Creating a Successful Financial Plan

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1 CHAPTER 11 Creating a Successful Financial Plan The Importance of a Financial Plan Financial planning is essential to running a successful business and is not that difficult! Common mistake among business owners: Failing to collect and analyze basic financial data. Many entrepreneurs run their companies without any kind of financial plan. Only 11% of business owners analyze their companies financial statements as part of the managerial planning process

2 Basic Financial Statements Balance Sheet Snapshot. Estimates the firm s worth on a given date; built on the accounting equation: Assets = Liabilities + Owner s Equity Income Statement Moving picture. Compares the firm s expenses against its revenue over a period of time to show its net income (or loss): Net Income = Sales Revenue - Expenses Statement of Cash Flows Shows the change in the firm's working capital over a period of time by listing the sources and uses of funds Creating Projected Financial Statements Projected financial statements: Income statements Balance sheet Helps the entrepreneur transform business goals into reality Challenging for a business start-up Start-ups should focus on creating projections for two years

3 Ratio Analysis How is my company doing? A method of expressing the relationships between any two elements on financial statements. Barometers of a company s health. Studies indicate few small business owners compute financial ratios and use them to manage their businesses Liquidity Ratios - Tell whether or not a small business will be able to meet its obligations as they come due. 1. Current Ratio - Measures solvency by showing the firm's ability to pay current liabilities out of current assets. Current Ratio = Current Assets = $686,985 = 1.87:1 Current Liabilities $367,850 Interpretation: $1.87 of current assets come for every $1 of current liabilities

4 Liquidity Ratios - Tell whether or not a small business will be able to meet its obligations as they come due. 2. Quick Ratio - Shows the extent to which a firm s most liquid assets cover its current liabilities. Quick Ratio = Quick Assets = Current assets Inventory = Current Liabilities Current liabilities Quick Ratio = Quick Assets = 686, ,455 =.63:1 Current Liabilities $367,850 Interpretation: $0.63 of quick assets come for every $1 of current liabilities Leverage Ratios - Measure the financing provided by a firm s owners against that supplied by its creditors. 3. Debt Ratio - Measures the percentage of total assets financed by creditors rather than owners. Debt Ratio = Total Debt* = $367,850 + $212,150 =.68:1 Total Assets $847,655 *Current and long-term liabilities Interpretation: Creditors have claims of $0.68 against every $1 of assets owned by a company

5 Leverage Ratios - Measure the financing provided by a firm s owners against that supplied by its creditors. 4. Debt to Net Worth Ratio - Compares what a business owes to what it is worth. Debt to Net = Total Debt = $367,850 + $212,150 = 2.20:1 Worth Ratio Tangible Net Worth $267,655 $3,500 Interpretation: Company owes creditors $2.20 for every $1 of equity that a company owns Leverage Ratios - Measure the financing provided by a firm s owners against that supplied by its creditors. 5. Times Interest Earned - Measures the firm's ability to make the interest payments on its debt. Times Interest = EBIT+Tot. Int. Exp. = $60, ,850 Earned Total Interest Expense $39,850 = $100,479 = 2.52:1 $39,850 Interpretation: Company s earnings are 2.52 times greater than its interest expense

6 Operating Ratios - Evaluate a firm s overall performance and show how effectively it is putting its resources to work. 6. Average Inventory Turnover Ratio - Tells the average number of times a firm's inventory is turned over or sold out during the accounting period. Average Inventory = Cost of Goods Sold = $1,290,117 = 2.05 times Turnover Ratio Average Inventory* $630,600 a year *Average Inventory = Beginning Inventory + Ending Inventory 2 Interpretation: Company turns its inventory about two times a year, or once every 178 days Operating Ratios - Evaluate a firm s overall performance and show how effectively it is putting its resources to work. 7. Average Collection Period Ratio (days sales outstanding, DSO) - Tells the average number of days required to collect accounts receivable. Two Steps: Receivables Turnover = Credit Sales = $1,309,589 = 7.31 times Ratio Accounts Receivable $179,225 a year Average Collection = Days in Accounting Period = 365 = 50.0 Period Ratio Receivables Turnover Ratio 7.31 days Interpretation: Company turns over its receivables 7.31 times per year, or 50 days

7 Operating Ratios - Evaluate a firm s overall performance and show how effectively it is putting its resources to work. 8. Average Payable Period Ratio - Tells the average number of days required to pay accounts payable. Two Steps: Payables Turnover = Purchases = $939,827 = 6.16 times Ratio Accounts Payable $152,580 a year Average Payable = Days in Accounting Period = 365 = 59.3 days Period Ratio Payables Turnover Ratio 6.16 Interpretation: Company takes an average of 59.3 days to pay its accounts with suppliers Operating Ratios - Evaluate a firm s overall performance and show how effectively it is putting its resources to work. 9. Net Sales to Total Assets Ratio - Measures a firm s ability to generate sales given its asset base. Net Sales to = Net Sales = $1,870,841 = 2.21:1 Total Assets Total Assets $847,655 Interpretation: Company is generating $2.21 in sales for every $1 of its assets

8 Profitability Ratios - Measure how efficiently a firm is operating; offer information about a firm s bottom line. 10. Net Profit on Sales Ratio - Measures a firm s profit per dollar of sales revenue. Net Profit on = Net Income = $60,629 = 3.24% Sales Net Sales $1,870,841 Interpretation: For every dollar in sales company generates, company keeps $ (3.24%) in profit Profitability Ratios - Measure how efficiently a firm is operating; offer information about a firm s bottom line. 11. Net Profit to Assets (Return on Assets) Ratio tells how much profit a company generates for each dollar of assets that it owns. Net Profit to = Net Income = $60,629 = 7.15% Assets Total Assets $847,655 Interpretation: Company earns a return of 7.15% on its asset base

9 Profitability Ratios - Measure how efficiently a firm is operating; offer information about a firm s bottom line. 12. Net Profit to Equity Ratio - Measures an owner's rate of return on the investment (ROI) in the business. Net Profit to = Net Income = $60,629 = 22.65% Equity Owner s Equity $267,655 Interpretation: Company is earning 22.65% on the money it has invested in the business Ratios useful indicators of comparison. Standards vary from one industry to another. Critical numbers measure key financial and operational aspects of a company s performance. Examples: Sales per labor hour at a supermarket Food costs as a percentage of sales at a restaurant. Load factor (percentage of seats filled with passengers) at an airline

10 FIGURE 11.7 Trend Analysis of Ratios Ch. 6: Franchising and the Entrepreneur Putting Your Ratios to the Test When comparing your company s ratios to your industry s standards, ask the following questions: 1. Is there a significant difference in my company s ratio and the industry average? 2. If so, is this a meaningful difference? 3. Is the difference good or bad? 4. What are the possible causes of this difference? What is the most likely cause? 5. Does this cause require that I take action? 6. If so, what action should I take to correct the problem? Source: Adapted from George M. Dawson, Divided We Stand, Business Start-Ups, May 2000, p

11 Current ratio = 1.87:1 Current ratio = 1.50:1 Interpretation: $1.87 of current assets come for every $1 of current liabilities. Although Sam s falls short of the rule of thumb of 2:1, its current ratio is above the industry median by a significant amount. Sam s should have no problem meeting short-term debts as they come due Quick ratio = 0.63:1 Quick ratio = 0.50:1 Interpretation: $0.63 of quick assets come for every $1 of current liabilities. Again, Sam is below the rule of thumb of 1:1, but the company passes this test of liquidity when measured against industry standards

12 Debt ratio = 0.68:1 Debt ratio = 0.64:1 Interpretation: Creditors have claims of $0.68 against every $1 of assets owned by a company. Creditors provide 68% of Sam s total assets, very close to the industry median of 64%. Although the company does not appear to be overburdened with debt, Sam s might have difficulty borrowing, especially from conservative lenders Debt to net worth ratio = 2.20:1 Debt to net worth ratio = 1.90:1 Interpretation: Company owes creditors $2.20 for every $1 of equity that a company owns. Sam s owes $2.20 to creditors for every $1.00 the owner has invested in the business (compared to $1.90 to every $1.00 in equity for the typical business)

13 Times interest earned ratio = 2.52:1 Times interest earned ratio = 2.0:1 Interpretation: Company s earnings are 2.52 times greater than its interest expense. Sam s earnings are high enough to cover the interest payments on its debt by a factor of 2.52:1, slightly better than the typical firm in the industry Average inventory turnover ratio = 2.05 times per year Average inventory turnover ratio = 4.0 times per year Interpretation: Company turns its inventory about two times a year, or once every 178 days. Inventory is moving through Sam s at a very slow pace

14 Average collection period ratio = 50.0 days Average collection period ratio = 19.3 days Interpretation: Company turns over its receivables 7.31 times per year, or 50 days. Sam s collects the average account receivable after 50 days compared to the industry median of 19 days - more than 2.5 times longer Average payable period ratio = 59.3 days Average payable period ratio = 43 days Interpretation: Company takes an average of 59.3 days to pay its accounts with suppliers. Sam s payables are nearly 40 percent slower than those of the typical firm in the industry. Stretching payables too far could seriously damage the company s credit rating

15 Net sales to total assets ratio = 2.21:1 Net Sales to total assets ratio = 2.7:1 Interpretation: Company is generating $2.21 in sales for every $1 of its assets. is not generating enough sales, given the size of its asset base (compared to the industry standards) Net profit on sales ratio = 3.24% Net profit on sale ratio = 7.6% Interpretation: For every dollar in sales company generates, company keeps $ (3.24%) in profit. After deducting all expenses, Sam s has just 3.24 cents of every sales dollar left as profit - less than half the industry average

16 Net profit to assets ratio = 7.15% Net Sales to working capital ratio = 5.5% Interpretation: Company earns a return of 7.15% on its asset base. Sam s generates a return of 7.15% for every $1 in assets, which is 30% above the industry average Net profit on equity ratio = 22.65% Net profit on equity ratio = 12.6% Interpretation: Company is earning 22.65% on the money it has invested in the business. Sam s return on his investment in the business is an impressive 22.65%, compared to an industry median of just 12.6%

17 Breakeven Analysis Breakeven point - the level of operation at which a business neither earns a profit nor suffers a loss. It shows entrepreneurs minimum level of activity required to stay in business Calculating the Breakeven Point Step 1. Determine the expenses the business can expect to have. Step 2. Categorize the expenses in step 1 into fixed expenses and variable expenses. Step 3. Calculate the ratio of variable expenses to net sales. Then compute the contribution margin: Contribution Margin = 1 - Variable Expenses Net Sales Estimate Step 4. Compute the breakeven point: Breakeven Point ($) = Total Fixed Costs Contribution Margin

18 Calculating the Breakeven Point: The Magic Shop Step 1. Net Sales estimate is $950,000 with Cost of Goods Sold of $646,000 and total expenses of $236,500. Step 2. Variable Expenses: $705,125 Fixed Expenses: $177,375 Step 3. Contribution margin: Contribution Margin = 1 - Step 4. Breakeven Point: Breakeven Point $ = $177, $705,125 $950,000 =.26 = $682, FIGURE 11.8 Break-Even Chart for the Magic Shop Ch. 6: Franchising and the Entrepreneur

19 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America

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