Creating a Successful Financial Plan

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Creating a Successful Financial Plan
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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!

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Basic Financial Reports

• Balance Sheet Snapshot. Estimates the firms
  worth on a given date built on the accounting
  equation Assets Liabilities
  Owners Equity
• Income Statement Moving picture. Compares
  the firms 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 of funds and the uses of
  these funds.

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THE SCOREBOARD
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UNDERSTANDING THE BALANCE SHEET

• The balance sheet shows the financial condition
  or status of a company as of a certain date or
  point in time (a snapshot).
• Assets What you OWN.
• Liabilities What you OWE.
• Shareholders' Equity (assets less liabilities)
• Common Stock Reveals the owner(s) investment in
  the Paid In Capital company.
• Retained Earnings The amount of Net Income earned
  since the inception of the company that have been
  retained in the company (not paid out to the
  owners).

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Profit is primarily a dynamic of MAGNITUDE

• The objective of a company is to maximize sales
  and minimize or control expenses to generate the
  greatest Net Income or profit.
• Sales 100,000
• Expenses 95,000
• Net Income 5,000

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Cash Flow is primarily a dynamic of TIMING

• The objective in managing cash flow is to speed
  up your cash coming in and slow down or delay the
  cash going out.
• Month 1 Month 2 Month 3
• Beginning Cash 10,000 5,000
  (10,000)
• Cash In 90,000 80,000
  100,000
• Cash Out 95,000 95,000
  85,000
• Ending Cash 5,000 (10,000)
  5,000

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Ratio Analysis

• A method of expressing the relationships between
  any two elements on financial statements.
• Important barometers of a companys financial
  position.
• Study Only 27 percent of small business owners
  compute financial ratios and use them to manage
  their businesses.

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Twelve Key Ratios

• Liquidity 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
  686,985 1.871 Current Liabilities
  367,850

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Twelve Key Ratios

• Liquidity 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
  firms most liquid assets cover its current
  liabilities.
• Quick Ratio Quick Assets
  231,530 .631 Current Liabilities
  367,850

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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!

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Twelve Key Ratios

• Leverage Ratios - Measure the financing provided
  by a firms owners against that supplied by its
  creditors a gauge of the depth of the companys
  debt.
• 3. Debt Ratio - Measures the percentage of total
  assets financed by creditors rather than owners.
• Debt Ratio Total Debt 580,000
  .681 Total Assets 847,655

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Twelve Key Ratios

• Leverage Ratios - Measure the financing provided
  by a firms owners against that supplied by its
  creditors a gauge of the depth of the 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 2.201Worth Ratio Tangible
  Net Worth 264,155

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Twelve Key Ratios

• Leverage Ratios - Measure the financing provided
  by a firms 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
  100,479 2.521Earned Total
  Interest Expense 39,850
• Earnings Before Interest and Taxes

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Twelve Key Ratios

• Operating Ratios - Evaluate a firms 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
  1,290,117 2.05times Turnover Ratio Average
  Inventory 630,600 a year
• Average Inventory Beginning Inventory Ending
  Inventory 2

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Twelve Key Ratios

• Operating Ratios - Evaluate a firms 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
  1,309,589 7.31 times Ratio
  Accounts Receivable 179,225
  times a year
• Average Collection Days in Accounting
  Period 365 50.0 Period Ratio
  Receivables Turnover Ratio 7.31 days

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Twelve Key Ratios

• Operating Ratios - Evaluate a firms 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 Purchases
  939,827 6.16 times Ratio Accounts
  Payable 152,580 a year
• Average Payable Days in Accounting Period
  365 59.3 Period Ratio
  Payables Turnover Ratio 6.16 days

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Twelve Key Ratios

• Operating Ratios - Evaluate a firms overall
  performance and show how effectively it is
  putting its resources to work.
• 9. Net Sales to Total Assets Ratio - Measures a
  firms ability to generate sales given its asset
  base.
• Net Sales to Net Sales 1,870,841
  2.211 Total Assets Total Assets
  847,655

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Twelve Key Ratios

• Profitability Ratios - Measure how efficiently a
  firm is operating offer information about a
  firms bottom line.
• 10. Net Profit on Sales Ratio - Measures a firms
  profit per dollar 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 is operating offer information about a
  firms 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 Income
  60,629 7.15 Assets
  Total Assets 847,655

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Twelve Key Ratios

• Profitability Ratios - Measure how efficiently a
  firm is operating offer information about a
  firms 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
  60,629 22.65 Equity
  Owners Equity 267,655 Also called
  net worth

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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 companys 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

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Interpreting Ratios

• Sams Appliance Shop
• Current ratio 1.871

• Industry Median
• Current ratio 1.501

Although Sams falls short of the rule of thumb
of 21, its current ratio is above the industry
median by a significant amount. Sams should
have no problem meeting short-term debts as they
come due.
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Interpreting Ratios

• Sams Appliance Shop
• Quick ratio 0.631

• Industry Median
• Quick ratio 0.501

Again, Sam is below the rule of thumb of 11,
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
Sams. What steps should Sam take to deal with
this threat?
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Interpreting Ratios

• Sams Appliance Shop
• Debt ratio 0.681

• Industry Median
• Debt ratio 0.641

Creditors provide 68 percent of Sams total
assets, very close to the industry median of 64
percent. Although the company does not appear 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 worth ratio 2.201

• Industry Median
• Debt to net worth ratio 1.901

Sams owes 2.20 to creditors for every 1.00
the owner has invested in the business (compared
to 1.90 to every 1.00 in equity for the typical
business. Many lenders will see Sams as
borrowed up, having reached its borrowing
capacity. Creditors claims are more than twice
those of the owners.
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Interpreting Ratios

• Sams Appliance Shop
• Times interest earned ratio 2.521

• Industry Median
• Times interest earned ratio 2.01

Sams earnings are high enough to cover the
interest payments on its debt by a factor of
2.521, slightly better than the typical firm in
the industry. Sams has a cushion (although a
small one) in meeting its interest payments.
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Interpreting Ratios

• Sams Appliance Shop
• Average inventory turnover ratio 2.05 times
  per year

• Industry Median
• Average inventory turnover ratio 4.0 times per
  year

Inventory is moving through Sams at a very
slow pace. What could be causing this low
inventory turnover in Sams business?
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Interpreting Ratios

• Sams Appliance Shop
• Average collection period ratio 50.0 days

• Industry Median
• Average collection period ratio 19.3 days

Sams collects the average account receivable
after 50 days compared to the industry median of
19 days - more than 2.5 times longer. What is a
more meaningful comparison for this ratio? What
steps can Sam take to improve this ratio?
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Interpreting Ratios

• Sams Appliance Shop
• Average payable period ratio 59.3 days

• Industry Median
• Average payable period ratio 43 days

Sams payables are nearly 40 percent slower than
those of the typical firm in the industry.
Stretching payables too far could seriously
damage the companys credit rating. What are the
possible causes of this discrepancy?
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Interpreting Ratios

• Sams Appliance Shop
• Net sales to total assets ratio 2.211

• Industry Median
• Net Sales to total assets ratio 2.71

Sams Appliance Shop is not generating enough
sales, given the size of its asset base. What
factors could cause this?
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Interpreting Ratios

• Sams Appliance Shop
• Net profit on sales ratio 3.24

• Industry Median
• Net profit on sales ratio 7.6

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

• Sams Appliance Shop
• Net profit to assets ratio 7.15

• Industry Median
• Net profit to assets ratio 7.15

Sams generates a return of 7.15 percent for
every 1 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. Is this likely to be the result of
exceptional profitability, or is there another
explanation?
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Interpreting Ratios

• Sams Appliance Shop
• Net profit on equity ratio 22.65

• Industry Median
• Net profit on equity ratio 12.6

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

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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

Variable Expenses
1 -
Contribution Margin
Net Sales Estimate
Step 4. Compute the breakeven point
Total Fixed Costs
Breakeven Point

Contribution Margin
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Calculating the Breakeven PointThe Magic Shop

• Step 1. Net Sales estimate is 950,000 with Cost
  of Goods Sold of 646,000 and Total Expenses of
  236,500.
• Step 2. Variable Expenses of 705,125 Fixed
  Expenses of 177,375.
• Step 3. Contribution margin

705,125
Contribution Margin
1 -
.26
950,000
Step 4. Breakeven point
177,375
682,212
Breakeven Point

.26
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Breakeven Chart
Revenue Line
Profit Area
Breakeven Point Sales
Total Expense Line
Variable Expenses
Loss Area
Fixed Expense Line
Income and Expenses
0
Sales Volume