Authors: Inc The Staff of Entrepreneur Media

Start Your Own Business (105 page)

BOOK: Start Your Own Business

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Cash-Flow Analysis

The cash-flow statement enables you to track cash as it flows in and out of your business and reveals to you the causes of cash-flow shortfalls and surpluses. The operating activities are the daily occurrences that are essential to any business operation. If these are positive, it indicates to the owner that the business is self-sufficient in funding its daily operational cash flow internally. If the number is negative, then it indicates that outside funds were needed to sustain the operation of the business.

SAVE

Many new business owners can’t afford to seek paid professional advice. Here are three free resources for invaluable financial guidance: 1.
Your banker
: Even if you aren’t borrowing money for startup, get to know a loan officer where you have your checking account. Meet periodically to discuss the financial direction of your venture. 2.
Other business owners
: Make the time to network with other small-business owers. 3.
SCORE
: This is a national volunteer organization set up for the sole purpose of helping new business owners succeed.

Investing activities generally use cash because most businesses are more likely to acquire new equipment and machinery than to sell old fixed assets. When a company does need cash to fund investing activities in a given year, it must come from an internal operating cash-flow surplus, financing activity increases or cash reserves built up in prior years.

Financing activities represent the external sources of funds available to the business. Financing activities typically will be a provider of funds when a company has shortfalls in operating or investing activities. The reverse is often true when operating activities are a source of excess cash flow, as the overflow often is used to reduce debt.

The net increase/decrease in cash figure at the bottom of the cash-flow statement represents the net result of operating, investing and financing activities. If a business ever runs out of cash, it can’t survive, so this is a key number.

Our hypothetical clothing business, ABC Clothing Inc., provides a good example. In Year 1, the growth in the business’s accounts receivable and inventory required $115,000 in cash to fund operating activities. The purchase of $150,000 in equipment also drained cash flow. ABC funded these needs with the sale of common stock of $75,000 and loans totaling $210,000. The outcome was that the company increased its cash resources by $10,000.

Year 2 was a different story. Because the company had a net income of $126,000, there was a good deal more cash ($58,600) flowing in from customers than flowing out to suppliers, employees, other operating expenses, interest and taxes. This enabled ABC to reduce its overall outside debt by $47,600 and increase its cash balance by $10,000.

“Formula for success:
Rise early, work hard,
strike oil.”
—J. PAUL GETTY, FOUNDER
OF THE GETTY OIL COMPANY

When you start your business, you’ll be able to use the cash-flow statement to analyze your sources and uses of cash not only from year to year, but also from month to month if you set up your accounting system to produce monthly statements. You will find the cash-flow statement to be an invaluable tool in understanding the hows and whys of cash flowing into and out of your business.

As a new business owner, you will need accurate and timely financial information to help you manage your business effectively. Your financial statements will also be critical budgeting tools as you seek to achieve financial milestones in your business.

chapter 39

ON THE MONEY

Effectively Managing Your Finances

By J. Tol Broome Jr.
a freelance business writer and banker with 28 years of
experience in commercial lending

N
ow that you have the framework for establishing a bookkeeping system and for creating financial statements, what’s next? In this chapter, we will explore how to analyze the data that results from an effective financial management and control system. Additionally, we’ll consider the key elements of a good budgeting system. The financial analysis tools we will discuss are computing gross profit margin and markup, in addition to break-even, working capital and financial ratio analyses. In the section on budgeting, we will look at when, what and how to budget as well as how to perform a sensitivity analysis.

“Success is the ability
to go from one failure
to another without the
loss of enthusiasm.”
—WINSTON CHURCHILL

Gross Profit Margin and Markup

One of the most important financial concepts you will need to learn in running your new business is the computation of gross profit. And the tool that you use to maintain gross profit is markup.

The gross profit on a product sold is computed as:

Sales - Cost of Goods Sold = Gross Profit

To understand gross profit, it is important to know the distinction between variable and fixed costs. Variable costs are those that change based on the amount of product being made and are incurred as a direct result of producing the product. Variable costs include:

• Materials used

• Direct labor

• Packaging

• Freight

• Plant supervisor salaries

• Utilities for a plant or a warehouse

• Depreciation expense on production equipment and machinery

Fixed costs generally are more static in nature. They include:

• Office expenses such as supplies, utilities, a telephone for the office, etc.

• Salaries and wages of office staff, salespeople, officers and owners

• Payroll taxes and employee benefits

• Advertising, promotional and other sales expenses

• Insurance

• Auto expenses for salespeople

• Professional fees

• Rent

Variable expenses are recorded as cost of goods sold. Fixed expenses are counted as operating expenses (sometimes called selling and general and administrative expenses).

Gross Profit Margin

While the gross profit is a dollar amount, the gross profit margin is expressed as a percentage. It’s equally important to track since it allows you to keep an eye on profitability trends. This is critical, because many businesses have gotten into financial trouble with an increasing gross profit that coincided with a declining gross profit margin. The gross profit margin is computed as follows:

Gross Profit ÷ Sales = Gross Profit Margin

There are two key ways for you to improve your gross profit margin. First, you can increase your prices. Second, you can decrease the costs to produce your goods. Of course, both are easier said than done.

TIP

As you start your business, it will be important to track external financial trends to ensure you are headed in the right direction. It also will be critical to compare your company’s performance to others in your industry. If you are a member of a trade association, the group should offer comparative industry data. Information may also be available from your CPA or banker.

An increase in prices can cause sales to drop. If sales drop too far, you may not generate enough gross profit dollars to cover operating expenses. Price increases require a very careful reading of inflation rates, competitive factors, and basic supply and demand for the product you are producing.

The second method of increasing gross profit margin is to lower the variable costs to produce your product. This can be accomplished by decreasing material costs or making the product more efficiently. Volume discounts are a good way to reduce material costs. The more material you buy from sup pliers, the more likely they are to offer you discounts. Another way to reduce material costs is to find a less costly supplier. However, you might sacrifice quality if the goods purchased are not made as well.

Whether you are starting a manufacturing, wholesaling, retailing or service business, you should always be on the lookout for ways to deliver your product or service more efficiently. However, you also must balance efficiency and quality issues to ensure that they do not get out of balance.

Let’s look at the gross profit of ABC Clothing Inc. (see page 663) as an example of the computation of gross profit margin. In Year 1, the sales were $1 million and the gross profit was $250,000, resulting in a gross profit margin of 25 percent ($250,000/$1 million). In Year 2, sales were $1.5 million and the gross profit was $450,000, resulting in a gross profit margin of 30 percent ($450,000/$1.5 million).

It is apparent that ABC Clothing earned not only more gross profit dollars in Year 2, but also a higher gross profit margin. The company either raised prices, lowered variable material costs from suppliers or found a way to produce its clothing more efficiently (which usually means fewer labor hours per product produced).

Computing Markup

ABC Clothing did a better job in Year 2 of managing its markup on the clothing products that they manufactured. Many business owners often get confused when relating markup to gross profit margin. They are first cousins in that both computations deal with the same variables. The difference is that gross profit margin is figured as a percentage of the selling price, while markup is figured as a percentage of the seller’s cost.

Markup is computed as follows: