Financial Management: How To Make a Go Of Your Business

by Linda Howarth Mackay

Produced in cooperation with the American Association of Community and
Junior Colleges

Charles Liner, SEA Contracting Officer’s Technical Representative
Judy Nye, Project Director, AACJC
Martha McKemie, Senior Writer-Editor, SEA
Amelia Harris, Graphics, SEA


About the Author


I. The Necessity of Financial Planning

What is Financial Management?
Tools of Financial Planning

II. Understanding Financial Statements: A Health
Checkup for Your Business

The Balance Sheet
The Statement of Income

III. Financial Ratio Analysis

Balance Sheet Ratio Analysis
Income Statement Ratio Analysis
Management Ratios
Sources of Comparative Information

IV. Forecasting Profits

Facts Affecting Pro Forma Statements
The Pro Forma Income Statement
Comparison with Actual Monthly Performance
Break-Even Analysis

V. Cash Flow Management: Budgeting and
Controlling Costs

The Cash Flow Statement

VI. Pricing Policy

Establishing Selling Prices
A Pricing Example
The Retailers Mark-Up
Pricing Policies and Profitability Goals

VII. Forecasting and Obtaining Capital

Types and Sources of Capital
Borrowing Working Capital
Borrowing Growth Capital
Borrowing Permanent Equity Capital
Applying for Capital

VIII. Financial Management Planning

Long-Term Planning

For Further Information

About the Author

Linda Howarth Mackay has many years’ banking experience gained working in a
rural community bank and two large regional banks. Her expertise is in
commercial and agricultural lending and in correspondent banking. She is
also knowledgeable in the regulation of commercial bank lending practices,
with an extensive background in the establishment of policy and procedures
and in portfolio administration.

A graduate of Indiana University, Bloomington, Indiana, and numerous
banking, accounting, and lending seminars, she is now president of Howarth
Mackay, Incorporated, a company providing financial consultation to
businesses, financial institutions, and professional individuals.


This booklet was designed to equip instructors of the National Small
Business Training Network course “Financial Management: How to Make a Go of
Your Business” with the information required to acquaint the small business
owner/manager with the basic tools of sound financial management. It
supplements the course guide materials; it is not intended to replace their
use by the instructor.

The booklet may also be used by anyone interested in learning the concepts
of financial management.

I. The Necessity of Financial Planning

There is one simple reason to understand and observe financial planning in
your business–to avoid failure. Eight of ten new businesses fail primarily
because of the lack of good financial planning.

Financial planning affects how and on what terms you will be able to
attract the funding required to establish, maintain, and expand your
business. Financial planning determines the raw materials you can afford to
buy, the products you will be able to produce, and whether or not you will
be able to market them efficiently. It affects the human and physical
resources you will be able to acquire to operate your business. It will be
a major determinant of whether or not you will be able to make your hard
work profitable.

This manual provides an overview of the essential components of financial
planning and management. Used wisely, it will make the reader–the small
business owner/manager–familiar enough with the fundamentals to have a
fighting chance of success in today’s highly competitive business

A clearly conceived, well documented financial plan, establishing goals and
including the use of Pro Forma Statements and Budgets to ensure financial
control, will demonstrate not only that you know what you want to do, but
that you know how to accomplish it. This demonstration is essential to
attract the capital required by your business from creditors and investors.

What Is Financial Management?

Very simply stated, financial management is the use of financial statements
that reflect the financial condition of a business to identify its relative
strengths and weaknesses. It enables you to plan, using projections, future
financial performance for capital, asset, and personnel requirements to
maximize the return on shareholders’ investment.

Tools of Financial Planning

This manual introduces the tools required to prepare a financial plan for
your business’s development, including the following:

* Basic Financial Statements–the Balance Sheet and Statement of Income

* Ratio Analysis–a means by which individual business performance is
compared to similar businesses in the same category

* The Pro Forma Statement of Income–a method used to forecast future

* Break-Even Analysis–a method allowing the small business person to
calculate the sales level at which a business recovers all its costs or

* The Cash Flow Statement–also known as the Budget identifies the flow of
cash into and out of the business

* Pricing formulas and policies–used to calculate profitable selling
prices for products and services

* Types and sources of capital available to finance business operations

* Short- and long-term planning considerations necessary to maximize profits

The business owner/manager who understands these concepts and uses them
effectively to control the evolution of the business is practicing sound
financial management thereby increasing the likelihood of success.

II. Understanding Financial Statements: A Health Checkup for Your Business

Financial Statements record the performance of your business and allow you
to diagnose its strengths and weaknesses by providing a written summary of
financial activities. There are two’ primary financial statements: the
Balance Sheet and the Statement of Income.

The Balance Sheet

The Balance Sheet provides a picture of the financial health of a business
at a given moment, usually at the close of an accounting period. It lists
in detail those material and intangible items the business owns (known as
its assets) and what money the business owes, either to its creditors
(liabilities) or to its owners (shareholders’ equity or net worth of the

Assets include not only cash, merchandise inventory, land, buildings,
equipment, machinery, furniture, patents, trademarks, and the like, but
also money due from individuals or other businesses (known as accounts or
notes receivable).

Liabilities are funds acquired for a business through loans or the sale of
property or services to the business on credit. Creditors do not acquire
business ownership, but promissory notes to be paid at a designated future

Shareholders’ equity (or net worth or capital) is money put into a business
by its owners for use by the business in acquiring assets.

At any given time, a business’s assets equal the total contributions by the
creditors and owners, as illustrated by the following formula for the
Balance Sheet:

Assets = Liabilities + Net Worth

(Total (Funds (Funds
funds supplied supplied
invested in to the to the
assets of business business
the by its by its
business) creditors) owners)

This formula is a basic premise of accounting. If a business owes more
money to creditors than it possesses in value of assets owned, the net
worth or owner’s equity of the business will be a negative number.

The Balance Sheet is designed to show how the assets, liabilities, and net
worth of a business are distributed at any given time. It is usually
prepared at regular intervals; e.g., at each month’s end but especially at
the end of each fiscal (accounting) year.

By regularly preparing this summary of what the business owns and owes (the
Balance Sheet), the business owner/manager can identify and analyze trends
in the financial strength of the business. It permits timely modifications,
such as gradually decreasing the amount of money the business owes to
creditors and increasing the amount the business owes its owners.

All Balance Sheets contain the same categories of assets, liabilities, and
net worth. Assets are arranged in decreasing order of how quickly they can
be turned into cash (liquidity). Liabilities are listed in order of how
soon they must be repaid, followed by retained earnings (net worth or
owner’s equity), as illustrated in Figure 2-1, below, the sample Balance
Sheet for ABC Company.

The categories and format of the Balance Sheet are established by a system
known as Generally Accepted Accounting Principles (GAAP). The system is
applied to all companies, large or small, so anyone reading the Balance
Sheet can readily understand the story it tells.

Figure 2-1
ABC Company
December 31, 19-
Balance Sheet

Cash $ 1,896 Notes Payable, $ 2,000

Accounts 1,456 Accounts 2,240
Receivable Payable

Inventory 6,822 Accruals 940

Total Current $10,174 Total Current $ 5,180
Assets Liabilities

Equipment and 1,168 Total Liabilities 5,180

Prepaid Expenses 1,278 Net Worth 7,440

Total Assets $12,620 Total Liabilities $12,620
and New Worth

Balance Sheet Categories

Assets: An asset is anything the business owns that has monetary value.

* Current Assets include cash, government securities, marketable
securities, accounts receivable, notes receivable (other than from officers
or employees), inventories, prepaid expenses, and any other item that could
be converted into cash within one year in the normal course of business.

* Fixed Assets are those acquired for long-term use in a business such as
land, plant, equipment, machinery, leasehold improvements, furniture,
fixtures, and any other items with an expected useful business life
measured in years (as opposed to items that will wear out or be used up in
less than one year and are usually expensed when they are purchased). These
assets are typically not for resale and are recorded in the Balance Sheet
at their net cost less accumulated depreciation.

* Other Assets include intangible assets, such as patents, royalty
arrangements, copyrights, exclusive use contracts, and notes receivable
from officers and employees.

Liabilities: Liabilities are the claims of creditors against the assets of
the business (debts owed by the business).

* Current Liabilities are accounts payable, notes payable to banks, accrued
expenses (wages, salaries), taxes payable, the current portion (due within
one year) of long-term debt, and other obligations to creditors due within
one year.

* Long-Term Liabilities are mortgages, intermediate and long-term bank
loans, equipment loans, and any other obligation for money due to a
creditor with a maturity longer than one year.

* Net Worth is the assets of the business minus its liabilities. Net worth
equals the owner’s equity. This equity is the investment by the owner plus
any profits or minus any losses that have accumulated in the business.

The Statement of Income

The second primary report included in a business’s Financial Statement is
the Statement of Income. The Statement of Income is a measurement of a
company’s sales and expenses over a specific period of time. It is also
prepared at regular intervals (again, each month and fiscal year end) to
show the results of operating during those accounting periods. It too
follows Generally Accepted Accounting Principles (GAAP) and contains
specific revenue and expense categories regardless of the nature of the

Statement of Income Categories

The Statement of Income categories are calculated as described below:

* Net Sales (gross sales less returns and allowances)

* Less Cost of Goods Sold (cost of inventories)

* Equals Gross Margin (gross profit on sales before operating expenses)

* Less Selling and Administrative Expenses (salaries, wages, payroll taxes
and benefits, rent, utilities, maintenance expenses, office supplies,
postage, automobile/vehicle expenses, insurance, legal and accounting
expenses, depreciation)

* Equals Operating Profit (profit before other non-operating income or

* Plus Other Income (income from discounts, investments, customer charge

* Less Other Expenses (interest expense)

* Equals Net Profit (Loss) Before Tax (the figure on which your tax is

* Less Income Taxes (if any are due)

* Equals Net Profit (Loss) After Tax

For an example of a Statement of Income, see Figure 2-2, the statement of
ABC Company.

Figure 2-2
ABC Company
December 31, 19-
Income Statement

Net Sales $68,116
Cost of Goods Sold 47,696

Gross Profit on Sales $20,420
Wages $6,948
Delivery Expenses 954
Bad Debts Allowances 409
Communications 204
Depreciation Allowance 409
Insurance 613
Taxes 1,021
Advertising 1,566
Interest 409
Other Charges 749

Total Expenses $13,282
Net Profit 7,138
Other Income 886

Total Net Income $ 8,024

Calculating the Cost of Goods Sold

Calculation of the Cost of Goods Sold category in the Statement of Income
(or Profit-and-Loss Statement as it is sometimes called) varies depending
on whether the business is retail, wholesale, or manufacturing. In
retailing and wholesaling, computing the cost of goods sold during the
accounting period involves beginning and ending inventories. This, of
course, includes purchases made during the accounting period. In
manufacturing it involves not only finished-goods inventories, but also raw
materials inventories goods-in-process inventories, direct labor, and
direct factory overhead costs.

Regardless of the calculation for Cost of Goods Sold, deduct the Cost of
Goods Sold from Net Sales to get Gross Margin or Gross Profit. From Gross
Profit, deduct general or indirect overhead such as selling expenses,
office expenses, and interest expenses, to calculate your Net Profit. This
is the final profit after all costs and expenses for the accounting period
have been deducted.

III. Financial Ratio Analysis

The Balance Sheet and the Statement of Income are essential, but they are
only the starting point for successful financial management. Apply Ratio
Analysis to Financial Statements to analyze the success, failure, and
progress of your business.

Ratio Analysis enables the business owner/manager to spot trends in a
business and to compare its performance and condition with the average
performance of similar businesses in the same industry. To do this compare
your ratios with the average of businesses similar to yours and compare
your own ratios for several successive years, watching especially for any
unfavorable trends that may be starting. Ratio analysis may provide the
all-important early warning indications that allow you to solve your
business problems before your business is destroyed by them.

Balance Sheet Ratio Analysis

Important Balance Sheet Ratios measure liquidity and solvency (a business’s
ability to pay its bills as they come due) and leverage (the extent to
which the business is dependent on creditors’ funding). They include the
following ratios:

Liquidity Ratios.

These ratios indicate the ease of turning assets into cash. They include
the Current Ratio, Quick Ratio, and Working Capital.

Current Ratios. The Current Ratio is one of the best known measures of
financial strength. It is figured as shown below:

Total Current Assets
Current Ratio = ————————-
Total Current Liabilities

The main question this ratio addresses is: “Does your business have enough
current assets to meet the payment schedule of its current debts with a
margin of safety for possible losses in current assets, such as inventory
shrinkage or collectable accounts?” A generally acceptable current ratio is
2 to 1. But whether or not a specific ratio is satisfactory depends on the
nature of the business and the characteristics of its current assets and
liabilities. The minimum acceptable current ratio is obviously 1:1, but
that relationship is usually playing it too close for comfort.

If you decide your business’s current ratio is too low, you may be able to
raise it by:

* Paying some debts.
* Increasing your current assets from loans or other borrowings
with a maturity of more than one year.
* Converting noncurrent assets into current assets.
* Increasing your current assets from new equity contributions.
* Putting profits back into the business.

Quick Ratios. The Quick Ratio is sometimes called the “acid-test” ratio and
is one of the best measures of liquidity. It is figured as shown below:

Quick Ratio = Cash + Government Securities
+ Receivables
Total Current Liabilities

The Quick Ratio is a much more exacting measure than the Current Ratio. By
excluding inventories, it concentrates on the really liquid assets, with
value that is fairly certain. It helps answer the question: “If all sales
revenues should disappear, could my business meet its current obligations
with the readily convertible `quick’ funds on hand?”

An acid-test of 1:1 is considered satisfactory unless the majority of your
“quick assets” are in accounts receivable, and the pattern of accounts
receivable collection lags behind the schedule for paying current

Working Capital. Working Capital is more a measure of cash flow than a
ratio. The result of this calculation must be a positive number. It is
calculated as shown below:

Working Capital = Total Current Assets –
Total Current Liabilities

Bankers look at Net Working Capital over time to determine a company’s
ability to weather financial crises. Loans are often tied to minimum
working capital requirements.

A general observation about these three Liquidity Ratios is that the higher
they are the better, especially if you are relying to any significant
extent on creditor money to finance assets.

Leverage Ratio

This Debt/Worth or Leverage Ratio indicates the extent to which the
business is reliant on debt financing (creditor money versus owner’s

Debt/Worth Ratio = Total Liabilities
Net Worth

Generally, the higher this ratio, the more risky a creditor will perceive
its exposure in your business, making it correspondingly harder to obtain

Income Statement Ratio Analysis

The following important State of Income Ratios measure profitability:

Gross Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the
cost of goods sold from net sales. It measures the percentage of sales
dollars remaining (after obtaining or manufacturing the goods sold)
available to pay the overhead expenses of the company.

Comparison of your business ratios to those of similar businesses will
reveal the relative strengths or weaknesses in your business. The Gross
Margin Ratio is calculated as follows:

Gross Margin Ratio = Gross Profit
Net Sales
(Gross Profit = Net Sales – Cost of Goods Sold)

Net Profit Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the
Cost of Goods sold and all expenses, except income taxes. It provides a
good opportunity to compare your company’s “return on sales” with the
performance of other companies in your industry. It is calculated before
income tax because tax rates and tax liabilities vary from company to
company for a wide variety of reasons, making comparisons after taxes much
more difficult. The Net Profit Margin Ratio is calculated as follows:

Net Profit Margin Ratio = Net Profit Before Tax
Net Sales

Management Ratios

Other important ratios, often referred to as Management Ratios, are also
derived from Balance Sheet and Statement of Income information.

Inventory Turnover Ratio

This ratio reveals how well inventory is being managed. It is important
because the more times inventory can be turned in a given operating cycle,
the greater the profit. The Inventory Turnover Ratio is calculated as

Inventory Turnover Ratio = Net Sales
Average Inventory at Cost

Accounts Receivable Turnover Ratio

This ratio indicates how well accounts receivable are being collected. If
receivables are not collected reasonably in accordance with their terms,
management should rethink its collection policy. If receivables are
excessively slow in being converted to cash, liquidity could be severely
impaired. The Accounts Receivable Turnover Ratio is calculated as follows:

Net Credit Sales/Year = Daily Credit Sales
365 Days/Year

Accounts Receivable Turnover (in days) = Accounts Receivable
Daily Credit Sales

Return on Assets Ratio

This measures how efficiently profits are being generated from the assets
employed in the business when compared with the ratios of firms in a
similar business. A low ratio in comparison with industry averages
indicates an inefficient use of business assets. The Return on Assets Ratio
is calculated as follows:

Return on Assets = Net Profit Before Tax
Total Assets

Return on Investment (ROI) Ratio.

The ROI is perhaps the most important ratio of all. It is the percentage of
return on funds invested in the business by its owners. In short, this
ratio tells the owner whether or not all the effort put into the business
has been worthwhile. If the ROI is less than the rate of return on an
alternative, risk-free investment such as a bank savings account or
certificate of deposit, the owner may be wiser to sell the company, put the
money in such a savings instrument, and avoid the daily struggles of small
business management. The ROI is calculated as follows:

Return on Investment = Net Profit before Tax
Net Worth

These Liquidity, Leverage, Profitability, and Management Ratios allow the
business owner to identify trends in a business and to compare its progress
with the performance of others through data published by various sources.
The owner may thus determine the business’s relative strengths and

Sources of Comparative Information

Sources of comparative financial information which you may obtain from your
public library or the publishers include the following:

Almanac of Business and Industrial Financial Ratios, Leo Troy,
Prentice-Hall, Inc., Englewood Cliffs, NJ 07632

Annual Statement Studies, Robert Morris Associates, P. O. Box 8500, S-1140,
Philadelphia, PA 19178

Expenses in Retail Business, National Cash Register Corporation, Corporate
Advertising and Sales Promotion Dayton, OH 45479.

Key Business Ratios, Dun & Bradstreet, Inc., 99 Church Street, New York, NY
10007, ATTN: Public Relations and Advertising Department

IV. Forecasting Profits

Forecasting, particularly on a short-term basis (one year to three years),
is essential to planning for business success. This process, estimating
future business performance based on the actual results from prior periods,
enables the business owner/manager to modify the operation of the business
on a timely basis. This allows the business to avoid losses or major
financial problems should some future results from operations not conform
with reasonable expectations. Forecasts–or Pro Forma Income Statements and
Cash Flow Statements as they are usually called–also provide the most
persuasive management tools to apply for loans or attract investor money.
As a business expands, there will inevitably be a need for more money than
can be internally generated from profits.

Facts Affecting Pro Forma Statements

Preparation of Forecasts (Pro Forma Statements) requires assembling a wide
array of pertinent, verifiable facts affecting your business and its past
performance. These include:

* Data from prior financial statements, particularly:
a. Previous sales levels and trends
b. Past gross percentages
c. Average past general, administrative, and selling expenses necessary
to generate your former sales volumes
d. Trends in the company’s need to borrow (supplier, trade credit, and
bank credit) to support various levels of inventory and trends in
accounts receivable required to achieve previous sales volumes

* Unique company data, particularly:
a. Plant capacity
b. Competition
c. Financial constraints
d. Personnel availability

* Industry-wide factors, including:
a. Overall state of the economy
b. Economic status of your industry within the economy
c. Population growth
d. Elasticity of demand for the product or service your business
e. Availability of raw materials

Once these factors are identified, they may be used in Pro Formas, which
estimate the level of sales, expense, and profitability that seem possible
in a future period of operations.

The Pro Forma Income Statement

In preparing the Pro Forma Income Statement, the estimate of total sales
during a selected period is the most critical “guesstimate.” Employ
business experience from past financial statements. Get help from
management and salespeople in developing this all-important number.

Then assume, for example, that a 10 percent increase in sales volume is a
realistic and attainable goal. Multiply last year’s net sales by 1.10 to
get this year’s estimate of total net sales. Next, break down this total,
month by month, by looking at the historical monthly sales volume. From
this you can determine what percentage of total annual sales fell on the
average in each of those months over a minimum of the past three years. You
may find that 75 percent of total annual sales volume was realized during
the six months from July through December in each of those years and that
the remaining 25 percent of sales was spread fairly evenly over the first
six months of the year.

Next, estimate the cost of goods sold by analyzing operating data to
determine on a monthly basis what percentage of sales has gone into cost of
goods sold in the past. This percentage can then be adjusted for expected
variations in costs, price trends, and efficiency of operations.

Operating expenses (sales, general and administrative expenses,
depreciation, and interest), other expenses, other income, and taxes can
then be estimated through detailed analysis and adjustment of what they
were in the past and what you expect them to be in the future.

Comparison with Actual Monthly Performance

Putting together this information month by month for a year into the future
will result in your business’s Pro Forma Statement of Income. Use it to
compare with the actual monthly results from operations by using the SBA
form 1099 (4-82) Operating Plan Forecast (Profit and Loss Projection).
Obtain this form from your local SBA office. You will find it helpful to
refer to the SBA Guidelines for Profit and Loss Projection. Preparation of
the information is summarized below and on the back of the form 1099.

Revenue (Sales)

* List the departments within the business. For example, if your business
is appliance sales and service, the departments would include new
appliances, used appliances, parts, in-shop service, on-site service.

* In the “Estimate” columns, enter a reasonable projection of monthly sales
for each department of the business. Include cash and on-account sales. In
the “Actual” columns, enter the actual sales for the month as they become

* Exclude from the Revenue section any revenue not strictly related to the

Cost of Sales

* Cite costs by department of the business, as above.

* In the “Estimate” columns, enter the cost of sales estimated for each
month for each department. For product inventory, calculate the cost of the
goods sold for each department (beginning inventory plus purchases and
transportation costs during the month minus the inventory). Enter “Actual”
costs each month as they accrue.

Gross Profit

* Subtract the total cost of sales from the total revenue.


* Salary Expenses: Base pay plus overtime.

* Payroll Expenses: Include paid vacations, sick leave, health insurance,
unemployment insurance, Social Security taxes.

* Outside Services: Include costs of subcontracts, overflow work
farmed-out, special or one-time services.

* Supplies: Services and items purchased for use in the business, not for

* Repairs and Maintenance: Regular maintenance and repair, including
periodic large expenditures, such as painting or decorating.

* Advertising: Include desired sales volume, classified directory listing
expense, etc.

* Car, Delivery and Travel: Include charges if personal car is used in the
business. Include parking, tolls, mileage on buying trips, repairs, etc.

* Accounting and Legal: Outside professional services.

* Rent: List only real estate used in the business.

* Telephone.

* Utilities: Water, heat, light, etc.

* Insurance: Fire or liability on property or products, worker’s

* Taxes: Inventory, sales, excise, real estate, others.

* Interest.

* Depreciation: Amortization of capital assets.

* Other Expenses (specify each): Tools, leased equipment, etc.

* Miscellaneous (unspecified): Small expenditures without separate accounts.

Net Profit

* To find net profit, subtract total expenses from gross profit.

The Pro Forma Statement of Income, prepared on a monthly basis and
culminating in an annual projection for the next business fiscal year,
should be revised not less than quarterly. It must reflect the actual
performance achieved in the immediately preceding three months to ensure
its continuing usefulness as one of the two most valuable planning tools
available to management.

Should the Pro Forma reveal that the business will likely not generate a
profit from operations, plans must immediately be developed to identify
what to do to at least break even–increase volume, decrease expenses, or
put more owner capital in to pay some debts and reduce interest expenses.

Break-Even Analysis

“Break-Even” means a level of operations at which a business neither makes
a profit nor sustains a loss. At this point, revenue is just enough to
cover expenses. Break-Even Analysis enables you to study the relationship
of volume, costs, and revenue.

Break-Even requires the business owner/manager to define a sales
level–either in terms of revenue dollars to be earned or in units to be
sold within a given accounting period–at which the business would earn a
before tax net profit of zero. This may be done by employing one of various
formula calculations to the business estimated sales volume, estimated
fixed costs, and estimated variable costs.

Generally, the volume and cost estimates assume the following conditions:

* A change in sales volume will not affect the selling price per unit;

* Fixed expenses (rent, salaries, administrative and office expenses,
interest, and depreciation) will remain the same at all volume levels; and

* Variable expenses (cost of goods sold, variable labor costs including
overtime wages and sales commissions) will increase or decrease in direct
proportion to any increase or decrease in sales volume.

Two methods are generally employed in Break-Even Analysis, depending on
whether the break-even point is calculated in terms of sales dollar volume
or in number of units that must be sold.

Break-Even Point in Sales Dollars

The steps for calculating the first method are shown below:

1. Obtain a list of expenses incurred by the company during its past fiscal

2. Separate the expenses listed in Step 1 into either a variable or a fixed
expense classification. (See Figure 4-1, below, under “Classification of

3. Express the variable expenses as a percentage of sales. In the condensed
income statement (Figure 4-1) of the Small Business Specialties Co.
(below), net sales were $1,200,000. In Step 2, variable expenses were found
to amount to $720,000. Therefore, variable expenses are 60 percent of net
sales ($720,000 divided by $1,200,000). This means that 60 cents of every
sales dollar is required to cover variable expenses. Only the remainder, 40
cents of every dollar, is available for fixed expenses and profit.

4. Substitute the information gathered in the preceding steps in the
following basic break-even formula to calculate the breakeven point.

Figure 4-1

Condensed Income Statement
For year ending Dec. 31, 19-

Net sales (60,000 units @ $20 per unit)……………………..$1,200,000
Less cost of goods sold:
Direct material………………………..$195,000
Direct labor………………………….. 215,000
Manufacturing expenses (Schedule A)……… 300,000

Total………………………………………………. 710,000

Gross profit…………………………………………….. 490,000
Less operating expenses:
Selling expenses (Schedule B)……………$200,000
General and administrative expenses
(Schedule C)………………………… 210,000

Total………………………………………………. 410,000

Net Income……………………………………………….$ 80,000

Supporting Schedules of Expenses Other Than Direct Material and Labor

Schedule C
Schedule A Schedule B general and
manufacturing selling administrative
Total expenses expenses expenses

Rent……………..$ 60,000 $ 30,000 $ 8,000 $ 22,000
Insurance………… 11,000 9,000 1,000 1,000
Commissions………. 120,000 ……. 120,000 …….
Property tax……… 12,000 10,000 1,000 1,000
Telephone………… 7,000 1,000 5,000 1,000
Depreciation……… 80,000 70,000 5,000 5,000
Power……………. 100,000 100,000 ……. …….
Light……………. 60,000 30,000 10,000 20,000
Officers’ salaries… 260,000 50,000 50,000 160,000

Total………..$710,000 $300,000 $200,000 $210,000

Classification of Expenses

Total Variable Fixed

Direct material……………….$ 195,000 195,000 …….
Direct labor…………………. 215,000 215,000 …….
Manufacturing expenses………… 300,000 100,000 $200,000
Selling expenses……………… 200,000 50,000
General and admin. expenses……. 210,000 60,000 150,000

Total……………………$1,120,000 $720,000 $400,000

Where: S = F + V (Sales at the break-even point)
F = Fixed expenses
V = Variable expenses expressed as a percentage of sales.

This formula means that when sales revenues equal the fixed expenses and
variable expenses incurred in producing the sales revenues, there will be
no profit or loss. At this point, revenue from sales is just sufficient to
cover the fixed and the variable expenses. In this formula “S” is the break
even point.

For the Small Business Specialties Co., the break-even point (using the
basic formula and data from Figure 4-2) may be calculated as follows:

S = F + V
S = $400,000 + 0.605
10S = $4,000,000 + 6S
10S – 6S = $4,000,000
4S = $4,000,000
S = $1,000,000

Proof that this calculation is correct follows:

Sales at break-even point per calculation $1,000,000
Less variable expenses (60 percent of sales) 600,000

Marginal income 400,000
Less fixed expenses 400,000

Equals neither profit nor loss $ 0

Modification: Break-Even Point to Obtain Desired Net Income.

The first break-even formula can be modified to show the dollar sales
required to obtain a certain amount of desired net income. To do this, let
“S” mean the sales required to obtain a certain amount of net income, say
$80,000. The formula then reads:

S = F + V + Desired Net Income
S = $400,000 + 0.60S + $80,000
10S = $4,000,000 + 6S + 800,000
4S = $4,800,000
S = $1,200,000

Break-Even Point in Units to be Sold

You may want to calculate the break-even point in terms of units to be sold
instead of sales dollars. If so, a second formula (in which “S” means units
to be sold to break even) may be used:

Break-even Sales = Fixed expenses
(S = Units) —————————————–
Unit sales price – Unit variable expenses

S = $400,000 = $400,000
$20 – $12 $8

S = 50,000 units

The Small Business Specialties Co. must sell 50,000 units at $20 per unit
to break even under the assumptions contained in this illustration. The
sale of 50,000 units at $20 each equals $1 million, the break-even sales
volume in dollars calculated in the basic formula. This formula indicates
there is $8 per unit of sales that can be used to cover the $400,000 fixed
expense. Then $400,000 divided by $8 gives the number of units required to
break even.

Modification: Break-Even Point in Units to be Sold to Obtain Desired Net

The second formula can be modified to show the number of units required to
obtain a certain amount of net income. In this case, let S mean the number
of units required to obtain a certain amount of net income, again say
$80,000. The formula then reads as follows:

S = Fixed expenses + Net income
Unit sales price – Unit variable expense

S = $400,000 + $80,000 = $480,000
—————— ——–
$20 – $12 $8

S = 60,000 units

Break-even Analysis may also be represented graphically by charting the
sales dollars or sales units required to break even as in Figure 4-2, below.

Remember: Increased sales do not necessarily mean increased profits. If you
know your company’s break-even point, you will know how to price your
product to make a profit. If you cannot make an acceptable profit, alter or
sell your business before you lose your retained earnings.

V. Cash Flow Management: Budgeting and Controlling Costs

If there is anything more important to the successful financial management
of a business than the thorough, thoughtful preparation of Pro Forma Income
Statements, it is the preparation of the Cash Flow Statement, sometimes
called the Cash Flow Budget.

The Cash Flow Statement

The Cash Flow Statement identifies when cash is expected to be received and
when it must be spent to pay bills and debts. It shows how much cash will
be needed to pay expenses and when it will be needed. It also allows the
manager to identify where the necessary cash will come from. For example,
will it be internally generated from sales and the collection of accounts
receivable–or must it be borrowed? (The Cash Flow Projection deals only
with actual cash transactions; depreciation and amortization of good will
or other non-cash expense items are not considered in this Pro Forma.)

The Cash Flow Statement, based on management estimates of sales and
obligations, identifies when money will be flowing into and out of the
business. It enables management to plan for shortfalls in cash resources so
short term working capital loans may be arranged in advance. It allows
management to schedule purchases and payments in a way that enables the
business to borrow as little as possible. Because all sales are not cash
sales management must be able to forecast when accounts receivable will
become “cash in the bank” and when expenses–whether regular or
seasonal–must be paid so cash shortfalls will not interrupt normal
business operations.

The Cash Flow Statement may also be used as a Budget, permitting the
manager increased control of the business through continuous comparison of
actual receipts and disbursements against forecast amounts. This comparison
helps the small business owner identify areas for timely improvement in
financial management.

By closely watching the timing of cash receipts and disbursements, cash
balance on hand, and loan balances, management can readily identify such
things as deficiencies in collecting receivables, unrealistic trade credit
or loan repayment schedules. Surplus cash that may be invested on a
short-term basis or used to reduce debt and interest expenses temporarily
can be recognized. In short, it is the most valuable tool management has at
its disposal to refine the day-to-day operation of a business. It is an
important financial tool bank lenders evaluate when a business needs a
loan, for it demonstrates not only how large a loan is required but also
when and how it can be repaid.

A Cash Flow Statement or Budget can be prepared for any period of time.
However, a one-year budget matching the fiscal year of your business is
recommended. As in the preparation and use of the Pro Forma Statement of
Income, the projected Cash Flow Statement should be prepared on a monthly
basis for the next year. It should be revised not less than quarterly to
reflect actual performance in the preceding three months of operations to
check its projections.

In preparing the Cash Flow Statement or Budget start with the sales budget.
Other budgets are related directly or indirectly to this budget. The
following is a sales forecast in units:

Sales Budget–Units For the Year Ended December 31, 19__

Territory Total 1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
East………………..26,000 5,000 6,000 7,000 8,000
West………………..11,000 2,000 2,500 3,000 3,500

37,000 7,000 8,500 10,000 11,500

Assume you sell a single product and the sales price for it is $10. Your
sales budget in terms of dollars would look like this:

Sales Budget–Dollars For the Year Ended December 31, 19__

Territory Total 1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
East………………….$260,000 $50,000 $80,000 $ 70,000 $ 80,000
West…………………. 110,000 20,000 25,000 30,000 35,000

$370,000 $70,000 $85,000 $100,000 $115,000

Say the estimated per unit cost of the product is $1.50 for direct
material, $2.50 for direct labor, and $1.00 for manufacturing overhead. By
applying unit costs to the sales budget in units, you would come out with
this budget:

Cost of Goods Sold Budget For the Year Ended December 31, 19__

Total 1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
Direct material……$ 55,500 $10,500 $12,750 $15,000 $17,250
Direct labor……… 92,500 17,500 21,250 25,000 28,750
Mfg. overhead…….. 37,000 7,000 8,500 10,000 11,500

$185,000 $35,000 $42,500 $50,000 $57,500

Later on, before a cash budget can be compiled, you will need to know the
estimated cash requirements for selling expenses. Therefore, you prepare a
budget for selling expenses and another for cash expenditures for selling
expenses (total selling expenses less depreciation):

Selling Expenses Budget For the Year Ended December 31 19__

Total 1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
Commissions………….$46,500 $ 8,750 $10,625 $12,500 $14,375
Rent……………….. 9,250 1,750 2,125 2,500 2,875
Advertising…………. 9,250 1,750 2,125 2,500 2,875
Telephone…………… 4,625 875 1,062 1,250 1,437
Depreciation–office…. 900 225 225 225 225
Other………………. 22,250 4,150 5,088 6,025 6,983

$92,500 $17,500 $21,250 $25,000 $28,750

Selling Expenses Budget–Cash Requirements For the Year Ended
December 31, 19__

Total 1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
Total selling expenses..$92,500 $17,500 $21,250 $25,000 $28,750
Less: depreciation……
expense–office……… 900 225 225 225 225

Cash requirements…….$91,600 $17,275 $21,025 $24,775 $28,525

Basic information for an estimate of administrative expenses for the coming
year is easily compiled. Again, from that budget you can estimate cash
requirements for those expenses to be used subsequently in preparing the
cash budget.

Administrative Expenses Budget For the Year Ended December 31, 19___

Total 1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
Salaries……………..$22,200 $4,200 $5,100 $ 6,000 $ 6,900
Insurance……………. 1,850 350 425 500 575
Telephone……………. 1,850 350 425 500 575
Supplies…………….. 3,700 700 850 1,000 1,150
Bad debt expenses…….. 3,700 700 850 1,000 1,150
Other expenses……….. 3,700 700 850 1,000 1,150

$37,000 $7,000 $8,500 $10,000 $11,500

Administrative Expenses Budget–Cash Requirements
For the Year Ended December 31, 19___

Total 1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
Estimated adm. expenses…$37,000 $7,000 $8,500 $10,000 $11,500
Less: bad debt expenses… 3,700 700 850 1,000 1,150

Cash requirements………$33.300 $6,500 $7,650 $ 9,000 $10,350

Now, from the information budgeted so far, you can proceed to prepare the
budget income statement. Assume you plan to borrow $10,000 at the end of
the first quarter. Although payable at maturity of the note, the interest
appears in the last three quarters of the year. The statement will resemble
the following:

Budgeted Income Statement For the Year Ended December 31, 19___

Total 1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
Sales……………….$370,000 $70,000 $85,000 $100,000 $115,000
Cost of goods sold…… 185,000 35,000 42,500 50,000 57,500

Gross Margin…………$185,000 $35,000 $42,500 $ 50,000 $ 57,500

Operating expenses:
Selling…………….$ 92,500 $17,500 $21,250 $ 25,000 $ 28,750
Administrative……… 37,000 7,000 8,500 $ 10,000 $ 11,500

Total…………….$129,500 $24,500 $29,750 $ 35,000 $ 40,250

Net income
from operations……..$ 55,500 $10,500 $12,750 $ 15,000 $ 17,250
Interest expense……. 450 150 150 150

Net income before
Income taxes………..$ 55,050 $10,500 $12,600 $ 14,850 $ 17,100
Federal income tax….. 27,525 5,250 6,300 7,425 8,550

Net income…………..$ 27,525 $ 5,250 $ 6,300 $ 7,425 $ 8,550

Estimating that 90 percent of your account sales is collected in the
quarter in which they are made, that 9 percent is collected in the quarter
following the quarter in which the sales were made, and that 1 percent of
account sales is uncollectible, your accounts receivable budget of
collections would look like this:

Budget of Collections of Accounts Receivable For the Year Ended December
31, 19___

Total 1st 2nd 3rd 4th
(net) Quarter Quarter Quarter Quarter
4th Quarter Sales 19-0…$ 6,000 $ 6,000
1st Quarter Sales 19-1… 69,300 63,000 $ 6,300
2nd Quarter Sales 19-1… 84,150 76,500 $ 7,650
3rd Quarter Sales 19-1… 99,000 90,000 $ 9,000
4th Quarter Sales 19-1… 103,500 103,500

$361,950 $69,000 $82,800 $97,650 $112,500

Going back to the sales budget in units, now prepare a production budget in
units. Assume you have 2,000 units in the opening inventory and want to
have on hand at the end of each quarter the following quantities: 1st
quarter, 3,000 units; 2nd quarter, 3,500 units; 3rd quarter, 4,000 units;
and 4th quarter, 4,500 units.

Production Budget–Units For the Year Ended December 31, 19___

1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
Sales requirements……….. 7,000 8,500 10,000 11,500
Add: ending
inventory requirements…… 3,000 3,500 4,000 4,500

Total requirements……….10,000 12,500 14,000 16,000
Less: beginning
inventory………………. 2,000 3,000 3,500 4,000
requirements…………… 8,000 9,000 10,500 112,000

Next, based on the production budget, prepare a budget to show the
purchases needed during each of the four quarters. Expressed in terms of
dollars, you do this by taking the production and inventory fires and
multiplying them by the cost of material (previously estimated at $1.50 per
unit). You could prepare a similar budget expressed in units.

Budget of Direct Materials Purchases For the Year Ended December 31, 19___

1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
Required for production……..$12,000 $13,500 $15,750 $18,000
Required for ending inventory.. 4,500 52,250 6,000 6,750

Total……………………$16,500 $18,750 $21,750 $24,750
Less: beginning inventory…… 3,000 4,500 5,250 6,000

Required purchases………….$13,500 $14,250 $16,500 $18,750

Now suppose you pay 50 percent of your accounts in the quarter of the
purchase and 50 percent in the following quarter. Carryover payables from
last year were $5,000. Further, you always take the purchase discounts as a
matter of good business policy. Since net purchases (less discount) were
figured into the $1.50 cost estimate, purchase discounts do not appear in
the budgets. Thus your payment on purchases budget will come out like this:

Payment on Purchases Budget For the Year Ended December 31, 19___

Total 1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
4th Quarter Sales 19-0…$ 5,000 $ 5,000
1st Quarter Sales 19-1… 13,500 6,750 $ 6,750
2nd Quarter Sales 19-1… 14,250 7,125 $ 7.125
3rd Quarter Sales 19-1… 16,500 8,250 $ 8,250
4th Quarter Sales 19-1… 9,375 9,375

Payments by Quarters $58,625 $11,750 $13,875 $15,375 $17,625

Taking the data for quantities produced from the production budget in
units, calculate the direct labor requirements on the basis of units to be
produced. (The number and cost of labor hours necessary to produce a given
quantity can be set forth in supplemental schedules.)

Direct Labor Budget–Cash Requirements For the Year Ended December 31, 19__

Total 1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
Quantity……………. 39,500 8,000 9,000 10,500 12,000
Direct labor cost…….$98,750 $20,000 $22,500 $26,250 $30,000

Now outline the items that comprise your factory overhead, and prepare a
budget like the following:

Manufacturing Overhead Budget For the Year Ended December 31, 19___

Total 1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
Heat and power……….$10,000 $1,000 $2,500 $ 3,000 $ 3,500
Factory supplies…….. 5,300 1,000 1,500 1,800 1,000
Property taxes………. 2,000 500 500 500 500
Depreciation………… 2,800 700 700 700 700
Rent……………….. 8,000 2,000 2,000 2,000 2,000
Superintendent………. 9,400 2,800 1,800 2,500 4,300

$39,500 $8,000 $9,000 $10.500 $12,000

Figure the cash payments for manufacturing overhead by subtracting
depreciation, which requires no cash outlay, from the totals above, and you
will have the following breakdown:

Manufacturing Overhead Budget–Cash Requirements
For the Year Ended December 31, 19___

Total 1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
Productions–units…… 39,500 8,000 9,000 10,500 12,000

Mfg.overhead expenses…$39,500 $8,000 $9,000 $10,500 $12,000
Less: depreciation…… 2,800 700 700 700 700

Cash requirements…….$36,700 $7,300 $8,300 $ 9,800 $11,300

Now comes the all important cash budget. You put it together by using the
Collection of Accounts Receivable Budget; Selling Expenses Budget–Cash
Requirements; Administrative Expenses Budget–Cash Requirements; Payment of
Purchases Budget; Direct Labor Budget–Cash Requirements; and Manufacturing
Budget–Cash Requirements.

Take $15,000 as the beginning balance, and assume that dividends of $20,000
are to be paid in the fourth quarter.

Cash Budget For the Year Ended December 31, 19___

Total 1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
Beginning cash balance $ 15,000 $15,000 $ 3,850 $ 13,300 $ 25,750
Cash collections 361,950 69,000 82,800 97,650 112,500

Total $376,950 $84,000 $86,650 $110,950 $138,250

Cash payments
Purchases $ 58,625 $11,750 $13,875 $ 15,375 $ 17,625
Direct labor 98,750 20,000 22,500 26,250 30,000
Mfg. overhead 38,700 7,300 8,300 9,800 11,300
Selling expense 91,600 17,275 21,025 24,775 28,525
Adm. expenses 33,300 6,300 7,650 9,000 10,350
Federal income tax 27,525 27,525
Dividends 20,000 20,000
Interest expenses 450 450
Loan repayment 10,000 10,000

Total $376,950 $90,150 $73,350 $ 85,200 $128,250

Cash deficiency ($ 6,150)
Bad loan received 10,000 10,000

Ending cash balance $ 10,000 $ 3,850 $13,300 $ 25,750 $ 10,000

Now you are ready to prepare a budget balance sheet. Take the account
balances of last year and combine them with the transactions reflected in
the various budgets you have compiled. You will come out with a sheet
resembling this:

Budgeted Balance Sheet December 31, 19___
19___ 19___
Current assets:
Cash $ 10,000 $ 15,000
Accounts receivable 11,500 6,666
Less: allowance for doubtful accounts (1,150) (666)
Raw materials 6,750 3,000
Finished goods 22,500 10,000

Total current assets $ 49,600 34,000

Fixed assets:
Land $ 50,000 $ 50,000
Building 148,000 148,000
Less: allowance for depreciation (37,000) (33,000)

Total fixed assets $161,100 $164,700

Total assets $210,600 $198,700

Liabilities and Shareholders’ Equity

Current liabilities:
Account payable $ 9,375 $ 5,000

Shareholders’ equity:
Capital stock (10,000 shares; $10 par value) $100,000 $110,000
Retained earnings 101,225 93,700

$201,225 $193,700

Total liabilities and shareholders’ equity $210,600 $198,700

In order to make the most effective use of your budgets to plan profits,
you will want to establish reporting devices. Throughout the time span you
have set, you need periodic reports and reviews on both efforts and
accomplishments. These let you know whether your budget plan is being
attained and help you keep control throughout the process. It is through
comparing actual performance with budgeted projections that you maintain
control of the operations.

Your company should be structured along functional lines, with well
identified areas of responsibility and authority. Then, depending upon the
size of your company, the budget reports can be prepared to correspond with
the organizational structure of the company.

Two typical budget reports are shown below to demonstrate various forms
these reports may take.

Report of Actual and Budgeted Sales For the Year Ended December 31, 19___

Variations from
budget (under)
Actual sales Budgeted sales Quarterly Cumulative
1st Quarter $ $ $ $
2nd Quarter
3rd Quarter
4th Quarter

Budgeted Report on Selling Expenses For the Year Ended December 31, 19___

Budget ≥ Actual ≥ Variation≥ Budget ≥ Actual ≥Variations≥ Remarks
This ≥ This ≥ This ≥ Year to ≥ Year to ≥ Year to ≥
Month ≥ Month ≥ Month ≥ Date ≥ Date ≥ Date ≥

≥ ≥ ≥ ≥ ≥ ≥
≥ ≥ ≥ ≥ ≥ ≥
≥ ≥ ≥ ≥ ≥ ≥
≥ ≥ ≥ ≥ ≥ ≥
≥ ≥ ≥ ≥ ≥ ≥
≥ ≥ ≥ ≥ ≥ ≥

Remember, the Cash Flow Statement used as the business’s Budget allows the
owner/manager to anticipate problems rather than react to them after they
occur. It permits comparison of actual receipts and disbursements against
projections to identify errors in the forecast. If cash flow is analyzed
monthly, the manager can correct the cause of the error before it harms

VI. Pricing Policy

Identifying the actual cost of doing business requires careful and accurate
analysis. No one is expected to calculate the cost of doing business with
complete accuracy. However, failure to calculate all actual costs properly
to ensure an adequate profit margin is a frequent and often overlooked
cause of business failure.

Establishing Selling Prices

The costs of raw materials, labor, indirect overhead, and research and
development must be carefully studied before setting the selling price of
items offered by your business. These factors must be regularly
re-evaluated, as costs fluctuate.

Regardless of the strategies employed to maximize profitability, the method
of costing products offered for resale is basic. It involves four major

* Direct Material Costs
* Direct Labor Costs
* Overhead Expenses
* Profit Desired

Combining these factors allows you to calculate an item’s minimum sales
price, which is described below:

1. Calculate your Direct Material Costs. Direct material costs are the
total cost of all raw materials used to produce the item for sale. Divide
this total cost by the number of items produced from these raw materials to
derive the Total Direct Materials Cost Per Item.

2. Calculate your Direct Labor Costs. Direct labor costs are the wages paid
to employees to produce the item. Divide this total direct labor cost by
the total number of items produced to get the Total Direct Labor Cost Per

3. Calculate your Total Overhead Expenses. Overhead expenses include rent,
gas and electricity, telephone, packing and shipping, delivery and freight
charges, cleaning expenses, insurance, office supplies, postage, repairs
and maintenance, and the manager’s salary. In other words, all operating
expenses incurred during the same time period that you used for calculating
the costs above (one year, one quarter, or one month). Divide the Total
Overhead Expense by the number of items produced for sale during that same
time period to get the Total Overhead Expense Per Item.

4. Calculate Total Cost Per Item. Add the Total Direct Material Cost Per
Item, the Total Direct Labor Cost Per Item, and the Total Overhead Expense
Per Item to derive the Total Cost Per Item.

5. Calculate the Profit Per Item. Now, calculate the profit you determine
appropriate for each category of item offered for sale based on the sales
and profit strategy you have set for your business.

6. Calculate the Total Price Per Item. Add the Profit Figure Per Item to
the Total Cost Per Item.

A Pricing Example

You produce skirts that take 1 1/2 yards of fabric per skirt, and you can
manufacture three skirts per day. The fabric costs $2.00 per yard. The
normal work week is five days. If you complete three skirts per day, your
week’s production is 15 skirts.

1. Calculate Direct Materials Cost

Materials Cost

Fabric for 1 week’s production:
15 skirts x 1 1/2 yds. each = 22 1/2 yds. x $2 per yd. $45.00

Linings, interfacings, etc.:
$.50 per skirt x 15 skirts 7.50

Zippers, buttons, snaps:
$.50 per skirt x 15 skirts 7.50

Belts, ornaments, etc.:
$.75 per skirt x 15 skirts 11.25

Notions, seam binding, etc.:
1 week’s supply 5.00
Total Direct Materials Cost: $76.25 per week

Total Direct Materials Cost per week = $5.08 Direct Materials
———————————— Cost per skirt
15 skirts per week

2. Calculate Direct Labor Costs

Wages paid to employees = $100.00 per week

Total Direct Labor Cost per week = $6.67 Direct Labor Cost
——————————– per skirt
15 skirts

3. Calculate Overhead Expenses Per Month

Overhead Expenses Monthly
Owner’s Salary $400.00
Rent 100.00
Electricity 24.00
Telephone 12.00
Insurance 15.00
Cleaning 20.00
Packing Materials and Supplies 15.00
Delivery and Freight 20.00
Office Supplies, Postage 10.00
Repairs and Maintenance 15.00
Payroll Taxes 5.00

Total Monthly Overhead Expenses: $636.00

15 skirts per week x 4 weeks in one month = 60 skirts per month.

Total Monthly Overhead Expenses = $10.60 Overhead Cost
——————————- per skirt
60 skirts per month

4. Calculate the Total Cost per Skirt by adding the total individual costs
per skirt calculated in the three preceding steps.

Total Direct Material Cost per Skirt $ 5.08
Total Direct Labor Cost per Skirt 6.67
Total Overhead Expense per Skirt 10.60


5. Assume you want to make a profit of $5.00 per skirt.

6. Calculate the Total Price Per Item:

Total Cost per Skirt $22.35
Total Profit per Skirt 5.00

Total Selling Price Per Skirt $27.35

The Retailer’s Mark-Up

A word of caution is in order regarding the popular but misunderstood
pricing method known as retailers mark-up. Retail mark-up means the amount
added to the price of an item to arrive at the retail sales price, either
in dollars or as a percentage of the cost.

For example, if a single item costing $8.00 is sold for $12.00 it carries a
mark-up of $4.00 or 50 percent. If a group of items costing $6,000 is
offered for $10,000, the mark-up is $4,000 or 66 2/3 percent. While in
these illustrations the mark-up percentage appears generally to equal the
gross margin percentages, the mark-up is not the same as the gross margin.
Adding mark-up to the price merely to simplify pricing will almost always
adversely affect profitability.

To demonstrate, assume a manager determines from past records that the
business’s operating expenses average 29 percent of sales. She decides that
she is entitled to a profit of 3 percent. So she prices her goods at a 32
percent gross margin, in order to earn a 3 percent profit after all
operating expenses are paid. What she fails to realize, however, is that
once the goods are displayed, some may be lost through pilferage. Others
may have to be marked down later in order to sell them, or employees may
purchase some of them at a discount. Therefore, the total reductions
(mark-downs, shortages, discounts) in the sales price realized from selling
all the inventory actually add up to an annual average of six percent of
total sales. To correctly calculate the necessary mark-up required to yield
a 32 percent gross margin, these reductions to inventory must be
anticipated and added into its selling price. Using the formula:

Initial Mark-up = Desired Gross Margin + Retail Reductions
100 Percent + Retail Reductions

32 percent + 6 percent = 38 percent = 35.85 percent
———————– ———–
100 percent + 6 percent 106 percent

To obtain the desired gross margin of 32 percent, therefore, the retailer
must initially mark up his inventory by nearly 36 percent.

Pricing Policies and Profitability Goals

Break-Even Analysis, discussed in Chapter IV, and Return on Investment,
described in Chapter III, should be reviewed at this time. Remember, all
costs (direct and indirect), the break-even point, desired profit, and the
methods of calculating sales price from these factors must be thoroughly
studied when you establish pricing policies and profitability goals. They
should be understood before you offer items for sale because an omission or
error in these calculations could make the difference between success and

Selling Strategy

Proper product pricing is only one facet of overall planning for
profitability. A second major factor to be determined once costs,
break-even point, and profitability goals have been analyzed, is the
selling strategy. Three sales planning approaches are used (often
concurrently) by businesses to develop final pricing policies, as they
strive to compete successfully.

In the first, employed as a short-term strategy in the earliest stages of a
business, the owner/manager sells products at such low prices that the
business only breaks even (no profit), while trying to attract future
steady customers. As volume grows, the owner/manager gradually builds in
the profit margin necessary to achieve the targeted Return on Investment.

“Loss leaders” are a second strategy practiced in both developing and
mature business. While a few items are sold at a loss, most goods are
priced for healthy profits. The hope is that while customers are in the
store to purchase the low-price items, they will also buy enough other
goods to make the seller’s overall profitability higher than if he had not
used “come-ons.” The seller wants to maximize total profit and can
sacrifice profit on a few items to achieve that goal.

The third strategy recognizes that maximum profit does not result only from
selling goods at relatively high profit margins. The relationship of
volume, price, cost of merchandise, and operational expenses determines
profitability. Price increases may result in fewer sales and decreased
profits. Reductions in prices, if sales volume is substantially increased,
may produce satisfactory profits.

There is no arbitrary rule about this. It is perfectly possible for two
stores, with different pricing structures to exist side by side and both be
successful. It is the owner/manager’s responsibility to identify and
understand the market factors that affect his or her unique business
circumstances. The level of service (delivery, availability of credit,
store hours, product advice, and the like) may permit a business to charge
higher prices in order to cover the costs of such services. Location, too,
often permits a business to charge more, since customers are often willing
to pay a premium for convenience.

The point is that many considerations go into setting selling prices. Some
small businesses do not seek to compete on price at all, finding an un- or
under-occupied market niche, which can be a more certain path to success.
What is important is that all factors that affect pricing must be
recognized and analyzed for their costs as well as their benefits.

VII. Forecasting and Obtaining Capital

Forecasting the need for capital, whether debt or equity, has already been
discussed in Chapter V. This chapter looks at the types and uses of
external capital and the usual sources of such capital.

Types and Sources of Capital

The capital to finance a business has two major forms: debt and equity.
Creditor money (debt) comes from trade credit, loans made by financial
institutions, leasing companies, and customers who have made prepayments on
larger–frequently manufactured–orders. Equity is money received by the
company in exchange for some portion of ownership. Sources include the
entrepreneur’s own money; money from family, friends, or other
non-professional investors; or money from venture capitalists, Small
Business Investment Companies (SBICs), and Minority Enterprise Small
Business Investment Companies (MESBICs) both funded by the SBA.

Debt capital, depending upon its sources (e.g., trade, bank, leasing
company, mortgage company) comes into the business for short or
intermediate periods. Owner or equity capital remains in the company for
the life of the business (unless replaced by other equity) and is repaid
only when and if there is a surplus at liquidation of the business–after
all creditors are repaid.

Acquiring such funds depends entirely on the business’s ability to repay
with interest (debt) or appreciation (equity). Financial performance
(reflected in the Financial Statements discussed in Chapter II) and
realistic, thorough management planning and control (shown by Pro Formas
and Cash Flow Budgets), are the determining factors in whether or not a
business can attract the debt and equity funding it needs to operate and

Business capital can be further classified as equity capital, working
capital, and growth capital. Equity capital is the cornerstone of the
financial structure of any company. As you will recall from Chapter II,
equity is technically the part of the Balance Sheet reflecting the
ownership of the company. It represents the total value of the business,
all other financing being debt that must be repaid. Usually, you cannot get
equity capital–at least not during the early stages of business growth.

Working capital is required to meet the continuing operational needs of the
business, such as “carrying” accounts receivable purchasing inventory, and
meeting the payroll. In most businesses, these needs vary during the year,
depending on activities (inventory build-up, seasonal hiring or layoffs,
etc.) during the business cycle.

Growth capital is not directly related to cyclical aspects of the business.
Growth capital is required when the business is expanding or being altered
in some significant and costly way that is expected to result in higher and
increased cash flow. Lenders of growth capital frequently depend on
anticipated increased profit for repayment over an extended period of time,
rather than expecting to be repaid from seasonal increases in liquidity as
is the case of working capital lenders.

Every growing business needs all three types: equity, working, and growth
capital. You should not expect a single financing program maintained for a
short period of time to eliminate future needs for additional capital.

As lenders and investors analyze the requirements of your business, they
will distinguish between the three types of capital in the following way:
1) fluctuating needs (working capital); 2) needs to be repaid with profits
over a period of a few years (growth capital); and 3) permanent needs
(equity capital).

If you are asking for a working capital loan, you will be expected to show
how the loan can be repaid through cash (liquidity) during the business’s
next full operating cycle, generally a one year cycle. If you seek growth
capital, you will be expected to show how the capital will be used to
increase your business enough to be able to repay the loan within several
years (usually not more than seven). If you seek equity capital, it must be
raised from investors who will take the risk for dividend returns or
capital gains, or a specific share of the business.

Borrowing Working Capital

Chapter II defined working capital as the difference between current
assets and current liabilities. To the extent that a business does not
generate enough money to pay trade debt as it comes due, this cash must be

Commercial banks obviously are the largest source of such loans, which have
the following characteristics: 1) The loans are short-term but renewable;
2) they may fluctuate according to seasonal needs or follow a fixed
schedule of repayment (amortization); 3) they require periodic full
repayment (“clean up”); 4) they are granted primarily only when the ratio
of net current assets comfortably exceeds net current liabilities; and 5)
they are sometimes unsecured but more often secured by current assets
(e.g., accounts receivable and inventory). Advances can usually be obtained
for as much as 70 to 80 percent of quality (likely to be paid) receivables
and to 40 to 50 percent of inventory. Banks grant unsecured credit only
when they feel the general liquidity and overall financial strength of a
business provide assurance for repayment of the loan.

You may be able to predict a specific interval, say three to five months,
for which you need financing. A bank may then agree to issue credit for a
specific term. Most likely, you will need working capital to finance
outflow peaks in your business cycle. Working capital then supplements
equity. Most working capital credits are established on a one-year basis.

Although most unsecured loans fall into the one-year line of credit
category, another frequently used type, the amortizing loan, calls for a
fixed program of reduction, usually on a monthly or quarterly basis. For
such loans your bank is likely to agree to terms longer than a year, as
long as you continue to meet the principal reduction schedule.

It is important to note that while a loan from a bank for working capital
can be negotiated only for a relatively short term, satisfactory
performance can allow the arrangement to be continued indefinitely.

Most banks will expect you to pay off your loans once a year (particularly
if they are unsecured) in perhaps 30 or 60 days. This is known as “the
annual clean up,” and it should occur when the business has the greatest
liquidity. This debt reduction normally follows a seasonal sales peak when
inventories have been reduced and most receivables have been collected.

You may discover that it becomes progressively more difficult to repay debt
or “clean up” within the specified time. This difficulty usually occurs
because: 1) Your business is growing and its current activity represents a
considerable increase over the corresponding period of the previous year;
2) you have increased your short-term capital requirement because of new
promotional programs or additional operations; or 3) you are experiencing a
temporary reduction in profitability and cash flow.

Frequently, such a condition justifies obtaining both working capital and
amortizing loans. For example, you might try to arrange a combination of a
$15,000 open line of credit to handle peak financial requirements during
the business cycle and $20,000 in amortizing loans to be repaid at, say
$4,000 per quarter. In appraising such a request, a commercial bank will
insist on justification based on past experience and future projections.
The bank will want to know: How the $15,000 line of credit will be
self-liquidating during the year (with ample room for the annual clean up);
and how your business will produce increased profits and resulting cash
flow to meet the schedule of amortization on the $20,000 portion in spite
of increasing your business’s interest expense.

Borrowing Growth Capital

Lenders expect working capital loans to be repaid through cash generated in
the short-term operations of the business, such as, selling goods or
services and collecting receivables. Liquidity rather than overall
profitability supports such borrowing programs. Growth capital loans are
usually scheduled to be repaid over longer periods with profits from
business activities extending several years into the future. Growth capital
loans are, therefore secured by collateral such as machinery and equipment,
fixed assets which guarantee that lenders will recover their money should
the business be unable to make repayment.

For a growth capital loan you will need to demonstrate that the growth
capital will be used to increase your cash flow through increased sales,
cost savings, and/or more efficient production. Although your building,
equipment, or machinery will probably be your collateral for growth capital
funds, you will also be able to use them for general business purposes, so
long as the activity you use them for promises success. Even if you borrow
only to acquire a single piece of new equipment, the lender is likely to
insist that all your machinery and equipment be pledged.

Instead of bank financing a particular piece of new equipment, it may be
possible to arrange a lease. You will not actually own the equipment, but
you will have exclusive use of it over a specified period. Such an
arrangement usually has tax advantages. It lets you use funds that would be
tied up in the equipment, if you had purchased it. It also affords the
opportunity to make sure the equipment meets your needs before you purchase

Major equipment may also be purchased on a time payment plan, sometimes
called a Conditional Sales Purchase. Ownership of the property is retained
by the seller until the buyer has made all the payments required by the
contract. (Remember, however, that time payment purchases usually require
substantial down payments and even leases require cash advances for several
months of lease payments.)

Long-term growth capital loans for more than five but less than fifteen
years are also obtainable. Real estate financing with repayment over many
years on an established schedule is the best example. The loan is secured
by the land and/or buildings the money was used to buy. Most businesses are
best financed by a combination of these various credit arrangements.

When you go to a bank to request a loan, you must be prepared to present
your company’s case persuasively. You should bring your financial plan
consisting of a Cash Budget for the next twelve months, Pro Forma Balance
Sheets, and Income Statements for the next three to five years. You should
be able to explain and amplify these statements and the underlying
assumptions on which the figures are based. Obviously, your assumptions
must be convincing and your projections supportable. Finally, many banks
prefer statements audited by an outside accountant with the accountant’s
signed opinion that the statements were prepared in accordance with
generally accepted accounting principles and that they fairly present the
financial condition of your business.

If borrowing growth capital is necessary and no private conventional source
can be found, the U.S. Small Business Administration (SBA) may be able to
guarantee up to 90 percent of a local bank loan. By law, SBA cannot
consider a loan application without evidence that the loan could not be
obtained elsewhere on reasonable terms without SBA assistance. Even for
such guaranteed loans, however, the borrower must demonstrate the ability
to repay.

Borrowing Permanent Equity Capital

Permanent capital sometimes comes from sources other than the business
owner/manager. Considered ownership contributions, they are different from
“stockholders equity” in the traditional sense of the phrase. Small
Business Investment Companies (SBIC’s) licensed and financed by the Small
Business Administration are authorized to provide venture capital to small
business concerns. This capital may be in the form of secured and/or
unsecured loans or debt securities represented by common and preferred

Venture capital, another source of equity capital, is extremely difficult
to define; however, it is high risk capital offered with the principal
objective of earning capital gains for the investor. While venture
capitalists are usually prepared to wait longer than the average investor
for a profitable return, they usually expect in excess of 15 percent return
on their investment. Often they expect to take an active part in
determining the objectives of the business. These investors may also assist
the small business owner/manager by providing experienced guidance in
marketing, product ideas, and additional financing alternatives as the
business develops. Even though turning to venture capital may create more
bosses, their advice could be as valuable as the money they lend. Be aware,
however, that venture capitalists are looking for businesses with real
potential for growth and for future sales in the millions of dollars.

Figure 7-1
Financing Sources for Your Business

Equity (Sell part of company)
* Family, friends, and other non-professional investors
* Venture Capitalists
* Small Business Investment Companies (SBICs and MESBICs)

Personal Loans
* Banks
– Unsecured loans (rare)
– Loans secured by:
Real Estate
Stocks and Bonds
* Finance Companies
– Loans secured by:
Real Estate
Personal Assets
* Credit Unions
– Unsecured “signature” loans
– Loans secured by:
Real Estate (some credit unions)
Personal Assets
* Savings and Loan Associations
– Unsecured loans (rare)
– Loans secured by Real Estate
* Mortgage Brokers and Private Investors
– Loans secured by Real Estate
* Life Insurance Companies
– Policy loans (borrow against cash value)

Business Loans


* Banks (short-term)
– Unsecured loans (for established, financially sound companies only)
– Loans secured by:
Accounts Receivable
* Banks (long-term)
– Loans secured by:
Real Estate
– Loans guaranteed by:
Small Business Administration (SBA)
Farmers Home Administration (FmHA)
* Commercial Finance Companies
– Loans secured by:
Real Estate
Accounts Receivable
* Life Insurance Companies
– Loans secured by commercial Real Estate (worth at least $150,000)
* Small Business Administration (SBA)
– Loans secured by:
All available business assets
All available personal assets
* Suppliers
– Trade Credit
* Customers
– Prepayment on orders


* Banks
* Leasing Companies
– Loans secured by:
Sales of Receivables (called “factoring”)

(Source: The Business Store, Santa Rosa, California.)

Applying for Capital

Below is the minimum information you must make available to lenders and

1. Discussion of the Business
* Name, address, and telephone number.
* Type of business you are in now or want to expand or start.

2. Amount of Money You Need to Borrow
* Ask for all you will need. Don’t ask for a part of the total and
think you can come back for more later. This could indicate to the
lender that you are a poor planner.

3. How You Will Use the Money
* List each way the borrowed money will be used.
* Itemize the amount of money required for each purpose.

4. Proposed Terms of the Loan
* Include a payback schedule. Even though the lender has the final say
in setting the terms of the loan, if you suggest terms, you will
retain a negotiating position.

5. Financial Support Documents

* Show where the money will come from to repay the loan through the
following projected statements:
– Profit and Loss Statements (one year for working capital loan
requests and three to five years for growth capital requests)
– Cash Flow Statements (one year for working capital loan requests
and three to five years for growth capital requests)

6. Financial History of the Business
* Include the following financial statements for the last three years:
– Balance Sheet
– Profit and Loss Statement
– Accounts Receivable and Accounts Payable Listings and Agings

7. Personal Financial Statement of the Owner(s)
* Personal Assets and Liabilities
* Resume(s)

8. Other Useful information Includes
* Letters of Intent from Prospective Customers
* Leases or Buy/Sell Agreements Affecting Your Business
* Reference Letters

Although it is not required, it is useful to calculate the ratios described
in Chapter III for your business over the past three years. Use this
information to prove the strong financial health and good trends in your
business’s development and to demonstrate that you use such management
tools to plan and control your business’s growth.

VIII. Financial Management Planning

Studies overwhelmingly identify bad management as the leading cause of
business failure. Bad management translates to poor planning by management.

All too often, the owner is so caught up in the day-to-day tasks of getting
the product out the door and struggling to collect receivables to meet the
payroll that he or she does not plan. There never seems to be time to
prepare Pro Formas or Budgets. Often new managers understand their products
but not the financial statements or the bookkeeping records, which they
feel are for the benefit of the IRS or the bank. Such overburdened
owner/managers can scarcely identify what will affect their businesses next
week, let alone over the coming months and years. But, you may ask, “What
should I do? How can I, as a small business owner/manager, avoid getting
bogged down? How can I ensure success?”

Success may be ensured only by focusing on all factors affecting a
business’s performance. Focusing on planning is essential to survival.

Short-term planning is generally concerned with profit planning or
budgeting. Long-term planning is generally strategic, setting goals for
sales growth and profitability over a minimum of three to five years.

The tools for short- and long-term plans have been explained in the
previous chapters: Pro Forma Income Statements, Cash Flow Statements or
Budgets, Ratio Analysis, and pricing considerations. The business’s
short-term plan should be prepared on a monthly basis for a year into the
future, employing the Pro Forma Income Statement and the Cash Flow Budget.

Long-Term Planning

The long-term or strategic plan focuses on Pro Forma Statements of Income
prepared for annual periods three to five years into the future. You may be
asking yourself, “How can I possibly predict what will affect my business
that far into the future?” Granted, it’s hard to imagine all the variables
that will affect your business in the next year, let alone the next three
to five years. The key, however, is control–control of your business’s
future course of expansion through the use of the financial tools explained
in the preceding chapters.

First determine a rate of growth that is desirable and reasonably
attainable. Then employ Pro Formas and Cash Flow Budgets to calculate the
capital required to finance the inventory, plant, equipment, and personnel
needs necessary to attain that growth in sales volume. The business
owner/manager must anticipate capital needs in time to make satisfactory
arrangements for outside funds if internally generated funds from retained
earnings are insufficient.

Growth can be funded in only two ways: with profits or by borrowing. If
expansion outstrips the capital available to support higher levels of
accounts receivable, inventory, fixed assets, and operating expenses, a
business’s development will be slowed or stopped entirely by its failure to
meet debts as they become payable. Such insolvency will result in the
business’s assets being liquidated to meet the demands of the creditors.
The only way to avoid this “outstripping of capital” is by planning to
control growth. Growth must be understood to be controlled. This
understanding requires knowledge of past financial performance and of the
future requirements of the business.

These needs must be forecast in writing–using the Pro Forma Income
Statement in particular–for three to five years in the future. After
projecting reasonable sales volumes and profitability, use the Cash Flow
Budget to determine (on a quarterly basis for the next three to five years)
how these projected sales volumes translate into the flow of cash in and
out of the business during normal operations. Where additional inventory,
equipment, or other physical assets are necessary to support the sales
forecast you must determine whether or not the business will generate
enough profit to sustain the growth forecast.

Often, businesses simply grow too rapidly for internally generated cash to
sufficiently support the growth. If profits are inadequate to carry the
growth forecast, the owner/manager must either make arrangements for
working growth capital to borrowed, or slow growth to allow internal cash
to “catch up” and keep pace with the expansion. Because arranging financing
and obtaining additional equity capital takes time, this need must be
anticipated well in advance to avoid business interruption.

To develop effective long-term plans, you should do the following steps:

1. Determine your personal objectives and how they affect your willingness
and ability to pursue financial goals for your business. This
consideration, often overlooked, will help you determine whether or not
your business goals fit your personal plans. For example, suppose you hope
to become a millionaire by age 45 through your business but your long-term
strategic plan reveals that only modest sales growth and very slim profit
margins on that volume are attainable in your industry. You must either
adjust your personal goals or get into a different business. Long-range
planning enables you to be realistic about the future of your personal and
business expectations.

2. Set goals and objectives for the company (growth rates, return on
investment direction as the business expands and mature). Express these
goals in specific numbers, for example, sales growth of 10 percent a year,
increases in gross and net profit margins of 2 to 3 percent a year, a
return on investment of not less than 9 to 10 percent a year. Use these
long-range plans to develop forecasts of sales and profitability and
compare actual results from operations to these forecasts. If after these
goals are established actual performance continuously falls short of
target, the wise business owner will reassess both the realism of
expectations and the desirability of continuing to pursue the enterprise.

3. Develop long-range plans that enable you to attain your goals and
objectives. Focus on the strengths and weaknesses of your business and on
internal and external factors that will affect the accomplishment of your
goals. Develop strategies based upon careful analysis of all relevant
factors (pricing strategies, market potential, competition, cost of
borrowed and equity capital as compared to using only profits for
expansions, etc.) to provide direction for the future of your business.

4. Focus on the financial, human, and physical requirements necessary to
fulfill your plan by developing forecasts of sales, expenses, and retain
earnings over the next three to five years.

5. Study methods of operation, product mix, new market opportunities, and
other such factors to help identify ways to improve your company’s
productivity and profitability.

6. Revise, revise. Always use your most recent financial statements to
adjust your short- and long-term plans. Compare your company’s financial
performance regularly with current industry data to determine how your
results compare with others in your industry. Learn where your business may
have performance weaknesses. Don’t be afraid to modify your plans if your
expectations have been either too aggressive or too conservative.

Planning is a perpetual process. It is the key to prosperity for your

For Further Information

U.S. Small Business Administration Publications

Business Development Booklets

The following booklets and other publications are available from the
Superintendent of Documents, U.S. Government Printing Office, Washington,
DC 20402. Write GPO to obtain SBA Order Form 115B, which lists publications
and current prices.

Handbook of Small Business Finance–Small Business Management Series No. 15.

Ratio Analysis for Small Business–Small Business Management Series No. 20.

Guides for Profit Planning–Small Business Management Series No. 25.

Financial Control by Time-Absorption Analysis–Small Business Management
Series No. 37.

Purchasing Management and Inventory Control for Small Business–Small
Business Management Series No. 41.

Managing for Profits–Nonseries (GPO Stock No. 045-000-00206-3).

Business Development Pamphlets

Many pamphlets are available from the U.S. Small Business Administration
for a small processing fee. Write SBA, P. O. Box 15434, Fort Worth, TX
76119 to request SBA Order Form 115A.

Other Sources

Retailing, Principles and Methods, Richard D. Irwin, Inc., Chicago, IL.

“Understanding Financial Statements,” Small Business Reporter, 1980, Bank
of America NT & SA, San Francisco, CA.

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