Creating a Successful Financial Plan

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. 11-2 1

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. 11-3 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 11-4 2

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. 11-5 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. 11-6 3

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 = 686,985 455,455 =.63:1 Current Liabilities $367,850 Interpretation: $0.63 of quick assets come for every $1 of current liabilities. 11-7 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. 11-8 4

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. 11-9 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. = $60,629 + 39,850 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. 11-10 5

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. 11-11 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. 11-12 6

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. 11-13 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. 11-14 7

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 $0.0324 (3.24%) in profit. 11-15 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. 11-16 8

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. 11-17 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. 11-18 9

FIGURE 11.7 Trend Analysis of Ratios Ch. 6: Franchising and the Entrepreneur 11-19 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. 34. 11-20 10

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. 11-21 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. 11-22 11

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. 11-23 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). 11-24 12

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. 11-25 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. 11-26 13

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. 11-27 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. 11-28 14

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). 11-29 Net profit on sales ratio = 3.24% Net profit on sale ratio = 7.6% Interpretation: For every dollar in sales company generates, company keeps $0.0324 (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. 11-30 15

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. 11-31 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%. 11-32 16

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. 11-33 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 11-34 17

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 $ = $177,375.26 $705,125 $950,000 =.26 = $682,212 11-35 FIGURE 11.8 Break-Even Chart for the Magic Shop Ch. 6: Franchising and the Entrepreneur 11-36 18

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