Launching a successful business requires an entrepreneur to create a solid financial plan. Not only is such a plan important in raising the capital needed to get a company off the ground, but it also is an essential ingredient in managing a growing business. This chapter provided a brief review of the three basic financial statements:
The balance sheet – Built on the accounting equation: Assets = Liabilities + Owner's Equity (Capital), it provides an estimate of the company's value on a particular date. The income statement – This statement compares the firm's revenues against its expenses to determine its net profit (or loss). It provides information about the company's bottom line. The statement of cash flows – This statement show the change in the company's working capital over the accounting period by listing the sources and the uses of funds.Projected financial statements are a basic component of a sound financial plan. They help the manager plot the company's financial future by setting operating objectives and by analyzing the reasons for variations from targeted results. Also, the small business in search of start up funds will need these pro forma statements to present to prospective lenders and investors. They also assist in determining the amount of cash, inventory, fixtures, and other assets the business will need to begin operation.
Ratio analysis is a tool designed to help the owner interpret the firm's financial statements to learn how efficiently the organization is being managed. The twelve key ratios described in this chapter are divided into four major categories: liquidity ratios, which show the small firm's ability to meet its current obligations: leverage ratio, which tell how much of the company's financing is provided by owners and how much by creditors; operating ratios, which show how effectively the firm uses its resources; and profitability ratios, which disclose the company's profitability. To benefit from ratio analysis, the small company should compare its ratios to those of other companies in the same line of business. Many agencies and organizations regularly publish such statistics. If there is a discrepancy between the small firm's ratios and those of the typical business the owner should investigate the reason for the difference. A below-average ratio does not necessarily mean that the business is in trouble.
Business owners should know their firm's break-even point, the level of operations at which total revenues equal total costs; it is the point at which companies neither earn a profit nor incur a loss. Although just a simple screening device, break-even analysis is a useful planning tool, and it allows lenders and investors to evaluate the potential success of a small business.
- How should a small business manager use the ratios discussed in this chapter?
- Outline the key points of the twelve ratios discussed n this chapter. What signals does each give the manager?
- Describe the method of building a projected income statement and a projected balance sheet of a beginning business.
- Why are pro forma financial statements important to the financial planning process?
- How can break-even analysis help an entrepreneur planning to launch a business?
Ask an owner of a small business to provide you with copies of the firm's financial statements (current or past).
- Using these statements, compute the twelve key ratios described in this module.
- Compare the firm's ratios with those of the typical firm in this line of busines.
- Interpret the the ratios and make suggestions for operating improvements.
- Prepare a break-even analysis for the owner.