Growing and Managing A Small Business: An Entrepreneurial Perspective

Growing and
Managing
a Small
Business
An Entrepreneurial
Perspective
Copyright Houghton Mifflin Company. All rights reserved.
17 | 2
CHAPTER 17
MANAGING AND EVALUATING
FINANCIAL PERFORMANCE
17 | 3
Learning Outcomes
Describe the accounting and record-keeping
options available to a business.
List and explain the purpose of the three main
financial statements.
Discuss the purpose of financial ratios and how
they can be used to describe the health of the
business.
Describe how to use cost-volume-profit analysis
to answer key questions about the financial
health of the business.
Explain key methods for accounts receivable
planning and financing
17 | 4
Chapter Outline
Accounting And Record-keeping Systems
Financial Statement Creation And Analysis
Ratios
Cost-volume-profit Analysis
Cash Planning And Working Capital
Management
Accounts Receivable

17 | 5
Why Accounting?
Any accounting system must accomplish
several things:
1. Produce an accurate picture of the companys
financial health.
2. Allow for comparisons of current financials with
previous periods.
3. Yield accepted financial statements consistent
with Generally Accepted Accounting Principles
(GAAP).
4. Facilitate the filing of financial and tax reports.
5. Expose fraud, theft, waste, and errors.
17 | 6
Accounting Options
Cash Method
Under the cash method, the easier of the two,
revenue and expenses are recognized and recorded
when they are realizedin other words, when the
revenue has been received and the expenses have
been paid.
Accrual Method
Used most often by growing companies, revenue is
recognized and reported when, for example, a sale
has taken place (the cash has not necessarily been
received), and expenses are reported when they are
incurred (not necessarily paid). Single-entry vs.
double-entry systems

17 | 7
Accounting Options
single-entry system
basically a checkbook system in which income
and expenses are recorded in one record.
double-entry system
uses journals and ledgers, thereby requiring that
each entry be posted twice, once in the journal and
once in the general ledger.
The result is a built-in balancing system to check
for errors and a natural basis for the financial
statements.
For this reason, it is highly recommended that all
businesses use this system from the very
beginning.
17 | 8
FINANCIAL STATEMENT
CREATION AND ANALYSIS

Income Statement
Balance Sheet
Cash Flow Statement (from operations)
17 | 9
FINANCIAL STATEMENT
Income Statement

often called the profit and loss statement
the first statement to be prepared
uses the accrual method
tax liability is determined from this
17 | 10
FINANCIAL STATEMENT
Balance Sheet
assets should equal the value of equity
and liabilities

Assets are equipment, inventory, cash,
facilities etc.
Liabilities are notes payable and
installments on loans, owners equity etc.
17 | 11
FINANCIAL STATEMENT
Cash flow statement
A record of inflow and outflow of cash and cash
equivalents

Normal operating:
inflow - cash sales and collected accounts receivable
outflows - inventory, payment of accounts payable
Non-operating: Inflow-loans and added capital
outflows-principal or interest on debt,
dividend distribution, legal claims etc.
17 | 12
Understanding Financial Statements
Financial Statements (Accounting Statements)
Reports of a firms financial performance and
resources, including an income statement and a
balance sheet
Helps determine a startups financial requirements
Assesses the financial implications
of a business plan
17 | 13
Understanding Financial Statements
Income Statement
A report showing the profit or loss from a firms
operations over a given period of time.
How profitable is the business?
Sales Expenses = Profits
Revenue from product or service sales
Cost of producing product/service (cost of goods sold, COGS)
Operating expenses (marketing, selling, general and
administrative expenses, and depreciation)
Financing costs (interest paid)
Tax payments
17 | 14
Sections of the Income Statement
Revenue from sales (net sales after returns)
Cost of goods sold (COGS)
The cost of producing or acquiring goods or services
to be sold by a firm
Gross profit
Sales less the cost of goods sold
Operating expenses
Costs related to marketing and selling a firms
product or service, general and administrative
expenses, etc.
Earnings before interest, taxes, depreciation and
amortization (EBITDA)

17 | 15
Sections of the Income Statement
Depreciation expenses
Costs related to a fixed asset, such as a building or
equipment, distributed over its useful life
Operating income (EBIT)
Earnings before interest and taxes are paid
Interest expenses
Financing costs paid to lenders on borrowed money
Taxes paid (if a C-corporation)
Net income/(loss) to owners (net profit)
Income that may be distributed to the owners or
reinvested in the company
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Exhibit 10.1
Operating Activities
Sales Revenue
=
= =
Operating Income
Earnings Before Taxes
Net Income Available
to Owners
Cost of producing or
acquiring product or
service
(cost of goods sold)
Gross profit
Marketing and selling
expenses, general and
administrative
expenses and
depreciation
(operating expenses)
,

=

Financing Activities
Operating Income
Interest expense
on debt
(financing costs)

Taxes
Earnings Before Taxes
Income taxes

The Income Statement: An Overview
17 | 17
Income Statement for Petri & Associates Leasing, Inc.,
for the Year Ending December 31, 2005
Sales revenue $850,000
Cost of goods sold $ 550,000
Gross profit $300,000
Operating expenses:
Marketing expenses $12,000
Wages and Benefits 78,000
General and administrative expenses 80,000
Earnings before int, tax, deprec, amort (EBITDA) $130,000
Depreciation $30,000
Operating income $100,000
Interest expense $20,000
Earnings before taxes $ 80,000
Income tax (25%) $20,000
Net income $ 60,000
Dividends paid $15,000
Change in retained earnings $ 45,000
17 | 18
The Balance Sheet
Balance Sheet
A report showing a firms assets, liabilities, and
owners equity at a specific point in time
Total Assets = Outstanding debt + Owners equity
17 | 19
Exhibit 10.3
Current Assets
Cash
Accounts receivable
Inventories
Other Assets
Long-term
investments, patents
+
+
Total Assets
= =
Fixed Assets
Machinery and
equipment
Buildings and land
Debt Capital
Accounts payable
Accrued expenses
Short-term notes
Long-term notes
Mortgages
+
Total Debt and Equity
Owner's Equity
Owner's net worth
or
Partnership equity
or
Common stock equity
Assets
Debt (Liabilities) and
Equity (Net Worth)
Current Debt
Long-term Debt
The
Balance
Sheet: An
Overview
17 | 20
Balance Sheet: Current Assets
Current Assets (Working Capital)
Assets that can be converted to cash within the
firms operating cycle
Cash: Currency and negotiable instruments
Accounts receivable: the amount of credit
extended to customers that is currently outstanding
Inventory: raw materials and products held in
anticipation of eventual sale
17 | 21
Balance Sheet: Fixed Assets
Fixed assets
Relatively permanent resources intended for use in the business (not
for resale) [land, equipment, buildings]
Depreciable assets
Assets whose value declines (depreciates) over time
Gross fixed assets
Original cost of depreciable assets before any depreciation expense
has been taken
Accumulated depreciation
Total depreciation expense taken over the assets life
Net fixed assets
Gross fixed assets less accumulated depreciation
Other assets
Assets other than current assets or fixed assets, such as patents,
copyrights, and goodwill
17 | 22
The Balance Sheet: Debt
Long-term debt
Loans and mortgages from banks and other sources
with repayment terms of more than 12 months
Mortgage
A long-term loan from a creditor for which real estate or
other assets are pledged as collateral
17 | 23
The Balance Sheet: Types of Financing
Owners equity
Money that the owners invest in the business
Owners are residual owners of the firm.
Creditors have first claim on the assets of the firm.
Retained earnings
Profits less withdrawals (dividends) over the life of
the business
Owners
equity
=
Owners
investment

Cumulative dividends
paid to owners
Cumulative
profits
+
Owners
equity
=
Owners
investment
+
Earnings retained
within the business
17 | 24
Balance
Sheets for
Petri &
Associates
Leasing,
Inc., for
December
31, 2004
and 2005
Exhibit 10.4
17 | 25
Lets Make Our Own Statements
THE DOG ATE MY STATEMENTS!!!!
(Only paper scraps are left on the floor!)

Advertising Expense = $16000 Inventories = $14000
Interest Expense = $1000
Cash = $6000 Brother-in-law equity = $3000
Additional Investment needed = $9000 Equipment = $23000
Net Sales = $75000 My equity investment = $2000
Accumulated Depreciation = $13000 Rent = $4000
Accounts Payable = $6000 Office Overhead = $14000
Depreciation = $10000 90 Day Bank Loan = $10000
Cost of Goods Sold = $40000
17 | 26
Our Projected Income Statement
Net Sales $ 75000
Cost of Goods Sold 40000
Gross Profit $35000
Advertising Expense 16000
Office Overhead 14000
Rent 4000
Earnings Before Depreciation (EBITDA) $ 1000
Depreciation 10000
OPERATING INCOME (EBIT) -$9000
Interest Expense 1000
Earnings Before Taxes (EBT) -$10000
Income Tax -0-
NET INCOME (LOSS) -$10000
17 | 27
Our Projected Balance Sheet
ASSETS
Cash $6000
Inventory 14000
Total Current Assets $20000
Equipment 23000
Less: Accum Deprec 13000
Total Fixed Assets $10000
TOTAL ASSETS $30000
Accounts Payable 6000
90 Day Bank Loan 10000
Total Current Liabilities $16000
Paid in Equity - Me 2000
Equity-Brother-in-law 3000
Total Equity (Net Worth) $ 5000
Addl Investment Needed $ 9000
TOTAL DEBT & EQUITY $30000
17 | 28
Profits Versus Cash Flows
Accrual-Basis Accounting
A method of accounting that matches revenues when
they are earned with the expenses associated with
those revenues
Sales reflect both cash and credit (noncash) sales
Inventory purchased on credit is a noncash expense
Depreciation is a noncash expense
Income tax is accrued and may not be entirely expensed
Cash-Basis Accounting
A method of accounting that reports transactions only
when cash is received or a payment is made
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The Fit of the Income Statement and the Balance Sheet
Exhibit 10.5
17 | 30
The Cash Flow Statement
Cash Flow Statement
A financial report showing a firms income (cash)
when it is received and expenses when they are paid.
When does the cash actually come in, and go out of
the firm?
Cash flows from normal operations (operating activities)
Cash flows related to the investment in or sale of assets
(investment activities)
Cash flows related to financing the firm
(financing activities)
17 | 31
The Cash Flow Statement (contd.)
Cash Flows from Operations
Net cash flows generated from operating a
business
Calculated by adding back to operating income
depreciation, deducting income taxes, and
factoring in any changes in net working capital
Adjusted Income
After-tax cash flow
Net Working Capital
Money invested in current assets less accounts
payable and accruals (CA-CL = WC)
17 | 32
The Cash Flow Statement (contd.)
Cash Flows from Investment Activities
Cash inflows and outflows resulting from the sale or
purchase of equipment or another depreciable asset
Cash Flows from Financing Activities
Cash inflows and outflows resulting from:
Paying dividends and interest expense
Increasing or decreasing short-term and long-term debt
Issuing or repurchasing stock
17 | 33
CASH PLANNING AND WORKING CAPITAL
MANAGEMENT
Include
Cash purchases
Cash sales
Loan payments and
interest (actual)
Cash expenditures
incurred (actual)
Exclude
Depreciation
Credit purchases
Credit sales
Accrued expenditures
17 | 34
CASH PLANNING AND WORKING CAPITAL
MANAGEMENT
Four steps in preparation
Step 1: Estimate Cash Sales
Step 2: Estimate Cash Inflows from Accounts
Receivable
Step 3: Estimate Cash Outflows
Step 4: Estimate the Minimum Cash Balance
17 | 35
CASH FLOW PLANNING
Month1 Month2 Month3
Sales . Month 0 = 56,200 59,450 54,000 63,375
BEGINNING CASH $10,000 $ 6,252 $ 5,912
Add:
Cash Sales (80% of current sales) +47,560 +43,200 +50,700
Accts Rec collected (mo.lag 20%) +11,240 +11,890 +10,800

Less:
Labor + benefits (64% of sales) -38,048 -34,560 -40,560
Rent, utilities, overhead - 2,000 - 2,110 - 2,320
Loan payment + interest -22,500 -15,500 -22,500
Equipment purchases -0- - 3,260 - 1,000

ENDING CASH $ 6,252 $ 5,912 $ 1,032
17 | 36
How to Finance Working Capital
Long-Term
Require more equity be invested initially
Ask owners for a cash infusion (increase investment)

Short-Term
Unsecured Bank Loan (a 90 day promissory note)
Line of Credit
(service fee based on whole amount, whether used or not)
Revolving Credit Lines (works like a credit card)
Factor accounts receivable (sell A/R at a discount)
Inventory loans (uses inventory as collateral)
Commercial paper (270 days maximum, sold on market)
17 | 37
Managing Accounts Receivable
Accounts Receivables = credit sales

Requires proper management of credit

Requires regular review of status

Extending credit to customers adds costs to the firm
Cost of checking credit
Cost of keeping records
Cost of bad debt write-offs
Interest costs of financing accounts receivables
Cost of collecting on delinquent accounts

17 | 38
Accounts Receivable Policies
Credit and Collection Policies
- governs how and when credit is extended
- sets credit standards - conditions customers must meet to get credit
- sets a credit period (30, 45, 60, or 90 days)
- establishes a collection policy when customers fail to comply

How to Handle the Delinquent Collections
cancel their credit
withhold products and services
Assess late charges
Place collections with an agency
Write off the bad debt

Compliance with the Fair Debt Collection Practices Act
Cant threaten the customer or use abusive language
Cant contact the customers employer or family
Cant falsely imply that a lawsuit has been filed
17 | 39
COST-VOLUME-PROFIT ANALYSIS
Determining the Selling Price
Maintaining the Same Profit Level with
Increased Costs
Sales Required to Achieve a Specific
Profit
Break-Even Analysis
17 | 40
Cost Profit Volume Analysis - The basic formula
Total Units (TU), Fixed costs (FC),
Profit (P), Contribution margin (CM),
Selling Price (SP), Variable Costs (VC),

(FC+P)
TU = ------------------
CM = (SP - VC)
17 | 41
Break-Even Analysis
Divide total fixed costs by the contribution
margin (price charged variable cost/unit)

Fixed costs
BE = -------------------
CM=(SP-VC)
Getty Images
17 | 42
Break-Even Analysis - Illustration
Waynes Detailing Shop
Monthly Fixed Costs (rent, utilities, advertising, office expenses, etc) = $1500
Charges $100 for each car detailed
Pays workers $12/hr plus 30% for benefits
It takes 3 hours to detail one car
Uses up about $10 worth of cleaning supplies for each job

FC = $1500 SP = $100 VC = ($10 + [$12x3x1.30]) = $56.80 CM = $43.20

Fixed costs
BE = ------------------- 1500/43.2 = 34.72 cars/month
CM=(SP-VC)
17 | 43
Break-Even Analysis - Illustration
Waynes Detailing Shop
Monthly Fixed Costs (rent, utilities, advertising, office expenses, etc) = $1500
Charges $100 for each car detailed
Pays workers $12/hr plus 30% for benefits
It takes 3 hours to detail one car
Uses up about $10 worth of cleaning supplies for each job

If Waynes Detailing Shop can average 50 cars a month, what would his monthly
profit be projected to be? What would his annual profits be?

FC = $1500 SP = $100 VC = ($10 + [$12x3x1.3]) = $56.80 CM = $43.20

Monthly revenue = 50x$100 = $5000 Monthly Fixed Costs = $1500
Monthly variable expenses = 50x56.80 = $2840

Monthly profit = (Revenue Variable Exp Fixed Exp) = $660/month, or $7920/yr
17 | 44
Ratios
Liquidity Ratios
Leverage Ratios
Activity Ratios
Profitability Ratios

Getty Images
17 | 45
Key Financial Ratios per Schwab
LIQUIDITY RATIOS
Current Ratio = Current Assets/Current Liabilities
Quick (Acid Test) Ratio = (Current Assets Inventories)/Current Liabilities
Working Capital Percentage = (Current Assets-Current Liabilities)/Net Sales

LEVERAGE RATIOS
Debt to Assets Ratio = Total Liabilities/Total Assets
Debt to Equity Ratio = Total Liabilities/Total Equity
Times Interest Earned = Operating Income/Interest Expense

ACTIVITY RATIOS
Accounts Receivable Turnover = Credit Sales/Accounts Receivable
Average Collection Period = (Accounts Receivable x 365)/Net Sales
Inventory Turnover = Cost of Goods Sold/Finished Goods Inventory
Asset Turnover = Net Sales/Total Assets

PROFITABILITY RATIOS
Return on Assets = Operating Income/Total Assets
Return on Equity = Net Income/Total Equity
Net Profit Margin = Net Income/Net Sales
17 | 46
Income Statement for Petri & Associates Leasing
Company for the Year Ending December 31, 2005
17 | 47
Balance
Sheet for
Petri &
Associates
Leasing
Company
for
December
31, 2005
17 | 48
Liquidity Ratios
Current Ratio
Quick or Acid Test
Working Capital Percentage
17 | 49
Can You Pay Your Bills?
LIQUIDITY RATIOS
Current Ratio
Comparing cash and near-cash current
assets against the debt (current liabilities)
coming due and payable within one year
3.50
$100,000
$350,000
ratio Current
Industry norm for current ratio = 2.70
s liabilitie Current
assets Current
ratio Current
17 | 50
Can You Pay Your Bills? (contd.)
LIQUIDITY RATIOS
Acid-Test Ratio (Quick Ratio)
A measure of a companys liquidity that
excludes inventories
Industry norm for acid-test ratio = 1.55
liabilities Current
Inventories - assets Current
ratio Acid-test

1.30
$100,000
$220,000 - $350,000
ratio

Acid-test
17 | 51
Can You Pay Your Bills? (contd.)
LIQUIDITY RATIOS
Working Capital Percentage
A measure of a companys working capital as a
percentage of total sales revenue

Industry norm for working capital percentage = .335
Working Capital Percentage = (Current Assets Current Liabilities)
Net Sales

Working Capital Percentage = ($350,000 - $100,000) = .294 or 29.4%
$850,000
17 | 52
Leverage Ratios
Debt to Assets Ratio
Debt to Equity Ratio
Times Interest Earned

Getty Images
17 | 53
How Much Debt Are You Using?
LEVERAGE RATIOS
To what extent have the firms assets been financed by
debt?
Debt/Assets Ratio
The ratio of total debt to total assets
Assets Total
Debt Total
ratio s Debt/Asset
32.6% or 0.326,
$920,000
$300,000
ratio s Debt/Asset
Industry norm for debt/assets ratio = 40.0%
17 | 54
How Much Debt Are You Using? (contd)
LEVERAGE RATIOS
How much debt is being used, compared to what the owners
have invested in the business?

Debt/Equity Ratio
The ratio of total debt to total equity
Equity Total
Debt Total
ratio y Debt/Equit
48.4% or 0.484,
$620,000
$300,000
ratio y Debt/Equit
Industry norm for debt/equity ratio = 66.7%
17 | 55
How Much Debt Are You Using? (contd)
LEVERAGE RATIOS
Times Interest Earned Ratio
The ratio of operating income to interest
charges
Expense Interest
Income Operating
earned interest Times
5.00
$20,000
$100,000
earned interest Times
Industry norm for time interest earned = 4.00
17 | 56
Activity Ratios
Accounts Receivable Turnover Ratio
Average Collection Period
Inventory Turnover
17 | 57
Are You Managing the Firm Well?
ACTIVITY RATIOS
Account Receivable Turnover Ratio
The number of times accounts receivable
rolls over during a year
receivable Accounts
sales Credit
turnover receivable Accounts
10.63
$80,000
$850,000
turnover receivable Accounts
Industry norm for accounts receivable turnover = 10.43
17 | 58
Are You Managing the Firm Well? (contd.)
ACTIVITY RATIOS
Average Collection Period
The average time it takes a firm to collect its
accounts receivable
Sales Credit
365 x receivable Accounts
Period Collection Average
days 34.35
$850,000
365) x ($80,000
Period Collection Average
Industry norm for average collection period = 35 days
17 | 59
Are You Managing the Firm Well? (contd.)
ACTIVITY RATIOS
Inventory Turnover
The number of times inventories roll over
during the year
Inventory
sold goods of Cost
turnover Inventory
2.50
$220,000
$550,000
turnover Inventory
Industry norm for inventory turnover = 4.00
17 | 60
Profitability Ratios
Profit Margin
Return on Assets/Return on Investment
Return on Equity
17 | 61
Are You Getting a Good Rate of Return
on Each Dollar of Sales?
Net Profit Margin
The rate of return that owners earn on each dollar of
sales
Sales
Income Net
Margin Profit Net
7.0% or 0.07,
$850,000
$60,000
Margin Profit Net
Industry norm for net profit margin = 9.5%
17 | 62
Are You Making a Good Return
on Your Assets?
Return on Assets
A measure of operating profits relative to
total assets
Industry norm for ROA: 13.20%
17 | 63
Are You Getting a Good Rate of Return on
Your Investment?
Return on Equity
The rate of return that owners earn on their
investment
Equity Total
Income Net
Equity on Return
9.7% or 0.097,
$620,000
$60,000
Equity on Return
Industry norm for return on equity = 12.5%
17 | 64
End Chapter 17

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