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\deflang1033\pard\plain\f4\fs18 Financial Management: How To Make a Go Of Your Business
\par
\par by Linda Howarth Mackay
\par
\par Produced in cooperation with the American Association of Community and
\par Junior Colleges
\par
\par Charles Liner, SEA Contracting Officer's Technical Representative
\par Judy Nye, Project Director, AACJC
\par Martha McKemie, Senior Writer-Editor, SEA
\par Amelia Harris, Graphics, SEA
\par
\par Contents
\par
\par About the Author
\par
\par Introduction
\par
\par I. The Necessity of Financial Planning
\par
\par What is Financial Management?
\par Tools of Financial Planning
\par
\par II. Understanding Financial Statements: A Health
\par Checkup for Your Business
\par
\par The Balance Sheet
\par The Statement of Income
\par
\par III. Financial Ratio Analysis
\par
\par Balance Sheet Ratio Analysis
\par Income Statement Ratio Analysis
\par Management Ratios
\par Sources of Comparative Information
\par
\par IV. Forecasting Profits
\par
\par Facts Affecting Pro Forma Statements
\par The Pro Forma Income Statement
\par Comparison with Actual Monthly Performance
\par Break-Even Analysis
\par
\par V. Cash Flow Management: Budgeting and
\par Controlling Costs
\par
\par The Cash Flow Statement
\par
\par VI. Pricing Policy
\par
\par Establishing Selling Prices
\par A Pricing Example
\par The Retailers Mark-Up
\par Pricing Policies and Profitability Goals
\par
\par VII. Forecasting and Obtaining Capital
\par
\par Types and Sources of Capital
\par Borrowing Working Capital
\par Borrowing Growth Capital
\par Borrowing Permanent Equity Capital
\par Applying for Capital
\par
\par VIII. Financial Management Planning
\par
\par Long-Term Planning
\par
\par For Further Information
\par
\par About the Author
\par
\par Linda Howarth Mackay has many years' banking experience gained working in a
\par rural community bank and two large regional banks. Her expertise is in
\par commercial and agricultural lending and in correspondent banking. She is
\par also knowledgeable in the regulation of commercial bank lending practices,
\par with an extensive background in the establishment of policy and procedures
\par and in portfolio administration.
\par
\par A graduate of Indiana University, Bloomington, Indiana, and numerous
\par banking, accounting, and lending seminars, she is now president of Howarth
\par Mackay, Incorporated, a company providing financial consultation to
\par businesses, financial institutions, and professional individuals.
\par
\par Introduction
\par
\par This booklet was designed to equip instructors of the National Small
\par Business Training Network course "Financial Management: How to Make a Go of
\par Your Business" with the information required to acquaint the small business
\par owner/manager with the basic tools of sound financial management. It
\par supplements the course guide materials; it is not intended to replace their
\par use by the instructor.
\par
\par The booklet may also be used by anyone interested in learning the concepts
\par of financial management.
\par
\par I. The Necessity of Financial Planning
\par
\par There is one simple reason to understand and observe financial planning in
\par your business--to avoid failure. Eight of ten new businesses fail primarily
\par because of the lack of good financial planning.
\par
\par Financial planning affects how and on what terms you will be able to
\par attract the funding required to establish, maintain, and expand your
\par business. Financial planning determines the raw materials you can afford to
\par buy, the products you will be able to produce, and whether or not you will
\par be able to market them efficiently. It affects the human and physical
\par resources you will be able to acquire to operate your business. It will be
\par a major determinant of whether or not you will be able to make your hard
\par work profitable.
\par
\par This manual provides an overview of the essential components of financial
\par planning and management. Used wisely, it will make the reader--the small
\par business owner/manager--familiar enough with the fundamentals to have a
\par fighting chance of success in today's highly competitive business
\par environment.
\par
\par A clearly conceived, well documented financial plan, establishing goals and
\par including the use of Pro Forma Statements and Budgets to ensure financial
\par control, will demonstrate not only that you know what you want to do, but
\par that you know how to accomplish it. This demonstration is essential to
\par attract the capital required by your business from creditors and investors.
\par
\par What Is Financial Management?
\par
\par Very simply stated, financial management is the use of financial statements
\par that reflect the financial condition of a business to identify its relative
\par strengths and weaknesses. It enables you to plan, using projections, future
\par financial performance for capital, asset, and personnel requirements to
\par maximize the return on shareholders' investment.
\par
\par Tools of Financial Planning
\par
\par This manual introduces the tools required to prepare a financial plan for
\par your business's development, including the following:
\par
\par * Basic Financial Statements--the Balance Sheet and Statement of Income
\par
\par * Ratio Analysis--a means by which individual business performance is
\par compared to similar businesses in the same category
\par
\par * The Pro Forma Statement of Income--a method used to forecast future
\par profitability
\par
\par * Break-Even Analysis--a method allowing the small business person to
\par calculate the sales level at which a business recovers all its costs or
\par expenses
\par
\par * The Cash Flow Statement--also known as the Budget identifies the flow of
\par cash into and out of the business
\par
\par * Pricing formulas and policies--used to calculate profitable selling
\par prices for products and services
\par
\par * Types and sources of capital available to finance business operations
\par
\par * Short- and long-term planning considerations necessary to maximize profits
\par
\par The business owner/manager who understands these concepts and uses them
\par effectively to control the evolution of the business is practicing sound
\par financial management thereby increasing the likelihood of success.
\par
\par II. Understanding Financial Statements: A Health Checkup for Your Business
\par
\par Financial Statements record the performance of your business and allow you
\par to diagnose its strengths and weaknesses by providing a written summary of
\par financial activities. There are two' primary financial statements: the
\par Balance Sheet and the Statement of Income.
\par
\par The Balance Sheet
\par
\par The Balance Sheet provides a picture of the financial health of a business
\par at a given moment, usually at the close of an accounting period. It lists
\par in detail those material and intangible items the business owns (known as
\par its assets) and what money the business owes, either to its creditors
\par (liabilities) or to its owners (shareholders' equity or net worth of the
\par business).
\par
\par Assets include not only cash, merchandise inventory, land, buildings,
\par equipment, machinery, furniture, patents, trademarks, and the like, but
\par also money due from individuals or other businesses (known as accounts or
\par notes receivable).
\par
\par Liabilities are funds acquired for a business through loans or the sale of
\par property or services to the business on credit. Creditors do not acquire
\par business ownership, but promissory notes to be paid at a designated future
\par date.
\par
\par Shareholders' equity (or net worth or capital) is money put into a business
\par by its owners for use by the business in acquiring assets.
\par
\par At any given time, a business's assets equal the total contributions by the
\par creditors and owners, as illustrated by the following formula for the
\par Balance Sheet:
\par
\par Assets = Liabilities + Net Worth
\par
\par (Total (Funds (Funds
\par funds supplied supplied
\par invested in to the to the
\par assets of business business
\par the by its by its
\par business) creditors) owners)
\par
\par This formula is a basic premise of accounting. If a business owes more
\par money to creditors than it possesses in value of assets owned, the net
\par worth or owner's equity of the business will be a negative number.
\par
\par The Balance Sheet is designed to show how the assets, liabilities, and net
\par worth of a business are distributed at any given time. It is usually
\par prepared at regular intervals; e.g., at each month's end but especially at
\par the end of each fiscal (accounting) year.
\par
\par By regularly preparing this summary of what the business owns and owes (the
\par Balance Sheet), the business owner/manager can identify and analyze trends
\par in the financial strength of the business. It permits timely modifications,
\par such as gradually decreasing the amount of money the business owes to
\par creditors and increasing the amount the business owes its owners.
\par
\par All Balance Sheets contain the same categories of assets, liabilities, and
\par net worth. Assets are arranged in decreasing order of how quickly they can
\par be turned into cash (liquidity). Liabilities are listed in order of how
\par soon they must be repaid, followed by retained earnings (net worth or
\par owner's equity), as illustrated in Figure 2-1, below, the sample Balance
\par Sheet for ABC Company.
\par
\par The categories and format of the Balance Sheet are established by a system
\par known as Generally Accepted Accounting Principles (GAAP). The system is
\par applied to all companies, large or small, so anyone reading the Balance
\par Sheet can readily understand the story it tells.
\par
\par Figure 2-1
\par ABC Company
\par December 31, 19-
\par Balance Sheet
\par
\par Cash $ 1,896 Notes Payable, $ 2,000
\par Bank
\par
\par Accounts 1,456 Accounts 2,240
\par Receivable Payable
\par
\par Inventory 6,822 Accruals 940
\par
\par Total Current $10,174 Total Current $ 5,180
\par Assets Liabilities
\par
\par Equipment and 1,168 Total Liabilities 5,180
\par Fixtures
\par
\par Prepaid Expenses 1,278 Net Worth 7,440
\par
\par Total Assets $12,620 Total Liabilities $12,620
\par and New Worth
\par
\par Balance Sheet Categories
\par
\par Assets: An asset is anything the business owns that has monetary value.
\par
\par * Current Assets include cash, government securities, marketable
\par securities, accounts receivable, notes receivable (other than from officers
\par or employees), inventories, prepaid expenses, and any other item that could
\par be converted into cash within one year in the normal course of business.
\par
\par * Fixed Assets are those acquired for long-term use in a business such as
\par land, plant, equipment, machinery, leasehold improvements, furniture,
\par fixtures, and any other items with an expected useful business life
\par measured in years (as opposed to items that will wear out or be used up in
\par less than one year and are usually expensed when they are purchased). These
\par assets are typically not for resale and are recorded in the Balance Sheet
\par at their net cost less accumulated depreciation.
\par
\par * Other Assets include intangible assets, such as patents, royalty
\par arrangements, copyrights, exclusive use contracts, and notes receivable
\par from officers and employees.
\par
\par Liabilities: Liabilities are the claims of creditors against the assets of
\par the business (debts owed by the business).
\par
\par * Current Liabilities are accounts payable, notes payable to banks, accrued
\par expenses (wages, salaries), taxes payable, the current portion (due within
\par one year) of long-term debt, and other obligations to creditors due within
\par one year.
\par
\par * Long-Term Liabilities are mortgages, intermediate and long-term bank
\par loans, equipment loans, and any other obligation for money due to a
\par creditor with a maturity longer than one year.
\par
\par * Net Worth is the assets of the business minus its liabilities. Net worth
\par equals the owner's equity. This equity is the investment by the owner plus
\par any profits or minus any losses that have accumulated in the business.
\par
\par The Statement of Income
\par
\par The second primary report included in a business's Financial Statement is
\par the Statement of Income. The Statement of Income is a measurement of a
\par company's sales and expenses over a specific period of time. It is also
\par prepared at regular intervals (again, each month and fiscal year end) to
\par show the results of operating during those accounting periods. It too
\par follows Generally Accepted Accounting Principles (GAAP) and contains
\par specific revenue and expense categories regardless of the nature of the
\par business.
\par
\par Statement of Income Categories
\par
\par The Statement of Income categories are calculated as described below:
\par
\par * Net Sales (gross sales less returns and allowances)
\par
\par * Less Cost of Goods Sold (cost of inventories)
\par
\par * Equals Gross Margin (gross profit on sales before operating expenses)
\par
\par * Less Selling and Administrative Expenses (salaries, wages, payroll taxes
\par and benefits, rent, utilities, maintenance expenses, office supplies,
\par postage, automobile/vehicle expenses, insurance, legal and accounting
\par expenses, depreciation)
\par
\par * Equals Operating Profit (profit before other non-operating income or
\par expense)
\par
\par * Plus Other Income (income from discounts, investments, customer charge
\par accounts)
\par
\par * Less Other Expenses (interest expense)
\par
\par * Equals Net Profit (Loss) Before Tax (the figure on which your tax is
\par calculated)
\par
\par * Less Income Taxes (if any are due)
\par
\par * Equals Net Profit (Loss) After Tax
\par
\par For an example of a Statement of Income, see Figure 2-2, the statement of
\par ABC Company.
\par
\par Figure 2-2
\par ABC Company
\par December 31, 19-
\par Income Statement
\par
\par Net Sales $68,116
\par Cost of Goods Sold 47,696
\par
\par Gross Profit on Sales $20,420
\par Expenses
\par Wages $6,948
\par Delivery Expenses 954
\par Bad Debts Allowances 409
\par Communications 204
\par Depreciation Allowance 409
\par Insurance 613
\par Taxes 1,021
\par Advertising 1,566
\par Interest 409
\par Other Charges 749
\par
\par Total Expenses $13,282
\par Net Profit 7,138
\par Other Income 886
\par
\par Total Net Income $ 8,024
\par
\par Calculating the Cost of Goods Sold
\par
\par Calculation of the Cost of Goods Sold category in the Statement of Income
\par (or Profit-and-Loss Statement as it is sometimes called) varies depending
\par on whether the business is retail, wholesale, or manufacturing. In
\par retailing and wholesaling, computing the cost of goods sold during the
\par accounting period involves beginning and ending inventories. This, of
\par course, includes purchases made during the accounting period. In
\par manufacturing it involves not only finished-goods inventories, but also raw
\par materials inventories goods-in-process inventories, direct labor, and
\par direct factory overhead costs.
\par
\par Regardless of the calculation for Cost of Goods Sold, deduct the Cost of
\par Goods Sold from Net Sales to get Gross Margin or Gross Profit. From Gross
\par Profit, deduct general or indirect overhead such as selling expenses,
\par office expenses, and interest expenses, to calculate your Net Profit. This
\par is the final profit after all costs and expenses for the accounting period
\par have been deducted.
\par
\par III. Financial Ratio Analysis
\par
\par The Balance Sheet and the Statement of Income are essential, but they are
\par only the starting point for successful financial management. Apply Ratio
\par Analysis to Financial Statements to analyze the success, failure, and
\par progress of your business.
\par
\par Ratio Analysis enables the business owner/manager to spot trends in a
\par business and to compare its performance and condition with the average
\par performance of similar businesses in the same industry. To do this compare
\par your ratios with the average of businesses similar to yours and compare
\par your own ratios for several successive years, watching especially for any
\par unfavorable trends that may be starting. Ratio analysis may provide the
\par all-important early warning indications that allow you to solve your
\par business problems before your business is destroyed by them.
\par
\par Balance Sheet Ratio Analysis
\par
\par Important Balance Sheet Ratios measure liquidity and solvency (a business's
\par ability to pay its bills as they come due) and leverage (the extent to
\par which the business is dependent on creditors' funding). They include the
\par following ratios:
\par
\par Liquidity Ratios.
\par
\par These ratios indicate the ease of turning assets into cash. They include
\par the Current Ratio, Quick Ratio, and Working Capital.
\par
\par Current Ratios. The Current Ratio is one of the best known measures of
\par financial strength. It is figured as shown below:
\par
\par Total Current Assets
\par Current Ratio = -------------------------
\par Total Current Liabilities
\par
\par The main question this ratio addresses is: "Does your business have enough
\par current assets to meet the payment schedule of its current debts with a
\par margin of safety for possible losses in current assets, such as inventory
\par shrinkage or collectable accounts?" A generally acceptable current ratio is
\par 2 to 1. But whether or not a specific ratio is satisfactory depends on the
\par nature of the business and the characteristics of its current assets and
\par liabilities. The minimum acceptable current ratio is obviously 1:1, but
\par that relationship is usually playing it too close for comfort.
\par
\par If you decide your business's current ratio is too low, you may be able to
\par raise it by:
\par
\par * Paying some debts.
\par * Increasing your current assets from loans or other borrowings
\par with a maturity of more than one year.
\par * Converting noncurrent assets into current assets.
\par * Increasing your current assets from new equity contributions.
\par * Putting profits back into the business.
\par
\par Quick Ratios. The Quick Ratio is sometimes called the "acid-test" ratio and
\par is one of the best measures of liquidity. It is figured as shown below:
\par
\par Quick Ratio = Cash + Government Securities
\par + Receivables
\par ---------------------------
\par Total Current Liabilities
\par
\par The Quick Ratio is a much more exacting measure than the Current Ratio. By
\par excluding inventories, it concentrates on the really liquid assets, with
\par value that is fairly certain. It helps answer the question: "If all sales
\par revenues should disappear, could my business meet its current obligations
\par with the readily convertible `quick' funds on hand?"
\par
\par An acid-test of 1:1 is considered satisfactory unless the majority of your
\par "quick assets" are in accounts receivable, and the pattern of accounts
\par receivable collection lags behind the schedule for paying current
\par liabilities.
\par
\par Working Capital. Working Capital is more a measure of cash flow than a
\par ratio. The result of this calculation must be a positive number. It is
\par calculated as shown below:
\par
\par Working Capital = Total Current Assets -
\par Total Current Liabilities
\par
\par Bankers look at Net Working Capital over time to determine a company's
\par ability to weather financial crises. Loans are often tied to minimum
\par working capital requirements.
\par
\par A general observation about these three Liquidity Ratios is that the higher
\par they are the better, especially if you are relying to any significant
\par extent on creditor money to finance assets.
\par
\par Leverage Ratio
\par
\par This Debt/Worth or Leverage Ratio indicates the extent to which the
\par business is reliant on debt financing (creditor money versus owner's
\par equity):
\par
\par Debt/Worth Ratio = Total Liabilities
\par -----------------
\par Net Worth
\par
\par Generally, the higher this ratio, the more risky a creditor will perceive
\par its exposure in your business, making it correspondingly harder to obtain
\par credit.
\par
\par Income Statement Ratio Analysis
\par
\par The following important State of Income Ratios measure profitability:
\par
\par Gross Margin Ratio
\par
\par This ratio is the percentage of sales dollars left after subtracting the
\par cost of goods sold from net sales. It measures the percentage of sales
\par dollars remaining (after obtaining or manufacturing the goods sold)
\par available to pay the overhead expenses of the company.
\par
\par Comparison of your business ratios to those of similar businesses will
\par reveal the relative strengths or weaknesses in your business. The Gross
\par Margin Ratio is calculated as follows:
\par
\par Gross Margin Ratio = Gross Profit
\par ------------
\par Net Sales
\par (Gross Profit = Net Sales - Cost of Goods Sold)
\par
\par Net Profit Margin Ratio
\par
\par This ratio is the percentage of sales dollars left after subtracting the
\par Cost of Goods sold and all expenses, except income taxes. It provides a
\par good opportunity to compare your company's "return on sales" with the
\par performance of other companies in your industry. It is calculated before
\par income tax because tax rates and tax liabilities vary from company to
\par company for a wide variety of reasons, making comparisons after taxes much
\par more difficult. The Net Profit Margin Ratio is calculated as follows:
\par
\par Net Profit Margin Ratio = Net Profit Before Tax
\par ---------------------
\par Net Sales
\par
\par Management Ratios
\par
\par Other important ratios, often referred to as Management Ratios, are also
\par derived from Balance Sheet and Statement of Income information.
\par
\par Inventory Turnover Ratio
\par
\par This ratio reveals how well inventory is being managed. It is important
\par because the more times inventory can be turned in a given operating cycle,
\par the greater the profit. The Inventory Turnover Ratio is calculated as
\par follows:
\par
\par Inventory Turnover Ratio = Net Sales
\par --------------------------
\par Average Inventory at Cost
\par
\par Accounts Receivable Turnover Ratio
\par
\par This ratio indicates how well accounts receivable are being collected. If
\par receivables are not collected reasonably in accordance with their terms,
\par management should rethink its collection policy. If receivables are
\par excessively slow in being converted to cash, liquidity could be severely
\par impaired. The Accounts Receivable Turnover Ratio is calculated as follows:
\par
\par
\par Net Credit Sales/Year = Daily Credit Sales
\par ---------------------
\par 365 Days/Year
\par
\par Accounts Receivable Turnover (in days) = Accounts Receivable
\par -------------------
\par Daily Credit Sales
\par
\par Return on Assets Ratio
\par
\par This measures how efficiently profits are being generated from the assets
\par employed in the business when compared with the ratios of firms in a
\par similar business. A low ratio in comparison with industry averages
\par indicates an inefficient use of business assets. The Return on Assets Ratio
\par is calculated as follows:
\par
\par Return on Assets = Net Profit Before Tax
\par ---------------------
\par Total Assets
\par
\par
\par Return on Investment (ROI) Ratio.
\par
\par The ROI is perhaps the most important ratio of all. It is the percentage of
\par return on funds invested in the business by its owners. In short, this
\par ratio tells the owner whether or not all the effort put into the business
\par has been worthwhile. If the ROI is less than the rate of return on an
\par alternative, risk-free investment such as a bank savings account or
\par certificate of deposit, the owner may be wiser to sell the company, put the
\par money in such a savings instrument, and avoid the daily struggles of small
\par business management. The ROI is calculated as follows:
\par
\par
\par Return on Investment = Net Profit before Tax
\par ---------------------
\par Net Worth
\par
\par These Liquidity, Leverage, Profitability, and Management Ratios allow the
\par business owner to identify trends in a business and to compare its progress
\par with the performance of others through data published by various sources.
\par The owner may thus determine the business's relative strengths and
\par weaknesses.
\par
\par Sources of Comparative Information
\par
\par Sources of comparative financial information which you may obtain from your
\par public library or the publishers include the following:
\par
\par Almanac of Business and Industrial Financial Ratios, Leo Troy,
\par Prentice-Hall, Inc., Englewood Cliffs, NJ 07632
\par
\par Annual Statement Studies, Robert Morris Associates, P. O. Box 8500, S-1140,
\par Philadelphia, PA 19178
\par
\par Expenses in Retail Business, National Cash Register Corporation, Corporate
\par Advertising and Sales Promotion Dayton, OH 45479.
\par
\par Key Business Ratios, Dun & Bradstreet, Inc., 99 Church Street, New York, NY
\par 10007, ATTN: Public Relations and Advertising Department
\par
\par IV. Forecasting Profits
\par
\par Forecasting, particularly on a short-term basis (one year to three years),
\par is essential to planning for business success. This process, estimating
\par future business performance based on the actual results from prior periods,
\par enables the business owner/manager to modify the operation of the business
\par on a timely basis. This allows the business to avoid losses or major
\par financial problems should some future results from operations not conform
\par with reasonable expectations. Forecasts--or Pro Forma Income Statements and
\par Cash Flow Statements as they are usually called--also provide the most
\par persuasive management tools to apply for loans or attract investor money.
\par As a business expands, there will inevitably be a need for more money than
\par can be internally generated from profits.
\par
\par Facts Affecting Pro Forma Statements
\par
\par Preparation of Forecasts (Pro Forma Statements) requires assembling a wide
\par array of pertinent, verifiable facts affecting your business and its past
\par performance. These include:
\par
\par * Data from prior financial statements, particularly:
\par a. Previous sales levels and trends
\par b. Past gross percentages
\par c. Average past general, administrative, and selling expenses necessary
\par to generate your former sales volumes
\par d. Trends in the company's need to borrow (supplier, trade credit, and
\par bank credit) to support various levels of inventory and trends in
\par accounts receivable required to achieve previous sales volumes
\par
\par * Unique company data, particularly:
\par a. Plant capacity
\par b. Competition
\par c. Financial constraints
\par d. Personnel availability
\par
\par * Industry-wide factors, including:
\par a. Overall state of the economy
\par b. Economic status of your industry within the economy
\par c. Population growth
\par d. Elasticity of demand for the product or service your business
\par provides
\par e. Availability of raw materials
\par
\par Once these factors are identified, they may be used in Pro Formas, which
\par estimate the level of sales, expense, and profitability that seem possible
\par in a future period of operations.
\par
\par The Pro Forma Income Statement
\par
\par In preparing the Pro Forma Income Statement, the estimate of total sales
\par during a selected period is the most critical "guesstimate." Employ
\par business experience from past financial statements. Get help from
\par management and salespeople in developing this all-important number.
\par
\par Then assume, for example, that a 10 percent increase in sales volume is a
\par realistic and attainable goal. Multiply last year's net sales by 1.10 to
\par get this year's estimate of total net sales. Next, break down this total,
\par month by month, by looking at the historical monthly sales volume. From
\par this you can determine what percentage of total annual sales fell on the
\par average in each of those months over a minimum of the past three years. You
\par may find that 75 percent of total annual sales volume was realized during
\par the six months from July through December in each of those years and that
\par the remaining 25 percent of sales was spread fairly evenly over the first
\par six months of the year.
\par
\par Next, estimate the cost of goods sold by analyzing operating data to
\par determine on a monthly basis what percentage of sales has gone into cost of
\par goods sold in the past. This percentage can then be adjusted for expected
\par variations in costs, price trends, and efficiency of operations.
\par
\par Operating expenses (sales, general and administrative expenses,
\par depreciation, and interest), other expenses, other income, and taxes can
\par then be estimated through detailed analysis and adjustment of what they
\par were in the past and what you expect them to be in the future.
\par
\par Comparison with Actual Monthly Performance
\par
\par Putting together this information month by month for a year into the future
\par will result in your business's Pro Forma Statement of Income. Use it to
\par compare with the actual monthly results from operations by using the SBA
\par form 1099 (4-82) Operating Plan Forecast (Profit and Loss Projection).
\par Obtain this form from your local SBA office. You will find it helpful to
\par refer to the SBA Guidelines for Profit and Loss Projection. Preparation of
\par the information is summarized below and on the back of the form 1099.
\par
\par Revenue (Sales)
\par
\par * List the departments within the business. For example, if your business
\par is appliance sales and service, the departments would include new
\par appliances, used appliances, parts, in-shop service, on-site service.
\par
\par * In the "Estimate" columns, enter a reasonable projection of monthly sales
\par for each department of the business. Include cash and on-account sales. In
\par the "Actual" columns, enter the actual sales for the month as they become
\par available.
\par
\par * Exclude from the Revenue section any revenue not strictly related to the
\par business.
\par
\par Cost of Sales
\par
\par * Cite costs by department of the business, as above.
\par
\par * In the "Estimate" columns, enter the cost of sales estimated for each
\par month for each department. For product inventory, calculate the cost of the
\par goods sold for each department (beginning inventory plus purchases and
\par transportation costs during the month minus the inventory). Enter "Actual"
\par costs each month as they accrue.
\par
\par Gross Profit
\par
\par * Subtract the total cost of sales from the total revenue.
\par
\par Expenses
\par
\par * Salary Expenses: Base pay plus overtime.
\par
\par * Payroll Expenses: Include paid vacations, sick leave, health insurance,
\par unemployment insurance, Social Security taxes.
\par
\par * Outside Services: Include costs of subcontracts, overflow work
\par farmed-out, special or one-time services.
\par
\par * Supplies: Services and items purchased for use in the business, not for
\par resale.
\par
\par * Repairs and Maintenance: Regular maintenance and repair, including
\par periodic large expenditures, such as painting or decorating.
\par
\par * Advertising: Include desired sales volume, classified directory listing
\par expense, etc.
\par
\par * Car, Delivery and Travel: Include charges if personal car is used in the
\par business. Include parking, tolls, mileage on buying trips, repairs, etc.
\par
\par * Accounting and Legal: Outside professional services.
\par
\par * Rent: List only real estate used in the business.
\par
\par * Telephone.
\par
\par * Utilities: Water, heat, light, etc.
\par
\par * Insurance: Fire or liability on property or products, worker's
\par compensation.
\par
\par * Taxes: Inventory, sales, excise, real estate, others.
\par
\par * Interest.
\par
\par * Depreciation: Amortization of capital assets.
\par
\par * Other Expenses (specify each): Tools, leased equipment, etc.
\par
\par * Miscellaneous (unspecified): Small expenditures without separate accounts.
\par
\par Net Profit
\par
\par * To find net profit, subtract total expenses from gross profit.
\par
\par The Pro Forma Statement of Income, prepared on a monthly basis and
\par culminating in an annual projection for the next business fiscal year,
\par should be revised not less than quarterly. It must reflect the actual
\par performance achieved in the immediately preceding three months to ensure
\par its continuing usefulness as one of the two most valuable planning tools
\par available to management.
\par
\par Should the Pro Forma reveal that the business will likely not generate a
\par profit from operations, plans must immediately be developed to identify
\par what to do to at least break even--increase volume, decrease expenses, or
\par put more owner capital in to pay some debts and reduce interest expenses.
\par
\par
\par Break-Even Analysis
\par
\par "Break-Even" means a level of operations at which a business neither makes
\par a profit nor sustains a loss. At this point, revenue is just enough to
\par cover expenses. Break-Even Analysis enables you to study the relationship
\par of volume, costs, and revenue.
\par
\par Break-Even requires the business owner/manager to define a sales
\par level--either in terms of revenue dollars to be earned or in units to be
\par sold within a given accounting period--at which the business would earn a
\par before tax net profit of zero. This may be done by employing one of various
\par formula calculations to the business estimated sales volume, estimated
\par fixed costs, and estimated variable costs.
\par
\par Generally, the volume and cost estimates assume the following conditions:
\par
\par * A change in sales volume will not affect the selling price per unit;
\par
\par * Fixed expenses (rent, salaries, administrative and office expenses,
\par interest, and depreciation) will remain the same at all volume levels; and
\par
\par * Variable expenses (cost of goods sold, variable labor costs including
\par overtime wages and sales commissions) will increase or decrease in direct
\par proportion to any increase or decrease in sales volume.
\par
\par Two methods are generally employed in Break-Even Analysis, depending on
\par whether the break-even point is calculated in terms of sales dollar volume
\par or in number of units that must be sold.
\par
\par Break-Even Point in Sales Dollars
\par
\par The steps for calculating the first method are shown below:
\par
\par 1. Obtain a list of expenses incurred by the company during its past fiscal
\par year.
\par
\par 2. Separate the expenses listed in Step 1 into either a variable or a fixed
\par expense classification. (See Figure 4-1, below, under "Classification of
\par Expenses.")
\par
\par 3. Express the variable expenses as a percentage of sales. In the condensed
\par income statement (Figure 4-1) of the Small Business Specialties Co.
\par (below), net sales were $1,200,000. In Step 2, variable expenses were found
\par to amount to $720,000. Therefore, variable expenses are 60 percent of net
\par sales ($720,000 divided by $1,200,000). This means that 60 cents of every
\par sales dollar is required to cover variable expenses. Only the remainder, 40
\par cents of every dollar, is available for fixed expenses and profit.
\par
\par 4. Substitute the information gathered in the preceding steps in the
\par following basic break-even formula to calculate the breakeven point.
\par
\par Figure 4-1
\par
\par THE SMALL-BUSINESS SPECIALTIES CO.
\par Condensed Income Statement
\par For year ending Dec. 31, 19-
\par
\par Net sales (60,000 units @ $20 per unit)..........................$1,200,000
\par Less cost of goods sold:
\par Direct material.............................$195,000
\par Direct labor................................ 215,000
\par Manufacturing expenses (Schedule A)......... 300,000
\par
\par Total....................................................... 710,000
\par
\par Gross profit..................................................... 490,000
\par Less operating expenses:
\par Selling expenses (Schedule B)...............$200,000
\par General and administrative expenses
\par (Schedule C).............................. 210,000
\par
\par Total....................................................... 410,000
\par
\par Net Income.......................................................$ 80,000
\par
\par
\par Supporting Schedules of Expenses Other Than Direct Material and Labor
\par
\par Schedule C
\par Schedule A Schedule B general and
\par manufacturing selling administrative
\par Total expenses expenses expenses
\par
\par Rent.................$ 60,000 $ 30,000 $ 8,000 $ 22,000
\par Insurance............ 11,000 9,000 1,000 1,000
\par Commissions.......... 120,000 ....... 120,000 .......
\par Property tax......... 12,000 10,000 1,000 1,000
\par Telephone............ 7,000 1,000 5,000 1,000
\par Depreciation......... 80,000 70,000 5,000 5,000
\par Power................ 100,000 100,000 ....... .......
\par Light................ 60,000 30,000 10,000 20,000
\par Officers' salaries... 260,000 50,000 50,000 160,000
\par
\par Total...........$710,000 $300,000 $200,000 $210,000
\par
\par
\par Classification of Expenses
\par
\par Total Variable Fixed
\par
\par Direct material...................$ 195,000 195,000 .......
\par Direct labor...................... 215,000 215,000 .......
\par Manufacturing expenses............ 300,000 100,000 $200,000
\par Selling expenses.................. 200,000 50,000
\par General and admin. expenses....... 210,000 60,000 150,000
\par
\par Total........................$1,120,000 $720,000 $400,000
\par
\par
\par
\par Where: S = F + V (Sales at the break-even point)
\par F = Fixed expenses
\par V = Variable expenses expressed as a percentage of sales.
\par
\par This formula means that when sales revenues equal the fixed expenses and
\par variable expenses incurred in producing the sales revenues, there will be
\par no profit or loss. At this point, revenue from sales is just sufficient to
\par cover the fixed and the variable expenses. In this formula "S" is the break
\par even point.
\par
\par For the Small Business Specialties Co., the break-even point (using the
\par basic formula and data from Figure 4-2) may be calculated as follows:
\par
\par S = F + V
\par S = $400,000 + 0.605
\par 10S = $4,000,000 + 6S
\par 10S - 6S = $4,000,000
\par 4S = $4,000,000
\par S = $1,000,000
\par
\par Proof that this calculation is correct follows:
\par
\par Sales at break-even point per calculation $1,000,000
\par Less variable expenses (60 percent of sales) 600,000
\par
\par Marginal income 400,000
\par Less fixed expenses 400,000
\par
\par Equals neither profit nor loss $ 0
\par
\par Modification: Break-Even Point to Obtain Desired Net Income.
\par
\par The first break-even formula can be modified to show the dollar sales
\par required to obtain a certain amount of desired net income. To do this, let
\par "S" mean the sales required to obtain a certain amount of net income, say
\par $80,000. The formula then reads:
\par
\par S = F + V + Desired Net Income
\par S = $400,000 + 0.60S + $80,000
\par 10S = $4,000,000 + 6S + 800,000
\par 4S = $4,800,000
\par S = $1,200,000
\par
\par Break-Even Point in Units to be Sold
\par
\par You may want to calculate the break-even point in terms of units to be sold
\par instead of sales dollars. If so, a second formula (in which "S" means units
\par to be sold to break even) may be used:
\par
\par Break-even Sales = Fixed expenses
\par (S = Units) -----------------------------------------
\par Unit sales price - Unit variable expenses
\par
\par S = $400,000 = $400,000
\par -----------------------
\par $20 - $12 $8
\par
\par S = 50,000 units
\par
\par The Small Business Specialties Co. must sell 50,000 units at $20 per unit
\par to break even under the assumptions contained in this illustration. The
\par sale of 50,000 units at $20 each equals $1 million, the break-even sales
\par volume in dollars calculated in the basic formula. This formula indicates
\par there is $8 per unit of sales that can be used to cover the $400,000 fixed
\par expense. Then $400,000 divided by $8 gives the number of units required to
\par break even.
\par
\par Modification: Break-Even Point in Units to be Sold to Obtain Desired Net
\par Income.
\par
\par The second formula can be modified to show the number of units required to
\par obtain a certain amount of net income. In this case, let S mean the number
\par of units required to obtain a certain amount of net income, again say
\par $80,000. The formula then reads as follows:
\par
\par S = Fixed expenses + Net income
\par ----------------------------------------
\par Unit sales price - Unit variable expense
\par
\par S = $400,000 + $80,000 = $480,000
\par ------------------ --------
\par $20 - $12 $8
\par
\par S = 60,000 units
\par
\par Break-even Analysis may also be represented graphically by charting the
\par sales dollars or sales units required to break even as in Figure 4-2, below.
\par
\par Remember: Increased sales do not necessarily mean increased profits. If you
\par know your company's break-even point, you will know how to price your
\par product to make a profit. If you cannot make an acceptable profit, alter or
\par sell your business before you lose your retained earnings.
\par
\par
\par
\par V. Cash Flow Management: Budgeting and Controlling Costs
\par
\par If there is anything more important to the successful financial management
\par of a business than the thorough, thoughtful preparation of Pro Forma Income
\par Statements, it is the preparation of the Cash Flow Statement, sometimes
\par called the Cash Flow Budget.
\par
\par The Cash Flow Statement
\par
\par The Cash Flow Statement identifies when cash is expected to be received and
\par when it must be spent to pay bills and debts. It shows how much cash will
\par be needed to pay expenses and when it will be needed. It also allows the
\par manager to identify where the necessary cash will come from. For example,
\par will it be internally generated from sales and the collection of accounts
\par receivable--or must it be borrowed? (The Cash Flow Projection deals only
\par with actual cash transactions; depreciation and amortization of good will
\par or other non-cash expense items are not considered in this Pro Forma.)
\par
\par The Cash Flow Statement, based on management estimates of sales and
\par obligations, identifies when money will be flowing into and out of the
\par business. It enables management to plan for shortfalls in cash resources so
\par short term working capital loans may be arranged in advance. It allows
\par management to schedule purchases and payments in a way that enables the
\par business to borrow as little as possible. Because all sales are not cash
\par sales management must be able to forecast when accounts receivable will
\par become "cash in the bank" and when expenses--whether regular or
\par seasonal--must be paid so cash shortfalls will not interrupt normal
\par business operations.
\par
\par The Cash Flow Statement may also be used as a Budget, permitting the
\par manager increased control of the business through continuous comparison of
\par actual receipts and disbursements against forecast amounts. This comparison
\par helps the small business owner identify areas for timely improvement in
\par financial management.
\par
\par By closely watching the timing of cash receipts and disbursements, cash
\par balance on hand, and loan balances, management can readily identify such
\par things as deficiencies in collecting receivables, unrealistic trade credit
\par or loan repayment schedules. Surplus cash that may be invested on a
\par short-term basis or used to reduce debt and interest expenses temporarily
\par can be recognized. In short, it is the most valuable tool management has at
\par its disposal to refine the day-to-day operation of a business. It is an
\par important financial tool bank lenders evaluate when a business needs a
\par loan, for it demonstrates not only how large a loan is required but also
\par when and how it can be repaid.
\par
\par A Cash Flow Statement or Budget can be prepared for any period of time.
\par However, a one-year budget matching the fiscal year of your business is
\par recommended. As in the preparation and use of the Pro Forma Statement of
\par Income, the projected Cash Flow Statement should be prepared on a monthly
\par basis for the next year. It should be revised not less than quarterly to
\par reflect actual performance in the preceding three months of operations to
\par check its projections.
\par
\par In preparing the Cash Flow Statement or Budget start with the sales budget.
\par Other budgets are related directly or indirectly to this budget. The
\par following is a sales forecast in units:
\par
\par Sales Budget--Units For the Year Ended December 31, 19__
\par
\par Territory Total 1st 2nd 3rd 4th
\par Quarter Quarter Quarter Quarter
\par East....................26,000 5,000 6,000 7,000 8,000
\par West....................11,000 2,000 2,500 3,000 3,500
\par
\par 37,000 7,000 8,500 10,000 11,500
\par
\par
\par Assume you sell a single product and the sales price for it is $10. Your
\par sales budget in terms of dollars would look like this:
\par
\par Sales Budget--Dollars For the Year Ended December 31, 19__
\par
\par Territory Total 1st 2nd 3rd 4th
\par Quarter Quarter Quarter Quarter
\par East......................$260,000 $50,000 $80,000 $ 70,000 $ 80,000
\par West...................... 110,000 20,000 25,000 30,000 35,000
\par
\par $370,000 $70,000 $85,000 $100,000 $115,000
\par
\par
\par Say the estimated per unit cost of the product is $1.50 for direct
\par material, $2.50 for direct labor, and $1.00 for manufacturing overhead. By
\par applying unit costs to the sales budget in units, you would come out with
\par this budget:
\par
\par Cost of Goods Sold Budget For the Year Ended December 31, 19__
\par
\par Total 1st 2nd 3rd 4th
\par Quarter Quarter Quarter Quarter
\par Direct material......$ 55,500 $10,500 $12,750 $15,000 $17,250
\par Direct labor......... 92,500 17,500 21,250 25,000 28,750
\par Mfg. overhead........ 37,000 7,000 8,500 10,000 11,500
\par
\par $185,000 $35,000 $42,500 $50,000 $57,500
\par
\par
\par Later on, before a cash budget can be compiled, you will need to know the
\par estimated cash requirements for selling expenses. Therefore, you prepare a
\par budget for selling expenses and another for cash expenditures for selling
\par expenses (total selling expenses less depreciation):
\par
\par Selling Expenses Budget For the Year Ended December 31 19__
\par
\par Total 1st 2nd 3rd 4th
\par Quarter Quarter Quarter Quarter
\par Commissions.............$46,500 $ 8,750 $10,625 $12,500 $14,375
\par Rent.................... 9,250 1,750 2,125 2,500 2,875
\par Advertising............. 9,250 1,750 2,125 2,500 2,875
\par Telephone............... 4,625 875 1,062 1,250 1,437
\par Depreciation--office.... 900 225 225 225 225
\par Other................... 22,250 4,150 5,088 6,025 6,983
\par
\par $92,500 $17,500 $21,250 $25,000 $28,750
\par
\par
\par Selling Expenses Budget--Cash Requirements For the Year Ended
\par December 31, 19__
\par
\par Total 1st 2nd 3rd 4th
\par Quarter Quarter Quarter Quarter
\par Total selling expenses..$92,500 $17,500 $21,250 $25,000 $28,750
\par Less: depreciation......
\par expense--office......... 900 225 225 225 225
\par
\par Cash requirements.......$91,600 $17,275 $21,025 $24,775 $28,525
\par
\par
\par Basic information for an estimate of administrative expenses for the coming
\par year is easily compiled. Again, from that budget you can estimate cash
\par requirements for those expenses to be used subsequently in preparing the
\par cash budget.
\par
\par Administrative Expenses Budget For the Year Ended December 31, 19___
\par
\par Total 1st 2nd 3rd 4th
\par Quarter Quarter Quarter Quarter
\par Salaries.................$22,200 $4,200 $5,100 $ 6,000 $ 6,900
\par Insurance................ 1,850 350 425 500 575
\par Telephone................ 1,850 350 425 500 575
\par Supplies................. 3,700 700 850 1,000 1,150
\par Bad debt expenses........ 3,700 700 850 1,000 1,150
\par Other expenses........... 3,700 700 850 1,000 1,150
\par
\par $37,000 $7,000 $8,500 $10,000 $11,500
\par
\par
\par Administrative Expenses Budget--Cash Requirements
\par For the Year Ended December 31, 19___
\par
\par Total 1st 2nd 3rd 4th
\par Quarter Quarter Quarter Quarter
\par Estimated adm. expenses...$37,000 $7,000 $8,500 $10,000 $11,500
\par Less: bad debt expenses... 3,700 700 850 1,000 1,150
\par
\par Cash requirements.........$33.300 $6,500 $7,650 $ 9,000 $10,350
\par
\par
\par Now, from the information budgeted so far, you can proceed to prepare the
\par budget income statement. Assume you plan to borrow $10,000 at the end of
\par the first quarter. Although payable at maturity of the note, the interest
\par appears in the last three quarters of the year. The statement will resemble
\par the following:
\par
\par Budgeted Income Statement For the Year Ended December 31, 19___
\par
\par Total 1st 2nd 3rd 4th
\par Quarter Quarter Quarter Quarter
\par Sales...................$370,000 $70,000 $85,000 $100,000 $115,000
\par Cost of goods sold...... 185,000 35,000 42,500 50,000 57,500
\par
\par Gross Margin............$185,000 $35,000 $42,500 $ 50,000 $ 57,500
\par
\par Operating expenses:
\par Selling................$ 92,500 $17,500 $21,250 $ 25,000 $ 28,750
\par Administrative......... 37,000 7,000 8,500 $ 10,000 $ 11,500
\par
\par Total................$129,500 $24,500 $29,750 $ 35,000 $ 40,250
\par
\par Net income
\par from operations........$ 55,500 $10,500 $12,750 $ 15,000 $ 17,250
\par Interest expense....... 450 150 150 150
\par
\par Net income before
\par Income taxes...........$ 55,050 $10,500 $12,600 $ 14,850 $ 17,100
\par Federal income tax..... 27,525 5,250 6,300 7,425 8,550
\par
\par Net income..............$ 27,525 $ 5,250 $ 6,300 $ 7,425 $ 8,550
\par
\par
\par Estimating that 90 percent of your account sales is collected in the
\par quarter in which they are made, that 9 percent is collected in the quarter
\par following the quarter in which the sales were made, and that 1 percent of
\par account sales is uncollectible, your accounts receivable budget of
\par collections would look like this:
\par
\par Budget of Collections of Accounts Receivable For the Year Ended December
\par 31, 19___
\par
\par Total 1st 2nd 3rd 4th
\par (net) Quarter Quarter Quarter Quarter
\par 4th Quarter Sales 19-0...$ 6,000 $ 6,000
\par 1st Quarter Sales 19-1... 69,300 63,000 $ 6,300
\par 2nd Quarter Sales 19-1... 84,150 76,500 $ 7,650
\par 3rd Quarter Sales 19-1... 99,000 90,000 $ 9,000
\par 4th Quarter Sales 19-1... 103,500 103,500
\par
\par $361,950 $69,000 $82,800 $97,650 $112,500
\par
\par Going back to the sales budget in units, now prepare a production budget in
\par units. Assume you have 2,000 units in the opening inventory and want to
\par have on hand at the end of each quarter the following quantities: 1st
\par quarter, 3,000 units; 2nd quarter, 3,500 units; 3rd quarter, 4,000 units;
\par and 4th quarter, 4,500 units.
\par
\par Production Budget--Units For the Year Ended December 31, 19___
\par
\par 1st 2nd 3rd 4th
\par Quarter Quarter Quarter Quarter
\par Sales requirements........... 7,000 8,500 10,000 11,500
\par Add: ending
\par inventory requirements...... 3,000 3,500 4,000 4,500
\par
\par Total requirements..........10,000 12,500 14,000 16,000
\par Less: beginning
\par inventory................... 2,000 3,000 3,500 4,000
\par Production
\par requirements............... 8,000 9,000 10,500 112,000
\par
\par
\par Next, based on the production budget, prepare a budget to show the
\par purchases needed during each of the four quarters. Expressed in terms of
\par dollars, you do this by taking the production and inventory fires and
\par multiplying them by the cost of material (previously estimated at $1.50 per
\par unit). You could prepare a similar budget expressed in units.
\par
\par Budget of Direct Materials Purchases For the Year Ended December 31, 19___
\par
\par 1st 2nd 3rd 4th
\par Quarter Quarter Quarter Quarter
\par Required for production........$12,000 $13,500 $15,750 $18,000
\par Required for ending inventory.. 4,500 52,250 6,000 6,750
\par
\par Total........................$16,500 $18,750 $21,750 $24,750
\par Less: beginning inventory...... 3,000 4,500 5,250 6,000
\par
\par Required purchases.............$13,500 $14,250 $16,500 $18,750
\par
\par
\par Now suppose you pay 50 percent of your accounts in the quarter of the
\par purchase and 50 percent in the following quarter. Carryover payables from
\par last year were $5,000. Further, you always take the purchase discounts as a
\par matter of good business policy. Since net purchases (less discount) were
\par figured into the $1.50 cost estimate, purchase discounts do not appear in
\par the budgets. Thus your payment on purchases budget will come out like this:
\par
\par Payment on Purchases Budget For the Year Ended December 31, 19___
\par
\par Total 1st 2nd 3rd 4th
\par Quarter Quarter Quarter Quarter
\par 4th Quarter Sales 19-0...$ 5,000 $ 5,000
\par 1st Quarter Sales 19-1... 13,500 6,750 $ 6,750
\par 2nd Quarter Sales 19-1... 14,250 7,125 $ 7.125
\par 3rd Quarter Sales 19-1... 16,500 8,250 $ 8,250
\par 4th Quarter Sales 19-1... 9,375 9,375
\par
\par Payments by Quarters $58,625 $11,750 $13,875 $15,375 $17,625
\par
\par
\par Taking the data for quantities produced from the production budget in
\par units, calculate the direct labor requirements on the basis of units to be
\par produced. (The number and cost of labor hours necessary to produce a given
\par quantity can be set forth in supplemental schedules.)
\par
\par Direct Labor Budget--Cash Requirements For the Year Ended December 31, 19__
\par
\par Total 1st 2nd 3rd 4th
\par Quarter Quarter Quarter Quarter
\par Quantity................ 39,500 8,000 9,000 10,500 12,000
\par Direct labor cost.......$98,750 $20,000 $22,500 $26,250 $30,000
\par
\par Now outline the items that comprise your factory overhead, and prepare a
\par budget like the following:
\par
\par Manufacturing Overhead Budget For the Year Ended December 31, 19___
\par
\par Total 1st 2nd 3rd 4th
\par Quarter Quarter Quarter Quarter
\par Heat and power..........$10,000 $1,000 $2,500 $ 3,000 $ 3,500
\par Factory supplies........ 5,300 1,000 1,500 1,800 1,000
\par Property taxes.......... 2,000 500 500 500 500
\par Depreciation............ 2,800 700 700 700 700
\par Rent.................... 8,000 2,000 2,000 2,000 2,000
\par Superintendent.......... 9,400 2,800 1,800 2,500 4,300
\par
\par $39,500 $8,000 $9,000 $10.500 $12,000
\par
\par
\par Figure the cash payments for manufacturing overhead by subtracting
\par depreciation, which requires no cash outlay, from the totals above, and you
\par will have the following breakdown:
\par
\par Manufacturing Overhead Budget--Cash Requirements
\par For the Year Ended December 31, 19___
\par
\par Total 1st 2nd 3rd 4th
\par Quarter Quarter Quarter Quarter
\par Productions--units...... 39,500 8,000 9,000 10,500 12,000
\par
\par Mfg.overhead expenses...$39,500 $8,000 $9,000 $10,500 $12,000
\par Less: depreciation...... 2,800 700 700 700 700
\par
\par Cash requirements.......$36,700 $7,300 $8,300 $ 9,800 $11,300
\par
\par
\par Now comes the all important cash budget. You put it together by using the
\par Collection of Accounts Receivable Budget; Selling Expenses Budget--Cash
\par Requirements; Administrative Expenses Budget--Cash Requirements; Payment of
\par Purchases Budget; Direct Labor Budget--Cash Requirements; and Manufacturing
\par Budget--Cash Requirements.
\par
\par Take $15,000 as the beginning balance, and assume that dividends of $20,000
\par are to be paid in the fourth quarter.
\par
\par Cash Budget For the Year Ended December 31, 19___
\par
\par Total 1st 2nd 3rd 4th
\par Quarter Quarter Quarter Quarter
\par Beginning cash balance $ 15,000 $15,000 $ 3,850 $ 13,300 $ 25,750
\par Cash collections 361,950 69,000 82,800 97,650 112,500
\par
\par Total $376,950 $84,000 $86,650 $110,950 $138,250
\par
\par Cash payments
\par Purchases $ 58,625 $11,750 $13,875 $ 15,375 $ 17,625
\par Direct labor 98,750 20,000 22,500 26,250 30,000
\par Mfg. overhead 38,700 7,300 8,300 9,800 11,300
\par Selling expense 91,600 17,275 21,025 24,775 28,525
\par Adm. expenses 33,300 6,300 7,650 9,000 10,350
\par Federal income tax 27,525 27,525
\par Dividends 20,000 20,000
\par Interest expenses 450 450
\par Loan repayment 10,000 10,000
\par
\par Total $376,950 $90,150 $73,350 $ 85,200 $128,250
\par
\par Cash deficiency ($ 6,150)
\par Bad loan received 10,000 10,000
\par
\par Ending cash balance $ 10,000 $ 3,850 $13,300 $ 25,750 $ 10,000
\par
\par
\par Now you are ready to prepare a budget balance sheet. Take the account
\par balances of last year and combine them with the transactions reflected in
\par the various budgets you have compiled. You will come out with a sheet
\par resembling this:
\par
\par Budgeted Balance Sheet December 31, 19___
\par Assets
\par 19___ 19___
\par Current assets:
\par Cash $ 10,000 $ 15,000
\par Accounts receivable 11,500 6,666
\par Less: allowance for doubtful accounts (1,150) (666)
\par Inventory:
\par Raw materials 6,750 3,000
\par Finished goods 22,500 10,000
\par
\par Total current assets $ 49,600 34,000
\par
\par Fixed assets:
\par Land $ 50,000 $ 50,000
\par Building 148,000 148,000
\par Less: allowance for depreciation (37,000) (33,000)
\par
\par Total fixed assets $161,100 $164,700
\par
\par Total assets $210,600 $198,700
\par
\par Liabilities and Shareholders' Equity
\par
\par Current liabilities:
\par Account payable $ 9,375 $ 5,000
\par
\par Shareholders' equity:
\par Capital stock (10,000 shares; $10 par value) $100,000 $110,000
\par Retained earnings 101,225 93,700
\par
\par $201,225 $193,700
\par
\par Total liabilities and shareholders' equity $210,600 $198,700
\par
\par
\par In order to make the most effective use of your budgets to plan profits,
\par you will want to establish reporting devices. Throughout the time span you
\par have set, you need periodic reports and reviews on both efforts and
\par accomplishments. These let you know whether your budget plan is being
\par attained and help you keep control throughout the process. It is through
\par comparing actual performance with budgeted projections that you maintain
\par control of the operations.
\par
\par Your company should be structured along functional lines, with well
\par identified areas of responsibility and authority. Then, depending upon the
\par size of your company, the budget reports can be prepared to correspond with
\par the organizational structure of the company.
\par
\par Two typical budget reports are shown below to demonstrate various forms
\par these reports may take.
\par
\par Report of Actual and Budgeted Sales For the Year Ended December 31, 19___
\par
\par Variations from
\par budget (under)
\par Actual sales Budgeted sales Quarterly Cumulative
\par 1st Quarter $ $ $ $
\par 2nd Quarter
\par 3rd Quarter
\par 4th Quarter
\par
\par Budgeted Report on Selling Expenses For the Year Ended December 31, 19___
\par
\par Budget \'b3 Actual \'b3 Variation\'b3 Budget \'b3 Actual \'b3Variations\'b3 Remarks
\par This \'b3 This \'b3 This \'b3 Year to \'b3 Year to \'b3 Year to \'b3
\par Month \'b3 Month \'b3 Month \'b3 Date \'b3 Date \'b3 Date \'b3
\par
\par \'b3 \'b3 \'b3 \'b3 \'b3 \'b3
\par \'b3 \'b3 \'b3 \'b3 \'b3 \'b3
\par \'b3 \'b3 \'b3 \'b3 \'b3 \'b3
\par \'b3 \'b3 \'b3 \'b3 \'b3 \'b3
\par \'b3 \'b3 \'b3 \'b3 \'b3 \'b3
\par \'b3 \'b3 \'b3 \'b3 \'b3 \'b3
\par
\par Remember, the Cash Flow Statement used as the business's Budget allows the
\par owner/manager to anticipate problems rather than react to them after they
\par occur. It permits comparison of actual receipts and disbursements against
\par projections to identify errors in the forecast. If cash flow is analyzed
\par monthly, the manager can correct the cause of the error before it harms
\par profitability.
\par
\par VI. Pricing Policy
\par
\par Identifying the actual cost of doing business requires careful and accurate
\par analysis. No one is expected to calculate the cost of doing business with
\par complete accuracy. However, failure to calculate all actual costs properly
\par to ensure an adequate profit margin is a frequent and often overlooked
\par cause of business failure.
\par
\par Establishing Selling Prices
\par
\par The costs of raw materials, labor, indirect overhead, and research and
\par development must be carefully studied before setting the selling price of
\par items offered by your business. These factors must be regularly
\par re-evaluated, as costs fluctuate.
\par
\par Regardless of the strategies employed to maximize profitability, the method
\par of costing products offered for resale is basic. It involves four major
\par categories:
\par
\par * Direct Material Costs
\par * Direct Labor Costs
\par * Overhead Expenses
\par * Profit Desired
\par
\par Combining these factors allows you to calculate an item's minimum sales
\par price, which is described below:
\par
\par 1. Calculate your Direct Material Costs. Direct material costs are the
\par total cost of all raw materials used to produce the item for sale. Divide
\par this total cost by the number of items produced from these raw materials to
\par derive the Total Direct Materials Cost Per Item.
\par
\par 2. Calculate your Direct Labor Costs. Direct labor costs are the wages paid
\par to employees to produce the item. Divide this total direct labor cost by
\par the total number of items produced to get the Total Direct Labor Cost Per
\par Item.
\par
\par 3. Calculate your Total Overhead Expenses. Overhead expenses include rent,
\par gas and electricity, telephone, packing and shipping, delivery and freight
\par charges, cleaning expenses, insurance, office supplies, postage, repairs
\par and maintenance, and the manager's salary. In other words, all operating
\par expenses incurred during the same time period that you used for calculating
\par the costs above (one year, one quarter, or one month). Divide the Total
\par Overhead Expense by the number of items produced for sale during that same
\par time period to get the Total Overhead Expense Per Item.
\par
\par 4. Calculate Total Cost Per Item. Add the Total Direct Material Cost Per
\par Item, the Total Direct Labor Cost Per Item, and the Total Overhead Expense
\par Per Item to derive the Total Cost Per Item.
\par
\par 5. Calculate the Profit Per Item. Now, calculate the profit you determine
\par appropriate for each category of item offered for sale based on the sales
\par and profit strategy you have set for your business.
\par
\par 6. Calculate the Total Price Per Item. Add the Profit Figure Per Item to
\par the Total Cost Per Item.
\par
\par A Pricing Example
\par
\par You produce skirts that take 1 1/2 yards of fabric per skirt, and you can
\par manufacture three skirts per day. The fabric costs $2.00 per yard. The
\par normal work week is five days. If you complete three skirts per day, your
\par week's production is 15 skirts.
\par
\par 1. Calculate Direct Materials Cost
\par
\par Materials Cost
\par
\par Fabric for 1 week's production:
\par 15 skirts x 1 1/2 yds. each = 22 1/2 yds. x $2 per yd. $45.00
\par
\par Linings, interfacings, etc.:
\par $.50 per skirt x 15 skirts 7.50
\par
\par Zippers, buttons, snaps:
\par $.50 per skirt x 15 skirts 7.50
\par
\par Belts, ornaments, etc.:
\par $.75 per skirt x 15 skirts 11.25
\par
\par Notions, seam binding, etc.:
\par 1 week's supply 5.00
\par \'c4\'c4\'c4\'c4\'c4\'c4
\par Total Direct Materials Cost: $76.25 per week
\par
\par Total Direct Materials Cost per week = $5.08 Direct Materials
\par ------------------------------------ Cost per skirt
\par 15 skirts per week
\par
\par 2. Calculate Direct Labor Costs
\par
\par Wages paid to employees = $100.00 per week
\par
\par Total Direct Labor Cost per week = $6.67 Direct Labor Cost
\par -------------------------------- per skirt
\par 15 skirts
\par
\par 3. Calculate Overhead Expenses Per Month
\par
\par Overhead Expenses Monthly
\par Expenses
\par Owner's Salary $400.00
\par Rent 100.00
\par Electricity 24.00
\par Telephone 12.00
\par Insurance 15.00
\par Cleaning 20.00
\par Packing Materials and Supplies 15.00
\par Delivery and Freight 20.00
\par Office Supplies, Postage 10.00
\par Repairs and Maintenance 15.00
\par Payroll Taxes 5.00
\par
\par Total Monthly Overhead Expenses: $636.00
\par
\par 15 skirts per week x 4 weeks in one month = 60 skirts per month.
\par
\par Total Monthly Overhead Expenses = $10.60 Overhead Cost
\par ------------------------------- per skirt
\par 60 skirts per month
\par
\par 4. Calculate the Total Cost per Skirt by adding the total individual costs
\par per skirt calculated in the three preceding steps.
\par
\par Total Direct Material Cost per Skirt $ 5.08
\par Total Direct Labor Cost per Skirt 6.67
\par Total Overhead Expense per Skirt 10.60
\par
\par TOTAL COST PER SKIRT $22.35
\par
\par 5. Assume you want to make a profit of $5.00 per skirt.
\par
\par 6. Calculate the Total Price Per Item:
\par
\par Total Cost per Skirt $22.35
\par Total Profit per Skirt 5.00
\par
\par Total Selling Price Per Skirt $27.35
\par
\par The Retailer's Mark-Up
\par
\par A word of caution is in order regarding the popular but misunderstood
\par pricing method known as retailers mark-up. Retail mark-up means the amount
\par added to the price of an item to arrive at the retail sales price, either
\par in dollars or as a percentage of the cost.
\par
\par For example, if a single item costing $8.00 is sold for $12.00 it carries a
\par mark-up of $4.00 or 50 percent. If a group of items costing $6,000 is
\par offered for $10,000, the mark-up is $4,000 or 66 2/3 percent. While in
\par these illustrations the mark-up percentage appears generally to equal the
\par gross margin percentages, the mark-up is not the same as the gross margin.
\par Adding mark-up to the price merely to simplify pricing will almost always
\par adversely affect profitability.
\par
\par To demonstrate, assume a manager determines from past records that the
\par business's operating expenses average 29 percent of sales. She decides that
\par she is entitled to a profit of 3 percent. So she prices her goods at a 32
\par percent gross margin, in order to earn a 3 percent profit after all
\par operating expenses are paid. What she fails to realize, however, is that
\par once the goods are displayed, some may be lost through pilferage. Others
\par may have to be marked down later in order to sell them, or employees may
\par purchase some of them at a discount. Therefore, the total reductions
\par (mark-downs, shortages, discounts) in the sales price realized from selling
\par all the inventory actually add up to an annual average of six percent of
\par total sales. To correctly calculate the necessary mark-up required to yield
\par a 32 percent gross margin, these reductions to inventory must be
\par anticipated and added into its selling price. Using the formula:
\par
\par Initial Mark-up = Desired Gross Margin + Retail Reductions
\par ----------------------------------------
\par 100 Percent + Retail Reductions
\par
\par 32 percent + 6 percent = 38 percent = 35.85 percent
\par ----------------------- -----------
\par 100 percent + 6 percent 106 percent
\par
\par To obtain the desired gross margin of 32 percent, therefore, the retailer
\par must initially mark up his inventory by nearly 36 percent.
\par
\par Pricing Policies and Profitability Goals
\par
\par Break-Even Analysis, discussed in Chapter IV, and Return on Investment,
\par described in Chapter III, should be reviewed at this time. Remember, all
\par costs (direct and indirect), the break-even point, desired profit, and the
\par methods of calculating sales price from these factors must be thoroughly
\par studied when you establish pricing policies and profitability goals. They
\par should be understood before you offer items for sale because an omission or
\par error in these calculations could make the difference between success and
\par failure.
\par
\par Selling Strategy
\par
\par Proper product pricing is only one facet of overall planning for
\par profitability. A second major factor to be determined once costs,
\par break-even point, and profitability goals have been analyzed, is the
\par selling strategy. Three sales planning approaches are used (often
\par concurrently) by businesses to develop final pricing policies, as they
\par strive to compete successfully.
\par
\par In the first, employed as a short-term strategy in the earliest stages of a
\par business, the owner/manager sells products at such low prices that the
\par business only breaks even (no profit), while trying to attract future
\par steady customers. As volume grows, the owner/manager gradually builds in
\par the profit margin necessary to achieve the targeted Return on Investment.
\par
\par "Loss leaders" are a second strategy practiced in both developing and
\par mature business. While a few items are sold at a loss, most goods are
\par priced for healthy profits. The hope is that while customers are in the
\par store to purchase the low-price items, they will also buy enough other
\par goods to make the seller's overall profitability higher than if he had not
\par used "come-ons." The seller wants to maximize total profit and can
\par sacrifice profit on a few items to achieve that goal.
\par
\par The third strategy recognizes that maximum profit does not result only from
\par selling goods at relatively high profit margins. The relationship of
\par volume, price, cost of merchandise, and operational expenses determines
\par profitability. Price increases may result in fewer sales and decreased
\par profits. Reductions in prices, if sales volume is substantially increased,
\par may produce satisfactory profits.
\par
\par There is no arbitrary rule about this. It is perfectly possible for two
\par stores, with different pricing structures to exist side by side and both be
\par successful. It is the owner/manager's responsibility to identify and
\par understand the market factors that affect his or her unique business
\par circumstances. The level of service (delivery, availability of credit,
\par store hours, product advice, and the like) may permit a business to charge
\par higher prices in order to cover the costs of such services. Location, too,
\par often permits a business to charge more, since customers are often willing
\par to pay a premium for convenience.
\par
\par The point is that many considerations go into setting selling prices. Some
\par small businesses do not seek to compete on price at all, finding an un- or
\par under-occupied market niche, which can be a more certain path to success.
\par What is important is that all factors that affect pricing must be
\par recognized and analyzed for their costs as well as their benefits.
\par
\par VII. Forecasting and Obtaining Capital
\par
\par Forecasting the need for capital, whether debt or equity, has already been
\par discussed in Chapter V. This chapter looks at the types and uses of
\par external capital and the usual sources of such capital.
\par
\par Types and Sources of Capital
\par
\par The capital to finance a business has two major forms: debt and equity.
\par Creditor money (debt) comes from trade credit, loans made by financial
\par institutions, leasing companies, and customers who have made prepayments on
\par larger--frequently manufactured--orders. Equity is money received by the
\par company in exchange for some portion of ownership. Sources include the
\par entrepreneur's own money; money from family, friends, or other
\par non-professional investors; or money from venture capitalists, Small
\par Business Investment Companies (SBICs), and Minority Enterprise Small
\par Business Investment Companies (MESBICs) both funded by the SBA.
\par
\par Debt capital, depending upon its sources (e.g., trade, bank, leasing
\par company, mortgage company) comes into the business for short or
\par intermediate periods. Owner or equity capital remains in the company for
\par the life of the business (unless replaced by other equity) and is repaid
\par only when and if there is a surplus at liquidation of the business--after
\par all creditors are repaid.
\par
\par Acquiring such funds depends entirely on the business's ability to repay
\par with interest (debt) or appreciation (equity). Financial performance
\par (reflected in the Financial Statements discussed in Chapter II) and
\par realistic, thorough management planning and control (shown by Pro Formas
\par and Cash Flow Budgets), are the determining factors in whether or not a
\par business can attract the debt and equity funding it needs to operate and
\par expand.
\par
\par Business capital can be further classified as equity capital, working
\par capital, and growth capital. Equity capital is the cornerstone of the
\par financial structure of any company. As you will recall from Chapter II,
\par equity is technically the part of the Balance Sheet reflecting the
\par ownership of the company. It represents the total value of the business,
\par all other financing being debt that must be repaid. Usually, you cannot get
\par equity capital--at least not during the early stages of business growth.
\par
\par Working capital is required to meet the continuing operational needs of the
\par business, such as "carrying" accounts receivable purchasing inventory, and
\par meeting the payroll. In most businesses, these needs vary during the year,
\par depending on activities (inventory build-up, seasonal hiring or layoffs,
\par etc.) during the business cycle.
\par
\par Growth capital is not directly related to cyclical aspects of the business.
\par Growth capital is required when the business is expanding or being altered
\par in some significant and costly way that is expected to result in higher and
\par increased cash flow. Lenders of growth capital frequently depend on
\par anticipated increased profit for repayment over an extended period of time,
\par rather than expecting to be repaid from seasonal increases in liquidity as
\par is the case of working capital lenders.
\par
\par Every growing business needs all three types: equity, working, and growth
\par capital. You should not expect a single financing program maintained for a
\par short period of time to eliminate future needs for additional capital.
\par
\par As lenders and investors analyze the requirements of your business, they
\par will distinguish between the three types of capital in the following way:
\par 1) fluctuating needs (working capital); 2) needs to be repaid with profits
\par over a period of a few years (growth capital); and 3) permanent needs
\par (equity capital).
\par
\par If you are asking for a working capital loan, you will be expected to show
\par how the loan can be repaid through cash (liquidity) during the business's
\par next full operating cycle, generally a one year cycle. If you seek growth
\par capital, you will be expected to show how the capital will be used to
\par increase your business enough to be able to repay the loan within several
\par years (usually not more than seven). If you seek equity capital, it must be
\par raised from investors who will take the risk for dividend returns or
\par capital gains, or a specific share of the business.
\par
\par Borrowing Working Capital
\par
\par Chapter II defined working capital as the difference between current
\par assets and current liabilities. To the extent that a business does not
\par generate enough money to pay trade debt as it comes due, this cash must be
\par borrowed.
\par
\par Commercial banks obviously are the largest source of such loans, which have
\par the following characteristics: 1) The loans are short-term but renewable;
\par 2) they may fluctuate according to seasonal needs or follow a fixed
\par schedule of repayment (amortization); 3) they require periodic full
\par repayment ("clean up"); 4) they are granted primarily only when the ratio
\par of net current assets comfortably exceeds net current liabilities; and 5)
\par they are sometimes unsecured but more often secured by current assets
\par (e.g., accounts receivable and inventory). Advances can usually be obtained
\par for as much as 70 to 80 percent of quality (likely to be paid) receivables
\par and to 40 to 50 percent of inventory. Banks grant unsecured credit only
\par when they feel the general liquidity and overall financial strength of a
\par business provide assurance for repayment of the loan.
\par
\par You may be able to predict a specific interval, say three to five months,
\par for which you need financing. A bank may then agree to issue credit for a
\par specific term. Most likely, you will need working capital to finance
\par outflow peaks in your business cycle. Working capital then supplements
\par equity. Most working capital credits are established on a one-year basis.
\par
\par Although most unsecured loans fall into the one-year line of credit
\par category, another frequently used type, the amortizing loan, calls for a
\par fixed program of reduction, usually on a monthly or quarterly basis. For
\par such loans your bank is likely to agree to terms longer than a year, as
\par long as you continue to meet the principal reduction schedule.
\par
\par It is important to note that while a loan from a bank for working capital
\par can be negotiated only for a relatively short term, satisfactory
\par performance can allow the arrangement to be continued indefinitely.
\par
\par Most banks will expect you to pay off your loans once a year (particularly
\par if they are unsecured) in perhaps 30 or 60 days. This is known as "the
\par annual clean up," and it should occur when the business has the greatest
\par liquidity. This debt reduction normally follows a seasonal sales peak when
\par inventories have been reduced and most receivables have been collected.
\par
\par You may discover that it becomes progressively more difficult to repay debt
\par or "clean up" within the specified time. This difficulty usually occurs
\par because: 1) Your business is growing and its current activity represents a
\par considerable increase over the corresponding period of the previous year;
\par 2) you have increased your short-term capital requirement because of new
\par promotional programs or additional operations; or 3) you are experiencing a
\par temporary reduction in profitability and cash flow.
\par
\par Frequently, such a condition justifies obtaining both working capital and
\par amortizing loans. For example, you might try to arrange a combination of a
\par $15,000 open line of credit to handle peak financial requirements during
\par the business cycle and $20,000 in amortizing loans to be repaid at, say
\par $4,000 per quarter. In appraising such a request, a commercial bank will
\par insist on justification based on past experience and future projections.
\par The bank will want to know: How the $15,000 line of credit will be
\par self-liquidating during the year (with ample room for the annual clean up);
\par and how your business will produce increased profits and resulting cash
\par flow to meet the schedule of amortization on the $20,000 portion in spite
\par of increasing your business's interest expense.
\par
\par Borrowing Growth Capital
\par
\par Lenders expect working capital loans to be repaid through cash generated in
\par the short-term operations of the business, such as, selling goods or
\par services and collecting receivables. Liquidity rather than overall
\par profitability supports such borrowing programs. Growth capital loans are
\par usually scheduled to be repaid over longer periods with profits from
\par business activities extending several years into the future. Growth capital
\par loans are, therefore secured by collateral such as machinery and equipment,
\par fixed assets which guarantee that lenders will recover their money should
\par the business be unable to make repayment.
\par
\par For a growth capital loan you will need to demonstrate that the growth
\par capital will be used to increase your cash flow through increased sales,
\par cost savings, and/or more efficient production. Although your building,
\par equipment, or machinery will probably be your collateral for growth capital
\par funds, you will also be able to use them for general business purposes, so
\par long as the activity you use them for promises success. Even if you borrow
\par only to acquire a single piece of new equipment, the lender is likely to
\par insist that all your machinery and equipment be pledged.
\par
\par Instead of bank financing a particular piece of new equipment, it may be
\par possible to arrange a lease. You will not actually own the equipment, but
\par you will have exclusive use of it over a specified period. Such an
\par arrangement usually has tax advantages. It lets you use funds that would be
\par tied up in the equipment, if you had purchased it. It also affords the
\par opportunity to make sure the equipment meets your needs before you purchase
\par it.
\par
\par Major equipment may also be purchased on a time payment plan, sometimes
\par called a Conditional Sales Pur