look at the firm’s operating profit margin- (OPM)- a measure of profitability before paying interest and taxes. The benchmark for this ratio varies from industry to industry. OPM = Operating Income divided by total sales revenue or: Operating Income Sales Operating Income (from the income statement) is income before interest and taxes. In our example they have only shown income before taxes, \$602,000 which will work for us. The “sales” figure comes from the income statement line labeled “net sales” which is \$3,400,000 Thus the OPM for our company is \$602,000 = .177 (rounds to .18) \$3,400,000 This means they are making 18% on their sales before paying interest and taxes. A company would obviously like this percentage to be as high as possible. 3. There are several other ratios which can be calculated such as: a. The Debt to Equity ratio- a measure of a firm’s long-term ability to pay all debts. This ratio should definitely be less than 1 (having more equity than liabilities). This ratio comes from the balance sheet.
5. 5. Debt to Equity ratio = Total Liabilities Total owner’s equity Another term for total owner’s equity is “total net worth”. See if you can figure this one. b. Return on Assets- a measure of profitability is: ROA = Net Income Total Assets For this one you need to look at both the income statement and the balance sheet. Again, see if you can calculate this one. Depreciation Depreciation in actual practice is fairly complicated. Here we will look at only the simplest aspects of depreciation. When it comes to paying taxes, all of us want to pay as little taxes as possible, including businesses. One of the largest taxes businesses have to pay is an asset tax which is based on the worth of their assets; thus, the less an asset is worth, the less the amount of taxes owed on it. As an asset (let’s say an airplane) is purchased and used, the wear and tear it experiences during use inevitably reduces its value. Tax law provides for this reduction in value with use and this is called “depreciation.” Different pieces of equipment are allowed to depreciate at different rates and this is specified in the tax law. We’ll leave that to the accountants, but let’s say the airplane initially cost \$200,000 and tax law allows me fully depreciate this asset in 10 years. That means that at the end of ten years, a company will owe no taxes on this asset because at that point it will have been “fully depreciated.” This doesn’t mean that the asset is worthless at the end of that time. We know that even a rental aircraft that is well-cared for will last much longer, but depreciation is figured for tax reasons only. I could sell this airplane at the end of that ten years and it might be worth \$100,000 or more to me. As an example: For tax purposes, at the end of the first year of use of my airplane, it will be worth \$180,000 for the purposes of paying taxes on it (it is depreciated at a rate of \$20,000 per year until it is fully depreciated). At the end of the second year of use it is worth \$160,000 and so on until fully depreciated. Break-Even Analysis Let’s say you, as an FBO manager are trying to decide if it will be worth your while to offer aerobatic training (or any other type of specialized training or other for-profit activity). It would be a good idea for you to know at what point you will break-even
6. 6. financially before you make the decision to move ahead with it. If you don’t know when you will break-even you might continue to dump money into some project and never realize a return on it. Break-Even Point- Point at which all costs are recovered. Note: to figure the break-even point, you need to know the contribution margin which is the amount each unit of sales contributes to the fixed costs of sales. Contribution Margin- Revenue made minus variable costs. As an example: You are considering selling a new type of aviation navigation plotter you will get from Jeppesen. You plan to sell this plotter at \$5. Each plotter costs you \$2 to buy from Jeppesen. In order to sell this plotter, Jeppesen requires you to make an initial investment of \$800 in a display case (the case has a continuous playig DVD showing how this plotter is better than others and how it is worth the price). Here is how the break-even analysis would look. Let x = the number of plotters that must be sold in order to break-even on this venture. Here’s the formula which uses simple algebra: \$5.00x = \$2.00x + \$800.00 \$3.00x = \$800 X = \$800 \$3.00 X = (266.6666666) or 267 Thus, 267 plotters must be sold at \$5.00 each to break-even on this venture. At that point, all of the fixed costs will have been recovered (each plotter contributes \$3 to the fixed cost of the display case or has a \$3 contribution margin). Overhead costs: The \$800 fixed cost is considered to be the “overhead” cost. The utilities that a business pays (lights, water, etc.) are other forms of overhead costs. Direct costs: Another way of saying variable costs. Direct/variable costs are those that change with the volume sold. In the above break-even analysis, each plotter costs you \$2 therefore that is the variable cost for that plotter; if you don’t sell any then those costs don’t go up.
7. 7. Most common reason for a new business to fail- 80% of new businesses fail and here’s why: In a word: “undercapitalization” or lack of money to pay short-term financial obligations (bills, payroll, suppliers, etc.) while the business reaches a self-sustaining profitability level- a process which may take several months to a few years (in other words, not being able to feed the business until it can stand on its own two feet). Often, inexperienced business owners will take too much in salary from the business thus starving it for cash. Reasons new businesses don’t generate enough cash-flow can be that: 1. They may not focus enough on generating sales 2. They may siphon off too much in salaries 3. They may allow too many customers to rack up accounts payable. a. A certain percentage of accounts payable to you will never be realized. Others will come in several months after the good or service was rendered. This again, starves the business for needed cash to pay its obligations (again, payroll, bills, etc. and people who aren’t paid won’t come to work thus aggravating the situation). To increase your cash flow potential into the business: 1. Take only the basic salary you need to live 2. Place strict limits on sales “on account” (buy now pay later etc.) a. (Realize that some customers won’t use your business if they have to pay up front so offering it as an option can increase business.) b. Charge substantially for past due accounts to discourage them c. Offer discounts for cash payments Profit A reward for a risk taken- usually financial. Most of the time a successful business goal is to maximize profits but sometimes an established business can modify those goals for the sake of providing a service to the community. 1. As an example, providing transportation to and from distant treatment for a local child struggling with cancer can foster much goodwill in the community toward your business. 2. Offering flight training at a cost which is below the maximum amount you could get in order to make flight training more available to more in the community can also foster goodwill and increase your business potential.
8. 8. Profit Centers Profit centers are the different revenue generating departments of a business such as: 1. Flight Instruction 2. Line Service 3. Maintenance Shop 4. Pilot Supplies