Authors: Inc The Staff of Entrepreneur Media

Start Your Own Business (108 page)

BOOK: Start Your Own Business

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In addition to analyzing the average number of days it takes to make a product (inventory days) and collect on an account (accounts receivable days) vs. the number of days financed by accounts payable, the operating cycle analysis provides one other important analysis.

From the operating cycle, a computation can be made of the dollars required to support one day of accounts receivable and inventory, and the dollars provided by a day of accounts payable. Let’s consider ABC Clothing’s operating cycle (see page 687). Had the company maintained accounts receivable at Year 1 levels in Year 2, it would have freed up $20,550 in cash flow ($4,110 x 5 days). Likewise, the 10-day improvement in inventory management in Year 2 enhanced cash flow by $28,770 ($2,877 x 10 days).

You can see that working capital has a direct impact on cash flow in a business. Since cash flow is the name of the game for all business owners, a good understanding of working capital is imperative to making any venture successful.

Building a Financial Budget

For many small-business owners, the process of budgeting is limited to figuring out where to get the cash to meet next week’s payroll. There are so many financial fires to put out in a given week that it’s hard to find the time to do any short- or long-range financial planning. But failing to plan financially might mean that you are unknowingly planning to fail.

Business budgeting is one of the most powerful financial tools available to any small-business owner. Put simply, maintaining a good short- and long-range financial plan enables you to control your cash flow instead of having it control you.

Operating Cycle Worksheet

Year 1
Year 2
Accounts Receivable Days
Inventory Days
Operating Cycle
Accounts Payable Days
Days to Be Financed
Purchases
$
$
$ Per Day Accounts Receivable
$
$
$ Per Day Inventory
$
$
$ Per Day Accounts Payable
$
$

Calculations are as follows:

Year 1	Year 2
Accounts Receivable Days
Inventory Days
Operating Cycle
Accounts Payable Days
Days to Be Financed
Purchases	$	$
$ Per Day Accounts Receivable	$	$
$ Per Day Inventory	$	$
$ Per Day Accounts Payable	$	$

The most effective financial budget includes both a short-range month-to-month plan for at least a calendar year and a long-range quarter-to-quarter plan you use for financial statement reporting. It should be prepared during the two months preceding the fiscal year-end to allow ample time for sufficient information-gathering.

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Everything’s rosy, huh? Business owners tend to overestimate their income and underestimate expenses. So when preparing your budget, it’s always a good idea to have an objective third party review your information to make sure you’re being realistic.

The long-range plan should cover a period of at least three years (some go up to five years) on a quarterly basis, or even an annual basis. The long-term budget should be updated when the short-range plan is prepared.

While some owners prefer to leave the one-year budget unchanged for the year for which it provides projections, others adjust the budget during the year based on certain financial occurrences, such as an unplanned equipment purchase or a larger-than-expected upward sales trend. Using the budget as an ongoing planning tool during a given year certainly is recommended. However, here is a word to the wise: Financial budgeting is vital, but it is important to avoid getting so caught up in the budget process that you forget to keep doing business.

What Do You Budget?

Many financial budgets provide a plan only for the income statement; however, it is important to budget both the income statement and balance sheet. This enables you to consider potential cash-flow needs for your entire operation, not just as they pertain to income and expenses. For instance, if you had already been in business for a couple of years and were adding a new product line, you would need to consider the impact of inventory purchases on cash flow.

Budgeting only the income statement also doesn’t allow a full analysis of the effect of potential capital expenditures on your financial picture. For instance, if you are planning to purchase real estate for your operation, you need to budget the effect the debt service will have on cash flow. In the future, a budget can also help you determine the potential effects of expanding your facilities and the resulting higher rent payments or debt service.

How Do You Budget?

In the startup phase, you will have to make reasonable assumptions about your business in establishing your budget. You will need to ask questions such as:

• How much can be sold in Year 1?

• How much will sales grow in the following years?

• How will the products and/or services you are selling be priced?

• How much will it cost to produce your product? How much inventory will you need?

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Budgeting shouldn’t be approached as something to do when you have time but instead as a priority and part of your overall business financial management plan. Breaking your budget into monthly increments eases the process, making it less overwhelming. Make some general financial goals for the year, then determine how you can achieve them—one month at a time—through a monthly budget.

• What will your operating expenses be?

• How many employees will you need? How much will you pay them? How much will you pay yourself? What benefits will you offer? What will your payroll and unemployment taxes be?

• What will the income tax rate be? Will your business be an S corporation or a C corporation?

• What will your facilities needs be? How much will it cost you in rent or debt service for these facilities?

• What equipment will be needed to start the business? How much will it cost? Will there be additional equipment needs in subsequent years?

• What payment terms will you offer customers if you sell on credit? What payment terms will your suppliers give you?

• How much will you need to borrow?

• What will the collateral be? What will the interest rate be?

As for the actual preparation of the budget, you can create it manually or with the budgeting function that comes with most bookkeeping software packages. You can also purchase separate budgeting software such as Quicken or Microsoft Money. Yes, this seems like a lot of information to forecast. But it’s not as cumbersome as it looks. (See page 698 for a financial budget and income statement worksheet; you should find a similar format in any budgeting software.)

The first step is to set up a plan for the following year on a month-to-month basis. Starting with the first month, establish specific budgeted dollar levels for each category of the budget. The sales numbers will be critical since they will be used to compute gross profit margin and will help determine operating expenses, as well as the accounts receivable and inventory levels necessary to support the business. In determining how much of your product or service you can sell, study the market in which you will operate, your competition, potential demand that you might already have seen, and economic conditions. For cost of goods sold, you will need to calculate the actual costs associated with producing each item on a percentage basis.

HOW DO YOU RATE?

R
atio analysis is a financial management tool that enables you to compare the trends in your financial performance as well as provides some measurements to compare your performance against others in your industry. Comparing ratios from year to year highlights areas in which you are performing well and areas that need tweaking. Most industry trade groups can provide you with industry averages for key ratios that will provide a benchmark against which you can compare your company.

Financial ratios can be divided into four subcategories: profitability, liquidity, activity and leverage. Here are 15 financial ratios that you can use to manage your new business. (See 694 for sample financial ratios for ABC Clothing Inc.)
•
Profitability Ratios
Gross Profit ÷ Sales = Gross Profit Margin
Operating Profit ÷ Sales = Operating Profit Margin
Net Profit ÷ Sales = Net Profit Margin
Net Profit ÷ Owner’s Equity = Return on Equity
Net Profit ÷ Total Assets = Return on Assets

•
Liquidity Ratios
Current Assets ÷ Current Liabilities = Current Ratio
(Current Assets - Inventory) ÷ Current Liabilities = Quick Ratio
Working Capital ÷ Sales = Working Capital Ratio

•
Activity Ratios
(Accounts Receivable x 365) ÷ Sales = Accounts Receivable Days
(Inventory x 365) ÷ Cost of Goods Sold = Inventory Days
(Accounts Payable x 365) ÷ Purchases = Accounts Payable Days
Sales ÷ Total Assets = Sales to Assets

•
Leverage Ratios
Total Liabilities ÷ Owner’s Equity = Debt to Equity
Total Liabilities ÷ Total Assets = Debt Ratio
(Net Income + Depreciation) ÷ Current Maturities of Long-Term Debt
= Debt Coverage Ratio

Comparative Financial Ratios

ABC Clothing Inc.

Year 1
Year 2
Profitability Ratios:
Gross Profit Margin
25.0%
30.0%
Operating Profit Margin
5.0%
11.7%
Net Profit Margin
3.7%
8.4%
Return on Equity
33.1%
52.9%
Return on Assets
9.0%
25.2%

Liquidity Ratios:
Current Ratio
1.57
2.32
Quick Ratio
0.54
0.98
Working Capital Ratio
0.10
0.15

Activity Ratios:
Accounts Receivable Days
30
35
Inventory Days Accounts Payable
90 90
85 85
Days Accounts Payable Days
32
29
Sales to Assets
2.43
3.00

Leverage Ratios:
Debt to Equity
2.68
1.10
Debt Ratio
0.73
0.52
Debt Coverage Ratio
2.24
5.20

Year 1	Year 2
Profitability Ratios:
Gross Profit Margin	25.0%	30.0%
Operating Profit Margin	5.0%	11.7%
Net Profit Margin	3.7%	8.4%
Return on Equity	33.1%	52.9%
Return on Assets	9.0%	25.2%