Section 3:
Launching the Business
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Essentials of Entrepreneurship and Small
Business Management
Ninth Edition
Chapter 12
Creating a Successful
Financial Plan

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Learning Objectives (1 of 2)
1. Describe how to prepare the basic financial statements
and use them to manage a small business.
2. Create projected (pro forma) financial statements.

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Learning Objectives (2 of 2)
3. Understand the basic financial statements through ratio
analysis.
4. Explain how to interpret financial ratios.
5. Conduct a break-even analysis for a small company.

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Financial Management
• 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
businesses are doing financially but also why they are
performing that way.

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The Importance of a Financial Plan
• Common mistake among business owners: Failing to
collect and analyze basic financial data.
• Many entrepreneurs run their companies without any kind
of financial plan.
• About 75% of business owners do not understand or fail to
focus on the financial details of their companies.
• Financial planning is essential to running a successful
business and is not that difficult!

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Basic Financial Statements (1 of 3)
• Balance Sheet:
– “Snapshot”
– Estimates the firm’s worth on a given date; built on the
accounting equation:
Assets = Liabilities + Owner’s Equity

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Basic Financial Statements (2 of 2)
• Income Statement:
– “Moving picture”
– Compares the firm’s expenses against its revenue over
a period of time to show its net income (or loss):
Net Income = Sales Revenue – Expenses

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Customer Profitability Map
Figure 12.3 Customer Profitability Map

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Basic Financial Statements (3 of 3)
• Statement of Cash Flows:
– Shows the change in the firm's working capital over a
period of time by listing the sources and uses of
funds.

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Creating Projected Financial Statements
• Helps the entrepreneur transform business goals into
reality
• Challenging for a business start-up
– They should be realistic and well-researched!
• Start-ups should create two-year projections
• Projected financial statements:
– Income statement
– Balance sheet

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Ratio Analysis
• Ratio analysis:
– A method of expressing the relationships between any
two elements on financial statements.
– Important barometers of a company’s health.
• Studies indicate few small business owners compute
financial ratios and use them to manage their businesses.

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Twelve Key Ratios (1 of 4)
• Liquidity Ratios:
– Tell whether or not a small business will be able to
meet its maturing obligations as they come due.
 Current Ratio
 Quick ratio

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Current Ratio
Current Ratio:
• Measures solvency by showing the firm's ability to pay
current liabilities out of current assets.
Current Assets $686,985
Current Ratio = = = 1.87:1
Current Liabilities $367,850

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Quick Ratio
Quick Ratio:
• Shows the extent to which a firm’s most liquid assets cover
its current liabilities.
Quick Assets 686,985 455,455
Quick Ratio = = =.63:1
Current Liabilities $367,850


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Twelve Key Ratios (2 of 4)
• 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!
 Debt ratio
 Debt to net worth ratio
 Times-interest-earned ratio

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Debt Ratio
Debt Ratio:
• Measures the percentage of total assets financed by
creditors rather than owners.
TotalDebt $367,850 + 212,150
Debt Ratio = = = .68:1
Total Assets $847,655

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Debt to Net Worth Ratio
Debt to Net Worth Ratio:
• Compares what a business “owes” to “what it is worth.”
TotalDebt $580,000
Debt toNet WorthRatio = = = 2.20:1
Tangible Net Worth $264,155

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Times-Interest-Earned Ratio
Times Interest Earned:
• Measures the firm's ability to make the interest payments
on its debt.
EBIT * $60,629 + 39,850
TimesInterest Earned = = =
Total Interest Expense $39,850
$100,479
= = 2.52:1
$39,850
*Earnings Before Interest and Taxes

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Twelve Key Ratios (3 of 4)
• Operating Ratios:
– Evaluate a firm’s overall performance and show how
effectively it is putting its resources to work.
 Average Inventory Turnover Ratio
 Average Collection Period Ratio
 Average Payable Period Ratio
 Net Sales to Total Assets Ratio

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Average Inventory Turnover Ratio
Average Inventory Turnover Ratio:
• Tells the average number of times a firm's inventory is
“turned over” or sold out during the accounting period.
Cost of Goods Sold $1,290,117
Average Inventory Turnover Ratio = = = 2.05 times a year
Average Inventory* $630,600
Beginning Inventory + Ending Inventory
*Average Inventory =
2

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Average Collection Period Ratio
Average Collection Period Ratio:
– Tells the average number of days required to collect
accounts receivable (days sales outstanding, DSO).
• Two Steps:
Credit Sales $1,309,589
Receivables Turnover Ratio = = = 7.31 times a year
Accounts Receivable $179,225
Days in Accounting Period 365
Average Collection Ratio = = = 50.0 Period
Receivables Turnover Ratio 7.31 days

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How Lowering Your Average Collection Period
Can Save You money (1 of 2)
Table 12.1 How Lowering Your Average Collection Period
Can Save You Money
Too often, entrepreneurs fail to recognize the importance of collecting their
accounts receivable on time. After all, collecting accounts is not as glamorous or
as much fun as generating sales. Lowering a company’s average-collection-
period ratio, however, can produce tangible – and often significant – savings. The
following formula shows how to convert an improvement in a company’s average-
collection-period ratio into dollar savings:
 

Annual savings
(Credit sales Annual interest rate Number of days average collection period is lowered)
365
where
Credit sales = company’s annual credit sales in dollars
Annual interest rate = the interest rate at which the company borrows money
Number of days average collection period is lowered = the difference between
the previous year’s average collection period ratio and the current one

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How Lowering Your Average Collection Period
Can Save You money (2 of 2)
[Table 12.1Continued]
Example
Sam’s Appliance Shop’s average-collection-period ratio is 50 days. Suppose that
the previous year’s average-collection-period ratio was 58 days, so this year
there has been an eight-day improvement. The company’s credit sales for the
most recent year were $1,309,589. If Sam borrows money at 8.75%, this eight-
day improvement has generated savings for Sam’s Appliance Shop of:
 
 
$1
,309,589 8.75 8 days
Savings $2,512
365 days
By collecting his accounts receivable just eight days faster, on average, Sam has
saved his business more than $2,500! Of course, if a company’s average-
collection-period ratio rises, the same calculation will tell the owner how much
that change costs.

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Average Payable Period Ratio
Average Payable Period Ratio:
– Tells the average number of days required to pay
accounts payable.
• Two Steps:
Purchases $939,827
Payables Turnover Ratio = = = 6.16 times a year
Accounts Payable $152,580
Days in Accounting Period 365
Average Payable Period Ratio = = = 59.3 days
Payables Turnover Ratio 6.16

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Net Sales to Total Assets Ratio
Net Sales to Total Assets Ratio:
• Measures a firm’s ability to generate sales given its asset
base.
Net Sales $1,870,841
Net Sales to Total Assets = = = 2.21:1
Total Assets $847,655

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Twelve Key Ratios (4 of 4)
• Profitability Ratios:
– Measure how efficiently a firm is operating; offer
information about a firm’s “bottom line.”
 Net Profit on Sales Ratio
 Net Profit to Assets Ratio
 Net Profit to Equity Ratio

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Net Profit on Sales Ratio
Net Profit on Sales Ratio:
• Measures a firm’s profit per dollar of sales revenue.
Net Profit $60,629
Net Profit on Sales = = = 3.24%
Net Sales $1,870,841

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

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Net Profit to Equity Ratio
Net Profit to Equity* Ratio:
• Measures an owner's rate of return on the investment
(ROI) in the business.
Net Income $60,629
Net Profit to Equity = = = 22.65%
Owner's 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; the key is to
watch for “red flags.”
• Critical numbers: measure key financial and operational
aspects of a company’s 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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Financial Benchmarking
• When comparing critical numbers to the industry
standards, ask:
– Is there a significant difference in my company’s ratio
and the industry average?
– If so, what is the difference meaningful?
– Is the difference good or bad?
– What are the possible causes of this difference? What
is the most likely cause?
– Does this cause require that I take action?
– If so, what action should I take to correct the problem?

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Ratio Analysis: Sam’s Appliance Shop (1 of 12)
Sam’s Appliance Shop Industry Median
Current ratio = 1.87:1 Current ratio = 1.60:1
Although Sam’s falls short of the rule of thumb of 2:1, its
current ratio is above the industry median by a significant
amount. Sam’s should have no problem meeting short-term
debts as they come due.

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Ratio Analysis: Sam’s Appliance Shop (2 of 12)
Sam’s Appliance Shop Industry Median
Quick ratio = 0.63:1 Quick ratio = 0.81:1
Again, Sam is below the rule of thumb of 1:1, 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 Sam’s. What
steps should Sam take to deal with this threat?

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Ratio Analysis: Sam’s Appliance Shop (3 of 12)
Sam’s Appliance Shop Industry Median
Debt ratio = 0.68:1 Debt ratio = 0.69:1
Creditors provide 68% of Sam total assets, very close to the
industry median of 69%. Although the company does not
appear to be overburdened with debt, Sam might have
difficulty borrowing, especially from conservative lenders.

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Ratio Analysis: Sam’s Appliance Shop (4 of 12)
Sam’s Appliance Shop Industry Median
Debt to net worth ratio = 2.20:1 Debt to net worth ratio = 2.27:1
Sam owes $2.20 to creditors for every $1.00 the owner has
invested in the business (compared to $2.27 to every $1.00
in equity for the typical business). Many lenders will see Sam
as “borrowed up,” having reached its borrowing capacity.
Creditor’s claims are more than twice those of the owners.

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Ratio Analysis: Sam’s Appliance Shop (5 of 12)
Sam’s Appliance Shop Industry Median
Times interest earned ratio = 2.52:1 Times interest earned ratio = 12.55:1
Sam’s earnings are high enough to cover the interest
payments on its debt by a factor of 2.52:1, slightly better
than the typical firm in the industry. Sam has a cushion
(although a small one) in meeting its interest payments.

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Ratio Analysis: Sam’s Appliance Shop (6 of 12)
Sam’s Appliance Shop Industry Median
Average inventory turnover ratio =
2.05 times per year
Average inventory turnover ratio = 4.1
times per year
Inventory is moving through Sam at a very slow pace. What
could be causing this low inventory turnover in Sam’s
business?

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Ratio Analysis: Sam’s Appliance Shop (7 of 12)
Sam’s Appliance Shop Industry Median
Average collection period ratio = 50.0
days
Average collection period ratio = 14.2
days
Sam collects the average account receivable after 50 days
compared to the industry median of 14 days – nearly four
times longer. What is a more meaningful comparison for this
ratio? What steps can Sam take to improve this ratio?

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Ratio Analysis: Sam’s Appliance Shop (8 of 12)
Sam’s Appliance Shop Industry Median
Average collection period ratio = 59.3
days
Average collection period ratio = 32.4
days
Sam’s payables are significantly slower than those of the
typical firm in the industry. Stretching payables too far could
seriously damage the company’s credit rating. What are the
possible causes of this discrepancy?

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Ratio Analysis: Sam’s Appliance Shop (9 of 12)
Sam’s Appliance Shop Industry Median
Net sales to total assets ratio = 2.21:1 Net sales to total assets ratio = 4.06:1
Sam’s Appliance Shop is not generating enough sales, given
the size of its asset base. What factors could cause this?

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Ratio Analysis: Sam’s Appliance Shop (10 of 12)
Sam’s Appliance Shop Industry Median
Net profit on sales ratio = 3.24% Net profit on sales ratio = 7.11%
After deducting all expenses, Sam has just 3.24 cents of
every sales dollar left as profit – more than 50% below the
industry median. Sam may discover that some of his
operating expenses are out of balance.

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Ratio Analysis: Sam’s Appliance Shop (11 of 12)
Sam’s Appliance Shop Industry Median
Net profit to assets ratio = 7.15% Net profit to assets ratio = 21.41%
Sam generates a return of 7.15% for every $1 in assets,
which is nearly 67% below the industry average and the
company’s cost of capital. This is another sign that Sam’s
business is not as profitable as it should be based on
industry standards.

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Ratio Analysis: Sam’s Appliance Shop (12 of 12)
Sam’s Appliance Shop Industry Median
Net profit to equity ratio = 22.65% Net profit to equity ratio = 70.04%
Sam’s return on his investment in the business is 22.65%,
well below the industry average, another indication that the
company is not as profitable as it should be.

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Trend Analysis of Ratio
Figure 12.5 Trend Analysis of the Current Ratio

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Break-Even Analysis
• Breakeven point:
– The level of operation at which a business neither
earns a profit nor incurs a loss.
• 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.
Step 4: Compute the breakeven point:
Total Fixed Costs
Breakeven Point ($) =
Contribution Margin

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Calculating the Breakeven Point: The Magic
Shop
Step 1: Net Sales estimate: $950,000
Cost of Goods Sold: $646,000
Total expenses: $236,500.
Step 2: Variable Expenses: $705,125
Fixed Expenses: $177,375
Step 3: Contribution Margin =
$705,125
1 .26
$950,000
 
Step 4: Breakeven Point =
$177,375
$682,212
.26


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Breakeven Chart for the Magic Shop
Figure 12.6 Breakeven Chart for the Magic Shop

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Conclusion
• Preparing a financial plan is a critical step
• Entrepreneurs can gain valuable insight through:
– Pro forma statements
– Ratio analysis
– Breakeven analysis

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