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Creating a Solid Financial Plan

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SECTION THREE Building a Business Plan: Financial Issues CHAPTER SEVEN Creating a Solid Financial Plan Learning Objectives Upon completion of this chapter, you will be able to: 1 Understand the importance
SECTION THREE Building a Business Plan: Financial Issues CHAPTER SEVEN Creating a Solid Financial Plan Learning Objectives Upon completion of this chapter, you will be able to: 1 Understand the importance of preparing a financial plan. 2 Describe how to prepare financial statements and use them to manage a small business. 3 Create projected financial statements. 4 Understand basic financial statements through ratio analysis. 5 Explain how to interpret financial ratios. 6 Conduct a break-even analysis for a small company. You can t tell who s swimming naked until after the tide goes out. David Darst In the wake of numerous corporate financial scandals in which managers misrepresented their companies financial positions, one pundit offers this definition of EBIT (in reality, earnings before interest and taxes): earnings before irregularities and tampering. Mortimer B. Zuckerman 193 194 SECTION 3 BUILDING A BUSINESS PLAN: FINANCIAL ISSUES 1. Understand the importance of preparing a financial plan. One of the most important steps in launching a new business venture is fashioning a well-designed, practical, realistic financial plan. Potential lenders and investors expect to see a financial plan before putting their money into a start-up company. More important, however, a financial plan is a vital tool to help entrepreneurs manage their businesses more effectively, steering their way around the pitfalls that cause failures. Entrepreneurs who ignore the financial aspects of their businesses run the risk of watching their companies become another failure statistic. Many empirical studies have verified the positive correlation between the degree of planning (including financial planning) that entrepreneurs engage in and the success of their new ventures. These studies also show a significant positive relationship between formal planning by small companies and their financial performance. 1 One financial expert says of small companies, Those that don t establish sound controls at the start are setting themselves up to fail. 2 However, both research and anecdotal evidence suggests that a significant percentage of entrepreneurs run their companies without any kind of financial plan and never analyze their companies financial statements as part of the decision-making process. Why is the level of financial planning and analysis so low among entrepreneurs? The primary reason is the lack of financial know-how. One survey of small business owners by Greenfield Online found that accounting was the most intimidating part of managing their businesses and that more than half had no formal financial training at all. 3 To reach profit objectives, entrepreneurs cannot afford to be intimidated by financial management and must be aware of their companies overall financial position and the changes in financial status that occur over time. Norm Brodsky, a veteran entrepreneur and author, says, When you learn the basics of accounting, you realize that the numbers aren t as complicated as you feared and that you re developing the knowledge you need to be in control of your company. 4 This chapter focuses on some very practical tools that help entrepreneurs to develop workable financial plans, keep them focused on their company s financial plans, and enable them to create a plan for earning a profit. They can use these tools to anticipate changes and plot an appropriate profit strategy to meet them head on. These profit planning techniques are not difficult to master, nor are they overly time consuming. We will discuss the techniques involved in preparing projected (pro forma) financial statements, conducting ratio analysis, and performing break-even analysis. 2. Describe how to prepare financial statements and use them to manage a small business. Basic Financial Reports Before we begin building projected financial statements, it would be helpful to review the basic financial reports that measure a company s overall financial position: the balance sheet, the income statement, and the statement of cash flows. Every business, no matter how small, will benefit from preparing these basic financial statements. Building them is the first step toward securing a small company s financial future. Most accounting experts advise entrepreneurs to use one of the popular computerized small business accounting programs, such as Intuit s market-leading QuickBooks, Sage s Peachtree Accounting, or Microsoft s Small Business Accounting, to manage routine record-keeping tasks that form the underlying framework of these financial statements. These programs make analyzing a company s financial statements, preparing reports, and summarizing data a snap. A survey by Microsoft, however, reports that less than half of small companies use dedicated accounting software; most use a combination of homemade spreadsheets and paper records to handle their accounting needs. 5 Working with an accountant to set up a smoothly functioning accounting system at the outset and then having an employee or a part-time bookkeeping service enter the transactions is most efficient for the businesses that use these packages. The Balance Sheet Like a digital camera, the balance sheet takes a snapshot of a business, providing owners with an estimate of the company s worth on a given date. Its two major sections show the assets a business owns and the claims creditors and owners have against those assets. The balance sheet is usually prepared on the last day of the month. Figure 7.1 shows the balance sheet for a small business, Sam s Appliance Shop, for the year ended December 31, 201X. The balance sheet is built on the fundamental accounting equation: Assets = Liabilities + Owner œ s equity. Any increase or decrease on one side of the equation must be CHAPTER 7 CREATING A SOLID FINANCIAL PLAN 195 FIGURE 7.1 Balance Sheet, Sam s Appliance Shop For Year Ending December 31, 201X Assets Current assets Cash $49,855 Accounts receivable $179,225 Less allowance for doubtful accounts $6,000 $173,225 Inventory $455,455 Prepaid expenses $8,450 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 and 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 wages/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 Owner s Equity Sam Lloyd, capital $267,655 Total liabilities and owner s equity $847,655 offset by an equal increase or decrease on the other side, hence the name balance sheet. It provides a baseline from which to measure future changes in assets, liabilities, and owner s equity (or net worth). The first section of the balance sheet lists the company s assets (valued at cost, not actual market value) and shows the total value of everything the business owns. Current assets consist of cash and items to be converted into cash within 1 year or within the normal operating cycle of the company, whichever is longer, such as accounts receivable and inventory, and fixed assets are those acquired for long-term use in the business. Intangible assets include items that, although valuable, do not have tangible value, such as goodwill, copyrights, and patents. The second section shows the company s liabilities the creditors claims against the company s assets. Current liabilities are those debts that must be paid within 1 year or within the normal operating cycle of the company, whichever is longer, and long-term liabilities are those that come due after 1 year. This section of the balance sheet also shows the owner s equity, the value of the owner s investment in the business. It is the balancing factor on the balance sheet, representing all of the owner s capital contributions to the business plus all accumulated earnings not distributed to the owner(s). 196 SECTION 3 BUILDING A BUSINESS PLAN: FINANCIAL ISSUES The Income Statement The income statement (or profit and loss statement, or P&L ) compares expenses against revenue over a certain period of time to show the firm s net income or loss. Like a digital video recorder, the income statement provides a moving picture of a company s profitability over time. The annual P&L statement reports the bottom line of the business over the fiscal or calendar year. Figure 7.2 shows the income statement for Sam s Appliance Shop for the year ended December 31, 201X. To calculate net income or loss, owners record sales revenue for the year, which includes all income that flows into the business from the sale of goods and services. Income from other sources (rent, investments, interest) also must be included in the revenue section of the income statement. To determine net revenue, owners subtract the value of returned items and refunds from gross revenue. Cost of goods sold represents the total cost of purchasing (including shipping) the merchandise that the company sells during the year. Wholesalers and retailers calculate cost of goods sold by adding purchases to beginning inventory and subtracting ending inventory. Service companies typically have no cost of goods sold. Subtracting the cost of goods sold from net sales revenue results in a company s gross profit. Allowing the cost of goods sold to get out of control whittles away a company s gross profit, virtually guaranteeing a net loss at the bottom of the income statement. Dividing gross profit by net sales revenue produces the gross profit margin, a percentage that every entrepreneur should watch closely. If a company s gross profit margin slips too low, it is likely that it will operate at a FIGURE 7.2 Income Statement, Sam s Appliance Shop For Year Ending December 31, 201X Net sales revenue $1,870,841 Cash sales $561,252 Credit sales $1,309,589 Cost of goods sold Beginning inventory, 1/1/xx $805,745 Purchases $939,827 Goods available for sale $1,745,572 Ending inventory, 12/31/xx $455,455 Cost of goods sold $1,290,117 Gross profit $580,724 Operating expenses Advertising $139,670 Insurance $46,125 Depreciation Building $18,700 Equipment $9,000 Salaries $224,500 Travel $4,000 Entertainment $2,500 Total operating expenses $444,495 General expenses Utilities $5,300 Telephone $2,500 Postage $1,200 Payroll taxes $25,000 Total general expenses $34,000 Other expenses Interest expense $39,850 Bad check expense $1,750 Total other expenses $41,600 Total expenses $520,095 Net income $60,629 CHAPTER 7 CREATING A SOLID FINANCIAL PLAN 197 loss (negative net income). A declining gross profit margin also restricts a company s ability to invest in revenue-generating activities, such as marketing, advertising, and business development. Many business owners whose companies are losing money mistakenly believe that the problem is inadequate sales volume; therefore, they focus on pumping up sales at any cost. In many cases, however, the losses are due to an inadequate gross profit margin, and pumping up sales only deepens their losses! Repairing a poor gross profit margin requires a company to raise prices, cut manufacturing or purchasing costs, refuse orders with low profit margins, or add new products with more attractive profit margins. Increasing sales will not resolve the problem. One business owner admits that he fell victim to this myth of profitability. His company was losing money, and in an attempt to correct the problem he focused his efforts on boosting sales. His efforts were successful, but the results were not. The costs he incurred to add sales produced withering gross profit margins, and by the time he deducted operating costs the business had incurred an even greater net loss! Cash flow suffered, the business could not pay its bills on time, and the owner ended up filing for Chapter 11 bankruptcy. Now a successful business owner, this entrepreneur says, Ever since, I ve tracked my gross [profit] margins like a hawk. 6 Monitoring the gross profit margin over time and comparing it to those of other companies in the same industry are important steps to maintaining a company s long-term profitability. Operating expenses include those costs that contribute directly to the manufacture and distribution of goods. General expenses are indirect costs incurred in operating the business. Other expenses is a catch-all category covering all other expenses that don t fit into the other two categories. Total revenue minus total expenses gives the company s net income (or loss). Reducing expenses increases a company s net income, and even small reductions in expenses can add up to big savings. ENTREPRENEURIAL Profile Jay Goltz and Chicago Art Source Jay Goltz, owner of a picture-framing and home furnishings business in Chicago, recently purchased a machine that shreds cardboard, making it suitable as a packing material. Not only did the move eliminate the cardboard the company was putting into landfills, but it also allowed Goltz to save $10,000 per year on purchases of packing material. 7 Business owners must be careful when embarking on cost-cutting missions, however. Although minimizing costs can improve profitability, entrepreneurs must be judicious in their cost-cutting, taking a strategic approach rather than imposing across-the-board cuts. Brad Smith, CEO of Intuit, a company that develops software and provides business services for small businesses, knows that research and development and product innovation are keys to the company s success. We re not going to cut innovation, he vows. For 25 years, this company has been fueled by new product innovation. We re protecting the innovation pipeline so that [our future] is strong. 8 Cutting costs in areas that are vital to a company s success such as a retail jeweler cutting its marketing budget during a recession can inhibit its ability to compete and do more harm than good. In fact, a study by McGraw-Hill Research reports that companies that advertise consistently even during recessions perform better in the long run; companies that advertised aggressively during a recent recession generated sales that were 256 percent higher than those that did not advertise consistently. 9 In other cases, entrepreneurs on cost-cutting vendettas alienate employees and sap worker morale by eliminating nitpicking costs that affect employees but retaining expensive perks for themselves. One business owner enraged employees by cutting the budget for the company Christmas party to $5 (for the whole event) and encouraging employees not to skip lines on interoffice envelopes (which, one worker calculated, cost the company $ per skipped line). Although his reasons for cutting costs were valid, this CEO lost all credibility because employees knew that he had a chauffeur drive him to work every day and when he traveled he stayed only at upscale, butler-serviced hotels! 10 The Statement of Cash Flows The statement of cash flows shows the changes in a company s working capital from the beginning of the accounting period by listing the sources of funds and the uses of these funds. Many 198 SECTION 3 BUILDING A BUSINESS PLAN: FINANCIAL ISSUES small businesses never need such a statement; instead, they rely on a cash budget, a less formal managerial tool that tracks the flow of cash into and out of a company over time. (We will discuss cash budgets in Chapter 8.) Sometimes, however, creditors, lenders, investors, or business buyers may require this information. To prepare the statement of cash flows, owners must assemble the balance sheets and the income statements summarizing the present year s operations. They begin with the company s net income for the accounting period (from the income statement). Then they add the sources of funds borrowed funds, owner contributions, decreases in accounts payable, decreases in inventory, depreciation, and any others. Depreciation is listed as a source of funds because it is a noncash expense that is deducted as a cost of doing business. Because the owners have already paid for the item being depreciated, its depreciation is a source of funds. Next the owners subtract the uses of these funds plant and equipment purchases, dividends to owners, repayment of debt, increases in accounts receivable, decreases in accounts payable, increases in inventory, and so on. The difference between the total sources and the total uses of funds is the increase or decrease in working capital. By investigating the changes in their companies working capital and the reasons for them, owners can create a more practical financial plan of action for the future. These statements are more than just complex documents used only by accountants and financial officers. When used in conjunction with the analytical tools described in the following sections, they can help entrepreneurs map their companies financial future and actively plan for profit. Merely preparing these statements is not enough, however; entrepreneurs and their employees must understand and use the information contained in them to make the business more effective and efficient. Open Book Management In 1982, Jack Stack led a management buyout of a failing division of International Harvester that refurbished engines. In one of the most highly leveraged buyouts in corporate history, the managers invested $100,000 of their own money and borrowed $9 million to purchase the business, leaving the company, Springfield Remanufacturing Company (SRC), with an incredible debt to equity ratio of 90 to 1! Facing a huge debt load and a short time horizon to turn SRC around, Stack and his team of managers knew that one key to success was to ignite a passion for the company among its employees. Stack s idea was to give everyone in the factory from cam rod grinders to purchasing agents access to SRC s financial statements and teach them how to read, analyze, and understand the company s critical numbers. Managers met with teams of employees in weekly meetings to discuss the numbers, answer questions, and solicit ideas about how to improve them in a process he called open book management, a revolutionary concept at the time. The idea behind open book management, says Stack, is to get employees to start approaching their jobs as if they owned the place, which, in fact, they might. Some companies that practice open book management, including SRC, share ownership of the business with their employees through employee stock ownership plans (ESOPs). Our goal was to teach our employees to think and act like owners, says Stack. We started by trying to improve their financial literacy by turning topics like accounting into a game. We played this game with real money, however, and the game s pieces were each and every employee s quality of life. We called it The Great Game of Business. Using The Great Game of Business, managers transformed employees into owners of every line of the company s balance sheet, income statement, and cash flows statement, which enabled workers at every level of operation to understand how they could move the numbers in the right direction. Rather than having some engineer with a stopwatch trying to get people to work faster for less money, open book management gives everyone the chance to see what they need to do to succeed, says Stack. In its first full year of operation, SRC lost $60,500 on sales of $16 million. Within 10 years, the company was earning a profit of $1.3 million on sales of $66 million. Today, SRC is the leading success story of open book management, having evolved into a collection of 37 employee-owned businesses that employ more than 1,200 workers and make everything from race car engines to home furnishings. Stack s daughter, who owns a small
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