Creating a Successful Financial

Plan
(Chapter-11)
 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 business are
downing financially, but also why they are performing that way.

Balance sheet
A financial statement that provides a snapshot of a business’s financial position, estimating
its worth on a given date it is built on the fundamental accounting equation:
Asset= liabilities + owners equity

Current assets:
Assets such as cash and other items to be converted into cash within one year or within the
company’s normal operating cycle.
 Assets

Current asset
Cash $49,855
Accounts receivable $179,225
Less: allowance for doubtful accounts $6000 $173,225
Inventory $455,455
Prepaid expenses $8450

Total current assets $686,985

Fixed assets
Land $59,150
Buildings $74,650
Less: accumulated depreciation $7,050 $67,600
Equipment $22,375
Less: accumulated depreciation $1,250 $21,125
Furniture & Fixtures $10,295
Less: accumulated depreciation $1,000 $9,295
Total fixed assets $157,170
Intangibles ( Goodwill) $3,500
Total assets $847,655
 Liabilities
Current liabilities
Accounts payable $152,580
Notes payable $83,920
Accrued interest/ salaries payable $38,150
Accrued interest payable $42,380
Accrued taxes payable $50,820
Total Current liabilities $367,850

Long term Liabilities

Mortgage $127,150
Note payable $85,000
Total Long term Liabilities $212,150

Owners Equity
sam LIoyd, capital $267,655
Total liabilities and owners equity $847,655
Fixed assets:
Assets acquired for long term use in a business.

Liabilities:
Creditors claim against a company assets. Current liabilities those debts that must be paid with in one
year or within the normal operating cycle of a company.

Current liabilities:
current liabilities are often understood as all liabilities of the business that are to be settled in cash within
the fiscal year or the operating cycle of a given firm, whichever period is longer.

Long term liabilities:

Liabilities that come due after one year.

Owner’s Equity:
Owner's equity represents the owner's investment in the business minus the owner's draws or
withdrawals from the business plus the net income (or minus the net loss) since the business began.
Income statement ( profit and loss statement)
A Financial statement that represent a moving picture of a business, comparing its expenses against
its revenue over a period of time to show its net profit or loss.

Cost of goods sold:

Cost of goods sold is the carrying value of goods sold during a particular period.
Gross profit margin:
gross profit divided by net sales revenue.

Operating expenses
Those costs that contribute directly to the manufacture and distribution of good.

Statement of cash flows

A financial statement showing the changes in a company working capital form the
beginning of the year by listing both the source and the uses of those funds.
 Ratio analysis
A method of expressing the relationship between any two accounting elements that
allows business owners to analyze their company's financial performance.

Twelve key ratios:

Liquidity ratios:

Tell whether a small business’s will be able to meet its short term obligation
as they come due.
Current ratio:
Measures a small firms solvency by indicating its ability to pay current liabilities out of current assets .

current assets
Current Ratio = Current liabilities
= $686,985
$367,50
= 1.87:1

Sam’s appliance shop has $1.87 in current assets for every $1 it has in
current liabilities.
Quick Ratio (acid test ratio)
A conservative measure of a firms liquidity measuring the extend to which its most liquid assets cover its current liabilities.

Quick asset
Quick Ratio: current liabilities
= $686,985- $455,455
$367,850
= 0.63:1
Sam's Appliance shop has 63 cents in quick assets for every $1 of current
liabilities.
Leverage Ratio:
Measure the financing supplied by a firms owners against that supplied by its creditors
they are a gauge of the depth of a company’s debt.

Debt Ratio:
Measure the percentage of total assets finances by a company's creditor compared to its
owners.
Total debt( or liabilities)
Debt ratio: Total assets
= $367,850 + $212,150
$ 847,655
= 0.68:1
Creditors have claims of 68 cents against every $1 of assets that Sam’s Appliance shop owns.
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.

Total debt ( or liabilities)

Debt to net worth Ratio: Tangible net worth
= $367,850 + $212,150
$267,655 – $3,500
= 2.20:1
Sam's Appliance shop owes creditors $2.20 for every $1 of equity
that Sam owns.
Time interest earned Ratio:
Measure a small firms ability to make the interest payments on its debt.

Earrings before interest and taxes ( EBIT)

Time interest earned Ratio: Total interest Expense
= 60,629 – 39,850
39,850
= 2.52:1
Sam's Appliance shop earnings are 2.5 time greater than its interest Expense.
Operating Ratio:
Help a entrepreneur evaluate a small company's overall performance and indicate how
effectively the business employs its resources.

Average inventory turnover Ratio:

Measure the number of times its average inventory is sold out or turned over during an
accounting period.
  𝐂𝐨𝐬𝐭 𝐨𝐟 𝐠𝐨𝐨𝐝𝐬 𝐬𝐨𝐥𝐝
𝐀 𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐫𝐚𝐭𝐢𝐨=
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚

= 2.05 times per year

Sam’ Appliance Shop turns its inventory about two times a year, or
once every 178 days.
7. Average Collection period ratio (days sales
outstanding, DSO)
Measures the number of days it takes to collect accounts receivable
 

=7.31 times / year

Sam’s Appliance Shop turn over its receivables 7.31 times per
year.
Average Collection period ratio (days sales outstanding, DSO) (Con…)

= 50 days

Sam’s application Shop’s accounts receivable are

outstanding for an average of 50 days.
8. Average payable period ratio

Measures the number of days it takes a company to pay its accounts

payable
 

= 6.16 times/years
8. Average payable period ratio (Con…)

= 59.3 days

Sam’s Appliance Shop takes an average of 59 days to pay its

accounts with suppliers
 9. Net sales to total assets (total asset turnover)
ratio

Measure a company’s ability to generate sales in relation to

 its asset base

= 2.21 : 1

Sam’s Appliance Shop is generating $2.21 in sales for every dollar of

assets.
 Profitability ratios
Includes how efficiently a small company is being managed
10. Net profit on sales ratio (profit margin on sales or net
profit margin)
Measures  a company’s profit per dollar of sales

= 3.24%

For every dollar in sales Sam’s Appliance Shop generates, Sam keeps 3.24
cents in profit.
 Operating leverage
A situation in which increases in operating efficiency mean that expenses as a
percentage of sales revenue flatten or even decline.

11. Net profit to assets ratio

Measures how much profit a company generates for each dollar of assets
that it owns.  

= 7.15%

Sam’s Appliance shop earns a return of 7.15% on its asset

base
 12. Net profit to equity ratio (return on net
worth ratio)
  Measures the owners rate of return on investment

= 22.65%

Sam is earning 22.65% on the money he has invested in this business

 Critical numbers
Includes that measure key financial & operational aspects of a company’s
performance; when these number are moving in the right direction, a business
is on track to reach its objectives

What to do all of these Numbers Mean?

 Liquidity Ratio

1. Current ratio = 1.87:1 1.50:1

Sam's Appliance Shop falls short of the rule of thumb of 2:1, but its current ratio is
above the industry median by a significant amount. Sam's should have no problem
meeting its short-term debts as they come due. By this measure, the company's liquidity
is solid.
2. Quick ratio = 0.63:1 0.50:1
Again, Sam's is below the rule of thumb of 1:1, but the company passes this test of liquidity
when measured against industry standards. Sam's 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. Sam should consider building a cash reserve as a precautionary measure.
Leverage ratios. These measure the financing supplied by a firm's owners against that
supplied by its creditors and serve as a gauge of the depth of a company's debt.

3. Debt ratio = 0.68:1 0.64:1

Creditors provide 68 percent of Sam's total assets, very close to the industry median of 64
percent. Although Sam's does not appear to be overburdened with debt, the company might
have difficulty borrowing additional money, especially from conservative lenders.
 
4. Debt to net worth ratio 2.20:1 1.90:1
Sam's Appliance Shop owes creditors $2.20 for every $1.00 the owner has invested in the business
(compared to $1.90 in debt to every $1.00 in equity for the typical business). Although this is not
an exorbitant amount of debt, many lenders and creditors will see Sam's as "borrowed up." The
company's borrowing capacity is limited because creditors' claims against the business are more
than twice those of owners. Sam should consider increasing his owner's equity in the business
through retained earnings or by paying down some of the company's debt.
5. Times interest earned ratio = 2.52:1 2.0:1
Sam's earnings are high enough to cover the interest payments on its debt by factor of 2.52,
slightly better than the typical firm in the industry, whose earnings cover its interest payments just
two times. Sam's Appliance Shop has a cushion (although a small one) in meeting its interest
payments.
Operating ratios: These evaluate the firm's overall performance and show how effectively it is
putting its resources to work.

6. Average inventory turnover ratio 2.05 times/year 4.0 times/year

Inventory is moving through Sam's at a very slow pace, half that of the industry median. The
company has a problem with slow-moving items in its inventory and. perhaps, too much
inventory. Which items are they, and why are they slow-moving? Does Sam need to drop some
product lines? Sam must analyze his company's inventory and reevaluate his inventory control
7. Average collection period ratio 50.0 days 19.3 days

Sam's Appliance Shop collects the average account receivable after 50 days
(compared with the industry endian of 19 days), more than two and one-half
times. longer. A more meaningful comparison is against Sam's credit terms; if
credit terms are net 30 (or anywhere close to that), Sam's has a dangerous
collection problem, one that drains cash and profits and demands immediate
attention! He must implement the cash management procedures.
8. Average payable period ratio = 59.3 days 43days
Sam's payables are nearly 40 percent slower than those of the typical firm in the industry. Stretching payables
too far could seriously damage the company's credit rating, causing suppliers to cut off future trade credit.
This could be a sign of cash flow problems or a sloppy accounts payable procedure. This problem also
demands immediate attention. Once again, Sam must implement proper cash management procedures to
resolve this problem.

9. Net sales to total assets ratio = 2.21:1 2.7:1

Sam's Appliance Shop is not generating enough sales, given the size of its asset base. This could be the result
of a number of factors-improper inventory, inappropriate pricing, poor location, poorly trained sales
personnel, and many others. The key is to find the cause... Fast!
Profitability ratios: These measure how efficiently a firm is operating and offer information about its
bottom line.
10. Net profit on sales ratio = 3.24% 7.6%
After deducting all expenses, 3.24 cents of each sales dollar remain as profit for Sam's-less than half
the industry median. Sam should check his company's gross profit margin and investigate its
operating expenses, checking them against industry standards and looking for those that are out of
balance.
 

11. Net profit to assets ratio = 7.15% 5.5%

Sam's generates just a return of 7.15% for every SI in assets, which is 30 percent above the industry
average. Given his asset base, Sam is squeezing an above-average return out of his company. This
could be an indication that Sam's is highly profitable; however, given the previous ratio, this is
unlikely. It is more likely that Sam's asset base is thinner than the industry average.
12. Net profit to equity ratio = 22.65% 12.6%
Sam's Appliance Shop's owners are earning 22.65 percent on the money they
have invested in the business. This yield is nearly twice that of the industry
median, and give the previous ratio, is more a result of the owners’ relatively
low investment in the business than an indication of its superior profitability.
Sam is using O.P.M. (Other People’s Money) to generate a profit in his
business.
 Break-Even
Analysis
Break-even point
The level of operation (sales dollars or production quantity) at which a company
neither earns a profit nor incurs a loss.

Fixed expenses
Expenses that do not vary with changes in the volume of sales or production.

Variable expenses
Expenses that vary directly with changes in the volume of sales or production.
Step 1 Determine the expenses the business can expect to incur. With the help of a budget, an
entrepreneur can develop estimates of sales revenue, cost of goods sold, and expenses for the
upcoming accounting period. The Magic Shop expects net sales of $950,000 in the upcoming
year, with a cost of goods sold of $646,000 and total expenses of $236,500.
 
Step 2 Categorize the expenses estimated in Step 1 into fixed expenses and variable expenses.
Separate semi variable expenses into their component parts. From the budget, the owner
anticipates variable expenses (including the cost of goods sold) of $705,125 and fixed expenses
of S177,375.

Step 3 Calculate the ratio of variable expenses to net sales. For the Magic Shop, this percentage
is $705,125 ÷ $950,000 = 74 percent. So, the Magic Shop uses $0.74 out of
every sales dollar to cover variable expenses, leaving $0.26 as a contribution margin to cover
fixed costs and make a profit
 Step 3 Calculate the ratio of variable expenses to net sales. For the Magic Shop, this
percentage is $705,125 ÷ $950,000 = 74 percent. So, the Magic Shop uses $0.74 out of
every sales dollar to cover variable expenses, leaving $0.26 as a contribution margin to
cover fixed costs and make a profit

Step 4 Compute the break-even point by inserting this information into the following
formula:

= $682,212
Thus, the Magic Shop will break even with sales of $682,212. At this point, sales
revenue generated will just cover total fixed and variable expense. The Magic
Shop will earn no profit and will incur no loss., We can verify this with the
following calculations:

Sales at break-event point $682,212

- Variable expenses(74% of sales) (504,837)
Contribution margin 177375
- Fixed expenses (177375)
Net profit (or net loss) $ 000
 Adding in a Profit
What if the Magic Shop's owner wants to do better than just break even? His
analysis can be adjusted to consider such a possibility. Suppose the owner
expects a reasonable profit (before taxes) of $80,000. What level of sales
must the Magic Shop achieve to generate this? He can calculate this by
treating the desired profit as if it were a fixed cost. In other words, he
modifies the formula to include the desired net income:
 S

=$989,904

To achieve a net profit of $80000 (Before taxes), the magic Shop must generate
net sales of $989,904.
For example, suppose that Trilex Manufacturing Company estimates its fixed costs for
producing its line of small appliances at $390,000. The variable costs (including material, direct
labor, and factory overhead) amount to $12.10 per unit, and the selling price per unit is $17.50.
So, Trilex computes its contribution margin in the following way:
Contribution margin = Price per unit – Variable cost per unit
=$17.50 per unit - $12.10 per unit
=$5.40 per unit
 

= 72,222 units

Break-even sales = 72,222 unit × $17.50 per unit

= $1,263,889
For example, if Trilex wanted to earn a $60,000 profit, its required sales
 

would be:

= 83.333 units

Which would require 83.333 unit × $17.50 per unit = $1,458,328 in sales
Thank