Course Materials
BANKING THE INDEPENDENT BUSINESS
Steven C. LeFever
Chairman
Profit Mastery
Seattle, Washington
August 10 - 12, 2016
© Business Resource Services Inc.
200 First Avenue West · Suite 301 · Seattle, WA 98119
Phone 206-284-5102 · Fax 206-282-4092
E-mail [email protected]
·
Website www.brs-seattle.com
Profit Mastery: Banking the Independent Business
Madison, WI August 12-14, 2015 Presented by Steve LeFever, Chairman Profit Mastery Seattle, WA Business Resource Services Inc.  200 First Avenue West  Suite 301  Seattle, Washington 98119 Phone 206‐284‐5102  Fax 206‐282‐4092  E‐mail: [email protected]  Website www.profitmastery.net Bio
Steve LeFever, Chairman and Founder, Business Resource Services
Finance = boring. For Steve LeFever, this equation doesn’t work.
With a superior command of his subject material, he makes finance compelling,
interesting, and funny. Steve’s unique ability to take complex topics and translate
them into plain English separates him from the crowd.
Our clients routinely tell us they never expected to take away so much new
knowledge from a keynote speech. Steve has a rare skill – being able to motivate
business owners and advisors to enthusiastically explore the financial workings of a
business and change the areas that need changing. Steve will make you believe that
finance ≠ boring; instead you’ll agree with him when he says, “Finance is fun!”
Part comedian, part financial manager, former commercial banker, current
entrepreneur, and 100% world-class presenter, Steve drives home his message with a no-nonsense, laugh-out-loud approach
that makes him the top-rated presenter at virtually every conference he attends. For over 20 years, Steve has combined
humor and practical knowledge in hard-hitting, substantive presentations. His ratings currently rank him as the highlight of
our clients’ conventions in a wide spectrum of industries.
An internationally-recognized author and advocate for independent business, Steve’s book, “Profit Mastery: KnowledgeDriven Financial Performance” has sold over one million copies.
Steve has travelled widely, and the Profit Mastery program has been presented on three continents in eight languages over
two decades to hundreds of thousands of business owners, managers, commercial bankers, accountants, and business
coaches.
Recent Keynote Bookings
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Sample List of Keynotes Speeches
Pearle Vision, Las Vegas, NV
National Association of Quick Printers, Austin,
TX
Sylvan Learning, Phoenix, AZ
Faegre & Benson Franchise Summit,
Minneapolis, MN
Do it Best, Indianapolis, IN
Famous Dave’s, Las Vegas, NV
Association of SBDC, Orlando, FL
Oreck, Nashville, TN
Multi-Unit Franchisee Show, Las Vegas, NV
Comfort Keepers, Louisville, KY
Hearts on Fire, Las Vegas, NV
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Beyond Survival: Seven Steps
to Fiscal Fitness (60-90 minutes)
Taking Stock, Taking Action:
Managing Your Business In An Uncertain
Economy (60-75 minutes)
Break-Even Analysis: Your Path
to Greater Profits (75-90 minutes)
Small Business Banking: Full
Service or Lip Service? (60-75 minutes)
Compelling Subject Matter - Financial management education is repeatedly cited as the single greatest need for business
owners across all industries. Steve LeFever is the acknowledged expert on the subject. Our educational programs take the
mystery out of the numbers. Audience members with differing levels of expertise will gain specific tools that can be applied
immediately to improve the financial health of their companies.
Industry Knowledge - Steve possesses a breadth of knowledge and experience in banking, finance, and small business
management. His work with the Risk Management Association (RMA), the Association of Small Business Development Centers
(ASBDC), and financial institutions around the globe help keep his insights sharp and his information relevant to business
owners, operators, and managers.
Business Resource Services • 200 First Avenue West • Suite 301 • Seattle, WA 98119
800-488-3520 toll free • [email protected] • www.brs-seattle.com
© 2010 Business Resource Services
Profit Mastery:
Keeping the Company in Shape
Whether you’re a manufacturer, wholesaler, retailer, service, farmer or professional — you are (or
will be) a business owner. Since you became involved in business, you have undoubtedly come to the
realization that you have many roles — or “hats” — to wear if you are to be successful.
Independent Business
Of the more than 26,000,000 businesses operating in today's economy, over 98% would be
defined as “small”; and yet, their cumulative effect is staggering. Consider the following
statistics: small business accounts for . . .
Over 50% of private employment
Creation of 75% of new jobs
Over 45% of total business output
Over 50% of the GDP (Gross Domestic Product)
In addition, small business accounts for about two-thirds of the innovation and, currently, the
growth rate in employment in small business is over eight times that of employment growth in
other sectors.
Entrepreneurs
In ever-increasing numbers, people are going into business for themselves. Sometimes this is
planned, sometimes not: some marry it, some inherit it, some get laid off. Others have a drive to
build a better mousetrap; or to build net worth; or to pursue that special American Dream of a
better life. Maybe it's just the chance to be a part of something that you built; succeeding on
your own merits. Maybe it's a combination of all of these. In any case, the entrepreneurial spirit
is alive and well.
Your Role
What is your role in your business? Most of the time, if there are two people involved in a
business, one knows how to make it and one knows how to sell it. The financial management is
often left to others — with the implicit understanding that if we can make it and sell it, then
we're okay.
©BRS 2015
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Financial Management
Profit Mastery addresses your role as a money manager. Of course, most business owners have
not been trained professionally in accounting or finance; but given the uncertain nature of
business and economic cycles combined with an increasingly rapid rate of technological change,
monitoring your financial condition and making sound financial decisions has never been more
important. In short, financial management is too important to leave solely to accountants and
bankers — after all, it's your business that will either prosper or suffer as a result of financial
decisions.
Business Failures
Of all the new businesses that are formed each year, approximately 80% fail within the first ten
years. Records show over 90% of business failures are attributable to faulty management —
more precisely, poor financial management. Here are the primary financial killers:
1. Failure to plan properly before start up.
2. Failure to monitor financial position.
3. Failure to understand the relationship between price, volume, and costs.
4. Failure to manage cash flow.
5. Failure to manage growth.
6. Failure to borrow properly.
7. Failure to plan for transition.
Profit Mastery: Control
Attempts to achieve physical fitness through crash diets, impulsive exercise, or superficial
cosmetic and other quick-fix methods almost never work. The same is true in your business.
Financial survival and health are the result of continuous management and control applied
according to a plan. And the plan needs to be backed up by a sound knowledge of basic financial
issues. That's how profit mastery is achieved and maintained.
The goal of this program is to provide access to all the necessary parts of the process. Your
challenge is to gain control; to format the information and apply the process; to recognize
symptoms and follow them back to causes — and to design corrective action steps. Financial
management is not an all-or-nothing proposition. Whether this program is a first step or a review
of techniques learned long ago, the journey through the process can be as rewarding as the result.
©BRS 2015
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Financial Performance
Statements and Ratio Analysis
DEFINITION......Financial position refers to the economic condition of your business in
comparison to its own past performance and to other companies of
similar size.
REVIEW ..............Section One reviewed the basic legal and tax issues affecting all
businesses. The information in this section actually provides the
means for a critical analysis of management roles and business
organization in relation to both tax and non-tax issues.
IMPACT ..............Determining your financial position is crucial to “fine tuning” your
management decisions. It provides the level of detail a business owner
needs to make sound choices.
RESULTS ............The information derived from financial position calculations lets you
focus your attention on the causes of your business’ financial strengths
and weaknesses. With this information you can take positive action to
keep what is working and to improve what isn’t.
The Goal:
Determining your solvency, risk, and efficiency
The Tools:
Statement Spread Sheets
Financial Management Ratios
Cause and Effect “Road Map”
©BRS 2015
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Key Terms
Assets ....................................................................... Everything that the business owns — including such items as cash,
inventory, prepaid expenses, and vehicles.
Balance Sheet ................................................. A statement of financial position that shows the assets, liabilities and net
worth of the business.
Current Assets ................................................ What the business owns that’s expected to be turned into cash within
one year — such as accounts receivable and inventory.
Liabilities ............................................................. What the business owes to creditors — to the people who supply funds
that must be repaid. Debt is another term for liability.
Current Liabilities ...................................... Obligations that are due to be repaid within one year.
Long-Term Debt ........................................... Obligations that are scheduled to be repaid in a period greater than
one year.
Net Worth ........................................................... What the business owes to the owners — the investment that the owners
have in the company. Also called owners’ equity.
Retained Earnings....................................... The net profits (positive or negative) from the income statement that are
left to accumulate in the business.
Leverage ............................................................... The increased rate of return that is made on net worth by using debt to
acquire assets.
Income Statement ........................................ The summary of the revenues, costs and expenses of a company that are
recognized during an accounting period.
Gross Profit ....................................................... Sales minus the Cost of Goods Sold, which is the cost of buying raw
materials and producing finished goods.
Net Profit ............................................................. The amount remaining after all expenses have been met. The difference
between total sales and total costs and expenses.
©BRS 2015
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The Financial Operating Cycle:
You’re in the Dollars and Cents Business
As the owner of an independent business, you’re challenged by having to play multiple roles in a
limited time. You put on and take off a series of management hats — and sometimes you wear
them simultaneously. But the one hat you can never shed is that of financial manager and
planner. You can’t take it off and you can’t give it away.
In fact, when you finally have an accounting system that produces timely and accurate financial
statements, your primary ownership responsibility begins — understanding and interpreting
exactly what it is you have.
The process of analyzing your statements is a glamourless nuts-and-bolts kind of task. The best
way to start — indeed, the only way to start — is to roll up your sleeves and dig in. Three steps
are required:
First .........understand how your statements are formulated — their
structure, composition, and how they work together.
Second .....actually use your data to produce a series of financial ratios.
Third........interpret — use the ratios to analyze the causes and effects of
financial events in your company.
The Right Information
We live in an age where access to information has increased exponentially. Computers now
have the ability to bombard us with a magnitude of data — the sheer volume of which is enough
to destroy one’s interest in analyzing and using it.
Many of us have grown to believe that computers don’t make mistakes and, therefore, computergenerated information must surely be accurate. Maybe computers don’t make errors; but people
do. We’ve even coined a phrase for this process: GIGO — Garbage In, Garbage Out.
In no area of our business lives is this phenomenon more relevant than in the area of financial
management. Relatively sophisticated accounting systems are capable of generating mountains
of data — in fact, far in excess of what most of us need. As former commercial lenders, we
analyze and use financial data regularly and never cease to be amazed at the quality of
information that passes for financial statements. It seems that many business owners get the
wrong data at the wrong time for the wrong reasons.
We’ve often said that for many of our clients, their primary strengths as business practitioners
were knowing how to “make it” or “sell it.” Most were not CPA’s by training and many
considered financial management as nothing more than a “necessary evil.”
©BRS 2015
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Most closely-held businesses did not invest in the added expense of audited statements, so
financial data was often limited to a compilation of data provided by the owner — and
accompanied by a solid don’t-blame-me disclaimer from the accountant. In many cases, if
financial data was produced at all, it was often received months after the fact.
For many businesses, financial record-keeping evolved only as a means to minimize taxes.
Accountants are retained and rewarded based on their ability to make profits disappear — sort of
a “watch carefully, the fingers never leave the hands” approach.
How Many Sets of Statements?
Many businesses wisely produce more than one set of statements from “the books” (the General
Journal and General Ledger). How many sets? Usually, at least two — and sometimes three.
One for the tax man — who uses the tax rules and regulations to produce the smallest taxable net
profit possible; one for the banker — with the brightest profit picture possible; and (maybe) one
for the owner — with the most realistic picture possible. Since the statements usually aren’t
labeled, we sometimes wondered which set we had been given.
As an owner, the worst person to kid is yourself. You are the boss and should be the first to
know when there is a problem brewing. In fact, information developed and decisions made
solely for tax purposes may not be good business decisions in the long run. Put another way: a
good tax decision that is a bad business decision . . . is a bad decision.
Most businesses have never given much thought to the reason they want profits. Everyone
knows profits are the measure of success in a capitalistic system. But there are really three
fundamental uses for profits:
1. To distribute to owners
2. To purchase new assets for growth
3. To repay debt
Certainly everyone recognizes the need for distribution to owners; that’s the name of the game.
Also, most companies want to grow, and to grow you need more assets. Finally, you need
profits to repay debt used to purchase existing assets (many bankers, of course, would accuse us
of having our priorities reversed; repayment of debt is number one in their books).
Let’s pose a question: which one of the three uses of profits is the most important? Hopefully
the answer you’d arrive at is all three. For the long-term viability of any company, the business
must supply suitable profits to satisfy all three requirements.
©BRS 2015
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The Income Statement
Since accurate, timely information is the key to effective decision making, let’s briefly review
how the financial data is generally formatted on the income statement to arrive at a measure of
profitability.
The income statement (also called a profit and loss statement or a “P & L”) simply represents the
results of operations over a given time — say a quarter or a year. The primary benchmarks are
gross profit and net profit. Gross profit measures what remains after direct expenses — such as
direct labor and materials — are subtracted from revenue. Net profit measures what remains
after general operating expenses are subtracted from the gross profit. The key financial issues
relating to the income statement are pricing, margin maintenance, and expense control.
In contrast to the balance sheet, which gives a cumulative picture of your business, the income
statement shows the operating results for one period — a month, a quarter or a year. Here is a
sample income statement from one of our case studies. Take a look at the format and accounting
categories.
Cascade Office Systems
Income Statement
For the Twelve Month Period
Sales
$1,520,000
Cost Of Goods Sold
1,200,000
Gross Profit
$ 320,000
Expenses
Salary ........................................................... 152,000
Payroll Taxes ................................................. 16,400
Advertising ...................................................... 2,000
Utilities ............................................................ 4,800
Office Supplies ................................................ 5,500
Insurance .......................................................... 7,800
Bad Debts ........................................................ 4,000
Depreciation................................................... 19,000
Vehicles ........................................................... 8,600
Accounting....................................................... 5,800
Travel/Entertainment ....................................... 9,500
Shop Supplies .................................................. 5,500
Taxes ................................................................ 4,000
Other .............................................................. 2,100
Total Expenses
$ 247,000
Operating Profit
$ 73,000
Interest
Other Income/(Expense)
(26,600)
8,000
Net Profit Before Tax
$ 54,400
Tax
Net Profit After Tax
9,500
$ 44,900
©BRS 2015
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The Balance Sheet
Although the income statement is familiar to most business owners, the balance sheet often
remains a mystery. We termed it the “forgotten statement” because some bank customers left it
out of their loan proposals altogether. Since they didn’t use it much, it didn’t seem that
important.
The balance sheet, however, represents the most important information to a lender: it provides an
accurate reflection of the financial health of the business. Let’s review the parts of this key
financial statement.
The balance sheet gives you a financial “snapshot” of your business on one particular date and
time. It shows the cumulative record of business activity since the business opened — day one
to the present. The two “sides” of the balance sheet are:
Assets: what the business owns.
Liabilities and Net Worth: what the business owes (to those who
supplied the funds to buy the assets — the creditors and the
owners).
Most people define the relationship between the three components of the balance sheet —
ASSETS, LIABILITIES, and NET WORTH — in the following manner:
Assets – Liabilities = Net Worth
What you own minus what you owe is what you’re worth — at least on paper.
However, for the purposes of financial analysis, it makes a lot more sense to look at the
relationship in the following manner:
Assets
=
Liabilities
+
Net Worth
This equation represents the undeniable capitalistic formula. The sides of the balance sheet must
balance (assets always equal liabilities plus net worth) because for every dollar invested in
assets, someone had to supply the dollar. The next page contains a sample balance sheet from
the same case study we used for the income statement.
©BRS 2015
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Cascade Office Systems
Balance Sheet
as of Year End
Assets
Liabilities and Net Worth
Cash
Accounts Rec. - Trade
Inventory
Accounts Rec. - Officer
Other
$ 41,700
169,400
212,200
3,000
10,700
Notes Payable - Bank
Current Portion - LT Debt
Accounts Payable - Trade
Accruals
Other
$ 52,800
32,500
99,800
44,100
26,700
Total Current Assets
437,000
Total Current Liabilities
255,900
Vehicles
Furniture/Fixtures
Equipment
Buildings
Land
Accumulated Depreciation
25,700
24,300
108,300
130,000
20,000
(85,000)
Long-Term Debt
144,300
Total Liabilities
400,200
Capital Stock
Retained Earnings
60,000
200,100
Fixed Assets (net)
223,300
Net Worth
260,100
Total Assets
Total liabilities
And Net Worth
$660,300
$660,300
Stated another way, from a financing perspective, an asset is something you own; but to own it,
you had to buy it. The question is: who supplied the money to buy the assets? You need to look
to the right-hand side of the balance sheet for the two sources: the creditors and owners.
Together they supplied all the funds to purchase the assets.
Retained Earnings — The Key Link in the Financial Cycle
From our sample balance sheet, you can see that the two primary components of the net worth
section are capital stock and retained earnings.
Retained earnings are perhaps the most misunderstood area of the entire balance sheet. There are
two key features of retained earnings to keep in mind:
1. They’re cumulative — since the day the company began.
2. They are generally not cash.
©BRS 2015
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This second feature is especially important. Is it possible to have retained earnings but no cash?
The answer is an emphatic YES! So where have the earnings gone? The answer to this question
brings us around to profits again — and establishes our concept of a dynamic financial
relationship between the income statement and the balance sheet.
The fact is, both the balance sheet and the income statement together are needed for effective
financial analysis — one is relatively useless without the other. Here’s a visual representation of
the relationship between the balance sheet and the income statement — and of the dynamic
financial cycle that needs to operate in every business.
The Financial Operating Cycle
INCOME STATEMENT
Sales
Net Profit
BALANCE SHEET
Assets
= Liabilities
+ Net
EFFICIENCY
Uses of Profits:
Back to:
Assets
Liabilities
Net Worth
1. To pay for new assets.
2. To pay off debt
3. To pay out to the owners.
Let’s look at the cycle in detail. As we just noted above, an asset is something you own. But in
order to own it, someone must supply funds to buy it. In a business there are two sources who
supply funds: the creditors and the owners.
But why do you own assets? Unless you collect them, you generally have them to produce sales.
And why do you produce sales? Why, to make net profit, of course. This, however is not the
end of the story. At the end of the accounting period, the bookkeeper closes out all the revenue
and expense accounts, and whatever is on the bottom line is transferred to retained earnings.
Visually, the procedure would look something like the diagram on the following page.
©BRS 2015
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THE BALANCE SHEET / INCOME STATEMENT CONNECTION
ASSETS
Cash
Accounts Receivable
Inventory
Total Current Assets
Land
Building
Fixtures
Equipment
Depreciation
Total Fixed Assets (net)
Total Assets
Sales
- Cost of Goods Sold
Gross Profit
Operating Expenses
Salaries
Rent
Advertising
Depreciation
Taxes
LIABILITIES
Notes Payable
Accounts Payable
Accruals
Total Current Liabilities
Long-Term Debt
Mortgages
Total Long-Term Liabilities
Total Expenses
Operating Profit
- Interest and Other Income
Net Profit Before Tax
- Tax
Net Profit (after tax)
NET WORTH
Capital Stock
Retained Earnings
Total Net Worth
Total Liabilities and Net Worth
Efficiency — How Well the Cycle Operates
After the bookkeeper closes out the net profit after tax line and transfers the amount to retained
earnings, net worth is increased (that is, of course, if net profit after tax was positive). So profits
increase net worth. But where did the cash go? Well, it went to one of the three uses of profits:
 To pay out to the owners in the form of dividends
 To pay off existing liabilities
 To pay for new assets
And so it goes — around and around. But there is one last component that measures how well it
all works: efficiency. Efficiency in converting assets to revenue, efficiency in converting revenue
to profits, efficiency in structuring liabilities and net worth. Generally speaking, the key to
business success lies in keeping this financial cycle working properly.
Almost everything we do in life gets measured in some form of performance analysis: baseball
batting averages, grade point averages, even the likelihood of rain today. Each of these numbers is
a ratio — a comparison. Using a series of financial ratios, we will outline the process of financial
performance analysis — using the information from the financial statements to measure the health
and progress of the business.
This means your information has to be both timely and accurate. Otherwise, GIGO. And this is
one of the many places in business that you don’t want to fool yourself because, after all, you're in
the dollars and cents business.
©BRS 2015
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The Working Capital Cycle
For many business owners, a second cycle, the working capital cycle, operates within their balance
sheet. For those of us who have inventory and/or accounts receivable in our businesses it is
important to track how efficiently we manage those assets.
Here’s how the cycle works: we start out with cash and purchase some inventory. We then turn
loose our crack sales force who sell the inventory, and every once in a while we hear those two
dreaded words in business - “charge it” or “bill me”, and an account receivable is created. Don’t
worry, our collection department efficiently collects the payments due and we are back to cash
again — cash to purchase new inventory and a little left over to do some other things in the
business, like pay rent, make payroll, etc. Visually the cycle looks like this:
Working Capital Cycle
Cash
Accounts
Receivable
Inventory
This cycle works for every business in the world. “Aha!” you say, “my business is different. I’m
a retailer and all my customers pay in cash.” In that case your cycle goes from cash to inventory
and back to cash again. Or you are a service business with no inventory; in this case your cycle
runs from cash to accounts receivable and back to cash again. The principles in each case are the
same, how we apply them might be different. The similarities far outweigh the differences as we
all are in the same business - the business of dollars and cents, how cash flows through our
businesses.
As bankers we used to call this cycle “the survival cycle”. Every business owner needs to know
what drives the cycle in their business, and what sucks cash out of the cycle. It is a key measure
of our efficiency as business owners. Managing the cycle more efficiently (making the circle turn
faster) will generate more cash for our business and reduce the level of bank loans needed to
supplement our working capital.
©BRS 2015
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Profit Mastery
Relationships that Show the Health of Your Business
Taken together, the balance sheet and income statement represent a complete financial picture of
your company. As we mentioned, many businesses produce at least two sets of financial
statements (and maybe three: one for the IRS, one for the banker, and one for the owner). But
remember you can't fool all of the people all of the time and the worst possible person to kid is
yourself. You need clear, concise, “decision-relevant” information.
With that in mind, let's take your financial information and develop a set of measurements that
will allow us to monitor both your current position and your progress. We will do this through the
development of a series of financial relationships or ratios.
Making Valid Comparisons
A ratio is nothing more than one number in relation to another. They have the very practical
property of reducing a relationship to a single number no matter the size of the two numbers
involved. For example, the ratio of 2:1 can be derived from the number 20 divided by 10, or 200
divided by 100, or 200,000 divided by 100,000. The ratio doesn't care about the absolute size, it
only cares about the relationship. It's this relationship we will use to measure and manage your
financial effectiveness.
Clearly, the question that arises is “which relationships to measure?” There are many possibilities
and each financial analyst will have his or her own preference. We use the K.I.S.S. principle
(Keep it Simple, Stupid!) — that is, calculate enough information to get the job done, but not so
much as to become confusing. The charts on the following pages provide the ones we think are
basic for almost any business.
The action steps are simple: first, you need financial statements for three years — or as many as
you have. Second, you need to lay out your statements in a spread sheet format, which is nothing
more than putting all the financial data on one sheet, side-by-side, by year. Third, use the same
spread sheet format to calculate your financial ratios.
Take a few minutes to study the attached ratios — how they're derived and what they measure.
Note that the ratios are broken down into three functional areas: balance sheet ratios, profitability
ratios, and asset management ratios. We will be looking to develop financial “balance”; no one
individual ratio tells the entire story. Taken together, however, they begin the process of
analyzing performance and, more importantly, planning for the future.
Using Ratios as Tools
In general, there are three ways to use these ratios to analyze your business: first, to compare your
current performance to your performance in prior years — your trends; second, to compare your
present performance to others in your industry; and third, to compare your ratios to your plans in
developing a workable operating strategy.
You operate and manage your company with limited resources, management, capital, and time.
You can't fix current problems or spot developing ones unless you know where to look. This
Profit Mastery® process we're describing is merely an efficient, effective method to keep your
finger on the pulse of your company.
©BRS 2015
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Balance Sheet Ratios
Ratio
Current
Quick
Debt-to-Worth
What it Means In Dollars and Cents
How to Calculate
Current Assets
Current Liabilities
Cash + Accounts Receivable
Current Liabilities
Total Liabilities
Net Worth
Measures solvency: The number of dollars in Current Assets
for every $1 in Current Liabilities.
For example: a Current Ratio of 1.76 means that for every
$1 of Current Liabilities, the company has $1.76 in
Current Assets with which to pay them.
Measures liquidity: The number of dollars in Cash and
Accounts Receivable for each $1 in Current Liabilities.
For example: a Quick Ratio of 1.14 means that for every
$1 of Current Liabilities, the company has $1.14 in Cash
and Accounts Receivable with which to pay them.
Measures financial risk: The number of dollars of Debt owed
for every $1 in Net Worth.
For example: a Debt-to-Worth Ratio of 1.05 means that
for every $1 of Net Worth that the owners have invested,
the company owes $1.05 of Debt to its creditors.
Income Statement Ratios
Gross Margin
Net Margin
Gross Profit
Sales
Net Profit Before Tax
Sales
Measures profitability at the Gross Profit level: The number
of dollars of Gross Margin produced for every $1 of Sales.
For example: a Gross Margin Ratio of 34.4% means that
for every $1 of Sales, the company produces 34.4 cents of
Gross Profit.
Measures profitability at the Net Profit level: The number of
dollars of Net Profit produced for every $1 of Sales.
For example: a Net Margin Ratio of 2.9% means that for
every $1 of Sales, the company produces 2.9 cents of Net
Profit.
Overall Efficiency Ratios
Sales-To-Assets
Sales
Total Assets
Return On Assets
Net Profit Before Tax
Total Assets
Return On
Investment
Net Profit Before Tax
Net Worth
©BRS 2015
Measures the efficiency of Total Assets in generating sales:
The number of dollars in Sales produced for every $1
invested in Total Assets.
For example: a Sales-to-Assets ratio of 2.35 means that
for every $1 dollar invested in Total Assets, the company
generates $2.35 in Sales.
Measures the efficiency of Total Assets in generating Net
Profit: The number of dollars in Net Profit produced for
every $1 invested in Total Assets.
For example: a Return on Assets ratio of 7.1% means that
for every $1 invested in Assets, the company is generating
7.1 cents in Net Profit Before Tax.
Measures the efficiency of Net Worth in generating Net
Profit: The number of dollars in Net Profit produced for
every $1 invested in Net Worth.
For example: a Return on Investment ratio of 16.1% means
that for every $1 invested in Net Worth, the company is
generating 16.1 cents in Net Profit Before Tax.
14
Specific Efficiency Ratios
Inventory
Turnover
Cost of Goods Sold
Inventory
Inventory
Turn-Days
360
Inventory Turnover
Accounts
Receivable
Turnover
Sales
Accounts Receivable
Average
Collection
Period
360
A/R Turnover
Accounts
Payable Turnover
Average
Payment
Period
©BRS 2015
Cost of Goods Sold
Accounts Payable
360
A/P Turnover
Measures the rate at which Inventory is being used on an
annual basis.
For example: an Inventory Turnover ratio of 9.81 means
that the average dollar volume of Inventory is used up
almost ten times during the fiscal year.
Converts the Inventory Turnover ratio into an average “days
inventory on hand” figure.
For example: a Inventory Turn-Days ratio of 37 means
that the company keeps an average of thirty-seven days of
Inventory on hand throughout the year.
Measures the rate at which Accounts Receivable are being
collected on an annual basis.
For example: an Accounts Receivable Turnover ratio of
8.00 means that the average dollar volume of Accounts
Receivable are collected eight times during the year.
Converts the Accounts Receivable Turnover ratio into the
average number of days the company must wait for its
Accounts Receivable to be paid.
For example: an Accounts Receivable Turnover ratio of
45 means that it takes the company 45 days on average to
collect its receivables.
Measures the rate at which Accounts Payable are being
paid on an annual basis.
For example: an Accounts Payable Turnover ratio of
12.04 means that the average dollar volume of Accounts
Payable are paid about twelve times during the year.
Converts the Accounts Payable Turnover ratio into the
average number of days that a company takes to pay its
Accounts Payable.
For example: an Accounts Payable Turnover ratio of 30
means that it takes the company 30 days on average to pay
its bills.
15
Diagnosis
The following provides possible causes for selected ratios that are either too high or too low — in relation
to a company's own past performance and/or industry standards.
Balance Sheet Ratios
Current Ratio
High: May indicate an imbalance in the investment in long-term assets, or an economic condition
conducive to maintaining high liquidity.
Low: May indicate financing of long-term assets with short-term money.
Quick Ratio
High: May indicate an excess of cash. Normally implies under-investment in inventory. The effect
normally shows up in reduced sales and reduced profits.
Low: May manifest itself in a shortage of cash, and usually indicates problems similar to current ratio
and/or problems associated with over-investment in inventory.
Debt - to - Worth Ratio
High: Too much risk, leverage is too great. If economy goes bad and sales drop, interest expenses can
destroy profits. Often caused by unmanaged growth.
Low: Company is too safe; not enough risk equates with not enough return. There is too much equity in
the company and too much debt capacity causing low ROI.
Income Statement Ratios
Low:
Low:
Gross Margin Ratio
Caused by not taking discounts due to low cash, high inventory causing mark downs, poor pricing,
poor buying, or excessive shrinkage. The “low price, high volume” concept should be used with
caution: the real keys to success are cash flow and profits, not sales alone.
Net Margin Ratio
Indicates that the company's prices are relatively low or that its costs are relatively high — or both.
Asset Management Ratios
Sales - to - Assets
Indicates that the company is not generating a sufficient volume of business given the size of its
asset investment.
Inventory Turnover
High: May indicate inadequate finished goods inventory, raw materials, or W.I.P. inventory.
Low: May indicate excessive finished goods inventory, raw materials, or W.I.P. inventory.
Return on Assets
Low: Indicates low profitability, or over-investment in assets — or both. Too many assets for the sales
produced will normally cause low cash problems.
Return on Investment
High: May indicate too much leverage or risk. Too much debt financing causes return to appear
abnormally high. Can signal trouble in times of rising interest rates, shrinking margins, and
economic slow downs.
Low: Indicates low profits or over-capitalization — or both. Over-capitalization indicates too much
equity and not enough risk-taking. Usually excess debt capacity causes reduced cash flow and
increased bad debt expenses.
Low:
©BRS 2015
16
RX FOR SURVIVAL:
Treat the Causes, Not the Symptoms
Human nature is a funny thing. We always seem to enjoy operating “on the edge.” Business and
financial experts continually tell us to plan, plan, plan. But usually we don't. We wait, wait, wait.
We hear a lot about preventive maintenance: you have the Fram oil filter man saying “you can
pay me now - or pay me later.” But usually we wait until we're sick to go to the doctor — on the
theory that “If it aint broke don't fix it!” We wait for the symptoms of problems to appear — and
then respond. The problem is that sometimes it's too late.
In business, of course, we call this approach “seat-of-the-pants” management. In business and
trade journals, it's been praised and romanticized: the entrepreneurial spirit . . . the go-for-broke,
gut-feel attitude. Horse puckey! Now, don't get us wrong; we believe in these attitudes. But they
need to be put within a structure — a framework which capitalizes on strengths and shores up
weaknesses in a business.
Causes and Effects
The diagram you see on page 19 (which looks like a California road map or an engineering flow
chart) presents just such a framework. Functionally, it represents the financial skeleton of your
business. As you can see, it's a self-contained system; however, as with any system, it requires
maintenance to function properly.
Problems — in business or anywhere else — are solved when we get to the causes. In medicine
doctors only treat the symptoms of a disease when the causes are unknown. Business owners
generally identify three major financial symptoms: low cash, low gross margin, and/or low net
profit.
That's right: low cash, low gross margin or low net profits are not the causes of financial
problems; they are the effects — or symptoms — of other hidden financial problems. And that's
where the diagram becomes useful. To find causes we must trace back from the effects to
examine a variety of possible causes for the symptoms.
The Road Map presents the “big picture” overview, but at the same time leads us through a
process of analysis designed to pinpoint potential problem areas. This cause-and-effect analysis is
an invaluable resource for business owners.
Now, in order to take positive action in any situation, you need to know three things:
Where you are.
Where you want to go.
How to get there.
Your own financial statements — past and present — and your own ratio calculations can show
you your present position. By comparing your position with that of the industry as a whole, you
can determine where you would like to be at the end of the next operating period. The “Road
Map” can help you determine how to get there.
©BRS 2015
17
To read the map, start at any box and work backward against the arrows, inserting the phrase “is
caused by” between the categories in the boxes. For example:
LOW GROSS MARGIN
HIGH HIDDEN COSTS
* is caused by *
* is caused by *
NO CASH DISCOUNTS
HIGH ACCOUNTS RECEIVABLE
LOW PRODUCTIVITY
TOO MUCH INVENTORY
BOOKKEEPING ERRORS
SHRINKAGE
POOR BUYING
POOR PRICING
Just a short word on “Low Gross Margin” — it's highlighted for a reason. Without an adequate
margin (long-term), you may as well hang 'em up. Not maintaining margin is almost always an
issue in terms of problems— direct or indirect. It's like a big star on the state map: all towns are
important, but some are more important than others.
Now, let's start at “Low Cash” and take it in all directions until you've traveled through the entire
system. It's a fascinating journey. Don't worry if you get strange glances as you sit there
absentmindedly talking through it aloud. The key here is interdependence. When you think
you've got it, try explaining it to someone else; then you'll know for sure.
Keep in mind that our financial “skeleton” is rather general: it applies to any business. Your
industry may not have some of the “parts”, but don't feel cheated! Just as people come in all
shapes and sizes — so do businesses. If some of these categories don't apply to you, simply leave
them out. For instance, retail stores may not have accounts receivable. Just leave that part out and
be glad that you have one less area to worry about managing!
Seeing the “Big Picture”
Many people visualize financial problems or issues as isolated occurrences. One of the primary
benefits of our financial cause-and-effect diagram is, in fact, to highlight the interdependent nature
of the financial system in your business. Remember, this diagram doesn't care how big your
business is — it works for the corner deli and it works for General Motors.
Effective financial management falls somewhere between art and science. The goal is balance and
control — combined with intuition and risk-taking — and luck. But we've always considered
“luck” as the point at which opportunity and preparation intersect. And to achieve and maintain
balance and control requires a process. This process is cause-and-effect analysis.
Our challenge for you is simple and straightforward: use this format to take a trip through your
business. As with any trip, you can't reach your destination without a map and that's what this
framework is — a financial road map. You may find that it generates more questions than it
answers, but that's good — because you can't solve problems until you know what to ask and
where to look!
©BRS 2015
18
The Steps You Take To
Determine Your Course of Action
1. Gather Information
Obtain your financial statements for the last three years. Financial statements have a variety
of uses besides just showing sales and profits, but getting information out of them requires
your active participation.
2. Package the Information
Put the data in a spread sheet format; that is, place consecutive years in side-by-side columns.
3. Calculate Your Financial Ratios
These ratios are nothing more than the relationships between sets of two numbers, but they
let us focus on those relationships rather than on the “raw” financial data. This packet
contains the ratios that we believe are essential. In addition, you may want to add others that
are specific to your type of industry.
4. Record Your Industry Composite Guidelines (if available)
Many trade associations and financial organizations produce financial data and ratio studies
for particular industries. Robert Morris Annual Statement Studies is one of the most common
sources (your local bank should have a copy available).
5. Compare Your Results
Look for trends in the financial statement spread sheets and in the ratio spread sheet. Also
look for changes in trends. Compare your business (1) against prior years, (2) against the
industry standards, and (3) against your future plans.
6. Analyze the Possible Causes of Problems
Ratio analysis can identify problems. The next step is to identify causes and then develop
solutions. The financial cause-and-effect “Road Map” can help in finding possible causes of
problems.
7. Take Action
Many times the worst decision is to do nothing. Usually inaction represents a “wait-andhope” approach, indicating an inability to focus attention on the financial aspects of a
business. Formulate a plan, implement the plan, then monitor the results. Taking action is,
of course, the hard part. But if you follow the steps contained in this workbook, we
guarantee that you will be better prepared to face and make those critical financial decisions.
©BRS 2015
19
Case Study
Cascade Office Systems
Cascade Office Systems originally opened in ten years ago when John Thomas
began manufacturing custom wood office furniture for a select clientele. (He had
just taken early retirement from a major manufacturer, where he had been a
successful sales rep for over 20 years.)
The new business was a gradual success on the strength of Mr. Thomas's
reputation and his ability to deliver quality furniture at a reasonable price.
Mr. Thomas semi-retired from the business four years ago, turning it over to his
daughter and son-in-law, Laura and Rob. Both of them perceived a growing
market opportunity revolving around the production of custom office furniture for
computers. While not forsaking the existing business, they implemented an
impressive development campaign two years ago, including an expansion of the
existing building. A year ago, they began their marketing effort with an
aggressive promotion based on price and quality.
It's now the end of their most recent fiscal year and they have come to you for
financial assistance. They are flushed with excitement, telling you things will be
great if they can just get the funds they need to get “over the hump.” They brush
off any talk of problems as “only temporary.”
What observations can you offer?
ACTION STEPS:
©BRS 2015
Step 1.
Gather accurate financial information.
Step 2.
Package the information so you can see relationships.
Step 3.
Calculate financial ratios.
Step 4.
Record your industry composites (if available).
Step 5.
Compare your results.
Step 6.
Analyze the possible causes of problems.
Step 7.
Take action — formulate a plan, implement it,
and monitor the results.
20
Cascade Office Systems
Balance Sheet Spreadsheet as of November 30
ASSETS
Cash
Accounts Receivable
Inventory
Other — A/R officer
Prepaid
Other
Two Years
Ago
One Year
Ago
Most Recent
Year
41,700
169,400
212,200
3,000
10,700
16,500
167,000
164,800
12,300
270,000
419,000
16,700
24,800
Total Current Assets
Leasehold Improvements
Vehicles
Furniture/Fixtures/Office Equip
Equipment
Buildings
Land
Accumulated Depreciation
437,000
365,000
726,100
25,700
24,300
108,300
130,000
20,000
(85,000)
30,700
28,300
120,300
267,700
20,000
(106,000)
30,700
59,700
120,300
267,700
30,000
(132,000)
Fixed Assets (net)
223,300
361,000
376,400
Other — patent acquisition
28,500
660,300
726,000
1,131,000
52,800
32,500
99,800
44,100
26,700
63,400
30,000
127,800
55,200
33,400
282,400
25,000
310,100
67,300
49,600
Total Current Liabilities
Long-Term Debt
Mortgages
Other
Total Long-Term Liabilities
255,900
144,300
309,800
114,300
734,400
89,300
144,300
114,300
89,300
Total Liabilities
400,200
424,100
823,700
60,000
60,000
60,000
200,100
241,900
247,300
Net Worth
260,100
301,900
307,300
Total Liabilities and Net Worth
660,300
726,000
1,131,000
Total Assets
LIABILITIES & NET WORTH
Notes Payable — bank
Current Portion — long-term
Accounts Payable — trade
Accruals
Other
Other
Capital Stock
Additional Paid-In Capital
Retained Earnings
©BRS 2015
21
Trends
Cascade Office Systems
Income Statement Spreadsheet
for the 12-months ending November 30
Two Years
Ago
One Year
Ago
Most Recent
Year
1,520,000
1,670,000
2,160,000
1,200,000
1,336,000
1,760,000
320,000
334,000
400,000
152,000
16,400
2,000
158,000
16,900
10,500
219,900
27,000
12,200
4,800
5,500
7,800
4,000
19,000
8,600
5,800
9,500
5,500
4,000
2,100
5,200
4,500
8,200
4,000
21,000
6,400
6,200
4,700
5,500
4,500
700
6,100
5,000
8,800
8,000
26,000
5,200
6,800
1,200
7,000
7,000
6,000
Total Expenses
247,000
256,300
346,200
Operating Profit
73,000
77,700
53,800
Other Income/(Expense)
Interest
Other Income
(26,600)
8,000
(27,600)
(49,500)
2,000
Net Profit Before Taxes
54,400
50,100
6,300
9,500
8,300
900
44,900
41,800
5,400
Sales
Cost of Goods Sold
Gross Profit
Expenses
Salary
Payroll Taxes
Advertising
Rent
Utilities
Office Supplies
Insurance
Bad Debts
Depreciation
Vehicles
Accounting
Travel / Entertainment
Shop Supplies
Taxes
Other
Other
Tax
Net Profit After Tax
©BRS 2015
22
Trends
Cascade Office Systems
Ratio Analysis Spreadsheet
Two
One Yr.
Yrs. Ago
Ago
1.
Most
Recent
Year
Industry
Composite
BALANCE SHEET RATIOS: Stability (or “Staying Power”)
Current Assets
Current
1.7
1.1
2.
Quick
Current Liabilities
Cash + Accts. Rec.
3.
Debt-to-Worth
Current Liabilities
Total Liabilities
0.8
0.5
1.5
1.4
Net Worth
INCOME STATEMENT RATIOS: Profitability (or “Earning Power”)
Gross Profit
Gross Margin
21%
20%
4.
5.
Net Margin
Sales
Net Profit B4 Tax
3.5%
3.0%
Sales
ASSET MANAGEMENT RATIOS: Overall Efficiency Ratios
Sales
Sales-to-Assets
2.3
2.3
6.
7.
Return on Assets
8.
Return on
Investment
9.
10.
11.
12.
13.
14.
Total Assets
Net Profit B4 Tax
Total Assets
Net Profit B4 Tax
8.2%
6.9%
20.9%
16.5%
Net Worth
ASSET MANAGEMENT RATIOS: Working Capital Cycle Ratios
Cost of Goods Sold
Inventory
5.6
8.1
Inventory
Turnover
360
Inventory
64
44
Inventory Turnover
Turn-Days
Sales
8.9
10
Accounts Receivable
Accts Receivable
Turnover
360
Accounts Receivable
40
36
Accts Rec Turnover
Turn-Days
Cost of Goods Sold
Accounts Payable
12
10.4
Accounts Payable
Turnover
360
Average Payment
30
34
Accts Pay Turnover
Period
©BRS 2015
23
9.8
Calculations,
Trends, or
Observations
©BRS 2015
24
Simulated RMA Data Page
for CASCADE OFFICE SYSTEMS
MANUFACTURERS — WOOD FURNITURE — EXCEPT UPHOLSTERED
SIC #2511
Current Data
0-1MM
55
%
1-10MM
62
%
10-50MM
26
%
Comparative Historical Data
50-100MM
2
%
ALL
145
% |
ASSET SIZE
NUMBER OF STATEMENTS
ASSETS
|
|
|
100.0
100.0
100.0
100.0 |
|
Total
|
LIABILITIES
|
|
|
.
|
|
|
|
|
|
|
100.0 |
Net Worth
Total Liabilities & Net Worth
|
|
INCOME DATA
Net Sales
4.0
|
100.0 |
|
25.8 |
|
3.3 |
|
|
|
|
|
|
100.0
100.0
100.0
100.0
100.0
100.0
30.1
22.2
23.0
2.9
3.2
Gross Profit
Profit Before Taxes
RATIOS
5
2.2
1.6
1.0
2.8
1.8
1.4
3.6
2.5
2.0
|
2.9 |
1.8 |
1.3 |
1.3
0.7
0.4
1.4
0.8
0.5
1.7
1.2
0.7
1.4 |
0.8 |
0.5 |
Quick
|
|
|
2
Current
|
|
|
|
4
1
17
41
59
21.8
8.9
6.2
32
43
54
11.4
8.5
6.8
38
50
54
9.6
7.3
6.8
28
43
55
13.0 |
8.4 |
6.6 |
Sales / Receivables
|
|
|
12 and 11
41
64
101
8.8
5.7
3.6
49
74
107
7.4
4.9
3.4
70
89
122
5.2
4.1
3.0
50
74
114
7.3 |
4.9 |
3.2 |
Cost of Sales / Inventory
|
|
|
10 and 9
1.0
1.8
4.7
(48)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
0.5
1.2
2.3
0.6
0.8
1.7
0.6 |
1.2 |
2.9 |
40.5
29.6
20.8 (61) 15.8
0.9
4.7
29.1
11.8
5.0
31.9 |
(137) 16.6 |
4.2 |
16.1
8.5
- 1.5
18.4
4.6
1.0
14.6 |
6.6 |
0.9 |
14.6
6.9
1.1
|
|
|
3
% Profit Before Taxes / Tangibles
Net Worth
|
|
|
8
% Profit Before Taxes / Total
Assets
|
|
|
7
Debt / Worth
|
|
3.1
2.4
1.9
2.9
2.4
1.7
2.0
1.8
1.5
2.8 |
2.1 |
1.7 |
|
©2013 BRS
25
|
|
Sales / Total Assets
|
|
|
|
6
Profit Mastery Assessment (PMA)
Summary Report
Cascade Office Systems
Cash
Inventory
Hidden Costs & Interest
A/R
Hidden Costs & Interest
Gross Margin
Labor
Buying
Pricing
Cash Discounts
Refinance
Other
Other
Other
Totals
©BRS 2015
26
Profit (NPBT)
Low Gross Margin (Ratio #4) What’s their Low Gross Margin costing? Their Peers’ Margin: 22.2%
Difference
+/‐ 4%
Sales in Year 3: $2,000,000 X margin difference:
X .04 Margin $ Left on the Table: $80,000
Primary Impact: Profit No Cash Discounts on Payables
COGs
$1,760,000
760,000 Labor
$1,000,000 Purchases
$500,000
Extend discounts
X
Discounts
.02
$10,000 in missed discounts
Low Productivity COGS
$1,760,000
- 1,000,000 Purchases
$760,000 Labor
X
.05
$38,000
Low Productivity
Inefficiency
Poor buying and poor pricing If he can manage just a 1% improvement in each of these areas:  Buying: 1% x $1,000,000 = $10,000
 Pricing: 1% x $2,160,000 ~ $22,000
©BRS 2015
27
Too Much Inventory? (Ratio #9 & #10)  Industry achieves 4.9 turns
 Actual COGS was $1,760,000
COGS
Inventory = Turnover
COGS Turnover = Inventory
COGS = Targeted Inventory
Targeted Turnover COGS Target Inv. Turn =
$1,760,000
4.9 Actual Inventory
$419,000
‐Targeted Inventory
‐ $359,000
Excess Inventory
$60,000
= $359,000 The cost of 1 Day = $60,000 / 12 days = $5,000/day
Primary Impact: Cash
©BRS 2015
28
Too Much A/R? (Ratios #11 and #12)
Sales
Targeted Turnover
$2,160,000
=
8.5
Actual A/R = $270,000
Targeted A/R = $254,000
$16,000 in Excess A/R
The cost of 1 day = $16,000/2 = $8,000/day
Primary Impact : CASH
©BRS 2015
29
= $254,000
Hidden Costs  Inventory
Excess Inventory x 25% = $60,000 x .25 = $15,000  A/R
Excess A/R x 25% = $16,000 x .25 = $ 4,000 Total Hidden Costs = $19,000 Primary Impact : Profit Proper Financing Balance Sheet Structure Relates to upper left box on “Roadmap” Use Cascade Balance Sheet: Year 1 Year 2 Year 3 $435,000 $365,000 ‐$255,900 $309,800 $181,000 $55,000 Total Current Assets
‐ Total Current Liabilities = Working Capital
Working Capital Decrease
$126,000 How did this occur? Buildings L/T Debt N/P Bank (S/T) $130,000 $267,700 $144,000 $114,300 $63,400 $282,400 The issue? Match the term of the loan with the life of the asset ‐‐‐‐ period. ©BRS 2015
30
Ratio Supplement:
Service Businesses and Professional Practices
The process of ratio analysis that we have gone through for Cascade Office Systems applies to
all businesses. But service businesses and professional practices can use the modified set of
ratios to monitor their financial position more accurately.
Balance Sheet Ratios
Use the same ratios on page 14* but add:
Cash Ratio = Cash/Current Liabilities
Measures the ability of the company to pay its bills with out relying on collection of accounts
receivable. Indicates how well the company could respond to a sudden crisis or opportunity.
* NOTE: For many service companies, the current and quick ratios will be nearly identical
because inventory is the main component that differentiates the two.
Income Statement Ratios
Use the ratios on page 14; change “Sales” to “Revenues” or “Fees” as appropriate.
Asset Management Ratios
Use the ratios on page 14 but add:
Fixed Asset Utilization Ratio = Total Revenues/Net Fixed Assets
Measures how productive the company's fixed assets (i.e. equipment) are in generating revenue.
A low ratio may indicate ineffective use of fixed assets or excessive fixed assets.
Working Capital Cycle Ratios
Use the ratios on page 15, but delete “Inventory Turnover” and “Inventory Turn-Days” and add:
Accounts Receivable Aging Schedule
Accounts Receivable Turnover and Average Collection Period represent overall averages for an
accounting period. A more detailed means of monitoring accounts receivable is to “age” them
— that is, to list each account and identify its payment status. The following is a sample aging
format:
Accounts Receivable Aging Schedule
Account
Red
White
Black
Blue
Total
©BRS 2015
0-30 days
$XXX
30-60 days
60-90 days
Over 90 days
$XXX
$XXX
$XXX
$XXX
$XXX
$XXX
31
$XXX
$XXX
$XXX
Productivity Ratios
The following ratios (or modifications of them) are among those commonly used to measure
efficiency in production of services:
Average Revenue Per Client
=
Total Revenue
÷
# Clients Served
Average Revenue Per Job
=
Total Revenue
÷
# Of Jobs
Average Daily Volume
=
Total Clients
÷
# Of Days Worked
Average Revenue Per Hour
=
Total Revenue
÷
# Of Hours Worked
Individual Productivity:
Take any of the above ratios and calculate for
individuals producing the services.
A Word on Selecting and Computing Ratios
As we said earlier, computing ratios is a relatively simple activity. The key for you is to
determine which ratios are the appropriate ones to use in your company's analysis. Any time we
compare two different numbers to one another, we come up with a new ratio. Therefore, you
could potentially compute scores of ratios using the numbers found on your balance sheet and
income statement.
But, do the ratios you come up with make sense? If so, are they meaningful to you? For
instance, you could compare the dollars of Personnel Expense (from the Income Statement) to
the dollars of Fixed Assets (from the Balance Sheet) and derive a ratio. What does it tell you?
Probably nothing! But, if you compare Sales to Personnel Expense, the ratio may tell you how
efficiently you're using your people resources to produce revenues. Now that's something you
might be interested in knowing. The point is, you need to select a set of ratios which actually
communicate to you about how your business is operating, and then stick with and use those
ratios over time to be able to spot trends, strengths and weaknesses, and areas of opportunity.
If you're not sure which ratios may be the best to use in your business, talk with your accounting
professional—they know ratios and your business. That's why you pay them good money—to
be a source of information and guidance in your role as a financial manager.
You also need to know that there may be more than one way to compute a specific ratio.
Depending on your particular business, one method may be more accurate and meaningful to use
than another. For instance, we used balance sheet dollars as of the date of the financial statement
to compute the Inventory, Accounts Receivable, and Accounts Payable turn ratios on Page 14.
In your own business, that method is probably okay if you have very steady volumes of costs of
goods purchases and generation of credit sales throughout the year. However, if you experience
cyclical patterns during the year, the use of "as of" dollars may tend to skew your ratios,
depending on when your cycles occur, compared to the date of the statement being used.
It may be more meaningful for you to use average dollars of Inventory, Accounts Receivable,
and Accounts Payable — either on an annualized, quarterly, or semi-annual basis — in order to
reduce the effect which your cycles may have on the ratios. These are but a few examples of
how to use different methods to calculate ratios. Again, if you're not certain which method is
best suited for your own business, consult with your accountant.
©BRS 2015
32
Mark-Up Versus Margin:
Clarifying the Issue
There are many people who believe mark-up and margin are the same thing — and sometimes
they are. But generally they're not. The issue is how to arrive at a target selling price when you
know the cost. The important concern here is the amount of gross profit dollars contributed from
sales to cover general overhead.
Here's a simple example to illustrate the point:
Item selling price:
$ 1.50
Item cost:
$ 1.00
Does this price-cost relationship represent 50% mark-up or 33% mark-up?
Regardless of your answer, we can safely say that this example represents a gross profit margin
of 33%. The standard income statement format gives us the following:
Gross Profit Margin = Gross Profit Dollars
(GPM)
Total Sales
Since:
Total Sales
– Cost of Goods Sold
Gross Profit
Gross Profit Margin % =
©BRS 2015
.50
1.50
= .33 = 331/3%
33
$1.50
1.00
.50
The real question is: what mark-up does this represent? Or, stated another way, how much do
you have to mark up a product over cost to produce a 331/3% gross profit margin? The answer
here depends on how you define mark-up. Here are the two possible definitions:
Definition A (the common definition):
Mark-Up = Selling Price – Cost
Cost
= 1.50 – 1.00
1.00
= 50%
Definition B (as defined by retailers):
Mark-Up = Selling Price – Cost
Selling Price
= 1.50 – 1.00
1.50
= 331/3%
It's important to note that either definition of mark-up leads to a 331/3% gross profit margin.
Using the more conventional definition, it requires a 50% mark-up to produce a 331/3% gross
profit margin, but retailers would say it requires a 331/3% mark-up. In other words, mark-up and
margin are the same thing when using the retail definition.
We believe that confusion — and errors! — arise when you hear someone say the mark-up and
the margin are the same (Definition B), then conclude that you simply multiply the cost by the
mark-up (Definition A) to get the margin.
©BRS 2015
34
Here's an example: you assume that you can get a 40% margin by using a 40% mark-up
(Definition A), so you do the following with an item costing $1.00:
WRONG!
$1.00  40% = $0.40 mark-up
Selling Price = $1.40
But this does not yield a 40% margin:
Sales
– Cost
Gross Profit
$1.40
- 1.00
$0.40
Gross Profit Margin = Sales – Cost
Sales
= 1.40 – 1.00
1.40
= 28.6%
As you can see, marking up the cost 40% produces only a 28.6% gross profit margin. Such a
mistake would produce a shortfall of 12% — or $120,000, if sales were $1,000,000.
The moral: understand how to set prices; it's the gross profit you need. Mark-up only represents
a concept to produce gross profit. If you confuse these issues, it can cost you dearly in dollars
and cents.
Standard (Definition A) MARK-UP/MARGIN Table
MARGIN %
COST
MULTIPLIER
MARK-UP %
662/3%
3.00
200%
60%
2.50
150%
50%
2.00
100%
331/3%
1.50
50%
25%
1.33
331/3%
Now try a few examples using a cost of $1.00 to verify that it works — and how it works.
©BRS 2015
35
Answer Sheet
Cascade Office Systems
Ratio Analysis Spreadsheet
Two Yrs. One Yr.
Ago
Ago
Most
Recent
Year
Industry
Composite
Calculations,
Trends, or
Observations
BALANCE SHEET RATIOS: Stability (or “Staying Power”)
1.
Current
2.
Quick
3.
Debt-to-Worth
Current Assets
Current Liabilities
Cash + Accts. Rec.
Current Liabilities
Total Liabilities
Net Worth
1.7
1.1
0.99
1.8
0.8
0.5
0.38
0.8
1.5
1.4
2.68
1.2
726,100
734,400
282,300
734,400
823,700
307,300
INCOME STATEMENT RATIOS: Profitability (or “Earning Power”)
4.
Gross Margin
5.
Net Margin
Gross Profit
Sales
Net Profit Before Tax
Sales
21%
20%
18.5% 22.2%
3.5%
3.0%
0.29%
3.2%
400,000
2,160,000
6,300
2,160,000
ASSET MANAGEMENT RATIOS: Overall Efficiency Ratios
6.
Sales-to-Assets
7.
Return on Assets
8.
Return on
Investment
Sales
2.3
2.3
1.9
2.4
8.2%
6.9%
0.56%
6.9%
20.9%
16.5%
2.0%
15.8%
Total Assets
Net Profit Before Tax
Total Assets
Net Profit Before Tax
Net Worth
ASSET MANAGEMENT RATIOS: Working Capital Cycle Ratios
Cost of Goods Sold
Inventory
9.
5.6
8.1
4.2
Inventory
Turnover
360
Inventory
10.
64
44
86
Inventory Turnover
Turn-Days
Sales
Accounts Receivable
11.
8.9
10
8
Accounts
Receivable
Turnover
360
Accounts Receivable
12.
40
36
45
Accts. Rec. Turnover
Turn-Days
Cost of Goods Sold
Accounts Payable
13.
12
10.4
5.7
Accounts Payable
Turnover
360
Average Payment
14.
30
34
63
Accts. Pay. Turnover
Period
©BRS 2015
36
4.9
74
8.5
43
9.8
37
2,160,000
1,131,000
6,300
1,131,000
6,300
307,300
1,760,000
419,000
360
4.2
2,160,000
270,000
360
8
1,760,000
310,100
360
5.7
Profit Mastery Assessment (PMA) Cascade Office Systems Issue Cash Accts. Rec .
$16,000 Inventory $60,000 Profit Hidden Costs $19,000 Gross Margin ‐Discounts ‐Productivity ‐Buying ‐Pricing $80,000 ($10,000) ($38,000) ($10,000) ($22,000) Refinance $126,000 TOTALS $202,000 ©BRS 2015
37
$99,000 ©BRS 2015
38
$126K (C)
$80K (P)
$38K (P)
$10K (P)
$19K (P)
$10K (P)
$60K (C)
$22K (P)
$16K (C)
Income Statement Management
Knowing Your Costs
DEFINITION......Managing the income statement implies managing the relationship
between costs, volume and pricing. Break-even analysis is the tool
that lets owners and managers gauge the results of changes in costs or
pricing.
REVIEW ..............We have completed the section on financial statement analysis, which
gives us a picture of the past. With break-even analysis, we have a
method to analyze the present.
IMPACT ..............Break-even analysis focuses attention on two kinds of costs -- fixed
costs and variable costs -- and how changes in either affect profits.
The analysis answers questions such as: “Will a decrease in price
produce more sales?”
RESULTS ............Using the break-even tool, we will be able to relate changes in costs
and/or changes in pricing to the corresponding changes that are
required in sales volume if a given level of profit is to be maintained.
The Goal:
Calculating the sales required to incur no profit, but no
loss -- and to evaluate the impact of changes in costs on
the selling price-cost-volume relationship.
The Tools:
Break - Even Analysis
Break - Even Proofs
Expansion Analysis
©BRS 2015
39
Key Terms
Break-Even ..................................... To have no profit and no loss; the point at which revenues
exactly cover expenses.
Variable Costs ................................ Expenses that vary directly with sales; those costs that are
incurred only if sales are made.
Variable Cost Percentage .............. The percent of each dollar of sales that goes to cover variable
costs.
Fixed Costs ..................................... Expenses that do not vary with sales; those costs that are
incurred whether or not any sales are made.
Contribution Margin ..................... The amount left after variable costs are paid. The amount
that is left to contribute to covering fixed costs (and profits).
Contribution Margin Percentage . The percent of each dollar of sales that is left after the
variable cost percentage has been deducted; the amount from
each dollar of sales that is contributed to cover fixed costs and
profits.
Target Profit ................................... The amount of profit that is planned. The profit that is added
to fixed
costs to determine the sales goals -- in relation to a given
contribution margin.
©BRS 2015
40
The “Cup Theory”
The Concept Of Contribution Margin
Sales Dollars
Contribution Margin
(percent of sales)
Variable
Cost
Cup
Fixed
Cost
Cup
Net
Profit
Cup
Net profits occur if there’s anything left
after the fixed cost cup is filled.
A useful and effective method of assessing cost-volume-profit relationships is through the
application of break-even analysis. Break-even, of course, refers to the point where there is no
profit and no loss - revenues exactly covering costs. But this analysis revolves around a second
concept - that of contribution margin.
Contribution Margin
First, a definition. Contribution margin represents the percent of each sales dollar left after
variable costs are removed. (Variable costs represent those costs that are both proportional to
sales and caused by sales.)
Basically, whatever remains of each sales dollar after subtracting the variable costs represents the
funds available to cover fixed costs. By definition, fixed costs represent those costs which exist
independently of sales; that is, they are neither proportional to - nor caused by - sales. They're
there whether or not you sell anything.
A certain percentage of each sales dollar - and it varies from business to business - remains after
the proportional - or variable - costs are removed. This remaining portion of each sales dollar is
contributed to the amount necessary to cover the fixed costs.
To the extent that you have just enough dollars contributed to cover all the fixed costs, financial
people say you are “at break-even” - no profit, no loss. To the extent that sales produce a
contribution margin greater than the fixed costs, you have a profit. Furthermore, to the extent
that sales are not sufficient to produce enough dollars of contribution to cover fixed costs, you
have a loss.
©BRS 2015
41
Filling the Cups
It is perhaps easiest to visualize this concept as a series of cups stacked on top of one another.
The figure at the beginning of this section represents this “cup theory” graphically. The top cup
represents the costs which are variable. As you can see, all the funds “left over” -- or contributed
-- flow down to fill the cup labeled fixed costs on the second level. In addition, once the fixed
costs have been covered (or the cup “filled”) any remaining funds flow down to the third level
and become profits.
This concept becomes an extremely useful tool -- not so much to calculate the exact break-even
point, but more importantly to investigate the impact on required sales volume if we change the
size of the cups. That is, what happens to required sales volume if the contribution margin
changes? (In other words, if the size of the variable cup changes?) And what is the impact on
sales volume if the size of the fixed cost cup changes?
First, let's talk about fixed costs. If the fixed cost “cup” gets bigger, you need more dollars of
contribution margin to fill it; thus, break-even sales increase as fixed costs increase.
Conversely, as fixed costs decrease (the size of the cup decreases), fewer contribution dollars are
required and “break-even sales” is a smaller figure.
Now, let's look at changing the variable cost percentage -- or the contribution margin. As the
variable cost percentage increases, the variable cost “cup” increases and there is a decrease in the
amount contributed from each sales dollar. Thus, you need more sales dollars to fill the fixed
cost “cup” and break-even sales rise. Clearly, just the opposite is true when the variable cost
percentage decreases and the contribution margin increases. With a decrease in the variable cost
“cup”, there is an increase in the amount contributed from each sales dollar. Correspondingly,
you need fewer sales dollars to fill the fixed cost “cup”, and break-even sales decrease.
So the real value in “break-even” analysis lies not just in calculating the current break-even
sales, but rather in evaluating the impact on sales volume of changes in either variable costs or
fixed costs -- or both. By attaching numerical formulas to the concepts we've outlined here, we
can assess the required volume change, given a measurable change in the cost structure. To a
measurable degree, it is possible to analyze marketing strategies in light of varying cost
structures.
Knowing Your Costs
The core of this analysis, however, is rooted deeply in the importance of knowing your costs.
Quite frankly, this is often the weakest area of most entrepreneurs. In the absence of any firm
grip on costs, most business owners set their prices based solely on the competition. This, of
course, presumes your competitors know their costs, and the rest, as they say, is history . . .
Take a few minutes, and think through the concepts we've presented here, then read on and work
through our examples. Once you understand the concepts, work through your own situation.
Remember, all you need is a current profit-and-loss statement to produce this analysis. You'll
also find out that a complete understanding of how costs behave in your business will be your
strongest ally when it gets down to “the crunch.”
©BRS 2015
42
Know Thy Costs . . .
And Manage the “Creepers”
Everyone knows their costs, right? This is a concept that's as age-old as Methuselah. Well, do
you know yours? Furthermore, do you know how those costs behave in your business? Finally,
can you answer the question, “Why would anyone in their right mind care?”
We firmly maintain that this information ought to be “walkin'-around-in-your-head” knowledge.
Not only does the behavior of these costs have a significant impact upon your profitability, but
also it should impact your marketing strategy.
For the last few sections, we've talked about financial statements and ratio analysis as one way to
“get your arms” around the management of your business -- and it is. But in the financial time
continuum of your business, financial statements represent past history. We can't change
yesterday; we can only learn from it. We can only impact today and tomorrow.
Costs are controllable today. Suppose we posed the question, “Your costs will go up $1,000;
what do you have to have in increased sales just to stay even?” You guessed it; far too many
times, the answer is $1,000. Bad sign.
So let's talk about costs and we'll give you a tool to manage costs and a method to analyze your
cost decisions. The problem is understanding how costs behave, and the tool is break-even
analysis. Break-even analysis is a financial tool that illustrates the relationships between COSTVOLUME-PRICE. By definition, break-even is the exact sales volume at which the business
neither makes a profit nor incurs a loss.
To calculate break-even, we first need to define two broad classes of costs based on how they
behave in the business. First, fixed costs. Within a reasonable sales range, fixed costs do not
vary with sales or production volume. Examples would include administrative salaries, rent,
interest, insurance, utilities, and depreciation. Next, variable costs. Variable costs are those
which are directly proportional to the sales volume i.e., no sales, no variable costs. Examples
would include direct materials (i.e., cost of goods sold), commissions, and bad debts. Think of
variable costs this way: sales cause variable costs. If sales don't cause them, consider them
fixed.
Okay, so now how do you calculate break-even? As outlined in the “Steps To Calculate BreakEven” on pages and , from your existing profit/loss statement, total all your current fixed
costs. Let's say your total comes to $100,000. Next, calculate your total variable costs as a
percent of your total sales. Let's say your “variable cost percent” turns out to be 75%.
What does this mean in terms of $1.00? Well, for every $1.00 of sales, 75 cents goes to variable
costs. What's left? Yes, 25 cents. To cover what? Right, fixed costs. So now we have to
answer the question, “How many 25-cents in $100,000 of fixed costs?” The answer, of course, is
400,000. This means that you will have to do $400,000 to break-even. This is diagrammed on
the next page using the term “contribution margin” to replace the term “what's left?”
©BRS 2015
43
Break-Even Calculation
Fixed Costs:
Sales:
Variable Cost %:
Formula:
Break-Even Proof
$100,000
400,000
75%
Sales:
Less: 75% variable cost
Contribution Margin
Less: fixed costs
Net Profit
$100,000
(100% - 75%)
Break-Even Sales:
$400,000
– 300,000
$100,000
– 100,000
$0
$400,000
The key issue is not so much how to calculate break-even, as it is how to use it. For example, we
once discovered that our company had contracted for a coffee service and our annual costs went
up $1,000. How much in additional sales did we need to cover this increase?
Fixed Cost Increment
100% - 75%
=
1,000
.25
= $4,000
Sales had to increase $4,000 just to pay for the coffee. It's these “creepers” you must watch
every day because for every $1.00 increase in “fixed costs” (as they “creep” on you), you have
to achieve a $4.00 sales increase just to stay even.
There was another experience some years ago that has stuck with us to this very day. We
stopped by a client's shop one day, only to discover him fuming around mad as hell. Seems an
employee had just destroyed a $6,000 cement mixer. We said, “We sure understand.” He
replied, “No, fellas, you don't understand at all ― that's not the problem.” So we said, “Guess
we don't understand.”
He stormed over to the trash bin and pulled out three discarded C-clamps. “See this,” he fumed.
“They'll only break one cement mixer in their life ― and it's insured. But they'll throw away
three C-clamps every day forever. Add it up!” We did. And if you add it up for your business,
you may find a few surprises and some new ways to “manage the creepers.”
©BRS 2015
44
Break-Even Analysis
Break-even analysis identifies that point where revenues exactly cover costs -- so that no profit is
generated, but no loss is incurred. As a management tool, it extends to a much broader
application. Using it, you can answer questions such as:
 What additional sales will I need to cover the rent increase my landlord is
proposing?
 If I raise prices, how much can my sales drop before my profits are affected?
 If sales drop (in a recession, for example), how much do I need to cut fixed costs
to maintain my current level of profit?
 If I cut my price, what additional sales will I have to make in order to maintain
my current profit level?
Steps to Calculate Break-Even
Step 1
Classify expenses from your current income statement into two cost categories:
variable. Then add up the total for each category.
fixed or
Fixed Costs are those that remain constant over a reasonable range of sales, or do not vary
appreciably with sales volume. For example:
 Rent
 Office Supplies
 Advertising
 Salaries
 Payroll Taxes
 Utilities
 Depreciation
 Interest Expense
 Insurance
When these do change, they tend to jump in increments ― such as rent increases for additional
space, depreciation on new equipment purchases, or salaries for additional staff. When this type
of increase occurs, break-even needs to be recalculated.
Variable Costs are those that vary directly ― or proportionally ― to sales. An easy way to
evaluate whether a cost is fixed or variable is to ask: do sales cause this cost? If sales cause the
cost, it's variable. For example:
 Direct Labor
 Commissions
 Direct Materials
 Bad Debts
If you can't decide what to call an expense, be conservative and call it fixed ― thus making your
break-even point higher.
©BRS 2015
45
Step 2
Determine the variable expense percentage -- that is, the total variable expense as a percentage
of sales:
VARIABLE COSTS
SALES
=
VARIABLE COST PERCENTAGE
Step 3
Determine the contribution margin -- that is, the amount from each sales dollar which is left
after deducting variable costs -- to cover fixed costs:
SALES % – VARIABLE COST %
=
CONTRIBUTION MARGIN %
Which is the same thing as:
100% – VARIABLE COST % = CONTRIBUTION MARGIN %
Step 4
Calculate break-even using one of the two following formulas:
To calculate break-even in dollars:
BREAK–EVEN
=
FIXED COSTS
CONTRIBUTION MARGIN%
NOTE: Express contribution margin as a decimal -- not a percentage.
To calculate break-even in units (if your product can be measured
in just one type of unit -- such as yards, gallons, cases, or hours):
BREAK–EVEN
©BRS 2015
=
FIXED COSTS
SELLING
VARIABLE
PRICE —
COST
PER UNIT
PER UNIT
46
The Cup Theory The Concept of Contribution Margin Sales Dollars
Contribution Margin
(percent of sales)
Variable
Cost
Cup
Fixed
Cost
Cup
Net
Profit
Cup
Steve’s Pen Company ©BRS 2015
47
Case Study
Olympic Flooring - Practice Example
Two years ago Bob Nelson wanted to figure his break-even sales volume, so he went through his
income statement and classified his costs and totaled each category. Here's what he got:
Variable Costs: ....................$496,000
Fixed Costs: ........................$109,200
In that year, his Sales were:
Sales ....................................$620,000
What were break-even sales for Olympic Flooring that year? Use your break-even worksheet to
do the calculations.
©BRS 2015
48
Case Study
Olympic Flooring
Once again you have been called in to provide some assistance to Bob Nelson. He has already
gone through his most recent income statement and classified his costs into fixed and variable.
Here is what he came up with:
Variable Costs: ....................$904,680
Fixed Costs: ........................$151,820
Bob's sales in the most recent year were:
Sales .................................$1,077,000
Your job now is to calculate his variable cost percentage, his contribution margin, and his breakeven sales point; then answer the questions below. (Remember: Bob made a profit this year he was not at break-even sales last year.)
1. What are break-even sales for Olympic Flooring?
2. What additional annual sales are needed if rent increases by $2,000 per month?
3. What total sales will be necessary to generate a $50,000 profit -- assuming that
there is no rent increase?
©BRS 2015
49
Case Study
Olympic Flooring
Olympic has a homogeneous unit -- yards -- that can be used to measure all product sold. What
Bob needs to know now is how many yards he needs to sell. Here is the cost breakdown per
yard:
Sales Price (per yard) ................................. $5.00/yard
Variable Cost (per yard) ............................ $4.20/yard
Fixed Cost .................................................. $151,820
1.
How many yards must be sold to break-even?
2.
How many yards must be sold by a new salesperson (who will get an annual salary
of $20,000) to cover their cost?
3. How many yards must be sold if the selling price is raised to $5.10 -- assuming there is
no new salesperson and no change in variable cost?
©BRS 2015
50
Break-Even Analysis Worksheets
For Calculating Cost - Volume - Profit Relationships
The following pages contain two sets of break-even analysis worksheets:
one for calculating break-even using a DOLLAR BASIS
and
one for calculating break-even using a UNIT BASIS
BE SURE YOU ARE USING THE RIGHT ONE FOR THE ANALYSIS YOU ARE DOING!
©BRS 2015
51
Cost - Volume - Profit Relationships
Break-Even Analysis: Dollar Basis
Step 1. Classify Your Costs
Using your most recent income statements, classify all costs as either fixed or variable,
then total each category.
Actual Total Sales = $_______________
Total Variable Costs = $_______________
Total Fixed Costs = $_______________
Step 2. Calculate Variable Cost Percent
“For every $1.00 of sales, what percent goes away to variable costs.”
Variable Cost Percentage = Total Variable Costs = $_______________ = _____%
Actual Total Sales
$
Step 3. Calculate Contribution Margin
“For every $1.00 of sales (after paying for variable costs), what percent is left to cover fixed
costs . . . plus any targeted profit?”
100% – Variable Cost Percentage = 100% – _____% = _____%
Step 4. Calculate Break-Even Sales
“How many ‘cents-es’ does it take to cover your fixed costs?”
Break-Even Sales = Total Fixed Costs = $_______________ = $_______________
Contribution Margin
%
NOTE: To calculate the sales needed to generate a target profit, just add that target profit
amount to your total fixed costs, then divide that amount by your contribution margin.
Step 5. Check Your Calculations
“Does the sales level you figured actually ‘break-even’ ― or give you the profits you target?”
Break-Even Sales
_______________
minus Variable Costs *
–
_______________
equals Contribution Dollars =
_______________
minus Fixed Costs –
_______________
equals Net Profit
=
_______________
*Compute this figure by multiplying Break-Even (above) by the Variable Cost Percent in Step 2.
©BRS 2015
52
Cost - Volume - Profit Relationships
Break-Even Analysis: Unit Basis
Step 1. Classify Your Costs
Using your most recent income statements, classify all costs as either fixed or variable,
then total each category. Record the actual number of units sold and actual sales volume.
Actual Total Sales = $_______________
Total Variable Costs = $_______________
Total Fixed Costs = $_______________
Total Units Sold = ________________
Step 2. Calculate Your Price Per unit
Price Per Unit =
Total Sales
Number of Units Sold
=$_______________ per unit
Step 3. Calculate Your Variable Cost Per Unit
Variable Cost Per Unit = Total Variable Costs = $_______________ per unit
Total Units Sold
Step 4. Calculate Your Contribution Dollars Per Unit
Price per Unit – Variable Cost per Unit
= $_____________ per unit – $_____________ per unit = $_____________ per unit
Step 5. Calculate Your Break-Even Sales in Units
Break-Even Sales =
=
Total Fixed Costs
Contribution Dollars per Unit
$_______________ =__________ units needed in sales to “break-even”
$
per unit
NOTE:
To calculate the sales needed to generate a target profit, just add that target profit
amount to your total fixed costs, then divide that amount by your contribution margin.
©BRS 2015
53
Expansion Analysis
Using Break-Even as a Decision Tool
SITUATION:
Many times clients have come to us with plans for expansion -- or plans to
purchase or start a new venture. The outline below represents a “quick and
dirty” method of evaluating the sales volume necessary to cover costs -including target (or required) profits. We've also included both an example
and a blank form to use when you need to analyze expansion possibilities.
EXAMPLE:
You have three stores, and you plan to open a fourth. By doing a little
financial analysis, you find that your cost structure is as follows:
Fixed Costs.........................................$250,000
Variable Cost % .................................60% (as a percent of sales)
Your Planned Investment ...................$1,000,000
Your Target ROI ................................20%
Target Profit .......................................$200,000 (20% of $1,000,000)
Here are the calculations:
Formula
= Fixed Costs + Target Profit
100% – Variable Cost %
= 250,000 + 200,000
.4
= 450,000
.4
= $1,125,000
So you need sales of $1,125,000 to cover your fixed costs and provide your target profit of
$200,000.
NOTE: No expansion analysis is complete without a market analysis focusing on the sales
you'll most likely get. You then can compare what you'll get -- which the market analysis will
tell you -- with what you need -- from your financial analysis.
If what you'll get is greater than what you need -- it's a go. If what you'll get is less than what
you need -- it's back to the drawing board.
©BRS 2015
54
Expansion Analysis Worksheet
Estimate:
1. Fixed Costs (in dollars) ........................................................................._______________
2. Variable Costs (as a % of sales) ............................................................_______________
3. Total Investment Planned (in dollars) ..................................................._______________
4. Desired Return On Investment (ROI - expressed as a decimal) ..........._______________
Calculate:
A. Multiply investment required by desired return to determine “target net profit
in dollars”:
Item 3  Item 4 =
A
B. Add fixed cost (dollars) plus “target net profit” to yield “the nut you've got to
crack”:
Item 1 + Item A =
B
C. Subtract variable cost % (% of sales) from 100% to yield “contribution
margin percent”:
100% – Item 2 =
C
%
D. Divide the “nut to crack” (Item B above) by the contribution margin decimal
(Item C above) to determine “sales necessary to cover costs and provide
target ROI”:
Item B =
Item C
D
NOTE: This analysis gives you the financial parameters of the issue. You will
still need to acquire market data to make a realistic assessment of
feasibility -- and also take into account numerous non-financial issues.
©BRS 2015
55
Answer Sheet
Olympic Flooring Break-Even
Page 6:
Step 2: Compute the Variable Cost Percentage
Variable Costs
divided by Sales
=Variable Cost % (V.C.%)
=
=
=
496,000
620,000
80%
=
=
=
100%
-80%
20% (or, .2, when stated as a decimal)
=
=
=
109,200
.2
$546,000
Step 3: Compute the Contribution Margin Percentage
Sales Percentage
less Variable Cost Percentage
=Contribution Margin % (C.M.%)
Step 4: Compute Break Even in Dollars
Fixed Costs
divided by Contribution Margin %
=Break Even (B.E.)
Page 7
1. Step 2:
V.C.
Sales
=V.C. %
=
=
=
904,680
1,077,000
84%
Step 3:
Sales%
- V.C.%
=C.M.%
=
=
=
100%
-84%
16%
Step 4:
F.C.
C.M. %
=B.E.
=
=
=
151,820
.16
$948,875
2. Step 4:
F.C.
C.M. %
=B.E.
=
=
=
$24,000
.16
$150,000
(.16)
(or, $2,000/.16 = $12,500 x 12 = $150,000)
©BRS 2015
56
Answer Sheet
Olympic Flooring Break-Even
Page 7 (continued)
3.
Existing Fixed Costs
+ Profit Goal*
= Total Fixed Costs
=
=
=
$151,820
+ 50,000
$201,820
(*Profit dollars “behave” like a fixed cost)
Step 4:
F.C.
C.M. %
=B.E.
=
=
=
$201,820
.16
$1,261,375
Page 8:
1. Step 4:
Fixed Costs
C.M. per unit
=B.E.
2. Step 4:
Fixed Costs
C.M. per unit
=B.E.
3. Step 4:
Raise
price
2% to $5.10
Fixed Costs
C.M. per unit
=B.E.
3.Extra Credit
Lower price
2% to $4.90
Fixed Costs
C.M. per unit
=B.E.
=
=
151,820 = 151,820
(5.00 – 4.20) =
.80
=
189,775 square yards (units)
=
=
20,000
.80
=
25,000 square yards (units)
=
=
151,820 = 151,820
(5.10 – 4.20) =
.90
=
168,689 square yards (units)
=
=
151,820 = 151,820
(4.90 – 4.20) =
.70
=
216,886 square yards (units)
If Olympic raises its price by 2%, sales can drop 11%, and still make the same profit.
If Olympic lowers its price by 2%, sales must increase by 14% to make the same profit
©BRS 2015
57
Balance Sheet Management
Controlling Your Growth
DEFINITION......Managing your balance sheet implies taking positive control of
growth. With a tool called "Financial Gap," we will project what
funds will be necessary to support projected growth -- and where those
funds will come from.
REVIEW ..............The income statement shows the rewards of growth -- in increased
sales and increased profits. Cash flow analysis shows the funds
required to support seasonal growth.
IMPACT ..............Permanent, long-term growth imposes other requirements on the
company. As sales increase, many types of assets -- especially
inventory and accounts receivable -- increase proportionally. The
balance sheet shows the cost of growth in terms of decreased solvency,
liquidity, and increased risk to the company.
RESULTS ............By projecting the funds needed for sales growth and examining
alternative sources for the funds, we can manage growth. Using
Financial Gap as a tool, we can help to insure that increased sales
produce increased benefit -- and guard against the company "growing
itself out of business."
THE GOAL:
Project a balance sheet, evaluate the need for funds, evaluate
financial management effectiveness, and manage growth.
THE TOOLS:
Financial Gap
a technique which uses the "percent of sales" calculation.
©BRS 2015
58
KEY TERMS
Financial Gap .................................
The difference between the funds needed to buy new assets
and the funds available. The amount of new debt and/or equity that
the company will have to borrow in order to support increased
sales.
Percent of Sales ............................. A method for measuring the variable assets and liabilities that a
company needs to support a given level of sales. Each category of
variable assets and variable liabilities for a completed year is divided
by sales for that year. The resulting percentage can then be applied to
projected sales for future years to determine the new investment
needed for each category.
Variable Asset ................................ An asset that increases (or decreases) as sales rise or fall. For
example, more sales would mean more accounts receivable - even
though the company was collecting them just as efficiently as before
the sales increase (In other words, the pie would be cut the same, but
it would be a larger pie).
Variable Liability........................ A liability that increases to support payment of the variable assets,
which increase as a result of a sales increase. For example, more sales
would require that more inventory be kept on hand (to avoid stockouts). This, in turn, would mean carrying more accounts payable -- if
the company maintained its accounts payable turnover at the same rate
as before the increase.
Sustainable Growth .................. The rate at which a company can grow while still maintaining its
targeted debt-to-worth ratio. In other words, how fast a company can
grow if it is to maintain a specified level of financial risk.
©BRS 2015
59
Net Profits Don't Guarantee Cash Flow
Many years ago, we were involved with a partner in the jewelry supply industry. The wholesale
distribution company grew from $17,000 in sales the first year to a little over $2 million in sales
our fourth year. At this point, something very strange happened. While we were celebrating our
remarkable growth in sales and profits, we ran out of cash -- constantly. We looked at each other
and asked a question I've heard many times since: "If we're profitable, how come we don't have
any money?"
The answer, of course, revolves around the basic tendency of most of us to measure financial
success with our eyes firmly riveted only on sales -- ignoring exactly where the money is going.
To get a handle on the issue, we'll need to review the basic financial relationships and to focus on
that "forgotten" financial statement -- the balance sheet. As we've mentioned before, the
fundamental, undeniable, capitalistic formula is:
Assets = Liabilities + Net Worth
An asset is something you own; but to own it, you have to buy it. To buy it, someone has to
supply the money. And, as you know, the money is supplied by either the creditors (liabilities)
or the owners (net worth).
Now, why would you own assets in the first place? Unless your hobby is collecting them, most
businesses use them to generate sales and hopefully sales will generate profits.
In our section on financial position, we looked at the relationship between the balance sheet and
the income statement with this "efficiency" diagram:
©BRS 2015
60
THE FINANCIAL OPERATING CYCLE
Increased Sales "cause"
increased Assets
Sales
Net Profit
Increased Assets "cause"
increased Liabilities + Net
Assets
=
Liabilities + Net Worth
EFFICIENCY
Uses of Profits:
Back to:
Assets
Liabilities
Net Worth
1. To pay for new assets.
2. To pay off
3. To pay out to the owners.
When looking at financial position, we said that we need assets to make sales. Now, to see the
effects of growth, we have reversed the asset-sales arrow. This change illustrates a new way of
looking at the relationship. At any given level of sales, you need a certain amount of assets -and if you make more sales, you'll need more assets.
What we're saying is that to make profits, you need sales -- and to make sales, you need assets -and to acquire assets, you need a supply of funds. In a nutshell, this simple framework outlines
all the issues and variables involved in the financial management process.
What's the glue that supports this framework? Right back to efficiency. First, in converting
assets to sales and second, in converting sales to profits. The efficient company will need fewer
assets to produce the same sales; thus, since they need to acquire fewer assets, they will need less
capital.
Our opening paragraph asked where the money goes. Perhaps a better, and certainly more
practical issue is: Where does the money come from to buy assets?
In fact, there are really only four sources of funds to acquire new assets, and we've listed them
below:
1.
New equity.
2.
Net profits -- in the form of retained earnings.
3.
Trade credit -- or, as we call them, free liabilities.
4.
Bank debt.
©BRS 2015
61
Most business owners don't want to put in new equity; they usually are looking for legal ways to
take out more money. Net profits are generally a rather small percentage of the total funds
needed. There are definite limits to credit suppliers are willing to extend; therefore, in many
situations, bank debt becomes the only available source. Although we don't usually think of
them in this way, the bank becomes the "source of last resort," which is called in to fill the
Financial Gap. Financial Gap is defined as the difference between the value of new assets
required to support a given level of sales and the total funds supplied by new equity, net profits,
and trade credit.
Of course, you've probably never gone to the bank for a loan and said, "Hi, there. You're my last
resort because I've used up all of my other sources of funds!" -- but that's the economic reality
behind needing the bank and the bankers know it -- they didn't fall off the turnip truck yesterday
(Last week, perhaps -- but not yesterday).
Actually, during the last twenty years or so the banks have come a long way in terms of
recognizing a number of economic realities in relation to their business customers. For one
thing, they've learned that net profits don't guarantee cash flow: profitable growing companies
can have just as much trouble paying back loans as unprofitable ones. What the banks needed to
do (and did) was to change their outmoded definition of cash flow.
The traditional banking definition of cash flow was Net Profits plus Depreciation. As you can
see, such a definition only focused on sources, not uses of funds -- and it ignored completely
any changes taking place on the balance sheet.
Funds provided by operation can easily be channeled into assets other than cash -- inventories,
receivables, and/or fixed assets. When this happens, there is no "cash flow" to pay back the
bank. Consequently, since the mid-eighties, the banking industry has made increasing use of this
concept we've called Financial Gap. Our next step, then, is to examine how the financial
community uses this Financial Gap concept to evaluate your need for funds and your need for
management skills.
©BRS 2015
62
The Sponge Technique:
Squeeze the Balance Sheet to Improve Cash Flow
Everyone knows the value of a sponge: it absorbs water. This is a pretty good deal. Well, your
company's balance sheet is just like a sponge -- except that it soaks up cash, rather than water.
This is not necessarily a good financial deal. As the sponge nears its capacity to absorb
additional water, it becomes increasingly less efficient. The same thing occurs with your balance
sheet and the phenomenon has two basic causes.
Increasing sales -- or growth -- creates a need for additional money to finance an increased level
of assets. As we noted in the last section, the main source for most companies is from creditors - in other words, debt. Risk (in the form of increased debt) increases accordingly, and increasing
interest expense may even put downward pressure on profits.
Furthermore, growth in sales is often accompanied by a decrease in the efficiency of operation.
This inefficiency really surfaces on the balance sheet as proportionally more assets are required
to support new sales levels. In other words, the rate of asset growth increases faster than sales;
you make the same percent of profit -- but you make it less efficiently.
So, what do you do? From our perspective, the clear message in a growth situations is straight
forward: Manage better. We've listed below a few of the ways that can be done:
_____ Manage current assets (inventory, A/R) more efficiently
_____ Restructure debt (long-term, not short term)
_____ Make more profit
_____ Sell existing unproductive assets
_____ Curtail expansion
_____ Lease fixed assets
_____ Implement sale-leaseback of existing fixed assets
_____ Accept more risk (i.e., more debt)
_____ Don't grow (use pricing, etc. to limit growth)
_____ Get new equity -- a passive investor or active partner
©BRS 2015
63
This checklist represents the action steps necessary to manage growth effectively; you need to
arrive at the particular combination of components which will work for you (Remember, when it
comes to the balance sheet, doing "nothing" is usually the worst possible decision).
By earning the same level of profits more efficiently, sufficient cash is "squeezed out" of the
balance sheet to significantly reduce the borrowing requirements.
Consequently, this concept that we've labeled "Financial Gap" can be applied two ways. First,
it's effective as a tool to estimate borrowing needs in a growth situation -- at an existing level of
asset management efficiency. More importantly, it's an indispensable management planning tool
for developing goals and standards of performance for efficient management.
Keep in mind, then, that there are three fundamental parameters in evaluating the growth
capabilities of expanding companies:
1. How efficient is the company now?
2. The financial requirements of a particular company; that is, what new assets will
be needed?
3. The owner's abilities as an "asset manager" -- strong or weak?
Growth is reflected on the profit and loss statement as increases in sales and (hopefully) profits.
The "cost of growth" is generally reflected on the balance sheet in the form of increased debt to
offset decreased efficiency.
These are controllable issues. If you choose not to control them, then your banker may choose
to "help." This help will come in the form of restrictive covenants regarding asset management - that is, turnover requirements for inventory and/or accounts receivable (Listen for the
comment: "I'm doing this for your own good!")
What they're really saying is that borrowing implies a partnership; you supply efficient
management and your banker will supply sufficient funds. Banks are in business to finance
efficient growth - not to subsidize your inefficiency.
The sponge analogy? Well, efficiency translates to squeezing your balance sheet to free up the
funds you need to grow; otherwise, you'll find it squeezing you.
©BRS 2015
64
Steps to Calculate Financial Gap
First .........Evaluate which assets and liabilities vary with sales.
Normally Variable: cash, accounts receivable, inventory, accounts payable, and
accrued expenses.
And note payable; this is our "plug" figure -- the FINANCIAL GAP we need to fill.
Second .....Evaluate projected levels of assets which do not vary with sales.
Assets Not Normally Variable: land, buildings, equipment, and furniture/fixtures.
(These assets are normally projected based on company "capacity." They do not vary
constantly as a percentage of sales but rather, when an increase is made, they "jump"
to a new level in a "stair-step" fashion).
Third........Project a new net worth by taking existing net worth and adding projected net profit
after tax.
Fourth......Calculate each "variable" asset as a percent of sales.
Example:
Sales
=
$600,000
Accounts Receivable
=
$108,000
The "percent of sales" for Accounts Receivable is simply:
Accounts Receivable
=
Sales
©BRS 2015
108,000
600,000
65
=
.18
=
18%
Fifth .........Apply the percentages derived in Step Four to the new projected sales level.
Project new sales level
=
$900,000
Accounts Receivable %
=
18%
New level of Accounts Receivable is:
18%  $900,000 = $162,000
Sixth.........Project the new balance sheet.
Begin at Cash and move DOWN the assets side to Total Assets. As you move down
the Asset side, you will be adding projected asset elements together to arrive at Total
Assets.
Then, move ACROSS to Total Liabilities + Net Worth.
Finally, move UP the liabilities side. As you move up the Liabilities side, you will be
subtracting projected liability and net worth elements to arrive at the projected final
figure.
The final figure filled in is Notes Payable -- this is your FINANCIAL GAP.
Seventh ....Calculate the new balance sheet ratios -- the current ratio, the quick ratio, and debt-toworth. Compare these to your existing ratios.
Eighth ......Analyze. Is this where you want to be? If not, consider any or all of the following
options:
©BRS 2015
_____
Manage current assets.
_____
Restructure debt.
_____
Make more profit.
_____
Sell existing unproductive assets.
_____
Curtail expansion.
_____
Lease fixed assets.
_____
Implement sale-leaseback of existing fixed assets.
_____
Accept more risk.
_____
Don't grow (use pricing, etc. to limit growth).
_____
Get new equity.
66
Case Study
Evergreen Distributing
Evergreen Distributing is a small, local supplier of Olympic Flooring. Recently, however, their
sales have begun to increase rapidly. In the year just completed, sales reached $600,000, and
now they have a real opportunity -- and a decision to make:
 If they continue on their present course, they expect sales to rise to $900,000.
 If they "go for it" they figure they can reach $1,600,000 in sales next year.
In either case, they expect profits to remain the same as they were this year:
Net Profit After Tax: 3% of Sales
For the year just completed -- sales of $600,000 -- the balance sheet looked like this:
PERCENT
OF SALES*
PERCENT
OF SALES*
4%
Note Payable .................. $
Accounts Receivable ..... 108,000
18%
Accounts Payable ............ 90,000
15%
Inventory ........................ 156,000
26%
Accruals ........................... 42,000
7%
Total
Current Assets ...... $ 288,000
Equipment ...................... 150,000
0
Financial
Gap
Cash.............................. $ 24,000
Total
Current Liabilities .. $ 132,000
25%
Long-Term Liabilities ..... 140,000
Land/Building ........... 120,000
Total Liabilities ......... 272,000
Total Fixed Assets.... 270,000
Net Worth ...................... 286,000
Total Assets ................ $ 558,000
Total Liabilities
and Net Worth ...... $ 558,000
* Assets
and liabilities that vary with sales are indicated by an entry in the percent-ofsales column. Variable assets (as a percent of sales) are: 4% + 18% + 26% + 25% =
73%. This, in turn, is equal to Total Variable Assets/Total Sales = 438,000/600,000 = .73
©BRS 2015
67
Evergreen Distributing
Balance Sheet
TO DO: Calculate the balance sheet that Evergreen will have if they achieve their projections
of $900,000 in sales, then evaluate the financial health of the company using your
balance sheet ratios.
Projected Sales .....................$ 900,000
Projected NPAT .........................$ 27,000
PERCENT
OF SALES*
PERCENT
OF SALES*
Financial
Gap
Cash..................... $ __________
4%
Note Payable ....... $ __________
Accts. Receivable ... __________
18%
Accounts Payable ... __________
15%
Inventory ................. __________
26%
Accruals .................. __________
7%
Total
Current Assets ... $ =========
Equipment ............... __________
Land/Building ........
Total
Current Liabilities .. $ ========
25%
Long-Term Liabilities
120,000
Total Fixed Assets __________
Total Assets .......... $ =========
140,000
Total Liabilities ..... __________
Net Worth ............... __________
(old Net Worth* = 286,000)
Total Liabilities
and Net Worth .$ =========
* Reminder:
to determine what net worth will be after reaching the projected sales level,
take the old net worth (from the actual year just completed) and add the net profit after
tax from the projected year.
BALANCE SHEET RATIOS
At $600,000
At $900,000
Current
_______________
_______________
Quick
_______________
_______________
Debt-To-Worth
_______________
_______________
©BRS 2015
68
FOR REFERENCE:
BALANCE SHEET RATIO REVIEW
HOW DERIVED
DEFINITION
SOLVENCY:
Current Ratio
Current Assets
Current Liabilities
Measures solvency:
the company's ability to pay its bills.
LIQUIDITY:
Quick Ratio
(or acid test ratio)
Cash + Accts Rec.
Current Liabilities
Measures liquidity:
the company's ability to generate
cash; to pay bills without relying
on sale of inventories.
LEVERAGE:
Debt-to-Net Worth
©BRS 2015
Total Liabilities
Net Worth
Measures the company's ability
to withstand adversity:
shows the riskiness of the company.
69
Evergreen Distributing
Balance Sheet
TO DO: Calculate the balance sheet that Evergreen will have if they achieve their projections
of $1,600,000 in sales -- then evaluate the financial health of the company, both in
relation to their present situation and the alternative of going to $900,000 in sales.
Projected Sales .....................$ 1,600,000
Projected NPAT .........................$ 48,000
PERCENT
OF SALES*
PERCENT
OF SALES*
Financial
Gap
Cash..................... $ __________
4%
Note Payable ....... $ __________
Accts. Receivable ... __________
18%
Accounts Payable ... __________
15%
Inventory ................. __________
26%
Accruals .................. __________
7%
Total
Current Assets ... $ =========
Equipment ............... __________
Land/Building ........
Total
Current Liabilities .. $ ========
25%
Long-Term Liabilities
120,000
Total Fixed Assets __________
Total Assets .......... $ =========
140,000
Total Liabilities ..... __________
Net Worth ............... __________
(old Net Worth* = 286,000)
Total Liabilities
and Net Worth .$ =========
* Reminder:
to determine what net worth will be after reaching the projected sales level,
take the old net worth (from the actual year just completed) and add the net profit after
tax from the projected year.
BALANCE SHEET RATIOS
At $600,000
At $900,000
At $1,600,000
Current
_______________
_______________
_______________
Quick
_______________
_______________
_______________
Debt-To-Worth
_______________
_______________
_______________
©BRS 2015
70
FOR REFERENCE:
BALANCE SHEET RATIO REVIEW
HOW DERIVED
DEFINITION
SOLVENCY:
Current Ratio
Current Assets
Current Liabilities
Measures solvency:
the company's ability to pay its bills.
LIQUIDITY:
Quick Ratio
(or acid test ratio)
Cash + Accts Rec.
Current Liabilities
Measures liquidity:
the company's ability to generate
cash; to pay bills without relying
on sale of inventories.
LEVERAGE:
Debt-to-Net Worth
©BRS 2015
Total Liabilities
Net Worth
Measures the company's ability
to withstand adversity:
shows the riskiness of the company.
71
Managing Evergreen Distributing
Selected Options from Page 1
Here are three options that we selected to target improvement in Evergreen's efficiency. If
Evergreen can attain these goals, the company can have the benefits of growth without the cost
of growth that usually show up on the balance sheet.
MANAGE INVENTORY TURNOVER
Evergreen's Cost of Goods Sold is 70% of sales:
Inventory Turnover
Inventory Turn-Days
$900,000  70% = $630,000
=
Cost of Goods Sold
Inventory
=
$630,000
$234,000
=
2.7 turns per year
=
360 days
Inventory Turnover
=
360
2.7
=
133 days
In other words, the inventory turns once every 133 days. But . . . if Evergreen could turn the
inventory more efficiently (that is, faster), they would produce an inventory savings. At four
turns per year, for example:
©BRS 2015
4 turns
=
90 days
Inventory
=
Cost of Goods Sold
Inventory Turnover
=
$630,000
4
=
$157,500
Inventory at 2.7 turns:
$234,000
minus
Inventory at 4.0 turns:
– $157,500
equals
Inventory Savings
72
$ 76,500
MANAGE ACCOUNTS RECEIVABLE TURNOVER
The same principle applies to Accounts Receivable management.
Accounts Receivable Turnover
=
Credit Sales
A/R
=
$900,000
$162,000
=
5.6
Average Collection Period
=
360 days
A/R Turnover
Accounts Receivable Turn Days
=
360
5.6
=
64 days
If Evergreen can improve its A/R collection to 45 days, then:
Accounts Receivable Turnover
Accounts Receivable
minus
equals
=
360 days
Avg Coll Period
=
360
45
=
8
=
Credit Sales
A/R Turnover
=
$900,000
8
=
$112,500
A/R at 5.6 turns:
A/R at 8.0 turns:
A/R Savings
$162,000
– $112,500
$ 49,500
RESTRUCTURE DEBT
During the projected year, Evergreen will purchase $75,000 of equipment:
Ending Equipment:
$225,000
minus
Beginning Equipment:
– $150,000
equals
Equipment Purchase:
$ 75,000
In the Financial Gap projection, the funds needed to pay for this purchase were classified as a Current
Liability (payable within one year). If this equipment purchase is financed with 80% long-term debt, then
$60,000 will be in a long-term note, thereby "freeing up" that amount of cash flow in the coming year
which otherwise would have had to be used to repay short-term debt:
$75,000  80% = $60,000
plus
equals
©BRS 2015
Old Long-Term Debt:
Added Long-Term Debt:
New Long-Term Debt
73
$140,000
+ $ 60,000
$200,000
Evergreen Distributing
"Managed" Balance Sheet
If Evergreen was able to implement the efficiency improvements listed above -- and achieved its
target sales level of $900,000, with a net profit after tax of $27,000 -- it's balance sheet would
look like this:
PERCENT
OF SALES
PERCENT
OF SALES
Cash.............................. $ 36,000
Note Payable ......................... $ 0
Accounts Receivable ..... 112,500
Accounts Payable ............ 75,000
Inventory ....................... 157,000
Accruals .......................... 63,000
Total
Current Assets ...... $ 306,000
Total
Current Liabilities .. $ 138,000
Equipment ...................... 225,000
Long-Term Liabilities .... 200,000
Land/Building .......... 120,000
Total Liabilities ......... 338,000
Total Fixed Assets.... 345,000
Net Worth ...................... 313,000
Total Liabilities
and Net Worth ...... $ 651,000
Total Assets ................ $ 651,000
Financial
Gap
BALANCE SHEET RATIOS
At $600,000
At $900,000
At $900,000
"Managed"
Current
Current Assets
Current Liabilities
2.18
1.33
2.22
Quick
Cash + A/R
Current Liabilities
1.00
0.61
1.08
Total Liabilities
Net Worth
0.95
1.48
1.08
Debt-to-Worth
©BRS 2015
74
Answer Sheet
Evergreen Distributing
Balance Sheet
TO DO: Calculate the balance sheet that Evergreen will have if they achieve their projections
of $900,000 in sales, then evaluate the financial health of the company using your
balance sheet ratios.
Projected Sales .....................$ 900,000
Projected NPAT .........................$ 27,000
PERCENT
OF SALES*
PERCENT
OF SALES*
Financial
Gap
Cash................................$ 36,000
4%
Note Payable .................$126,000
Accts. Receivable............162,000
18%
Accounts Payable ............135,000
15%
Inventory .........................234,000
26%
Accruals ............................63,000
7%
Total
Current Assets ...........$ 432,000
Equipment .......................225,000
Total
Current Liabilities .....$ 324,000
25%
Long-Term Liabilities .
Land/Building .......... 120,000
140,000
Total Liabilities ............464,000
Total Fixed Assets........345,000
Net Worth........................313,000
(old Net Worth* = 286,000)
Total Liabilities
and Net Worth ........$ 777,000
Total Assets...................$777,000
* Reminder: to determine what net worth will be after reaching the projected sales level, take
the old net worth (from the actual year just completed) and add the net profit after tax from
the projected year.
BALANCE SHEET RATIOS
At $600,000
At $900,000
Current
2.18
1.33
Quick
1.0
.61
Debt-To-Worth
©BRS 2015
.95
75
1.48
Answer Sheet
Evergreen Distributing
Balance Sheet
TO DO: Calculate the balance sheet that Evergreen will have if they achieve their projections
of $1,600,000 in sales ―then evaluate the financial health of the company, both in
relation to their present situation and the alternative of going to $900,000 in sales.
Projected Sales .....................$ 1,600,000
Projected NPAT .........................$ 48,000
PERCENT
OF SALES*
PERCENT
OF SALES*
Financial
Gap
Cash................................$ 64,000
4%
Note Payable .................$462,000
Accts. Receivable............288,000
18%
Accounts Payable ............240,000
15%
Inventory .........................416,000
26%
Accruals ..........................112,000
7%
Total
Current Assets ............$768,000
Total
Current Liabilities ......$814,000
Equipment .......................400,000
25%
Long-Term Liabilities .
Land/Building .......... 120,000
140,000
Total Liabilities ............954,000
Total Fixed Assets........520,000
Net Worth........................334,000
(old Net Worth* = 286,000)
Total Liabilities
and Net Worth ......$1,288,000
Total Assets................$1,288,000
* Reminder: to determine what net worth will be after reaching the projected sales level, take
the old net worth (from the actual year just completed) and add the net profit after tax from
the projected year.
BALANCE SHEET RATIOS
At $600,000
At $900,000
Current
2.18
1.33
.94
Quick
1.0
.61
.43
Debt-To-Worth
.95
1.48
2.86
©BRS 2015
76
At $1,600,000