Chapter 8 Using Financial Statements to Guide a Business Entrepreneurship Chapter 8 Using Financial Statements to Guide a Business

Entrepreneurs Use Financial Statements Income statement Cash flow statement Balance sheet Data for the financial statements comes from the accounting journal. The statements show the health of the business at a glance.

Income Statement: Scorecard for the Entrepreneur Prepared monthly and at end of fiscal year Also called “profit and loss statement” Shows whether or not business is making a profit Profit is entrepreneur’s reward for adding value to scarce resources

Eight Parts of the Income Statement Revenue Cost of Goods Sold (COGS) Other Variable Costs Contribution Margin (Gross Profit) Fixed Operating Costs (USAIIRD) Pre-Tax Profit Taxes Net Profit/(Loss)

Income Statement

A Simple Income Statement

Income Statement for a More Complex Business

Return on Investment (ROI) Entrepreneurs “invest” time, energy, or money into something 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% What is made over what is paid, times 100.

To Calculate ROI for a Business, You Need 3 Things: Net Profit: found on bottom line of the income statement. Investment: all money used to start the business (Start-Up Investment) plus additional money invested later. The period of time for which you are calculating ROI (typically one month or one year).

Income Statement Ratios Express each line of the income statement as a percentage by dividing sales into it and multiplying by 100. This makes it easy to see how each item is affecting the business’s profit. Return on Sales (ROS) = Net Income/Sales Operating Ratio = Fixed Operating Costs/Sales

Same Size Analysis: Used to Compare Income Statements

The Balance Sheet A “point-in-time” statement Shows how a business is financed Prepared at end of fiscal year 3 items Assets = things a company owns that are worth money Liabilities = debts a company must pay, including unpaid bills Owner’s Equity (OE) = Assets-Liabilities, also called “net worth”

Balance Sheet

Short and Long-Term Assets Assets are all items worth money owned by the business: Current assets—cash or items that can be quickly turned into cash Accounts receivables Inventory Supplies Long-term assets—items that would take the business more than one year to use Equipment Furniture Machinery Real estate

Current and Long-Term Liabilities Liabilities are all debts owed by the business. Current liabilities—debts that must be paid within one year Bills Lines of credit Short-term loans Long-term liabilities—debts that will be paid over more than one year Bank loans Mortgages

The Balance Sheet Equation Assets – Liabilities = Owner’s Equity or Assets = Owner’s Equity – Liabilities Owner’s Equity is also called: Net worth Capital

Assets Must Equal (“Balance”) Liabilities + O.E. If an item was financed with debt, the loan is a liability. If an item was purchased with the owner’s money, it was financed with equity. Liabilities and owner’s equity pay for all items owned by the business (assets).

Analyzing a Balance Sheet The balance sheet shows how a business is financed. Investors use ratios and “same-size” analysis to analyze a balance sheet.

“Same-Size” Balance Sheet Analysis

Quick and Current Ratios Quick Ratio: Cash + marketable securities Current Liabilities Should always be greater than 1 Shows whether there is enough cash to cover all bills within 24 hours Current Ratio: Current Assets Shows whether a business could sell some assets to pay off its debts

Debt Ratios Debt ratios show at a glance how much of the company is financed with debt and how much with equity. Debt-to-Equity Ratio: Debt/Equity Example: ratio of 1 means for every $1 of debt the company owns $1 of assets. Debt Ratio: Debt/Assets Example: ratio of 0.5 means company is in debt for 50% of its assets. Entrepreneurs like to have a fairly high debt ratio, because it means they are financing the business not with their own money but with credit from creditors and suppliers.

Operating Efficiency Ratios Collection Period Ratio: Average accounts receivable (Balance Sheet) Average daily sales (Income Statement) Receivable Turnover Ratio: Total Sales (Income Statement) Average Accounts Receivables (Balance Sheet) Inventory Turnover Ratio: Cost of Goods Sold (Income Statement) Average Inventory (Balance Sheet) = # of days = # of times = # of times