ENTREPRENEURSHIP

Lecture No: 19

Resource Person:

Malik Jawad SaboorAssistant Professor

Department of Management SciencesCOMSATS Institute of Information Technology

Islamabad.

Previous Lecture Review

• Define Franchising.• Explain the benefits and the drawbacks of buying a franchise.• Discuss the right way to buy a franchise.• Outline the major trends shaping franchising.

OBJECTIVES

• Myths & Tips about Franchising• Understand the importance of preparing a

financial plan.• Projected Financial Statements- Mistakes.• Understand the basic financial statements

through ratio analysis.

Ten Myths of Franchising

1. Franchising is the safest way to go into business because franchises never fail.

2. I’ll be able to open my franchise for less money than the franchiser estimates.

3. The bigger the franchise organization, the more successful I’ll be.

4. I’ll use 80 percent of the franchiser’s business system, but I’ll improve upon it by substituting my experience and know-how.

Ten Myths of Franchising

5. All franchises are the same.6. I don’t have to be a hands-on manager. I can be an

absentee owner and still be very successful. 7. Anyone can be a satisfied, successful franchise

owner.

(Continued)

Ten Myths of Franchising

8. Franchising is the cheapest way to get into business for yourself.

9. The franchiser will solve my business problems for me; after all, that’s why I pay an ongoing royalty fee.

10. Once I open my franchise, I’ll be able to run things the way I want to.

(Continued)

Detecting Dishonest Franchisers

• Claims that the contract is “standard; no need to read it.”

• Failure to provide a copy of the required disclosure documents.

• Marginally successful prototype or no prototype.• Poorly prepared operations manual.• Promises of future earnings with no documentation.• High franchisee turnover or termination rate.• Unusual amount of litigation by franchisees.

Detecting Dishonest Franchisers

• Attempts to discourage your attorney from evaluating the contract before signing it.

• No written documentation.• A high pressure sale. • Claims to be exempt from federal disclosure laws.• “Get rich quick” schemes, promising huge profits with

minimal effort.• Reluctance to provide a list of existing franchisees.• Evasive, vague answers to your questions.

(Continued)

The Right Way to Buy a Franchise

• Evaluate yourself - What do you like and dislike?• Research your market.• Consider your franchise options.• Talk to existing franchisees.• Ask the franchiser some tough questions.• Make your choice.

Financial Reporting

Common mistake among business owners: Failing to collect and analyze basic financial data.

One-third of entrepreneurs run their companies without any kind of financial plan.

Only 11 percent of business owners analyze their companies’ financial statements as part of the managerial planning process.

Financial planning is essential to running a successful business and is not that difficult!

Basic Financial Reports

• Balance Sheet – “Snapshot.” Estimates the firm’s worth on a given date; built on the accounting equation: Assets = Liabilities + Owner’s Equity

• Assets: Items of value owned or controlled by the business that contributes towards generating revenue.

• Liabilities: Liabilities are the financial obligations or debts of the business and include claims that creditors.

• Capital: Equity includes the initial and ongoing capital investments made by the owners, retained earnings

(or accumulated losses), and reserves.

Basic Financial Reports

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

Revenue

Expenses

Basic Financial Reports

Statement of Cash Flows – shows the change in the firm's working capital over a period of time by listing the sources of funds and the uses of these funds.

Records Cash Flow from

Operating Activities

Investment Activities

Financing Activities

Projected Financial Statements- Mistakes

• Stating “These are Conservative”

• No Assumptions Listed

• Top Down Assumptions

• No Scenario

Projected Financial Statements- Mistakes

• Assumptions Not Based on Data

• No Written Explanation

• No Bad Debt Expense

• Excluding Loan Payments

Projected Financial Statements- Mistakes

• Excluding Taxes

• Excluding Depreciation

• No Breakeven Analysis

• Excluding Founder Salary

Ratio Analysis

A method of expressing the relationships between any two elements on financial statements.

Important barometers of a company’s financial position.

Study: Only 27 percent of small business owners compute financial ratios and use them to manage their businesses.

Advantages of Ratio Analysis

• It simplifies the financial statements.• It helps in comparing companies of different

size with each other.• It helps in trend analysis which involves

comparing a single company over a period.• It highlights important information in simple

form quickly. A user can judge a company by just looking at few numbers instead of reading the whole financial statements.

Twelve Key RatiosLiquidity Ratios - Tell whether or not a small business will be able to meet its maturing 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 Current Liabilities

Twelve Key RatiosLiquidity Ratios - Tell whether or not a small business will be able to meet its maturing 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 Liabilities

Twelve Key Ratios• Leverage Ratios - Measure the financing provided

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

• Careful!! Debt is a powerful tool, but, like dynamite, you must handle it carefully!

Twelve Key Ratios

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

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

Debt Ratio = Total Debt Total Assets

Twelve Key Ratios

Leverage Ratios - Measure the financing provided by a firm’s owners against that supplied by its creditors; a gauge of the depth of the company's debt.

4. Debt to Equity - Compares what a business “owes” to “what it is worth.”

Debt to Equity = Total Debt

Ratio Total Equity

Twelve Key RatiosLeverage Ratios - Measure the financing provided by a firm’s owners against that supplied by its creditors; a gauge of the depth of the company's debt.

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

Times Interest = EBIT* Earned Total Interest Expense

*Earnings Before Interest and Taxes

Low HighDegree of Leverage

Optimal Zone

Ben

efit

s o

f L

ever

age

The Right Amount of Debt is a Balancing Act.

How Lenders View Liquidity and Leverage

Liquidity Leverage

Low If chronic, this is often evidence of mismanagement. It is a sign that the owner has not planned for the company's working capital needs. In most businesses characterized by low liquidity, there is usually no financial plan. This situation is often associated with last minute or "Friday night" financing.

This is a very conservative position. With this kind of leverage, lenders are likely to lend money to satisfy a company's capital needs. Owners in this position should have no trouble borrowing money.

Average This is an indication of good management. The company is using its current assets wisely and productively. Although they may not be impressed, lenders feel comfortable making loans to companies with adequate liquidity.

If a company's leverage is comparable to that of other businesses of similar size in the same industry, lenders are comfortable making loans. The company is not overburdened with debt and is demonstrating its ability to use its resources to grow.

High Some lenders look for this because it indicates a most conservative company. However, companies that constantly operate this way usually are forgoing growth opportunities because they are not making the most of their assets.

Businesses that carry excessive levels of debt scare most lenders off. Companies in this position normally will have a difficult time borrowing money unless they can show lenders good reasons for making loans. Owners of these companies must be prepared to sell lenders on their ability to repay.

Source: Adapted from David H. Bangs, Jr., Financial Troubleshooting, Upstart Publishing Company, (Dover, New Hampshire, 1992), p. 124.

Twelve Key RatiosOperating 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 Turnover Ratio Average Inventory

Average Inventory = Beginning Inventory + Ending Inventory 2

Twelve Key RatiosOperating 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 Ratio Accounts Receivable

Average Collection = Days in Accounting Period Ratio Receivables Turnover Ratio

Twelve Key RatiosOperating 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= PurchasesRatio Accounts Payable

Average Payable = Days in Accounting PeriodPeriod Ratio Payables Turnover Ratio

Twelve Key RatiosOperating 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 Total Assets Total Assets

Twelve Key RatiosProfitability 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 IncomeSales Net Sales

Twelve Key RatiosProfitability 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 IncomeAssets Total Assets

Twelve Key RatiosProfitability 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 Equity Owner’s Equity

Interpreting Ratios

Ratios – useful yardsticks of comparison. Standards vary from one industry to another;

key is to watch for “red flags.” 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

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.

Limitations of Ratio Analysis

• Different companies operate different environmental conditions

• Financial accounting information is affected by estimates and assumptions.

• Ratio analysis explains relationships between past information while users are more concerned about current and future information.

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

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

• It is 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.

Calculating the Breakeven Point

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. Then compute the contribution margin:

Contribution Margin = 1 - Variable ExpensesNet Sales Estimate

Step 4. Compute the breakeven point:

Breakeven Point$

= Total Fixed Costs Contribution Margin

Breakeven Chart

Sales Volume

Total ExpenseLine

RevenueLine

Fixed ExpenseLine

Inco

me

and

Exp

ense

s

Breakeven Point Profit Area

Loss Area

0

Lecture Review

Reference: Essentials of Entrepreneurship & Small Business Management, Zimmer, Scarborough &Wilson, 5th Edition

• Myths & Tips about Franchising• Understand the importance of preparing a

financial plan.• Projected Financial Statements- Mistakes.• Understand the basic financial statements

through ratio analysis.