Small Business

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This chapter will take you through the components of the profit and loss and the balance sheet financial statements. It will also describe to you other key accounting considerations for small business.

COGS and Expenses

Breakeven Analysis

Income: Revenues and Gains

Profit and Loss Statement

Assets

Liabilities and Equity

Balance Sheet

Key Accounting Considerations

COGS and Expenses

The figure is shown as part of the profit and loss statement. After the cost of goods sold is subtracted from business revenue, the gross profit is arrived at.

Cost of goods sold (COGS) are only the costs that are directly tied to the production of a product. This is the labour that is required and any material costs actually used to make it. Any downstream costs such as marketing or distribution are not included in COGS.

Cost of goods sold is calculated using the following formula:

COGS = Opening Stock + Purchases Made - Closing Stock

You can calculate the gross profit for your business using the following procedure:

Sales

- Cost Of Goods Sold (COGS)

= Gross profit

C.O.G.S. = Opening Stock + Purchases - Closing Stock

Expenses are all business outlays for the period, other than those relating to any monies paid to business owners such as dividends and drawings. Expenses are categorised into three areas:

Selling and distribution expenses -all expenses associated with developing, selling and distributing a product. Examples include shipping, advertising, staff salaries and wages.

Administrative expenses -all expenses associated with business administration such as purchases of office equipment, depreciation of office furniture and insurance expenses.

Finance expenses -all business outlays associated with the business' financing and cash flow activities. For example, the recording of bad debts, rent expense, and interest expense paid to creditors.

Breakeven Analysis

By performing a break-even analysis regularly, you can effectively check the progress of your business in meeting your sales target or in meeting its break-even point.

Your business breaks even when it neither incurs a loss nor earns a profit. That is, it is making just enough sales income to cover its operating expenses.

By analysing the business' expenses, you can determine the minimum level of sales that are required to achieve a certain profit level. It can also be used as a tool to calculate the minimum price to charge for your product in order to cover all operating costs.

Calculating the break-even point

The following calculation enables you to determine break-even point in sales dollar terms. That is, the total number of sales that need to be made in order to cover operating expenses and for the business not to make a financial loss.

Step 1: Determine your expected sales for the financial period.

Step 2: Categorise your expenses into fixed and variable expenses:

Fixed Expenses - expenses that do not change as your volume of sales or production changes. E.g., Rent

Variable Expenses - expenses that change as your volume of sales or production changes. E.g., Wages and inventory expenses.

Step 3: Calculate the contribution margin expressed as a percentage of sales. The contribution margin represents the amount of sales available to cover fixed expenses and profit.

Contribution margin

Sales - Variable Costs

= ...%

Sales

Step 4: Calculate the break-even point.

Break-even sales

Total fixed costs ÷

= $ .......

Contribution margin (%)

To calculate the number of product units the business would need to sell in order to achieve this sales level you divide the break-even sales figure by your cost per unit of product.

The break-even analysis is a useful planning tool, particularly when approaching potential sources of financing as it provides you with an opportunity to prove the viability of your business. Further, it is an opportunity to perform a sales, expense, pricing and profit analysis for your business's products, particularly for the first few years of its operation.

For more information on break-even analysis visit Small Business Victoria to download a brochure on how to perform a break-even analysis.

Income: Revenues and Gains

Income represents the total amount of money that your business earns or derives within a certain period of time. It is made from revenue and gains or losses.

Revenues are the money inflows that result from the performance of day-to-day business activities and business investments.

Performance of day-to-day business activities consist of either the receipt of cash or the right to receive cash in the future such as accounts receivable. Usually this occurs through business sales made for the provision of goods or services made in cash or credit. The sales figure used is net sales after deducting discounts given, returned goods and allowances such as for Goods and Services Tax.

Performance of business investments may be earnings derived from shares in another company or from a loan which was provided a loan to another business. Hence, the dividends made on those shares and the interest received from the loan is revenue.

If the business decides to sell its business assets, a gain made from the sale is income and is disclosed separately from revenue on the profit and loss statement. A gain or loss is calculated by subtracting the proceeds from the sale of the asset from the book value of the asset. If a loss is made on the sale of a business asset the loss is still recognised in the business' profit and loss statement.

You can calculate the income for your business by following the template below:

Sales

Less COGS

Gross profit

Gains

Gain from sale of equipment

Loss on sale of equipment

Total Income

Gross profit + Gains

Profit and Loss Statement

If income exceeds business expenses, the business will have effectively made a profit. On the other hand, if expenses exceed income, a loss would have been made.

A profit and loss statement is one of a business' main financial statements, along with the balance sheet and cash flow statement.

Profit and loss statements, also known as income statements or statements of financial performance, are a summary of the income and expenses of a business that determine the profit made in a given time period. Profit and loss statements are usually performed periodically, either annually, quarterly or monthly.

The profit and loss statement has a basic mathematical formula:

Sales - Expenses = Net profit

A profit and loss statement is a great tool for identifying items of high expenditure or expenses that were unproductive in producing profit. By analysing the profit and loss statement you can better control business expenditure and thereby potentially increase profits.

The following table illustrates the structure of the income statement as well as some sample account headings that go under each income statement classification:

(Your business name)

Income Statement

for the period ended __ / __ / ____

Income

Revenues

Sales

Less sales returns

Service revenue

Less discounts given

Net sales revenue

Add all revenue figures

Less COGS

Opening stock

Plus purchases made

Less closing stock

Cost of Goods Sold

Add all COGS figures

Gross Profit

Net sales revenue - COGS

Gains

Gain made on sale of equipment

Loss on sale of equipment

Total income

Gross profit + Gains

Expenses

Advertising Expense

Rent Expense

Telephone Expense

Administration Expense

Insurance Expense

Interest Expense

Total Expenses

Add all expenses

Net Profit

Total revenue - Total expenses

Using this general format you can project (budget) your income earnings and expected expenditure for the next twelve months. It may be beneficial if you identify each projection period on the projected profit and loss statement, carefully identify your expenses and be reasonably conservative with your income projections.

To assist you in developing your profit and loss statements, you can download the following sample templates:

12 month profit and loss statement

5 year profit and loss statement

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Financial Plan

Q1.Prepare a 12 month and 5 year profit and loss statement for your business. You can download sample templates here. Give answer

Assets

Assets are items that your business owns which have commercial value and help to generate revenue for your business. Assets may be tangible in that they have physical characteristics such as inventory or office equipment, or they can be intangible assets without physical existence such as copyrights, patents or research and development. Assets are classified into two categories:

Current assets: cash or other assets that would normally be consumed or converted into cash within twelve months, such as accounts receivable and inventory.

Non-current assets: all assets that would not be consumed or converted into cash within twelve months, including land, buildings and equipment.

As most assets lose value over time through obsolescence, age or wear and tear they can also be reduced from an accounting point of view which is called depreciation.

Depreciation is a non cash expense which accounts for the reduction in value of the asset over its useful life. Depreciation also has the effect of lowering the company's reported earnings.

When calculating asset depreciation there are four factors that need to be taken into account:

1. The cost of the asset, including all necessary costs to bring the asset into use such as shipping and installation costs.

2. The asset's anticipated useful life.

3. The estimated residual value of the asset at the end of its useful life.

4. The method of calculating depreciation:

Straight Line Method

Units of Production based depreciation

Accelerated Depreciation

The straight line method is the most common depreciation method for small business as it is the simplest to use. This method allocates the amount to be depreciated evenly over the useful life of the asset. It can be calculated as follows:

Straight Line Depreciation = (Cost - Residual value) ÷ Useful life

Liabilities and Equity

Liabilities are any existing obligations that the business has to its creditors, which will ultimately result in the outflow of assets or cash to another entity. Liabilities are classified into two categories:

Current liabilities are liabilities are due and payable within twelve months. These include accounts payable, wages and rent.

Non-current liabilities are liabilities that are due and payable in a period over twelve months. An example is long-term loans such as mortgage repayments.

Equity is what is left after deducting all the business' liabilities from its total assets. It is classified into two categories:

Capital contributions are made by business owners. It is important to note that creditor's claims to your business' assets take legal precedence over business owners. Hence, business owners take the ultimate risk when investing in the business.

Retained earnings are from the business' previous profitable periods of operation. Start-up businesses don't have this during their first year of operation.

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Financial Plan

Q1.Identify all assumptions regarding your liabilities and equity when preparing your business' projected financial statements. Give answer

Balance Sheet

Assets: items of future economic benefit belonging to the business. They are divided into two categories; current assets and non-current assets.

A balance sheet is one of a business' main financial statements, along with the income statement and cash flow statement. It summarises the financial position of your business at a point in time, by providing a snapshot of how much you own and how much you owe

There are three key sections to a balance sheet:

Liabilities: future economic obligations that have been committed to by the business. Similarly to assets, liabilities are divided into current liabilities and non-current liabilities.

Equity: the residual interest in the assets of a business after deduction of its liabilities. Equity is also divided into two categories, capital and retained earnings.

You can prepare a Balance Sheet by following the format below:

(Your Business Name)

Balance Sheet

as at __ / __ / ____

Current Assets

Cash at bank

Inventory

Accounts Receivable

Other current asset

Total Current Assets

Add all current assets

Non-Current Assets

Equipment and Machinery

Land and Buildings

Other non-current asset

Total Non-Current Assets

Add all non-current assets

Total Assets

Current assets + non-current assets

Current Liabilities

Accounts Payable

Interest Payable

Other current liability

Total Current Liabilities

Add all current liabilities

Non-Current Liabilities

Mortgage payable

Other non-current liability

Total Non-Current Liabilities

Add all non-current liabilities

Total Liabilities

Current liabilities + non-current liabilities

Net Assets

Total assets - total liabilities

Equity

Business Owner, Capital

Retained Profits

Other Equity

Total Equity

Add all equity accounts

Note: Net Assets should equal Total Equity

To assist you in developing your balance sheets, you can download the following sample templates:

12 month balance sheet

5 year balance sheet

[1] Curtis, V. 2004. Small Business for Dummies. 2nd edn. Wiley Publishing Australia Pty Ltd, Milton QLD.

Build your marketing plan

Financial Plan

Q1.Prepare a 12 month and 5 year balance sheet for your business. To ensure accuracy and consistency, the figures should be taken from your profit and loss statements. You can download sample templates here. Give answer

Key Accounting Considerations

By law, the Australian Taxation Office requires you to:

The following describes some other accounting issues that need consideration:

Record keeping:

Record keeping is an essential part of running your business effectively. There are legal requirements that must be adhered to when recording your business transactions. Record keeping also has the benefits of making business decisions and managing the business easier as the information is kept up to date, allowing for a more informed decision.

Keep business records and documents that identify and explain all transactions.

Retain these records for a minimum of five years.

Record in English or in a form that tax officers can understand in order to determine your tax liability.

You may be subjected to a penalty for not adhering to these requirements, so refer to the ATO website for more information. Some of the business records that you must have include:

sales records

purchases/expenses records

income tax records.

A full list of records that must be retained for taxation purposes can be found on the ATO website.

Pricing structure:

Price is the monetary value for a product that the customer is required to give up to purchase the product. As a business owner you will want to cover the costs the business incurs to produce the product, as well as make a profit on top of this. Therefore a solid pricing structure is important. The way you price your product will also depend on your business, whether it is a manufacturer, retailer, or primary producer. Each has different types of costs that need to be accommodated for.

For more information on pricing visit the Department of State and Regional Development "Pricing and Costing: managing for a profitable business" tutorial.

Inventory control:

Managing inventory is an important aspect of maintaining your business. It ensures the efficient flow of resources throughout the production process as well as the inventory that is generating the big sales for your business. There are four main types of stock that need to be managed:

raw materials and components - ready to use in production

work in progress - unfinished goods

finished goods ready for sale

consumables - for example, fuel and stationery.

Inventory systems can be electronically controlled (e.g. perpetual inventory systems) or manually controlled (e.g. Periodic). Inventory control systems software is widely available. Therefore, when developing such a system, ensure the system meets the needs of your business.

Cash Flow

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This chapter will assist you in understanding the concept of cash flow, its importance in managing your business and how you can develop a cash flow statement. You will also learn about managing payment risk.

What is Cash Flow?

Cash Flow Forecasting

Cash Flow Management

How to Write a Cash Flow Statement

What is Cash Flow?

Cash flow is the measure of money flowing in and out of your business at any given time. In an ideal business cycle, you will always have more cash flowing in than flowing out. The reality is however, that most businesses have to produce or deliver goods/services to their customers while also paying their staff and suppliers before they get paid themselves.

This lag in payments in and payments out is often a major challenge for businesses and how well it is managed is critical to the business' immediate financial health and long term sustainability.

The task of managing cash flow is increased in complexity as the number of transactions and amounts of money involved grows, also resulting in greater impacts for the business if it is not managed well.

As a simple test, a sign of a healthy cash flow is always having cash available to pay all wages and bills on time. When businesses cannot do this, they can face a "cash crisis". In this situation they can have trouble accessing supplies and potentially disrupt their operations and ability to generate revenue.

Cash inflows are any receipts of cash to a business and can include:

payment for goods or services from your customers

receipt of a bank loan

interest on savings and investments

shareholder investments

tax returns

Cash outflows are any cash outgoings and can include:

purchase of stock, raw materials or equipment

wages, rents and daily operating expenses

loan repayments

income tax, payroll tax and other taxes

asset purchases.

Cash Flow Forecasting

For business planning purposes, a cash flow forecast can be used for both short and long term forecasting.

Cash flow forecasting enables you to predict peaks and troughs in your cash balance. It uses estimated or real figures and shows the expected flow of cash in and out of your business as well as predicting the bank balance at the end of each month.

Cash Flow Management

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You can effectively manage cash flow and the often resulting lag between payments in and payments out by introducing a cash flow management system. This does not have to be a complicated system but simply a list of steps as per the following that you always undertake to help minimise the lag period and avoid the potential for a cash crisis.

These simple steps can include the following;

ask your customers for shorter payment terms at the time of sales negotiations

seek contract down payments and payment in advance for major material purchases

get bills out quickly and chase debts promptly and firmly

consider offering a small discount for prompt settlement of bills

ask for extended credit terms with suppliers

order less stock but more often

lease rather than buy equipment

review the profitability of your selling prices

Other steps you can implement to help you manage your long term cash flow include;

Keep cash flow forecasts up-to-date: ensure that your forecasts are up-to-date and accurate, and where possible, use actual figures (not budgeted). If you come across any changes in your forecast, always update it quickly.

Be aware of changing market & external conditions: this means you need to be conscious of any changes that may affect your business such as changes in demand, increased competition and new technologies, rising interest rates, economic downturns etc.

Avoid over-investing: while using extra cash to purchase assets for your business can improve productivity and competitiveness, it can be very useful to retain backup funds to cover any unexpected costs that may arise, such as repairs for breakdowns of equipment.

Manage inventory: purchasing supplies in bulk may increase savings, however, having excessive amounts of stock may tie up that can be better used elsewhere.

Credit management

While providing attractive credit terms

A credit management system can incorporate a range of measures to minimise the overall amount of money a business has tied up with debtors. These can include well defined credit policies, preventative measures to minimise the risk of credit defaults, incentives for on-time or early payment and reasonable credit terms and conditions.

The following points can be incorporated into your credit policy and followed prior to providing credit:

Conduct a credit check on new clients

Ensure that your credit policy and conditions are clearly explained to your clients

Ensure all agreements, including the conditions of credit, are made in writing and signed

If practical, collect a deposit or pre-payment before supplying goods/services. Alternatively you may collect progress payments to reduce the risk of bad debts.

Implement a structured practice for following up overdue debts. In the first instance, this may involve making a phone call, visiting your clients or sending a polite reminder letter.

You should remember that you are not obliged to provide credit to risky clients.

Debt Collection

If you still incur bad debts after having implemented credit management strategies, you may pursue payment through any of the following methods:

1. Consultation

2. Letter of demand

3. Legal proceedings

It can be advantageous to exhaust all options (such as consultation and letter of demand) before attempting to recover debts through legal proceedings as this can as it may be complicated, costly, and time consuming.

How to Write a Cash Flow Statement

A cash flow statement is divided into three sections:

A cash flow statement is one of a business' main financial statements, along with the balance sheet and income statement. It focuses on the sources and uses of cash through operating, investing and financing activities. Activities that result in the receipt of cash are cash inflows, and activities that result from the spending of cash are cash outflows.

Cash flow from operating activities - cash inflows and outflows resulting from day-to-day business operations, including the collection of cash from sales and payment of expenses.

Cash flow from investing activities - result from the purchase or sale of the business's non-current assets, that is, assets owned for longer than 12 months.

Cash flow from financing activities - any financing activity that changes the size and composition of the business' long-term financing structure. This includes repayments of the principal on the business mortgage or capital contributions the business owner has made to the business.

You can prepare a Cash Flow Statement for your business by following the structure below:

(Your business name)

Statement of Cash Flows

For the year ended __ / __ / ____

Cash flow from operating activities

Receipts from customers

Payments to suppliers

Payments to employees

Interest payments

Interest received

Taxes paid

Net cash flow from operating activities

Total of above figures

Cash flow from investing activities

Purchases of equipment

Purchases of property

Proceeds from sale of equipment

Proceeds from sale of property

Net cash flow from investing activities

Total of above figures

Cash flow from financing activities

Proceeds from borrowings

Payments of borrowings (repayment of principal)

Investment into business

Drawings from business investment

Net cash flow from financing activities

Total of above figures

Net increase (decrease) in cash held

Total of above 3 total figures

Cash at beginning of period

Cash at end of period

Net increase + cash at beginning

To assist you in developing your cash flow statements, you can download the following sample templates:

12 month cash flow statement

5 year cash flow statement

Build your marketing plan

Financial Plan

Q1.Prepare a 12 month and 5 year cash flow statement for your business. To ensure accuracy and consistency, the figures should be taken from your profit and loss statements and balance sheets. You can download sample templates here. Give answer

Performance Indicators

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What are Key Performance Indicators?

In this chapter you will learn about performance indicators and how they can be used to measure your business' progress towards its goals. You will also learn how to calculate key financial ratios, how to benchmark, and how to utilise two common performance management tools.

Financial Ratios

Benchmarking

Performance Management Tools

What are Key Performance Indicators?

Critical success factors are those areas of a business that must be achieved in order for the business to achieve its goals and objectives as set out in its Strategic Plan.

Key performance indicators are metrics used to help a business define and measure progress towards achieving its objectives or critical success factors. They are quantifiable measures that can be expressed in either financial or non-financial terms and reflect the nature of your business.

Examples of key performance indicators include:

unit sales

return on investment

market share percentage

product quality

Examples of critical success factors include:

decrease expenses by 10% by end of 2009

reduce staff turnover by 20% by 2010

introduce a new product into the market by May 2009

improve unit sales by 500 units per year on a particular product by 2012

Financial objectives define what your business is to accomplish in terms of its finances. For example, to achieve sales of $75000 in the first six months, or to reduce the overdraft from $150000 to $100000 over the first 12 months. When developing your financial objectives, there are several important factors to consider.

Specific, measurable, achievable, realistic and time specific (SMART)

When setting objectives it is very important to ensure that your objectives are; specific, measurable, achievable, realistic and time specific, OR SMART for short. The "SMART" approach allows you to effectively manage your financial activities and importantly be able to determine how successful they have been and whether they have delivered the particular benefits sought.

The "SMART" approach is explained to illustrate how you address each area;

Specific - are your objectives stated in a way that is precise about what you are hoping to achieve?

Measurable - Can you quantify each objective, i.e. can you use a unit of measure such as market share in percentage or dollars or other to provide a way to check your level of success?

Achievable - Are your objectives reasonable in terms of what you can actually achieve or are you setting your sights too high?

Realistic - Do you have sufficient employees and resources to achieve the objectives you have set, if you don't then they are likely to be unrealistic?

Time Specific - When are you hoping to achieve these objectives, you need to define a timing plan with target timing for each specific objective?

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Financial Plan

Q1.Identify your key financial objectives. Give answer

Financial Ratios

Financial ratios are used as a tool to analyse the financial situation of your business through its financial statements. It allows you to determine your business' progress in achieving business goals, particularly when compared with budgeted ratios. By comparing your business' current period's ratios to previous years, you can perform a trend analysis to identify if your business has improved from one year to the next.

Following are some of the most common ratios:

Solvency Ratios: enable you to analyse your business' ability to pay its long-term (greater than 12 months) debt obligations.

Debt Ratio: compares the level of debt you have to finance your business compared to the amount of equity, or capital contributions made by business owners to the business. It is reflected as a number.

Debt Ratio

Total liabilities ÷

Total assets

Typically a debt ratio of greater than one indicates that your business has more debt than assets and may experience difficulties in the longer term to repay long-term debt obligations. Therefore, a lower ratio is preferable, as this means that your business has more assets than liabilities.

Profitability Ratios: used to assess your business' ability to generate income from the expenses incurred during the period.

Net profit margin: determines how much profit your business generates for every dollar of revenue, it is expressed as a percentage (%). It is usually reflective of your business' pricing margin.

Net Profit Margin

Net Profit before income tax ÷

Sales x 100

Return on assets: determines how efficient assets are being used to generate income, this is expressed as a percentage (%).

Return on assets

Net Profit before income tax ÷

Total assets x 100

Usually, a high return on assets may typically be representative of a high profit margin, a rapid turnover of current assets, or both.

Liquidity ratios: enable you to analyse your business' ability to repay short term (less than 12 months) debt obligations.

Working capital ratio (or current ratio): determines whether your business has enough current assets to cover its current or immediate liabilities.

Working capital ratio

Current assets ÷

Current liabilities x 100

A ratio that is less than one means your business may not have enough current assets, which are those assets that can be readily converted into cash, to meet short-term debt obligations. This could typically be the result of an increase in short-term debt, a decrease in current assets, or both.

Inventory turnover ratio: indicates how quickly your business is using or turning its stock.

Inventory turnover ratio

Cost of Goods sold ÷

Current period inventory

A low turnover ratio may indicate that either your business' inventory is naturally slow moving or that there may be problems with your inventory such as the presence of obsolete stock or low customer demand for the inventory, or in fact you are ordering far too much at a time and it is sitting on the shelf.

Receivables turnover ratio: indicates your business' effectiveness at collecting its due account receivables, that is, the number of times receivables are collected within the period.

Receivables turnover ratio

Net credit sales ÷

Average accounts receivable

A high ratio implies that either your business is operating on a cash basis or is effective at collecting its receivable accounts as they fall due.

All ratios should be calculated regularly to measure the effectiveness and efficiency of the financial management system the business has in place.

Benchmarking

What is benchmarking - Queensland Government

Benchmarking is the process of identifying and adopting successful business and operational practices within an industry. It enables you to identify your business' position in the market and possible areas where you could improve.

There are three main levels to benchmark your business against:

Industry sector - comparisons can inform you about common industry practices and standards.

Business size - compare your business with businesses of similar size to benchmark your efficiency and effectiveness.

Business operations - make comparisons with businesses similar to yours to find potential solutions to boost sales or operational areas.

For more information on benchmarking visit:

Benchmarking - Business Victoria

Performance Management Tools