Entrepreneurship and Small Business Management Chapter 13 Using Financial Statements to Guide a Business Ch 13 Performance Objectives Understand an income statement Examine a balance sheet to determine a business’s financing strategy Use the balance sheet equation for analysis Perform a financial ratio analysis of an income statement Entrepreneurship and Small Business Management, 1/e © 2012 Pearson Education, Upper Saddle River, NJ 07458 Ch 13 Performance Objectives (continued) Calculate return on investment Perform same-size (common-size) analysis of an income statement Use quick, current, and debt ratios to analyze a balance sheet Entrepreneurship and Small Business Management, 1/e © 2012 Pearson Education, Upper Saddle River, NJ 07458 Financial Statements Entrepreneurs use three basic financial statements: Income statement Balance sheet Cash flow statement Together, these financial reports show the health of a business at a glance Entrepreneurship and Small Business Management, 1/e © 2012 Pearson Education, Upper Saddle River, NJ 07458 Income Statement Shows profit or loss over a particular time period Revenues > Expenses = Positive Balance Expenses > Revenues = Negative Balance Prepared monthly Serves as a scorecard; helps reveal problems Entrepreneurship and Small Business Management, 1/e © 2012 Pearson Education, Upper Saddle River, NJ 07458 Parts of an Income Statement Revenue COGS/COSS Gross profit Other variable costs Contribution margin Fixed operating costs Entrepreneurship and Small Business Management, 1/e Earnings before interest and taxes Pre-tax profit Taxes Net profit/(loss) © 2012 Pearson Education, Upper Saddle River, NJ 07458 Income Statement: Basic Format Entrepreneurship and Small Business Management, 1/e © 2012 Pearson Education, Upper Saddle River, NJ 07458 Income Statement Calculations Entrepreneurship and Small Business Management, 1/e © 2012 Pearson Education, Upper Saddle River, NJ 07458 A Simple Income Statement Entrepreneurship and Small Business Management, 1/e © 2012 Pearson Education, Upper Saddle River, NJ 07458 An Income Statement for a More Complex Business Entrepreneurship and Small Business Management, 1/e 10 © 2012 Pearson Education, Upper Saddle River, NJ 07458 Types/Examples of Assets Current assets—cash, items easily turned into cash, and items used within one year Accounts receivable Inventory Supplies Long-term assets—items that would take the business more than one year to use Equipment Furniture Machinery Real estate Entrepreneurship and Small Business Management, 1/e 14 © 2012 Pearson Education, Upper Saddle River, NJ 07458 Types/Examples of Liabilities Current liabilities—debts scheduled for payment within one year (includes portion of long-term debt due within the year) Long-term liabilities—debts to be paid over a time period longer than one year Examples of liabilities: Accounts payable (bills) Loans from banks, family, or friends Mortgages Lines of credit Entrepreneurship and Small Business Management, 1/e 15 © 2012 Pearson Education, Upper Saddle River, NJ 07458 The Balance Sheet Equation Assets – Liabilities = Owner’s Equity (OE) or Assets = Liabilities + Owner’s Equity or Liabilities = Assets – Owner’s Equity (Net worth and capital are other names for OE.) Entrepreneurship and Small Business Management, 1/e 16 © 2012 Pearson Education, Upper Saddle River, NJ 07458 Total Assets Must Equal (“Balance”) Total Liabilities + Owner’s Equity If an item was financed with debt, the loan is a liability If an item was purchased with the owner’s (or shareholders’) money, it was financed with equity Liabilities and owner’s equity pay for all assets Entrepreneurship and Small Business Management, 1/e 17 © 2012 Pearson Education, Upper Saddle River, NJ 07458 Analyzing Balance Sheet Data Compare balance sheets from two different points in time to see progress Calculate the percentage of change between the reports for each line item An increase in owner’s equity is one way to measure success Entrepreneurship and Small Business Management, 1/e 18 © 2012 Pearson Education, Upper Saddle River, NJ 07458 Income Statement Ratios Express each line item as a percentage of sales to see the relationship between items Amount (M) Calculation % of Sales Sales $10 ($10 ÷ $10) x 100 100% Less total COGS $4 ($4 ÷ $10) X 100 40% Less other var costs $0 Contribution margin $6 ($6 ÷ $10) X 100 60% Less fixed op costs Entrepreneurship and Small Business $3 ($3 ữ $10) x 30% 100 â 2012 Pearson Education, Upper Saddle River, NJ Management, 1/e $ 19 ($3 ÷ $10) x Profit 30% 07458 Return on Investment (ROI) Entrepreneurs “invest” time, energy, and money because they expect a “return” of money or satisfaction Return on investment (ROI) measures return as a percentage of the original investment (Net Profit ÷ Investment) X 100 = ROI% Entrepreneurship and Small Business Management, 1/e 20 © 2012 Pearson Education, Upper Saddle River, NJ 07458 Things Needed to Calculate ROI Net profit—amount the firm has earned beyond what it has spent to cover costs Total investment—start-up investment plus any additional money invested later Period of time for which you are calculating ROI—typically one month or one year Entrepreneurship and Small Business Management, 1/e 21 © 2012 Pearson Education, Upper Saddle River, NJ 07458 Return on Sales (ROS) ROS is also called the “profit margin” because it is an important measure of business profitability Net income ÷ sales = ROS To express this ratio as a percentage, multiply it by 100 Entrepreneurship and Small Business Management, 1/e 22 © 2012 Pearson Education, Upper Saddle River, NJ 07458 Volume and Price Impact ROS ROS Margin Range Very low Low 2-5% 6-10% Typical Product Very high volume OR very high price High volume OR high price Moderate 11-20% Moderate volume AND moderate price High 20-30% Low volume OR low price Very high 30% and up Entrepreneurship and Small Business Management, 1/e Very low volume OR very low price 23 © 2012 Pearson Education, Upper Saddle River, NJ 07458 Common-Sized (“Same-Size”) Analysis Lets you compare income statements, even if sales amounts vary Compare your expenses with those incurred by other businesses in your industry, or for your own company at different points in time Operating ratio—expresses what percentage of sales dollars a particular expense item is using up Entrepreneurship and Small Business Management, 1/e 24 © 2012 Pearson Education, Upper Saddle River, NJ 07458 Quick and Current Ratios Quick Ratio: (Cash + Marketable Securities) ÷ Current Liabilities Marketable securities—investments such as certificates of deposit or Treasury bills If the quick ratio is greater than one, there is enough cash to cover all bills (but not loans) within 24 hours Current Ratio: Current Assets ÷ Current Liabilities If the current ratio is greater than one, the business could sell some assets to pay off its debts Entrepreneurship and Small Business Management, 1/e 25 © 2012 Pearson Education, Upper Saddle River, NJ 07458 Debt Ratios Debt-to-Equity Ratio: Total Debt ÷ Equity Indicates how many dollars in the business were provided by owners/investors Example: A ratio of 1-to-1 means for every $1 of debt, the company owns $1 of assets Debt Ratio: Total Debt ÷ Total Assets Indicates how many dollars in the business were provided by creditors Example: A ratio of 0.5 means the company is in debt for 50% of its assets Entrepreneurship and Small Business Management, 1/e 26 © 2012 Pearson Education, Upper Saddle River, NJ 07458 Operating Efficiency Ratios Collection-period ratio—measures the average number of days that sales are going uncollected Receivable turnover ratio—measures the efficiency of your company’s efforts to collect receivables Inventory turnover ratio—measures how quickly inventory is being sold Entrepreneurship and Small Business Management, 1/e 27 © 2012 Pearson Education, Upper Saddle River, NJ 07458 Formulas for Calculating Operating Efficiency Ratios Collection-Period Ratio: Average Accounts Receivable (Balance Sheet) = # of days Average Daily Sales (Income Statement) Receivable Turnover Ratio: Total Sales (Income Statement) = # of times Average Accounts Receivable (Balance Sheet) Inventory Turnover Ratio: Cost of Goods Sold (Income Statement) = # of times Average Inventory (Balance Sheet) Entrepreneurship and Small Business Management, 1/e 28 © 2012 Pearson Education, Upper Saddle River, NJ 07458 ... Basic Format Entrepreneurship and Small Business Management, 1/e © 2012 Pearson Education, Upper Saddle River, NJ 07458 Income Statement Calculations Entrepreneurship and Small Business Management, ... Statement Entrepreneurship and Small Business Management, 1/e © 2012 Pearson Education, Upper Saddle River, NJ 07458 An Income Statement for a More Complex Business Entrepreneurship and Small Business. .. company Entrepreneurship and Small Business Management, 1/e 12 © 2012 Pearson Education, Upper Saddle River, NJ 07458 Balance Sheet (Horizontal Format) Entrepreneurship and Small Business Management,