1. Entrepreneurship and Small Business Management
Chapter 13
Using Financial Statements to Guide a Business

2. Ch. 13 Performance Objectives
Understand an income statement.
Examine a balance sheet to determine a business’s financing strategy.
Use the balance sheet equation for analysis.
Perform a financial ratio analysis of an income statement.

3. Ch. 13 Performance Objectives (continued)
Calculate return on investment.
Perform same-size (common-size) analysis of an income statement.
Use quick, current, and debt ratios to analyze a balance sheet.

4. Financial Statements
Entrepreneurs use three basic financial statements:
Income statement
Balance sheet
Cash flow statement
Together, these financial reports show the health of a business at a glance.

5. Income Statement Shows profit or loss over a particular time period
Revenues > Expenses = Positive Balance
Expenses > Revenues = Negative Balance
Prepared monthly
Serves as a scorecard; helps reveal problems

6. Parts of an Income Statement
Revenue
COGS/COSS
Gross profit
Other variable costs
Contribution margin
Fixed operating costs
Earnings before interest and taxes
Pre-tax profit
Taxes
Net profit/(loss)

7. Income Statement: Basic Format

8. Income Statement Calculations

9. A Simple Income Statement

10. An Income Statement for a More Complex Business

11. Balance Sheet
Called a “point-in-time” financial statement because it shows the state of a business at a given moment
Typically prepared quarterly and at the end of the fiscal year (12-month accounting period chosen by the firm)

12. Parts of a Balance Sheet
Assets—things the company owns that are worth money
Liabilities—the company’s debts that must be paid (including unpaid bills)
Owner’s Equity (OE)—
Assets – Liabilities = OE
Also called “net worth”
The amount of capital in the company

13. Balance Sheet (Horizontal Format)

14. Types/Examples of Assets
Current assets—cash, items easily turned into cash, and items used within one year
Accounts receivable
Inventory
Supplies
Long-term assets—items that would take the business more than one year to use
Equipment
Furniture
Machinery
Real estate

15. Types/Examples of Liabilities
Current liabilities—debts scheduled for payment within one year (includes portion of long-term debt due within the year)
Long-term liabilities—debts to be paid over a time period longer than one year
Examples of liabilities:
Accounts payable (bills)
Loans from banks, family, or friends
Mortgages
Lines of credit

16. The Balance Sheet Equation
Assets – Liabilities = Owner’s Equity (OE) or
Assets = Liabilities + Owner’s Equity
Liabilities = Assets – Owner’s Equity
(Net worth and capital are other names for OE.)

17. Total Assets Must Equal (“Balance”) Total Liabilities + Owner’s Equity
If an item was financed with debt, the loan is a liability.
If an item was purchased with the owner’s (or shareholders’) money, it was financed with equity.
Liabilities and owner’s equity pay for all assets.

18. Analyzing Balance Sheet Data
Compare balance sheets from two different points in time to see progress.
Calculate the percentage of change between the reports for each line item.
An increase in owner’s equity is one way to measure success.

19. Income Statement Ratios
Express each line item as a percentage of sales to see the relationship between items.
Amount (M)
Calculation
% of Sales
Sales
$10
($10 ÷ $10) x 100
100%
Less total COGS
$ 4
($4 ÷ $10) X 100
40%
Less other var. costs
$ 0
Contribution margin
$ 6
($6 ÷ $10) X 100
60%
Less fixed op. costs
$ 3
($3 ÷ $10) x 100
30%
Profit
Taxes
$ 1
($1 ÷ $10) x 100
10%
Net profit/(loss)
$ 2
($2 ÷ $10) x 100
20%

20. Return on Investment (ROI)
Entrepreneurs “invest” time, energy, and money because they expect a “return” of money or satisfaction.
Return on investment (ROI) measures return as a percentage of the original investment.
(Net Profit ÷ Investment) X 100 = ROI%

21. Things Needed to Calculate ROI
Net profit—amount the firm has earned beyond what it has spent to cover costs
Total investment—start-up investment plus any additional money invested later
Period of time for which you are calculating ROI—typically one month or one year

22. Return on Sales (ROS)
ROS is also called the “profit margin” because it is an important measure of business profitability.
Net income ÷ sales = ROS
To express this ratio as a percentage, multiply it by 100.

23. Volume and Price Impact ROS
Margin Range
Typical Product
Very low
2-5%
Very high volume OR very high price
Low
6-10%
High volume OR high price
Moderate
11-20%
Moderate volume AND moderate price
High
20-30%
Low volume OR low price
Very high
30% and up
Very low volume OR very low price

24. Common-Sized (“Same-Size”) Analysis
Lets you compare income statements, even if sales amounts vary.
Compare your expenses with those incurred by other businesses in your industry, or for your own company at different points in time.
Operating ratio—expresses what percentage of sales dollars a particular expense item is using up

25. Quick and Current Ratios
Quick Ratio:
(Cash + Marketable Securities) ÷ Current Liabilities
Marketable securities—investments such as certificates of deposit or Treasury bills
If the quick ratio is greater than one, there is enough cash to cover all bills (but not loans) within 24 hours.
Current Ratio:
Current Assets ÷ Current Liabilities
If the current ratio is greater than one, the business could sell some assets to pay off its debts.

26. Debt Ratios Debt-to-Equity Ratio: Total Debt ÷ Equity
Indicates how many dollars in the business were provided by owners/investors
Example: A ratio of 1-to-1 means for every $1 of debt, the company owns $1 of assets.
Debt Ratio: Total Debt ÷ Total Assets
Indicates how many dollars in the business were provided by creditors
Example: A ratio of 0.5 means the company is in debt for 50% of its assets.

27. Operating Efficiency Ratios
Collection-period ratio—measures the average number of days that sales are going uncollected
Receivable turnover ratio—measures the efficiency of your company’s efforts to collect receivables
Inventory turnover ratio—measures how quickly inventory is being sold

28. Formulas for Calculating Operating Efficiency Ratios
Collection-Period Ratio:
Average Accounts Receivable (Balance Sheet)
Average Daily Sales (Income Statement)
Receivable Turnover Ratio:
Total Sales (Income Statement)
Inventory Turnover Ratio:
Cost of Goods Sold (Income Statement)
Average Inventory (Balance Sheet)
= # of days
= # of times
= # of times