Module:

Entrepreneurship
Dr Tamer Karam
Essentials of Entrepreneurship and Small
Business Management
Eighth Edition
Section 3: Launching the Business

Chapter 10
Creating a
Successful
Financial Plan

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Learning Objectives
1. Describe how to prepare the
basic financial statements
and use them to manage a
small business.
2. Create projected (pro forma)
financial statements.
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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Copyright © 2011 Pearson Education, Inc. Publishing as Prentice Hall
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 11.3 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 = 1.87 :1

Current Ratio=
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 = .63 :1

Quick Ratio=
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.

Total Debt = $367,850 + 212,150 = .68 :1

Debt Ratio =
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.”

Total Debt $580,000
Debt to Net Worth Ratio = = = 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 =

Times Interest 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

*Average Inventory = Beginning Inventory + Ending 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)
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, and 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)
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, 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 six-day improvement has
generated savings for Sam’s Appliance Shop of

Savings = $1,309,589 ´ 8.75% ´ 8 days = = $2,512

365 days

By collecting his accounts receivable just eight days faster on average,

Sam has saved his business more than $2,512! 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 = 0.50:1

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 = 0.62:1

Creditors provide 68% of Sam’s total assets, very close to

the industry median of 62%. Although the company does not
appear to be overburdened with debt, Sam’s 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 = 2.30:1

Sam’s owes $2.20 to creditors for every $1.00 the owner has
invested in the business (compared to $2.30 to every $1.00
in equity for the typical business). Many lenders will see
Sam’s 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 = 2.10:1

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’s 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 = Average inventory turnover ratio = 4.4
times per year
2.05 times per year

Inventory is moving through Sam’s 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 Average collection period ratio = 10.3
days
days

Sam’s collects the average account receivable after 50 days

compared to the industry median of 11 days – about five 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 = 50.0 Average collection period ratio = 10.3
days
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 = 3.4:1

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 = 4.3%

After deducting all expenses, Sam’s has just 3.24 cents of

every sales dollar left as profit – nearly 25% 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 = 4.0%

Sam’s generates a return of 7.15% for every $1 in assets, which is

nearly 79% above the industry average. Given his asset base,
Sam is squeezing an above-average return out of his company. Is
this likely to be the result of exceptional profitability, or is there
another explanation?

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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 = 16.0%

Sam’s return on his investment in the business is an

impressive 22.65%, compared to an industry median of just
16.0%. Is this the result of high profitability, or is there
another explanation?

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Trend Analysis of 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
$705,125
Step 3: Contribution Margin = 1- = .26
$950,000
$177,375
Step 4: Breakeven Point = =$682,212
.26

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Breakeven Chart for the Magic Shop

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Group Excericse:
All Is Not Paradise
in Eden’s Garden:
Group Excericse:
All Is Not Paradise
in Eden’s Garden:
Group Excericse:
All Is Not Paradise
in Eden’s Garden:
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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