PowerPoint Presentations for Small Business Management: Launching and Growing New Ventures, Fifth Canadian Edition Adapted by Cheryl Dowell Algonquin College

Chapter 13 Evaluating and Managing Financial Performance

LOOKING AHEAD After studying this chapter, you should be able to: 1. Describe the purpose and content of financial statements. 2.Identify the basic requirements for an accounting system. 3.Explain two alternative accounting options. 4.Describe the purpose of and procedures related to internal control. 5.Evaluate a firm’s operating liquidity. Copyright © 2013 by Nelson Education Limited 13-3

LOOKING AHEAD Copyright © 2013 by Nelson Education Limited Assess a firm’s profitability. 7.Measure a firm’s use of debt or equity financing. 8.Evaluate the rate of return earned on the owner’s investment. 9. Describe the working capital cycle of a small business. 10. Identify the important issues in managing a firm’s cash flows. 11. Explain the key issues in managing accounts receivable, inventory, and accounts payable.

UNDERSTANDING FINANCIAL STATEMENTS Copyright © 2013 by Nelson Education Limited 13-5 Reports of a firm’s financial performance and resources, including an income statement, a balance sheet and a cash flow – Helps determine a start-up’s financial requirements – Assesses the financial implications of a business plan LO 1

INCOME STATEMENT “How profitable is the business?” Revenue from product or service sales Costs of producing product or service Operating expenses (marketing, selling, general and administrative expenses, and depreciation) Financing costs (interest paid) Tax payments Sales – Expenses = Profits Copyright © 2013 by Nelson Education Limited 13-6 LO 1

Copyright © 2013 by Nelson Education Limited 13-7 INCOME STATEMENT LO 1

ACCOUNTING TERMS income statement a financial report showing the profit or loss from a firm’s operations over a given period of time. Also known as profit and loss statement gross profitsales less the cost of goods sold cost of goods sold the cost of producing or acquiring goods or services to be sold by a firm operating expenses costs related to general administrative expenses and selling and marketing a firm’s product or service Copyright © 2013 by Nelson Education Limited 13-8 LO 1

ACCOUNTING TERMS operating incomeearnings before interest and taxes are paid financing coststhe amount of interest owed to lenders on borrowed money net income available to owners income that may be distributed to the owners or reinvested in the company Copyright © 2013 by Nelson Education Limited 13-9 LO 1

THE BALANCE SHEET Report showing a firm’s assets, liabilities (debt), and owners’ equity at a specific point in time Outstanding debt + Owners’ equity = Total assets Snapshot of a business’s financial position at a specific point in time Copyright © 2013 by Nelson Education Limited LO 1

Assets that can be converted to cash within the firm’s operating cycle—cash, accounts receivable, and inventories Current Assets (working capital) Relatively permanent resources intended for the use of the firm Fixed Assets Intangible assets (patents, copyrights, goodwill) Other Assets Copyright © 2013 by Nelson Education Limited THE BALANCE SHEET Types of Assets LO 1

Accounts payable Accrued expenses Short-term notes Repaid within a 12 month period Short-term Debt Capital (current) Loans and mortgages from banks and other lenders with maturities greater than one year Long-Term Debt Capital Copyright © 2013 by Nelson Education Limited THE BALANCE SHEET Types of Financing LO 1

THE BALANCE SHEET Types of Financing Copyright © 2013 by Nelson Education Limited Owners’ Equity Capital – Money that the owners invest in the business – Owners are “residual owners” of the firm – Creditors have first claim on the assets of the firm LO 1

Owners’ Equity = Owners’ investment – Owners’ cash withdrawals Cumulative profits + Owners’ Equity = Owners’ investment + Earnings retained within the firm Copyright © 2013 by Nelson Education Limited THE BALANCE SHEET Types of Financing LO 1

BALANCE SHEET ASSETS Copyright © 2013 by Nelson Education Limited LO 1

THE FIT OF THE INCOME STATEMENT AND THE BALANCE SHEET Copyright © 2013 by Nelson Education Limited LO 1

BASIC REQUIREMENTS FOR ACCOUNTING SYSTEMS Copyright © 2013 by Nelson Education Limited accurate, thorough picture of operating results quick comparison of current data with prior years’ operating results and budgetary goals facilitate prompt filing of reports and tax returns to regulatory and tax-collecting government agencies reveal employee fraud, theft, waste, and record-keeping errors LO 2

THE RECORD-KEEPING SYSTEM Major Types of Internal Accounting Records – Accounts receivable records – Accounts payable records – Inventory records – Payroll records – GST/HST and PST – Cash records – Fixed asset records – Other accounting records Copyright © 2013 by Nelson Education Limited LO 2

Cash method Revenues and expenses are recognized only when payments are received or expenses are paid Accrual method Revenue and expenses are reported when they are incurred, regardless of when they are received or paid Copyright © 2013 by Nelson Education Limited ALTERNATIVE ACCOUNTING OPTIONS LO 3

Single-entry system A chequebook system of accounting Reflecting only receipts and disbursements Double-entry system A self-balancing accounting system that uses journals and ledgers Copyright © 2013 by Nelson Education Limited ALTERNATIVE ACCOUNTING OPTIONS LO 3

INTERNAL ACCOUNTING CONTROLS Copyright © 2013 by Nelson Education Limited System of checks and balances that safeguards assets and enhances the accuracy and reliability of financial statements Types of internal controls: – Identifying transactions requiring owner authorization – Ensuring cheques issued have supporting documentation – Limiting access to accounting records and computers – Sending bank statements directly to the owner – Safeguarding blank cheques – Requiring employees to take vacations – Controlling access to computer facilities LO 4

ASSESSMENT OF FINANCIAL PERFORMANCE Liquidity can it meet its short-term (one year or less) financial commitments? Profitability producing adequate operating profits on its assets Stability how is the firm financing its assets? Return to owners: an acceptable return on their equity investment? Copyright © 2013 by Nelson Education Limited LO 4

FINANCIAL RATIOS Copyright © 2013 by Nelson Education Limited 23 SME Benchmarking Tool LO 4

Copyright © 2013 by Nelson Education Limited CAN FIRM MEET ITS FINANCIAL COMMITMENTS? Current Ratio Comparing cash and near-cash current assets against the debt (current liabilities) coming due and payable within one year. Industry norm for 2011 current ratio = 1.5 LO 5

MEASURES OF LIQUIDITY Copyright © 2013 by Nelson Education Limited liabilitiesCurrent Inventories - assetsCurrent ratio Acid-test  1.35 $100,000 $210,000 - $345,000 ratio  Acid-test Industry norm for 2011 acid-test ratio = 1.35 Acid-test ratio (quick ratio) – measure of a company’s liquidity that excludes inventories LO 5

Copyright © 2013 by Nelson Education Limited MEASURES OF LIQUIDITY Industry norm for average collection period = 26 days Average Collection Period – average time it takes a firm to collect its accounts receivable LO 5

Copyright © 2013 by Nelson Education Limited MEASURES OF LIQUIDITY Industry norm for inventory turnover = 5.48 times Inventory Turnover – number of times inventories “roll over” during the year LO 5

Copyright © 2013 by Nelson Education Limited RETURN ON INVESTED CAPITAL LO 6

CALCULATE RETURN ON INVESTMENT (ROI) assets Total Sales × profits Operating Operating income return on investment (OIROI)  Copyright © 2013 by Nelson Education Limited LO 6

CALCULATE RETURN ON INVESTMENT (ROI) A measure of operating profits relative to total assets Industry norm for OIROI: 6.96% AssetsTotal income Operating  Operating income return on investment or 10.87% 000 $920, $100,000  Operating income return on investment Copyright © 2013 by Nelson Education Limited LO 6

MEASURING RETURN ON INVESTMENT (ROI) Operating Profit Margin The ratio of operating profits to sales, showing how well a firm manages its income statement. Industry norm for operating profit margin: 3.0% Copyright © 2013 by Nelson Education Limited LO 6

MEASURING RETURN ON INVESTMENT (ROI) Total Asset Turnover A ratio of sales to total assets, showing the efficiency with which the firm’s assets are used to generate sales. Industry norm for total asset turnover = 2.3 Copyright © 2013 by Nelson Education Limited LO 6

TURNOVER RATIOS Accounts receivable turnover Inventory turnover Fixed asset turnover Industry Norm Copyright © 2013 by Nelson Education Limited LO 6

HOW IS THE FIRM FINANCING ITS ASSETS Financial Leverage: The use of debt in financing a firm’s assets Debt-Equity Ratio Industry norm for debt ratio = 42% Copyright © 2013 by Nelson Education Limited LO 7

HOW IS THE FIRM FINANCING ITS ASSETS Times Interest Earned Ratio: The ratio of operating income to interest charges Industry norm for time interest earned = 7.2 Copyright © 2013 by Nelson Education Limited LO 7

RETURN ON EQUITY The rate of return that owners earn on their investment. Industry norm for return on equity = 23.5% Copyright © 2013 by Nelson Education Limited LO 8

WORKING CAPITAL Copyright © 2013 by Nelson Education Limited Working Capital Management – management of current assets and current liabilities Net Working Capital – sum of a firm’s current assets (cash, accounts receivable, and inventories) less current liabilities (short-term notes, accounts payable, and accruals) LO 9

Copyright © 2013 by Nelson Education Limited FINANCIAL RATIO ANALYSIS LO 9

Copyright © 2013 by Nelson Education Limited FINANCIAL RATIO ANALYSIS LO 9

Copyright © 2013 by Nelson Education Limited WORKING -CAPITAL CYCLE LO 9

Copyright © 2013 by Nelson Education Limited WORKING -CAPITAL TIME LINE LO 9

Copyright © 2013 by Nelson Education Limited WORKING -CAPITAL TIME LINE LO 9

Copyright © 2013 by Nelson Education Limited MANAGING CASH FLOWS LO 10 The Nature of Cash Flows – flow of actual cash through a firm Net Cash Flow – difference between inflow and outflows Net Profit – difference between revenue and expenses The Growth Trap – cash shortage resulting from rapid growth

MANAGING CASH FLOWS Copyright © 2013 by Nelson Education Limited LO 10

Copyright © 2013 by Nelson Education Limited CASH FLOW FORECAST LO 10

MANAGING ACCOUNTS RECEIVABLE Credit-Management Practices Use the most effective methods for collecting overdue accounts Review previous credit experiences to determine impediments to cash flow Minimize the time between shipping, invoicing, and sending notices on billings Provide incentives for prompt paymentAge accounts receivable on a monthly or even a weekly basisUse a lock box Copyright © 2013 by Nelson Education Limited LO 11

ACCOUNTS RECEIVABLE FINANCING Copyright © 2013 by Nelson Education Limited LO 11

Copyright © 2013 by Nelson Education Limited MANAGING INVENTORY LO 11 Negotiation – Asks creditors for adjustments or additional time Timing – Creditors’ funds can supply short-term cash needs until payment is demanded – Accounts with cash discounts for early payment should be examined for their savings potential – “Buy now, pay later”—pay early enough to get cash discounts and timely enough to avoid late-payment fees