3-Managing Small Business Finances Notes

Managing Small Business Finances

Introduction

Sources and applications of funds are critical for small business owners.
Errors in these areas can jeopardize the firm's survival.
Shortage of funds can lead to missed profit opportunities.
Unused funds diminish profitability.
Proper financial management is essential.

Financial Planning for Small Business

Financial planning is essential to maximize financial rewards.
Small businesses require financial planning, though less complex than large corporations.

Importance of Financial Planning

Financial planning helps small business owners manage finances systematically.
It allows informed decisions and reduces errors caused by unplanned choices during operations.

What is Financial Planning?

Financial planning analyzes future events and their impact on a firm.
This includes financial flows, investment outcomes, and financing options.
For small businesses, it focuses on:
- Setting profit goals
- Identifying funding sources
- Making financing decisions
Budgeting is a key tool in financial planning.

What is a Budget?

A budget is an estimate of income and expenditure for a future period (usually a year).
It aims to satisfy the target market, employees, and management goals.

Steps in Budget Preparation

Build the foundation for the budget
Determine anticipated fixed costs
Establish projected non-operating income and costs.

A budget is prepared using these steps:
- Project the best estimate of the volume of products or services expected and the revenue to be received.
- Divide the estimates into monthly figures.
- Obtain an estimate of monthly cost of sale or rentals, by products or service

Types of Budgets Applicable to Small Business

Various individual budgets are used for specific purposes.

Cash budgets - applicable to all firms
Production budgets - for small manufacturing firms
Sales budget - for small service firms

The Cash Budget

A cash budget is a forecast of future cash receipts and cash disbursements over time.
It is also referred to as a cash receipts and cash disbursements statement.
Main sections of a cash budget:
1. Total cash available:
  - Contains the beginning cash and expected cash receipts
2. Cash disbursements:
  - Lists all cash outlays except for interest payments on short-term loans
3. Cash excess or deficiency:
  - Shown by subtracting cash needs from cash available
4. Financing:
  - Shows planned borrowings and repayments, including interests
5. Cash balance:
  - Result of cash available plus borrowings less cash disbursements

The Production Budget

The production budget estimates the quantity of goods to be manufactured during the budget period.
It describes how many units must be produced to meet sales needs and satisfy ending inventory requirements.
The production budget is the primary basis for planning the following:
1. Raw material requirements
2. Labor needs
3. Capital additions
4. Factory cash requirements
5. Factory costs

The Merchandise Purchase Budget

In a retailing firm, the merchandise purchases budget is the equivalent of the manufacturing firm's production budget.
It identifies the quantity of each item that must be purchased for resale, the unit cost of the items, and the total purchase cost.
The merchandise purchases budget usually includes the following:
1. Planning of sales
2. Stocks
3. Reductions
4. Markdowns
5. Employee discounts
6. Stocks shortages
7. Purchases
8. Gross margin

The Sales Budget

The sales budget applicable to service firms identifies each service and its quality that will be sold.
The services produced are identical to services sold.

Financial Analysis

Financial analysis refers to the process of interpreting the past, present, and future financial conditions of the firm.
Basic requirements for financial analysis:
- Financial Statements
- Break-even Analysis
- Financial Ratio Analysis

1. Financial Statements

a. Balance sheet
- Gives a financial profile of a business at any given point.
- Shows its assets, liabilities, and net worth.
b. Income statement
- Shows the revenue and other income, expenses, and net income covering a period of time, usually one year.
- Different profit measures found in the income statement:
  - Gross profit: sales minus cost of goods sold
  - Operating profit: gross profit minus operating expenses
  - Profit before tax: operating profit plus other income (e.g., interest earned from investing idle cash) minus interest expense on borrowed funds
  - Net profit: profit before tax minus tax liability
c. Statement of changes in financial positions
- Designed to explain the financial changes that occur in a company from one accounting period to the next.

2. Break-even Analysis

Break-even analysis is a useful tool in managing the finances of the firm.
Break-even Point
- Break-even point in units (BEFU):
  - Calculates the number of units a company needs to sell to cover all fixed and variable costs.
- Break-even point in pesos (BEPP):
  - Gives the revenue required to reach the break-even point.
Formulas:
$BEFU = \frac{F}{P-V}$
$BEPP = \frac{F}{1-\frac{V}{P}}$
- Where:
  - F = Fixed costs (costs that do not change with production, e.g., rent, salaries)
  - P = Price per unit (the selling price of one unit of the product)
  - V = Variable costs per unit (costs that change with production, e.g., raw materials, labor)

Example

Situation: A small bakery sells cupcakes at ₱50 each. The cost to make one cupcake (ingredients, packaging, etc.) is ₱20. The bakery has ₱30,000 in fixed costs (rent, electricity, salaries).
The owner wants to know:
1. How many cupcakes must be sold to break even? (BEFU)
2. How much total revenue (in pesos) is needed to break even? (BEPP)
Calculations:
1. Calculate BEFU (Break-Even Point in Units)
  - Where: F = 30,000 (Fixed costs), P = 50 (Selling price per unit), V = 20 (Variable cost per unit)
  - $BEFU = \frac{30000}{50-20} = 1000$
  - Interpretation: The bakery must sell 1,000 cupcakes to cover all costs and break even.
2. Calculate BEPP (Break-Even Point in Pesos)
  - Where: F = 30,000 (Fixed costs), P = 50 (Selling price per unit), V = 20 (Variable cost per unit)
  - $BEPP = \frac{30000}{1-\frac{20}{50}} = 50000$
  - Interpretation: The bakery must generate ₱50,000 in total revenue to break even.
3. Interpretation
  - If the bakery sells less than 1,000 cupcakes (or earns less than ₱50,000 in revenue), they will operate at a loss.
  - If they sell exactly 1,000 cupcakes (earning ₱50,000), they will break even (zero profit, zero loss).
  - Selling more than 1,000 cupcakes means they start making a profit.

3. Financial Ratio Analysis

Financial ratios help assess a firm's financial health, identify trends, manage cash flow, and predict profitability.
They also reveal a company's competitive strength within its industry.
Key ratios are derived from the balance sheet and income statement, providing insights into business performance.
Small business owners (SBOs) can use these ratios to identify strengths, weaknesses, and necessary actions for improvement.
Financial ratios may be classified as follows:
- a. Liquidity ratios
- b. Activity ratios
- c. Profitability ratios
- d. Leverage ratios

a. Liquidity Ratios

Reveals the firm's ability to pay debts as they become due.
The most commonly used liquidity ratios are:
- Current Ratio = $\frac{Current assets}{current liabilities}$
- Quick ratio = $\frac{current assets}{ current liabilities}$

b. Activity Ratios

Also known as turnover ratios, provide a glimpse on how effectively the firm is using its assets.
Examples are:
- Accounts receivable turnover
- Inventory turnover

c. Profitability Ratios

Assess a company's ability to earn profits from its sales or operations, balance sheet assets, or shareholders' equity.
They indicate how efficiently a company generates profit and value for shareholders.

d. Leverage Ratios

Leverage ratios, also known as solvency ratios, are financial metrics that analyze a company's debt burden and its ability to meet financial obligations.