MODULE 8

PREPARING FINANCIAL STATEMENTS

Some entrepreneurs run into financial difficulty even when they attain high sales volumes. Their concern with the day-to-day operation of their business ventures causes them to overlook the part of the business plan that will tell them if, and when, they will make a profit. They have neglected financial planning. You will learn about this critical part of the business plan in this chapter. Through financial planning, you will describe your business plan in terms of dollars.

OBJECTIVES:

After studying this module, the student should be able to:

1.      Prepare a cash budget, an income statement, and a balance sheet.

2.      Describe how price, volume, cost of sales, and operating expenses affect net profit.

3.      Set a goal for a new enterprise.

FINANCIAL STATEMENTS      

Financial statements can take various forms depending on how you want to use them. Their purpose is to document important facts about the enterprise’s operation. The business plan for a new enterprise should include three financial statements: a cash budget, an income statement, and a balance sheet.

Cash Budget

A cash budget is a measure of changes in the cash an enterprise will have available from month to month. Businesses use cash budgets to estimate cash needs for a period in the future, usually twelve months.

The first step in preparing a cash budget is to determine the cash balance at the beginning of the month. This shows how much cash is on hand (e.g., in cash registers) and in the bank.

The second step is to estimate cash receipts. Cash receipts include all funds that will be received from cash sales, collection of credit sales, and loans. This estimate will be based on your sales forecast. When cash receipts are added to the cash balance, the sum is the total cash available for use by the business during the month.

The next step in the budget process is to estimate cash disbursements. These refer to cash that will have to be paid out during the month for purchases and operating or continuing expenses. The largest cash outlays are usually for merchandise and wages and salaries.

Finally, when you subtract the total cash disbursements from total cash available, the result is the cash balance at the end of the month. This figure then becomes the beginning cash balance for the next month.

The cash budget formula is:

                                      Beginning Cash Balance for MONTH 1

                                          +   Cash Receipts                                 .

                                          =   Total Cash Available

                                          -     Total Cash Disbursements              .

                                          =   Cash Balance at End of MONTH 1

                                          =   Beginning Cash Balance for MONTH 2

To further explain how a cash budget is prepared, let us assume that Christian and Manuel are planning to open a T-shirt shop on July 1. All the one-time costs of start-up have been paid and they have PhP20,000 in cash.

Christian and Manuel have decided to sell only on a cash basis, at least for the time being. They estimate their sales for the first three months as follows: PhP30,000 in July, PhP40,000 in August, and PhP48,000 in September. They believe their cash disbursements for those months will be PhP32,000, PhP41,000, and PhP49,000 respectively.

As their cash budget shows, sales increase each month, but the cash balance decreases because their expenses increase each month. This may be a signal that the business is heading for trouble. Without the cash budget, the partners might not have learned of the problem until it was too late. At least now they have time to do something about it. Fore example. They should find out if they are overspending in some areas. Maybe they have spent too much on merchandise, or they may want to arrange for a loan in case the cash balance continues to slide. The loan could then be repaid when the cash situation improves.

Income Statement

The income statement shows how a business has performed over a certain period of time. It is also referred to as a profit-and-loss statement.

Some entrepreneurs prepare income statements just once a year; others do so more frequently. An entrepreneur of a new enterprise should prepare an income statement every month, or at least every three months. You will then have a better idea of how the business is operating. If problems occur, you will be able to take quick action.

The parts included in an income statement are sales, cost of sales, gross profit, expenses, and net profit.

The term sales refers to all income that flows into the business from sales activity. Extractive business ventures, manufacturers, wholesalers, and retailers obtain this income from the sale of goods. Service businesses derive their sales income from fees charged when services are provided.

Cost of sales represents the cost of the products or services sold in a given time period. Cost of sales is called cost of goods sold by retailers and wholesalers. It represents what they pay for products they sell. In manufacturing, cost of sales is known as cost of goods manufactured.

It includes only those costs directly associated with making the product. A service business may calculate the cost of services sold based on wages paid to persons providing the service.

Gross profit, known as gross margin when stated as a percentage, is determined by subtracting cost of sales from sales. Gross profit should not be confused with net profit, a term to be described below. The formula for calculating gross profit is:

Gross Profit = Sales – Cost of Sales

Expenses are all the costs of running an enterprise, other than those included in the cost of sales. Many continuing costs are expenses. Some of the items included are advertising, insurance, rent, utilities, and interest on debt.

Net profit is the income remaining after paying all expenses, including taxes.

The parts of an income statement are related as follows:

Net Profit = Sales – Cost of Sales – Expenses

or

Net Profit = Gross Profit – Expenses

A projected income statement is based on the entrepreneur’s estimates of sales, cost of sales, and expenses for the first year. Such a statement should be included in every business plan. Without a projected income statement, the entrepreneur will not be able to determine the profit potential of the new enterprise.

When the business is actually in operation, data will be available to prepare a regular income statement. That is, the statement would be based on actual rather than projected figures.

Balance Sheet 

The balance sheet is used to keep track of what an enterprise owns, what it owes, and what the owner has invested. A balance sheet is like a picture of the enterprise’s assets and claims against those assets for a particular date.

This financial statement is called a balance sheet because assets balance with, or are equal to, liabilities plus net worth. This is shown as follows:

Assets = Liabilities + Net Worth

Assets are items or possessions used in the business which have monetary value. On the balance sheet, assets are divided into three groups: current assets, fixed assets, and intangible assets.

Current assets are those which the enterprise would not expect to hold longer than one year. This group includes cash as well as other items that can be easily and quickly converted to cash. Examples are merchandise in inventory and accounts receivable, which are sums of money owed to the enterprise by customers.

Fixed assets are items that the business expects to own for more than one year. These items are not used up, or converted into cash, in a short period of time. Typical examples are land, buildings, equipment, and trucks.

The third group of assets is intangible assets. These assets have value and are useful to the enterprise, but they do not exist in a physical sense. A common example is goodwill, which you may have to pay for when buying an existing enterprise. Goodwill is extra money paid because the enterprise has a good reputation. Other intangible assets found in balance sheets are copyrights, patents, and franchises.

Liabilities are debts of the enterprise. They are usually divided into two groups: current liabilities and fixed liabilities.

Current Liabilities are debts that are due to be paid in one year or less. Debts commonly included in this category are:

            Accounts payable       - Amounts owed to suppliers for goods and services provided.

            Notes payable          - Short-term loans that have to be repaid within a year.

            Accrued expenses      - Expenses incurred but not yet paid, such as wages that have been earned but not yet paid.

Debts that are due to be paid in more than a year are called fixed liabilities. They are also known as long-term liabilities. Mortgages and long-term loans are examples.

The excess of the value of the assets over the value of the liabilities is called net worth. This includes all money invested by owners, known as owner’s capital, plus accumulated profits less withdrawals. The method for computing net worth is:

Net Worth = Total Assets – Total Liabilities

The balance sheet is important because it reveals the enterprise’s ability to repay both long-term and short-tem debts. For this reason, bankers and other lenders often ask to see this financial statement before lending money.

BASIC PROFIT VARIABLES

Entrepreneurs make countless decisions about how their businesses are to operate. Some decisions are made infrequently and have long-term effects. An example is the decision to select a location for the enterprise. Other decisions, such as setting the price for an item, are made more frequently and have short-term effects. Ultimately, however, all decisions are related to the four basic profit variables of price, volume of sales, cost of sales, and operating expenses. A change in any one of the variable affects net profit.

As shown in Figure A, the owners of Fiesta Chair Store estimate that they will sell 1,000 chairs at a price of Php100 each. Total sales for the year will be Php100,000. The owners also expect to pay Php60 for each bicycle and to incur Php35,000 in operating expenses during the year.

Fiesta Chair Shop Projected Income Statement For Year Ended December 31, 2006                                                                         Original Estimate Sales (1,000 units @ 100)                                                  100,000 Cost of Sales (1,000 unites @ 60)                                        60,000 Gross Profit                                                                     40,000 Operating Expenses                                                          35,000 Net Profit                                                                          5,000   Figure A

 

Assume the Fiesta’s owners want to see how changes in the basic profit variables would affect the original estimates shown in Figure A. The series of income statements in Figure B through E will illustrate the impact of these changes.

A Change in Price

One way to increase profits is to raise prices. Assume that the owners of Fiesta Chair Shop could raise prices by 5%, or Php5, and still sell 1,000 chairs during the year. Perhaps they are able to do this because their prices are not as high as their competitors’ prices. With the price increase of 5%, the selling price for each chair would be Php105. The sales figure on the income statement would be determined as follows: 1,000 chairs x Php105 = Php105,000. The effect on net profit is shown in Figure B.

Fiesta Chair Shop Projected Income Statement For Year Ended December 31, 2006                                                    Change in Price      Original Estimate Sales (1,000 units @ 105)                          105,000             100,000 Cost of Sales (1,000 unites @ 60)                60,000               60,000 Gross Profit                                             45,000               40,000 Operating Expenses                                  35,000               35,000 Net Profit                                                10,000               5,000   Figure B

 

The percent by which a number increases or decreases can be determined by following two steps. First, find the peso amount of the increase or decrease from the original estimate. Second, divide the peso amount of the increase or decrease by the original estimate. The answer is the percent by which the number increased or decreased.

Notice that if the owners raised prices 5%, net profit would increase by 100%, from Php5,000 to Php10,000. This example points out the importance of making sound pricing decisions. Even small increases in prices can improve profits. Charging prices that are too low can lower profits or cause losses.

A Change in Volume of Sales

Prices charged for individual products and the number of products sold, or volume, together that determine the sales figure appearing on the income statement. Rather than increasing their prices, assume now that the owners of Fiesta Chair Shop want to see what would happen if they lower their prices. Specifically, they believe that they could sell 1,200 chairs, instead of 1,000, if they lower the price by 5%, or Php5. The selling price becomes Php95. On the income statement, the sales figure would be the product of multiplying Php95 by 1,200, or Php114,000. The effect on net profit of this change in sales volume is shown in Figure C.

Net profit will increase from Php5,000 to Php7,000 if the shop can sell 200 more chairs  at the lower price of Php95. Note that the increase in sales volume was accompanied by an increase in cost of sales. This, of course, is a result of the need to buy 200 additional chairs for resale. In this example, the selling price was reduced by Php5, while sales volume increased by 20% and profit increased by 40%.

Fiesta Chair Shop Projected Income Statement For Year Ended December 31, 2006                                                 Change in Volume    Original Estimate Sales (1,200 units @ 95)                          114,000            100,000 Cost of Sales (1,000 unites @ 60)                72,000               60,000 Gross Profit                                             42,000               40,000 Operating Expenses                                  35,000               35,000 Net Profit                                                 7,000                 5,000   Figure C

 

A Change in Cost of Sales

Another way to increase net profit is to reduce cost of sales. Assume that Fiesta Chair Shop’s owners have decided to replace the chairs they now carry with another manufacturer’s chair. The new product is equal in quality to the current product, but it costs 5% less, or Php57 per chair. In Figure D, sales are Php100,000 and the cost of sales is Php57,000. Notice the effect of the change in cost of sales.

As a result of a 5% decrease in the cost of each unit sold, Fiesta Chair Shop’s owners would see their net profit change from Php5,000 to Php8,000, an increase of 60%.

A Change in Operating Expenses

A fourth way to increase net profit is to reduce operating expenses. Assume that the owners Fiesta Chair Shop have studied every operating expense, such as wages, salaries, and rent, and they have decided that they could reduce some of those expenses to save Php5,000 during the year. Most of the savings would come from reducing the number of hours worked by their part-time employees and working more hours themselves. As shown in Figure E, the Php5,000 reduction in operating expenses results in a Php5,000 increase in net profit.

When other factors remain the same, net profit increases with:

Fiesta Chair Shop Projected Income Statement For Year Ended December 31, 2006                                        Change in Cost of Sales        Original Estimate Sales (1,000 units @ 100)                        100,000            100,000 Cost of Sales (1,000 unites @ 57)                57,000               60,000 Gross Profit                                             43,000               40,000 Operating Expenses                                  35,000               35,000 Net Profit                                                 8,000               5,000   Figure D

1.      An increase in price.

2.      An increase in volume.

3.      A decrease in cost of sales.

4.      A decrease in operating expenses.

With the exception of sales volume, which is accompanied by a change in cost of sales, the other variables operate independently of one another. That is, a change in one variable does not affect another variable.

Fiesta Chair Shop Projected Income Statement For Year Ended December 31, 2006                                  Change in Operating Expenses    Original Estimate Sales (1,000 units @ 100)                        100,000            100,000 Cost of Sales (1,000 unites @ 60)                60,000               60,000 Gross Profit                                             40,000               40,000 Operating Expenses                                  30,000               35,000 Net Profit                                                10,000               5,000   Figure E

 

SETTING YOUR GOAL     

As you finish reading this final module, you may have realized that you want to become an entrepreneur. If so, choose a tentative date for starting your enterprise. It may be next week, next year, or a few years away. The important thing is that you give yourself a target date. Then think about these questions:

1.      What will you be doing between now and the day you begin the enterprise? What work experience and further schooling can you obtain to prepare for a career in entrepreneurship?

2.      What can you do to make sure you are financially prepared to create your own enterprise? How much money can you save in the meantime?

If you are serious about becoming an entrepreneur, you can use your business plan as a guide in reaching your goal.

Questions to Answer:

Part I.

Match the following terms with the statements that best define the terms. Write the letter of your choice in the space provided.

Part II.

Write a short answer to each of the questions below.

1.      What financial statements should be included in the business plan?

2.      Describe the cash budget formula.

3.      Show how the parts of an income statement are related.

4.      Explain why one type of financial statement is called a balance sheet.

5.      Describe each of the four basic profit variables.

6.      What questions should you ask yourself after setting a tentative date for starting a new enterprise?