Small Business Management MGMT5601 Topic 9: Financing the Small Firm (2) Cash & Profit

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1 Small Business Management MGMT5601 Topic 9: Financing the Small Firm (2) Cash & Profit Professor Tim Mazzarol UWA Business School SBM MGMT5601 UWA Business School MBA Program

2 Learning outcomes In this topic you should learn how to: Know financial accounting terms. Understand the importance of the working capital cycle within the small firm. Understand and calculate the breakeven point. Understand and apply the power of gross profit margin. Recognise the importance of pricing for profit. Review credit policy issues and relate these to cash flow management and profitability. Mazzarol all rights reserved

3 Confusion over accounting jargon in SMEs Questions asked by ownermanagers: Why does a balance sheet have to balance? Is it good to have lots of assets? Shouldn t we minimize our liabilities? Equity isn t it about being equal? Why do we call people to who we owe a debt Creditors? Why do we call people we give credit to Debtors? Why do you say Profit and Loss? Surely it should be Profit OR Loss? Why is a car a FIXED asset when I can move it? Why are workers Variable?

4 The Holy Trinity Balance Sheet Provides a crosssectional snapshot of the firm s net worth Assets Liabilities = Owner s Equity Profit & Loss Statement Provides a picture of the firm s past trading history Income Expenses = Net Profit Cash Flow Forecast Provides a forward estimate of the firm s expected sales income & expenditures Debtors Creditors = Net Income

5 Balance Sheet Is a snapshot in time of the firm s value Liabilities Equity Assets Money owed to others Net Worth Cash, Receivables, Stock, Equipment & Property Comparing balance sheets over time shows the overall performance of the business. Balance sheet analysis allows the small business owner to make decisions about the overall strength of their firm. The Balance sheet shows the amount of cash and liquid assets available at that time and accounts receivable for future cash flow and working capital. Shows longer term assets that provide a foundation for future growth. Also shows the debt the firm has to pay within the financial year along with any longer term debt. Source: Shultz (2006)

6 Balance Sheet - Assets ASSETS: Current Assets (Cash & Cash Equivalents) Assets that are reasonably expected to be consumed sold for cash, or transformed into cash within the normal operating cycle (i.e. the financial year). Identifies the firm s working capital (liquidity). Inventory should be as low as possible. Non-Current Assets Durable assets used in the operation of the business. Accumulated Depreciation The aggregate of charges against earnings to write off the cost of an asset over its estimated useful life. Other Assets May consist of intangible such as patents, prepaid expenses, surrender value of life insurance. Current Assets Current Liabilities Cash $260,000 Accounts payable $350,000 Accounts receivable $580,000 Accrued expenses $190,000 Inventory $10,000 Income tax payable $10,000 Prepaid Expenses $120,000 Short term notes $50,000 Total Current Assets $970,000 Total Current Liabilities Non-Current Assets Non-Current Liabilities $600,000 Equipment, Furniture $50,000 Mortgages $100,000 Less: Depreciation ($20,000) Shareholders Equity & Retained Earnings $30,000 Total Assets $1,000,000 Total Liabilities & Equity $300,000 $1,000,000 Sources: Tarantino (2001) Shultz (2006)

7 Balance Sheet - Liabilities Current Assets Current Liabilities Cash $260,000 Accounts payable $350,000 Accounts receivable $580,000 Accrued expenses $190,000 Inventory $10,000 Income tax payable $10,000 Prepaid Expenses $120,000 Overdraft $50,000 Total Current Assets $970,000 Total Current Liabilities Non-Current Assets Non-Current Liabilities $600,000 Equipment, Furniture $50,000 Mortgages $100,000 Less: Depreciation ($20,000) Shareholders Equity & Retained Earnings $30,000 Total Assets $1,000,000 Total Liabilities & Equity $300,000 $1,000,000 LIABILITIES: Current Liabilities Obligations that must be paid from current assets during the normal operating cycle. Usually includes monies to be paid to creditors, expenses accrued from past period, accumulated tax liabilities (e.g. GST) and short term credit. Non-Current Liabilities Obligations such as mortgages that do not have to be paid in the normal operating cycle. Might also include director s loans Shareholder Equity & Retained Earnings Shareholder equity can include common and preferential stock. Retained Earnings is profits from past trading periods not distributed to shareholders. Total Liabilities and Equity Together these two items should equal total assets. Sources: Tarantino (2001) Shultz (2006)

8 Graphic display of the Balance Sheet Fixed Assets (less depreciation), $100,000 Equity & Retained Profits, $350,000 Mortgages, $50,000 Current Assets, $900,000 Current Liabilities, $600,000 Assets Liabilities

9 Dynamic Balance Sheet Assets = Funding Need Liabilities = Funding Available F I X E D Net Fixed Assets: Property, Plant & Equipment Less Depreciation Net Fixed Assets $50,000 -$20,000 $30,000 Net Equity: Share Capital & Retained Profits Director s Loans (provided by owner) Intangibles (e.g. patents, goodwill at purchase) $300,000 V A R I A B L E Net Working Assets: Inventory Accounts Receivable (Debtors) Prepaid Expense Less Current liabilities: Accounts Payable (Creditors) Accrued Expenses Income Tax Payable Short Term Notes $10,000 $580,000 $120,000 -$350,000 -$190,000 -$10,000 -$50,000 Borrowings: Creditor Strain (Accounts Payable Overdue) Mortgages Less Cash $100,000 -$260,000 Net Working Assets $110,000 Net Borrowings -$160,000 Assets = Funding Need $140,000 Liabilities = Funding Available $140,000 Shows total asset or funding needed against funding available within the business. Any short fall between assets and liabilities is usually filled by creditor strain and/or director s loans.

10 Profit and Loss Statement Shows the firm s performance over a given time period including sales revenues, both variable and fixed costs and the amount of profit generated. The P&L statement breaks down the income and expenses by major categories and can be valuable to show how profitable a business is. Regular monitoring of the P&L on a monthly or quarterly basis allows corrective action to be taken. Sales Revenue Cost of Goods Sold Gross Profit Overhead Costs Net Profit (EBIT) Money paid to the firm by customers. Variable Costs e.g. direct labour and materials. Profit from sale of goods or services before allocation of overhead costs. Fixed costs e.g. salaries, rent & admin expenses. The bottom line Earnings Before Interest & Tax Sources: Tarantino (2001) Shultz (2006)

11 Profit and Loss Statement key elements The P&L Statement shows the performance of the business over a given time period Profit & Loss Statement Revenue $1,500,000 Less: Operating Expenses (COGS) $500,000 Gross Profit $1,000,000 Less Overhead Costs: Administration & Salaries $500,000 Depreciation $20,000 Earnings Before Interest & Tax $480,000 Converting to % of sales provides ability to compare trends: Gross profit margin = (Gross Profit x 100) Sales Gross profit margin = 66.7% Overheads = 33.3% EBIT = 32% Interest charges $20,000 Income Tax Payable $110,000 Net Income $350,000 Net Profit Margin = 23.3% Sources: Tarantino (2001) Shultz (2006)

12 Cash Flow Statement Cash Flow Statement reports the sources and uses of cash during a specific time period. Usually examines cash flow from operations, investments and financing. Forecasting cash flow is important to knowing how the business is performing., any variance between forecasts and actual cash flow requires urgent attention. Accounts Receivable Accounts Payable Operating Cash Flow Cash flow from other sources Net Change in Cash Flow Money owed to firm by debtors. Money owed by firm to creditors. Cash income (+/-) prepaid expenses, inventory & tax payable Cash flow from investments & financing The amount of cash (+/-) during the period. Sources: Tarantino (2001) Shultz (2006)

13 Cash Flow Statement key elements Cash Flow Statement shows how much cash is available plus sources and uses of cash in the business Cash Flow Statement Net income from P&L $350,000 Changes in Assets & Liabilities: Accounts Receivable ($320,000) Inventory ($5,000) Prepaid Expenses ($10,000) Accounts Payable $20,000 Income Tax Payable $2,000 ($313,000) Operating Cash Flow before depreciation $37,000 Depreciation $20,000 Cash flow from operations $57,000 Cash flow from investments ($10,000) Cash flow from financing (mortgage) ($40,000) Cash flow from operations Includes net income from P&L, plus changes in assets and liabilities. Accounts receivable is cash outflow as the money has not yet been received. Accounts payable is cash inflow because the money has not yet been paid so it held at bank. Cash flow from investments Is cash outflow from the purchase of new investments and inflow if sold. Cash flow from financing Includes cash obtained from long or short term loans, or the sale of any equity in the business. Any payment of debt or dividend payments to shareholders is recorded as an outflow. Change in cash bottom line shows if firm has had a positive or negative cash flow for the period. Change in Cash $7,000 Sources: Tarantino (2001) Shultz (2006)

14 Cash flow forecasting

15 The Working Capital Cycle purchases production costs CASH selling and distribution costs sales receipts suppliers (trade creditors) raw materials work in progress finished goods sales customers (trade debtors) Source: Snaith and Walker, 1999

16 The Financial Operating Cycle Working capital is essential to the operation of the business. Assets in the balance sheet are used to create sales and are funded by liabilities and net worth (e.g. owners equity and retained profits. The P&L statement shows sales revenues, less cost of goods sold (COGS) and overhead costs resulting in a net profit or loss. Any profits can then be distributed by the owner in one of three ways: 1. To purchase more assets 2. To repay debt 3. To pay dividends to the owner Source: Sgambelluri (2010)

17 Improving the small business cash flow

18 Improving small business cash flow Tips for improving cash flow: 1. Get the payment upfront 50% if possible. 2. Invoice same day you deliver the service or the product. 3. Collect payment on time chase payment as soon as it is due. 4. Take advantage of credit or payment terms from suppliers. 5. Keep you overheads flexible outsource tasks. 6. Manage inventory don t keep too much stock. 7. Don t be dependent on one or two suppliers.

19 Cash and Working Capital Measures Cash Flow Forecast Stock as % of Sales Debtors as % of Sales Creditors as % of Sales Creditor Strain as % of Sales Creditor Strain = unauthorized extra credit taken from suppliers True Working Assets as % of Sales (Stock + Debtors Creditors + Creditor Strain)

20 Financial DOC. Analysis Debt From the balance sheet: Debt/Equity Ratio Does the business have too much debt? Should be less than one. Should be more equity than debt. Current Ratio Current assets Current liabilities Determines if a business can pay its bills when they fall due? Ratio should be greater than two. Operations From the P&L statement: Gross profit margin Net profit margin Has profit grown with revenues? Cash From the balance sheet How much cash is available? From the cash flow statement Are they positive or negative? How has cash been obtained & used? How fast does cash cycle? Days receivable ratio Days payable ratio How much cash reserve? Source: Tarantino (2001)

21 DOC Analysis - Debt Current Assets Current Liabilities Cash $260,000 Accounts payable $350,000 Accounts receivable $580,000 Accrued expenses $190,000 Inventory $10,000 Income tax payable $10,000 Prepaid Expenses $120,000 Overdraft $50,000 Total Current Assets $970,000 Total Current Liabilities Non-Current Assets Non-Current Liabilities $600,000 Equipment, Furniture $50,000 Mortgages $100,000 Less: Depreciation ($20,000) Shareholders Equity & Retained Earnings $30,000 $300,000 Debt = $700,000 (current liabilities plus mortgages) Equity = $300,000 Debt/Equity Ratio = 2.33 Should be less than ONE suggesting that the firm may have too much debt. Current Assets = $970,000 Current Liabilities = $600,000 Current Ratio = 1.62 Should be greater than TWO. Suggests the firm may have difficulty in covering its current liabilities when they come due. This business may have some debt problems. Total Assets $1,000,000 Total Liabilities & Equity $1,000,000 Source: Tarantino (2001)

22 DOC Analysis - Operations Profit & Loss Statement Revenue $1,500,000 Less: Operating Expenses (COGS) $500,000 Gross Profit $1,000,000 Less Overhead Costs: Administration & Salaries $500,000 Depreciation $20,000 Earnings Before Interest & Tax $480,000 Interest charges $20,000 Income Tax Payable $110,000 Net Income $350,000 The business has a positive net income of $350,000 for this period with gross margin of 66.7%. However, only a comparison with past years will tell if the firm is trending in the right direction. At least three consecutive years of financial statements should be examined to see just how well the business has been trading. Source: Tarantino (2001)

23 DOC Analysis - Cash Current Assets Current Liabilities Cash $260,000 Accounts payable $350,000 Accounts receivable $580,000 Accrued expenses $190,000 Inventory $10,000 Income tax payable $10,000 Prepaid Expenses $120,000 Overdraft $50,000 Total Current Assets $970,000 Total Current Liabilities Non-Current Assets Non-Current Liabilities $600,000 Equipment, Furniture $50,000 Mortgages $100,000 Less: Depreciation ($20,000) Shareholders Equity & Retained Earnings $30,000 Total Assets $1,000,000 Total Liabilities & Equity $300,000 $1,000,000 Business has $260,000 in cash. Cash Flow Statement shows a positive cash inflow of $7,000. But how long to bring new cash in? Debtor Collection Period (365 days x Accounts Receivable) Sales (365 x $580,000) $1,500,000 = 141 days It takes around 3.5 months for this business to collect its accounts receivable from debtors. This could be too long if working capital is not sufficient. Cash reserve should equal 3-4 months Yearly expenses (COGS + Overheads) 12 months $1,000, = $83,333 per month $83,333 x 3.5 = $291,665 cash required Firm lacks sufficient cash reserve. Source: Source: OECD Tarantino (2006)(2001)

24 Radar Chart for Financial KPIs Radar Chart Gross Contribution 70% Net Working Assets 60% 50% 40% Net Contribution Gross margin unchanged Net margin fallen by 10% 30% 20% 10% Break Even gap risen by 17% Stock turnover fallen by 3% 0% Debtors risen by 6% Debtor collection >120 days Creditors Break-even Gap Creditors fallen by 6% Creditor payment >60 days Net Working Assets risen by 10% Debtors Stock Year 2 Year 1

25 Financial control Are cash flows being monitored? What key financial measures are used? Are such measures relevant for this business? Do all decision makers understand them? Are they used for decision making? Is the owner-manager in control?

26 Gross Profit Margin Gross Profit Margin: The gap between sales and variable costs The real income of the business Example: Sales $100 Direct material cost $40 Labour cost $20 Delivery cost $ 5 Total $ 65 Gross Profit $ 35 Gross Margin %: Gross Margin/Sales = Gross Margin % 35 / 100 = 35%

27 Power of Gross Profit Margin Sales $ Gross Margin % Gross Margin $ 1,000 10% % % % %

28 Power of Gross Profit Margin Sales $ Gross Margin % Gross Margin $ 1,000 10% % % % % 100

29 Power of Gross Profit Margin Gross Margin $ Gross Margin % Sales $ 100 5% % % % % % %

30 Power of Gross Profit Margin Gross Margin $ Gross Margin % Sales $ 100 5% 2, % 1, % % % % % 200

31 How Gross Profit Margin Impacts Pricing Chart-A Existing % Gross Margin % price reduction % volume increase for same gross profit A higher Gross Margin allows more flexibility in pricing strategy

32 Profitability Sales Gross Profit % Expenses/Fixed Costs Breakeven sales Net profit before tax as % of sales Retained profit as % of sales

33 Break-Even Point The break-even point is the stage where a company s sales is equal to its cost of production. By definition, the company will lose money if sales are less than this amount, and make a profit if sales are greater than this amount.

34 Break-Even Graph Sales The higher a business operates above the Breakeven Line the greater its Margin of Safety Sales $216,000 Profit Breakeven Line $80,000 Loss $70,000 Months

35 Calculating Break-Even FIXED COST GROSS MARGIN % Example: = BREAK EVEN POINT 1) Fixed Costs $ 3,000 2) Gross Margin 30% 3) Break Even $10,000 Sales $ 30% = $2,100 = Gross Margin Less B/Even 30% = $3,000 = Fixed costs Short fall ($ 3,000) = ($ 900)

36 Calculating Break-Even FIXED COST GROSS MARGIN % Example: = BREAK EVEN POINT 1) Fixed Costs $ 3,000 2) Gross Margin 30% 3) Break Even $10,000 Sales $ 30% = $4,500 = Gross Margin Less B/Even $ 30% = $3,000 = Fixed costs Excess over B/E $ 5,000 = $1,500 $1,500 profit is made on sales of $5,000 over B/Even

37 Ways to Reduce Break-Even Break Even Point can be reduced by: Cutting fixed costs Improving gross margin percentage Example: 1) Fixed Costs reduced by $600 to $2,400 2) Gross Margin increased to 40% 3) Break Even falls to $6,000 Sales $ 40% = $2,800 = Gross Margin Less B/Even $ 40% = $2,400 = Fixed costs Excess over B/E $ 1,000 = $ 400 $400 profit is made on sales of $1,000 over B/Even

38 Break-Even Example Annual Forecast 1. Sales $216, Opening stock $76, Plus purchases $120, Less closing stock $100, Goods or materials used ( ) $96, Wages or Salaries $64, Fixed Costs $20,720 Projected Profits 1. Sales $216, Goods or materials used ( ) $96, Wages or salaries $64, Less variable costs ( 5 + 6) $160, Gross Profit (profit before fixed costs 1 8) $56, Less Fixed Costs $20, Net Profit (profit after fixed costs 9 7) $35,280 Gross Profit Margin: (Gross profit x 100) Sales ($56,000 x 100) $216,000 = 25.9% If gross profit is reached and fixed costs don t change break-even is calculated: (Fixed Costs x 100) Gross Profit Margin ($20,720 x 100) 25.9% = $80,000 B/Even turnover required $80,000 OR $80,000 turnover at 25.9% profit margin = $20,270 (enough to cover fixed costs) Break-Even required per month: $80, months = $6,666 per month

39 Four Types of Manager S B The Busy Fool Break-Even rises along with sales wiping out profits. S B The Excellent Manager Break-Even falls as sales rise leading to increasing profits. S B The Bad Manager Break-Even rises as sales fall eroding profits. S B The Good Manager Break-Even falls as Sales fall maintaining profits.

40 Principles of Financial Control Measure break even regularly Focus on getting break even down relative to sales and keep it below sales Reduce break even relative to sales by improving gross margin or reducing fixed costs Improve gross margin by: Raising prices Reducing variable costs Better mix of sales with higher contribution per product Avoid trying to increase sales by reducing prices as this usually increases break even more quickly (Busy Fool)

41 Case study: Kitsol Pty Ltd Assess the financial performance of KITSOL so far, examine its break even, gross profit and working capital requirements. What type of managers have the owners been? Prepare a dynamic balance sheet and a radar chart for KITSOL. Calculate the funding requirement for KITSOL and determine if the owners can afford to fund a future planned growth strategy.

42 End of Presentation