Financial Management: How To Make a Go Of Your Business

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Produced in cooperation with the American Association of Community and
Junior Colleges

Charles Liner, SEA Contracting Officer's Technical Representative
Judy Nye, Project Director, AACJC
Martha McKemie, Senior Writer-Editor, SEA
Amelia Harris, Graphics, SEA

About the Author

Linda Howarth Mackay has many years' banking experience gained working in a
rural community bank and two large regional banks. Her expertise is in
commercial and agricultural lending and in correspondent banking. She is
also knowledgeable in the regulation of commercial bank lending practices,
with an extensive background in the establishment of policy and procedures
and in portfolio administration.

A graduate of Indiana University, Bloomington, Indiana, and numerous
banking, accounting, and lending seminars, she is now president of Howarth
Mackay, Incorporated, a company providing financial consultation to
businesses, financial institutions, and professional individuals.

Introduction

This booklet was designed to equip instructors of the National Small
Business Training Network course "Financial Management: How to Make a Go of
Your Business" with the information required to acquaint the small business
owner/manager with the basic tools of sound financial management. It
supplements the course guide materials; it is not intended to replace their
use by the instructor.

The booklet may also be used by anyone interested in learning the concepts
of financial management.

I. The Necessity of Financial Planning

There is one simple reason to understand and observe financial planning in
your business--to avoid failure. Eight of ten new businesses fail primarily
because of the lack of good financial planning.

Financial planning affects how and on what terms you will be able to
attract the funding required to establish, maintain, and expand your
business. Financial planning determines the raw materials you can afford to
buy, the products you will be able to produce, and whether or not you will
be able to market them efficiently. It affects the human and physical
resources you will be able to acquire to operate your business. It will be
a major determinant of whether or not you will be able to make your hard
work profitable.

This manual provides an overview of the essential components of financial
planning and management. Used wisely, it will make the reader--the small
business owner/manager--familiar enough with the fundamentals to have a
fighting chance of success in today's highly competitive business
environment.

A clearly conceived, well documented financial plan, establishing goals and
including the use of Pro Forma Statements and Budgets to ensure financial
control, will demonstrate not only that you know what you want to do, but
that you know how to accomplish it. This demonstration is essential to
attract the capital required by your business from creditors and investors.

What Is Financial Management?

Very simply stated, financial management is the use of financial statements
that reflect the financial condition of a business to identify its relative
strengths and weaknesses. It enables you to plan, using projections, future
financial performance for capital, asset, and personnel requirements to
maximize the return on shareholders' investment.

Tools of Financial Planning

This manual introduces the tools required to prepare a financial plan for
your business's development, including the following:

* Basic Financial Statements--the Balance Sheet and Statement of Income

* Ratio Analysis--a means by which individual business performance is
compared to similar businesses in the same category

* The Pro Forma Statement of Income--a method used to forecast future
profitability

* Break-Even Analysis--a method allowing the small business person to
calculate the sales level at which a business recovers all its costs or
expenses

* The Cash Flow Statement--also known as the Budget identifies the flow of
cash into and out of the business

* Pricing formulas and policies--used to calculate profitable selling
prices for products and services

* Types and sources of capital available to finance business operations

* Short- and long-term planning considerations necessary to maximize profits

The business owner/manager who understands these concepts and uses them
effectively to control the evolution of the business is practicing sound
financial management thereby increasing the likelihood of success.

II. Understanding Financial Statements: A Health Checkup for Your Business

Financial Statements record the performance of your business and allow you
to diagnose its strengths and weaknesses by providing a written summary of
financial activities. There are two' primary financial statements: the
Balance Sheet and the Statement of Income.

The Balance Sheet

The Balance Sheet provides a picture of the financial health of a business
at a given moment, usually at the close of an accounting period. It lists
in detail those material and intangible items the business owns (known as
its assets) and what money the business owes, either to its creditors
(liabilities) or to its owners (shareholders' equity or net worth of the
business).

Assets include not only cash, merchandise inventory, land, buildings,
equipment, machinery, furniture, patents, trademarks, and the like, but
also money due from individuals or other businesses (known as accounts or
notes receivable).

Liabilities are funds acquired for a business through loans or the sale of
property or services to the business on credit. Creditors do not acquire
business ownership, but promissory notes to be paid at a designated future
date.

Shareholders' equity (or net worth or capital) is money put into a business
by its owners for use by the business in acquiring assets.

At any given time, a business's assets equal the total contributions by the
creditors and owners, as illustrated by the following formula for the
Balance Sheet:

Assets = Liabilities + Net Worth

(Total (Funds (Funds
funds supplied supplied
invested in to the to the
assets of business business
the by its by its
business) creditors) owners)

This formula is a basic premise of accounting. If a business owes more
money to creditors than it possesses in value of assets owned, the net
worth or owner's equity of the business will be a negative number.

The Balance Sheet is designed to show how the assets, liabilities, and net
worth of a business are distributed at any given time. It is usually
prepared at regular intervals; e.g., at each month's end but especially at
the end of each fiscal (accounting) year.

By regularly preparing this summary of what the business owns and owes (the
Balance Sheet), the business owner/manager can identify and analyze trends
in the financial strength of the business. It permits timely modifications,
such as gradually decreasing the amount of money the business owes to
creditors and increasing the amount the business owes its owners.

All Balance Sheets contain the same categories of assets, liabilities, and
net worth. Assets are arranged in decreasing order of how quickly they can
be turned into cash (liquidity). Liabilities are listed in order of how
soon they must be repaid, followed by retained earnings (net worth or
owner's equity), as illustrated in Figure 2-1, below, the sample Balance
Sheet for ABC Company.

The categories and format of the Balance Sheet are established by a system
known as Generally Accepted Accounting Principles (GAAP). The system is
applied to all companies, large or small, so anyone reading the Balance
Sheet can readily understand the story it tells.

Figure 2-1
ABC Company
December 31, 19-
Balance Sheet

Cash $ 1,896 Notes Payable, $ 2,000
Bank

Accounts 1,456 Accounts 2,240
Receivable Payable

Inventory 6,822 Accruals 940

Total Current $10,174 Total Current $ 5,180
Assets Liabilities

Equipment and 1,168 Total Liabilities 5,180
Fixtures

Prepaid Expenses 1,278 Net Worth 7,440

Total Assets $12,620 Total Liabilities $12,620
and New Worth

Balance Sheet Categories

Assets: An asset is anything the business owns that has monetary value.

* Current Assets include cash, government securities, marketable
securities, accounts receivable, notes receivable (other than from officers
or employees), inventories, prepaid expenses, and any other item that could
be converted into cash within one year in the normal course of business.

* Fixed Assets are those acquired for long-term use in a business such as
land, plant, equipment, machinery, leasehold improvements, furniture,
fixtures, and any other items with an expected useful business life
measured in years (as opposed to items that will wear out or be used up in
less than one year and are usually expensed when they are purchased). These
assets are typically not for resale and are recorded in the Balance Sheet
at their net cost less accumulated depreciation.

* Other Assets include intangible assets, such as patents, royalty
arrangements, copyrights, exclusive use contracts, and notes receivable
from officers and employees.

Liabilities: Liabilities are the claims of creditors against the assets of
the business (debts owed by the business).

* Current Liabilities are accounts payable, notes payable to banks, accrued
expenses (wages, salaries), taxes payable, the current portion (due within
one year) of long-term debt, and other obligations to creditors due within
one year.

* Long-Term Liabilities are mortgages, intermediate and long-term bank
loans, equipment loans, and any other obligation for money due to a
creditor with a maturity longer than one year.

* Net Worth is the assets of the business minus its liabilities. Net worth
equals the owner's equity. This equity is the investment by the owner plus
any profits or minus any losses that have accumulated in the business.

The Statement of Income

The second primary report included in a business's Financial Statement is
the Statement of Income. The Statement of Income is a measurement of a
company's sales and expenses over a specific period of time. It is also
prepared at regular intervals (again, each month and fiscal year end) to
show the results of operating during those accounting periods. It too
follows Generally Accepted Accounting Principles (GAAP) and contains
specific revenue and expense categories regardless of the nature of the
business.

Statement of Income Categories

The Statement of Income categories are calculated as described below:

* Net Sales (gross sales less returns and allowances)

* Less Cost of Goods Sold (cost of inventories)

* Equals Gross Margin (gross profit on sales before operating expenses)

* Less Selling and Administrative Expenses (salaries, wages, payroll taxes
and benefits, rent, utilities, maintenance expenses, office supplies,
postage, automobile/vehicle expenses, insurance, legal and accounting
expenses, depreciation)

* Equals Operating Profit (profit before other non-operating income or
expense)

* Plus Other Income (income from discounts, investments, customer charge
accounts)

* Less Other Expenses (interest expense)

* Equals Net Profit (Loss) Before Tax (the figure on which your tax is
calculated)

* Less Income Taxes (if any are due)

* Equals Net Profit (Loss) After Tax

For an example of a Statement of Income, see Figure 2-2, the statement of
ABC Company.

Figure 2-2
ABC Company
December 31, 19-
Income Statement

Net Sales $68,116
Cost of Goods Sold 47,696

Gross Profit on Sales $20,420
Expenses
Wages $6,948
Delivery Expenses 954
Bad Debts Allowances 409
Communications 204
Depreciation Allowance 409
Insurance 613
Taxes 1,021
Advertising 1,566
Interest 409
Other Charges 749

Total Expenses $13,282
Net Profit 7,138
Other Income 886

Total Net Income $ 8,024

Calculating the Cost of Goods Sold

Calculation of the Cost of Goods Sold category in the Statement of Income
(or Profit-and-Loss Statement as it is sometimes called) varies depending
on whether the business is retail, wholesale, or manufacturing. In
retailing and wholesaling, computing the cost of goods sold during the
accounting period involves beginning and ending inventories. This, of
course, includes purchases made during the accounting period. In
manufacturing it involves not only finished-goods inventories, but also raw
materials inventories goods-in-process inventories, direct labor, and
direct factory overhead costs.

Regardless of the calculation for Cost of Goods Sold, deduct the Cost of
Goods Sold from Net Sales to get Gross Margin or Gross Profit. From Gross
Profit, deduct general or indirect overhead such as selling expenses,
office expenses, and interest expenses, to calculate your Net Profit. This
is the final profit after all costs and expenses for the accounting period
have been deducted.

III. Financial Ratio Analysis

The Balance Sheet and the Statement of Income are essential, but they are
only the starting point for successful financial management. Apply Ratio
Analysis to Financial Statements to analyze the success, failure, and
progress of your business.

Ratio Analysis enables the business owner/manager to spot trends in a
business and to compare its performance and condition with the average
performance of similar businesses in the same industry. To do this compare
your ratios with the average of businesses similar to yours and compare
your own ratios for several successive years, watching especially for any
unfavorable trends that may be starting. Ratio analysis may provide the
all-important early warning indications that allow you to solve your
business problems before your business is destroyed by them.

Balance Sheet Ratio Analysis

Important Balance Sheet Ratios measure liquidity and solvency (a business's
ability to pay its bills as they come due) and leverage (the extent to
which the business is dependent on creditors' funding). They include the
following ratios:

Liquidity Ratios.

These ratios indicate the ease of turning assets into cash. They include
the Current Ratio, Quick Ratio, and Working Capital.

Current Ratios. The Current Ratio is one of the best known measures of
financial strength. It is figured as shown below:

Total Current Assets
Current Ratio = -------------------------
Total Current Liabilities

The main question this ratio addresses is: "Does your business have enough
current assets to meet the payment schedule of its current debts with a
margin of safety for possible losses in current assets, such as inventory
shrinkage or collectable accounts?" A generally acceptable current ratio is
2 to 1. But whether or not a specific ratio is satisfactory depends on the
nature of the business and the characteristics of its current assets and
liabilities. The minimum acceptable current ratio is obviously 1:1, but
that relationship is usually playing it too close for comfort.

If you decide your business's current ratio is too low, you may be able to
raise it by:

* Paying some debts.
* Increasing your current assets from loans or other borrowings
with a maturity of more than one year.
* Converting noncurrent assets into current assets.
* Increasing your current assets from new equity contributions.
* Putting profits back into the business.

Quick Ratios. The Quick Ratio is sometimes called the "acid-test" ratio and
is one of the best measures of liquidity. It is figured as shown below:

Quick Ratio = Cash + Government Securities
+ Receivables
---------------------------
Total Current Liabilities

The Quick Ratio is a much more exacting measure than the Current Ratio. By
excluding inventories, it concentrates on the really liquid assets, with
value that is fairly certain. It helps answer the question: "If all sales
revenues should disappear, could my business meet its current obligations
with the readily convertible `quick' funds on hand?"

An acid-test of 1:1 is considered satisfactory unless the majority of your
"quick assets" are in accounts receivable, and the pattern of accounts
receivable collection lags behind the schedule for paying current
liabilities.

Working Capital. Working Capital is more a measure of cash flow than a
ratio. The result of this calculation must be a positive number. It is
calculated as shown below:

Working Capital = Total Current Assets -
Total Current Liabilities

Bankers look at Net Working Capital over time to determine a company's
ability to weather financial crises. Loans are often tied to minimum
working capital requirements.

A general observation about these three Liquidity Ratios is that the higher
they are the better, especially if you are relying to any significant
extent on creditor money to finance assets.

Leverage Ratio

This Debt/Worth or Leverage Ratio indicates the extent to which the
business is reliant on debt financing (creditor money versus owner's
equity):

Debt/Worth Ratio = Total Liabilities
-----------------
Net Worth

Generally, the higher this ratio, the more risky a creditor will perceive
its exposure in your business, making it correspondingly harder to obtain
credit.

Income Statement Ratio Analysis

The following important State of Income Ratios measure profitability:

Gross Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the
cost of goods sold from net sales. It measures the percentage of sales
dollars remaining (after obtaining or manufacturing the goods sold)
available to pay the overhead expenses of the company.

Comparison of your business ratios to those of similar businesses will
reveal the relative strengths or weaknesses in your business. The Gross
Margin Ratio is calculated as follows:

Gross Margin Ratio = Gross Profit
------------
Net Sales
(Gross Profit = Net Sales - Cost of Goods Sold)

Net Profit Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the
Cost of Goods sold and all expenses, except income taxes. It provides a
good opportunity to compare your company's "return on sales" with the
performance of other companies in your industry. It is calculated before
income tax because tax rates and tax liabilities vary from company to
company for a wide variety of reasons, making comparisons after taxes much
more difficult. The Net Profit Margin Ratio is calculated as follows:

Net Profit Margin Ratio = Net Profit Before Tax
---------------------
Net Sales

Management Ratios

Other important ratios, often referred to as Management Ratios, are also
derived from Balance Sheet and Statement of Income information.

Inventory Turnover Ratio

This ratio reveals how well inventory is being managed. It is important
because the more times inventory can be turned in a given operating cycle,
the greater the profit. The Inventory Turnover Ratio is calculated as
follows:

Inventory Turnover Ratio = Net Sales
--------------------------
Average Inventory at Cost

Accounts Receivable Turnover Ratio

This ratio indicates how well accounts receivable are being collected. If
receivables are not collected reasonably in accordance with their terms,
management should rethink its collection policy. If receivables are
excessively slow in being converted to cash, liquidity could be severely
impaired. The Accounts Receivable Turnover Ratio is calculated as follows:

Net Credit Sales/Year = Daily Credit Sales
---------------------
365 Days/Year

Accounts Receivable Turnover (in days) = Accounts Receivable
-------------------
Daily Credit Sales

Return on Assets Ratio

This measures how efficiently profits are being generated from the assets
employed in the business when compared with the ratios of firms in a
similar business. A low ratio in comparison with industry averages
indicates an inefficient use of business assets. The Return on Assets Ratio
is calculated as follows:

Return on Assets = Net Profit Before Tax
---------------------
Total Assets

Return on Investment (ROI) Ratio.

The ROI is perhaps the most important ratio of all. It is the percentage of
return on funds invested in the business by its owners. In short, this
ratio tells the owner whether or not all the effort put into the business
has been worthwhile. If the ROI is less than the rate of return on an
alternative, risk-free investment such as a bank savings account or
certificate of deposit, the owner may be wiser to sell the company, put the
money in such a savings instrument, and avoid the daily struggles of small
business management. The ROI is calculated as follows:

Return on Investment = Net Profit before Tax
---------------------
Net Worth

These Liquidity, Leverage, Profitability, and Management Ratios allow the
business owner to identify trends in a business and to compare its progress
with the performance of others through data published by various sources.
The owner may thus determine the business's relative strengths and
weaknesses.

Sources of Comparative Information

Sources of comparative financial information which you may obtain from your
public library or the publishers include the following:

Almanac of Business and Industrial Financial Ratios, Leo Troy,
Prentice-Hall, Inc., Englewood Cliffs, NJ 07632

Annual Statement Studies, Robert Morris Associates, P. O. Box 8500, S-1140,
Philadelphia, PA 19178

Expenses in Retail Business, National Cash Register Corporation, Corporate
Advertising and Sales Promotion Dayton, OH 45479.

Key Business Ratios, Dun & Bradstreet, Inc., 99 Church Street, New York, NY
10007, ATTN: Public Relations and Advertising Department

IV. Forecasting Profits

Forecasting, particularly on a short-term basis (one year to three years),
is essential to planning for business success. This process, estimating
future business performance based on the actual results from prior periods,
enables the business owner/manager to modify the operation of the business
on a timely basis. This allows the business to avoid losses or major
financial problems should some future results from operations not conform
with reasonable expectations. Forecasts--or Pro Forma Income Statements and
Cash Flow Statements as they are usually called--also provide the most
persuasive management tools to apply for loans or attract investor money.
As a business expands, there will inevitably be a need for more money than
can be internally generated from profits.

Facts Affecting Pro Forma Statements

Preparation of Forecasts (Pro Forma Statements) requires assembling a wide
array of pertinent, verifiable facts affecting your business and its past
performance. These include:

* Data from prior financial statements, particularly:
a. Previous sales levels and trends
b. Past gross percentages
c. Average past general, administrative, and selling expenses necessary
to generate your former sales volumes
d. Trends in the company's need to borrow (supplier, trade credit, and
bank credit) to support various levels of inventory and trends in
accounts receivable required to achieve previous sales volumes

* Unique company data, particularly:
a. Plant capacity
b. Competition
c. Financial constraints
d. Personnel availability

* Industry-wide factors, including:
a. Overall state of the economy
b. Economic status of your industry within the economy
c. Population growth
d. Elasticity of demand for the product or service your business
provides
e. Availability of raw materials

Once these factors are identified, they may be used in Pro Formas, which
estimate the level of sales, expense, and profitability that seem possible
in a future period of operations.

The Pro Forma Income Statement

In preparing the Pro Forma Income Statement, the estimate of total sales
during a selected period is the most critical "guesstimate." Employ
business experience from past financial statements. Get help from
management and salespeople in developing this all-important number.

Then assume, for example, that a 10 percent increase in sales volume is a
realistic and attainable goal. Multiply last year's net sales by 1.10 to
get this year's estimate of total net sales. Next, break down this total,
month by month, by looking at the historical monthly sales volume. From
this you can determine what percentage of total annual sales fell on the
average in each of those months over a minimum of the past three years. You
may find that 75 percent of total annual sales volume was realized during
the six months from July through December in each of those years and that
the remaining 25 percent of sales was spread fairly evenly over the first
six months of the year.

Next, estimate the cost of goods sold by analyzing operating data to
determine on a monthly basis what percentage of sales has gone into cost of
goods sold in the past. This percentage can then be adjusted for expected
variations in costs, price trends, and efficiency of operations.

Operating expenses (sales, general and administrative expenses,
depreciation, and interest), other expenses, other income, and taxes can
then be estimated through detailed analysis and adjustment of what they
were in the past and what you expect them to be in the future.

Comparison with Actual Monthly Performance

Putting together this information month by month for a year into the future
will result in your business's Pro Forma Statement of Income. Use it to
compare with the actual monthly results from operations by using the SBA
form 1099 (4-82) Operating Plan Forecast (Profit and Loss Projection).
Obtain this form from your local SBA office. You will find it helpful to
refer to the SBA Guidelines for Profit and Loss Projection. Preparation of
the information is summarized below and on the back of the form 1099.

Revenue (Sales)

* List the departments within the business. For example, if your business
is appliance sales and service, the departments would include new
appliances, used appliances, parts, in-shop service, on-site service.

* In the "Estimate" columns, enter a reasonable projection of monthly sales
for each department of the business. Include cash and on-account sales. In
the "Actual" columns, enter the actual sales for the month as they become
available.

* Exclude from the Revenue section any revenue not strictly related to the
business.

Cost of Sales

* Cite costs by department of the business, as above.

* In the "Estimate" columns, enter the cost of sales estimated for each
month for each department. For product inventory, calculate the cost of the
goods sold for each department (beginning inventory plus purchases and
transportation costs during the month minus the inventory). Enter "Actual"
costs each month as they accrue.

Gross Profit

* Subtract the total cost of sales from the total revenue.

Expenses

* Salary Expenses: Base pay plus overtime.

* Payroll Expenses: Include paid vacations, sick leave, health insurance,
unemployment insurance, Social Security taxes.

* Outside Services: Include costs of subcontracts, overflow work
farmed-out, special or one-time services.

* Supplies: Services and items purchased for use in the business, not for
resale.

* Repairs and Maintenance: Regular maintenance and repair, including
periodic large expenditures, such as painting or decorating.

* Advertising: Include desired sales volume, classified directory listing
expense, etc.

* Car, Delivery and Travel: Include charges if personal car is used in the
business. Include parking, tolls, mileage on buying trips, repairs, etc.

* Accounting and Legal: Outside professional services.

* Rent: List only real estate used in the business.

* Telephone.

* Utilities: Water, heat, light, etc.

* Insurance: Fire or liability on property or products, worker's
compensation.

* Taxes: Inventory, sales, excise, real estate, others.

* Interest.

* Depreciation: Amortization of capital assets.

* Other Expenses (specify each): Tools, leased equipment, etc.

* Miscellaneous (unspecified): Small expenditures without separate accounts.

Net Profit

* To find net profit, subtract total expenses from gross profit.

The Pro Forma Statement of Income, prepared on a monthly basis and
culminating in an annual projection for the next business fiscal year,
should be revised not less than quarterly. It must reflect the actual
performance achieved in the immediately preceding three months to ensure
its continuing usefulness as one of the two most valuable planning tools
available to management.

Should the Pro Forma reveal that the business will likely not generate a
profit from operations, plans must immediately be developed to identify
what to do to at least break even--increase volume, decrease expenses, or
put more owner capital in to pay some debts and reduce interest expenses.

Break-Even Analysis

"Break-Even" means a level of operations at which a business neither makes
a profit nor sustains a loss. At this point, revenue is just enough to
cover expenses. Break-Even Analysis enables you to study the relationship
of volume, costs, and revenue.

Break-Even requires the business owner/manager to define a sales
level--either in terms of revenue dollars to be earned or in units to be
sold within a given accounting period--at which the business would earn a
before tax net profit of zero. This may be done by employing one of various
formula calculations to the business estimated sales volume, estimated
fixed costs, and estimated variable costs.

Generally, the volume and cost estimates assume the following conditions:

* A change in sales volume will not affect the selling price per unit;

* Fixed expenses (rent, salaries, administrative and office expenses,
interest, and depreciation) will remain the same at all volume levels; and

* Variable expenses (cost of goods sold, variable labor costs including
overtime wages and sales commissions) will increase or decrease in direct
proportion to any increase or decrease in sales volume.

Two methods are generally employed in Break-Even Analysis, depending on
whether the break-even point is calculated in terms of sales dollar volume
or in number of units that must be sold.

Break-Even Point in Sales Dollars

The steps for calculating the first method are shown below:

1. Obtain a list of expenses incurred by the company during its past fiscal
year.

2. Separate the expenses listed in Step 1 into either a variable or a fixed
expense classification. (See Figure 4-1, below, under "Classification of
Expenses.")

3. Express the variable expenses as a percentage of sales. In the condensed
income statement (Figure 4-1) of the Small Business Specialties Co.
(below), net sales were $1,200,000. In Step 2, variable expenses were found
to amount to $720,000. Therefore, variable expenses are 60 percent of net
sales ($720,000 divided by $1,200,000). This means that 60 cents of every
sales dollar is required to cover variable expenses. Only the remainder, 40
cents of every dollar, is available for fixed expenses and profit.

4. Substitute the information gathered in the preceding steps in the
following basic break-even formula to calculate the breakeven point.