Preparing and Understanding Financial Statements by pge12085

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									CHAPTER 7

PREPARING AND UNDERSTANDING
FINANCIAL STATEMENTS
LEARNING OBJECTIVES

After reading this chapter, students should be able to:

   Understand why financial planning is important in new ventures.
   Determine the cash breakeven point for a new venture.
   Conduct what-if scenarios using spreadsheets.
   Prepare a sales forecast.
   Prepare pro forma profit and loss statements.
   Prepare pro forma cash flow statements.
   Prepare pro forma balance sheets.


CHAPTER OUTLINE AND LECTURE

7-1 INTRODUCTION

Entrepreneurs and business owners must develop financial forecasts so they can allocate
resources according to a rational plan.

   Through finanical planning, companies of all sizes, including entrepreneurial ventures, are
    able to control their growth and spending patterns while comparing their actual financial
    performance against their estimated performance.

    o Comparing estimated versus actual performance on a regular basis can help keep a new
      venture on track and prevent it from straying too far from its revenue and cost control
      targets.
    o Large companies do a lot of financial planning. Much of their planning has to do with
      how the company will invest the cash it has on hand.

   The entrepreneurial venture is unlikely to have cash to invest in anything other than the
    venture itself. Thus, in the early stages of a venture, entrepreneurs are more concerned with
    developing reliable estimates and building a realistic financial plan.
Chapter 7: Preparing and Understanding Financial Statements                              7-2


    o A business model is simply the strategies and tactics a business uses to ensure that, at
      least at some point, its revenues will be greater than its costs, resulting in profit.
    o A systematic method for estimating revenue in terms of dollars and cents is done through
      a sales forecast.

7-2 FINANCIAL PLANNING

In order to control the operations of a business, the entrepreneur requires a well-designed
financial plan.

   This can help the entrepreneur stay focused and on track despite the lack of profits during
    this critical phase of the venture’s life cycle.
   The goal is to determine the funds needed to launch and sustain the venture as it grows.
   The financing needed to launch a venture depends on many factors, including the industry,
    experience of the entrepreneur, location of the venture, and inventory requirements.
   In addition to these expenses, the entrepreneur must obtain sufficient seed capital to sustain
    the venture to the point at which its revenues exceed its expenses (it becomes profitable).
   Creating a financial plan helps the entrepreneur transform business goals into reality. In the
    start-up stage, the entrepreneur should estimate the costs for entry into an accounting system.
   This estimate is achieved through pro forma financial statements; the three primary financial
    statements that businesses use to forecast and record operating results:

    o The profit and loss statement,
    o The cash flow statement, and
    o The balance sheet.

   In a business plan, entrepreneurs are typically required to provide pro forma statements that
    estimate operating activity for at least three years and sometimes as much as five years.

    o These statements estimate the profitability and overall financial condition of the company
      over the three-year period.
    o They play an important part in convincing investors and lenders to provide the capital the
      company needs to achieve its growth objectives.
    o These projections also enable the entrepreneur to plan for difficulties, such as periods of
      growth during which capital will be needed to hire additional people, acquire more office
      space and equipment, and purchase additional marketing collateral.

   At minimum, it is essential that the pro forma projections encompass the time periods that
    include:

    o The cash breakeven point: The point in the venture’s growth at which revenues exceed
      costs on a routine (monthly) basis.
    o The profit breakeven point: The point in the venture’s development at which the
      accumulated negative profits are less than the accumulated positive profits.
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   The challenge in developing pro forma financial statements lies in building them on a
    foundation of reasonable and reality-based assumptions.

    o These assumptions provide a set of starting numbers such as price per unit and sales
      volume, that are reasonable guesses.
    o Once the assumptions have been set, they are used to develop the pro forma spreadsheet.
    o Using a spreadsheet enables the entrepreneur to develop a number of what-if scenarios.
    o In general, investors and lenders look at four criteria when evaluating the assumptions
      that underlie financial statements:

            Clarity of expression
            Consistency with knowledge of commercial practices
            Internal consistency
            Comprehensiveness

    o Documenting the assumptions also helps the entrepreneur recall the rationale that lies
      behind them and enables logical changes if business conditions should change.
    o Some of the assumptions that entrepreneurs typically use to generate pro forma financial
      statements include:

            The volume of unit sales per month
            Price per unit of sale
            Costs of selling each unit
            Costs of overhead for the business
            Cost of capital for loans
            Cost of business supplies
            Travel and entertainment costs
            Number and cost of human resources
            Cost of insurance and other professional support

   A spreadsheet is a two-dimensional set of columns and rows and can easily be developed
    using software such as Microsoft Excel.

    o The columns of the spreadsheet usually represent the passage of time; the rows of the
      spreadsheet are the line items that need to be accounted for in each of the time periods.
    o A line item most often is a unit of sale or an expense that the business tracks as part of its
      obligations under GAAP or to enhance its ability to control operations.
    o Columns and rows intersect in what are referred to as cells.

            Cells of a spreadsheet can contain text, a raw number, or a formula that generates a
             number based on other information in the spreadsheet.
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   Entrepreneurial accounting, which is focused on recording and categorizing the operating
    results of the venture. Both types of analysis use the three basic financial statements.
   Before these pro forma statements can be developed, however, the entrepreneur must first
    produce a sales forecast for the venture.

7-2a     The Sales Forecast

The sales forecast, or revenue estimate, is necessary for an entrepreneur to produce the three
basic financial statements.

   A three-year sales forecast is required to generate the numbers that will comprise those
    statements.
   When developing a sales forecast, it is easier for the entrepreneur to think in terms of unit
    volume than total revenue to be generated.
   Multiplying customer volume times the average meal price will determine the venture’s
    revenue.
   The entrepreneur must be careful to ensure that his or her assumptions about sales volume
    have a basis in reality.
   Once pricing has been set, the number of units sold will determine revenue, as indicated in
    this equation:

                                                        P× V= R
                                                Price × volume = revenue

   Inexperienced entrepreneurs are often tempted to manipulate volume assumptions to produce
    revenue estimates that satisfy their desired level of profit.

    o Sales volume assumptions should always be based on market data.
    o Sales volume for each unit has been reasonably estimated for each monthly period,
    o Enter a simple formula into the spreadsheet that multiplies price time’s volume to derive
      expected revenues.

   Most businesses require a period of time before they achieve sales volumes near capacity
    levels. This period of time is called the ramp-up period.

    o The speed of the ramp-up is a function of the type of business and the intensity of
      marketing efforts.

   Another common error that entrepreneurs make in developing a sales forecast is
    overestimating revenue.

    o     It usually takes longer than anticipated for a new venture to acquire and retain sufficient
         customers to produce sustaining revenue.
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    o To account for different operating results, many entrepreneurs develop more than one
      sales forecast, often distinguished as worst case, base case, and best case.

            A worst-case sales forecast will use ultraconservative estimates of sales volume.
            A base-case sales forecast is defined as the most likely scenario barring unforeseen
             problems.
            A best-case sales forecast uses volume estimates that might be attainable if
             everything goes right in the opening and early stages of the venture and continues
             over the projection period.

    o In general, the entrepreneur should reserve best-case projections for private purposes. If
      best-case projections are shared with investors, employees, or others, those people might
      develop incorrect expectations about the venture’s potential.

7-2b     The Profit and Loss Statement

The purpose of the profit and loss statement (P&L) is to state accurately and fairly the profit or
loss of the operations of a company for a given accounting period using GAAP rules.

   One of the primary GAAP rules governing the P&L statement is that the revenue of any
    accounting period should have the appropriate costs of acquiring that revenue attributed in
    the same accounting period.
   Another important GAAP rule that governs the P&L statement separates revenue spent on
    items that are consumed during the accounting period from revenue spent on items that are
    only partially consumed during the period.
   The rule states that revenue spent on any item that has a useful life of more than one year, a
    so-called capital good, is considered a capital expense.
   Spreading the cost of a capital good over the period of its useful life is called depreciation.
    This transaction is treated differently on the cash flow statement.
   Depreciation is called a noncash expense because it is listed as an expense each month on the
    P&L but shows up only once in the cash flow statement, when the transaction occurs.
   It is important to note that all the operating costs of the company must be included in one of
    the three cost categories: cost of goods, selling costs, or general and administrative (G&A)
    costs.

    o This enables the entrepreneur to understand and control the venture.

            Cost of Goods: The cost of goods category includes all costs required to prepare the
             venture’s products or services for sale.

             1. This category may include costs of raw materials, costs of shipping raw materials,
                production, production payroll, or costs to deliver a service.
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             2. Many entrepreneurs list in this category all expenses that are not more clearly
                categorized as selling or G&A costs.

            Gross profit: Gross profit is defined as the venture’s revenue minus cost of goods.

             1. This figure represents the amount of money the business has for its operations.
             2. Looked at another way, gross profit is the amount of money the entrepreneur has
                to spend on selling and G&A costs and to produce profit.

            Gross margin: Gross margin is simply gross profit expressed as a percentage of
             revenue.

             1. It is easier to compare variations in accounting periods with one another using the
                percentage (gross margin) than it is to compare dollar amounts (gross profit).
             2. Slight variations in gross margins across accounting periods may warrant
                investigation. In most businesses, gross margins have a steady trend.
             3. Large variations can indicate problems in purchasing or production costs.

            Sales and marketing expenses: These expenses are associated with marketing and
             selling the venture’s products and services.

             1. All marketing collateral and advertising are selling costs, as are salesperson
                salaries.

            General and administrative expenses: The G&A category is intended to include
             costs that are incurred for the benefit of the entire operation.

             1. Expense items normally listed here include salaries and benefits or expenditures
                not tied directly to production or sales, rent or lease payments, utilities, supplies,
                travel and entertainment, and other items required for operations.
             2. Another term that is often used for these expenses is overhead.

            Profit or net income: Profit, or net income, reflects the so-called bottom line for the
             accounting period.

             1. This figure is generated by subtracting total expenses from total revenues. Net
                income can be positive or negative depending on whether revenues exceeded
                expenses for the period.
             2. Many income statements also calculate net margin, which is a percentage
                obtained by dividing net income by revenue and multiplying times 100.
             3. The net margin figure enables the entrepreneur to compare the performance of the
                venture against others in the industry.

   If the entrepreneur has been diligent to include all revenue and expense items, the P&L
    statement provides a great deal of information about the health of the venture.
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    o The entrepreneur can avoid becoming overwhelmed by the complexity of the P&L
      statement by focusing on a few summary figures. The most important summary figures
      are the gross margin and net income figures.
    o Gross margin tells the entrepreneur whether or not the venture’s cost of goods is in line
      with standards in the industry.
    o Net income is the figure that tells the entrepreneur whether the business has been
      profitable and whether funds are available to distribute to investors or to reinvest into the
      venture.
    o Discovering an entrepreneurial opportunity does not necessarily mean inventing
      something totally new.
    o Carefully studying the P&L statements of competitors in an industry can lead to the
      discovery of a business model that changes the cost structure of the industry.
    o The P&L statement produces numbers that tell the entrepreneur how the business is doing
      from an accounting perspective.
    o This point of view is a critical one, but the entrepreneur must also track the flow of cash
      into and out of the venture through the cash flow statement.

7-2c     The Cash Flow Statement

The purpose of the cash flow statement is to help the entrepreneur manage cash. In a new
venture, cash management is critical.

   Compared to larger firms, new ventures often have understaffed and under-trained
    accounting personnel, volatile cash flows, limited access to new capital, and a significant
    proportion of their net worth tied up in working capital.

    o These limitations are often compounded by management's focus on growth, which can
      put additional pressure on the cash management system by increasing net working capital
      requirements.
    o Working capital is one of the most difficult financial concepts for the small-business
      owner to understand. It is the amount by which current assets exceed current liabilities.

   Fast growth and rising profits mean thin bank accounts for many new ventures. Because
    growth requires larger cash balances and because more funds are tied up in receivables,
    inventory, and payroll, the venture usually will need additional fixed assets.

    o For most businesses, the relationship between sales and assets is stable and predictable,
      even in dynamic markets.
    o This cause-and-effect relationship means that as sales grow, operating cash requirements
      increase.
    o The more rapid the rate of growth, the more complicated is the behavior of the venture’s
      cash flow.
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    o For most entrepreneurs, the cash flow statement is the simplest of the three basic
      accounting statements to use and understand because knowledge of GAAP rules is not
      necessary.
    o The only rule governing the cash flow statement is that cash inflows must be recorded in
      the accounting period during which the cash was received and cash outflows must be
      recorded in the accounting period during which cash was expended.
    o The revenue line items are consolidated figures derived from the sales forecast.
    o The cash flow statement can be produced with each line item entered in the same manner
      as the sales forecast or in consolidated form.

   The outflow line items are similar to those in the income statement. The entrepreneur should
    enter as much detail as necessary to control the venture.

    o Because cash is such an important factor in business success, the entrepreneur should
      strive to produce a cash flow statement that provides ample detail about how the venture
      is using its cash.

   The second outflow line item, sales tax, records the state sales tax that must be paid.

    o Cash for sales tax is collected and held in trust by the business until it is remitted to the
      state. Sales tax is based on customer purchases.
    o It should not be confused with income tax, which is paid on the net income of the
      business.
    o The calculation of the amount of income tax due the government must await the
      completion of the accounting for the period involved.
    o Sales tax can be computed for each customer transaction. The other outflow line items in
      the cash flow statement must cover all transactions that involve cash.
    o At the beginning of a business, items that are purchased monthly on credit will display
      zeros in all cells until the month the payment is made.

   Cash payment for items bought on credit is delayed by the length of time that credit has been
    extended. Extending credit to customers is tempting for new ventures because they are able
    to book revenue on the P&L statement when the sale is made.
   The beginning cash position for a start-up venture is always set at $0 in Year One because all
    the cash transactions for the venture’s first month are included in the statement’s inflows and
    outflows for that month.
   The net change line item indicates the net cash change for the month, whether positive or
    negative.
   The ending cash line shows the cumulative cash position of the company at the end of each
    month.

    o Each month the venture’s cash position is adjusted by the net change for that month,
      which is added to the beginning cash to arrive at the ending cash for that month. Note that
      the ending cash of each month is the beginning cash of the ensuing month.
Chapter 7: Preparing and Understanding Financial Statements                              7-9



   At the end of a fiscal year, which is the twelve-month period the venture is using to record its
    operating performance and which may or may not correspond to the calendar year; the
    ending balance is the next year’s beginning balance.
   To determine how much money a business needs at start-up, the entrepreneur simply needs to
    examine the cash flow statement to identify the lowest negative ending cash position.

    o The lowest negative ending cash position is the minimum amount of money needed to
      start the business.
    o It is not possible for a business to operate with a negative cash ending balance during any
      month.
    o If a negative balance is indicated in any month, arrangements must be made to add
      additional capital or to obtain additional credit.
    o The conservative entrepreneur, preparing for a worst-case scenario, may seek to raise
      invested capital that is two times or more this “lowest negative” estimated cash position
      before launching the venture.
    o The greater the entrepreneur’s experience in the industry and the greater the amount of
      research that underlies the cash flow statement projections, the smaller the contingency
      factor required.

7-2d     The Balance Sheet

The purpose of the balance sheet is to record the capital position of the company, adjusted for
operating results.

   The balance sheet reflects the status of the business at a point in time.

    o It summarizes the cash position and the profit position of the company at the date of the
      statement and accounts for all capital transactions that have taken place since the last
      balance sheet.

   The statement is called a balance sheet because its two major parts must balance according to
    the fundamental accounting equation

                                          Assets = liabilities + owners' equity

    o The date on the balance sheet is the point in time for which the numbers on the statement
      are valid. The numbers might change significantly the next day, but they were valid on
      the date indicated on the balance sheet.
    o Given that the balance sheet is essentially a “snapshot” of the business at a particular
      time, a series of balance sheets is needed to correctly analyze the condition of a company.
    o Sometimes a venture’s balance sheet indicates the possibility of serious trouble on the
      horizon. The major headings on the balance sheet.
Chapter 7: Preparing and Understanding Financial Statements                                 7-10


Assets

The venture’s assets are listed in the order of their liquidity—how quickly they can be turned
into cash. Therefore, the first category of assets is labeled current assets.

   Current assets can be converted to cash within one year, and cash is the first asset listed. Two
    additional current assets are usually accounts receivable and inventory.
   The next category of assets is fixed assets.

    o Fixed assets are those that are not expected to be available as liquid assets in less than a
      year.
    o Many of these fixed assets are depreciated, and the amount of the depreciation is also
      shown in this section.

   Other assets are the final category of assets listed on the balance sheet.

    o This category includes assets and capitalized expenses not used in the daily business but
      not yet charged off to expenses.

Liabilities

Liabilities are debts the business owes to its creditors. Businesses list liabilities on the balance
sheet in the order in which they are due to be paid. Two types of liabilities are listed on the
balance sheet: current and long term.

   Financial obligations of the firm that will be repaid within one year are classed as current
    liabilities.
   Because current liabilities must be repaid within one year, they could create a financial
    crunch for a firm with inadequate cash reserves or other liquid assets.
   Working capital, the difference between current assets and current liabilities, reflects the
    firm's ability to meet its short-term obligations.
   Amounts owed that must be repaid more than one year from the balance sheet date are called
    long-term liabilities.

Owners’ Equity

Owners' equity represents the claims of the owners, partners, and shareholders against the firm's
assets.

   One of the ways that businesses raise capital to operate is by issuing capital stock and selling
    shares of ownership to stockholders.
   A firm's profits can be either distributed as dividends to shareholders or retained and
    reinvested in the firm.
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   Retained earnings are a firm's accumulated net income minus dividends to shareholders.
    Retained earnings help a firm grow and expand by providing the means to invest in land or
    buildings or expand the items carried in inventory.
Chapter 7: Preparing and Understanding Financial Statements                               7-12


KEY TERMS

Assumptions: Starting points for the development of pro forma financial statements.

Base-case sales forecast: A sales forecast that presents the most likely scenario barring
unforeseen problems.

Beginning cash: Figure in the summary of a cash flow statement that represents the amount of
cash available to the business at the beginning of each month.

Best-case sales forecast: A sales forecast that uses volume estimates that might be attainable if
everything goes right in the opening and early stages of the venture and continues over the
projection period.

Business model: The strategies and tactics a business uses to ensure that, at least at some point,
its revenues will be greater than its costs, resulting in profit.

Capital expense: Money spent to purchase a capital good.

Capital good: A useful item that has an expected life of more than one year.

Cash breakeven point: The point in time at which the venture’s cash flow crosses into and
remains in positive territory.

Cell: The intersection of a column and a row in a spreadsheet.

Current assets: Items owned by the company that are cash or near cash, that is, something that
could easily be converted to cash (e.g., a stock certificate).

Current liabilities: Financial obligations of the firm that will be repaid within one year.

Depreciation: The loss of value of a capital good over its expected lifetime.

Ending cash: Figure in the summary of the cash flow statement that shows the cumulative cash
position of the company at the end of each month.

Fiscal year: The twelve-month period in which a firm records its operating performance.

Fixed assets: Assets that are not expected to be available as liquid assets in less than a year.

Formulas: Equations that are entered into cells of a spreadsheet to automatically update entries
in the cell based on changes elsewhere in the spreadsheet.

Income tax: State and federal taxes that are deducted from the income statement based on a
company’s income.
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Line items: The rows in a profit and loss statement.

Long-term liabilities: Amounts owed by companies that must be repaid more than one year
from the balance sheet date.

Net change: Figure in the summary of the cash flow statement that indicates the net cash change
for the month, whether positive or negative.

Net margin: A percentage calculated by dividing net income by revenue and multiplying times
100.

Noncash expense: An expense, such as depreciation, that is listed as an expense each month on
the P&L but shows up only once in the cash flow statement, when the transaction occurs.

Other assets: Balance sheet category that includes assets and capitalized expenses not used in
the daily business but not yet charged off to expenses.

Overhead: Another term for general and administrative expenses, or costs that are incurred for
the benefit of the entire operation.

Pro forma financial statements: The three basic financial statements common to all ventures:
the profit and loss statement, the cash flow statement, and the balance sheet.

Profit and loss statement: Fair and accurate statement of the profit or loss of a company’s
operations for a given accounting period, using GAAP rules.

Profit breakeven point: The point in the venture’s development at which the accumulated
negative profits are less than the accumulated positive profits.

Ramp-up period: A period of time in the sales forecast during which sales are increasing month
by month to reach capacity levels.

Retained earnings: A firm's accumulated net income minus dividends to shareholders.

Sales forecast: The estimate of how many units of each product or service type will be sold over
a period of time and at what price.

Sales tax: State and federal taxes that must be taken off the income statement based on revenue.

Seed capital: Early-stage money usually obtained through personal funds, friends and family, or
angel investors.
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Spreadsheet: A software-based system that enables the real-time entry and manipulation of
figures into financial statements.

Start-up expenses: Expenses incurred to launch a new venture; examples include rent,
marketing and advertising, furniture and fixtures, initial inventory, utility expenses, and salaries.

What-if scenarios: Changes in a spreadsheet that can be deliberately entered to determine what
would happen if the change were to occur in reality.

Working capital: The amount by which current assets exceed current liabilities.

Worst-case sales forecast: A sales forecast that uses ultraconservative estimates of sales
volume.
Chapter 7: Preparing and Understanding Financial Statements                              7-15



PRACTICE QUIZ

    1. The cash breakeven point is the point in the venture’s growth at which revenues exceed
       costs. Answer: True
       Reference: 7-2

    2. The sales forecast, or revenue estimate, is necessary for an entrepreneur to produce the
       three basic financial statements. Answer: True
       Reference: 7-2a

    3. The ramp-up period is the period of time required by a start-up company before it
       achieves sales volumes near capacity levels. Answer: True
       Reference: 7-2a

    4. Depreciation is called a cash expense. Answer: False
       Rationale: Depreciation is a noncash expense because it has no effect on the cash
       position.
       Reference: 7-2b

    5. All the operating costs of a company must be included in one of the three cost categories:
       cost of goods, selling costs, or general and administrative (G&A) costs. Answer: True
       Reference: 7-2b

    6. The cash breakeven point is the point in the venture’s development at which the
       accumulated negative profits are less than the accumulated positive profits. Answer:
       False
       Rationale: The point in the venture’s development at which the accumulated negative
       profits are less than the accumulated positive profits is called the profit breakeven point.
       After this stage, the firm starts making profits.
       Reference: 7-2

    7. The purpose of the balance sheet is to state accurately and fairly the profit or loss of the
       operations of a company for a given accounting period using GAAP rules. Answer: False
       Rationale: The purpose of the profit and loss statement is to state accurately and fairly
       the profit or loss of the operations of a company for a given accounting period using
       GAAP rules. The purpose of the balance sheet is to summarize the cash position and the
       profit position of the company at the date of the statement and to account for all capital
       transactions that have taken place since the last balance sheet.
       Reference: 7-2d

    8. The GAAP rule states that revenue spent on any item that has a useful life of more than
       one year is considered a capital expense. Answer: True
       Reference: 7-2b
Chapter 7: Preparing and Understanding Financial Statements                              7-16


    9. Spreading the cost of a capital good over the period of its useful life is called
       amortization. Answer: False
       Rationale: Spreading the cost of a capital good over the period of its useful life is called
       depreciation. Depreciation is noncash expense.
       Reference: 7-2b

    10. The cost of goods sold category includes all costs required to prepare the venture’s
        products or services for sale. Answer: True
        Reference: 7-2b

    11. A venture’s revenue minus cost of goods is defined as
        a. Gross profit.
        b. Gross loss.
        c. Gross margin.
        d. None of the above.
        Answer: A
        Rationale: Gross profit is defined as the venture’s revenue minus cost of goods. This
        figure represents the amount of money the business has for its operations.
        Reference: 7-2b

    12. Gross margin is gross profit expressed as a percentage of
        a. Loss.
        b. Cost.
        c. Revenue.
        d. None of the above.
        Answer: C
        Rationale: Gross margin is gross profit expressed as a percentage of revenue. It is easier
        for an entrepreneur to compare variations in accounting periods using a percentage than
        using dollar amounts.
        Reference: 7-2b

    13. In a cash flow statement, the lowest negative ending cash position is the ________
        amount of money needed to start the business.
        a. Minimum
        b. Maximum
        c. Maxi-min
        d. None of the above
        Answer: A
        Rationale: To determine how much money a business needs at start-up, the entrepreneur
        simply needs to examine the cash flow statement to identify the lowest negative ending
        cash position. The lowest negative ending cash position is the minimum amount of
        money needed to start the business.
        Reference: 7-2c

    14. In a balance sheet, assets = _____ + owners' equity.
Chapter 7: Preparing and Understanding Financial Statements                                7-17



         a. Liabilities
         b. Gains
         c. Profits
         d. None of the above
         Answer: A
         Rationale: The purpose of the balance sheet is to summarize the cash position and the
         profit position of the company at the date of the statement and to account for all capital
         transactions that have taken place since the last balance sheet. The two major parts of a
         balance sheet must balance according to this fundamental accounting equation: assets =
         liabilities + owners' equity.
         Reference: 7-2d

    15. Assets that are not expected to be available as liquid assets in less than a year are called
        a. Fixed assets.
        b. No assets.
        c. Capital assets.
        d. None of the above.
        Answer: A
        Rationale: Fixed assets cannot be converted to cash in less than a year. Furniture,
        fixtures, buildings, land, equipment, and vehicles are a few examples of fixed assets.
        Reference: 7-2d
Chapter 7: Preparing and Understanding Financial Statements                              7-18


QUESTIONS TO BE DISCUSSED

1. Why is financial planning important for entrepreneurs? Who is likely to use the financial
   statements produced by a venture?

    Answer: In order to control the operations of a business, the entrepreneur requires a well-
    designed financial plan. Some analysts estimate that the average start-up venture can take as
    long as four years to become profitable.

        This can help the entrepreneur stay focused and on track despite the lack of profits during
         this critical phase of the venture’s life cycle.
        The goal is to determine the funds needed to launch and sustain the venture as it grows.
        The financing needed to launch a venture depends on many factors, including the
         industry, experience of the entrepreneur, location of the venture, and inventory
         requirements.
        In addition to these expenses, the entrepreneur must obtain sufficient seed capital to
         sustain the venture to the point at which its revenues exceed its expenses (it becomes
         profitable).
        Creating a financial plan helps the entrepreneur transform business goals into reality. In
         the start-up stage, the entrepreneur should estimate the costs for entry into an accounting
         system.

    As one of the objectives of the new venture is to obtain seed capital, the financial plan could
    be used by investors of the seed capital from sources such as friend and family and angel
    investors.

    REF: 7-2

2. What is the purpose of the sales forecast? Why does the entrepreneur need to document
   assumptions that underlie the sales forecast?

    Answer: The sales forecast, or revenue estimate, is necessary for an entrepreneur to
    produce the three basic financial statements the P&L account, the cash flow statement and
    the balance sheet.

    As the venture is new and yet to be operational most of the numbers taken for the sales
    forecast have to be based on assumptions. However, the entrepreneur must be careful to
    ensure that his or her assumptions about sales volume have a basis in reality.

    REF: 7-2a

3. What is a ramp-up period? How is a ramp-up period reflected in the sales forecast?
Chapter 7: Preparing and Understanding Financial Statements                                7-19



    Answer: Most businesses require a period of time before they achieve sales volumes near
    capacity levels. This period of time is called the ramp-up period. The speed of the ramp-up is
    a function of the type of business and the intensity of marketing efforts. The ramp-up period
    affects the revenue generation in the sales forecast.

    It usually takes longer than anticipated for a new venture to acquire and retain sufficient
    customers to produce sustaining revenue. To account for different operating results, many
    entrepreneurs develop more than one sales forecast, often distinguished as worst case, base
    case, and best case.

    REF: 7-2a

4. What is the purpose of the profit and loss statement? What are two primary GAAP rules that
   apply to the P&L statement?

    Answer: The purpose of the profit and loss statement (P&L) is to state accurately and fairly
    the profit or loss of the operations of a company for a given accounting period using GAAP
    rules.

        One of the primary GAAP rules governing the P&L statement is that the revenue of any
         accounting period should have the appropriate costs of acquiring that revenue attributed
         in the same accounting period.
        Another important GAAP rule that governs the P&L statement separates revenue spent
         on items that are consumed during the accounting period from revenue spent on items
         that are only partially consumed during the period.

    REF: 7-2b

5. Explain what is meant by the term gross profit. How does it differ from gross margin?
   Explain how the entrepreneur can use these two concepts to manage a venture.

    Answer:
    Gross profit: Gross profit is defined as the venture’s revenue minus cost of goods.

        This figure represents the amount of money the business has for its operations.

    Gross margin: Gross margin is simply gross profit expressed as a percentage of revenue.

        It is easier to compare variations in accounting periods with one another using the
         percentage (gross margin) than it is to compare dollar amounts (gross profit).

    In using the concept of gross profit and gross margins:
Chapter 7: Preparing and Understanding Financial Statements                              7-20


        Gross profit is the amount of money the entrepreneur has to spend on selling and G&A
         costs and to produce profit.
        In terms of the gross margins, slight variations across accounting periods may warrant
         investigation and large variations can indicate problems in purchasing or production
         costs.

    REF: 7-2b

6. What is the difference between selling costs and cost of goods sold?

    Answer: It is important to note that all the operating costs of the company must be included
    in one of the three cost categories: cost of goods sold, selling costs, or general and
    administrative (G&A) costs.

        Cost of goods sold: The cost of goods sold category includes all costs required to prepare
         the venture’s products or services for sale. This category may include costs of raw
         materials, costs of shipping raw materials, production, production payroll, or costs to
         deliver a service.
        Selling cost: Many entrepreneurs list in this category all expenses that are not more
         clearly categorized as selling or G&A costs. All marketing collateral and advertising are
         selling costs, as are salesperson salaries.

    REF: 7-2b

7. What is the purpose of the cash flow statement? How does it differ from the P&L statement?

    Answer: The purpose of the cash flow statement is to help the entrepreneur manage cash. In
    a new venture, cash management is critical. While the purpose of the profit and loss
    statement (P&L) is to state accurately the profit or loss of the operations of a company for a
    given accounting period using GAAP rules.

    REF: 7-2b, 7-2c

8. How can the entrepreneur use the cash flow statement to project start-up capital
   requirements?

    Answer: The purpose of the cash flow statement is to help the entrepreneur manage cash. In
    a new venture, cash management is critical.

    o Working capital requirements: It is the amount by which current assets exceed current
      liabilities.
    o Sales tax: The state sales tax that must be paid. Cash for sales tax is collected and held in
      trust by the business until it is remitted to the state. Sales tax is based on customer
      purchases.
Chapter 7: Preparing and Understanding Financial Statements                               7-21




    REF: 7-2c

9. What is the purpose of the balance sheet? Explain the fundamental equation that governs the
   balance sheet. How does the balance sheet differ from the other two financial statements?
   Explain.

    Answer: The purpose of the balance sheet is to record the capital position of the company,
    adjusted for operating results.

    It differs from the P&L and cash flow statements in a number of ways. One of the most
    important differences is that the balance sheet reflects the status of the business at a point in
    time. The balance sheet summarizes the cash position and the profit position of the company
    at the date of the statement and accounts for all capital transactions that have taken place
    since the last balance sheet.

    The statement is called a balance sheet because its two major parts must balance according to
    the fundamental accounting equation we:

                                Assets = liabilities + owners’ equity

    The date on the balance sheet is the point in time for which the numbers on the statement are
    valid. The numbers might change significantly the next day, but they were valid on the date
    indicated on the balance sheet. Given that the balance sheet is essentially a “snapshot” of the
    business at a particular time, a series of balance sheets is needed to correctly analyze the
    condition of a company.

    REF: 7-2d

10. Explain the difference between worst-case, base-case, and best-case scenarios. How should
    the entrepreneur treat the best-case scenario?

    Answer: Worst-case sales forecast: A sales forecast that uses ultraconservative estimates of
    sales volume.
    Base-case sales forecast: A sales forecast that presents the most likely scenario barring
    unforeseen problems.
    Best-case sales forecast: A sales forecast that uses volume estimates that might be attainable
    if everything goes right in the opening and early stages of the venture and continues over the
    projection period.

    REF: 7-2a
Chapter 7: Preparing and Understanding Financial Statements                              7-22


RUNNING CASE: COMMUTER COFFEE

“The Three Basic Accounting Statements”

Introduction: Carlos called the meeting to order. Everyone attended and reported that their
assignments had been completed. Shena stated that she had met with each of the groups to
prepare the assumptions for the financials.

Questions for Discussion

1. The group has elected to invest $40,000 in this venture. Do you think the investment is a
   good idea? Where do you think a group of college students will get that kind of money?
   Explain.

    Suggested approach: Based on the type of business the group intends to start of, the
    students must provide their opinion on whether a sum of $40,000 is a good idea.

    The group must obtain sufficient seed capital to sustain the venture to the point at which its
    revenues exceed its expenses. The seed capital could be obtained from sources such as
    personal funds, friend, and family and angel investors.

    REF: 7-2

2. What is meant by the term leasehold improvements? In this case, what are the improvements
   that might need to be made?

    Answer: Construction or improvements for the purpose of preparing the premises for a
    tenant to conduct business. These improvements are permanently attached to the premises
    and remain with the premises after the end of term of the lease is termed as leasehold
    improvement.

    The students should provide their opinion on what improvements might be required for the
    premises.

3. What are the advantages of using college students as the primary labor for this venture? What
   are some potential disadvantages? What alternatives would you suggest?

    Suggested approach: The students should provide their opinion on the use of college
    students as labor for the new venture. What in their opinion are the advantages or
    disadvantages of such as approach? The students should suggest alternatives for this
    approach.
Chapter 7: Preparing and Understanding Financial Statements                            7-23



EXPERIENTIAL EXERCISE 1

“Prepare a Sales Forecast”

Introduction: The exercise is designed to focus on the underlying assumptions that each group
uses to develop its sales forecast.

Suggested approach: The class is divided into teams of four to six individuals. Each group’s
task is to develop a one-year sales forecast for a simple business model as defined here.

Task: Each team specifies the underlying assumptions that form the basis of its sales forecast.
The assumptions that each team uses can include but are not limited to:

1.   Location
2.   Foot traffic at the location
3.   Average number of customers per day
4.   Average sale per customer
5.   Hours of operation
Chapter 7: Preparing and Understanding Financial Statements                           7-24


EXPERIENTIAL EXERCISE 2

“Discuss Financial Planning with an Entrepreneur”

Introduction: This exercise is based on the assumption that there is no better way to convince
students of the value of financial planning than to hear it from a practicing entrepreneur.

Suggested approach: The students are required to visit with an entrepreneur, or the instructor
will arrange to have an entrepreneur provide a guest lecture in the classroom. Based on this
meeting the students should answer the below mentioned questions:

1.   What are the most challenging cash flow issues that confront your industry?
2.   What credit terms are commonly offered to customers?
3.   How does your company manage its cash?
4.   How often do you review your company’s financial statements?
5.   Who else in the company reviews the financial statements?
6.   Who else outside the company reviews the financial statements?
7.   What role do financial statements play in setting strategy?
Chapter 7: Preparing and Understanding Financial Statements                           7-25



OTHER RESOURCES

Website of interest:

Entrepreneur.com
Go to this site and type in “sales forecast” in the search window on the homepage. There are
articles available that provide information on how to create sales forecasts and how these
forecasts can be used in a business plan.
http://www.entrepreneur.com/

								
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