One of the important steps in launching a new business venture is fashioning a well-designed, logical financial plan. Potential lenders and investors demand such a plan before putting their money into a start-up company. More importantly, this financial plan can be vital in helping entrepreneurs manage their businesses more effectively, steering their way around the pitfalls that cause failures. Entrepreneurs may ignore the financial aspects of their businesses run the risks of becoming just another failure statistics. One financial expert says of small companies, "Those that don't establish sound controls at the start are setting themselves up to fail." Still, according to one survey, one-third of all entrepreneurs run their companies without any kind of financial plan. Another study found that only 11 percent of small business owners analyze their financial statement as part of the managerial planning and decision-making process. To reach profit objective, small business managers must be aware of their firms overall financial position and the changes in financial status that occur over time.
Martin Liebmann's Company, Millrock, a maker of display racks and fixtures, was growing so fast that Liebmann thought a financial plan was unnecessary. He thought that fast growth would automatically lead to impressive profits. But when Millrock started losing money, Liebmann hired turnaround specialist Raleigh Minor to help him develop proper financial controls for the company. "Our business was suffering because management couldn't rely on financial controls and a reporting system," recalls Liebmann. "I recognized it would help if we could generate timely and accurate numbers." Minor helped setup a system of financial controls tailored to Millrock and its management team. The tracks for essential elements: weekly account receivable reports, weekly actual-versus-projected sales, weekly inventory reports, and a monthly accounts payable analysis." The financial controls helped me understand the changes and flow of our business," says Liebmann. "Once again, we're back on target with growth and profitability."
These lessons focuses on some very practical tools that will help the entrepreneur develop a financial plan, stay aware of her company's financial position and plan for profit. She can use these tools to help anticipate changes and plot appropriate strategy to meet them head on. These profit techniques are not difficult to master nor they are overly time consuming. We will discuss the techniques involved in preparing projected (proforma) financial statements, conducting ratio analysis, and performing breakeven analysis.
Before we begin building projected financial statements, it would be helpful to review the basic financial reports that measure a company's financial position: the balance sheet, the income statement and statement of cash flows. Study show that the level of financial reporting among small businesses is high; some 81 percent of the company's one survey regularly produce summary financial information, almost all of it in the form of these traditional financial statements.
The balance sheet provides owners with an estimate of the firm's work on given date. Its two major sections show what assets the business owns and claims creditors and owners have against those assets. The balance sheet is usually prepared on the last date of the month. Fig. 1.1 shows the balance sheets for Sam's Appliance Shop for the year ended December 31, 1997.
The balance sheet is built on the fundamental accounting equation: assets = liabilities + owner's equity. Any increase or decrease on one side of the equation must be offset by an equal increase or decrease on the other side. Hence, the name balance sheet. The first section of the balance sheet lists the firms's assets and shows the total value of everything the business owns. Curent assets consist of cash and items to be converted into cash within 1 year or within the company's normal operating cycle, whichever is longer, such as accounts receivable and inventory. Fixed assets are those acquired for long-term use in the business. Intangible assets include items that, although valuable, do not have tangible value, such as goodwill, copyrights, and patents.
The second section shows the business's liabilities – the creditors' claims against the firm's assets. Current liabilities are those debts that must be paid within 1 year or within the company's normal operating cycle, whichever is longer, and long-term liabilities are those that come due after 1 year. This section of the balance sheet also shows the owner's equity, the value of the owner's investment in the business.
THE INCOME STATEMENT. The income statement for (or profit and loss statement of P & L) compares expenses against revenue over a certain period of time to show the firm's net profit or loss. The income statement is a mowing picture of the firm's profitability over time. The annual P & L statement reports the business's bottom line over the fiscal/calendar year. Figure 1.2 shows the income statement for Sam's Appliance Shop for the year ended December 31,1997.
Fig 1.2:Income statement,
Sam's Appliance Shop
To calculate net profit or loss, the owner record sales revenues for the year, which includes all income that flows in to the business from sales of goods and services. Income from other sources (rent, investments, interest) also must be included in the revenue section of the income statement. To determine net sales revenue, owners subtract the value of returned items and refunds from gross revenue. Cost of goods sold represents the total cost, including shipping, of the merchandise sold during the year. Most wholesalers and retailers calculate cost of goods sold by adding purchases to beginning inventory and subtracting ending inventory. Service companies typically have no cost of good sold. Operating expenses include those cost that contribute directly to the manufacture and distribution of goods. General expenses are indirect cost incurred in operating the business. "Other expenses is a catchall category covering all other expenses that don't fit into the other two categories.Total revenue minus total expenses gives otal the net profit (or loss) for the year.
The statement of cash flows shows the change in the firm's working capital since the beginning of the year by the listing the sources of the funds and the uses of these funds. Many small businesses never need to prepare such a statement, but in some cases creditors, investors, new owners, or the IRS may require this information.
To prepare the statement, the balance sheets and the income statements summarizing the present year's operations must be assembled. Then the sources of funds - net income, borrowed funds, owner contributions, depreciation, and any others - are listed. Depreciation is listed as a cost of doing business. But because it is a non-cash expense that is deducted as a cost of doing the business. But because the owner has already paid for the item being depreciated, its depreciation is a source of funds. Next, the uses of these funds are listed - plant and equipment purchases, dividends to owners, repayment of debt, and so on. The difference between the total sources and the total uses is the increase or decrease in the working capital. By investigating the changes in the firm's working capital and the reasons for them, owners can create a more practical financial plan of action for the future of the enterprise.
These statements are more that just complex documents used only by accountants and financial officers. When used in conjunction with the analytical tolls described in the following sections, they can help small business managers map the firm's financial future and actively plan for profit. Mere preparation of these statements is not enough; owners and employees must understand and use the information contained in them.
Creating Projected Financial Statement
Creating projected financial statements via the budgeting process helps the small business owner transform business goals into reality. Once developed, a budget will answer such questions as: What profit can the business expect to obtain? If the owner's profit objective is x dollars, what sales level must she achieve? What fixed and variable expenses can she expect at that level of sales? The answers to these and to her questions are critical in formulating an successful financial plan for the small business.
This section will focus on creating projected income statements and balance sheets for the small business. These projected (or pro forma) statements estimate the business's profitability and overall financial condition for future months. They are an integral part of convincing potential lenders and investors to provide the financing needed to get the company off the ground. Also, because these statements project the firm's financial position through the end of the forecasted period, they help the owner plan the route to improved financial strength and healthy business growth.
Because the established business has a history of operating data from which to construct pro forma financial statements, the task is not nearly as difficult as it is for the beginning business. When creating pro forma financial statements for a brand new business, an entrepreneur typically relies on published statistics summarizing the operation of similar-size companies in the same industry. These statistics are available form a number of sources (described later), but this section draws on information found in Robert Morris Associates Annual Statement Studies, a compilation of financial data on thousands of companies across hundreds of industries [organized by Standard Industrial Classification (SIC) Code}.
The Pro Forma Statements For The New Small Business One of the most important tasks confronting the entrepreneur launching a new enterprise is to determine the funds needed to begin operation as well as those required to keep going through the initial growth period. The amount of money needed to begin a business depends on the type of operation, its location, inventory requirements, sales volume, and other factors. But every new firm must have enough capital to cover all start-up costs, including funds to rent or but the utilities, and other expenses. In addition, the owner must maintain a reserve of capital to carry the company until it begins to make a profit. Too often entrepreneurs are overly optimistic in their financial plans and fail to recognize that expenses initially exceed income for most small firms. This period of net losses is normal and may last from just a few months to several years. Owners must be able to meet payrolls, maintain adequate inventory, take advantage of cash discounts, grant customers credit, and meet personal obligations during this time.
The Pro Forma Income Statement. In creating a projected income statement, an entrepreneur has two options: to develop a sales forecast and work down, or to set a profit target and work up. Most businesses employ the latter method – the owner targets a profit figure and then determines what sales level he must achieve to reach it. Then he can prepare an outline of the expenses the business will incur in securing those sales, in any small business the annual profit must be large enough to produce a return for time the owners spend operating the business, plus a return on their investment in the business.
An entrepreneur who earns less than he could earn working or someone else must weigh carefully the advantages and disadvantages of choosing the path of entrepreneurship. Why be exposed to all of the risks, sacrifices, and hard work of beginning and operating a small business if the rewards are less than those of remaining in the secure employment of another? Ideally, the firm's net profit after taxes should be at least as much as the owner could earn by working for someone else.
An adequate profit must also include a reasonable return on the owner's total investment in the business. The owner's total investment is the amount contributed to the company at its inception plus any retained earnings (profits from previous years funneled back into the operation). If a would-be owner has $70,000 to invest and can invest it in securities and earn 10 percent, she should reconsider investing it in a small business that would yield only 3 percent.
So the owner's target income is the sum of a reasonable salary for the time spent running the business and a normal return on the amount invested in the firm. Determining how much this should be is the first step in creating the pro forma income statement.
The owner then must translate this target profit into a net sales figure for the forecasted period. To calculate net sales from a target profit, the owner needs published statistics for this type of business. Suppose an entrepreneur wants to launch a small retail bookstore and has determined that the target income is $29,000 annually. Statistics gathered from Robert Morris Associates' Annual Statement Studies show that the typical bookstore's net profit margin (net profit / net sales) is 9.3 percent. Using this information, he can compute the sales level required to produce a net profit of $29,900:
Fig. 1.3. Anticipated Expenses.Source: U.S. Small Business Administration, Checklist forGoing Into Business, Small Marketers Aid No. 71, Washington, DC, 1982, pp.
Fig. 1.4. Anticipated
expenditures for Fixture and Equipment. Source: U.S.
Small Business Administration.
Checklist for Going Into Business. Small Marketers Aid No. 71
Washington, DC. 1982 p. 12
Notice the inverse relationship between the small firm's average inventory turnover ration and its cash requirements.
Another decision facing the entrepreneur is how much inventory the business should carry. A rough estimate of the inventory requirement can be calculated from the information found on the projected income statement and from published statistics:
Cost of goods sold = $ 174,990 (from projected income statement)
Average inventory turnover = Cost of goods sold
Inventory Level
3.5 times a year =
Substituting,
3.5 times/year = $ 174,990
Inventory level
Solving algebraically,
Inventory level = $ 49,997
The owner can use the planning forms shown in figures 1.3 and 1.4 to estimate fixed assets ( land, building, Equipment, and fixtures). Suppose the estimate of fixed asset is as follows:
Fig 1. 5. Projected Balance Sheet for a small bookstore.
Liabilities. To complete the projected balance sheet, the owner must record a of the small firms liabilities—the claims against the assets. The bookstore owner was able to finance 50 percent of the inventory and fixtures through suppliers. The only major claim against the firm's asset is a note payable to entrepreneurs father-in-law for $ 20,000.
The final step is compile all of these items into a projected balance sheet as shown in fig. 1.5.
Once an entrepreneur has the business "up and running" with the help of a solid financial plan, the next step is to keep the company moving in the right direction with the help of proper financial controls. Establishing these controls – and using them consistently – is one of the keys to keeping a business vibrant and healthy. "If you don't keep a finger on the pulse of your company's finances, you risk making bad decisions," explains one business writer. "You could be in serious financial trouble and not even realize it."
A smoothly functioning system of financial controls is essential to business success. Such a system can serve as an early warning device for underlying problems that could destroy a young business. According to one writer,
A company's financial accounting and reporting systems will provide signals, through comparative analysis, of impending trouble, such as:
Decreasing sales and falling profit margins.
Increasing corporate overheads.
Growing inventories and accounts receivable.These are all signals of declining cash flows from operations, the lifeblood of every business. As cash flows decrease, the squeeze begins:
Payments to vendors become slower.
Maintenance on production equipment lags.
Raw material shortages appear. Equipment breakdowns occur.
All of these begin to have a negative impact on productivity. Now the downward spiral has begun in earnest. The key is hearing and focusing on the signals.
What are these signals, and how does an entrepreneur go about hearing and focusing on them? One extremely helpful tool is ratio analysis. Ratio analysis, a method of expressing the relationships between any two accounting elements, provides a convenient technique for performing financial analysis. These comparisons allow the small business manager to determine if the firm is carrying excessive inventory, experiencing heavy operating expenses, overextending credit, and managing to pay its debts on time, and answer other questions relating to the efficient operation of the firm. Unfortunately, few business owners actually use ratio analysis; one study discovered that just 2 percent of all entrepreneurs compute financial ratios and uses them in managing their businesses!
Clever business owners use financial ratio analysis to identify problems in their businesses while they are still problems, not business-threatening crises. Tracking these ratios over time permits an owner to spot a variety of "red flags" that are indications of these problem areas. This is critical to business success because a business owner cannot solve probles he does not know exist! At Atkinson-Baker & Associates, a Los Angeles court-reporting service, every one of the firm's fifty employees is responsible for tracking daily a key financial statistic relating to his or her job. CEO Alan Atkinson-Baker believes that waiting until the month's end to compile financial ratios takes away a company's ability to respond to events as they happen. "Employees quickly learn which numbers to track and how to compile or calculate them. "Each day everybody reports their statistics," explains Atkinson-Baker. "It all goes into a computer . . . and we keep track of it all." A spreadsheet summarized the calculations and generates twenty-seven graphs so managers can analyze trends in a meeting the following morning. One rule the company developed from its financial analysis is "Don't spend more today than you brought in yesterday." Atkinson-Baker explains, "You can never run into trouble as long as you stick to that rule." He also notes that effective financial planning would be impossible without timely data. "When we have had problem areas, the statistics have helped us catch them before they become a bigger problem," he says.
Business owners can also use ratio analysis to increase the likelihood of obtaining a bank loan. By analyzing the financial statements with ratios, an owner can anticipate potential problems and identify important strengths in advance. One bank loan officer explains, "We look closely at debt to net worth, debt to net income, and the quick ratio . . . We are primarily interested in trends."
But how many ratios should the small business manager monitor to maintain adequate financial control over the firm? The number of ratios that could be calculated is limited only by the number of accounts recorded on the firm's financial statements. However, a study conducted by the American Society of Accounting Executives concluded that "ratios may lose their significance and accuracy when they become excessively detailed. . . ."
TWELVE KEY RATIOS. We will describe twelve key ratios that will enable the owner to monitor the firm's financial position without becoming bogged down in financial details. This chapter presents explanations of these ratios and examples based on the balance sheet and income statement for Sam's Appliance Shop shown in Figs. 1.1 and 1.2.
Liquidity Ratios. Liquidity ratios tell whether the small business will be able to meet its maturing obligations as they come due. A small company with solid liquidity not only is able to pay its bills on time, but is also in a position to take advantage of attractive business opportunities as they arise. The primary measures of liquidity are the current ratio and the quick ratio.
Current Ratio. The current ratio measures the small firm's solvency by indicating its ability to pay current debts from current assets. It is calculated in the following manner:
Current ratio = Current assets Current liabilities = 686,985 367,850 = 1.87Current assets are those that the manager expects to convert into cash in the ordinary business cycle, and normally include cash, notes/accounts receivable, inventory, and any other and any other short-term marketable securities. Current liabilities are those short-term obligations that come due within 1 year, and include note/accounts payable, taxes payable, and accruals.
The current ratio is sometimes called the working capital ratio and is the most commonly used measure of short-term solvency. Typically, financial analysts suggest that a small business maintain a current ratio of at least 2 to1 (i.e., $2 of current assets for every $1 of current liabilities) to maintain a comfortable cushion of working capital. Generally, the higher the firm's current ratio, the stronger its financial position; but a high current ratio does not guarantee that the firm's assets are being used in the most profitable manner. For example, the business may be maintaining excessive balances of idle cash or may be overinvesting in inventory.
With its current ratio of 1.87, Sam's Appliance Shop could liquidate its current assets at 53.5 percent (1/1.87 = 0.535) of book value and still manage to pay its current creditors in full.
Quick Ratio. The quick ratio (or acid test ratio) is a more conservative measure of a firm's liquidity since it shows the extent to which its most liquid assets cover its current liabilities. It is calculated as follows:
Quick ratio = Quick assets Current liabilities = 686,985 – 455,455 367,850 = 0.63Quick assets include cash, readily marketable securities, and notes/accounts receivables, assets that can be converted into cash immediately if needed. Most small firms determine quick assets by subtracting inventory from current assets, because inventory cannot be converted into cash quickly. Also, inventories are the assets on which losses are most likely to occur in case of liquidation. The quick ratio is a more specific measure of a firm's ability to meet its short-term obligations and is a more rigorous test of its liquidity. It expresses capacity to pay current debts if all sales income ceased immediately. Generally, a quick ratio or 1 to 1 is considered satisfactory. A ratio of less than 1 to 1 indicates that the small firm is overly dependent on inventory and on future sales to satisfy short-term debt. A quick ratio of more than 1 to 1 indicates a greater degree of financial security.