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6.

1 Understanding the Key Financial Statements

Basic financial statements an entrepreneur needs to be familiar with are; the balance
sheet, the income statement, and the cash-flow statement.
The Balance Sheet  Reports a business’s financial position at a specific time.
The balance sheet is divided into two parts:

o The financial resources owned by the firm
o The claims against these resources

The financial resources the firm owns are called assets.


The claims creditors have against the company are called liabilities.

o Short-term liabilities must be paid during the coming 12 months.
o Long-term liabilities are not due and payable within the next 12 months.

The residual interest of the firm’s owners is known as owners’ equity.


UNDERSTANDING THE BALANCE SHEET
The balance sheet has three sections:

o
 assets (Current, Fixed)
 liabilities, and
 owners’ equity.

Current Assets
Cash and other assets expected to be turned into cash, sold, or used up during a
normal operating cycle (cash, accounts receivable, inventory, prepaid expenses)
Fixed Assets
Land, building, equipment, and other assets expected to remain with the firm for an
extended period; they are not totally used up in the production of the firm’s goods and
services.
Current Liabilities
Obligations due and payable during the next year or within the operating cycle
(accounts payable, notes payable, taxes payable, and loans payable).
Long-Term Liabilities
Obligations not due or payable for at least one year or not within the current operating
cycle (bank loans).
Contributed Capital
When a corporation is owned by individuals who have purchased stock in the business;
various kinds of stock can be sold by a corporation, the most typical being common
stock and preferred stock.
Retained Earnings
The accumulated net income over the life of the corporation to date; every year this
amount increases by the profit the firm makes and keeps within the company.
WHY THE BALANCE SHEET ALWAYS BALANCES
The balance sheet always balances because if something happens on one side of the
balance sheet, it is offset by something on the other side.
A Credit Transaction
When a company orders materials from a supplier, their inventory goes up
and accounts payable also goes up by the amount the supplier charged. The increase
in current assets is offset by an increase in current liabilities.
When the bill is paid by the company by issuing a check, cash declines by the billed
amount. At the same time, accounts payable decreases by this same amount. Again,
these are offsetting transactions, and the balance sheet remains in balance.
A Bank Loan
A company may have an outstanding bank loan of $200,000 in 2018. If the company
increases this loan by $110,000 in 2016, cash goes up by $110,000, and bank loan
increases by the same amount. In addition, if the firm uses this $110,000 to buy new
machinery, cash decreases by $110,000 and equipment increases by the same
amount.
A Stock Sale
A company issues and sells shares of common stock. The balance sheet action shows
that common stock increases as well as cash.
The Income Statement
Shows the change that has occurred in a firm’s position as a result of its operations over
a specific period.
            Revenue: obtained every time a business sells a product or performs a service
            Expenses: major expenses, inclusive of costs of goods sold
            Net income: excess of revenue over expenses 
UNDERSTANDING THE INCOME STATEMENT
The typical income statement has five major sections: (1) sales revenue, (2) cost of
goods sold, (3) operating expenses, (4) financial expense, and (5) income taxes
estimated.
Revenue—sales revenue is often referred to as gross revenue.
Cost of Goods Sold—the cost of goods for a given period equals the beginning
inventory plus any purchases the firm makes minus the inventory on hand at the end of
the period.
Operating Expenses—major expenses, exclusive of costs of goods sold, are classified
as operating expenses. Expenses often are divided into two broad subclassifications:
selling expenses and administrative expenses.
Financial Expense—financial expense is the interest expense on long-term loans.
Estimated Income Taxes— corporations pay estimated income taxes.
The Cash-Flow Statement
The cash-flow statement shows the effects of a company’s operating, investing, and
financing activities on its cash balance.
Key questions answered by the cash-flow statement:

o How much cash did the firm generate from operations? Operating cash
flows: cash generated from or used in the course of business operations of the
firm.
o How did the firm finance fixed capital expenditures? Financing activities:
cash flow effect of financing decisions of the firm (sale of stocks and bonds,
repurchase of securities, and payment of dividends)
o How much new debt did the firm add? Investing activities: cash flow
effects from long-term investing activities, such as purchase or sale of plant and
equipment

6.2 Preparing Financial Budgets

Preparing Financial Budgets


The operating budget is a statement of estimated income and expenses during a
specified period of time. Another common type of budget is the cash-flow budget, which
is a statement of estimated cash receipts and expenditures during a specified period of
time.
The Operating Budget
The first step in an operating budget is the preparation of the sales forecast.
Simple linear regression is a technique in which a linear equation states the relationship
among three variables.
Y = a + bx
Y - is a dependent variable, x is an independent variable,
a - is a constant, and
b - is the slope of the line (the change in Y divided by the change in x).
 After forecasting sales for the budget period, expenses must be estimated.
 Production budget: estimate of the number of units to be produced to meet the sales
forecast.
 The last step in preparing the operating budget is to estimate the operating expenses
for the period.

o

 fixed costs
 variable costs
 mixed costs

The Cash-Flow Budget


A statement of estimated cash receipts and expenditures over a specified period of time
is considered the cash-flow budget.

o Cash sales
o Cash payments received on account
o Loan proceeds

6.3 Pro Forma Statements

The final step in the budget process. These are projections of a firm’s financial position
during a future period or on a future date. There are two kinds of pro forma statements.

 Income statements—done first, as in normal accounting. The firm will have


already prepared the pro forma income statements for each month in the budget
period.
 Balance sheet— followed by the income statement as in the normal accounting
cycle but is more complex. The last balance sheet prepared before the budget
period began, the operating budget, and the cash-flow budget are needed to
prepare it.
6.4 Capital Budgeting

A technique the entrepreneur can use to help plan for capital expenditures. The first
step is to identify cash flows and timing. The second step is to obtain reliable estimates
of savings and expenses. 
There are three common methods used in capital budgeting. 
Payback Method

 Easiest
 The length of time required to “pay back” the original investment is the
determining criterion.
 A problem that occurs is that it ignores cash flows beyond payback period.

Net Present Value (NPV)

 This technique helps to minimize some of the shortcomings of the payback


method by recognizing the future cash flows beyond the payback period.
 This concept works on the premise that a dollar today is worth more than a dollar
in the future—how much more depends on the applicable cost of capital for the firm.

Internal Rate of Return

 This method is similar to NPV in that the future cash flows are discounted. They
are discounted at a rate that makes the NPV of the project equal to zero. This rate is
what is referred to as the internal rate of return on the project. The project with the
highest IRR is then selected. Thus, a project that would be selected under the NPV
method would also be selected under the IRR method.
 One of the drawbacks to using the IRR method is the difficulty that can be
encountered when using the technique.

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