Financial Management: How To Make a Go Of Your Business
by Linda Howarth Mackay
Produced in cooperation with the American Association of Community and Junior Colleges
Charles Liner, SEA Contracting Officer’s Technical Representative Judy Nye, Project Director, AACJC Martha McKemie, Senior Writer-Editor, SEA Amelia Harris, Graphics, SEA
Contents
About the Author
Introduction
I. The Necessity of Financial Planning
What is Financial Management? Tools of Financial Planning
II. Understanding Financial Statements: A Health Checkup for Your Business
The Balance Sheet The Statement of Income
III. Financial Ratio Analysis
Balance Sheet Ratio Analysis Income Statement Ratio Analysis Management Ratios Sources of Comparative Information
IV. Forecasting Profits
Facts Affecting Pro Forma Statements The Pro Forma Income Statement Comparison with Actual Monthly Performance Break-Even Analysis
V. Cash Flow Management: Budgeting and Controlling Costs
The Cash Flow Statement
VI. Pricing Policy
Establishing Selling Prices A Pricing Example The Retailers Mark-Up Pricing Policies and Profitability Goals
VII. Forecasting and Obtaining Capital
Types and Sources of Capital Borrowing Working Capital Borrowing Growth Capital Borrowing Permanent Equity Capital Applying for Capital
VIII. Financial Management Planning
Long-Term Planning
For Further Information
About the Author
Linda Howarth Mackay has many years’ banking experience gained working in a rural community bank and two large regional banks. Her expertise is in commercial and agricultural lending and in correspondent banking. She is also knowledgeable in the regulation of commercial bank lending practices, with an extensive background in the establishment of policy and procedures and in portfolio administration.
A graduate of Indiana University, Bloomington, Indiana, and numerous banking, accounting, and lending seminars, she is now president of Howarth Mackay, Incorporated, a company providing financial consultation to businesses, financial institutions, and professional individuals.
Introduction
This booklet was designed to equip instructors of the National Small Business Training Network course 'Financial Management: How to Make a Go of Your Business' with the information required to acquaint the small business owner/manager with the basic tools of sound financial management. It supplements the course guide materials; it is not intended to replace their use by the instructor.
The booklet may also be used by anyone interested in learning the concepts of financial management.
I. The Necessity of Financial Planning
There is one simple reason to understand and observe financial planning in your business--to avoid failure. Eight of ten new businesses fail primarily because of the lack of good financial planning.
Financial planning affects how and on what terms you will be able to attract the funding required to establish, maintain, and expand your business. Financial planning determines the raw materials you can afford to buy, the products you will be able to produce, and whether or not you will be able to market them efficiently. It affects the human and physical resources you will be able to acquire to operate your business. It will be a major determinant of whether or not you will be able to make your hard work profitable.
This manual provides an overview of the essential components of financial planning and management. Used wisely, it will make the reader--the small business owner/manager--familiar enough with the fundamentals to have a fighting chance of success in today’s highly competitive business environment.
A clearly conceived, well documented financial plan, establishing goals and including the use of Pro Forma Statements and Budgets to ensure financial control, will demonstrate not only that you know what you want to do, but that you know how to accomplish it. This demonstration is essential to attract the capital required by your business from creditors and investors.
What Is Financial Management?
Very simply stated, financial management is the use of financial statements that reflect the financial condition of a business to identify its relative strengths and weaknesses. It enables you to plan, using projections, future financial performance for capital, asset, and personnel requirements to maximize the return on shareholders’ investment.
Tools of Financial Planning
This manual introduces the tools required to prepare a financial plan for your business’s development, including the following:
* Basic Financial Statements--the Balance Sheet and Statement of Income
* Ratio Analysis--a means by which individual business performance is compared to similar businesses in the same category
* The Pro Forma Statement of Income--a method used to forecast future profitability
* Break-Even Analysis--a method allowing the small business person to calculate the sales level at which a business recovers all its costs or expenses
* The Cash Flow Statement--also known as the Budget identifies the flow of cash into and out of the business
* Pricing formulas and policies--used to calculate profitable selling prices for products and services
* Types and sources of capital available to finance business operations
* Short- and long-term planning considerations necessary to maximize profits
The business owner/manager who understands these concepts and uses them effectively to control the evolution of the business is practicing sound financial management thereby increasing the likelihood of success.
II. Understanding Financial Statements: A Health Checkup for Your Business
Financial Statements record the performance of your business and allow you to diagnose its strengths and weaknesses by providing a written summary of financial activities. There are two’ primary financial statements: the Balance Sheet and the Statement of Income.
The Balance Sheet
The Balance Sheet provides a picture of the financial health of a business at a given moment, usually at the close of an accounting period. It lists in detail those material and intangible items the business owns (known as its assets) and what money the business owes, either to its creditors (liabilities) or to its owners (shareholders’ equity or net worth of the business).
Assets include not only cash, merchandise inventory, land, buildings, equipment, machinery, furniture, patents, trademarks, and the like, but also money due from individuals or other businesses (known as accounts or notes receivable).
Liabilities are funds acquired for a business through loans or the sale of property or services to the business on credit. Creditors do not acquire business ownership, but promissory notes to be paid at a designated future date.
Shareholders’ equity (or net worth or capital) is money put into a business by its owners for use by the business in acquiring assets.
At any given time, a business’s assets equal the total contributions by the creditors and owners, as illustrated by the following formula for the Balance Sheet:
Assets = Liabilities + Net Worth
(Total (Funds (Funds funds supplied supplied invested in to the to the assets of business business the by its by its business) creditors) owners)
This formula is a basic premise of accounting. If a business owes more money to creditors than it possesses in value of assets owned, the net worth or owner’s equity of the business will be a negative number.
The Balance Sheet is designed to show how the assets, liabilities, and net worth of a business are distributed at any given time. It is usually prepared at regular intervals; e.g., at each month’s end but especially at the end of each fiscal (accounting) year.
By regularly preparing this summary of what the business owns and owes (the Balance Sheet), the business owner/manager can identify and analyze trends in the financial strength of the business. It permits timely modifications, such as gradually decreasing the amount of money the business owes to creditors and increasing the amount the business owes its owners.
All Balance Sheets contain the same categories of assets, liabilities, and net worth. Assets are arranged in decreasing order of how quickly they can be turned into cash (liquidity). Liabilities are listed in order of how soon they must be repaid, followed by retained earnings (net worth or owner’s equity), as illustrated in Figure 2-1, below, the sample Balance Sheet for ABC Company.
The categories and format of the Balance Sheet are established by a system known as Generally Accepted Accounting Principles (GAAP). The system is applied to all companies, large or small, so anyone reading the Balance Sheet can readily understand the story it tells.
Figure 2-1 ABC Company December 31, 19- Balance Sheet
Cash $ 1,896 Notes Payable, $ 2,000 Bank
Accounts 1,456 Accounts 2,240 Receivable Payable
Inventory 6,822 Accruals 940 ------- ------- Total Current $10,174 Total Current $ 5,180 Assets Liabilities
Equipment and 1,168 Total Liabilities 5,180 Fixtures
Prepaid Expenses 1,278 Net Worth 7,440 ------- ------- Total Assets $12,620 Total Liabilities $12,620 and New Worth
Balance Sheet Categories
Assets: An asset is anything the business owns that has monetary value.
* Current Assets include cash, government securities, marketable securities, accounts receivable, notes receivable (other than from officers or employees), inventories, prepaid expenses, and any other item that could be converted into cash within one year in the normal course of business.
* Fixed Assets are those acquired for long-term use in a business such as land, plant, equipment, machinery, leasehold improvements, furniture, fixtures, and any other items with an expected useful business life measured in years (as opposed to items that will wear out or be used up in less than one year and are usually expensed when they are purchased). These assets are typically not for resale and are recorded in the Balance Sheet at their net cost less accumulated depreciation.
* Other Assets include intangible assets, such as patents, royalty arrangements, copyrights, exclusive use contracts, and notes receivable from officers and employees.
Liabilities: Liabilities are the claims of creditors against the assets of the business (debts owed by the business).
* Current Liabilities are accounts payable, notes payable to banks, accrued expenses (wages, salaries), taxes payable, the current portion (due within one year) of long-term debt, and other obligations to creditors due within one year.
* Long-Term Liabilities are mortgages, intermediate and long-term bank loans, equipment loans, and any other obligation for money due to a creditor with a maturity longer than one year.
* Net Worth is the assets of the business minus its liabilities. Net worth equals the owner’s equity. This equity is the investment by the owner plus any profits or minus any losses that have accumulated in the business.
The Statement of Income
The second primary report included in a business’s Financial Statement is the Statement of Income. The Statement of Income is a measurement of a company’s sales and expenses over a specific period of time. It is also prepared at regular intervals (again, each month and fiscal year end) to show the results of operating during those accounting periods. It too follows Generally Accepted Accounting Principles (GAAP) and contains specific revenue and expense categories regardless of the nature of the business.
Statement of Income Categories
The Statement of Income categories are calculated as described below:
* Net Sales (gross sales less returns and allowances)
* Less Cost of Goods Sold (cost of inventories)
* Equals Gross Margin (gross profit on sales before operating expenses)
* Less Selling and Administrative Expenses (salaries, wages, payroll taxes and benefits, rent, utilities, maintenance expenses, office supplies, postage, automobile/vehicle expenses, insurance, legal and accounting expenses, depreciation)
* Equals Operating Profit (profit before other non-operating income or expense)
* Plus Other Income (income from discounts, investments, customer charge accounts)
* Less Other Expenses (interest expense)
* Equals Net Profit (Loss) Before Tax (the figure on which your tax is calculated)
* Less Income Taxes (if any are due)
* Equals Net Profit (Loss) After Tax
For an example of a Statement of Income, see Figure 2-2, the statement of ABC Company.
Figure 2-2 ABC Company December 31, 19- Income Statement
Net Sales $68,116 Cost of Goods Sold 47,696 ------- Gross Profit on Sales $20,420 Expenses Wages $6,948 Delivery Expenses 954 Bad Debts Allowances 409 Communications 204 Depreciation Allowance 409 Insurance 613 Taxes 1,021 Advertising 1,566 Interest 409 Other Charges 749 ------ Total Expenses $13,282 Net Profit 7,138 Other Income 886 ------- Total Net Income $ 8,024
Calculating the Cost of Goods Sold
Calculation of the Cost of Goods Sold category in the Statement of Income (or Profit-and-Loss Statement as it is sometimes called) varies depending on whether the business is retail, wholesale, or manufacturing. In retailing and wholesaling, computing the cost of goods sold during the accounting period involves beginning and ending inventories. This, of course, includes purchases made during the accounting period. In manufacturing it involves not only finished-goods inventories, but also raw materials inventories goods-in-process inventories, direct labor, and direct factory overhead costs.
Regardless of the calculation for Cost of Goods Sold, deduct the Cost of Goods Sold from Net Sales to get Gross Margin or Gross Profit. From Gross Profit, deduct general or indirect overhead such as selling expenses, office expenses, and interest expenses, to calculate your Net Profit. This is the final profit after all costs and expenses for the accounting period have been deducted.
III. Financial Ratio Analysis
The Balance Sheet and the Statement of Income are essential, but they are only the starting point for successful financial management. Apply Ratio Analysis to Financial Statements to analyze the success, failure, and progress of your business.
Ratio Analysis enables the business owner/manager to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry. To do this compare your ratios with the average of businesses similar to yours and compare your own ratios for several successive years, watching especially for any unfavorable trends that may be starting. Ratio analysis may provide the all-important early warning indications that allow you to solve your business problems before your business is destroyed by them.
Balance Sheet Ratio Analysis
Important Balance Sheet Ratios measure liquidity and solvency (a business’s ability to pay its bills as they come due) and leverage (the extent to which the business is dependent on creditors’ funding). They include the following ratios:
Liquidity Ratios.
These ratios indicate the ease of turning assets into cash. They include the Current Ratio, Quick Ratio, and Working Capital.
Current Ratios. The Current Ratio is one of the best known measures of financial strength. It is figured as shown below:
Total Current Assets Current Ratio = ------------------------- Total Current Liabilities
The main question this ratio addresses is: 'Does your business have enough current assets to meet the payment schedule of its current debts with a margin of safety for possible losses in current assets, such as inventory shrinkage or collectable accounts?' A generally acceptable current ratio is 2 to 1. But whether or not a specific ratio is satisfactory depends on the nature of the business and the characteristics of its current assets and liabilities. The minimum acceptable current ratio is obviously 1:1, but that relationship is usually playing it too close for comfort.
If you decide your business’s current ratio is too low, you may be able to raise it by:
* Paying some debts. * Increasing your current assets from loans or other borrowings with a maturity of more than one year. * Converting noncurrent assets into current assets. * Increasing your current assets from new equity contributions. * Putting profits back into the business.
Quick Ratios. The Quick Ratio is sometimes called the 'acid-test' ratio and is one of the best measures of liquidity. It is figured as shown below:
Quick Ratio = Cash + Government Securities + Receivables ---------------------------- Total Current Liabilities
The Quick Ratio is a much more exacting measure than the Current Ratio. By excluding inventories, it concentrates on the really liquid assets, with value that is fairly certain. It helps answer the question: 'If all sales revenues should disappear, could my business meet its current obligations with the readily convertible `quick’ funds on hand?'
An acid-test of 1:1 is considered satisfactory unless the majority of your 'quick assets' are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying current liabilities.
Working Capital. Working Capital is more a measure of cash flow than a ratio. The result of this calculation must be a positive number. It is calculated as shown below:
Working Capital = Total Current Assets - Total Current Liabilities
Bankers look at Net Working Capital over time to determine a company’s ability to weather financial crises. Loans are often tied to minimum working capital requirements.
A general observation about these three Liquidity Ratios is that the higher they are the better, especially if you are relying to any significant extent on creditor money to finance assets.
Leverage Ratio
This Debt/Worth or Leverage Ratio indicates the extent to which the business is reliant on debt financing (creditor money versus owner’s equity):
Debt/Worth Ratio = Total Liabilities ----------------- Net Worth
Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your business, making it correspondingly harder to obtain credit.
Income Statement Ratio Analysis
The following important State of Income Ratios measure profitability:
Gross Margin Ratio
This ratio is the percentage of sales dollars left after subtracting the cost of goods sold from net sales. It measures the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold) available to pay the overhead expenses of the company.
Comparison of your business ratios to those of similar businesses will reveal the relative strengths or weaknesses in your business. The Gross Margin Ratio is calculated as follows:
Gross Margin Ratio = Gross Profit ------------ Net Sales (Gross Profit = Net Sales - Cost of Goods Sold)
Net Profit Margin Ratio
This ratio is the percentage of sales dollars left after subtracting the Cost of Goods sold and all expenses, except income taxes. It provides a good opportunity to compare your company’s 'return on sales' with the performance of other companies in your industry. It is calculated before income tax because tax rates and tax liabilities vary from company to company for a wide variety of reasons, making comparisons after taxes much more difficult. The Net Profit Margin Ratio is calculated as follows:
Net Profit Margin Ratio = Net Profit Before Tax --------------------- Net Sales
Management Ratios
Other important ratios, often referred to as Management Ratios, are also derived from Balance Sheet and Statement of Income information.
Inventory Turnover Ratio
This ratio reveals how well inventory is being managed. It is important because the more times inventory can be turned in a given operating cycle, the greater the profit. The Inventory Turnover Ratio is calculated as follows:
Inventory Turnover Ratio = Net Sales ------------------------- Average Inventory at Cost
Accounts Receivable Turnover Ratio
This ratio indicates how well accounts receivable are being collected. If receivables are not collected reasonably in accordance with their terms, management should rethink its collection policy. If receivables are excessively slow in being converted to cash, liquidity could be severely impaired. The Accounts Receivable Turnover Ratio is calculated as follows:
Net Credit Sales/Year = Daily Credit Sales --------------------- 365 Days/Year
Accounts Receivable Turnover (in days) = Accounts Receivable ------------------- Daily Credit Sales
Return on Assets Ratio
This measures how efficiently profits are being generated from the assets employed in the business when compared with the ratios of firms in a similar business. A low ratio in comparison with industry averages indicates an inefficient use of business assets. The Return on Assets Ratio is calculated as follows:
Return on Assets = Net Profit Before Tax --------------------- Total Assets
Return on Investment (ROI) Ratio.
The ROI is perhaps the most important ratio of all. It is the percentage of return on funds invested in the business by its owners. In short, this ratio tells the owner whether or not all the effort put into the business has been worthwhile. If the ROI is less than the rate of return on an alternative, risk-free investment such as a bank savings account or certificate of deposit, the owner may be wiser to sell the company, put the money in such a savings instrument, and avoid the daily struggles of small business management. The ROI is calculated as follows:
Return on Investment = Net Profit before Tax --------------------- Net Worth
These Liquidity, Leverage, Profitability, and Management Ratios allow the business owner to identify trends in a business and to compare its progress with the performance of others through data published by various sources. The owner may thus determine the business’s relative strengths and weaknesses.
Sources of Comparative Information
Sources of comparative financial information which you may obtain from your public library or the publishers include the following:
Almanac of Business and Industrial Financial Ratios, Leo Troy, Prentice-Hall, Inc., Englewood Cliffs, NJ 07632
Annual Statement Studies, Robert Morris Associates, P. O. Box 8500, S-1140, Philadelphia, PA 19178
Expenses in Retail Business, National Cash Register Corporation, Corporate Advertising and Sales Promotion Dayton, OH 45479.
Key Business Ratios, Dun & Bradstreet, Inc., 99 Church Street, New York, NY 10007, ATTN: Public Relations and Advertising Department
IV. Forecasting Profits
Forecasting, particularly on a short-term basis (one year to three years), is essential to planning for business success. This process, estimating future business performance based on the actual results from prior periods, enables the business owner/manager to modify the operation of the business on a timely basis. This allows the business to avoid losses or major financial problems should some future results from operations not conform with reasonable expectations. Forecasts--or Pro Forma Income Statements and Cash Flow Statements as they are usually called--also provide the most persuasive management tools to apply for loans or attract investor money. As a business expands, there will inevitably be a need for more money than can be internally generated from profits.
Facts Affecting Pro Forma Statements
Preparation of Forecasts (Pro Forma Statements) requires assembling a wide array of pertinent, verifiable facts affecting your business and its past performance. These include:
* Data from prior financial statements, particularly: a. Previous sales levels and trends b. Past gross percentages c. Average past general, administrative, and selling expenses necessary to generate your former sales volumes d. Trends in the company’s need to borrow (supplier, trade credit, and bank credit) to support various levels of inventory and trends in accounts receivable required to achieve previous sales volumes
* Unique company data, particularly: a. Plant capacity b. Competition c. Financial constraints d. Personnel availability
* Industry-wide factors, including: a. Overall state of the economy b. Economic status of your industry within the economy c. Population growth d. Elasticity of demand for the product or service your business provides e. Availability of raw materials
Once these factors are identified, they may be used in Pro Formas, which estimate the level of sales, expense, and profitability that seem possible in a future period of operations.
The Pro Forma Income Statement
In preparing the Pro Forma Income Statement, the estimate of total sales during a selected period is the most critical 'guesstimate.' Employ business experience from past financial statements. Get help from management and salespeople in developing this all-important number.
Then assume, for example, that a 10 percent increase in sales volume is a realistic and attainable goal. Multiply last year’s net sales by 1.10 to get this year’s estimate of total net sales. Next, break down this total, month by month, by looking at the historical monthly sales volume. From this you can determine what percentage of total annual sales fell on the average in each of those months over a minimum of the past three years. You may find that 75 percent of total annual sales volume was realized during the six months from July through December in each of those years and that the remaining 25 percent of sales was spread fairly evenly over the first six months of the year.
Next, estimate the cost of goods sold by analyzing operating data to determine on a monthly basis what percentage of sales has gone into cost of goods sold in the past. This percentage can then be adjusted for expected variations in costs, price trends, and efficiency of operations.
Operating expenses (sales, general and administrative expenses, depreciation, and interest), other expenses, other income, and taxes can then be estimated through detailed analysis and adjustment of what they were in the past and what you expect them to be in the future.
Comparison with Actual Monthly Performance
Putting together this information month by month for a year into the future will result in your business’s Pro Forma Statement of Income. Use it to compare with the actual monthly results from operations by using the SBA form 1099 (4-82) Operating Plan Forecast (Profit and Loss Projection). Obtain this form from your local SBA office. You will find it helpful to refer to the SBA Guidelines for Profit and Loss Projection. Preparation of the information is summarized below and on the back of the form 1099.
Revenue (Sales)
* List the departments within the business. For example, if your business is appliance sales and service, the departments would include new appliances, used appliances, parts, in-shop service, on-site service.
* In the 'Estimate' columns, enter a reasonable projection of monthly sales for each department of the business. Include cash and on-account sales. In the 'Actual' columns, enter the actual sales for the month as they become available.
* Exclude from the Revenue section any revenue not strictly related to the business.
Cost of Sales
* Cite costs by department of the business, as above.
* In the 'Estimate' columns, enter the cost of sales estimated for each month for each department. For product inventory, calculate the cost of the goods sold for each department (beginning inventory plus purchases and transportation costs during the month minus the inventory). Enter 'Actual' costs each month as they accrue.
Gross Profit
* Subtract the total cost of sales from the total revenue.
Expenses
* Salary Expenses: Base pay plus overtime.
* Payroll Expenses: Include paid vacations, sick leave, health insurance, unemployment insurance, Social Security taxes.
* Outside Services: Include costs of subcontracts, overflow work farmed-out, special or one-time services.
* Supplies: Services and items purchased for use in the business, not for resale.
* Repairs and Maintenance: Regular maintenance and repair, including periodic large expenditures, such as painting or decorating.
* Advertising: Include desired sales volume, classified directory listing expense, etc.
* Car, Delivery and Travel: Include charges if personal car is used in the business. Include parking, tolls, mileage on buying trips, repairs, etc.
* Accounting and Legal: Outside professional services.
* Rent: List only real estate used in the business.
* Telephone.
* Utilities: Water, heat, light, etc.
* Insurance: Fire or liability on property or products, worker’s compensation.
* Taxes: Inventory, sales, excise, real estate, others.
* Interest.
* Depreciation: Amortization of capital assets.
* Other Expenses (specify each): Tools, leased equipment, etc.
* Miscellaneous (unspecified): Small expenditures without separate accounts.
Net Profit
* To find net profit, subtract total expenses from gross profit.
The Pro Forma Statement of Income, prepared on a monthly basis and culminating in an annual projection for the next business fiscal year, should be revised not less than quarterly. It must reflect the actual performance achieved in the immediately preceding three months to ensure its continuing usefulness as one of the two most valuable planning tools available to management.
Should the Pro Forma reveal that the business will likely not generate a profit from operations, plans must immediately be developed to identify what to do to at least break even--increase volume, decrease expenses, or put more owner capital in to pay some debts and reduce interest expenses.
Break-Even Analysis
'Break-Even' means a level of operations at which a business neither makes a profit nor sustains a loss. At this point, revenue is just enough to cover expenses. Break-Even Analysis enables you to study the relationship of volume, costs, and revenue.
Break-Even requires the business owner/manager to define a sales level--either in terms of revenue dollars to be earned or in units to be sold within a given accounting period--at which the business would earn a before tax net profit of zero. This may be done by employing one of various formula calculations to the business estimated sales volume, estimated fixed costs, and estimated variable costs.
Generally, the volume and cost estimates assume the following conditions:
* A change in sales volume will not affect the selling price per unit;
* Fixed expenses (rent, salaries, administrative and office expenses, interest, and depreciation) will remain the same at all volume levels; and
* Variable expenses (cost of goods sold, variable labor costs including overtime wages and sales commissions) will increase or decrease in direct proportion to any increase or decrease in sales volume.
Two methods are generally employed in Break-Even Analysis, depending on whether the break-even point is calculated in terms of sales dollar volume or in number of units that must be sold.
Break-Even Point in Sales Dollars
The steps for calculating the first method are shown below:
1. Obtain a list of expenses incurred by the company during its past fiscal year.
2. Separate the expenses listed in Step 1 into either a variable or a fixed expense classification. (See Figure 4-1, below, under 'Classification of Expenses.')
3. Express the variable expenses as a percentage of sales. In the condensed income statement (Figure 4-1) of the Small Business Specialties Co. (below), net sales were $1,200,000. In Step 2, variable expenses were found to amount to $720,000. Therefore, variable expenses are 60 percent of net sales ($720,000 divided by $1,200,000). This means that 60 cents of every sales dollar is required to cover variable expenses. Only the remainder, 40 cents of every dollar, is available for fixed expenses and profit.
4. Substitute the information gathered in the preceding steps in the following basic break-even formula to calculate the breakeven point.
Figure 4-1 --------------------------------------------------------------------------- THE SMALL-BUSINESS SPECIALTIES CO. Condensed Income Statement For year ending Dec. 31, 19-
Net sales (60,000 units @ $20 per unit)..........................$1,200,000 Less cost of goods sold: Direct material.............................$195,000 Direct labor................................ 215,000 Manufacturing expenses (Schedule A)......... 300,000 -------- Total....................................................... 710,000 ---------- Gross profit..................................................... 490,000 Less operating expenses: Selling expenses (Schedule B)...............$200,000 General and administrative expenses (Schedule C).............................. 210,000 -------- Total....................................................... 410,000 ---------- Net Income.......................................................$ 80,000 ---------- --------------------------------------------------------------------------- Supporting Schedules of Expenses Other Than Direct Material and Labor
Schedule C Schedule A Schedule B general and manufacturing selling administrative Total expenses expenses expenses
Rent.................$ 60,000 $ 30,000 $ 8,000 $ 22,000 Insurance............ 11,000 9,000 1,000 1,000 Commissions.......... 120,000 ....... 120,000 ....... Property tax......... 12,000 10,000 1,000 1,000 Telephone............ 7,000 1,000 5,000 1,000 Depreciation......... 80,000 70,000 5,000 5,000 Power................ 100,000 100,000 ....... ....... Light................ 60,000 30,000 10,000 20,000 Officers’ salaries... 260,000 50,000 50,000 160,000 -------- -------- -------- -------- Total...........$710,000 $300,000 $200,000 $210,000 -------- -------- -------- -------- --------------------------------------------------------------------------- Classification of Expenses
Total Variable Fixed
Direct material...................$ 195,000 195,000 ....... Direct labor...................... 215,000 215,000 ....... Manufacturing expenses............ 300,000 100,000 $200,000 Selling expenses.................. 200,000 50,000 General and admin. expenses....... 210,000 60,000 150,000 ---------- -------- -------- Total........................$1,120,000 $720,000 $400,000 ---------- -------- -------- ---------------------------------------------------------------------------
where: S = F + V (Sales at the break-even point) F = Fixed expenses V = Variable expenses expressed as a percentage of sales.
This formula means that when sales revenues equal the fixed expenses and variable expenses incurred in producing the sales revenues, there will be no profit or loss. At this point, revenue from sales is just sufficient to cover the fixed and the variable expenses. In this formula 'S' is the break even point.
For the Small Business Specialties Co., the break-even point (using the basic formula and data from Figure 4-2) may be calculated as follows:
S = F + V S = $400,000 + 0.605 10S = $4,000,000 + 6S 10S - 6S = $4,000,000 4S = $4,000,000 S = $1,000,000
Proof that this calculation is correct follows:
Sales at break-even point per calculation $1,000,000 Less variable expenses (60 percent of sales) 600,000 ---------- Marginal income 400,000 Less fixed expenses 400,000 ---------- Equals neither profit nor loss $ 0
Modification: Break-Even Point to Obtain Desired Net Income.
The first break-even formula can be modified to show the dollar sales required to obtain a certain amount of desired net income. To do this, let 'S' mean the sales required to obtain a certain amount of net income, say $80,000. The formula then reads:
S = F + V + Desired Net Income S = $400,000 + 0.60S + $80,000 10S = $4,000,000 + 6S + 800,000 4S = $4,800,000 S = $1,200,000
Break-Even Point in Units to be Sold
You may want to calculate the break-even point in terms of units to be sold instead of sales dollars. If so, a second formula (in which 'S' means units to be sold to break even) may be used:
Break-even Sales = Fixed expenses (S = Units) ----------------------------------------- Unit sales price - Unit variable expenses
S = $400,000 = $400,000 --------- -------- $20 - $12 $8
S = 50,000 units
The Small Business Specialties Co. must sell 50,000 units at $20 per unit to break even under the assumptions contained in this illustration. The sale of 50,000 units at $20 each equals $1 million, the break-even sales volume in dollars calculated in the basic formula. This formula indicates there is $8 per unit of sales that can be used to cover the $400,000 fixed expense. Then $400,000 divided by $8 gives the number of units required to break even.
Modification: Break-Even Point in Units to be Sold to Obtain Desired Net Income.
The second formula can be modified to show the number of units required to obtain a certain amount of net income. In this case, let S mean the number of units required to obtain a certain amount of net income, again say $80,000. The formula then reads as follows:
S = Fixed expenses + Net income ---------------------------------------- Unit sales price - Unit variable expense
S = $400,000 + $80,000 = $480,000 ------------------ -------- $20 - $12 $8
S = 60,000 units
Break-even Analysis may also be represented graphically by charting the sales dollars or sales units required to break even as in Figure 4-2, below.
Remember: Increased sales do not necessarily mean increased profits. If you know your company’s break-even point, you will know how to price your product to make a profit. If you cannot make an acceptable profit, alter or sell your business before you lose your retained earnings.
Figure 4-2 +---------------------------------------------------_Revenue (Sales) � _ � � _ � + _ � Total � _ � Costs � Potential Profit-----_---X _ ----- + _ _ � _ � _ _ � � � _ _ � � + _ _ � Variable � _ _ � Costs & � _ _ � Expenses + _ _ � � �-- -- -- -- -- -- -_Break-Even Profit � � � _ � � + _ _ � � � � _ _ � � � _ Loss _ � Fixed Cost Line � _------_--------------------------------------------� ----- � _ � � Fixed � Costs Sales Volume
V. Cash Flow Management: Budgeting and Controlling Costs
If there is anything more important to the successful financial management of a business than the thorough, thoughtful preparation of Pro Forma Income Statements, it is the preparation of the Cash Flow Statement, sometimes called the Cash Flow Budget.
The Cash Flow Statement
The Cash Flow Statement identifies when cash is expected to be received and when it must be spent to pay bills and debts. It shows how much cash will be needed to pay expenses and when it will be needed. It also allows the manager to identify where the necessary cash will come from. For example, will it be internally generated from sales and the collection of accounts receivable--or must it be borrowed? (The Cash Flow Projection deals only with actual cash transactions; depreciation and amortization of good will or other non-cash expense items are not considered in this Pro Forma.)
The Cash Flow Statement, based on management estimates of sales and obligations, identifies when money will be flowing into and out of the business. It enables management to plan for shortfalls in cash resources so short term working capital loans may be arranged in advance. It allows management to schedule purchases and payments in a way that enables the business to borrow as little as possible. Because all sales are not cash sales management must be able to forecast when accounts receivable will become 'cash in the bank' and when expenses--whether regular or seasonal--must be paid so cash shortfalls will not interrupt normal business operations.
The Cash Flow Statement may also be used as a Budget, permitting the manager increased control of the business through continuous comparison of actual receipts and disbursements against forecast amounts. This comparison helps the small business owner identify areas for timely improvement in financial management.
By closely watching the timing of cash receipts and disbursements, cash balance on hand, and loan balances, management can readily identify such things as deficiencies in collecting receivables, unrealistic trade credit or loan repayment schedules. Surplus cash that may be invested on a short-term basis or used to reduce debt and interest expenses temporarily can be recognized. In short, it is the most valuable tool management has at its disposal to refine the day-to-day operation of a business. It is an important financial tool bank lenders evaluate when a business needs a loan, for it demonstrates not only how large a loan is required but also when and how it can be repaid.
A Cash Flow Statement or Budget can be prepared for any period of time. However, a one-year budget matching the fiscal year of your business is recommended. As in the preparation and use of the Pro Forma Statement of Income, the projected Cash Flow Statement should be prepared on a monthly basis for the next year. It should be revised not less than quarterly to reflect actual performance in the preceding three months of operations to check its projections.
In preparing the Cash Flow Statement or Budget start with the sales budget. Other budgets are related directly or indirectly to this budget. The following is a sales forecast in units:
Sales Budget--Units For the Year Ended December 31, 19__
Territory Total 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter East....................26,000 5,000 6,000 7,000 8,000 West....................11,000 2,000 2,500 3,000 3,500 ------ ----- ----- ------ ------ 37,000 7,000 8,500 10,000 11,500 ------ ----- ----- ------ ------
Assume you sell a single product and the sales price for it is $10. Your sales budget in terms of dollars would look like this:
Sales Budget--Dollars For the Year Ended December 31, 19__
Territory Total 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter East......................$260,000 $50,000 $80,000 $ 70,000 $ 80,000 West...................... 110,000 20,000 25,000 30,000 35,000 -------- ------- ------- -------- -------- $370,000 $70,000 $85,000 $100,000 $115,000 -------- ------- ------- -------- --------
Say the estimated per unit cost of the product is $1.50 for direct material, $2.50 for direct labor, and $1.00 for manufacturing overhead. By applying unit costs to the sales budget in units, you would come out with this budget:
Cost of Goods Sold Budget For the Year Ended December 31, 19__
Total 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Direct material......$ 55,500 $10,500 $12,750 $15,000 $17,250 Direct labor......... 92,500 17,500 21,250 25,000 28,750 Mfg. overhead........ 37,000 7,000 8,500 10,000 11,500 -------- ------- ------- ------- ------- $185,000 $35,000 $42,500 $50,000 $57,500 -------- ------- ------- ------- -------
Later on, before a cash budget can be compiled, you will need to know the estimated cash requirements for selling expenses. Therefore, you prepare a budget for selling expenses and another for cash expenditures for selling expenses (total selling expenses less depreciation):
Selling Expenses Budget For the Year Ended December 31 19__
Total 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Commissions.............$46,500 $ 8,750 $10,625 $12,500 $14,375 Rent.................... 9,250 1,750 2,125 2,500 2,875 Advertising............. 9,250 1,750 2,125 2,500 2,875 Telephone............... 4,625 875 1,062 1,250 1,437 Depreciation--office.... 900 225 225 225 225 Other................... 22,250 4,150 5,088 6,025 6,983 ------- ------- ------- ------- ------- $92,500 $17,500 $21,250 $25,000 $28,750 ------- ------- ------- ------- -------
Selling Expenses Budget--Cash Requirements For the Year Ended December 31, 19__
Total 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Total selling expenses..$92,500 $17,500 $21,250 $25,000 $28,750 Less: depreciation...... expense--office......... 900 225 225 225 225 ------- ------- ------- ------- ------- Cash requirements.......$91,600 $17,275 $21,025 $24,775 $28,525 ------- ------- ------- ------- -------
Basic information for an estimate of administrative expenses for the coming year is easily compiled. Again, from that budget you can estimate cash requirements for those expenses to be used subsequently in preparing the cash budget.
Administrative Expenses Budget For the Year Ended December 31, 19___
Total 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Salaries.................$22,200 $4,200 $5,100 $ 6,000 $ 6,900 Insurance................ 1,850 350 425 500 575 Telephone................ 1,850 350 425 500 575 Supplies................. 3,700 700 850 1,000 1,150 Bad debt expenses........ 3,700 700 850 1,000 1,150 Other expenses........... 3,700 700 850 1,000 1,150 ------- ------ ------ ------- ------- $37,000 $7,000 $8,500 $10,000 $11,500 ------- ------ ------ ------- -------
Administrative Expenses Budget--Cash Requirements For the Year Ended December 31, 19___
Total 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Estimated adm. expenses...$37,000 $7,000 $8,500 $10,000 $11,500 Less: bad debt expenses... 3,700 700 850 1,000 1,150 ------- ------ ------ ------- ------- Cash requirements.........$33.300 $6,500 $7,650 $ 9,000 $10,350 ------- ------ ------ ------- -------
Now, from the information budgeted so far, you can proceed to prepare the budget income statement. Assume you plan to borrow $10,000 at the end of the first quarter. Although payable at maturity of the note, the interest appears in the last three quarters of the year. The statement will resemble the following:
Budgeted Income Statement For the Year Ended December 31, 19___
Total 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Sales...................$370,000 $70,000 $85,000 $100,000 $115,000 Cost of goods sold...... 185,000 35,000 42,500 50,000 57,500 -------- ------- ------- -------- -------- Gross Margin............$185,000 $35,000 $42,500 $ 50,000 $ 57,500 -------- ------- ------- -------- -------- Operating expenses: Selling................$ 92,500 $17,500 $21,250 $ 25,000 $ 28,750 Administrative......... 37,000 7,000 8,500 $ 10,000 $ 11,500 -------- ------- ------- -------- -------- Total................$129,500 $24,500 $29,750 $ 35,000 $ 40,250 -------- ------- ------- -------- -------- Net income from operations........$ 55,500 $10,500 $12,750 $ 15,000 $ 17,250 Interest expense....... 450 150 150 150 -------- ------- ------- -------- -------- Net income before Income taxes...........$ 55,050 $10,500 $12,600 $ 14,850 $ 17,100 Federal income tax..... 27,525 5,250 6,300 7,425 8,550 -------- ------- ------- -------- -------- Net income..............$ 27,525 $ 5,250 $ 6,300 $ 7,425 $ 8,550 -------- ------- ------- -------- --------
Estimating that 90 percent of your account sales is collected in the quarter in which they are made, that 9 percent is collected in the quarter following the quarter in which the sales were made, and that 1 percent of account sales is uncollectible, your accounts receivable budget of collections would look like this:
Budget of Collections of Accounts Receivable For the Year Ended December 31, 19___
Total 1st 2nd 3rd 4th (net) Quarter Quarter Quarter Quarter 4th Quarter Sales 19-0...$ 6,000 $ 6,000 1st Quarter Sales 19-1... 69,300 63,000 $ 6,300 2nd Quarter Sales 19-1... 84,150 76,500 $ 7,650 3rd Quarter Sales 19-1... 99,000 90,000 $ 9,000 4th Quarter Sales 19-1... 103,500 103,500 -------- ------- ------- ------- -------- $361,950 $69,000 $82,800 $97,650 $112,500
Going back to the sales budget in units, now prepare a production budget in units. Assume you have 2,000 units in the opening inventory and want to have on hand at the end of each quarter the following quantities: 1st quarter, 3,000 units; 2nd quarter, 3,500 units; 3rd quarter, 4,000 units; and 4th quarter, 4,500 units.
Production Budget--Units For the Year Ended December 31, 19___
1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Sales requirements........... 7,000 8,500 10,000 11,500 Add: ending inventory requirements...... 3,000 3,500 4,000 4,500 ------ ------ ------ ------- Total requirements..........10,000 12,500 14,000 16,000 Less: beginning inventory................... 2,000 3,000 3,500 4,000 Production ------ ------ ------ ------- requirements............... 8,000 9,000 10,500 112,000 ------ ------ ------ -------
Next, based on the production budget, prepare a budget to show the purchases needed during each of the four quarters. Expressed in terms of dollars, you do this by taking the production and inventory fires and multiplying them by the cost of material (previously estimated at $1.50 per unit). You could prepare a similar budget expressed in units.
Budget of Direct Materials Purchases For the Year Ended December 31, 19___
1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Required for production........$12,000 $13,500 $15,750 $18,000 Required for ending inventory.. 4,500 52,250 6,000 6,750 ------- ------- ------- ------- Total........................$16,500 $18,750 $21,750 $24,750 Less: beginning inventory...... 3,000 4,500 5,250 6,000 ------- ------- ------- ------- Required purchases.............$13,500 $14,250 $16,500 $18,750 ------- ------- ------- -------
Now suppose you pay 50 percent of your accounts in the quarter of the purchase and 50 percent in the following quarter. Carryover payables from last year were $5,000. Further, you always take the purchase discounts as a matter of good business policy. Since net purchases (less discount) were figured into the $1.50 cost estimate, purchase discounts do not appear in the budgets. Thus your payment on purchases budget will come out like this:
Payment on Purchases Budget For the Year Ended December 31, 19___
Total 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter 4th Quarter Sales 19-0...$ 5,000 $ 5,000 1st Quarter Sales 19-1... 13,500 6,750 $ 6,750 2nd Quarter Sales 19-1... 14,250 7,125 $ 7.125 3rd Quarter Sales 19-1... 16,500 8,250 $ 8,250 4th Quarter Sales 19-1... 9,375 9,375 ------- ------- Payments by Quarters $58,625 $11,750 $13,875 $15,375 $17,625 ------- ------- ------- ------- -------
Taking the data for quantities produced from the production budget in units, calculate the direct labor requirements on the basis of units to be produced. (The number and cost of labor hours necessary to produce a given quantity can be set forth in supplemental schedules.)
Direct Labor Budget--Cash Requirements For the Year Ended December 31, 19__
Total 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Quantity................ 39,500 8,000 9,000 10,500 12,000 Direct labor cost.......$98,750 $20,000 $22,500 $26,250 $30,000
Now outline the items that comprise your factory overhead, and prepare a budget like the following:
Manufacturing Overhead Budget For the Year Ended December 31, 19___
Total 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Heat and power..........$10,000 $1,000 $2,500 $ 3,000 $ 3,500 Factory supplies........ 5,300 1,000 1,500 1,800 1,000 Property taxes.......... 2,000 500 500 500 500 Depreciation............ 2,800 700 700 700 700 Rent.................... 8,000 2,000 2,000 2,000 2,000 Superintendent.......... 9,400 2,800 1,800 2,500 4,300 ------- ------ ------ ------- ------- $39,500 $8,000 $9,000 $10.500 $12,000 ------- ------ ------ ------- -------
Figure the cash payments for manufacturing overhead by subtracting depreciation, which requires no cash outlay, from the totals above, and you will have the following breakdown:
Manufacturing Overhead Budget--Cash Requirements For the Year Ended December 31, 19___
Total 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Productions--units...... 39,500 8,000 9,000 10,500 12,000 ------- ------ ------ ------- ------- Mfg.overhead expenses...$39,500 $8,000 $9,000 $10,500 $12,000 Less: depreciation...... 2,800 700 700 700 700 ------- ------ ------ ------- ------- Cash requirements.......$36,700 $7,300 $8,300 $ 9,800 $11,300 ------- ------ ------ ------- -------
Now comes the all important cash budget. You put it together by using the Collection of Accounts Receivable Budget; Selling Expenses Budget--Cash Requirements; Administrative Expenses Budget--Cash Requirements; Payment of Purchases Budget; Direct Labor Budget--Cash Requirements; and Manufacturing Budget--Cash Requirements.
Take $15,000 as the beginning balance, and assume that dividends of $20,000 are to be paid in the fourth quarter.
Cash Budget For the Year Ended December 31, 19___
Total 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Beginning cash balance $ 15,000 $15,000 $ 3,850 $ 13,300 $ 25,750 Cash collections 361,950 69,000 82,800 97,650 112,500 -------- ------- ------- -------- -------- Total $376,950 $84,000 $86,650 $110,950 $138,250 -------- ------- ------- -------- -------- Cash payments Purchases $ 58,625 $11,750 $13,875 $ 15,375 $ 17,625 Direct labor 98,750 20,000 22,500 26,250 30,000 Mfg. overhead 38,700 7,300 8,300 9,800 11,300 Selling expense 91,600 17,275 21,025 24,775 28,525 Adm. expenses 33,300 6,300 7,650 9,000 10,350 Federal income tax 27,525 27,525 Dividends 20,000 20,000 Interest expenses 450 450 Loan repayment 10,000 10,000 -------- ------- ------- ------- -------- Total $376,950 $90,150 $73,350 $ 85,200 $128,250 -------- ------- ------- ------- -------- Cash deficiency ($ 6,150) Bad loan received 10,000 10,000 -------- ------- Ending cash balance $ 10,000 $ 3,850 $13,300 $ 25,750 $ 10,000 -------- ------- ------- ------- --------
Now you are ready to prepare a budget balance sheet. Take the account balances of last year and combine them with the transactions reflected in the various budgets you have compiled. You will come out with a sheet resembling this:
Budgeted Balance Sheet December 31, 19___ Assets 19___ 19___ Current assets: Cash $ 10,000 $ 15,000 Ac
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