CHAPTER 16
FINANCIAL ANALYSIS OF A BUSINESS
HOW DO WE JUDGE SUCCESS OF A BUSINESS?
By the amount of money the business earns
Why do most business fail?
1. You start your business for the wrong reasons. Would the sole reason you start a business be that you want to make a lot of money? Do you think you would have more time for yourself or your family? If so, you’d better think again.
2. Insufficient Capital and unrealistic expectations of incoming revenues from sales. You underestimate the amount of money needed to not only start the business but also to stay in business and are forced to close before you have had a chance to succeed
3. Location, Location, Location. A good location can help a struggling businesses survive and a bad location can spell disaster to the best enterprise.
4. Lack of Planning. It is critical to have a business plan. Many businesses who close
their doors may have had success if there had been better planning.
5. Overexpansion. Essential to focus on slow and steady growth. Rapid expansion
creates an environment for bankruptcy.
6. No website. In the U.S. alone, the number of internet users (about 70 percent of the population) and e-commerce sales (about 70 billion in 2004, according to the Census Bureau) continue to rise and are expected to increase with each passing year. In 2004, the U.S. led the world in internet usage.
http://www.businessknowhow.com/startup/business-failure.htm
THE NUMBER ONE REASON FOR BUSINESS FAILURES IS:
7. Poor financial management. One of the leading reasons that businesses fail.
You, as the owner must understand and apply some basic principals
of accounting or your business could fail.
To ensure successful financial management, every business must:
1) keep thorough and accurate records
2) prepare important financial reports regularly
3) interpret financial information in the report
4) make decisions that affect future financial reports
FINANCIAL STATEMENT
By definition, financial statements are reports that summarize financial data over a period of time such as a month, three months, year, or life of business.
Financial data is used differently by different groups depending upon their needs:
A supplier would look at whether to extend credit to a company and how much
A bank would decide whether to lend a business money
A manager would look at past results to plan for the future and in making
day-to-day decisions and
An owner may decide whether to continue business operations based on financial reports.
But they are all looking to answer the same question:
Are we running an efficient and profitable business?
There are four basic financial statements: http://en.wikipedia.org/wiki/Financial_statement
1. Balance Sheet - also referred to as statement of financial condition, reports on a company's assets, liabilities and net equity as of a given point in time.
2. Income Statement - also referred to as Profit or loss statement, reports on a company's results of operations over a period of time.
3. Cash Flow Statement - reports on a company's cash flow activities, particularly its operating, investing and financing activities.
4. Statement of Retained Earnings - explains the changes in a company's retained earnings over the reporting period. Earnings not paid out as dividends but instead reinvested in the core business or used to pay off debt
We are going to focus on two of these statements--probably the ones most used by a business?
Financial reports used MOST by business:
1) Income Statement
2) Balance Sheet
BALANCE SHEET: or statement of financial position
FORMULA: ASSETS = LIABILITIES + OWNER’S EQUITY
(We will refer to is as Balance Sheet)
By definition, it is a financial statement that reports a business’s assets, liabilities,
and capital on a specific date.
It provides the specifics of types and amounts of assets and liabilities.
PARTS OF A BALANCE SHEET:
ASSETS: anything of value owned (ex: cash, building, equipment, inventory)
LIABILITIES: claims against assets --owner’s debt (ex:mortgage on building
CAPITAL - (NET WORTH, OWNER’S EQUITY, STOCKHOLDER’S EQUITY)
It is the amount an organization/individual is worth after subtracting
liabilities - assets
TWO SIDES TO BALANCE SHEETS:
ASSETS -- LISTED AND TOTALED ON LEFT SIDE
Areas under assets, could have:
Merchandise inventory - value of goods purchased to sell to customers at profit
Accounts Receivable - amount customers owe the business
LIABILITIES LISTED ON RIGHT SIDE
Areas under liabilities, could have:
Accounts Payable - amount company owes for purchases it made on credit
Mortgage payable - Mortgage on land, building
CAPITAL LISTED ON RIGHT SIDE BELOW LIABILITIES
CAPITAL ALSO CALLED: NET WORTH, OWNER’S EQUITY,
STOCKHOLDER’S EQUITY
Areas under capital: each owner listed with net worth
Found by subtracting liabilities from assets
Below is a simple accounting formuls: Assets = Liabilities + Capital
Capital can be referred to as Net Worth, Stockholder’s Equity, Owner’s Equity
Assets = Liabilities + Capital
50,000 = 20,000+ 30,000.
What is we don’t know one of the other parts of the formula?
If we know Assets and Liabilities but not Capital?
Assets - Liabilities = Capital 80,000 - 30,000 = 50,000
Back to our basic formula: Assets = Liabilities + Capital 40,000 + 60,000 = 80,000
Assets - Capital = Liabilities 120,000 = 80,000 = 40,000
So, no matter what area in the balance sheet you don’t know, you can easily figure out by adding or subtracting based on the formula: Assets = Liabilities + Capital
BALANCE SHEET SETUP AS THEY LOOK AT THEIR NOTES: (Crown Corporation)
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3 LINE HEADING: LINE 1 - COMPANY NAME
LINE 2 - BALANCE SHEET
LINE 3 - CURRENT DATE
Complete one side of balance sheet at a time. Complete left side, then right side.
Label left side: ASSETS. List assets below title line. Align numbers at right.
Total Assets.
Label right side: LIABILITIES. List liabilities below title line.
Total Liabilities
Label below Liabilities: CAPITAL. List owners, followed by capital
Total Capital if more than one owner listed.
Total Liabilities & Capital - Add Total Liabilities and Capital together.
This amount should equal Total Assets. If it does, double underline both totals.
ACCOUNTING EQUATION - ASSETS = LIABILITIES + CAPITAL
BALANCE SHEETS ARE PREPARED AT LEAST ONCE A YEAR
WHAT DO THEY PROVIDE YOU: A PICTURE OF YOUR FINANCIAL POSITION
ANALYSIS OF THIS BALANCE SHEET FOR CROWN CORPORATION:
1) Have positive net worth--have more assets than liabilities so positive net worth
2) Is it possible to have a negative net worth?
YES IF I have more liabilities than assets
ex: not making enough profits to cover expenses (ex: have a lot of obsolete inventory in computers I am selling. Price has dropped drastically below what I paid for them and I am losing money selling below my cost so eventually will have a net loss---might have to eat it (have to get rid of my inventory) and hopefully can generate enough money to cover losses and make profit--get out of computer business--go to some other line.)
SLIDE 11 INCOME STATEMENTS
SLIDE 12 INCOME STATEMENT - ALSO KNOWN AS PROFIT AND LOSS STATEMENT
is the financial statement that reports total revenue and expenses for a specific
period such as a month or year.
SLIDE 13 There are 3 major parts of an income statement:
1) REVENUE - income earned for the period, such as from the sale of goods and services
2) EXPENSES - all costs incurred in operating the business, such as the cost of materials used to manufacture the company’s product
3) PROFIT OR LOSS - the difference between total revenue and total expenses
SLIDE 14 If revenue is greater than expenses - company has earned a profit
If expenses are greater than revenue, company has incurred a loss
SLIDE: 15 Let’s look at some formulas for income statements
We know that profit or loss is based upon whether revenue is greater
than expenses. So, if revenues are $100,000 and expenses are $90,000
we have a $10,000 profit.
Turn to your worksheet and complete the three problems to determine
profit or loss.
SLIDE 16 Both are important financial statements but basically the different is:
INCOME STATEMENT shows profit or loss for specific period of time: year or less
BALANCE SHEET - shows financial condition of business as of a specific date--a quick look at how much cash on hand. It is a
picture of one day in the life of the firm.
SLIDE 17 THIS IS A SIMPLE INCOME STATEMENT FOR XYZ CORP.
Income statements can be for a month, quarterly which is what
most big companies do; every six months or yearly which is mandatory
for the government. Will want to do more often than that to see how
you are doing Usually do a balance sheet when you do an income
statement
THIS STATEMENT SHOWS HOW THEY DID FOR THE WHOLE
YEAR.
Revenue: Total income for goods I sold
Cost of Goods Sold: What I paid for the merchandise that was sold
Gross Profit: profit before expenses
example: I bought books for $40,000. I sold all of the books for $100,000
and gross profit is $60,000
revenue was $100,000
cost of goods sold was $40,000
gross profit is the profit before expenses is $60,000
will pay all expenses out of gross profit
Operating Expenses: Expenses needed to operate business during the year.
I subtract my operating expenses from my gross profit to determine
whether I have a net profit or net loss for the year or whatever
period I am doing an Income Statement for.
So what does this Income Statement show you? They made 10% on Sales
10,000 divided by $100,000 = 10% which is very good
Most companies make about 2% on sales.
SLIDE 18 CASH FLOW
Movement of cash into and out of a business.
It is money coming in verses money going out.
ex: think of a checkbook
I put money in (deposits)
I pay money out (to pay bills)
Positive cash flow: money left after paying bills
Can I have a negative cash flow? YES, not enough money to
pay bills
You each have a cash flow: You work at McDonalds--make $320 a month. That is part of your cash flow. You owe $400 for your car insurance. For this month, you will have a -80 cash flow because not enough money.
SLIDE 19 WORKING CAPITAL---DIFFERENCE BETWEEN CURRENT ASSETS AND CURRENT LIABILITIES
We already covered assets and liabilities -- current means it is
what can be converted to cash within a year:
ex: when a company purchases good on credit, it expects to pay its
bill within a year - current liability - accounts payable
when a company sells goods on credit, it expects to be paid
within a year - current asset - accounts receivable
As always, we want assets to be larger than liabilities. Corporations
with a larger working capital may find it easier to borrow money.
SLIDE 20
YES - CURRENT WORKING CAPITAL $50,000
SLIDE 21 GIVEN THE INFORMATION, ON YOUR HANDOUT
IS THERE A NET PROFIT OR NET LOSS FOR THE COMPANY
PREPARE A SIMPLE INCOME STATEMENT
HOOVER CORPORATION
INCOME STATEMENT
FOR YEAR ENDING DECEMBER 31, 20065
THAT IS ABOUT ALL WE WILL COVER IN CHAPTER 16
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