A business builds longevity by maintaining accurate financial records, budgeting, and applying ethical and legal accounting practices. Effective record keeping and budgeting can help a business avoid negative situations such as tax discrepancies, bankruptcy, failure, and waste. Objectives After reading this chapter, you will be able to: ; Explain accounting practices ; Describe why budgeting and accounting are important to entrepreneurship ; Create and interpret financial statements Chapter 6© B.E. Publishing, Inc. All rights reserved.

Business Finances Businesses have many expenses related to daily activities. Without a proper financial foundation, entrepreneurs may have difficulty producing products, compensating employees, marketing goods and services, and paying down debt. Each of these activities can help or hinder a business depending on how they are financially managed. Finances are key to an entrepreneur’s success in any industry. To ensure revenue and expenses are managed and controlled effectively, business owners use financial management processes, or methods for ensuring financial resources are properly allocated. Two critical financial management processes are accounting and budgeting. Accounting Practices Accounting is the system of recording, summarizing, and analyzing business and financial transactions. Accounting has many aspects, including maintaining financial records, verifying the accuracy of financial transactions and statements, and reviewing reported financial figures. For instance, accounting measures are used to verify a business’s total revenue, which is income earned by a business, as well as to analyze expenses or the income spent by a business. Accounting is critical for all businesses, regardless of the type of ownership, mission, or target markets. Keeping accurate records through accounting can help a business owner avoid tax discrepancies, bankruptcy, failure, revenue loss, and other negative situations. Incomplete or inaccurate business records, such as sales receipts, expense records, and taxes, can lead to financial problems for a new or established business. Many companies hire specific employees, called accountants, whose sole job is to monitor and manage business finances. Accountants work with businesses and financial institutions to provide precise feedback about where money has been spent, saved, allocated, or wasted. However, entrepreneurs just starting out may be the only employee of a small business and, therefore, will need to act as the accountant.© B.E. Publishing, Inc. All rights reserved.

To ensure accuracy and consistency in accounting records and procedures, accountants follow generally accepted accounting principles (GAAP). GAAP helps businesses record and report information so it can be accessed and understood by auditors, business owners, and investors. GAAP is particularly important when businesses sell stock to investors because it provides a snapshot of the financial state of a business. GAAP prevents companies from falsifying or obscuring financial information, creating a “level playing field” for all businesses. Financial records are audited to confirm companies comply with GAAP. An audit is an internal accounting control evaluating a business’s financial records to ensure they are accurate and that standard accounting principles were used. Audits can be performed by private companies to help businesses organize financial information. Audits are also performed by the IRS to check that a business is paying the correct amount in taxes. Accountants prepare financial statements during a period of time called a fiscal period. Usually a fiscal period for a business is one year, but it may be as brief as one month or one quarter. There are two basic accounting functions: cash-basis accounting and accrual-basis accounting. The methods differ in how they record revenue and expenses. Cash-basis accounting records business revenue and expenses based on when money is spent and received. If a business makes a $100 sale, the sale is not recorded in financial records until the money is received. If credit is used, this could mean that a business experiences a delay. For small business owners, cash-basis accounting suits their needs because of smaller- scale transactions. Inventory refers to the number of items a business currently holds. The amount of inventory a business carries must be balanced. If there is too much inventory, it is a sign that the business is not able to use all of the materials and is, therefore, leading to waste. If there is too little inventory, businesses cannot produce enough of their products to profit. Goods on hand inventory is the number of completed products a business has in stock. A business should have the right amount of goods on hand in its inventory. Excess inventory means a business is not profiting as much as it could be if those goods were on the market; a lack of inventory means a business is not keeping up with consumer demand. Accrual-basis accounting is a function of tracking financial records when the transactions occur and is not subject to when money is received. For instance, a business would enter the $100 sale in its records immediately when the sale occurs, even if it is before the customer pays. Businesses that carry inventories are required by the IRS to use accrual-basis accounting because it provides a more accurate representation of the company’s finances. Some situations call for alternative accounting methods, such as a special or hybrid approach. Special accounting methods may apply to certain circumstances, such as farmers. If approved by the IRS, farmers can use a crop accounting method that allows them to deduct the cost of crop production for the year it was sold. Hybrid accounting is another type of alternative accounting. Hybrid accounting combines more than one method of accounting, such as a special method with cash or accrual.© B.E. Publishing, Inc. All rights reserved.

Another important accounting function is monitoring accounts receivable and accounts payable. Accounts payable is the balance due to a creditor on a current account and accounts receivable refers to the balance due from a debtor on a current account. Keeping track of accounts receivable is important because it can cost businesses money when debtors fail to pay bills on time. For example, if a manufacturer extends credit and the borrower repeatedly misses payments, the manufacturer must assess how to collect the owed debt. Some businesses turn to collection agencies in such a scenario, which are businesses acting on behalf of creditors to collect owed money. Consistently monitoring accounts receivable is one strategy businesses can use to identify past-due accounts that should be immediately pursued. Accounting Equation A common function of accounting is the accounting equation, which is used to define a business’s assets. The accounting equation requires businesses to list and calculate their total assets and liabilities. Assets are items of value a business owns, such as cash, property, and equipment. Liabilities are items a business owes, such as debts. Assets minus liabilities equal a business’s net worth. Net worth in accounting is called owner’s equity or ending capital. The accounting equation can be written several ways using the following three factors: Owner’s Equity = Assets – Liabilities Assets = Liabilities + Owner’s Equity Liabilities = Assets – Owner’s Equity The accounting equation is used differently depending on which factors are being calculated. These factors can be rearranged to record ending capital or prove the accounting equation is in balance. For instance, imagine a business owner with $4,000 of savings who takes out a $10,000 loan to purchase equipment. The equipment he purchases can be added to his assets. His ending capital is calculated by: Owner’s Equity = Assets – Liabilities 4,000 = 14,000 – 10,000 His liability can also be calculated to check that the equation is balanced: Liabilities = Assets – Owners Equity 10,000 = 14,000 – 4,000© B.E. Publishing, Inc. All rights reserved.

ccounting Transactions An accounting transaction is an event that impacts a business’s financial statements. Every transaction has a credit and debit. Double-entry accounting is a form of recording transactions that log both credits and debits of every transaction. Double-entry accounting maintains financial accuracy by balancing accounts. For example, if a business purchases a piece of equipment for $10,000 using credit, it records the transaction as a debit in the left column of its asset account. This is because it is an increase to its equipment assets. The business also records a credit in the right column of an account, which represents an increase to liability in its accounts payable. Documentation of this transaction is shown in Figure 6.1. Debit Credit Assets $10,000 Accounts Payable $10,000 FIGURE 6.1 After debits and credits are determined, a business then uses an accounting journal to capture a detailed record of transactions in chronological order. Businesses may choose to log transactions in one general journal or use special journals for individual transaction types. For instance, a business may use a cash receipts journal to record receipts for cash transactions and a sales journals for recording product sales. Businesses evaluate their needs to determine if a general or special journal is most applicable for their accounting transactions. For example, a large corporation may benefit from special journals because it completes numerous sales each day. In contrast, a small business may be better suited with a general journal to track transactions in one central location. Once specific transaction information is recorded in a journal, the same transaction is transferred into a general ledger, a full record of all accounts and transactions. General ledgers are organized by account and track overall balances. Some businesses also use subsidiary ledgers, which are individual accounts for customers. A business uses subsidiary ledgers to monitor customers owing money, but also vendors that the business may owe. Likewise, a business can review a ledger to see whether it has paid a manufacturer in full for goods rendered.

Ethical and Legal Considerations in Accounting It is important for business owners to be ethical and honest in accounting practices when recording revenue and expenses. Investors and lenders must be confident that numbers used in accounting procedures are accurate and reliable. The role of ethics in accounting is to maintain a standard system of integrity and transparency when paying taxes, seeking credit, and distributing profits fairly across a business. Case Study Ethics in Entrepreneurship Ella owns a traveling boutique business where customers can book “posh parties” where she delivers clothing, jewelry, and shoes to customers’ locations for group shopping experiences. She has been very successful, booking party after party. She is so busy keeping up with the demand that she has let her financial accounting slip. She isn’t entirely sure how many parties she has failed to record the revenue of, but she thinks she has missed a dozen or so in the last few months. She’s not sure how to go back and account for that lost time and is considering just ignoring them and moving on, being sure to record all revenue from now on. What are internal accounting controls Ella can use to help her keep better track of her business finances? What responsibilities does Ella have in maintaining her financial records? What ethical actions should Ella consider in this scenario? There are many organizations that ensure accounting standards are applied, accepted, and ethical in nature. The American Institute of Certified Public Accountants, the Financial Accounting Standards Board, and the Securities and Exchange Commission are organizations that oversee work of accountants in the B2B and B2C markets to ensure ethical practices are used. Businesses should consider the legal implications of accounting practices, such as fines and punishments for money laundering, fraud, or nondisclosure. To maintain employability, accountants are also legally required to be certified at state levels.© B.E. Publishing, Inc. All rights reserved.

Budgeting In addition to accounting procedures, financial planning for businesses also includes budgeting. A business budget is a detailed estimate of income and expenses for a specific period of time. Budgets are used to control money needed for business operations. Financial planners, accountants, managers, and entrepreneurs work together to decide which departments or areas of a business require money. Budgeting is important because it helps entrepreneurs distribute money across a business so that all activities can operate productively. Effective budgets are developed both at the department level and company-wide. For example, a smartphone accessory company may need a specific budget for its production costs of smartphone cases. The budget for production costs must fit within the company’s overall budget. Businesses use cost control to ensure spending stays within budget. Money flowing in and out of a department is closely monitored. If a department is spending more than what has been allocated for use, a discrepancy will be recorded, or the difference between the budget and actual amount spent. Business owners can then take steps to modify department spending or the total budget. Budgeting Basics The key to successful budgeting is for a business to commit to having one. Some entrepreneurs find it difficult to stay on budget and achieve savings and spending goals, and as a result they give up. Budgets need to be flexible because the components will evolve over time as factors change. For example, revenue and expenses may fluctuate with market conditions and changes in circumstances. Flexibility is manageable as long as the primary focus of the budget is to reach financial goals and maintain positive cash flow. Creating a budget allows businesses to manage cash flow. Entrepreneurs who build and implement realistic budgets are helping to secure their financial futures. For business owners, a realistic budget also helps secure the financial future of their employees. Budgeting is particularly beneficial in the following ways: Controlling Money Maintaining a budget puts entrepreneurs in control of their money. Without a budget, money often controls operations instead of the other way around. Reducing Stress Not knowing how much money is available can be stressful. Following a budget and knowing precisely when money enters and exits an account can avoid financial distress. Budgets are not only helpful to business owners in this way, but also for individuals as it allows people to focus—stress free—on more important things in their lives.© B.E. Publishing, Inc. All rights reserved.

Increasing Confidence Knowing exactly where money is going builds confidence. Business owners that implement a budget make better decisions that align with company goals. Instead of questioning every purchase they make, they can simply review the budget to see if the business has the money available. Businesses that map out a clear cash flow plan can remain confident in their decision- making to manage operational costs efficiently. Get Involved Associations Trade associations are designed to support and advocate specific industry groups by providing numerous resources for members to grow and thrive. Associations usually require a fee to join in exchange for access to exclusive educational, networking, and financial services. Some associations that are helpful to entrepreneurs include the following: National Association for the Self-Employed: nase.org National Business Association: nationalbusiness.org National Federation of Independent Businesses: nfib.com National Association of Women Business Owners: nawbo.org International Franchise Association: franchise.org Characteristics of a Functioning Budget Understanding the characteristics of a functioning budget assists entrepreneurs in projecting a realistic portrait of finances. To understand how to develop, create, and implement a budget there are four critical characteristics to consider: SMART goals, time frame, revenue, and expenses. Define SMART Goals SMART goals are specific, measurable, achievable, results-focused, and time- bound. This method of goal setting applies to both business and consumer financial management. Goals are something that you strive to achieve over a certain amount of time. They change often because as you accomplish one goal, you move on to others. Developing a budget that incorporates financial goals is the most useful type because spending and saving decisions can be tailored based on the end goals.© B.E. Publishing, Inc. All rights reserved.

ime Frame Budgets should span a specific period of time, such as a week or a month. Income and bill paying schedules often influence the budget period. For example, if a business’s bills are all due at the end of each month, operating under a monthly time frame will likely make more sense than a weekly budget. It is important to define a time frame that is most applicable for each budgeting situation because the budget period is used to create estimates of revenue and expenses. Revenue After determining a budget time period, the next step is to identify the amount of income that will be available for that time frame. Businesses accomplish this by evaluating revenue. The two primary types of business revenue are operational and non-operational. Operational revenue is income earned from the sales of goods and services. Non-operational revenue is separate from operations and could be earned through factors such as investment dividends and accrued interest on accounts. Expenses There are two types of expenses that represent cash outflow: fixed and variable. A fixed expense is money spent on something that costs the same amount each month, such as rent of office space, business phone costs, or insurance payments. There are not many ways business owners can change the amount due, except perhaps to reduce the services received. For example, a data plan on a cell phone can be reduced to decrease expenses. In a typical small business, a fixed expense is independent of production and sales volume but may include insurance costs, employee salaries, and utilities. In contrast to a fixed expense, a variable expense fluctuates from month to month and is dependent on production and sales volume. This type of expense has the most flexibility for cutting back and getting ahead on finances. Examples of variable expenses in a typical small business include materials, shipping or freight costs, and production supplies. Despite entrepreneurs’ best efforts to accurately estimate fixed and variable expenses, there will be times in which an unplanned expense may arise. Evaluating the impact of unplanned spending on a budget is necessary to keep from overextending. The key to successful financial management is to monitor and review a budget and compare it with actual spending. For whatever period a budget covers, such as a week or month, conducting a careful comparison of what is actually earned and spent will drive smart financial decision-making. It is important to reexamine a budget frequently to determine how well positive cash flow is executed and to make adjustments based on evolving needs.© B.E. Publishing, Inc. All rights reserved.

If a budget indicates more is being spent than earned, it is important to examine areas to cut back, such as reducing variable expenses. The following are indicators that a budget needs updating. ; An increase or decrease in revenue occurs. ; Expenses change. ; Financial goals change. ; A major financial goal has been achieved. ; A pattern in overspending has been observed. Types of Business Budgets For financial planning and record-keeping purposes, there are four types of business budgets, as shown in Figure 6.2, integral to a company’s financial success: start-up, sales forecast, operating, and cash flow budget. Start-up Budget Projects the amount of money needed for the onset of business activities Sales Forecast Budget Predicts how much revenue will come into a business through sales within a period of time Operating Budget Predicts how much revenue will be generated and how much in expenses a business will pay in the future Cash Budget Projects a business’s cash flow FIGURE 6.2 Start-up Budget In a business plan, an entrepreneur indicates how much money is needed to start the business. This money is referred to as a company’s start-up budget, or the amount of money required to launch business activities. Creating a start-up budget requires extensive research. Entrepreneurs research how much manufacturers charge for goods, costs for renting office space, and money needed to pay workers and utilities. The owner’s research informs the way he or she will create the pro forma financial statements. A start-up budget should accurately depict the costs of business operations. It should describe all materials, construction, inventory, and personnel that will be needed to start the business. A timeline of when tasks will need to be© B.E. Publishing, Inc. All rights reserved.

completed and the cost associated with each item is also a helpful strategy when creating a start-up budget. For instance, a miscalculation on start-up costs affects a budget because a business has to find the additional funds to pay for the gap. This could damage a new business if it does not yet have the savings to cover the miscalculated cost. When setting a budget, being as detailed as possible can help an owner avoid failure. Sales Forecast Budget During the planning stage, it is important for entrepreneurs to forecast sales, or project how much money a business will make through sales. Sales forecasts are based on past sales trends and a market analysis. The sales forecast budget is the prediction of how much revenue a business will acquire through sales within a set period of time. Sales forecast budgets are part of pro forma income statements, or projected revenue for a business. Market analysts, accountants, and entrepreneurs carefully study data to determine how a business will earn future sales. They analyze financial history, market trends, and previous sales to predict future revenue. The information is used to set budgets to ensure a business’s profitability. Operating Budget The sales forecast budget is used to inform a business’s operating budget. An operating budget is a prediction of how much revenue will be generated and how much in expenses a business will pay in a future period of time. The nature of an operating budget is to guide businesses in allocating income. For instance, an operating budget may include revenue and how much money a business will need for production, marketing, and human resources. It should describe all supplies, personnel (e.g., wages and salaries), inventories, insurance, utilities, repair and maintenance, and other operating costs associated with funding the business once it is running. Entrepreneurs should also examine how much money will be needed on-hand to operate the business at a loss for a period of time (such as one year), until the business can become profitable. Operating budgets rely on analytics and assessing reasonable expectation. Entrepreneurs may not know exactly how much money a business will need to spend in the future because not all variables can be known. However, a business should adjust its operating budget accordingly as variables arise.© B.E. Publishing, Inc. All rights reserved.

Cash Flow Budget A business’s cash flow is projected using a cash flow budget. Cash flow is the money that comes into and out of a business. Cash flow budgets are used to determine if a business has enough cash to operate. For instance, if a business needs to cover $200,000 in expenses in a year, more than $200,000 of cash has to move through the business to account for its expenses and maintain operations. Cash flow budgets use estimated revenue and expenses to provide a picture of how money flows through a business. A healthy cash flow allows businesses to pay financial obligations when they come due even before the business has collected money that is owed to it. A careful watch on accounts receivable and accounts payable is the crux of establishing positive cash flow. Proper cash management is crucial to successful business operations because business owners can’t pay bills with their accounts receivable.

Payroll When monitoring accounting transactions, budgets, and other financial activities, businesses also need to consider how they will pay and compensate employees. A payroll is a list of a business’s employees and how they are to be compensated. Payroll is an important component of business records and is detailed in nature. The payroll register includes a description of employee earnings throughout their employment, tax deductions from their earnings, what benefits employees have received, whether they are paid wages or salaries, and more. Employers keep records about how they pay employees for tax purposes. Employers are required to withhold a certain amount of money from each employee paycheck to use for income tax, Social Security tax, and other tax purposes. Depending on the employee’s benefits, the employer may also withhold a portion of pay to allocate towards health insurance. Payroll also includes the process of paying employees. Paying employees is a business expense that must be recorded in accounting procedures and considered in a company’s budget. Employee compensation should be recorded and executed efficiently to ensure businesses have the finances for continued operation.© B.E. Publishing, Inc. All rights reserved.

Interpreting Financial Statements Entrepreneurs use financial concepts and tools like budgets and financial statements to make business decisions. Financial statements are documents that report the state of finances within a business. They communicate how profitable a business is, where money is being spent, and how much a business should be paying in taxes. Financial statements can give managers the necessary information to look forward into the future of the business and make better decisions on how to proceed. Accountants verify the accuracy of business financial records before creating formal financial statements to ensure information has been recorded without error. Business owners and other financial planning professionals have a responsibility to maintain financial records ethically and honestly; formal statements provide an accurate reflection of the financial state of a company. Financial statements are prepared at the end of a business’s accounting cycle. An accounting cycle is the process accountants take to record and report financial information. The accounting cycle yields financial statements that are interpreted by stakeholders, lenders, and owners. Anyone who has a share or interest in a company should review and interpret financial statements to assess the company’s profitability. Financial statements are important because they summarize the level of overall financial success. Analyzing financial statements involves calculating financial ratios, or relationships between different components of a financial statement that indicate the state of finances in a business. Financial ratios are determined by factors involved in four different financial statements: balance sheets, income statements, and cash flow statements. To calculate financial ratios and analyze how they impact a business, it is important to understand the functions of each type of financial statement. Business Ties to TechnologyIn the global economy, accuracy, speed, and convenience play a critical role in business operations. With the onset of online banking and the ease of transferring money on the internet, financial transactions are happening quicker and easier than ever before. Many banks now provide mobile services that offer the ability to transfer funds between accounts, deposit checks, and pay bills directly from a mobile device. For business owners and employees, being able to check their bank accounts in an instant provides increased awareness and faster decision-making in regards to business finances. Additionally, many accounts are secured using their owner’s thumbprint or personal passcode, making the accounts more protected than ever.© B.E. Publishing, Inc. All rights reserved.

Balance Sheets A balance sheet is used by all types of businesses to detail assets, liabilities, and owner’s equity at one specific moment in time. Balance sheets also include a statement of shareholder equity, which is determined by assets minus liabilities. The balance sheet, as depicted in Figure 6.3, lists the financial worth of each component. The balance sheet equation is: Assets = Liabilities + Owner’s Equity For instance, a company’s assets might include inventory at $1,000, cash at $500, and accounts receivable at $2,000. The total number of assets would equal $3,500 according to the balance sheet. FIGURE 6.3 Balance Sheet Smith’s Metal Works December 31, 20XX ASSETS Inventory $1,000.00 Cash $500.00 Accounts Receivable $2,000.00 Total Assets $3,500.00 LIABILITIES Credit Card $800.00 Accounts Payable $1,000.00 Total Liabilities $1,800.00 OWNER’S EQUITY Michael Smith, Capital $1,700.00 Total Liabilities and Owner’s Equity $3,500.00 The nature of the balance sheet is to assess the business’s current financial stability and aptitude. Interpreting the balance sheet requires an understanding of working capital, current assets, and current liabilities. Working capital refers to the amount of money a business has for immediate use. Working capital is calculated by assessing the difference between current assets and liabilities.© B.E. Publishing, Inc. All rights reserved.

Liquid assets, also called current assets, are items that can be used immediately or can be used as cash in one year. For instance, a business’s cash is considered a liquid asset, cash being currency that is paper money. The efficiency and speed of cash transactions make it a reliable source of income for a business. When a customer pays in cash for a product, the money is exchanged immediately, without having to go through a bank or technology device. Accounts receivable is also considered a current asset because a business will convert them to cash within a year by receiving payment. Businesses may also have illiquid assets, which are items that are not easily convertible to cash. For example, properties and vehicles represent illiquid assets because, while they have value, they require ready buyers to convert value to cash. Current liabilities are a business’s liabilities, such as loans, that are expected to be paid within one year. These may include trade credits or other types of short-term loans used by a business. The balance sheet shows the amount of money a business has for immediate use—its working capital—by subtracting current liabilities from assets. The formula looks like this: Current Assets – Current Liabilities = Working Capital Imagine Company A has $43,000 in current assets, such as cash, inventory, and materials. The business has $23,000 in outstanding debt that must be paid within the year. Company A has a working capital of $20,000, calculated as follows: 43,000 – 23,000 = 20,000 Working capital is an indicator of how prepared a business is to pay off short-term debts. Consider Company B that has only $23,000 in current assets and $43,000 in current liabilities. The business has a working capital of -$20,000, calculated as: 23,000 – 43,000 = -20,000 If a lender checks a business’s balance sheet to see its working capital in evaluation for a loan, Company A seems more capable of repaying a loan than Company B, which owes $20,000 before it can break even. Lenders assess working capital to evaluate a business’s capacity to pay back a loan or become profitable.© B.E. Publishing, Inc. All rights reserved.

Current Ratio One financial ratio that is used on a balance sheet is a current ratio, which shows how current assets and current liabilities are related. The current ratio can indicate how profitable a business is. It is calculated by dividing current assets by current liabilities. Current Assets / Current Liabilities = Current Ratio The current ratio shows how many assets there are per liability. A current ratio of less than one shows that a company may be unable to pay back debts. A current ratio that is much higher than one suggests a company is not adequately using its available capital and could indicate poor management. Consider the current ratio for Company A, which has $43,000 in current assets and $23,000 in current liabilities. 43,000 / 23,000 = 1.86 Company A has 1.86 dollars in current assets per 1 dollar of liability. Company A’s current ratio is written as: 1.86:1 Now consider Company B, which has $23,000 in assets and $43,000 in liabilities. 23,000 / 43,000 = 0.53 Company B has 0.53 in assets for every dollar of liability. Company B’s current ratio is written as: 0.53/1 Debt Ratio Another type of ratio that may be featured on a balance sheet is a debt ratio. The debt ratio shows the relationship between a business’s total assets and total liabilities. This means that all cash and debts are included in liabilities and assets, not just the ones that will be used within one year. The debt ratio can be used as a tool to compare a business against other businesses in an industry. It is calculated by dividing total liabilities by total assets. Total Liabilities / Total Assets = Debt Ratio© B.E. Publishing, Inc. All rights reserved.

Imagine that a business has $75,000 in total liabilities and $30,000 in total assets. Its debt ratio is calculated as: 75,000 / 30,000 = 2.5 This means that for every dollar a business has in assets, it owes $2.50. Average debt ratios will vary by industry, so businesses should compare their debt ratio to competitors. This will provide an indication for whether a business is average, better, or worse than similar companies. Income Statements An income statement is another important financial tool used to evaluate a business’s financial position. Income statements detail a company’s financial performance by showing revenue and expenses over a period of time. Income statements require companies to calculate total revenue and expenses to compute net, or total, income or loss. Figure 6.4 depicts how expenses and revenue are featured on an income statement. FIGURE 6.4 Horrock’s Garden Center Income Statement For Year End December 31, 20XX REVENUE Sales $32,000.00 Total Revenue $32,000.00 EXPENSES Advertising $1,000.00 Rent $8,000.00 Supplies $3,000.00 Utilities $1,000.00 Insurance $1,000.00 Total Expenses $14,000.00 NET PROFIT $18,000.00 The nature of income statements is to determine whether a business is profiting. For this reason, an income statement is also called a profit and loss statement because it demonstrates a business’s expenses compared to its income. Interpreting the nature of income statements requires an awareness of the relationship between business expenses and revenue.© B.E. Publishing, Inc. All rights reserved.

When the difference between revenue and expenses is positive, it indicates a net profit for a business. If the difference is negative, it is a net loss for a business. Revenue – Expenses = Net Profit or Loss For instance, a business that has generated $32,000 in revenue while spending $14,000 has a net profit of $18,000, as calculated below. 32,000 – 14,000 = 18,000 A business that has generated $11,000 in revenue while incurring $15,000 in expenses has a net loss of $4,000. 11,000 – 15,000 = -4,000 When comparing a business’s income statements to other income statements in an industry, businesses, lenders, and other financial experts use profit margin ratios. Profit margin ratios depict how a business is progressing financially. Two profit margin ratios used are net profit ratio and operating ratio. Net Profit Ratio A net profit ratio shows how much a business profits per one dollar of sales. Net profit ratios indicate how effective a business’s sales are in bringing in profit. It takes the business’s total income after it has paid taxes, production costs, and other expenses associated with generating income, and divides it by the total amount of money earned in sales, which is the amount of money it earned before the production and sales expenses. Net Income / Net Sales = Net Profit Ratio Consider a business that has a net income of $15,000 and makes sales of $35,000. It has a net profit ratio of 0.42, which means that the business profits $0.42 for every dollar it makes in a sale. 15,000 / 35,000 = 0.42 0.42/1 This information is used to assess the effectiveness of prices, production, and expenses within a business. The more a business can profit, the stronger it will be financially. Creditors and investors use this data to make decisions about lending capital to a business.© B.E. Publishing, Inc. All rights reserved.

Operating Ratio An operating ratio demonstrates the relationship of a company’s operating expenses to its net sales. It analyzes a business’s effectiveness in operations by determining how much of each dollar of sales goes to business operating expenses such as production, employee benefits, marketing costs, and other essential business tasks. An operating ratio is calculated by dividing operating expenses by sales. Operating Expenses / Sales = Operating Ratio Consider a business with $50,000 in operating costs that makes $65,000 in sales. 50,000 / 65,000 = 0.77 0.77/1 For every dollar in sales, a business is paying $0.77 in operating costs. Businesses should evaluate operating ratios to ensure they are productive and effective at managing the production process and other costs of business activities. Cash Flow Statements Cash flow statements indicate the flow of cash through a business. Businesses prepare cash flow statements to view where money in their business is allocated. A cash flow statement shows areas of the business that are costing the most money and areas bringing in funds. The nature of cash flow statements is to show how effectively a business manages money. If a business is spending more than it is earning, the business is said to have a negative cash flow. Negative cash flow makes it hard for a business to profit because it is not earning enough to make up for spending. If a business takes in more cash than it spends, it is said to have a positive cash flow. Businesses with positive cash flow can afford to pay off debts and are more attractive to lenders and potential investors.© B.E. Publishing, Inc. All rights reserved.

Budgeting for Profitability Profit is the financial gain calculated by the difference between amount earned and amount spent by a business. Businesses must remain profitable if they hope to avoid failure. For this reason, it is important that business owners identify factors that affect their business profits, such as revenue expenses, and the entrepreneur’s role. Revenue A business’s total revenue will affect its profit. This is because revenue is the “amount earned” portion of the calculation of profit, as shown in Figure 6.5. When a company’s revenue increases for any reason, its profits increase. Revenue can take the form of product sales or receiving money from investors. Expenses Expenses can also have a great impact on a company’s profits. This is because expenses represent the “amount spent” portion of the calculation of profit, as shown in Figure 6.5. The more expenses a company has, the more it has to subtract from its revenue. For example, if a business makes $90,000 in revenue from products but spends $75,000, its profit is $15,000. FIGURE 6.5 Expenses Amount Spent Revenue Amount Earned – Profits= Entrepreneur’s Role The role of an entrepreneur’s contribution of time, money, and expertise is an important one because productivity can have a profound impact on profits. The concept of productivity is a measure of economic output in terms of a worker’s input. When more work is accomplished with less time and effort, productivity increases and waste decreases, so businesses aim to be as productive as possible to maximize profit. For example, a wedding supply company that creates custom invitations may discover that it makes five unique designs per day when workers design the invitations by hand. That limits product development to just five items per day. But if that company uses the entrepreneur’s expertise in computer design technology to create the invitations, the business could produce 10 unique designs per day. The result is that more product is created using the same amount of work, meaning the business can make greater sales without having to increase expenses much—beyond the investment of the computer design technology. In this way, profits increase due to increased productivity and the contributions of the entrepreneur’s expertise.© B.E. Publishing, Inc. All rights reserved.

One Dream Fades and Another Begins Tom Little always thought he wanted to become a high school business teacher, but shortly after graduating college with a bachelor’s degree in business administration and secondary education, Little found teaching jobs to be few and far between. He settled for a corporate job instead, and after three years of working there, an opportunity to own his own business presented itself. At age 26, Tom Little purchased the franchise ServiceMaster Cleaning and Restoration. Tom’s dream to be a schoolteacher fizzled when he was working in his corporate position. Once the idea of having his own business emerged, however, it was his constant focus. When the opportunity to purchase the ServiceMaster franchise arose, he remembers consulting with his father who gave him some advice: “You are young, and if you lose everything—your house, your savings—you can start over. You have a desire to have your own business, so here is the chance.” Tom decided to take the leap. Now, 35 years later, the company is thriving with employees. ServiceMaster of Kalamazoo faces many challenges each day. Tom and his team try to label problems as challenges. Tom says, “It’s quite a simple approach, but it’s something I have found to bring positivity and solution-oriented thinking to our teams. Viewing things as challenges rather than problems brings the focus on people providing constructive and productive feedback for solutions.” Owning a growing business for 35 years is a great accomplishment, and Tom’s best advice for new entrepreneurs is to have integrity and consistency of character whether at home, work, school, or recreation.© B.E. Publishing, Inc. All rights reserved.

A start-up budget is a financial statement that includes an outline of all equipment, supplies, and marketing expenses required to start a business. Many businesses that have high start-up costs seek their funds from banks in the form of a “start-up loan.” Start-up funds can also be acquired through personal loans, cash loans, and credit advances. Banks usually require that a start-up budget be included in the business plan. Start-Up Budget Creating a budget of start-up funds is the first step in procuring capital for a business. Start- up budgets include the following items. 1. Cost of equipment required to start the business. Depending on the type of business, the cost of equipment can vary significantly. A home-based service business will require less equipment than a traditional storefront carrying inventory. Knowing equipment costs up front can save entrepreneurs from overspending in the future. 2. Cost of materials and supplies required to start the business. Most businesses need basic materials like paper, writing utensils, and office supplies. However, other businesses may require additional materials and supplies. Considering all of the materials and supplies before opening a business ensures entrepreneurs have every expense accounted for. 3. Advertising and marketing costs required to start the business Different advertising methods will have different prices, so it is important for business owners to define what each marketing strategy will cost before implementing it. Creating a Start-Up Budget It is important for every prospective new business owner to know exactly how much money will be required to launch, not only so that the funds can be obtained, but so that the business owner can create a budget and a sound financial plan. Review and contemplate the following questions to help you determine your start-up funds and budget: ; What type of equipment do you need? ; What materials and supplies do you need? ; What advertising and marketing will you utilize? ; What are your projected income and expenses? ; What financial statements will you utilize?© B.E. Publishing, Inc. All rights reserved.

Chapter Review Essentials of Entrepreneurship Unit 2 · Chapter 6 123 Chapter 6 Review In this chapter, you learned about financial records and accounting. Accounting procedures are critical to the management of finances in a business. Budgets can help an entrepreneur manage cash flow and spend funds wisely on necessary expenses. Accounting and budgets help entrepreneurs prepare financial statements that demonstrate profitability and appeal to potential lenders and investors. Instructions Demonstrate your knowledge of this chapter by completing the following review activities. Note: If you do not have access to the eText of this book, Chapter Review worksheets will be provided by your instructor. Define Key Terms Apply your knowledge of the chapter reading by defining key vocabulary terms. Test Your Knowledge Test your knowledge of the chapter reading by answering short answer questions. Read and Write Review Ethics in Entrepreneurship about a business owner who isn’t entirely truthful in her financial statements. Apply what you have learned by writing an essay about the ethical actions the business owner should consider. Listen and Speak Apply your knowledge of the chapter by preparing a presentation on financial statements and generally accepted accounting practices. Create and Design Use what you have learned in this chapter to identify types of assets and liabilities. Build It Review the Build It section from this chapter about start-up budgets. Apply what you have learned by creating a start-up budget for your business in the Build It activity.© B.E. Publishing, Inc. All rights reserved.