Lecture 10

CREATING A SUCCESSFUL
FINANCIAL PLAN
Financial management:
A process that provides entrepreneurs with
relevant financial information in an easy-to-read
format on a timely basis.

It allows entrepreneurs to know not only how

their businesses are doing financially but also why
they are performing that way.
Common mistake among business owners: Failing to
collect and analyze basic financial data.

Many entrepreneurs run their companies without

any kind of financial plan.

About 75% of business owners do not understand or

fail to focus on the financial details of their
companies.

Financial planning is essential to running a

successful business and is not that difficult!
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.
 Balance Sheet
•The balance sheet is built on the fundamental accounting equation:
Assets = Liabilities + Owner’s equity. Any increase or decrease on one side of the
equation must be offset by an increase or decrease on the other side

•Current assets consist of cash and items to be converted into cash within one year
or within the normal operating cycle of the company.

•Fixed assets are those acquired for long-term use in the business.

•The second section shows the business’s liabilities—the creditors’ claims against
the company’s assets.

•Current liabilities are those debts that must be paid within one year or within the
normal operating cycle of the company.

• long-term liabilities are those that come due after one year.

• This section of the balance sheet also shows the owner’s equity, the value of the
owner’s investment in the business
 Income Statement
•a financial statement that represents a moving picture of a business,
comparing its expenses against its revenue over a period of time to show its
net income (or loss).

•Cost of goods sold represents the total cost, including shipping, of the
merchandise sold during the accounting period.

•Subtracting the cost of goods sold from net sales revenue results in a
company’s gross profit.

•Dividing gross profit by net sales revenue produces the gross profit margin.

•If a company’s gross profit margin slips too low, it is likely that it will
operate at a loss (negative net income).

•Operating expenses include those costs that contribute directly to the

manufacturing and distribution of goods.
Helps the entrepreneur transform business goals into reality

Challenging for a business start-up

They should be realistic and well-researched!

Start-ups should create two-year projections

Projected financial statements:

Income statement

Balance sheet
A method of expressing the relationships between any two
elements on financial statements.
Studies indicate few small business owners compute

financial ratios and use them to manage their businesses.

Smart business owners use financial ratio analysis to identify

problems in their businesses while they are still problems and

not business-threatening crises.
Lenders and investors use ratios to analyze the financial

statements of companies looking for financing, comparing

them against industry averages and looking for trends over
time.
Liquidity Ratios:
Tell whether or not a small business will be able to meet its maturing
obligations as they come due.
1.Current Ratio
2.Quick ratio

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

$1.87 in current assets for every $1 it has in current liabilities.

With its current ratio of 1.87, company could liquidate its current assets at
53.5 percent (1 ÷ 1.87 = 53.5%) of its book value and still manage to
pay its current creditors in full.
2.Quick Ratio:
Shows the extent to which a firm’s most
liquid assets cover its current liabilities.

Quick Ratio = Quick Assets = 686,985 – 455,455 = 0.63:1

Current Liabilities $367,850

Company has 63 cents in quick assets for every $1 of current

liabilities.

Generally, a quick ratio of 1:1 is considered satisfactory.

A ratio of less than 1:1, as is the case with example above,

indicates that the small firm is dependent on inventory and
on future sales to satisfy short-term debt.

A quick ratio of greater than 1:1 indicates a greater degree of

financial security.
Leverage Ratios:

Measure the financing provided by the firm's owners

against that supplied by its creditors.

These ratios show the extent to which an

entrepreneur relies on debt capital (rather than equity

capital) to finance the business.
Careful! Debt is a powerful tool, but, like dynamite,

you must handle it carefully!

3.Debt ratio
4.Debt to net worth ratio
5.Times- interest- earned ratio
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

Creditors have claims of 68 cents against every $1 of assets that the

company owns, meaning that creditors have contributed twice as
much to the company’s asset base as its owners have.

Owners generally prefer higher leverage ratios; otherwise, business

funds must come either from the owners’ personal assets or from
taking on new owners, which means giving up more control over
the business.

In addition, with a greater portion of a firm’s assets financed by

creditors, the owner is able to generate profits with a smaller
personal investment
4.Debt to Net Worth Ratio:
expresses the relationship between the capital contributions from
creditors and those from owners and measures how highly
leveraged a company is .
Compares what a business “owes” to “what it is worth.”
Debt to Net = Total Debt = $580,000 = 2.20:1
Worth Ratio Tangible Net Worth $264,155

Company owes creditors $2.20 for every $1 of equity owned by owner.

A higher debt-to-net-worth ratio also means that the firm has less capacity
to borrow; lenders and creditors see the firm as being “borrowed up.”

A low ratio typically is associated with a higher level of financial security,

giving the business greater borrowing potential.
5.Times Interest Earned:
Measures the firm's ability to make the interest payments on its
debt.
This ratio measures the size of the cushion a company has in
covering the interest cost of its debt load

Times Interest = EBIT* = $60,629 + 39,850 =

Earned Total Interest Expense $39,850

= $100,479 = 2.52:1
$39,850
*Earnings Before Interest and Taxes
Company’s earnings are 2.5 times greater than its interest expense.
A high ratio suggests that a company has little difficulty meeting the
interest payments on its loans; creditors see this as a sign of safety
for future loans.
a low ratio is an indication that the company is overextended in its
debts; earnings will not be able to cover its debt service if this ratio
is less than one.
Operating Ratios:

Evaluate a firm’s overall performance and show how

effectively it is putting its resources to work.

6.Average Inventory Turnover Ratio

7.Average Collection Period Ratio

8.Average Payable Period Ratio

9.Net Sales to Total Assets Ratio

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
7.Average Collection Period Ratio:
Tells the average number of days required to collect
accounts receivable (days sales outstanding, DSO).
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
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
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

Company is generating $2.21 in sales for every

dollar of assets.
Profitability Ratios:
Measure how efficiently a
firm is operating; offer information about a firm’s “bottom line.”
10.Net Profit on Sales Ratio
11.Net Profit to Assets Ratio
12.Net Profit to Equity Ratio
10.Net Profit on Sales Ratio:
Measures a firm’s profit per dollar of sales
revenue.

Net Profit on = Net Profit = $60,629 = 3.24%

Sales Net Sales $1,870,841

For every dollar in sales company generates, owner keeps 3.24 cents in
profit.

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 Profit = $60,629 = 7.15%

Assets Total Assets $847,655
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

* Also called Net Worth

When comparing critical numbers to the industry

standards, ask:
Is there a significant difference in my company’s ratio and the

industry average?
If so, what is the difference meaningful?

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?

If so, what action should I take to correct the problem?

Sam’s Appliance Shop Industry Median
Quick ratio = 0.63:1 Quick ratio =
0.50:1

Again, Sam is below the rule of thumb of 1:1, but the company
passes this test of liquidity when measured against industry
standards. Sam relies on selling inventory to satisfy short-term
debt (as do most appliance shops). If sales slump, the result
could be liquidity problems for Sam’s. What steps should Sam
take to deal with this threat?
Sam’s Appliance Shop Industry Median
Debt ratio = 0.68:1 Debt ratio = 0.62:1

Creditors provide 68% of Sam’s total assets, very close to the

industry median of 62%. Although the company does not
appear to be overburdened with debt, Sam’s might have
difficulty borrowing, especially from conservative lenders.
Sam’s Appliance Shop Industry Median
Debt to net worth ratio = Debt to net worth ratio =
2.20:1 2.30:1

Sam’s owes $2.20 to creditors for every $1.00 the owner has
invested in the business (compared to $2.30 to every $1.00 in equity
for the typical business). Many lenders will see Sam’s as “borrowed
up,” having reached its borrowing capacity.
Sam’s Appliance Shop Industry Median
Times interest earned ratio = Times interest earned ratio = 2.10:1
2.52:1

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. Sam’s has a cushion (although a small one)
in meeting its interest payments.
Sam’s Appliance Shop Industry Median
Average inventory turnover Average inventory turnover ratio
ratio = 4.4 times per year
= 2.05 times per year

Inventory is moving through Sam’s at a very slow

pace. What could be causing this low inventory
turnover in Sam’s business?
Sam’s Appliance Shop Industry Median
Average collection period Average collection period
ratio = 50.0 days ratio = 10.3 days

Sam’s collects the average account receivable after 50 days

compared to the industry median of 11 days – about five times
longer. What steps can Sam take to improve this ratio?
Sam’s Appliance Shop Industry Median
Average payable period ratio = Average payable period ratio =
59.3 days 23 days

Sam’s payables are significantly slower than those of the typical firm in
the industry. Stretching payables too far could seriously damage the
company’s credit rating.
 Sam’s Appliance Shop Industry Median
Net sales to total assets Net sales to total assets
ratio = 2.21:1 ratio = 3.4:1

Sam’s Appliance Shop is not generating enough sales, given

the size of its asset base. What factors could cause this?
Sam’s Appliance Shop Industry Median
Net profit on sales ratio = Net profit on sales ratio =
3.24% 4.3%

After deducting all expenses, Sam’s has just 3.24 cents of every
sales dollar left as profit – nearly 25% below the industry median.
Sam may discover that some of his operating expenses are out of
balance.
Sam’s Appliance Shop Industry Median
Net profit to assets ratio = Net profit to assets ratio = 4.0%
7.15%

Sam’s generates a return of 7.15% for every $1 in assets, which is

nearly 79% above the industry average. Is this likely to be the result
of exceptional profitability, or is there another explanation?
Sam’s Appliance Shop Industry Median
Net profit to equity Net profit to equity ratio
ratio = 22.65% = 16.0%

Sam’s return on his investment in the business is an

impressive 22.65%, compared to an industry median of just
16.0%. Is this the result of high profitability, or is there
another explanation?
Breakeven point:
The level of operation at which a business
neither earns a profit nor incurs a loss.
A useful planning tool because it shows
entrepreneurs 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.
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 breakeven point:
Breakeven Point ($) = Total Fixed Costs
Contribution Margin
Step 1. Net Sales estimate: $950,000
Cost of Goods Sold: $646,000
Total expenses: $236,500.

Step 2. Variable Expenses: $705,125

Fixed Expenses: $177,375

Step 3. Contribution Margin = 1 - $705,125 = .26

$950,000

Step 4. Breakeven Point = $177,375 = $682,212

.26
Preparing a financial plan is a critical step

Entrepreneurs can gain valuable insight through:

Pro forma statements

Ratio analysis

Breakeven analysis