scarborough 10e ppt ch07

7/31/2019 Scarborough 10e PPT Ch07

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Chapter 7 Solid Financial Plan Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall 7-1

Creating a SolidFinancial Plan


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Financial Planning

Research:

Significant numbers of entrepreneurs run

their companies without any kind offinancial plan!

A significant positive relationship exists

between formal planning in smallcompanies and their financialperformances


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Basic Financial

Reports Balance Sheet - estimates the firm's worth on a

given date; built on the accounting equation:

Assets = Liabilities + Owner's Equity

Income Statement - compares the firm's expensesagainst 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 thefirm's working capital over a period of time by

listing the sources of funds and the uses of these

funds


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Foundation for Financial ForecastsMarketing analysis and forecasts Demand forproducts or servicesAssumptions

Forecasted (pro forma) Financial Elements

Cash Flow ForecastFrom operationsFrom investingFrom external sources of financing

Forecast

revenues

Projected start-upcapital

requirements

Forecast expenses

ForecastedBalance Sheet

Current assets

Fixed assets

Liabilities

Owners equity

Total liabilitiesand equity

ForecastedIncome

Statement

Sales

ExpensesDepreciation

Operatingincome

InterestTaxes

Net income

Financing Plan(Sources of Funds)

Copyright 2012 Pearson Education, Inc. publishing as Prentice HallChapter 7 Solid Financial Plan 7-4


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Twelve Key Ratios

Liquidity Ratios - Tell whether or not a smallbusiness will be able to meet its maturingobligations as they come due

1. Current Ratio - Measures solvency by showing afirm's ability to pay current liabilities out of currentassets

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



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Twelve Key Ratios

Liquidity Ratios - Tell whether or not a smallbusiness will be able to meet its maturingobligations as they come due

2. Quick Ratio - Shows the extent to which a firm'smost liquid assets cover its current liabilities

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



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Twelve Key Ratios Leverage Ratios - Measure the financing provided

by a firm's owners against that supplied by itscreditors; a gauge of the depth of a company'sdebt

Careful!! Debt is a powerful tool, but you mustcontrol it

Copyright 2012 Pearson Education, Inc. publishing as Prentice HallChapter 7 Solid Financial Plan7-7


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Low HighDegree of Leverage

Optimal Zone

Be

nefits

ofLeverage

The Right Amount of Debt is a Balancing Act



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Twelve Key Ratios

Leverage Ratios - Measure the financing providedby a firm's owners against that supplied by itscreditors; a gauge of the depth of a company's

debt

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

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



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Twelve Key Ratios

Leverage Ratios - Measure the financing provided by afirm's owners against that supplied by its creditors; agauge of the depth of a company's debt

4. Debt to Net Worth Ratio - Compares what a business"owes" to what it is worth

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



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Twelve Key Ratios

Leverage Ratios - Measure the financing provided by afirm's owners against that supplied by its creditors; agauge of the depth of a company's debt

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

Times Interest = EBIT* = $100,479 = 2.52:1

Earned Total Interest Expense $39,850

*Earnings Before Interest and Taxes



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Twelve Key Ratios

Operating Ratios - Evaluate a firm's overall performanceand show how effectively it is putting its resources towork

6. Average Inventory Turnover Ratio - Tells the averagenumber 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 timesTurnover Ratio Average Inventory* $630,600 a year

*Average Inventory = Beginning Inventory + Ending Inventory2

Days Inventory (or average age of inventory) = 365 2.05 = 178 days



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Twelve Key Ratios

Operating Ratios - Evaluate a firm's overall performance andshow how effectively it is putting its resources to work

7. Average Collection Period Ratio - Tells the average number

of days required to collect accounts receivable

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 daysPeriod Ratio Receivables Turnover Ratio 7.31



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Lowering Your Average CollectionPeriod Can Save You $$

Improving your companys average collection period

ratio translates into dollar savings:

Savings = Credit Sales x Annual Interest Rate x # of days avg. collection pd. Lowered365

Example:

Savings = $1,309,589 x 8.75% x 8 days = $2,512365 days



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Twelve Key Ratios

Operating Ratios - Evaluate a firm's overall performanceand show how effectively it is putting its resources towork

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

Two Steps:

Payables Turnover = Purchases = $939,827 = 6.16 timesRatio Accounts Payable $152,580 a year

Average Payable = Days in Accounting Period = 365 = 59.3 daysPeriod Ratio Payables Turnover Ratio 6.16



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Twelve Key Ratios

Operating Ratios - Evaluate a firm's overallperformance and show how effectively it is putting itsresources 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 = $1,870,841 = 2.21:1Total Assets Total Assets $847,655



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Twelve Key Ratios

Profitability Ratios - Measure how efficiently a firm isoperating; offer information about a firm's "bottomline"

10. Net Profit on Sales Ratio - Measures a firm's profit perdollar of sales revenue

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

Sales Net Sales $1,870,841



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Twelve Key Ratios

Profitability Ratios - Measure how efficiently a firm isoperating; offer information about a firms bottomline

11. Net Profit to Assets (Return on Assets) Ratio tellshow much profit a company generates for each dollarof assets that it owns

Net Profit to = Net Income = $60,629 = 7.15%Assets Total Assets $847,655



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Twelve Key Ratios

Profitability Ratios - Measure how efficiently a firm isoperating; offer information about a firm's bottomline

12. Net Profit to Equity Ratio - Measures the owner's rateof return on the investment in the business

Net Profit to = Net Income = $60,629 = 22.65%

Equity Owners Equity* $267,655

* Also called net worth



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Interpreting Ratios

Sams Appliance Shop

Current ratio = 1.87:1

Industry Median

Current ratio = 1.60:1

Although Sams falls short of the rule ofthumb of 2:1, its current ratio is above theindustry median by a significant amount.

Sams should have no problem meetingshort-term debts as they come due



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Interpreting Ratios

Sams Appliance Shop

Quick ratio = 0.63:1

Industry Median

Quick ratio = 0.50:1

Again, Sams is below the rule of thumbof 1:1, but the company passes this testof liquidity when measured againstindustry standards. Sams relies on selling

inventory to satisfy short-term debt (asdo most appliance shops). If sales slump,the result could be liquidity problems forSams



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Interpreting Ratios

Sams Appliance Shop

Debt ratio = 0.68:1

Industry Median

Debt ratio = 0.62:1

Creditors provide 68% of Sams totalassets, very close to the industry median of62%. Although the company does notappear to be overburdened with debt,

Sams might have difficulty borrowing,especially from conservative lenders



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Interpreting Ratios

Sams Appliance Shop

Debt to net worthratio = 2.20:1

Industry Median

Debt to net worthratio =2.30:1

Sams owes $2.20 to creditors for every

$1.00 the owner has invested in thebusiness (compared to $2.30 to every$1.00 in equity for the typical business.)Many lenders will see Sams as borrowedup, having reached its borrowingcapacity. Creditors claims are more thantwice those of the owners



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Interpreting Ratios

Sams Appliance Shop

Times interest earnedratio = 2.52:1

Industry Median

Times interest earnedratio =2.10:1

Sams earnings are high enough tocover the interest payments on its debtby a factor of 2.52:1, better than thetypical firm in the industry. Sams has acushion (although a small one) inmeeting its interest payments



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Interpreting Ratios

Sams Appliance Shop

Average inventoryturnover ratio = 2.05times per year

Industry Median

Average inventoryturnover ratio = 4.40times per year

Inventory is moving through Sams at avery slow pace. What could be causingsuch a low turnover in the business?



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Interpreting Ratios

Sams Appliance Shop

Average collectionperiod ratio = 50.0days

Industry Median

Average collectionperiod ratio = 10.5days

Sams collects the average accountreceivable after 50 days compared tothe industry median of 11 days nearly

5 times longer. What is a moremeaningful comparison for this ratio?



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Interpreting Ratios

Sams Appliance Shop

Average payable periodratio = 59.3 days

Industry Median

Average payableperiod ratio = 23 days

Sams payables are nearly 40 percentslower than those of the typical firm inthe industry. Stretching payables too far

could seriously damage the companyscredit rating. What are the possiblecauses of this discrepancy?



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Interpreting Ratios

Sams Appliance Shop

Net sales to totalassets ratio = 2.21:1

Industry Median

Net Sales to totalassets ratio = 3.4:1

Sams Appliance Shop is not generatingenough sales given the size of its assetbase. What could cause this?



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Interpreting Ratios

Sams Appliance Shop

Net profit on salesratio = 3.24%

Industry Median

Net profit on salesratio = 4.3%

After deducting all expenses, Sams hasjust 3.24 cents of every sales dollar leftas profit nearly 25% below the

industry median. Sam may discover thatsome of his operating expenses are outof balance



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Interpreting Ratios

Sams Appliance Shop

Net profit to assetsratio = 7.15%

Industry Median

Net sales to workingcapital ratio = 4.0%

Sams generates a return of 7.15% for every$1 in assets, which is nearly 79% above theindustry average. Given his asset base, Sam issqueezing an above-average return out of his

company. Is this likely to be the result ofexceptional profitability or is there anotherexplanation?



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Interpreting Ratios

Sams Appliance Shop

Net profit on equityratio = 22.65%

Industry Median

Net profit on equityratio = 16.0%

Sams return on his investment in thebusiness is an impressive 22.65%,compared to an industry median of just

16%. Is this the result of highprofitability or is there anotherexplanation?



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Breakeven Analysis

The breakeven point is the level of operationat which a business neither earns a profit norincurs a loss

It is a useful planning tool because it showsentrepreneurs the minimum level of activityrequired to stay in business

With one change in the breakevencalculation, an entrepreneur can alsodetermine the sales volume required to reacha particular profit target


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Calculating theBreakeven Point

Step 1. Determine the expenses the business canexpect to incur

Step 2. Categorize the expenses in step 1 into fixed

expenses and variable expensesStep 3. Calculate the ratio of variable expenses to

net sales. Then compute the contribution margin:

Contribution Margin = 1 -Variable Expenses

Net Sales EstimateStep 4. Compute the breakeven point:

Breakeven Point$

=Total Fixed Costs

Contribution Margin


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Calculating the BreakevenPoint: The Magic Shop

Step 1. Net Sales estimate is $950,000 with Cost ofGoods Sold of $646,000 and total expenses of$236,500

Step 2. Variable Expenses of $705,125; FixedExpenses of $177,375

Step 3. Contribution margin:

Contribution Margin = 1 -$705,125

$950,000

Step 4. Breakeven point:

Breakeven Point

$

=$177,375

.26

= .26

= $682,212


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Breakeven Chart

Sales Volume

Total Expense

Line

Revenue

Line

Fixed Expense

Line

Breakeven Point

Sales = $682,212

$682,212

$682,212

0



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All rights reserved. No part of this publication may bereproduced, stored in a retrieval system, or transmitted,in any form or by any means, electronic, mechanical,photocopying, recording, or otherwise, without the priorwritten permission of the publisher. Printed in theUnited States of America.

Copyright 2012 Pearson Education,Inc. Publishing as Prentice Hall

scarborough 10e ppt ch07

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