chapter 8: cash flow1 copyright 2002 prentice hall publishing company managing cash flow

Chapter 8: Cash Flow 1Copyright 2002 Prentice Hall Publishing Company

ManagingCash FlowManagingCash Flow


Cash ManagementCash Management

Young, growing companies are “cash sponges.”Young, growing companies are “cash sponges.” A business can be earning a profit and be A business can be earning a profit and be

forced to close because it runs out of cash! forced to close because it runs out of cash! Cash management – forecasting, collecting, Cash management – forecasting, collecting,

disbursing, investing, and planning for the cash disbursing, investing, and planning for the cash a company needs to operate smoothly. a company needs to operate smoothly.


Cash Flow EngineCash Flow Engine


Five Cash Management Roles of Five Cash Management Roles of an Entrepreneuran Entrepreneur

Cash FinderCash Finder Cash PlannerCash Planner Cash DistributorCash Distributor Cash CollectorCash Collector Cash ConserverCash Conserver

The Cash Flow CycleThe Cash Flow Cycle

OrderOrderGoodsGoods

Day 11

ReceiveReceiveGoodsGoods

1515

PayPayInvoiceInvoice

4040

1414 2525

218218

178178

SellSellGoods*Goods*

DeliverDeliverGoodsGoods

221221

33

CustomerCustomerPays**Pays**

SendSendInvoiceInvoice

230230

99

280280

5050

Cash Flow Cycle = 240 daysCash Flow Cycle = 240 days

* Based on Average Inventory Turnover:* Based on Average Inventory Turnover:

365 days 365 days = 178 days = 178 days 2.05 times/year2.05 times/year

** Based on Average Collection Period:** Based on Average Collection Period:

365 days 365 days = 50 days = 50 days 7.31 times/year7.31 times/year


The Cash BudgetThe Cash Budget

A “cash map,” showing the amount and A “cash map,” showing the amount and the timing of a firm’s cash receipts and the timing of a firm’s cash receipts and cash disbursements over time.cash disbursements over time.

Predicts the amount of cash a company Predicts the amount of cash a company will need to operate smoothly.will need to operate smoothly.

A helpful tool for visualizing the firm’s A helpful tool for visualizing the firm’s cash receipts and cash disbursements and cash receipts and cash disbursements and the resulting cash balance.the resulting cash balance.


Preparing a Cash BudgetPreparing a Cash Budget

Determine a Minimum Determine a Minimum Cash BalanceCash Balance

Forecast SalesForecast Sales Forecast Cash ReceiptsForecast Cash Receipts Forecast Cash Forecast Cash

DisbursementsDisbursements Estimate End-of-Month Estimate End-of-Month

Cash BalanceCash Balance


Remember Goldilocks, the Three Bears, Remember Goldilocks, the Three Bears, and the porridge: and the porridge: Not too much...Not too much... Not too little...Not too little... but a cash balance that’s just right ... for but a cash balance that’s just right ... for

you!you!

Determine a Minimum Determine a Minimum Cash BalanceCash Balance


The The heartheart of the cash budget of the cash budget Sales are ultimately transformed into Sales are ultimately transformed into

cash receipts and cash disbursements.cash receipts and cash disbursements. Prepare three sales forecasts:Prepare three sales forecasts:

» Most LikelyMost Likely» PessimisticPessimistic» OptimisticOptimistic

Forecast SalesForecast Sales


Sales Forecast for a Start-UpSales Forecast for a Start-Up

Example:Example:Number of cars in trading zoneNumber of cars in trading zone 84,000 84,000 x Percent of importsx Percent of imports x 24%x 24%= Number of imported cars in trading zone= Number of imported cars in trading zone 20,160 20,160Number of imports in trading zoneNumber of imports in trading zone 20,160 20,160 x Average expenditure on repairsx Average expenditure on repairs x $485x $485= Total import repair sales potential= Total import repair sales potential $9,777,600 $9,777,600Total import repair sales potentialTotal import repair sales potential $9,777,600 $9,777,600 x Estimated market sharex Estimated market share x 9.9%x 9.9%= Sales estimate= Sales estimate $967,982$967,982


Record all cash receipts when Record all cash receipts when actually actually received received (i.e., the cash method of (i.e., the cash method of accounting).accounting).

Determine the collection pattern for Determine the collection pattern for credit sales; then add cash sales.credit sales; then add cash sales.

Forecast Cash ReceiptsForecast Cash Receipts


Start with those disbursements that are fixed Start with those disbursements that are fixed amounts due on certain dates.amounts due on certain dates.

Review the business checkbook to ensure Review the business checkbook to ensure accurate estimates.accurate estimates.

Add a cushion to the estimate to account for Add a cushion to the estimate to account for “Murphy's Law.”“Murphy's Law.”

Don’t know where to begin? Try making a Don’t know where to begin? Try making a dailydaily list of the items that generate cash and list of the items that generate cash and those that consume it.those that consume it.

Forecast Cash DisbursementsForecast Cash Disbursements


Take Beginning Cash Balance...Take Beginning Cash Balance... Add Cash Receipts...Add Cash Receipts... Subtract Cash DisbursementsSubtract Cash Disbursements Result is Cash Surplus or Cash Shortage Result is Cash Surplus or Cash Shortage

(Repay or Borrow?)(Repay or Borrow?)

Estimate End-of-Month Estimate End-of-Month BalanceBalance


The “Big Three” ofThe “Big Three” of Cash Management Cash Management

Accounts ReceivableAccounts Receivable Accounts PayableAccounts Payable InventoryInventory


About 90% of industrial and wholesale sales About 90% of industrial and wholesale sales are on credit, and 40% of retail sales are on are on credit, and 40% of retail sales are on account.account.

Recent survey of small companies across a Recent survey of small companies across a variety of industries found that 77% extend variety of industries found that 77% extend credit to their customers.credit to their customers.

Remember: “A sale is not a sale until you Remember: “A sale is not a sale until you collect the money.”collect the money.”

The goal with accounts receivable is to collect The goal with accounts receivable is to collect your company’s cash as fast as you can.your company’s cash as fast as you can.

Accounts ReceivableAccounts Receivable


Establish a firm credit-granting policy.Establish a firm credit-granting policy. Screen credit customers carefully.Screen credit customers carefully. When an account becomes overdue, take action When an account becomes overdue, take action

immediatelyimmediately.. Add finance charges to overdue accounts (check the law Add finance charges to overdue accounts (check the law

first!).first!). Develop a system of collecting accounts.Develop a system of collecting accounts. Send invoices promptly.Send invoices promptly.

Accounts ReceivableAccounts Receivable

Beating the Cash CrisisBeating the Cash Crisis


Stretch out payment times as long as possible Stretch out payment times as long as possible without damaging your credit ratingwithout damaging your credit rating..

Verify Verify allall invoices before paying them. invoices before paying them. Take advantage of cash discounts.Take advantage of cash discounts. Negotiate the best possible terms with your Negotiate the best possible terms with your

suppliers.suppliers. Be honest with creditors; avoid the “the check is Be honest with creditors; avoid the “the check is

in the mail” syndrome.in the mail” syndrome. Schedule controllable cash disbursements to come Schedule controllable cash disbursements to come

due at different times.due at different times. Use credit cards wisely.Use credit cards wisely.

Accounts PayableAccounts PayableBeating the Cash CrisisBeating the Cash Crisis


Monitor it closely; it can drain a Monitor it closely; it can drain a company's cash.company's cash.

Avoid inventory “overbuying.” It ties up Avoid inventory “overbuying.” It ties up valuable cash at a zero rate of return.valuable cash at a zero rate of return.

Arrange for inventory deliveries at the Arrange for inventory deliveries at the latest possible date.latest possible date.

Negotiate quantity discounts with Negotiate quantity discounts with suppliers when possible.suppliers when possible.

InventoryInventoryBeating the Cash CrisisBeating the Cash Crisis


Avoiding the Cash CrunchAvoiding the Cash Crunch

Consider bartering. That means exchanging Consider bartering. That means exchanging goods and services for other goods and services, goods and services for other goods and services, to conserve cash.to conserve cash.

Trim overhead costs. For example:Trim overhead costs. For example: Lease rather than buyLease rather than buy Avoid nonessential cash outlaysAvoid nonessential cash outlays Negotiate fixed loan payments to coincide Negotiate fixed loan payments to coincide

with your company’s cash flowwith your company’s cash flow


Avoiding the Cash CrunchAvoiding the Cash Crunch

Trim overhead costs. For example:Trim overhead costs. For example: Buy used equipmentBuy used equipment Hire part-time employees and freelancersHire part-time employees and freelancers Develop an internal security system Develop an internal security system Devise a method for fighting check fraudDevise a method for fighting check fraud Change shipping termsChange shipping terms Switch to zero-based budgetingSwitch to zero-based budgeting

Keep your business plan currentKeep your business plan current Invest surplus cashInvest surplus cash

(continued)(continued)


Creating a Successful

Financial Plan

Creating a Successful

Financial Plan


Basic Financial ReportsBasic Financial Reports

Balance SheetBalance Sheet - Estimates the firm’s worth on a - Estimates the firm’s worth on a given date; built on the accounting equation: given date; built on the accounting equation:

Assets = Liabilities + Owner’s EquityAssets = Liabilities + Owner’s Equity Income StatementIncome Statement - Compares the firm’s expenses - Compares the firm’s expenses

against its revenue over a period of time to show against its revenue over a period of time to show its net profit (or loss):its net profit (or loss):

Net Profit = Sales Revenue - ExpensesNet Profit = Sales Revenue - Expenses Statement of Cash FlowsStatement of Cash Flows - Shows the change in the - Shows the change in the

firm’s working capital over a period of time by firm’s working capital over a period of time by listing the listing the sourcessources of funds and the of funds and the usesuses of these of these funds.funds.


Twelve Key RatiosTwelve Key RatiosLiquidity RatiosLiquidity Ratios - Tells whether or not the small - Tells whether or not the small

business will be able to meet its maturing business will be able to meet its maturing obligations as they come due.obligations as they come due.

1. 1. Current RatioCurrent Ratio - Measures solvency by showing the firm's - Measures solvency by showing the firm's ability to pay current liabilities out of current assets.ability to pay current liabilities out of current assets.

Current Ratio = Current Ratio = Current Assets Current Assets = = $686,985$686,985 = 1.87:1 = 1.87:1 Current Liabilities $367,850 Current Liabilities $367,850

2. 2. Quick RatioQuick Ratio - Shows the extent to which the firm’s most - Shows the extent to which the firm’s most liquid assets cover its current liabilities.liquid assets cover its current liabilities.

Quick Ratio = Quick Ratio = Quick Assets Quick Assets = = $231,530 $231,530 = .63:1 = .63:1 Current Liabilities $367,850 Current Liabilities $367,850


Twelve Key RatiosTwelve Key RatiosLeverage RatiosLeverage Ratios - Measure the financing - Measure the financing

provided by the firm’s owners against that provided by the firm’s owners against that supplied by its creditors; a gauge of the supplied by its creditors; a gauge of the depth of the company’s debt.depth of the company’s debt.

3. 3. Debt RatioDebt Ratio - Measures the percentage of total - Measures the percentage of total assets financed by creditors rather than owners.assets financed by creditors rather than owners.

Debt Ratio = Debt Ratio = Total Debt Total Debt = = $580,000 $580,000 = .68:1 = .68:1 Total Assets $847,655 Total Assets $847,655

4. 4. Debt to Net Worth RatioDebt to Net Worth Ratio - Compares what the - Compares what the business “owes” to what it “owns.”business “owes” to what it “owns.”

Debt to Net = Debt to Net = Total Debt Total Debt = = $580,000$580,000 = 2.20:1 = 2.20:1Worth Ratio Tangible Net Worth $264,155Worth Ratio Tangible Net Worth $264,155


Twelve Key RatiosTwelve Key Ratios

Leverage RatiosLeverage Ratios ( (Continued)Continued)

5. 5. Times Interest EarnedTimes Interest Earned - Measures the - Measures the firm’s ability to make the interest payments on firm’s ability to make the interest payments on its debt.its debt.

Times Interest = Times Interest = EBIT* EBIT* = = $80,479$80,479 = 4.05:1 = 4.05:1EarnedEarned Total Interest Expense $19,850 Total Interest Expense $19,850

*Earnings Before Interest and *Earnings Before Interest and TaxesTaxes



Operating RatiosOperating Ratios - Evaluate the firm’s overall - Evaluate the firm’s overall performance and show how effectively it is performance and show how effectively it is putting its resources to work.putting its resources to work.6. 6. Average Inventory Turnover RatioAverage Inventory Turnover Ratio - Tells the - Tells the average number of times the firm’s inventory is average number of times the firm’s inventory is “turned over” or sold out during the accounting period.“turned over” or sold out during the accounting period.

Average Inventory = Average Inventory = Cost of Goods Sold Cost of Goods Sold = = $1,290.117 $1,290.117 = = 2.05 2.05 timestimes Turnover Ratio Turnover Ratio Average Inventory* Average Inventory* $630,600 $630,600 a yeara year

*Average Inventory = Beginning Inventory + Ending *Average Inventory = Beginning Inventory + Ending InventoryInventory

2 2



Operating RatiosOperating Ratios - Evaluate the firm’s overall - Evaluate the firm’s overall performance and show how effectively it is performance and show how effectively it is putting its resources to work.putting its resources to work.

7. 7. Average Collection Period RatioAverage Collection Period Ratio - Tells the - Tells the average number of days required to collect average number of days required to collect accounts receivable.accounts receivable.

Two Steps:Two Steps:Receivables Turnover = Receivables Turnover = Credit Sales Credit Sales = =

$1,309,589$1,309,589 = = 7.317.31 timestimes Ratio Ratio Accounts Accounts Receivable $179,225 Receivable $179,225 a yeara year

Average Collection = Average Collection = Days in Accounting Period Days in Accounting Period = = 365365 = = 50.050.0 Period Ratio Period Ratio Receivables Turnover Receivables Turnover Ratio 7.31 Ratio 7.31 daysdays



Operating RatiosOperating Ratios (Continued)(Continued)

8. 8. Average Payable Period RatioAverage Payable Period Ratio - - Tells the Tells the average number of days required to pay accounts average number of days required to pay accounts payable.payable.

Two Steps:Two Steps:Payables Turnover = Payables Turnover = Purchases Purchases = = $939,827 $939,827 = =

6.16 times 6.16 times RatioRatio Accounts Payable $152,580 a yearAccounts Payable $152,580 a year

Average Payable = Average Payable = Days in Accounting Period Days in Accounting Period = = 365365 = 59.3 = 59.3 Period Ratio Period Ratio Payables Turnover Ratio 6.16 Payables Turnover Ratio 6.16 daysdays



Operating RatiosOperating Ratios (Continued) (Continued)

9. 9. Net Sales to Total Assets RatioNet Sales to Total Assets Ratio - - Measures the firm’s ability to generate Measures the firm’s ability to generate sales given its asset base.sales given its asset base.

Net Sales to = Net Sales to = Net Sales Net Sales = = $1,870,841$1,870,841 = 2.21:1 = 2.21:1 Total Assets Total Assets Total Assets Total Assets $847,655$847,655



Operating RatiosOperating Ratios (Continued) (Continued)

10. 10. Net Sales to Working Capital RatioNet Sales to Working Capital Ratio - - Measures how many dollars in sales the Measures how many dollars in sales the company generates for every dollar of working company generates for every dollar of working capital.capital.

Net Sales to = Net Sales to = Net Sales Net Sales = = $1,870,841$1,870,841 = 5.86:1 = 5.86:1 Total Assets Working Capital* $847,655Total Assets Working Capital* $847,655

*Working Capital = Current Assets - *Working Capital = Current Assets - Current LiabilitiesCurrent Liabilities



Profitability RatiosProfitability Ratios - Measure how - Measure how efficiently the firm is operating; offer efficiently the firm is operating; offer information about the firm’s “bottom information about the firm’s “bottom line.”line.”

11. 11. Net Profit on Sales RatioNet Profit on Sales Ratio - Measures - Measures the firm’s profit per dollar of sales revenue.the firm’s profit per dollar of sales revenue.

Net Profit on = Net Profit on = Net Income Net Income = = $60,629 $60,629 = 3.24% = 3.24% Sales Sales Net Sales $1,870,841 Net Sales $1,870,841



Profitability RatiosProfitability Ratios (Continued)(Continued)

12. 12. Net Profit to Equity RatioNet Profit to Equity Ratio - Measures the - Measures the owner’s rate of return on the investment in owner’s rate of return on the investment in the business.the business.

Net Profit to = Net Profit to = Net Income Net Income = = $60,629 $60,629 = = 22.65% 22.65% Equity Equity Owner’s Equity* $267,655 Owner’s Equity* $267,655

* Also called net * Also called net worthworth


Interpreting RatiosInterpreting Ratios

Sam’s Appliance ShopSam’s Appliance Shop

Current ratio = 1.87:1Current ratio = 1.87:1

Industry MedianIndustry Median

Current ratio = 1.50:1Current ratio = 1.50:1

Although Sam’s falls short of the rule of thumb of Although Sam’s falls short of the rule of thumb of 2:1, its current ratio is above the industry median 2:1, its current ratio is above the industry median by a significant amount. Sam’s should have no by a significant amount. Sam’s should have no problem meeting short-term debts as they come problem meeting short-term debts as they come due.due.

Current RatioCurrent Ratio - Measures solvency by showing the firm's ability - Measures solvency by showing the firm's ability to pay current liabilities out of current assets.to pay current liabilities out of current assets.




Quick ratio = 0.63:1Quick ratio = 0.63:1


Quick ratio = 0.50:1Quick ratio = 0.50:1

Again, Sam is below the rule of thumb of 1:1, but Again, Sam is below the rule of thumb of 1:1, but the company passes this test of liquidity when the company passes this test of liquidity when measured against industry standards. Sam relies on measured against industry standards. Sam relies on selling inventory to satisfy short-term debt (as do selling inventory to satisfy short-term debt (as do most appliance shops). If sales slump, the result most appliance shops). If sales slump, the result could be liquidity problems for Sam’s.could be liquidity problems for Sam’s.

Quick RatioQuick Ratio - Shows the extent to which the - Shows the extent to which the firm’s most liquid assets cover its current firm’s most liquid assets cover its current liabilities.liabilities.




Debt ratio = 0.68:1Debt ratio = 0.68:1


Debt ratio = 0.64:1Debt ratio = 0.64:1

Creditors provide 68% of Sam’s total assets. very Creditors provide 68% of Sam’s total assets. very close to the industry median of 64%. Although close to the industry median of 64%. Although the company does not appear to be overburdened the company does not appear to be overburdened with debt, Sam’s might have difficulty with debt, Sam’s might have difficulty borrowing , especially from conservative lenders.borrowing , especially from conservative lenders.

Debt RatioDebt Ratio - Measures the percentage of total - Measures the percentage of total assets financed by creditors rather than assets financed by creditors rather than owners.owners.



Sam’s Appliance ShopSam’s Appliance ShopDebt to net worth ratio Debt to net worth ratio = 2.20:1= 2.20:1

Industry MedianIndustry MedianDebt to net worth ratio Debt to net worth ratio =1.90:1=1.90:1

Sam’s owes $2.20 to creditors for every $1.00 Sam’s owes $2.20 to creditors for every $1.00 the owner has invested in the business the owner has invested in the business (compared to $1.90 to every $1.00 in equity for (compared to $1.90 to every $1.00 in equity for the typical business. Many lenders will see the typical business. Many lenders will see Sam’s as “borrowed up,” having reached its Sam’s as “borrowed up,” having reached its borrowing capacity. Creditor’s claims are borrowing capacity. Creditor’s claims are more than twice those of the owners.more than twice those of the owners.

Debt to Net Worth RatioDebt to Net Worth Ratio - Compares what the business “owes” - Compares what the business “owes” to what it “owns.”to what it “owns.”



Sam’s Appliance ShopSam’s Appliance ShopTimes interest earned Times interest earned ratio = 2.52:1ratio = 2.52:1

Industry MedianIndustry MedianTimes interest earned Times interest earned ratio =2.0:1ratio =2.0:1

Sam’s earnings are high enough to cover the Sam’s earnings are high enough to cover the interest payments on its debt by a factor of 2.52:1, interest payments on its debt by a factor of 2.52:1, slightly better than the typical firm in the slightly better than the typical firm in the industry. Sam’s has a cushion (although a small industry. Sam’s has a cushion (although a small one) in meeting its interest payments. one) in meeting its interest payments.

Times Interest EarnedTimes Interest Earned - Measures the firm’s - Measures the firm’s ability to make the interest payments on its ability to make the interest payments on its debt.debt.



Sam’s Appliance ShopSam’s Appliance ShopAverage inventory Average inventory turnover ratio = 2.05 turnover ratio = 2.05 times per yeartimes per year

Industry MedianIndustry MedianAverage inventory Average inventory turnover ratio = 4.0 times turnover ratio = 4.0 times per yearper year

Inventory is moving through Sam’s at a Inventory is moving through Sam’s at a very slow pace. What could be causing very slow pace. What could be causing such a low turnover in the business?such a low turnover in the business?

Average Inventory Turnover RatioAverage Inventory Turnover Ratio - Tells the average number - Tells the average number of times the firm’s inventory is “turned over” or sold out during of times the firm’s inventory is “turned over” or sold out during the accounting period.the accounting period.



Sam’s Appliance ShopSam’s Appliance ShopAverage collection Average collection period ratio = 50.0 daysperiod ratio = 50.0 days

Industry MedianIndustry MedianAverage collection Average collection period ratio = 19.3 daysperiod ratio = 19.3 days

Sam’s collects the average account receivable Sam’s collects the average account receivable after 50 days compared to the industry after 50 days compared to the industry median of 19 days median of 19 days –– more than 2.5 times more than 2.5 times longer. What is a more meaningful longer. What is a more meaningful comparison for this ratio?comparison for this ratio?

Average Collection Period RatioAverage Collection Period Ratio - Tells the average number of - Tells the average number of days required to collect accounts receivable.days required to collect accounts receivable.



Sam’s Appliance ShopSam’s Appliance ShopAverage payable period Average payable period ratio = 59.3 daysratio = 59.3 days

Industry MedianIndustry MedianAverage payable period Average payable period ratio = 43 daysratio = 43 days

Sam’s payables are nearly 40 percent slower Sam’s payables are nearly 40 percent slower than those of the typical firm in the industry. than those of the typical firm in the industry. Stretching payables too far could seriously Stretching payables too far could seriously damage the company’s credit rating. What are damage the company’s credit rating. What are the possible causes of this discrepancy?the possible causes of this discrepancy?

Average Payable Period RatioAverage Payable Period Ratio - Tells the average number of days - Tells the average number of days required to pay accounts payable.required to pay accounts payable.



Sam’s Appliance ShopSam’s Appliance ShopNet sales to total assets Net sales to total assets ratio = 2.21:1ratio = 2.21:1

Industry MedianIndustry MedianNet Sales to total assets Net Sales to total assets ratio = 2.7:1ratio = 2.7:1

Sam’s Appliance Shop is not generating Sam’s Appliance Shop is not generating enough sales, given the size of its asset enough sales, given the size of its asset base. What could cause this?base. What could cause this?

Net Sales to Total Assets RatioNet Sales to Total Assets Ratio - Measures the firm’s ability - Measures the firm’s ability to generate sales given its asset base.to generate sales given its asset base.



Sam’s Appliance ShopSam’s Appliance ShopNet sales to working Net sales to working capital ratio = 5.86:1capital ratio = 5.86:1

Industry MedianIndustry MedianNet Sales to working Net Sales to working capital ratio = 10.8:1capital ratio = 10.8:1

Sam’s generates just $5.86 in sales for Sam’s generates just $5.86 in sales for every $1 of working capital, just over half every $1 of working capital, just over half of what the typical firm in the industry of what the typical firm in the industry does. The message is clear: Sam’s is not does. The message is clear: Sam’s is not producing an adequate volume of sales. producing an adequate volume of sales. Possible causes . . . ?Possible causes . . . ?

Net Sales to Working Capital RatioNet Sales to Working Capital Ratio - Measures how many dollars - Measures how many dollars in sales the company generates for every dollar of working capital.in sales the company generates for every dollar of working capital.



Sam’s Appliance ShopSam’s Appliance ShopNet profit on sales Net profit on sales ratio = 3.24%ratio = 3.24%

Industry MedianIndustry MedianNet profit on sale Net profit on sale ratio = 7.6%ratio = 7.6%

After deducting all expenses, Sam’s has just After deducting all expenses, Sam’s has just 3.24 cents of every sales dollar left as profit 3.24 cents of every sales dollar left as profit –– less than half the industry average. Sam may less than half the industry average. Sam may discover that some of his operating expenses discover that some of his operating expenses are out of balance. are out of balance.

Net Profit on Sales RatioNet Profit on Sales Ratio - Measures the firm’s - Measures the firm’s profit per dollar of sales revenue.profit per dollar of sales revenue.



Sam’s Appliance ShopSam’s Appliance ShopNet profit on equity Net profit on equity ratio = 22.65%ratio = 22.65%

Industry MedianIndustry MedianNet profit on equity Net profit on equity ratio = 12.6%ratio = 12.6%

Sam’s return on his investment in the business is Sam’s return on his investment in the business is an impressive 22.65%, compared to an industry an impressive 22.65%, compared to an industry median of just 12.6%. Is this the result of high median of just 12.6%. Is this the result of high profitability or is there another explanation?profitability or is there another explanation?

Net Profit to Equity RatioNet Profit to Equity Ratio - Measures the owner’s rate of return - Measures the owner’s rate of return on the investment in the business.on the investment in the business.


Breakeven AnalysisBreakeven Analysis The breakeven point is the level of operation at The breakeven point is the level of operation at

which a business neither earns a profit nor incurs a which a business neither earns a profit nor incurs a loss. loss.

It is a useful planning tool because it shows It is a useful planning tool because it shows entrepreneurs the minimum level of activity required entrepreneurs the minimum level of activity required to stay in business.to stay in business.

The breakeven point may be calculated in dollars The breakeven point may be calculated in dollars and in units.and in units.

Adding Adding desired profit, markdowns, and theftdesired profit, markdowns, and theft when when computing the breakeven point provides a more computing the breakeven point provides a more significant insight into the financial analysis.significant insight into the financial analysis.


Break-Even AnalysisBreak-Even Analysis Break-even point:Break-even point: That quantity of output at which total That quantity of output at which total

revenue equals total cost, assuming a certain selling price.revenue equals total cost, assuming a certain selling price. Mark-upMark-up = Unit contribution to fixed costs/overhead = Unit contribution to fixed costs/overhead = =

Selling price - Variable cost.Selling price - Variable cost. Create an “Average Mark-up” if you’re selling a variety of Create an “Average Mark-up” if you’re selling a variety of

products at different prices and costs.products at different prices and costs. Definitions:Definitions:

Variable costs vary with the level of production.Variable costs vary with the level of production. Fixed costs/overhead remain constant regardless of the level Fixed costs/overhead remain constant regardless of the level of production.of production.

Breakeven Formulas:Breakeven Formulas: B.E. in Units SalesB.E. in Units Sales = Total fixed costs/overhead = Total fixed costs/overhead

Selling price - Variable costSelling price - Variable cost B.E. in $ SalesB.E. in $ Sales == B.E. in units x Selling priceB.E. in units x Selling price


Assume a store sells bubble gum machines for $100 that cost $75 to make. Monthly overhead is $10,000.

Breakeven Analysis

Mark-upB.E. in Units =

Fixed/Overhead Costs

B.E. in $ = B.E. in Units x Selling Price

Fixed/Overhead Costs=

Price - Variable Cost

B.E. in Units =$10,000

$100 - $75=

$10,000

$25= 400 units

B.E. in $ = 40 units x $100 = $40,000


Profit Analysis

Mark-up

B.E. in Units = Fixed/Overhead Costs + Profit + Markdowns/Theft

B.E. in $ = B.E. in Units x Selling Price

B.E. in Units =$10,000 + $5,000 + $2,500 $17,500

$25= 700 units

B.E. in $ = 700 units x $100 = $70,000

Each month, assume the owner needs to breakeven, make $5,000 profit to live on, and cover expected markdowns/theft.

=$25

Desired

chapter 8: cash flow1 copyright 2002 prentice hall publishing company managing cash flow

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