Chapter 9 – Managing Financial Aspect

Benchmarking• The comparative analyses of your sales, cost, and profit on a

monthly or yearly basis will give you a good picture of the changes in your sale. This can help you plan ways of increasing sale. High sales, however, do not necessarily guarantee high profits. It can also mean an increase in your operating cost, which can adversely affect profitability. In which case, you have to think of ways to minimize this cost.

Performance of Yantok Furniture

2004 2003 2002

Sales 2,174,700 2,065,965 1,957,230

Gross Profit Margin

777,132 738,275 699,419

Operating Expenses

274,680 260,964 247,212

Shows that even with an increase I sales, the profit of Yantok Furniture remained at 51.6% of sales.

Break - Even Analysis• An entrepreneur would want to know at what level of his

business will break-even. When sales “break-even” it means that the level of sales neither produces a loss nor a profit for the business. This happens when total sales revenue is equal to total cost. Seen from another angle, business can begin to generate a profit when its sale go beyond break-even point.

• Business profit depends on sales (volume multiplied by selling price) on one hand and cost on the other. In managing the finances of the business, you must be able to analyze such factors and cost, volume, and selling price, and their effects on the profit that the business can earn.

• Break even analysis is one of the tools being used to analyze and measure the profitability of an enterprise. Management can use this tool to determine the effects of certain decisions or situations on the firm’s operation. Such decision may include the following:

• A lower sale performance than the expected volume of sales.• An increase (or decrease) in selling prices.• Hiring of additional sales people.• Increase in the wages of direct labor.• Rise in the cost of raw materials.• Related factors affecting cost, volume of sales, and production

and selling prices.

Classification of Cost• When using break-even analysis, you need to classify your cost

and variable cost.• Fixed cost are those cost that remain constant regardless of

the volume of production. Examples are rentals, salaries of executives, depreciation, wages of indirect labor, and other cost like interest, annual fess, etc.

• Variable cost vary or change according to level or volume of business activity. Example are direct materials, direct labor and sales commissions. Note that direct labor is direct cost for piece rate work, but fixed cost if on a daily wage basis. Variable cost go up when production volume increases and go down when production volume decreases.

• There are also cost that can be classified as “semi – variable.” These cost have variable and fixed cost components. To facilitate the computation of the break-even point, you may split semi-variable into its fixed and variable portions or classify the cost as either fixed or variable.

Classification of Cost into Fixed and Variable

Fixed Cost Variable Cost Total Cost

Direct Materials 732,360

Direct Labor 313,860

Manufacturing Overhead

Indirect Labor 100,800

Indirect Materials 2,400

Depreciation 120,000

Miscellaneous Expenses

1,620

Operating Expenses

Salary 141,120

Rental 50,400

Supplies 7,200

Delivery Expenses 19,200

Electricity 11,520

Promotional Expenses

17,040

Water 4,320

Telephone 10,080

Professional Fees 6,000

Permits and license

1,800

Depreciation 6,000

Income 12,000

Total 499,500 1,058,220 1,557,720

The variable cost in the table is equivalent to 49 percent of total sales or P1,064,220 That is,

• = = 49%

• To compute for break-even sales (in pesos), use the formula:• At break-even, BES = Total Cost = FC + VC• Where:• BES = Break-Even Sales• FC = Fixed Cost• VC = Variable Cost

• BES = P499,500 +VC (which can be expressed as 0.49 BES)• = P499,500 + 0.49 BES• = • BES (Pesos) = 979,411.76

• In terms of units, break-even is computed as:• BES =

• =• = 326.47 - 326

Another way of computing for the break-even sales is by using the equation:

• BES = FC + (Volume x UVC)• Where:• BES = Break-Even Sales• FC = Fixed Cost• UVC = Unit Variable Cost• BES and VC can be expressed as:

• BES = Sales Volume x USP• VC = Sales Volume x UVC

• Where: • USP = Unit Selling Price• UVC = Unit Variable Cost

The equivalent expression into the original equation, we derive a new equation:

• Sales Volume x USP = FC + (Sales volume x UVC)

• Sales Volume x USP = FC + (sales volume x UVC)• Sales Volume x (USP – UVC) = FC

• Sale Volume = • Sales Volume x ( USP – UVC) = FC

• Sales Volume =

• BES (Units) =• =

• = 326.47 - 326

Source and Uses of Funds • A better understanding of cash management and financial

budgeting starts with an understanding of how funds normally flow in a business.

• You can tap various types of funds for your business. You can put up all your initial capital requirements, or you can borrow a portion of it from other sources.

1. Internal sources of funds• Owner’s Equity. When you saw your business with your own

money, this amount is called capital, owner’s capital, or owner’s equity. This is the most common source of starting capital for a small business. The initial funs can come from your personal savings, loans from family, relatives and friends similar sources. An advantage in starting with your own money is that you do not have to pay interest.

• Partner’s capital/stockholder’s equity. If aside from you there are other persons putting their money into the business, your total start – up funds are called partner’s capital.

• If you choose to incorporate the business, the funds coming from the stockholders comprise what is known as Stockholder’s Equity. Stockholders are issued shares of stock by the corporation representing their stake in the business.

• 2. External sources of funds. Funds that are borrowed are called liabilities. Liabilities that are to be repaid over a period of more than one year are called long – term liabilities. Those which are to be paid within a year or less, are known as short – term liabilities or current liabilities.

• Bank Loans. The next common source of capital is a bank. The bank’s loan offer assesses your loan application based on the four C’s of Credit: character, capacity, collateral, and capital. The amount of loan you can borrow is often based on the bank’s appraisal of the maximum value of the collateral you offer. Collateral is any property that does not greatly depreciate over time such as a piece of land, equipment or any property that has value. It is being offered by a borrower as security for a loan.

• Venture Capitalist. A venture capitalist is an individual or firm that provides financing to entrepreneurs in exchange for an ownership stake in the business. In the Philippines, there are few venture capitalist unlike in the other countries like the United States. If you are open to the concept, think of venture capitalist as potential business partners or investors who can contribute money to the business and still give you a free hand in running it.

• 3. Other Sources. There are government agencies and non – government organizations (NGOs) that provide start – up funds for micro, small and medium scale enterprise at low interest rates. One such agency is the Department of Trade and Industry that has programs that provide starting capital to sound business ventures, particularly in the rural areas.

Rules of sound financing• When borrowing money, you must not overlook the financial

structure of your business. Ideally, the 40:60 debt – equity ratio must prevail. When does the ratio mean? It means that your business must be finance by only 40% debt and 60% equity.

• Most banks and other financial institutions will allow you to borrow only if the resulting debt – equity ratio after borrowing is 60% debt and 40% equity.

• In addition to the debt – equity requirement, you must comply with the following rules to ensure that your firm will have a sound financial structure:

• Fixed assets and working capital requirements during normal operations must be finance from the owner’s equity and long – term loans or long term liabilities.

• Short – term requirements, like additional working needed during peak seasons must be funded from short – term loan like:

• Trade credits (30, 60, 90 days)• Short – term bank loans (2 or 3 months)• Pawnshops (3 months)• Funds from friends, relatives and family members

Uses of funds • Land and building where you will house and conduct business.• Machinery, equipment and tools to produce your products.• Delivery vehicles.• Payment for raw materials purchased, salaries and benefits of

workers, utilities such as electricity, water, and other items needed in the daily operation of your business.

Managing your funds • Scope and importance of cash management. To keep the

business going, it must have sufficient cash available for its immediate needs. Therefore, you need to keep a close watch over your cash position. This practice is called Cash Management.

• There are two primary objectives in cash management, namely:

• Provide adequate cash to meet the needs of business.• Safeguard cash from loss due to carelessness, or theft, fraud,

and other criminal acts.•

The use of cash budget enables an entrepreneur to be a better position to:

• Provide funds for seasonal needs.• Develop a sound borrowing program.• Take advantage of money – saving opportunities such as

discounts, economic order quantities, etc.• Plan for investing excess cash.

• Planning your cash requirement. To plan cash transactions, you need to go over to your books of accounts, sales records, production cost records, and cash statements. These records will serve as a guide in determining how much money will come in from sales and how much will be paid out for raw materials, labor and other operating expenses.

There are three steps in planning cash requirements:• 1. Make a sales forecast or estimated future sales. You can

make on a daily, weekly, monthly or yearly basis. You can start with an estimated for a day then forecasting your sales estimate for the succeeding days of the week.

• You should also provide allowances for the following factors:• The Weather • Major future activities or events such as town festival, school

opening, Christmas, religious celebrations, harvest seasons, etc.

• Opportunities to carry products.

Variety of common forecasting techniques• Arithmetic Straight – Line Method• Using the following assumptions• Sales in 2004 - 120 units• Sales in 2001 - 90 units• Total increase - 30 units• Average increase per year = 30 units = 10 units per year

• 3 years

• The sales will be then

Year Computation Sales (units)

2005 120 + 10 = 130

2006 130 + 10 = 140

2007 140 + 10 = 140

2008 150 + 10 = 150

Geometric percentage increase method• In the above example, the business realized an increase in

sales of 30 units from 2000 t o 2003, or 33% in three year’s time, or an average increase of 11% per year. Forecasting through this method will result the following:

Year Computation Sales (units)

2005 120 x 11% = 133

2006 133 x 11% = 147

2007 147x 11% = 163

2008 163 x 11% = 181

• 2. Based on the sales estimated, set up an operating budget. The operating budget includes the materials, labor overhead, and provisions for selling and administrative expenses.

• 3. Finally using the operating budget as your basis, prepare the cash budget.

The following are the steps in preparing cash budget• Estimate cash inflows. Calculate the sources of cash inflows

and the estimated amounts of receipts. A primary source of cash inflows is the sale of your products. In estimating the projected cash receipts, you must consider the policy of your business regarding terms of sales. Other sources of cash inflows include additional investment by owners, proceeds from loans, collection of receivables, etc.

• Estimated cash outflows. Anticipated disbursements to be considered in projected cash outflows include:

• Cash purchases• Payment of credit purchases• Salaries and wages• Administrative, selling overhead expenses • Prepayment like rentals, insurance etc.• Loan and interest payment, taxes and dividends or personal

drawings of owners

Motoring and controlling your cash budget• Monitoring is important aspect of cash management. You

need to carefully watch over your credit sales vis-a-vis the purchase of goods for stock. You might find yourself short of cash even if you have excellent control over your cash.

• After setting up your cash budget, your next task will be to see to it that your company operates within the budget. At the same time, you must make sure that the budget estimates are as realistic as possible so that cash will be available at the right time. There should also be a reasonable explanation for any difference between actual and budgeted expenses.

Pitfalls in cash management• You should maintain adequate cash balances when you are

operating a business. You should avoid cash shortage as well as excessive surpluses.

• But how do you determined the right cash balanced? Your projected financial needs and investments for the month or period will be the best basis.

• Synchronizing your cash flow is important because if you are spending more than what you are earning, you might be headed for hard times. Even investing in raw materials and other resources of business must be done with prudence. Proper cash management means investing your money wisely to create more profit. Letting money stand idle by purchasing implements that are not immediately needed for operation translates to opportunity cost – cost that you occur when opportunities to earn are lost.

Internal control in a small business• Given its limited resources, a small enterprise should

established adequate controls to protect its assets. Without any control system the business can bleed needlessly of its cash and liquid assets, otherwise called “the lifeblood of enterprise.”

• Safeguard cash from loss. The internal transaction of the firm are the easiest to monitor and control. Any business should therefore have internal system control system and the most basic principles borrow from check and balance and audit procedures whereby the work of one person is reviewed and examined by another independent persons.

Some of the commonly used internal practices are: • Separation of business funs from the owner’s personal fund• Immediate recording of cash receipts• Daily deposit of cash receipts• Used of petty cash fund for all payments other than checks• Monthly reconciliation of bank accounts• Approval of disbursements and signing of checks by

authorized people• Yearly audit of books by an independent certified public

accountant• Conduct of surprise cash counts• Careful selection of employees

Dealing with cash shortages.

• Cash may be obtained internally by:• Limiting the extension of credit and speeding up collection

efforts• Reducing inventories to a minimum, including finished goods,

work – in –process, and raw materials• Tightening up on trade relationship• Selling assets not needed in your operations

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