Financial Management: How To Make a Go Of Your Business

 

by Linda Howarth Mackay

 

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

 

Contents

 

About the Author

 

Introduction

 

I. The Necessity of Financial Planning

 

What is Financial Management?

Tools of Financial Planning

 

II. Understanding Financial Statements: A Health

Checkup for Your Business

 

The Balance Sheet

The Statement of Income

 

III. Financial Ratio Analysis

 

Balance Sheet Ratio Analysis

Income Statement Ratio Analysis

Management Ratios

Sources of Comparative Information

 

IV. Forecasting Profits

 

Facts Affecting Pro Forma Statements

The Pro Forma Income Statement

Comparison with Actual Monthly Performance

Break-Even Analysis

 

V. Cash Flow Management: Budgeting and

Controlling Costs

 

The Cash Flow Statement

 

VI. Pricing Policy

 

Establishing Selling Prices

A Pricing Example

The Retailers Mark-Up

Pricing Policies and Profitability Goals

 

VII. Forecasting and Obtaining Capital

 

Types and Sources of Capital

Borrowing Working Capital

Borrowing Growth Capital

Borrowing Permanent Equity Capital

Applying for Capital

 

VIII. Financial Management Planning

 

Long-Term Planning

 

For Further Information

 

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.

 

                                Figure 4-1

 

                     THE SMALL-BUSINESS SPECIALTIES CO.

                         Condensed Income Statement

                         For year ending Dec. 31, 19-

 

Net sales (60,000 units @ $20 per unit)..........................$1,200,000

Less cost of goods sold:

    Direct material.............................$195,000

    Direct labor................................ 215,000

    Manufacturing expenses (Schedule A)......... 300,000

                                               

     Total.......................................................   710,000

                                                                

Gross profit.....................................................   490,000

Less operating expenses:

    Selling expenses (Schedule B)...............$200,000

    General and administrative expenses

      (Schedule C).............................. 210,000

                                              

     Total.......................................................   410,000

                                                                

Net Income.......................................................$   80,000

                                                             

 

    Supporting Schedules of Expenses Other Than Direct Material and Labor

 

                                                                 Schedule C

                                   Schedule A    Schedule B     general and

                                  manufacturing   selling    administrative

                       Total        expenses      expenses         expenses

 

Rent.................$ 60,000      $ 30,000      $  8,000         $ 22,000

Insurance............  11,000         9,000         1,000            1,000

Commissions.......... 120,000       .......       120,000          .......

Property tax.........  12,000        10,000         1,000            1,000

Telephone............   7,000         1,000         5,000            1,000

Depreciation.........  80,000        70,000         5,000            5,000

Power................ 100,000       100,000       .......          .......

Light................  60,000        30,000        10,000           20,000

Officers' salaries... 260,000        50,000        50,000          160,000

                

     Total...........$710,000      $300,000      $200,000         $210,000

                 

 

                         Classification of Expenses

 

                                      Total       Variable          Fixed

 

Direct material...................$  195,000      195,000          .......

Direct labor......................   215,000      215,000          .......

Manufacturing expenses............   300,000      100,000         $200,000

Selling expenses..................   200,000                        50,000

General and admin. expenses.......   210,000       60,000          150,000

                              

     Total........................$1,120,000     $720,000         $400,000

                             

 

 

Where: S = F + V (Sales at the break-even point)

       F = Fixed expenses

       V = Variable expenses expressed as a percentage of sales.

 

This formula means that when sales revenues equal the fixed expenses and

variable expenses incurred in producing the sales revenues, there will be

no profit or loss. At this point, revenue from sales is just sufficient to

cover the fixed and the variable expenses. In this formula "S" is the break

even point.

 

For the Small Business Specialties Co., the break-even point (using the

basic formula and data from Figure 4-2) may be calculated as follows:

 

  S = F + V

  S = $400,000 + 0.605

10S = $4,000,000 + 6S

10S - 6S = $4,000,000

 4S = $4,000,000

  S = $1,000,000

 

Proof that this calculation is correct follows:

 

Sales at break-even point per calculation                  $1,000,000

Less variable expenses (60 percent of sales)                  600,000

                                                       

Marginal income                                               400,000

Less fixed expenses                                           400,000

                                                       

Equals neither profit nor loss                             $        0

 

Modification: Break-Even Point to Obtain Desired Net Income.

 

The first break-even formula can be modified to show the dollar sales

required to obtain a certain amount of desired net income. To do this, let

"S" mean the sales required to obtain a certain amount of net income, say

$80,000. The formula then reads:

 

  S = F + V + Desired Net Income

  S = $400,000 + 0.60S + $80,000

10S = $4,000,000 + 6S + 800,000

 4S = $4,800,000

  S = $1,200,000

 

Break-Even Point in Units to be Sold

 

You may want to calculate the break-even point in terms of units to be sold

instead of sales dollars. If so, a second formula (in which "S" means units

to be sold to break even) may be used:

 

  Break-even Sales  =               Fixed expenses

  (S = Units)          -----------------------------------------

                       Unit sales price - Unit variable expenses

 

       S            =  $400,000    =  $400,000

                       -----------------------

                       $20 - $12         $8

 

       S            =  50,000 units

 

The Small Business Specialties Co. must sell 50,000 units at $20 per unit

to break even under the assumptions contained in this illustration. The

sale of 50,000 units at $20 each equals $1 million, the break-even sales

volume in dollars calculated in the basic formula. This formula indicates

there is $8 per unit of sales that can be used to cover the $400,000 fixed

expense. Then $400,000 divided by $8 gives the number of units required to

break even.

 

Modification: Break-Even Point in Units to be Sold to Obtain Desired Net

Income.

 

The second formula can be modified to show the number of units required to

obtain a certain amount of net income. In this case, let S mean the number

of units required to obtain a certain amount of net income, again say

$80,000. The formula then reads as follows:

 

    S  =        Fixed expenses + Net income

          ----------------------------------------

          Unit sales price - Unit variable expense

 

    S  =  $400,000 + $80,000   =   $480,000

          ------------------       --------

             $20  -  $12              $8

 

    S  =  60,000 units

 

Break-even Analysis may also be represented graphically by charting the

sales dollars or sales units required to break even as in Figure 4-2, below.

 

Remember: Increased sales do not necessarily mean increased profits. If you

know your company's break-even point, you will know how to price your

product to make a profit. If you cannot make an acceptable profit, alter or

sell your business before you lose your retained earnings.

 

  

  

V. Cash Flow Management: Budgeting and Controlling Costs

 

If there is anything more important to the successful financial management

of a business than the thorough, thoughtful preparation of Pro Forma Income

Statements, it is the preparation of the Cash Flow Statement, sometimes

called the Cash Flow Budget.

 

The Cash Flow Statement

 

The Cash Flow Statement identifies when cash is expected to be received and

when it must be spent to pay bills and debts. It shows how much cash will

be needed to pay expenses and when it will be needed. It also allows the

manager to identify where the necessary cash will come from. For example,

will it be internally generated from sales and the collection of accounts

receivable--or must it be borrowed? (The Cash Flow Projection deals only

with actual cash transactions; depreciation and amortization of good will

or other non-cash expense items are not considered in this Pro Forma.)

 

The Cash Flow Statement, based on management estimates of sales and

obligations, identifies when money will be flowing into and out of the

business. It enables management to plan for shortfalls in cash resources so

short term working capital loans may be arranged in advance. It allows

management to schedule purchases and payments in a way that enables the

business to borrow as little as possible. Because all sales are not cash

sales management must be able to forecast when accounts receivable will

become "cash in the bank" and when expenses--whether regular or

seasonal--must be paid so cash shortfalls will not interrupt normal

business operations.

 

The Cash Flow Statement may also be used as a Budget, permitting the

manager increased control of the business through continuous comparison of

actual receipts and disbursements against forecast amounts. This comparison

helps the small business owner identify areas for timely improvement in

financial management.

 

By closely watching the timing of cash receipts and disbursements, cash

balance on hand, and loan balances, management can readily identify such

things as deficiencies in collecting receivables, unrealistic trade credit

or loan repayment schedules. Surplus cash that may be invested on a

short-term basis or used to reduce debt and interest expenses temporarily

can be recognized. In short, it is the most valuable tool management has at

its disposal to refine the day-to-day operation of a business. It is an

important financial tool bank lenders evaluate when a business needs a

loan, for it demonstrates not only how large a loan is required but also

when and how it can be repaid.

 

A Cash Flow Statement or Budget can be prepared for any period of time.

However, a one-year budget matching the fiscal year of your business is

recommended. As in the preparation and use of the Pro Forma Statement of

Income, the projected Cash Flow Statement should be prepared on a monthly

basis for the next year. It should be revised not less than quarterly to

reflect actual performance in the preceding three months of operations to

check its projections.

 

In preparing the Cash Flow Statement or Budget start with the sales budget.

Other budgets are related directly or indirectly to this budget. The

following is a sales forecast in units:

 

Sales Budget--Units For the Year Ended December 31, 19__

 

Territory               Total        1st      2nd      3rd      4th

                                   Quarter  Quarter  Quarter  Quarter

East....................26,000      5,000    6,000    7,000    8,000

West....................11,000      2,000    2,500    3,000    3,500

                   

                        37,000      7,000    8,500   10,000   11,500

                    

 

Assume you sell a single product and the sales price for it is $10. Your

sales budget in terms of dollars would look like this:

 

Sales Budget--Dollars For the Year Ended December 31, 19__

 

Territory                   Total      1st        2nd       3rd       4th

                                     Quarter    Quarter   Quarter   Quarter

East......................$260,000   $50,000    $80,000  $ 70,000  $ 80,000

West...................... 110,000    20,000     25,000    30,000    35,000

                   

                          $370,000   $70,000    $85,000  $100,000  $115,000

                     

 

Say the estimated per unit cost of the product is $1.50 for direct

material, $2.50 for direct labor, and $1.00 for manufacturing overhead. By

applying unit costs to the sales budget in units, you would come out with

this budget:

 

Cost of Goods Sold Budget For the Year Ended December 31, 19__

 

                       Total       1st        2nd       3rd       4th

                                 Quarter    Quarter   Quarter   Quarter

Direct material......$ 55,500    $10,500    $12,750   $15,000   $17,250

Direct labor.........  92,500     17,500     21,250    25,000    28,750

Mfg. overhead........  37,000      7,000      8,500    10,000    11,500

               

                     $185,000    $35,000    $42,500   $50,000   $57,500

                

 

Later on, before a cash budget can be compiled, you will need to know the

estimated cash requirements for selling expenses. Therefore, you prepare a

budget for selling expenses and another for cash expenditures for selling

expenses (total selling expenses less depreciation):

 

Selling Expenses Budget For the Year Ended December 31 19__

 

                         Total       1st        2nd       3rd      4th

                                   Quarter    Quarter   Quarter   Quarter

Commissions.............$46,500    $ 8,750    $10,625   $12,500   $14,375

Rent....................  9,250      1,750      2,125     2,500     2,875

Advertising.............  9,250      1,750      2,125     2,500     2,875

Telephone...............  4,625        875      1,062     1,250     1,437

Depreciation--office....    900        225        225       225       225

Other................... 22,250      4,150      5,088     6,025     6,983

                   

                        $92,500    $17,500    $21,250   $25,000   $28,750

                    

 

Selling Expenses Budget--Cash Requirements For the Year Ended

December 31, 19__

 

                         Total        1st        2nd        3rd       4th

                                    Quarter    Quarter    Quarter   Quarter

Total selling expenses..$92,500     $17,500    $21,250    $25,000   $28,750

Less: depreciation......

expense--office.........    900         225        225        225       225

                   

Cash requirements.......$91,600     $17,275    $21,025    $24,775   $28,525

                  

 

Basic information for an estimate of administrative expenses for the coming

year is easily compiled. Again, from that budget you can estimate cash

requirements for those expenses to be used subsequently in preparing the

cash budget.

 

Administrative Expenses Budget For the Year Ended December 31, 19___

 

                          Total      1st      2nd       3rd      4th

                                   Quarter  Quarter   Quarter  Quarter

Salaries.................$22,200    $4,200   $5,100   $ 6,000  $ 6,900

Insurance................  1,850       350      425       500      575

Telephone................  1,850       350      425       500      575

Supplies.................  3,700       700      850     1,000    1,150

Bad debt expenses........  3,700       700      850     1,000    1,150

Other expenses...........  3,700       700      850     1,000    1,150

                   

                         $37,000    $7,000   $8,500   $10,000  $11,500

                 

 

Administrative Expenses Budget--Cash Requirements

For the Year Ended December 31, 19___

 

                           Total      1st       2nd       3rd       4th

                                    Quarter   Quarter   Quarter   Quarter

Estimated adm. expenses...$37,000    $7,000    $8,500   $10,000   $11,500

Less: bad debt expenses...  3,700       700       850     1,000     1,150

                      

Cash requirements.........$33.300    $6,500    $7,650   $ 9,000   $10,350

                    

 

Now, from the information budgeted so far, you can proceed to prepare the

budget income statement. Assume you plan to borrow $10,000 at the end of

the first quarter. Although payable at maturity of the note, the interest

appears in the last three quarters of the year. The statement will resemble

the following:

 

Budgeted Income Statement For the Year Ended December 31, 19___

 

                          Total         1st        2nd       3rd       4th

                                      Quarter    Quarter   Quarter   Quarter

Sales...................$370,000      $70,000    $85,000  $100,000  $115,000

Cost of goods sold...... 185,000       35,000     42,500    50,000    57,500

               

Gross Margin............$185,000      $35,000    $42,500  $ 50,000  $ 57,500

                      

Operating expenses:

 Selling................$ 92,500      $17,500    $21,250  $ 25,000  $ 28,750

 Administrative.........  37,000        7,000      8,500  $ 10,000  $ 11,500

                       

   Total................$129,500      $24,500    $29,750  $ 35,000  $ 40,250

               

Net income

 from operations........$ 55,500      $10,500    $12,750  $ 15,000  $ 17,250

 Interest expense.......     450                     150       150       150

                  

Net income before

 Income taxes...........$ 55,050      $10,500    $12,600  $ 14,850  $ 17,100

 Federal income tax.....  27,525        5,250      6,300     7,425     8,550

                   

Net income..............$ 27,525      $ 5,250    $ 6,300  $  7,425  $  8,550

                    

 

Estimating that 90 percent of your account sales is collected in the

quarter in which they are made, that 9 percent is collected in the quarter

following the quarter in which the sales were made, and that 1 percent of

account sales is uncollectible, your accounts receivable budget of

collections would look like this:

 

Budget of Collections of Accounts Receivable For the Year Ended December

31, 19___

 

                            Total     1st       2nd       3rd       4th

                            (net)   Quarter   Quarter   Quarter   Quarter

4th Quarter Sales 19-0...$  6,000   $ 6,000

1st Quarter Sales 19-1...  69,300    63,000   $ 6,300

2nd Quarter Sales 19-1...  84,150              76,500   $ 7,650

3rd Quarter Sales 19-1...  99,000                        90,000  $  9,000

4th Quarter Sales 19-1... 103,500                                 103,500

               

                         $361,950   $69,000   $82,800   $97,650  $112,500

 

Going back to the sales budget in units, now prepare a production budget in

units. Assume you have 2,000 units in the opening inventory and want to

have on hand at the end of each quarter the following quantities: 1st

quarter, 3,000 units; 2nd quarter, 3,500 units; 3rd quarter, 4,000 units;

and 4th quarter, 4,500 units.

 

Production Budget--Units For the Year Ended December 31, 19___

 

                               1st        2nd       3rd       4th

                             Quarter    Quarter   Quarter   Quarter

Sales requirements........... 7,000      8,500    10,000    11,500

Add: ending

 inventory requirements...... 3,000      3,500     4,000     4,500

                        

 Total requirements..........10,000     12,500    14,000    16,000

Less: beginning

 inventory................... 2,000      3,000     3,500     4,000

Production              

  requirements............... 8,000      9,000    10,500   112,000

                          

 

Next, based on the production budget, prepare a budget to show the

purchases needed during each of the four quarters. Expressed in terms of

dollars, you do this by taking the production and inventory fires and

multiplying them by the cost of material (previously estimated at $1.50 per

unit). You could prepare a similar budget expressed in units.

 

Budget of Direct Materials Purchases For the Year Ended December 31, 19___

 

                                 1st      2nd        3rd       4th

                               Quarter  Quarter    Quarter   Quarter

Required for production........$12,000  $13,500    $15,750   $18,000

Required for ending inventory..  4,500   52,250      6,000     6,750

                             

  Total........................$16,500  $18,750    $21,750   $24,750

Less: beginning inventory......  3,000    4,500      5,250     6,000

                         

Required purchases.............$13,500  $14,250    $16,500   $18,750

                        

 

Now suppose you pay 50 percent of your accounts in the quarter of the

purchase and 50 percent in the following quarter. Carryover payables from

last year were $5,000. Further, you always take the purchase discounts as a

matter of good business policy. Since net purchases (less discount) were

figured into the $1.50 cost estimate, purchase discounts do not appear in

the budgets. Thus your payment on purchases budget will come out like this:

 

Payment on Purchases Budget For the Year Ended December 31, 19___

 

                          Total       1st       2nd      3rd       4th

                                    Quarter   Quarter  Quarter   Quarter

4th Quarter Sales 19-0...$ 5,000    $ 5,000

1st Quarter Sales 19-1... 13,500      6,750   $ 6,750

2nd Quarter Sales 19-1... 14,250                         7,125   $ 7.125

3rd Quarter Sales 19-1... 16,500                         8,250   $ 8,250

4th Quarter Sales 19-1...  9,375                                   9,375

                    

  Payments by Quarters   $58,625    $11,750   $13,875  $15,375   $17,625

                  

 

Taking the data for quantities produced from the production budget in

units, calculate the direct labor requirements on the basis of units to be

produced. (The number and cost of labor hours necessary to produce a given

quantity can be set forth in supplemental schedules.)

 

Direct Labor Budget--Cash Requirements For the Year Ended December 31, 19__

 

                          Total      1st      2nd      3rd      4th

                                   Quarter  Quarter  Quarter  Quarter

Quantity................ 39,500      8,000    9,000   10,500   12,000

Direct labor cost.......$98,750    $20,000  $22,500  $26,250  $30,000

 

Now outline the items that comprise your factory overhead, and prepare a

budget like the following:

 

Manufacturing Overhead Budget For the Year Ended December 31, 19___

 

                         Total     1st       2nd        3rd       4th

                                 Quarter   Quarter    Quarter   Quarter

Heat and power..........$10,000   $1,000    $2,500    $ 3,000   $ 3,500

Factory supplies........  5,300    1,000     1,500      1,800     1,000

Property taxes..........  2,000      500       500        500       500

Depreciation............  2,800      700       700        700       700

Rent....................  8,000    2,000     2,000      2,000     2,000

Superintendent..........  9,400    2,800     1,800      2,500     4,300

                  

                        $39,500   $8,000    $9,000    $10.500   $12,000

                

 

Figure the cash payments for manufacturing overhead by subtracting

depreciation, which requires no cash outlay, from the totals above, and you

will have the following breakdown:

 

Manufacturing Overhead Budget--Cash Requirements

For the Year Ended December 31, 19___

 

                          Total    1st      2nd       3rd      4th

                                 Quarter  Quarter   Quarter  Quarter

Productions--units...... 39,500    8,000    9,000    10,500   12,000

                 

Mfg.overhead expenses...$39,500   $8,000   $9,000   $10,500  $12,000

Less: depreciation......  2,800      700      700       700      700

                  

Cash requirements.......$36,700   $7,300   $8,300   $ 9,800  $11,300

             

 

Now comes the all important cash budget. You put it together by using the

Collection of Accounts Receivable Budget; Selling Expenses Budget--Cash

Requirements; Administrative Expenses Budget--Cash Requirements; Payment of

Purchases Budget; Direct Labor Budget--Cash Requirements; and Manufacturing

Budget--Cash Requirements.

 

Take $15,000 as the beginning balance, and assume that dividends of $20,000

are to be paid in the fourth quarter.

 

Cash Budget For the Year Ended December 31, 19___

 

                         Total      1st        2nd       3rd        4th

                                  Quarter    Quarter   Quarter    Quarter

Beginning cash balance  $ 15,000  $15,000    $ 3,850  $ 13,300   $ 25,750

Cash collections         361,950   69,000     82,800    97,650    112,500

                      

  Total                 $376,950  $84,000    $86,650  $110,950   $138,250

               

Cash payments

  Purchases             $ 58,625  $11,750    $13,875  $ 15,375   $ 17,625

Direct labor              98,750   20,000     22,500    26,250     30,000

  Mfg. overhead           38,700    7,300      8,300     9,800     11,300

  Selling expense         91,600   17,275     21,025    24,775     28,525

Adm. expenses             33,300    6,300      7,650     9,000     10,350

  Federal income tax      27,525   27,525

  Dividends               20,000                                   20,000

  Interest expenses          450                                      450

  Loan repayment          10,000                                   10,000

                    

    Total               $376,950  $90,150    $73,350  $ 85,200   $128,250

                  

  Cash deficiency                ($ 6,150)

  Bad loan received       10,000   10,000

                     

  Ending cash balance   $ 10,000  $ 3,850    $13,300  $ 25,750   $ 10,000

                

 

Now you are ready to prepare a budget balance sheet. Take the account

balances of last year and combine them with the transactions reflected in

the various budgets you have compiled. You will come out with a sheet

resembling this:

 

Budgeted Balance Sheet December 31, 19___

Assets

                                                 19___        19___

Current assets:

  Cash                                        $ 10,000     $ 15,000

  Accounts receivable                           11,500        6,666

 Less: allowance for doubtful accounts          (1,150)        (666)

 Inventory:

      Raw materials                              6,750        3,000

      Finished goods                            22,500       10,000

                                      

       Total current assets                   $ 49,600       34,000

                                      

  Fixed assets:

  Land                                        $ 50,000     $ 50,000

  Building                                     148,000      148,000

  Less: allowance for depreciation             (37,000)     (33,000)

                                       

     Total fixed assets                       $161,100     $164,700

                                           

  Total assets                                $210,600     $198,700

                                        

Liabilities and Shareholders' Equity

 

Current liabilities:

 Account payable                              $  9,375     $  5,000

                                        

Shareholders' equity:

 Capital stock (10,000 shares; $10 par value) $100,000     $110,000

 Retained earnings                             101,225       93,700

                                        

                                              $201,225     $193,700

                                       

Total liabilities and shareholders' equity    $210,600     $198,700

                                       

 

In order to make the most effective use of your budgets to plan profits,

you will want to establish reporting devices. Throughout the time span you

have set, you need periodic reports and reviews on both efforts and

accomplishments. These let you know whether your budget plan is being

attained and help you keep control throughout the process. It is through

comparing actual performance with budgeted projections that you maintain

control of the operations.

 

Your company should be structured along functional lines, with well

identified areas of responsibility and authority. Then, depending upon the

size of your company, the budget reports can be prepared to correspond with

the organizational structure of the company.

 

Two typical budget reports are shown below to demonstrate various forms

these reports may take.

 

Report of Actual and Budgeted Sales For the Year Ended December 31, 19___

 

                                                        Variations from

                                                        budget (under)

                  Actual sales   Budgeted sales    Quarterly     Cumulative

1st Quarter       $              $                 $              $

2nd Quarter

3rd Quarter

4th Quarter

 

Budgeted Report on Selling Expenses For the Year Ended December 31, 19___

 

  Budget  ³   Actual  ³ Variation³  Budget  ³  Actual  ³Variations³ Remarks

   This   ³    This   ³   This   ³  Year to ³  Year to ³ Year to  ³

  Month   ³   Month   ³  Month   ³   Date   ³   Date   ³   Date   ³

 

          ³           ³          ³          ³          ³          ³

          ³           ³          ³          ³          ³          ³

          ³           ³          ³          ³          ³          ³

          ³           ³          ³          ³          ³          ³

          ³           ³          ³          ³          ³          ³

          ³           ³          ³          ³          ³          ³

 

Remember, the Cash Flow Statement used as the business's Budget allows the

owner/manager to anticipate problems rather than react to them after they

occur. It permits comparison of actual receipts and disbursements against

projections to identify errors in the forecast. If cash flow is analyzed

monthly, the manager can correct the cause of the error before it harms

profitability.

 

VI. Pricing Policy

 

Identifying the actual cost of doing business requires careful and accurate

analysis. No one is expected to calculate the cost of doing business with

complete accuracy. However, failure to calculate all actual costs properly

to ensure an adequate profit margin is a frequent and often overlooked

cause of business failure.

 

Establishing Selling Prices

 

The costs of raw materials, labor, indirect overhead, and research and

development must be carefully studied before setting the selling price of

items offered by your business. These factors must be regularly

re-evaluated, as costs fluctuate.

 

Regardless of the strategies employed to maximize profitability, the method

of costing products offered for resale is basic. It involves four major

categories:

 

* Direct Material Costs

* Direct Labor Costs

* Overhead Expenses

* Profit Desired

 

Combining these factors allows you to calculate an item's minimum sales

price, which is described below:

 

1. Calculate your Direct Material Costs. Direct material costs are the

total cost of all raw materials used to produce the item for sale. Divide

this total cost by the number of items produced from these raw materials to

derive the Total Direct Materials Cost Per Item.

 

2. Calculate your Direct Labor Costs. Direct labor costs are the wages paid

to employees to produce the item. Divide this total direct labor cost by

the total number of items produced to get the Total Direct Labor Cost Per

Item.

 

3. Calculate your Total Overhead Expenses. Overhead expenses include rent,

gas and electricity, telephone, packing and shipping, delivery and freight

charges, cleaning expenses, insurance, office supplies, postage, repairs

and maintenance, and the manager's salary. In other words, all operating

expenses incurred during the same time period that you used for calculating

the costs above (one year, one quarter, or one month). Divide the Total

Overhead Expense by the number of items produced for sale during that same

time period to get the Total Overhead Expense Per Item.

 

4. Calculate Total Cost Per Item. Add the Total Direct Material Cost Per

Item, the Total Direct Labor Cost Per Item, and the Total Overhead Expense

Per Item to derive the Total Cost Per Item.

 

5. Calculate the Profit Per Item. Now, calculate the profit you determine

appropriate for each category of item offered for sale based on the sales

and profit strategy you have set for your business.

 

6. Calculate the Total Price Per Item. Add the Profit Figure Per Item to

the Total Cost Per Item.

 

A Pricing Example

 

You produce skirts that take 1 1/2 yards of fabric per skirt, and you can

manufacture three skirts per day. The fabric costs $2.00 per yard. The

normal work week is five days. If you complete three skirts per day, your

week's production is 15 skirts.

 

1. Calculate Direct Materials Cost

 

Materials                                                  Cost

 

Fabric for 1 week's production:

15 skirts x 1 1/2 yds. each = 22 1/2 yds. x $2 per yd.    $45.00

 

Linings, interfacings, etc.:

$.50 per skirt x 15 skirts                                  7.50

 

Zippers, buttons, snaps:

$.50 per skirt x 15 skirts                                  7.50

 

Belts, ornaments, etc.:

$.75 per skirt x 15 skirts                                 11.25

 

Notions, seam binding, etc.:

1 week's supply                                             5.00

                                                          ÄÄÄÄÄÄ

                       Total Direct Materials Cost:       $76.25 per week

 

  Total Direct Materials Cost per week = $5.08 Direct Materials

  ------------------------------------       Cost per skirt

            15 skirts per week

 

2. Calculate Direct Labor Costs

 

Wages paid to employees = $100.00 per week

 

      Total Direct Labor Cost per week = $6.67 Direct Labor Cost

      --------------------------------          per skirt

                 15 skirts

 

3. Calculate Overhead Expenses Per Month

 

Overhead Expenses                                        Monthly

                                                        Expenses

Owner's Salary                                           $400.00

Rent                                                      100.00

Electricity                                                24.00

Telephone                                                  12.00

Insurance                                                  15.00

Cleaning                                                   20.00

Packing Materials and Supplies                             15.00

Delivery and Freight                                       20.00

Office Supplies, Postage                                   10.00

Repairs and Maintenance                                    15.00

Payroll Taxes                                               5.00

                                                    

          Total Monthly Overhead Expenses:               $636.00

 

15 skirts per week x 4 weeks in one month = 60 skirts per month.

 

Total Monthly Overhead Expenses = $10.60 Overhead Cost

-------------------------------          per skirt

      60 skirts per month

 

4. Calculate the Total Cost per Skirt by adding the total individual costs

per skirt calculated in the three preceding steps.

 

Total Direct Material Cost per Skirt                      $ 5.08

Total Direct Labor Cost per Skirt                           6.67

Total Overhead Expense per Skirt                           10.60

                                                     

                TOTAL COST PER SKIRT                      $22.35

 

5. Assume you want to make a profit of $5.00 per skirt.

 

6. Calculate the Total Price Per Item:

 

Total Cost per Skirt                                      $22.35

Total Profit per Skirt                                      5.00

                                                    

  Total Selling Price Per Skirt                           $27.35

 

The Retailer's Mark-Up

 

A word of caution is in order regarding the popular but misunderstood

pricing method known as retailers mark-up. Retail mark-up means the amount

added to the price of an item to arrive at the retail sales price, either

in dollars or as a percentage of the cost.

 

For example, if a single item costing $8.00 is sold for $12.00 it carries a

mark-up of $4.00 or 50 percent. If a group of items costing $6,000 is

offered for $10,000, the mark-up is $4,000 or 66 2/3 percent. While in

these illustrations the mark-up percentage appears generally to equal the

gross margin percentages, the mark-up is not the same as the gross margin.

Adding mark-up to the price merely to simplify pricing will almost always

adversely affect profitability.

 

To demonstrate, assume a manager determines from past records that the

business's operating expenses average 29 percent of sales. She decides that

she is entitled to a profit of 3 percent. So she prices her goods at a 32

percent gross margin, in order to earn a 3 percent profit after all

operating expenses are paid. What she fails to realize, however, is that

once the goods are displayed, some may be lost through pilferage. Others

may have to be marked down later in order to sell them, or employees may

purchase some of them at a discount. Therefore, the total reductions

(mark-downs, shortages, discounts) in the sales price realized from selling

all the inventory actually add up to an annual average of six percent of

total sales. To correctly calculate the necessary mark-up required to yield

a 32 percent gross margin, these reductions to inventory must be

anticipated and added into its selling price. Using the formula:

 

  Initial Mark-up  =  Desired Gross Margin + Retail Reductions

                      ----------------------------------------

                          100 Percent + Retail Reductions

 

    32 percent + 6 percent  =  38 percent  =  35.85 percent

   -----------------------    -----------

   100 percent + 6 percent    106 percent

 

To obtain the desired gross margin of 32 percent, therefore, the retailer

must initially mark up his inventory by nearly 36 percent.

 

Pricing Policies and Profitability Goals

 

Break-Even Analysis, discussed in Chapter IV, and Return on Investment,

described in Chapter III, should be reviewed at this time. Remember, all

costs (direct and indirect), the break-even point, desired profit, and the

methods of calculating sales price from these factors must be thoroughly

studied when you establish pricing policies and profitability goals. They

should be understood before you offer items for sale because an omission or

error in these calculations could make the difference between success and

failure.

 

Selling Strategy

 

Proper product pricing is only one facet of overall planning for

profitability. A second major factor to be determined once costs,

break-even point, and profitability goals have been analyzed, is the

selling strategy. Three sales planning approaches are used (often

concurrently) by businesses to develop final pricing policies, as they

strive to compete successfully.

 

In the first, employed as a short-term strategy in the earliest stages of a

business, the owner/manager sells products at such low prices that the

business only breaks even (no profit), while trying to attract future

steady customers. As volume grows, the owner/manager gradually builds in

the profit margin necessary to achieve the targeted Return on Investment.

 

"Loss leaders" are a second strategy practiced in both developing and

mature business. While a few items are sold at a loss, most goods are

priced for healthy profits. The hope is that while customers are in the

store to purchase the low-price items, they will also buy enough other

goods to make the seller's overall profitability higher than if he had not

used "come-ons." The seller wants to maximize total profit and can

sacrifice profit on a few items to achieve that goal.

 

The third strategy recognizes that maximum profit does not result only from

selling goods at relatively high profit margins. The relationship of

volume, price, cost of merchandise, and operational expenses determines

profitability. Price increases may result in fewer sales and decreased

profits. Reductions in prices, if sales volume is substantially increased,

may produce satisfactory profits.

 

There is no arbitrary rule about this. It is perfectly possible for two

stores, with different pricing structures to exist side by side and both be

successful. It is the owner/manager's responsibility to identify and

understand the market factors that affect his or her unique business

circumstances. The level of service (delivery, availability of credit,

store hours, product advice, and the like) may permit a business to charge

higher prices in order to cover the costs of such services. Location, too,

often permits a business to charge more, since customers are often willing

to pay a premium for convenience.

 

The point is that many considerations go into setting selling prices. Some

small businesses do not seek to compete on price at all, finding an un- or

under-occupied market niche, which can be a more certain path to success.

What is important is that all factors that affect pricing must be

recognized and analyzed for their costs as well as their benefits.

 

VII. Forecasting and Obtaining Capital

 

Forecasting the need for capital, whether debt or equity, has already been

discussed in Chapter V. This chapter looks at the types and uses of

external capital and the usual sources of such capital.

 

Types and Sources of Capital

 

The capital to finance a business has two major forms: debt and equity.

Creditor money (debt) comes from trade credit, loans made by financial

institutions, leasing companies, and customers who have made prepayments on

larger--frequently manufactured--orders. Equity is money received by the

company in exchange for some portion of ownership. Sources include the

entrepreneur's own money; money from family, friends, or other

non-professional investors; or money from venture capitalists, Small

Business Investment Companies (SBICs), and Minority Enterprise Small

Business Investment Companies (MESBICs) both funded by the SBA.

 

Debt capital, depending upon its sources (e.g., trade, bank, leasing

company, mortgage company) comes into the business for short or

intermediate periods. Owner or equity capital remains in the company for

the life of the business (unless replaced by other equity) and is repaid

only when and if there is a surplus at liquidation of the business--after

all creditors are repaid.

 

Acquiring such funds depends entirely on the business's ability to repay

with interest (debt) or appreciation (equity). Financial performance

(reflected in the Financial Statements discussed in Chapter II) and

realistic, thorough management planning and control (shown by Pro Formas

and Cash Flow Budgets), are the determining factors in whether or not a

business can attract the debt and equity funding it needs to operate and

expand.

 

Business capital can be further classified as equity capital, working

capital, and growth capital. Equity capital is the cornerstone of the

financial structure of any company. As you will recall from Chapter II,

equity is technically the part of the Balance Sheet reflecting the

ownership of the company. It represents the total value of the business,

all other financing being debt that must be repaid. Usually, you cannot get

equity capital--at least not during the early stages of business growth.

 

Working capital is required to meet the continuing operational needs of the

business, such as "carrying" accounts receivable purchasing inventory, and

meeting the payroll. In most businesses, these needs vary during the year,

depending on activities (inventory build-up, seasonal hiring or layoffs,

etc.) during the business cycle.

 

Growth capital is not directly related to cyclical aspects of the business.

Growth capital is required when the business is expanding or being altered

in some significant and costly way that is expected to result in higher and

increased cash flow. Lenders of growth capital frequently depend on

anticipated increased profit for repayment over an extended period of time,

rather than expecting to be repaid from seasonal increases in liquidity as

is the case of working capital lenders.

 

Every growing business needs all three types: equity, working, and growth

capital. You should not expect a single financing program maintained for a

short period of time to eliminate future needs for additional capital.

 

As lenders and investors analyze the requirements of your business, they

will distinguish between the three types of capital in the following way:

1) fluctuating needs (working capital); 2) needs to be repaid with profits

over a period of a few years (growth capital); and 3) permanent needs

(equity capital).

 

If you are asking for a working capital loan, you will be expected to show

how the loan can be repaid through cash (liquidity) during the business's

next full operating cycle, generally a one year cycle. If you seek growth

capital, you will be expected to show how the capital will be used to

increase your business enough to be able to repay the loan within several

years (usually not more than seven). If you seek equity capital, it must be

raised from investors who will take the risk for dividend returns or

capital gains, or a specific share of the business.

 

Borrowing Working Capital

 

Chapter II defined working capital as the difference between current

assets and current liabilities. To the extent that a business does not

generate enough money to pay trade debt as it comes due, this cash must be

borrowed.

 

Commercial banks obviously are the largest source of such loans, which have

the following characteristics: 1) The loans are short-term but renewable;

2) they may fluctuate according to seasonal needs or follow a fixed

schedule of repayment (amortization); 3) they require periodic full

repayment ("clean up"); 4) they are granted primarily only when the ratio

of net current assets comfortably exceeds net current liabilities; and 5)

they are sometimes unsecured but more often secured by current assets

(e.g., accounts receivable and inventory). Advances can usually be obtained

for as much as 70 to 80 percent of quality (likely to be paid) receivables

and to 40 to 50 percent of inventory. Banks grant unsecured credit only

when they feel the general liquidity and overall financial strength of a

business provide assurance for repayment of the loan.

 

You may be able to predict a specific interval, say three to five months,

for which you need financing. A bank may then agree to issue credit for a

specific term. Most likely, you will need working capital to finance

outflow peaks in your business cycle. Working capital then supplements

equity. Most working capital credits are established on a one-year basis.

 

Although most unsecured loans fall into the one-year line of credit

category, another frequently used type, the amortizing loan, calls for a

fixed program of reduction, usually on a monthly or quarterly basis. For

such loans your bank is likely to agree to terms longer than a year, as

long as you continue to meet the principal reduction schedule.

 

It is important to note that while a loan from a bank for working capital

can be negotiated only for a relatively short term, satisfactory

performance can allow the arrangement to be continued indefinitely.

 

Most banks will expect you to pay off your loans once a year (particularly

if they are unsecured) in perhaps 30 or 60 days. This is known as "the

annual clean up," and it should occur when the business has the greatest

liquidity. This debt reduction normally follows a seasonal sales peak when

inventories have been reduced and most receivables have been collected.

 

You may discover that it becomes progressively more difficult to repay debt

or "clean up" within the specified time. This difficulty usually occurs

because: 1) Your business is growing and its current activity represents a

considerable increase over the corresponding period of the previous year;

2) you have increased your short-term capital requirement because of new

promotional programs or additional operations; or 3) you are experiencing a

temporary reduction in profitability and cash flow.

 

Frequently, such a condition justifies obtaining both working capital and

amortizing loans. For example, you might try to arrange a combination of a

$15,000 open line of credit to handle peak financial requirements during

the business cycle and $20,000 in amortizing loans to be repaid at, say

$4,000 per quarter. In appraising such a request, a commercial bank will

insist on justification based on past experience and future projections.

The bank will want to know: How the $15,000 line of credit will be

self-liquidating during the year (with ample room for the annual clean up);

and how your business will produce increased profits and resulting cash

flow to meet the schedule of amortization on the $20,000 portion in spite

of increasing your business's interest expense.

 

Borrowing Growth Capital

 

Lenders expect working capital loans to be repaid through cash generated in

the short-term operations of the business, such as, selling goods or

services and collecting receivables. Liquidity rather than overall

profitability supports such borrowing programs. Growth capital loans are

usually scheduled to be repaid over longer periods with profits from

business activities extending several years into the future. Growth capital

loans are, therefore secured by collateral such as machinery and equipment,

fixed assets which guarantee that lenders will recover their money should

the business be unable to make repayment.

 

For a growth capital loan you will need to demonstrate that the growth

capital will be used to increase your cash flow through increased sales,

cost savings, and/or more efficient production. Although your building,

equipment, or machinery will probably be your collateral for growth capital

funds, you will also be able to use them for general business purposes, so

long as the activity you use them for promises success. Even if you borrow

only to acquire a single piece of new equipment, the lender is likely to

insist that all your machinery and equipment be pledged.

 

Instead of bank financing a particular piece of new equipment, it may be

possible to arrange a lease. You will not actually own the equipment, but

you will have exclusive use of it over a specified period. Such an

arrangement usually has tax advantages. It lets you use funds that would be

tied up in the equipment, if you had purchased it. It also affords the

opportunity to make sure the equipment meets your needs before you purchase

it.

 

Major equipment may also be purchased on a time payment plan, sometimes

called a Conditional Sales Purchase. Ownership of the property is retained

by the seller until the buyer has made all the payments required by the

contract. (Remember, however, that time payment purchases usually require

substantial down payments and even leases require cash advances for several

months of lease payments.)

 

Long-term growth capital loans for more than five but less than fifteen

years are also obtainable. Real estate financing with repayment over many

years on an established schedule is the best example. The loan is secured

by the land and/or buildings the money was used to buy. Most businesses are

best financed by a combination of these various credit arrangements.

 

When you go to a bank to request a loan, you must be prepared to present

your company's case persuasively. You should bring your financial plan

consisting of a Cash Budget for the next twelve months, Pro Forma Balance

Sheets, and Income Statements for the next three to five years. You should

be able to explain and amplify these statements and the underlying

assumptions on which the figures are based. Obviously, your assumptions

must be convincing and your projections supportable. Finally, many banks

prefer statements audited by an outside accountant with the accountant's

signed opinion that the statements were prepared in accordance with

generally accepted accounting principles and that they fairly present the

financial condition of your business.

 

If borrowing growth capital is necessary and no private conventional source

can be found, the U.S. Small Business Administration (SBA) may be able to

guarantee up to 90 percent of a local bank loan. By law, SBA cannot

consider a loan application without evidence that the loan could not be

obtained elsewhere on reasonable terms without SBA assistance. Even for

such guaranteed loans, however, the borrower must demonstrate the ability

to repay.

 

Borrowing Permanent Equity Capital

 

Permanent capital sometimes comes from sources other than the business

owner/manager. Considered ownership contributions, they are different from

"stockholders equity" in the traditional sense of the phrase. Small

Business Investment Companies (SBIC's) licensed and financed by the Small

Business Administration are authorized to provide venture capital to small

business concerns. This capital may be in the form of secured and/or

unsecured loans or debt securities represented by common and preferred

stock.

 

Venture capital, another source of equity capital, is extremely difficult

to define; however, it is high risk capital offered with the principal

objective of earning capital gains for the investor. While venture

capitalists are usually prepared to wait longer than the average investor

for a profitable return, they usually expect in excess of 15 percent return

on their investment. Often they expect to take an active part in

determining the objectives of the business. These investors may also assist

the small business owner/manager by providing experienced guidance in

marketing, product ideas, and additional financing alternatives as the

business develops. Even though turning to venture capital may create more

bosses, their advice could be as valuable as the money they lend. Be aware,

however, that venture capitalists are looking for businesses with real

potential for growth and for future sales in the millions of dollars.

 

                        Figure 7-1

            Financing Sources for Your Business

 

Equity (Sell part of company)

   * Family, friends, and other non-professional investors

   * Venture Capitalists

   * Small Business Investment Companies (SBICs and MESBICs)

 

Personal Loans

   * Banks

     - Unsecured loans (rare)

     - Loans secured by:

       Real Estate

       Stocks and Bonds

   * Finance Companies

     - Loans secured by:

       Real Estate

       Personal Assets

   * Credit Unions

     - Unsecured "signature" loans

     - Loans secured by:

       Real Estate (some credit unions)

       Personal Assets

   * Savings and Loan Associations

     - Unsecured loans (rare)

     - Loans secured by Real Estate

   * Mortgage Brokers and Private Investors

     - Loans secured by Real Estate

   * Life Insurance Companies

     - Policy loans (borrow against cash value)

 

Business Loans

 

Loans

 

   * Banks (short-term)

     - Unsecured loans (for established, financially sound companies only)

     - Loans secured by:

       Accounts Receivable

       Inventory

       Equipment

   * Banks (long-term)

     - Loans secured by:

       Real Estate

     - Loans guaranteed by:

       Small Business Administration (SBA)

       Farmers Home Administration (FmHA)

    * Commercial Finance Companies

     - Loans secured by:

       Real Estate

       Equipment

       Inventory

       Accounts Receivable

   * Life Insurance Companies

     - Loans secured by commercial Real Estate (worth at least $150,000)

   * Small Business Administration (SBA)

     - Loans secured by:

       All available business assets

       All available personal assets

   * Suppliers

     - Trade Credit

   * Customers

     - Prepayment on orders

 

Leasing

 

   * Banks

   * Leasing Companies

     - Loans secured by:

       Equipment

   Sales of Receivables (called "factoring")

 

(Source: The Business Store, Santa Rosa, California.)

 

Applying for Capital

 

Below is the minimum information you must make available to lenders and

investors:

 

1. Discussion of the Business

   * Name, address, and telephone number.

   * Type of business you are in now or want to expand or start.

 

2. Amount of Money You Need to Borrow

   * Ask for all you will need. Don't ask for a part of the total and

     think you can come back for more later. This could indicate to the

     lender that you are a poor planner.

 

3. How You Will Use the Money

   * List each way the borrowed money will be used.

   * Itemize the amount of money required for each purpose.

 

4. Proposed Terms of the Loan

   * Include a payback schedule. Even though the lender has the final say

     in setting the terms of the loan, if you suggest terms, you will

     retain a negotiating position.

 

5. Financial Support Documents

 

   * Show where the money will come from to repay the loan through the

     following projected statements:

   - Profit and Loss Statements (one year for working capital loan

     requests and three to five years for growth capital requests)

   - Cash Flow Statements (one year for working capital loan requests

     and three to five years for growth capital requests)

 

6. Financial History of the Business

   * Include the following financial statements for the last three years:

   - Balance Sheet

   - Profit and Loss Statement

   - Accounts Receivable and Accounts Payable Listings and Agings

 

7. Personal Financial Statement of the Owner(s)

   * Personal Assets and Liabilities

   * Resume(s)

 

8. Other Useful information Includes

   * Letters of Intent from Prospective Customers

   * Leases or Buy/Sell Agreements Affecting Your Business

   * Reference Letters

 

Although it is not required, it is useful to calculate the ratios described

in Chapter III for your business over the past three years. Use this

information to prove the strong financial health and good trends in your

business's development and to demonstrate that you use such management

tools to plan and control your business's growth.

 

VIII. Financial Management Planning

 

Studies overwhelmingly identify bad management as the leading cause of

business failure. Bad management translates to poor planning by management.

 

All too often, the owner is so caught up in the day-to-day tasks of getting

the product out the door and struggling to collect receivables to meet the

payroll that he or she does not plan. There never seems to be time to

prepare Pro Formas or Budgets. Often new managers understand their products

but not the financial statements or the bookkeeping records, which they

feel are for the benefit of the IRS or the bank. Such overburdened

owner/managers can scarcely identify what will affect their businesses next

week, let alone over the coming months and years. But, you may ask, "What

should I do? How can I, as a small business owner/manager, avoid getting

bogged down? How can I ensure success?"

 

Success may be ensured only by focusing on all factors affecting a

business's performance. Focusing on planning is essential to survival.

 

Short-term planning is generally concerned with profit planning or

budgeting. Long-term planning is generally strategic, setting goals for

sales growth and profitability over a minimum of three to five years.

 

The tools for short- and long-term plans have been explained in the

previous chapters: Pro Forma Income Statements, Cash Flow Statements or

Budgets, Ratio Analysis, and pricing considerations. The business's

short-term plan should be prepared on a monthly basis for a year into the

future, employing the Pro Forma Income Statement and the Cash Flow Budget.

 

Long-Term Planning

 

The long-term or strategic plan focuses on Pro Forma Statements of Income

prepared for annual periods three to five years into the future. You may be

asking yourself, "How can I possibly predict what will affect my business

that far into the future?" Granted, it's hard to imagine all the variables

that will affect your business in the next year, let alone the next three

to five years. The key, however, is control--control of your business's

future course of expansion through the use of the financial tools explained

in the preceding chapters.

 

First determine a rate of growth that is desirable and reasonably

attainable. Then employ Pro Formas and Cash Flow Budgets to calculate the

capital required to finance the inventory, plant, equipment, and personnel

needs necessary to attain that growth in sales volume. The business

owner/manager must anticipate capital needs in time to make satisfactory

arrangements for outside funds if internally generated funds from retained

earnings are insufficient.

 

Growth can be funded in only two ways: with profits or by borrowing. If

expansion outstrips the capital available to support higher levels of

accounts receivable, inventory, fixed assets, and operating expenses, a

business's development will be slowed or stopped entirely by its failure to

meet debts as they become payable. Such insolvency will result in the

business's assets being liquidated to meet the demands of the creditors.

The only way to avoid this "outstripping of capital" is by planning to

control growth. Growth must be understood to be controlled. This

understanding requires knowledge of past financial performance and of the

future requirements of the business.

 

These needs must be forecast in writing--using the Pro Forma Income

Statement in particular--for three to five years in the future. After

projecting reasonable sales volumes and profitability, use the Cash Flow

Budget to determine (on a quarterly basis for the next three to five years)

how these projected sales volumes translate into the flow of cash in and

out of the business during normal operations. Where additional inventory,

equipment, or other physical assets are necessary to support the sales

forecast you must determine whether or not the business will generate

enough profit to sustain the growth forecast.

 

Often, businesses simply grow too rapidly for internally generated cash to

sufficiently support the growth. If profits are inadequate to carry the

growth forecast, the owner/manager must either make arrangements for

working growth capital to borrowed, or slow growth to allow internal cash

to "catch up" and keep pace with the expansion. Because arranging financing

and obtaining additional equity capital takes time, this need must be

anticipated well in advance to avoid business interruption.

 

To develop effective long-term plans, you should do the following steps:

 

1. Determine your personal objectives and how they affect your willingness

and