SECTION 3 Building a Business Plan: Financial Issues

Chapter 7 Creating a Solid Financial Plan

Basic Financial Reports
Creating Projected Financial Statements
Ratio Analysis
Interpreting Business Ratios
Break-Even Analysis
Chapter 8 Managing Cash Flow
Cash Management
Cash and Profits Are Not the Same
Preparing a Cash Budget
The “Big Three” of Cash Management
Avoiding the Cash Crunch
Importance of 1. For raising capital needed to get a company off the ground
Financial Plan 2. Essential ingredient in managing a growing company
3. Earning a profit does not occur by accident; it takes planning
Basic Financial 1. Balance sheet
Statements  Assets = Liabilities + Owner’s equity (Capital)
 Estimate of company’s value on a specific date
2. Income statement
 Comparison of revenues against expenses to known net income (or loss)
 Company’s bottom line information
3. Statement of cash flow
 Change in the company’s working capital over the accounting period by listing
the sources and uses of funds

ASSETS
Current Assets cash/other items to be converted into cash within 1 year or within
the normal operating cycle of the company (AR, inventory)
Fixed Assets acquired for long-term use
Intangible Assets goodwill, copyrights, patents

LIABILITIES
Current Liabilities must be paid within 1 year or within the normal operating cycle
of the company
Long-Term Liabilities come due after 1 year

OWNER’S EQUITY
OE value of owner’s investment in the business

Cost of Goods Sold total cost of purchasing (+ shipping) the merchandise that the
company sells during the year
Gross Profit Net sales revenue – COGS
Gross Profit Margin Gross profit/net sales revenue
Operating Expenses costs contributing directly to manufacturing/distribution
Net Income (or Loss) Total revenue – total expenses
Projected Financial 1. Plot company’s financial future by setting operating objectives and analyzing the
Statements reasons for variations from targeted results
2. Present to prospective lenders and investors
3. Determine amount of assets the business will need to begin operation
12 Key Ratios LIQUIDITY RATIO – ability to meet maturing obligations as they come due
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
1. 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 working capital ratio; short-term solvency
𝑄𝑢𝑖𝑐𝑘 𝑎𝑠𝑠𝑒𝑡𝑠
2. 𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 acid test ratio

LEVERAGE RATIO – measure financing of company’s owners against that supplied

by creditors
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 (𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠)
3. 𝐷𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜 = % of total assets financed by creditors
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 (𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠)
4. 𝐷𝑒𝑏𝑡 𝑡𝑜 𝑛𝑒𝑡 𝑤𝑜𝑟𝑡ℎ 𝑟𝑎𝑡𝑖𝑜 = ability to meet creditor and
𝑇𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝑛𝑒𝑡 𝑤𝑜𝑟𝑡ℎ
owner obligations in case of liquidation
𝐸𝐵𝐼𝑇
5. 𝑇𝑖𝑚𝑒𝑠 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑎𝑟𝑛𝑒𝑑 𝑟𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 ability to make interest
payments on its obligations

OPERATING RATIO – evaluate performance and how effectively the resources are
being utilized
𝐶𝑂𝐺𝑆
6. 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 # of times
inventory is sold out
o Days’ inventory (average age of inventory) = 365/AITR
o Average number of days units remain in inventory
𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 (𝑜𝑟 𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠)
7. 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 (𝐷𝑎𝑦𝑠 𝑠𝑎𝑙𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔) = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
8. 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 (𝐷𝑎𝑦𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔) =
𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑
𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
9. 𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 𝑡𝑜 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 = 𝑁𝑒𝑡 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 ability to generate sales in
relation to its assets

PROFITABILITY RATIO – how efficiently a business is being managed; ability to

make profit
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
10. 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑜𝑛 𝑠𝑎𝑙𝑒𝑠 𝑟𝑎𝑡𝑖𝑜 = ( 𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 ) (100%) profit per dollar of sales
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
11. 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑜𝑛 𝑎𝑠𝑠𝑒𝑡𝑠 𝑟𝑎𝑡𝑖𝑜 = (𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠) (100%) ROA; profit generated
per dollar of owned assets
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
12. 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 = (𝑂𝐸 (𝑜𝑟 𝑛𝑒𝑡 𝑤𝑜𝑟𝑡ℎ) (100%) ROI
Cash Management Forecasting, collecting, disbursing, investing, planning for the cash a company needs to
operate smoothly – FCDIP (5)
Cash budget – cash map; amount and timing of cash receipts/disbursements week-by-
week or month-by-month
Importance 1. Most important yet least productive asset for small businesses
2. Must be maintained to meet normal operating requirements (+ reserve for
emergencies) without retaining excessively large, unproductive cash balance
3. Without adequate cash, a small business will fail
CM Roles 1. Cash finder
(FPDCC) 2. Cash planner
3. Cash distributor
4. Cash collector
5. Cash conserver
Profit vs. Cash Profit (Net income) = Total revenues – Total expenses
 Accounting concept to measure efficiency of company’s operation
Cash – money readily available
Cash flow – measure company’s liquidity and ability to pay its obligations
Cash Budget 1. Determine an adequate minimum cash balance
Preparation (Steps) 2. Forecasting sales
3. Forecasting cash receipts
4. Forecasting cash disbursements – record in the month they will be paid, not when the
obligation is incurred
5. Estimating the end-of-month cash balance
“Big Three” of 1. AR – collect ASAP
Cash Management a. Clear, firm credit and collection policies
b. Screen customers availing credit
c. Send invoice promptly and act promptly on past-due accounts
2. AP – stretch out as long as possible without damaging credit rating
a. Verify invoices before paying
b. Cash discounts
c. Negotiate best possible credit terms
5-Point AP system:
a. Set scheduling goals
b. Keep paperwork organized
c. Prioritize
d. Be consistent
e. Look for warning signs
3. INV – excess inventory = zero rate of return and ties up cash unnecessarily
Avoiding the Cash 1. Trim overhead costs (BASED ON CHAPTER SUMMARY)
Crunch a. Barter
b. Lease assets
- Operating lease – return asset back to leasing company with no
further obligation
- Capital lease – option to purchase equipment
c. Avoid nonessential outlays
d. Use zero-based budgeting
e. Internal control system
2. Invest surplus cash (primary criteria – security and liquidity)