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Finance 2 - Forecasting Profits


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Finance 2 - Forecasting Profits

  1. 1. GENE452 – Technical Entrepreneurship Lecture Notes #9 – March 10, 2005 Review of Key Points from Last Week • Financial Statements are done on an accrual basis. • BUT, when running a business – CASH IS KING! • sales forecasting is an art, not a science • “Top-down methods” o % of total market share - in highly unconsolidated markets o % of total available market - in market dominated by another • “Bottom-up methods” o # of key clients - in industrial markets o # of units (as a function of production) - in a monopoly • "Sale" is an accounting concept. Not an activity. • A sale occurs whenever your accounting dept. says it has. • Cash often doesn’t match sales timing – typical 50-60 day delay • Trade Credit • Sales growth projections • Production Planning • “The suspicious hockey stick curve”
  2. 2. Tonight’s Lecture – Forecasting Profits Recall – profits and cash are related but not the same. In fact, they’re not that closely related at all – like distant cousins THE INCOME STATEMENT ...has several names • profit and loss statement • "P & L" • income statement • statement of earnings • statement of operations Purpose: show how company performed in previous year. The "P & L" is like a movie. It shows information about a company over a period of time. P&L has beginning and end: "for 12 mos. ending 31 December" An annual report will contain a P&L ending at the end of the firm’s Fiscal Year End (FYE)
  3. 3. Where Does the Money Go? The P & L tries to show you: Consumption of $1.00 of Sales Revenues Profit Taxes Interest Materials Overhead Labour
  4. 4. What P & L Shows Value of the product sold - SALES. Cost of the product sold (materials and labour)- COST OF GOODS SOLD Cost of running the company – OVERHEAD or OPERATING EXPENSE Cost of financial resources used - INTEREST EXPENSE Taxes paid - TAXES Whether benefit justified the cost – PROFIT / (LOSS)
  5. 5. A typical Canadian P & L CONSOLIDATED WIDGETS INC. statement of profit and loss fiscal year ending 31 December 2004 2003 2002 REVENUE (units sold x price per unit) ---- ---- --- COST OF SALES (units sold x materials, direct labour) ---- ---- --- GROSS PROFIT (profit made from selling the product) ---- ---- --- SALES GENERAL and ADMINISTRATIVE (fixed costs) eg. insurance, head office ---- ---- ---- DEPRECIATION EXPENSE (cost of used-up assets) ---- ---- ---- OPERATING PROFIT (profit from running company) ---- ---- --- INTEREST EXPENSE (debt x rate of interest) ---- ---- ---- PRE-TAX PROFIT ---- ---- ---
  6. 6. TAX ---- ---- ---- NET PROFIT (from investing in company) ---- ---- --- DIVIDENDS PAID (profit given to shareholders) ---- ---- --- RETAINED EARNINGS (the remainder, added to equity of firm) COST OF SALES Also called “Cost Of Goods Sold” or COGS Materials and labour that go directly into manufacturing product. Omits operating and general expenses incurred in running company. Consider a pizza business: "Cost of sales" includes: • 8 oz. dough 1/2 tin tomato paste • 4 oz. cheese 3 oz. pepperoni • 3 oz. bacon 6 mushrooms • 1 green pepper • 5 minutes of the chef's time • 10 minutes of electricity "Cost of sales" excludes: • $300,000 construction • Wages for the "hostess" • $20,000 fascia and signage • Wages for the cashier
  7. 7. • $50,000 interior decoration • Cleaning supplies • $100,000 tables, chairs, supplies • Insurance • Advertising GROSS PROFIT Gross Profit = Sales - Cost of Sales "Gross Profit" indicates: Whether business is making profits by manufacturing and selling the product If Gross Profit is negative, you have three options: 1. Raise your selling price 2. Reduce your cost of sales 3. Give up. SELLING GENERAL & ADMINISTRATIVE EXPENSE or OPERATING EXPENSE
  8. 8. Cost of operating (administering) the business. Not just making the product. Also known as: "overhead expenses" "general and administrative costs" ("G&A")
  9. 9. Pizza store: • $300,000 construction of the restaurant • $20,000 external fascia and signage on restaurant • $125,000 interior decoration, tables, chairs, supplies • Wages for the "hostess" • Wages for the cashier • Cleaning supplies • Insurance • Advertising For your business, another operating expense may be “R&D” The Nature of Operating Expenses For small firms, should be absolutely small. For large companies, will be relatively large. You need less office space than Microsoft or Magna International. Internal and external communication needs are smaller (don't need employee newsletters, audited annual reports, etc.). Management information needs are smaller (don’t need multi-million $ ERP and BIS software to know what’s going on in your business). Overhead costs don't vary linearly with sales: Thus, sometimes referred to as "fixed costs" However, they do tend to grow in steps (i.e. opening a new store) Shouldn't generally increase by more than rate of inflation.
  10. 10. DEPRECIATION (also called Amortization) Takes into account “using up” of assets Reduces taxable earnings Set by “CCA Rates” (Capital Cost Allowance) by CRA i.e. Computer Office Equipment depreciates at 45% per year OPERATING PROFIT Operating Profit = Gross Profit – Overheads - Depreciation Operating Profit has a variety of other names: • Profit Before Interest and Taxes (PBIT) • Earnings Before Interest and Taxes (EBIT) • Operating Income remember Gross Profit indicates: Whether profits are being made by manufacturing and selling the product. while Operating Profit indicates: Whether profits are being made by setting up and running a business to manufacture and sell a product.
  11. 11. If Operating profit is negative you have four options: 1. Raise your selling price 2. Reduce your cost of sales 3. Reduce your overhead costs 4. Increase your sales volumes INTEREST EXPENSE Financial capital is neither plentiful nor free. Interest paid on outstanding debt is a cost of business Interest Expense: Costs incurred through borrowing money in order to finance the business. Tax Corporate taxes can be INCREDIBLY complex. You will need a good accountant to figure things out. For planning purposes, a simplistic view: Small business tax rate: 21% on first $200,000 of profits Thereafter, assume 40%
  12. 12. Tax Loss Carry Forward Losses from prior years are netted against taxes payable. Example: Year 1 Year 2 Year 3 Year 4 Year 5 Profit/Loss $$ -300,000 -100,000 0 500,000 700,000 Cumulative $$ -300,000 -400,000 -400,000 +100,000 +779,000 Taxable $$ nil nil nil 100,000 700,000 Resulting Taxes nil nil nil 21,000* 242,000** * 21% of 100,000 = 21,000 ** 21% of 200,000 + 40% of 500,000 = 42,000 + 200,000 = 242,000 NET PROFIT Net Profit is the bottom line. Result after all costs and expenses have been deducted from revenues. Net Profit = Total Revenues - Total Expenses It represents benefit, or return, from owning the business. Often also stated on a per-share basis, or Earnings Per Share (EPS) DIVIDENDS PAID As a startup tech firm, you won’t be paying any. If you were, they would be paid out of net profits.
  13. 13. RETAINED EARNINGS This is what’s left over at the end, for “re-investment” in the firm. As you can see, Retained Earnings are not “cash in the bank.” They are a measure of additional equity in the firm after a period of operations. If negative, these will be stated as a deficit, and accumulated over time. Return on Investment Also called Return on Equity (ROE) Most important ratio in all of finance: Net Profit ROI = ------------------------ Owners’ Equity Next Week – Raising Finance Reading – Text Stage Eleven – Preparing Your Business Plan