Lecture 5 Basic financial accounting

Transcription

1 Lecture 5 GOVERNANCE AND ACCOUNTING IN SMES PROF. ENRICO BRACCI Agenda 1. Describe the basic financial reporting documents: Income statement Balance sheet Cash flow statement 2. How to prepare a financial report forecast 3. The understanding of the financial statement through ratio analysis 4. Break-even analysis 2 2 1

2 Financial Statements Entrepreneurs use three basic financial statements: Income statement Balance sheet Cash flow statement Together, these financial reports show the health of a business at a glance. 3 Income Statement Shows profit or loss over a particular time period. Revenues > Expenses = Positive Balance = Profit Expenses > Revenues = Negative Balance = Loss Serves as a scorecard; helps reveal problems. Profit is a reward for making the right choice. 4 2

3 Parts of an Income Statement Revenue(or Net sales) - COGS/COSS(equals = Purchases Beg. Inventory + End. Inventory) = Gross profit - Other variable costs = Contribution margin - Fixed operating costs = Earnings before interest, taxes, depreciation and amortization (EBITDA) - Depreciation and Amortization = Earnings before interest and taxes (EBIT) - Pre-tax profit -Taxes = Net profit/(loss) 5 Beyond the Double Bottom Line 6 3

4 An Income Statement for a More Complex Business 7 Balance Sheet Called a point-in-time financial statement because it shows the state of a business at a given moment. Typically prepared quarterly and at the end of the fiscal year (12-month accounting period chosen by the firm). 8 4

5 Parts of a Balance Sheet Assets things the company owns that are worth money. Liabilities the company s debts that must be paid (including unpaid bills). Owner s Equity (OE) Assets Liabilities = OE. Also called net worth. The amount of capital in the company. 9 Types/Examples of Assets Current assets cash, items easily turned into cash, and items used within one year. Accounts receivable Inventory Supplies Long-term assets items that would take the business more thanoneyeartouse. Equipment Furniture Machinery Real estate 10 5

6 Types/Examples of Liabilities Current liabilities debts scheduled for payment within one year(includes portion of long-term debt due within the year). Long-term liabilities debts to be paid over a time period longer than one year. Examples of liabilities: Accounts payable(bills). Loans from banks, family, or friends. Mortgages. Lines of credit. 11 Balance Sheet (Horizontal Format) 12 6

7 The Balance Sheet Equation Assets Liabilities = Owner s Equity (OE) or Assets = Liabilities + Owner s Equity or Liabilities = Assets Owner s Equity (Net worth and capital are other names for OE) 13 Total Assets Must Equal ( Balance ) Total Liabilities + Owner s Equity If an item was financed with debt, the loan is a liability. If an item was purchased with the owner s (or shareholders ) money, it was financed with equity. Liabilities and owner s equity pay for all assets. 14 7

8 Basic Financial Reports The Balance Sheet Snapshot of the business Estimates the firm's worth on a given date Assets = Liabilities + Owner's Equity Assets Current assets Fixed assets Intangible assets Liabilities Current liabilities Long-term liabilities Owner s equity 15 Basic Financial Reports The Income Statement The income statement 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 Cost of goods sold Gross profit Gross profit margin Operating expenses Net income or loss 16 8

9 Basic Financial Reports The Statement of Cash Flows Shows the change in the firm's working capital over a period of time by listing the sources of funds and the uses of these funds 17 Financial Planning Research shows: A significant positive relationship exists between formal planning in small companies and their financial performances But, significant numbers of entrepreneurs run their companies without any kind of financial plan! 18 9

10 Creating Projected (or pro-forma) Financial Statements Projected financial statements answer questions such as: What profit can the business expect to earn? If the founder s profit objective is xxx, what sales level must the business achieve? What fixed and variable expenses can the owner expect at that level of sales? They estimate the profitability and the overall financial condition of the business in the immediate future They are an integral part of convincing potential lenders and investors to provide the financing needed to get the company off the ground or to expand 19 Creating Projected Financial Statements: an overview Foundation for financial forecast - Business model, marketing analysis and forecast - Business model assumptions Forecast (Pro forma) financial elememts Forecasted balance sheet Current assets Fixed assets Total assets Liabilties Owners equity Total Liabilities & OE Projected start-up capital requirements Forecast revenue Forecast expenses Financing plan (Sources of funds) Forecasted income statement Sales Expenses Depreciation Operating income Interest Taxes Net Income Cash flow forecast - From operations - From investing - From exernal sources of financing 20 10

11 Ratio Analysis Ratio analysis: a method of expressing the relationships between any two accounting elements, provides a convenient technique for performing financial analysis Ratios serve as a barometer of the company s financial health 21 Analyzing Balance Sheet Data Compare balance sheets from two different points in time to see progress. Use ratios for a quick understanding. Calculate the percentage of change between the reports for each line item. An increase in owner s equity is one way to measure success

12 Type of ratios Economic/profitability ratios ROE ROI ROS Financial ratios Quick ratio Current ratio Debt ratios Operational efficiency ratios Accounts receivable days of collection and turnover Accounts payable days of payment and turnover Inventory days and turnover 23 Return on Equity (ROE) Also called Net profit to equity ratio, the Return on Equity measures return as a percentage of the Owners Equity (or Net Worth). (Net Profit / Owners Equity) X 100 = ROE% 24 12

13 Return on Investment (ROI) Entrepreneurs invest time, energy, and money because they expect a return of money or satisfaction. Return on investment (ROI) measures return as a percentage of the original investment. (EBIT / Investment) X 100 = ROI% Nb: also the NET PROFIT can be used in the formula instead of EBIT 25 Return on Sales (ROS) ROS is also called the profit margin because it is an important measure of business profitability. ROS% = (EBIT / sales) x 100 Nb: also the NET PROFIT can be used in the formula instead of EBIT 26 13

14 Quick Ratio Quick Ratio: (Cash + Marketable Securities) Current Liabilities Marketable securities investments such as certificates of deposit or Treasury bills. If the quick ratio is greater than one, there is enough cash to cover all current liabilities shortly. 27 Current Ratios Current ratio Current Assets Current Liabilities If the current ratio is greater than one, the business could sell some assets to pay off its debts. A ratio greater than 1,5 is considered appropriate A ratio smaller than 1 highlights a critical situation 28 14

15 Debt Ratios Debt-to-Equity Ratio: Total Debt Equity Indicates how many dollars in the business were provided by owners/investors. A ratio of 1-to-1 means for every $1 of debt, the company owns$1ofassets. Debt Ratio: Total Debt Total Assets Indicates how many dollars in the business were provided by creditors. A ratio of 0.5 means the company is in debt for 50% of its assets. 29 Formulas for Calculating Operating Efficiency Ratios Collection-period ratio measures the average number of days that sales are going uncollected. Average Accounts Receivable (Balance Sheet) X 360 =# of days Total net Sales (Income Statement) Receivable turnover ratio measures the efficiency of your company s efforts to collect receivables. Total Sales (Income Statement) Average Accounts Receivable (Balance Sheet) = # of times 30 15

16 Formulas for Calculating Operating Efficiency Ratios Payment-period ratio measures the average number of days that purchases are going unpaid. Average Accounts Payable (Balance Sheet) X 360 =# of days Total net Purchases (Income Statement) Payable turnover ratio measures the efficiency of your company s procurement activity. Total Purchases (Income Statement) Average Accounts Payable (Balance Sheet) = # of times 31 Operating Efficiency Ratios Inventory turnover ratio measures how quickly inventory is being sold. Cost of Goods Sold (Income Statement) = # of times Average Inventory (Balance Sheet) Inventory period ratio measures how quickly inventory is being sold in days. Average Inventory (Balance Sheet) X 360= # days Cost of Goods Sold (Income Statement) 32 16

17 Ratio Analysis Times interest earned ratio: a measure of a small company s ability to make the interest payments on its debt 33 Interpreting Business Ratios Key performance ratios vary across industries and within different segments of the same industry Key performance indicators (KPIs): ratios that are unique to their own operations 34 17

18 Interpreting Business Ratios Ask: Is there a significant difference in my company s ratio and the industry average? If so, is this a meaningful difference? Is the difference good or bad? What are the possible causes of this difference? What is the most likely cause? Does this cause require that I take action? What action should I take to correct the problem? 35 Interpreting Business Ratios What Do All These Numbers Mean? Goal: achieve ratios that are better than the industry average Where necessary, understand why figures are out of line Analyze figures over time Ratios are snapshots of the situation in a single instance 36 18

19 Breakeven Analysis Breakeven point: the level of operation (sales dollars or production quantity) at which it neither earns a profit nor incurs a loss The single most important financial figure to understand It is a useful planning tool because it shows entrepreneurs the minimum level of activity required to stay in business With one change in the breakeven calculation, an entrepreneur can also determine the sales volume required to reach a particular profit target 37 Breakeven Chart 38 19

20 Breakeven Analysis Calculating the Breakeven Point Step 1: Determine the expenses the business can expect to incur 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 Step 4: Compute the break-even point by inserting this information into this formula: 39 Breakeven Analysis Adding a Profit The breakeven formula can be modified to include a profit Profit is treated as a fixed cost 40 20

21 Breakeven Analysis Breakeven Point in Units Breakeven point can also be expressed in units produced or sold To compute breakeven point in units use this formula: 41 Breakeven Analysis Using Breakeven Analysis Breakeven analysis is a useful planning tool for entrepreneurs, especially when approaching potential lenders and investors for funds It provides an opportunity for integrated analysis of sales volume, expenses, income, and other relevant factors. With just a few calculations, an entrepreneur can determine the minimum level of sales needed to stay in business as well as the effects of various financial strategies on the business 42 21

22 Readings Scarborough, N., Cornwall, J. (2015), Entreprenurship and effective Small Business Management, Pearson, Chapter 14 Additional Reading Mariotti and Glackin (2015), Entreprenurship and small business management, Pearson, Chapter