CH-9-10 Risk Management Issues – Small Business: An Entrepreneurs Plan : Book Guide

This Document Contains Chapters 9 to 10 Chapter 9: Risk Management Issues I. Business Plan Building Block (SLIDE 9-2) Good planning can help the entrepreneur avoid ugly and unpleasant surprises. It is impossible to eliminate all the moments of unpleasantness that will surface during an operating period for any business. But with good planning, surprises can be avoided or dealt with before they become unpleasant. Surprises can’t be predicted, but a person can demonstrate that he or she has accounted for them before launching a business. To protect yourself from such unpleasant surprises, you need a plan and at least one Plan B. We begin this chapter by showing you how to create one. II. CHAPTER LEARNING OUTCOMES (SLIDE 9-3) After reading this chapter, students should be able to: • Develop a Plan B to minimize the ill effects of unfortunate surprises. • Determine your insurance needs and costs. • Draft a health and safety policy and action plan. • Develop a list of precautions that will help minimize the opportunities for employee dishonesty. • Understand the main characteristics of patents, copyrights, and trademarks. • Prepare a 12-month start-up checklist. III. LECTURE OUTLINE 1. Developing a Plan B (SLIDE 9-4) Explain that risk is a fact of life. Encourage your students to acknowledge risk, and find ways to minimize the consequences. Explain that we want them to be proactive and think about alternative strategies if their decisions don’t pan out. That’s why having at least one Plan B—an alternative strategy for bailing the business out of a tight spot created by some unforeseen or unfortunate situation—is a must before they open your doors. Box 9.1, page 220, presents a Plan B checklist that could help eliminate surprises, while Box 9.2 on page 223, provides some useful online resources. A supplier’s checklist is provided in Box 9.3, page 223. Explain that If they get into the habit of making lists, doing mind maps, and writing everything down in your 24/7 Adventure Notebook, they’ll improve their chances of surviving in small business. Encourage your students to complete Action Step 42, page 220, which will also help them anticipate potential surprises. 2. Insurance Planning (SLIDE 9-5, SLIDE 9-6 and SLIDE 9-7) Explain that if they plan on going into business for themselves, they will likely need some sort of insurance. Explain that in calculating their insurance needs, they should first consider all the insurable risks faced by their business. The key to purchasing insurance is “don’t risk more than you can tolerate losing.” Emphasize, however, that they can never be insured for a bad management decision—and that’s again why they have to have their plan B. In general, the following risks can be covered by insurance (SLIDE 9-5): 1. personal injury 2. employment practices 3. loss to the business caused by the death or disability 4. loss or damage of property 5. loss of income resulting from interruption of business 6. consequential losses 7. auto Explain that in order to determine what type or types of insurance should they carry, and how much coverage should they have, they should consider the following (SLIDE 9-6): 1. size of any potential loss 2. probability of loss 3. resources available to meet a loss if one occurs 4. probability of lawsuits (some industries and areas are heavily targeted) Types of business insurance are shown in Box 9.4, page 224. Explain that if they operate a home-based business, they will probably need extra insurance. In most cases, basic homeowner’s insurance will not cover all business needs. Explain that in particular, they must make sure that all vehicles are insured for business purposes. Three types of home insurance policies are (SLIDE 9-7 and Box 9.5 on page 226): 1. Homeowner’s policy endorsement 2. In-home business policy/program 3. Business owners policy (BOP) Explain that in addition to business insurance, they will likely need a business insurance professional who will probably not be the same person who brokered their homeowner’s or auto policies. Suggest that they network their way to a good business insurance agent—the same way we suggested they select a lawyer or accountant. Explain that joining an insurance group can save their money. Remind them that insurance can reimburse them only for unintentional, unforeseen, and uncontrollable losses, not for everyday business risks. Explain that if they have business partners or associates, it is very important that they draw up a shareholders’ agreement. The agreement should include a buy-sell option that clearly states what happens if one partner should die, become disabled, or want to sell his or her interest in the business. Shareholders agreements were discussed in Chapter 8, page 191. Table 9.1, page 227 and Action Step 43, page 226, will help your students calculate their insurance needs and costs. 3. Workplace Health and Safety (SLIDE 9-8 and SLIDE 9-9) Explain that workplace accidents can destroy their business. About $10 billion (including direct and indirect costs) are spent annually to compensate workers injured on the job. Both humanitarian desires and economic good sense have encouraged employers to create and maintain safer and healthier working conditions. Occupational health and safety (OHS) legislation in Canada outlines the general rights and responsibilities of the employer, the supervisor, and the worker. As a general rule, the legislation applies to all workers performing work for an employer. There are two basic levels of OHS legislation—federal and provincial. Each of the ten provinces, the three territories, and the federal government has its own OHS legislation which often makes this a complicated and confusing issue. Federal OHS legislation is governed by the Canada Labour Code, Part II. The majority of small-and medium-sized businesses are governed by provincial OHS law. In each province or territory, there is an OHS act that applies to most workplaces in that region. This act normally applies to all workplaces, except for private homes or farming operations. Because of the complexities of Canada’s OHS legislation, it is often difficult for a small business to know exactly what its responsibilities are. The federal government and most of the provincial governments have similar requirements in their OHS legislation. These requirements can be grouped into four broad categories: 1. OHS government, employee, and employer responsibilities 2. Joint Heath and Safety Committees (JHSC) 3. Workplace Hazardous Materials 4. Due Diligence Explain that all business owners must exercise due diligence. It is important that small business owners understand, in particular, this 4th responsibility. In the context of occupational health and safety, due diligence is the level of care, judgment, and caution that an employer would reasonably be expected to provide in order to prevent injuries or accidents in the workplace. As an employer, entrepreneurs may be legally responsible for situations that are not specifically addressed in the OHS legislation. Encourage your students to complete Action Step 44, page 231, which will help them begin drafting their health and safety policy and action plan. 4. Theft and Fraud Prevention (SLIDE 9-10) Explain that one of the nastiest surprises for a budding entrepreneur is employee dishonesty. Explain that the potential issues they may face include: credit card fraud, cheque deception, shoplifting, cash register vulnerability, and bookkeeping theft—to name just a few (page 231 provides more examples). Explain that they will not be able to eliminate theft and fraud, but there are a number of things they can do to reduce the risk. They can begin by establishing a code of conduct; have their employees sign the code of conduct and review it on a regular basis. Next, establish a set of anti-theft/fraud rules and procedures. Box 9.7, page 232, will help them get started. If they suspect employee dishonesty, take prompt action. 5. Getting Advice and Plan Ahead (SLIDE 9-11) Explain that there is another angle to planning called seeking advice. Suggest that your students find a small business guru or mentor who can help them with advice and counsel. Consider establishing an advisory board. Encourage them to use their network to find people who may help them. They can make anyone part of their team—their lawyer, accountant, professor of small business, and even their customer. Encourage them to plan ahead and to think about the things they need to start action on 12 months before they open their door for business. Box 9.9, page 233, provides an example of a 12-month checklist. 6. Think Points for Success Review the following think points with your students: √ Listen to your competition so that you can change and improve. √ Create partnerships and outsource what you can. √ Be aware of closing dates for Yellow Pages advertising and other key media. √ Keep a time log that tells everyone (you, your founders, your key employees) how you are progressing on the plan. √ Make sure your partners are as committed to the business as you are, and have a shareholders or partnership agreement. √ Keep an ongoing list of unfortunate surprises that could hurt your business. Write down how you can turn these surprises into opportunities. √ Always have a Plan B. And a Plan C. And a Plan D. √ Let some key customers in on your planning; let them see it with their own eyes. Go one step further—create a customer board of directors. 7. Checklist Questions and Actions to Develop Your Business Plan (SLIDE 9-13 and SLIDE 9-14) Review the following Checklist Questions and Actions to Develop Your Business: √ What operational goals and objectives do you want to achieve? √ What risks and challenges does your business face, and how will you address each one? √ Develop a start-up schedule beginning 12 months from the launch, indicating all the activities you must undertake (e.g., place, Yellow Pages phone advertisement), along with related costs up to start-up. √ What are the major cash drains in your business? √ What types of insurance and employee bonding will you have for your business? √ Do you have a health and safety policy in place? V. SUGGESTIONS FOR GUEST SPEAKERS Some guest speakers to consider include: 1. An inspector. Almost any inspector will do—city, county, fire, department of health, etc. Ask the inspector to talk about codes, starting with what is needed in a place that prepares food. 2. A utility company representative. Have the representative talk about deposits, requirements, etc. 3. A phone company representative. Invite the representative to discuss business telephone service. (The costs here will be a real eye-opener.) 4. Health and safety officer. Invite a health and safety officer from your college or university or a local business. Ask them to talk about such issues as: 1. How is a healthy and safe working environment encouraged? 2. What are the responsibilities of the organization? 3. Who is responsible for safety? 4. What are the responsibilities of the employees? 5. Is there a health and safety coordinator? 6. What are the rules and regulations regarding workers’ compensation? 7. What are the expectations of the government inspector? 5. An insurance agent. Get an insurance agent to outline the types of insurance, which can help a small business avoid financial loss. A good starting point would be Table 9.1, page 227. V. CLASS PROJECTS Class Project 1 1. Select a business most students have some knowledge of (e.g., gas station, fast food, bookstore, etc.). Divide the class into groups. Have one-third of the groups work on pre-start, the second third on the first three months, and the remaining third on four through twelve months. Have each group think about changing priorities and then list possible surprises. 2. Have each group write its list on the board, clearly indicating which segment the list pertains to. Encourage the whole class to brainstorm preventive actions. Stress the point that sometimes money can be less of a problem than dishonesty, municipal bureaucracy, etc. Part of the task is to plan ahead. The other part is to earmark those surprises that can be solved with money alone. 3. Now have each group act as owner/manager/entrepreneur. Review the lists and establish priorities on purchasing. What must be purchased during start-up and during the first three months? What can be delayed and for how long? Class Project 2 1. Tell the class the following story: What if this Surprise Happened to You? Two people have been working together for four years at a travel agency. They decided to start their own travel agency. They spent several weeks searching for a good location. Finally, they found a new shopping centre in an area with a high average income. The centre was scheduled to be completed in six months. They signed the lease and began all their other planning in order to be ready in six months. Because both of them were leaving their current employer at the same time and, not wanting to burn any bridges, they gave two months’ notice. Two months later, they were ready to start their new business but the contractor informed them that because of some delays, their location would not be ready for another 60 days. Their employer had, in the meantime, hired two replacements and didn’t need them to stay on. 2. Brainstorm and mind-map possible solutions. 3. Complete the exercise by telling the class what they really did (one possible solution): They quickly found a small office to rent on a month-by-month basis. They took as many of their former customers as they could. Four and a half months later, they moved into their new location. Bottom Line: When dealing with any type of new business, it is essential to plan for unexpected delays. Problems can turn into opportunities if you plan ahead. VI. INTERNET EXERCISES 1. Business insurance Have your students go to the Insurance News Network site at: http://www.insure.com/business/. Ask them to report on any one of the basic insurance business topics such as choosing a group health plan, auto, life, disability insurance and so on. 2. Health and safety—due diligence Have students link to the CCOHS Due Diligence site at: http://www.ccohs.ca/oshanswers/legisl/diligence.html. Get them to answer the following questions: 1. Why does due diligence have special significance? 2. How does an employer establish a due diligence program? 3. What is an example of a due diligence checklist? 3. Health and safety—protecting your business (Case Study 1, Question 2 (c), page 236 and Section IX below) 1. Get students to review the list of precautions in Box 9.7, page 232. 2. Then have them link on to “What Crime Concerns You?” http://crimeprevention.rutgers.edu/crimes.htm. 3. Get them to list 10 ways you plan to protect your business. 4. You may want to have them present the results to the class. VII. SUGGESTED LESSON PLAN VIII. SUGGESTED ACTIVITIES ACTIVITY 1: Review and Overview 1. Review Chapter 8 and answer any questions (Show SLIDE 8-2 and SLIDE 8-3 and SLIDE 8-4 and SLIDE 8-19 of Chapter 8 if necessary.). 2. Introduce Chapter 9 and show and explain SLIDE 9-2 and SLIDE 9-3. A good way to introduce the chapter is by asking students to recall the experience of Patty Fisher case in the opening caption, page 219. Aspiring daycare operator Patty Fisher was badly shaken by an unexpected hydro charge. Activity 2: Start-Up Concerns See NETA Lesson Plan #1 Activity 3: Insurance Planning Show and briefly explain SLIDE 9-5, SLIDE 9-6 and SLIDE 9-7 1. Optional group exercise (30–40 minutes) 1. Show and briefly explain SLIDE 9-5, SLIDE 9-6 and SLIDE 9-7. At this point you may also want to go over the types of business insurance (Box 9.4, page 224). 2. Have students get into groups (4–7 students) and select a business. Get them to think about the insurance needs of this business. Have them complete Table 9.1, page 227. Leave the annual cost column blank, for now. 3. Have group spokespersons share results with class. 4. After the exercise is completed, encourage at least one student in each group to go out and get estimates of the costs for each item of their selected business. Suggest they complete Action Step 43, page 226). Report back to the class in a week. 5. Encourage all students to complete Action Step 43 before they start their business. Remind the students that joining an insurance group can save them lots of money. 6. Complete this discussion by emphasizing that insurance is paid only for unintentional, unforeseen, and uncontrollable losses, not for everyday business risks. 2. Optional guest speaker exercise (50–60 minutes) You may want to substitute the above exercise with a guest speaker. For example, you could get an insurance agent to outline the types of insurance that can help a small business avoid financial loss. A good starting point for discussion would be Box 9.4, page 224. Activity 4: Networking Break Encourage students to network and learn more about each other during the break. Activity 5: Workplace Health and Safety Show and briefly explain SLIDE 9-8 and SLIDE 9-9. Your discussion will be based on pages 228. You may want to refer to the teaching notes that accompany these slides. Everyone in the workplace is responsible for health and safety. However, an employer may be legally responsible for situations that are not specifically addressed in OHS legislation. So, all business owners must exercise due diligence. It is important that students understand this major responsibility. Encourage students to complete Action Step 44, page 231, before they start their business. Activity 6: Employee Dishonesty See NETA Lesson Plan #2 Activity 7: Take Positive Steps Show and briefly explain SLIDE 9-11. Activity 8: Summary, Q&A, and Preparing for Chapter 10 1. Recap the key points for each objective (using SLIDE 9-2 and SLIDE 9-3 if necessary). 2. Encourage students to complete the Business Plan Building Block on page 235. 3. Show SLIDE 9-13 and SLIDE 9-14 and encourage students to complete the Checklist Questions and Actions to Develop Your Business Plan, page 236. You may also want to briefly review the Think Points for Success, page 235. 4. Show SLIDE 9-15 and encourage students to complete the questions for these two case studies. Answers to the case study questions are contained in Section IX below. 5. Respond to any questions that students may have. 6. Encourage students to go to the Nelson Small Business site: www.knowlescastillo6e.nelson.com. Click on to the Test Yourself link and complete the true or false/multiple choice, short answer, and matching exercise for Chapter 9. 7. Have students read Chapter 10 in preparation for the next lesson. Some instructors may want to encourage students to also prepare a mind map of key points contained in Chapter 10. IX. CASE STUDY Case: Your Business Idea Case Background By now you should have a fairly good idea of the kind of business you want to start. This first case study is about you and your business. We want you to be proactive and begin thinking about possible risks and health and safety issues for your business idea. Case Questions and Answers 1. Plan B solutions a. When survivors from any field or profession get together, they often like to share horror stories. In Table 9.2, we’ve collected a few of these small business “surprises” that we have encountered over the years. We want you to brainstorm with friends or classmates. Come up with some preventive measures to help avoid these costly surprises for your business—before you start your business. What are your Plan B solutions? Complete column 2 of Table 9.2. Answer: Plan B Solutions 1. Surprise: Unexpected Equipment Failure • Plan B: Implement a regular maintenance schedule and establish relationships with reliable repair services. 2. Surprise: Sudden Supply Chain Disruptions • Plan B: Develop relationships with multiple suppliers and maintain a buffer stock to manage disruptions. 3. Surprise: Cash Flow Issues • Plan B: Create a detailed financial plan with contingencies, and secure a line of credit for emergency funding. 4. Surprise: Regulatory Compliance Changes • Plan B: Stay informed on industry regulations through professional networks and consult with a compliance expert regularly. Suggested Answers: Note: These questions make for good class discussion. You might want to do a class or group brainstorm on these questions and mind-map the class responses. See Class Project 2 in the Lesson plan section VIII above. b. After brainstorming your Plan B solutions to Question 1a, we now want you to think about your business idea. Complete Table 9.3 by listing five costly surprises that might arise and provide your plan B solutions. If you can think of more than five, keep going. Be sure to put this in your 24/7 Adventure Notebook. Table 9.3 Answer: 1. Surprise: Legal Disputes • Plan B: Retain a legal advisor to review contracts and address potential issues proactively. 2. Surprise: Higher-than-Expected Operating Costs • Plan B: Develop a detailed budget with cost contingencies and regularly review expenses for efficiency. 3. Surprise: Market Demand Fluctuations • Plan B: Conduct ongoing market research and diversify product offerings to adapt to changing demands. 4. Surprise: Technology Failures • Plan B: Invest in reliable technology solutions and create backup systems to minimize disruptions. 5. Surprise: Key Staff Turnover • Plan B: Implement a comprehensive training program and maintain a network of potential hires to ensure smooth transitions. 2. Health and Safety You should be thinking about workplace health and safety issues before you start your business. a. In relation to occupational health and safety, what is meant by the term due diligence? Answer: According to the text, page 230, due diligence is the level of care, judgment, and caution that an employer would reasonably be expected to provide in order to prevent injuries or accidents in the workplace. Due diligence in occupational health and safety refers to the proactive measures taken by employers to ensure a safe work environment and comply with legal safety requirements. It involves identifying potential hazards, implementing safety protocols, and regularly reviewing practices to prevent accidents and injuries. This proactive approach demonstrates a commitment to employee well-being and regulatory compliance. b. Draft a health and safety policy statement for your business. Action Step 43 will provide you with some guidance. Answer: A health and safety policy will depend on the type of business. According to Action Step 44, page 231, this policy must address the following issues: • How will you encourage a healthy and safe working environment? • What will be your responsibilities as an owner? • Who will be responsible for safety? • What will be the responsibilities of your employees? • Do you need a safety coordinator? • What are the rules and regulations for your business regarding workers’ compensation? • Who is your government OHS inspector? What are his or her expectations? c. Before you start your business, you should familiarize yourself with the techniques to protect you and your business against the common business crimes, such as break-ins, fraud, employee theft, shoplifting, and vandalism. Review the list of precautions in Box 9.7 (page 232). Link onto “What Crime Concerns You?” http://crimeprevention.rutgers.edu/crimes.htm. List 10 ways you plan to protect your business. Answer: 1. Install Surveillance Cameras: Monitor and record activities to deter and address criminal behavior. 2. Use Alarm Systems: Implement motion detectors and alarm systems for break-in prevention. 3. Secure Entry Points: Reinforce doors and windows with high-quality locks and security bars. 4. Implement Access Control: Restrict access to sensitive areas with keycards or secure codes. 5. Conduct Regular Audits: Monitor financial and inventory records to detect fraud or theft. 6. Train Employees: Educate staff on recognizing and reporting suspicious behavior and theft. 7. Use Anti-Shoplifting Devices: Employ security tags and sensors on merchandise. 8. Enhance Lighting: Ensure exterior and interior areas are well-lit to deter vandalism. 9. Establish a Reporting System: Create a clear process for reporting theft and suspicious activities. 10. Maintain Good Relations with Law Enforcement: Build connections with local police to enhance security and response. Note: Answers to this question are provided on the Web site provided in the above question (http://crimeprevention.rutgers.edu/crimes.htm). This question also provides good material for class discussion. One teaching suggestion is to get students into groups. Have them do group mind maps of all their answers. Have each group present their results. Chapter 10: The Power of Numbers I. Business Plan Building Block (SLIDE 10-2) Financial statements and ratios are important measures of the financial health of your start-up business. Cash is the lifeblood of your business and cash flow is a key financial statement. Chapter 10 will help you to build a financial plan and stay in control of the money flow. It will also help you write the financial section of your business plan. Note: In our experience, we have found that many students dislike working with numbers. If they are thinking of owning a business one day, then they must be prepared to deal with numbers—especially those related to the business’s finances. II. CHAPTER LEARNING OUTCOMES (SLIDE 10-3 and SLIDE 10-4) After completing this chapter, students should be able to: • Formulate a personal financial vision. • Test your financial fitness • Assemble a team of financial advisors. • Estimate your start-up costs. • Create your own balance sheet. • Project monthly sales and propose a sales forecast. • Understand that cash is the lifeblood of your business. • Understand that bills are paid with cash, not profit. • Create a cash flow projection and a pro forma income statement. • Use ratios to measure the financial health of your business. III. LECTURE OUTLINE 1. Your Financial Fitness (SLIDE 10-5) Explain to your students that we want them to begin their journey to finance their business by reviewing your own personal financial situation. After all, if their personal finances are not in order, how can they expect to ask other people to invest in them and their business? The e-exercises and sources provided in Box 10.1, page 241, will help them do that. Remind them that that we will ask them to come back and review this information in Chapter 11 when it comes time to create their own personal financial statement. 2. Formulating a Personal Financial Vision (SLIDE 10-5) Explain that typically, entrepreneurs, like Ray and Joan Stewart in the opening caption, lack the guidance and direction of a personal financial vision. Suggest that we can’t tell them what their financial vision should be. That’s up to them. A few examples of a personal financial vision are provided (SLIDE 10-5). Explain that having a financial vision will not, of course, guarantee the success of their business venture—but it will provide them with some all-important guidance and direction. Ask: What is your financial vision? Encourage them to complete Action Step 45, page 240, and put their financial vision in writing. 3. Getting Financial Advice (SLIDE 10-6) Explain to your students that to help them with the financial section of their business plan—and perhaps with the formulation of their personal financial vision, as well—they will need to find advisors with expertise in a wide range of financial matters (forecasting, taxes, retirement planning, bookkeeping, etc.). Encourage your students to complete Action Step 46, page 242, and Table 10.1, page 243, will assist them with the task of assembling an advisory financial team. 4. Estimating Your Start-up Costs (SLIDE 10-7, SLIDE 10-8 and SLIDE 10-9) A financial plan will consist of five basic statements (SLIDE 10-7): 1. application of funds (start-up funding) 2. opening balance sheet 3. projected cash flow 4. projected or pro forma income statement 5. end of period, closing or year-end balance sheet Explain that to find out how much start-up money they will need, they are going to have to estimate all their expenses before starting their business. Then they will have to organize this information into an application of funds table. Explain to them that organizing their start-up funds into an application of funds table will help them create their opening balance sheet. Suggest to your students that they should divide their start-up expenses into four categories (SLIDE 10-8 and SLIDE 10-9): 1. general start-up costs—including organizational costs, prepaid expenses, and inventory and office supplies 2. leasehold improvements—carpeting, mirrors, light fixtures, etc. 3. equipment—tables, chairs, computer, and so on 4. cash reserve fund—cash on hand before you start your business (a pool of uncommitted cash) One method for calculating a cash reserve fund is shown in Table 10.2, page 243. Table 10.3 on page 244, provides examples of the types of start-up expenses. Encourage them to complete Action Step 47, page 243, which will help them estimate their start-up costs.5. Opening Balance Sheet (SLIDE 10-10 and SLIDE 10-11) A balance sheet is a financial snapshot of the financial health of your business—what your business owns and what your business owes—at a point in time. Not only is this a key financial statement required by all bankers but you will need a balance sheet even if you decide to finance your own business. There are two common types of balance sheets: the opening balance sheet and the closing or ending balance sheet. An opening balance sheet is a snapshot of the financial position of your business in the period immediately before you open your doors. Table 10.4, page 247, provides an example of a typical opening balance sheet. A balance sheet is normally divided into three major categories: 1. Assets—the dollar value of what the business owns. Assets are usually divided into three major categories: current assets, fixed assets, and other assets. 2. Liabilities—what the business owes others. Liabilities are normally divided into two categories: current liabilities and long-term liabilities. 3. Equity—what the business owes the owner(s). A balance sheet balances because what the business owns (its assets) always equals what the business owes (others—liabilities and the owner(s)—equity). 6. Key Balance Sheet Ratios (SLIDE 10-12 and SLIDE 10-13) Explain that balance sheet ratios will allow them to determine the financial health of their business. In this section, focus on two key ratios: liquidity ratios and solvency ratios. Liquidity ratios (SLIDE 10-12) show the number of dollars of liquid assets available to cover each dollar of current debt (or the ability to pay short-term obligations). The two basic liquidity indicators are the current or working capital ratio (current assets divided by current liabilities) and the quick ratio (most liquid assets divided by current liabilities). Explain that as a rule of thumb, the current ratio should be greater than two and the quick or acid test ratio should be greater than one. The higher these ratios are, the greater the liquidity. Explain that solvency ratios (SLIDE 10-13) measure the ability of a company to meet its long-term obligations. They measure the lenders support of the business. Two basic solvency ratios are the proprietorship ratio (owner’s investment divided by total assets) and the debt-to-equity ratio (total liabilities divided by owner’s equity). Banks and other lending institutions like to see a proprietorship ratio that is greater than .50. As a rule of thumb, the debt-to-equity ratio should be less than one. Lenders or creditors like to see that you have sufficient owner’s equity to meet all debts. 7. Cash Flow and Income Statement: Important Projections (SLIDES 10-14 to 10-16) Explain that both the income statement and the cash flow projections are necessary for the survival of a business. A projected (pro forma) income statement tells you when you’re going to make a profit on paper. But profit is not cash. Explain that you can make a profit and still not have the money to pay your bills. This happens often in business. In order to find out if you have enough money to finance your day-to-day expenses you will need a projected (pro forma) cash flow. 8. Cash Flow Projection (SLIDE 10-14 and SLIDE 10-15) Explain that a projected or pro forma cash flow is a financial statement that helps them control the money that comes into their business and the money that is spent (SLIDE 10-14). Further explain that the cash flow statement is a tool to help them control this money flow and thus avoid running out of cash. Normally, they should prepare a monthly cash flow for the first year, then a quarterly cash flow for at least the next two years. A cash flow is important because it: • Shows you can pay for day-to-day operations. • Shows the lender you have the cash to make loan payments. • Provides a format for planning the most effective use of cash. • Provides a schedule of receipts and payments of accounts. • Helps plan for unexpected changes in circumstances.Five steps to creating a cash flow are (SLIDE 10-15): 1. Calculate your opening balance. 2. Calculate projected sales for each month. 3. Forecast receipts. 4. Forecast disbursements. 5. Summary of cash flow. A cash flow of a business called DISCovery Books and Magazines Inc. is shown in Table 10.6, pages 256–257. Encourage your students to complete Action Step 48, page 258, which leads them to through the mechanics of a monthly cash flow projection. 9. Pro Forma Income Statement (SLIDE 10-16, SLIDE 10-17 and SLIDE 10-18) Explain that the pro forma or projected income statement (SLIDE 10-16) is an itemized statement of sales (or revenues) and corresponding expenses. Like cash flow, it is an indicator of the financial health of your business. The major difference is that the income statement is not about cash. Normally an income statement is for a one-year period (sometimes on a quarterly basis.) Explain that in a business plan, they may have to provide projected income statements for the first five years. But this will depend on the size and complexity of their business. The major elements of an income statement as shown in Table 10.9, page 264, are: • sales • cost of goods sold • gross profit • operating expenses • other expenses • net profit Explain the importance of understanding that profit is not cash. Explain that calculating income statement ratios (SLIDE 10-17 and SLIDE 10-18) will help them determine how healthy their business is and how it compares to other businesses in their selected industry. Four key income statement ratios are: 1. Gross profit margin equals gross profit (or contribution margin) divided by total sales. Sometimes this ratio is multiplied by 100 to yield a percentage value. The higher this ratio or percentage is, the better. 2. Profit margin equals net profit (before taxes) divided by total sales. In most cases, this ratio is multiplied by 100 to yield a percentage value. Again, the higher this ratio or percentage is the better off is the business. 3. Inventory turnover normally refers to the number of times, each year, a company turns over or replaces its inventory. The higher this ratio is, the better. 4. Gross margin return on inventory investment (GMROI) is an income statement ratio (gross profit margin x sales to stock ratio) that takes into consideration both gross profit and inventory turnover An example income statement for DISCovery Books and Magazines Inc. is provided in Table 10.8, page 262. An income statement worksheet is provided in Table 10.9, page 264. Encourage your students to complete Action Step 49, page 262, which will help them project their own income statement. 10. The Closing (or Ending) Balance Sheet (SLIDE 10-19) Explain that the closing or ending balance sheet will give them a final indicator of the financial health of their business. A typical closing balance sheet is shown in Table 10.10, page 269. Explain that given that they have an income statement and an ending balance sheet, there are a number of important ratios they could calculate based on both of these two statements. Two of the most important ratios are: 1. Return on investment (ROI) equals the net profit (before taxes) divided by total assets. This is usually multiplied by 100 to give a percentage. It is a measure of effectiveness—i.e., How well are your assets doing in generating profit? 2. Return on owner investment equals net profit (before taxes) divided by the owner’s equity (investment). This is usually multiplied by 100 to give a percentage. This ratio helps the owner decide if his/her investment is effective. The higher the ratio the better. 11. Break-Even Analysis (SLIDE 10-20 and SLIDE 10-21) Explain that the break-even point in their business is the point at which their sales revenue equals their total expenses (costs). Further explain that at this point they neither make money, nor do they lose any. For many start-ups the projected break-even is the first step in establishing the viability of the business idea as shown by the Jan’s Pottery example, page 272. The break-even can also be used to evaluate a business expansion or any other business expenditure. Explain that they are simply asking how much additional revenue will be required to cover the additional costs. Explain that to calculate break-even they will need to know the value of their fixed costs, the value of their variable costs, and their output capacity: 1. Fixed costs (sometimes referred to as indirect expenses) are those expenses, which do not depend on sales—rent and hydro, for example. 2. Variable costs (cost of goods) are those costs that depend on the level of sales—materials and shipping costs, for example. 3. Output capacity can be measured in units, billable hours or sales volume. There are two basic ways to calculate your break-even—unit method and revenue method. 1. Unit method. Break-even in units equals: fixed costs/(unit price – unit costs). As an example, see Table 10.11, page 272. 2. Revenue method. Break-even in revenue equals fixed costs/gross profit margin. An example of a break-even chart using this method is shown in Figure 10.1, page 275. 12. Think Points for Success Review the following think points with your students: √ Financial statements such as balance sheets, cash flows, and income statements bring the words of the business to life, and there must be a direct link between what is stated in the business plan and what appears in the financial statements. √ It’s cheaper to make mistakes on a spreadsheet before you go into business. √ When you work out numbers for a business plan, spend time completing your cash flow. Many business people feel that cash flow is the most important statement and we agree. √ If you have a negative cash position in any one period, be proactive and plan how you will pay your bills √ When you visit your banker to ask for money, make sure you know how much you’re going to need for the long run. √ Use balance sheet and income statement ratios to test the financial health of your business. √ Projecting will help you control the variables of your business: numbers, employees, promotion mix, product mix, and the peaks and valleys of seasonality. √ Do lots of “what-if” scenarios. Be cautious. Most entrepreneurs tend to be overly optimistic on sales and underestimate expenses. 13. Checklist Questions and Actions to Develop Your Business Plan (SLIDE 10-23 and SLIDE 10-24) Review the following Checklist Questions and Actions to Develop Your Business: √ Do you have a financial vision? √ What are your estimated start-up costs? √ Validate your sales forecast based on your primary and secondary market research. √ Identify all your cost and pricing assumptions. √ Prepare an opening balance sheet. √ Prepare a monthly cash flow the first year, and a quarterly cash flow for the next two years. Wherever there is a cash shortfall, it will require new equity, debt, or a bank line of credit. √ What is your fallback position if your sales forecast and cash flow do not reach expectations? √ Prepare an annual income statement for the first year. √ Prepare a closing balance sheet. √ What concerns might the banker have about your pro forma cash flow, income and expense statement, and balance sheet, and what is your response? √ Is your break-even within range of your minimum sales forecast? √ How do your financial ratios compare to industry averages obtained from sources such as SME Benchmarking Tool? IX. SUGGESTIONS FOR GUEST SPEAKERS Some guest speakers to consider include: 1. An accountant. Encourage the accountant to discuss why financial statements are important; how to select an accountant; accounting versus bookkeeping functions; how much accountants charge; and what students can do with numbers—income projection, sales projection, cash flow, and the balance sheet. 2. A computer software expert. Have the expert demonstrate the power of a computer spreadsheet, showing how to use it to ask “what-ifs.” 3. A sales manager of a medium-size firm. Have the manager walk the students through a sales projection. 4. A banker. It is a great opportunity to introduce the class to a banker who manages small business accounts. What are the banker’s expectations? V. CLASS PROJECTS Project 1: Ingredients of a Sales Projection 1. Have students talk to other business owners in similar businesses. 2. Have them research trade journals and talk with people in trade associations. 3. Have them work out a seasonality scenario. Where are the peaks? Where are the valleys? 4. Have them assess the maximum amount of business they can do for a period of time say two monthswithin current physical and financial limitations. 5. Have them list expenses. Are the expenses fixed, like rent? Or are they variable, like office supplies? 6. Have them develop percentages for various expenses as they relate to sales. Example: Sales are $10,000; rent is $2,000. What is the percentage relationship? Project 2: Break-Even Analysis Give your students the following monthly numbers: • Fixed costs: $20,775 • Cost of goods sold : $10,800 • Sales: $38,000 Ask them to calculate the break-even level of sales. (The break-even formula is on page 275.) Answer: Gross profit = total sales – cost of goods sold = $38,000 - $10,800 = $27,200 Gross profit margin = gross profit/total sales = $27,200/$38,000 = .72 Break-even = fixed costs/gross profit margin = $20,775/.72 = $28,854 Answer: $28,854 (or $29,000 rounded) VI. INTERNET EXERCISES 1. Check out Your Financial Fitness (Box 10.1, page 241) 1. How Do You Manage Your Money? Do you think you’re doing a good job of managing your money? Or do you feel your spending is out of sync with your income? To see what kind of shape you’re in, take a few minutes to fill out the Canadian Banker’s Association’s financial fitness test: www.cba.ca/en/viewPub.asp?fl=6&sl=23&docid=27&pg=2. You can also find this text in .pdf format, page 6, at: www.cba.ca/en/content/publications/Man_Mony.pdf 2. Test your Financial IQ What is your aptitude and interest in personal financial planning? Take the MSN Money Financial IQ Test: http://moneycentral.msn.com/investor/calcs/n_finq/main.asp 3. Is Financial Planning Important to You? Take the one-minute test from the Canadian Financial Planners Standards Council: www.cfp-ca.org/public/public_testyourfinancialiq.asp 4. Take the Debt Quiz: If you think that you may have a debt problem, take a few moments to answer the following questions: www.creditcounsellingcanada.ca/debt_quiz.html 2. Online Calculators 1. Break-even Suppose you had calculated the following for your new business: Average per unit revenue was $50 Average per unit cost was $25 Estimated monthly fixed cost was $5,000 Link on to: Bplans.com, Break Even Calculator: http://www.bplans.com/common/calculators/breakeven.cfm What would be your monthly break-even in units and revenue? Answer: Monthly units: 200 units Monthly revenue: $10,000 2. How much interest and principal will I pay? When you get a loan (business or personal) you will have to pay the bank or lender both principal and interest. Suppose you need a $30,000 loan for your business . You plan to pay for it over five years. The interest rate is 8%. Link on to: Bankrate.ca: http://www.bankrate.com/can/popcalc2.asp How much interest and principal would you pay over the five years? Answer: Total payments (principal and interest): $101.38 per month for 60 months = $6082.80 Principal: $5,000 Interest: $6082.80 - $5000 = $1082.80 VII. SUGGESTED LESSON PLAN VIII. SUGGESTED ACTIVITIES ACTIVITY 1: Review and Overview 1. Review Chapter 9 and answer any questions. (Show SLIDE 9-2 and SLIDE 9-3 and SLIDE 9-14 of Chapter 9 if necessary.) 2. Introduce Chapter 10 and show and explain SLIDE 10-2, SLIDE 10-3 and SLIDE 10-4. 3. Some students may be intimidated by numbers, while others may have a strong financial background. It is important, therefore, to ask those who have financial talents to play a leadership role in the group discussions and brainstorms. Small business people have to learn to help and support each other and this will be a good chance to get started. Activity 2: Beginning your Financial Journey and Getting Advice (SLIDE 10-4, SLIDE 10-5 and SLIDE 10-6) See NETA Lesson Plan #1 Activity 3: Five Essential Statements 1. Show SLIDE 10-7 and explain that a comprehensive business plan will contain at least five essential tables or financial statements. Each of these five statements is discussed in detail in this chapter. Some students may not need to know all this information right now. Therefore, you may wish to avoid too many details at this point. 2. For those students who do not have a solid financial background, you could suggest that they seek the help of a financial advisor. 3. Encourage them to complete Table 10.1, page 243, and Action Step 46, page 242. Activity 4: Estimating Your Start-up Costs See NETA Lesson Plan #2 Activity 5: Networking Break Encourage students to network and learn more about each other during the break. Activity 6: Opening Balance Sheet and Balance Sheet Ratios Show and briefly explain SLIDE 10-10, SLIDE 10-11, SLIDE 10-12 and SLIDE 10-13. Optional small group and class exercise (30–45 minutes) 1. Show and briefly explain SLIDE 10-10 and SLIDE 10-11. 2. Ask students to get into groups of 2-3 students. Again you may want to suggest that they have at least one student who is “strong in finance” in each group. 3. Ask the groups to complete the opening balance sheet Table 10.13, page 244, in case study 2, question #2 (a), page 278. Note: Students will require the completed application of funds table from question #1. You must provide this if they don’t have it. (Section IX, case study 2, question 1 (a) below.) 4. When they have completed Table 10.13, page 279, show the answer (Section IX below). 5. Show and briefly explain SLIDE 10-12 and SLIDE 10-13. 6. Answer any questions Activity 7: Cash Flow 1. Show and briefly explain SLIDE 10-14, SLIDE 10-15 and SLIDE 16. 2. You may want to emphasize that the cash flow projections are necessary for the survival of your business. 3. Some instructors have found it useful to refer to the DISCovery Books and Magazine case as they are discussing the elements of cash flow. Activity 8: Income Statement and Income Statement Ratios Show and briefly explain SLIDE 10-16, SLIDE 10-17, and SLIDE 10-18. Optional small group and class exercise (20–40 minutes) 1. Show and briefly explain SLIDE 10-16, SLIDE 10-17, and SLIDE 10-18. 2. Ask students to get into groups of 3–5 students. Again you may want to suggest that they have at least one student who is “strong in finance” in each group. 3. Ask the groups to complete the income statement case study 2, Question 4 (a), page 278. 4. When they have completed the exercise, show and discuss the answer (Section IX below). 5. Answer any questions Activity 9: Ending Balance Sheet and Key Ratios Show and briefly explain SLIDE 10-19. Activity 10: Break-Even Analysis Show and briefly explain SLIDE 10-20 and SLIDE 10-21. Activity 11: Summary, Q&A, and Preparing for Chapter 11 1. Recap the key points for each objective (using SLIDE 10-2 and SLIDE 10-3 if necessary). 2. Encourage students to complete the Business Plan Building Block on page 277. 3. Show SLIDE 10-23 and SLIDE 24 and encourage students to complete the Checklist Questions and Actions to Develop Your Business Plan, page 277. You may also want to briefly review the Think Points for Success, page 276. 4. Show SLIDE 10-25 and SLIDE 10-26 and encourage students to complete the questions for these two case studies. Suggested answers are contained in Section IX below. 5. Respond to any questions that students may have. 6. Encourage students to go to the Nelson Small Business site: www.knowlescastillo6e.nelson.com. Click on to the Test Yourself link and complete the true or false/multiple choice, short answer, and matching exercise for Chapter 10. 7. Have students read Chapter 11 in preparation for the next lesson. Some instructors may want to encourage students to also prepare a mind map of key points contained in Chapter 11. IX. CASE STUDY Case Study 1: Financing Your Business—Getting Started, Part I Note: Part Two of this case study is provided in the Chapter 11 case study. As we learned in this chapter, a financial plan to open a business should contain at least four basic financial statements for the first year of operation: • an opening balance sheet based on your application and sources of funds, • a projected monthly cash flow for the first year of operation, • a projected income statement for the first year, and • an ending balance sheet after the first year of operation. If you’re now ready with the financial information for your business idea, we encourage you to “take a stab at it” and create a first draft of your financial plan. Remember, even once it is completed, it is not written in stone. This plan, especially if you use the financial templates provided in Box 10.3, can be used to answer plenty of “what if” statements, such as “What if I want to pay off my business loan over a shorter period of time?” Answer: Note: Answers to this case study question will vary depending on the business. Many students may not be ready with the financial estimates to complete their financial plan. Encourage these students to complete case study question 2. Encourage students to use the templates provided in Box 10.3, page 260. If students have trouble creating their statements, (due to lack of information, time, or lack of financial skills) you might want to have them carry out the case study 2 exercise below. This will help them learn how to understand and create the basic financial tables. Encourage those students who are able to create their own financial tables to begin analyzing them using the basic ratios discussed in the text. Below are some of the major points you might want to emphasize. Application of Funds • Is the application of funds table justified—especially the cash reserve fund? • Encourage students to complete Table 10.3, page 260, and encourage them to be able to justify their estimates. Opening Balance Sheet • Is the opening balance sheet supported by an application of funds table? • Encourage students to complete Table 10.2, page 243, and Table 10.3, page 244, and encourage them to be able to justify their estimates. • Students may want to use the balance sheet template provided in Table 10.4, page 247. They may also want to use the templates provided in Box 10.3, page 244. • Do total assets = total application of funds? • Are the dollar estimates in the application of funds recorded properly in the opening balance sheet? For example, is the cash reserve fund recorded as cash in the opening balance sheet? • Is the current portion of the long term debt = to the total principle payments for the first year as recorded on the cash flow? • Do total assets = liabilities + equity Cash Flow • Encourage students to follow the cash flow instructions provided in the text, pages 252–261. • Every effort should be made to justify total sales on a monthly basis. • Students should make sure they justify their purchases. Here they may have to rely on their own market research or industry averages (SME Benchmarking Tool, for example). • Total bank payments must be divided into principal payments and interest payments. • The number in the opening balance column, row 39 must equal the cash (under current assets) in the opening balance sheet. • Students may want to use the cash flow worksheet provided in Table 10.7, page 259. They may also want to use the templates provided in Box 10.3, page 260. Income Statement • Projected income statement estimates must be consistent with the opening balance sheet and the cash flow. For example: • Opening inventory recorded on the income statement must be the same estimate as opening inventory recorded on the opening balance sheet. • Only interest payments (not principal payments) are recorded on the income statement. • Depreciation is not recorded on the cash flow but is recorded on the income statement. • Students may want to use the template provided in Table 10.9, page 264. They may also want to use the templates provided in Box 10.3, page 260. Closing Balance Sheet The main point here is that the total assets, liabilities, and equity are derived from the opening balance sheet, cash flow, and income statement. For example: • Cash on closing balance sheet = the cash in the last row, last column of the cash flow. (We have found that some students mistakenly record their own cash (equity) as cash under current assets.) • Depreciation in the closing balance sheet is the depreciation in the income statement. • Total liabilities in the opening balance sheet minus principal payments in the cash flow equals total liabilities in the closing balance sheet. • Profit recorded on the income statement is the profit recorded on the closing balance sheet. • If students follow the accounting rules and make no arithmetic errors, the closing balance sheet will balance: Assets = Liabilities + Equity. • Students may want to use the template provided in Table 10.10, page 262. They may also want to use the templates provided in Box 10.3, page 260. Case Study 2: DISCovery Books and Magazines—Financial Statements If you are not ready to do a financial plan for your business idea, we encourage you to answer the following case study questions based on the DISCovery Books and Magazines Inc. example we have referred to throughout this chapter. Note: You may not have enough time to cover all these questions. One option is to use this case in your classroom discussion. Another option, is to assign one or two questions. For example, you may want to complete the application of funds table in class and then assign the opening balance sheet for homework and discussion. 1. Application of Funds Complete the following application of funds table for DISCovery using the cash flow statement (Table 10.6, page 256) and the income statement (Table 10.8, page 262) provided in the text. Answer Notes: -Opening inventory: $50,000—from the income statement (Table 10.8) -Organizational costs: $2,800—Total general start-up ($62,375) – prepaid expenses ($9,575) – opening inventory ($50,000) = organizational costs ($2,800). -Cash reserve fund: $10,000—from line 39, cash flow (Table 10.6) -Application of funds: $115,000—from line 39 ($10,000) + line 34 ($105,000); or line 13 (Assets = Application of funds = Liabilities ($35,000) + Equity ($80,000)—from the cash flow (Table 10.6). -Equipment: $22,825—Application of funds ($115,000) – General start-up costs ($62,375) – Leasehold improvements ($19,800) – Cash reserve fund ($10,000) = $22,825. 2. Opening Balance Sheet a. Complete Table 10.13 —Opening Balance Sheet for DISCovery—using the completed Application of Funds table (question 1 above); cash flow statement (Table 10.6, page 256); and the income statement (Table 10.8, page 262) provided in the text. Note: Students should make sure they have the correct answer to Question #1 above. This will make this exercise a better learning experience. -Cash: $10,000—from cash reserve fund (question #1) above or the cash flow line 39 (Table 10.6). -Opening inventory: $50,000—from general start-up costs (question #1 above) or income statement (Table 10.8). -Prepaid expenses: $9,575—from general start-up costs (question #1 above). -Total current assets: $69,575—cash ($10,000) + inventory ($50,000) + prepaid expenses ($9,575) + other current assets (0) -Equipment: $22,825—from question #1 above. -Leasehold improvements: ($19,800)—from question #1 above. -Total fixed assets: $42,625—equipment ($22,825) + leasehold improvements ($19,800). -Total other assets: $2,800—organizational costs from the general start-up costs (question #1 above). Total assets: $115,000—total current assets ($69,575) + total fixed assets ($42,625) + total other assets ($2,800). -Total liabilities: $35,000—from the cash flow, line 11 (Table 10.6). -Long-term loans (current portion): $3,000—from the cash flow, line 27 (text, 10.6). Total current liabilities: $3,000—line 16 + line 17 + line 18 + line 19. -Long-term loans (minus current portion): $32,000—total liabilities ($35,000) – current portion of long-term loan ($3,000). -Total long-term liabilities: $3,000—line 21 + line 22 + line 23 + line 24. -Total equity: $80,000—from the cash flow, line 10 (Table 10.6) -Equity (cash): $60,000—total equity ($80,000) – equity in the form of equipment/material/labour ($20,000). -Total liabilities + equity: $115,000—total liabilities ($35,000) + equity ($80,000) = $115,000. Note this number also equals total assets ($115,000) and application of funds ($115,000). b. Evaluate this opening balance sheet for DISCovery using the current ratio, quick ratio and debt-to-equity ratio. Compare the current ratio and the debt-to- equity ratio with the industry averages based on those provided by Industry Canada’s SME Benchmarking Tool (http://ic.gc.ca) for incorporated businesses (NAICS 45121), lower half category (average sales of $147,000). Answer: Current ratio. The current ratio is a liquidity ratio that indicates the firm's ability to pay its current debt obligations with current assets. The current ratio for DISCovery is 23 (current assets/current liabilities = $69,575/$3,000 = 23). Based on the opening balance sheet, DISCovery has a very healthy current ratio. As noted in the text, as a rule of thumb, this ratio should be greater than 2. According to SME Benchmarking Tool, the industry ratio is 1.2 (incorporated businesses, average sales of 147,000). DISCovery’s current ratio is much higher than the rule of thumb and the industry average. However, note that the industry current ratio of 1.2 is rather low. On an industry basis, the current ratio (liquidity) is below the rule of thumb and as such the industry, on a liquidity basis, is not particularly healthy. Quick ratio. The quick ratio is 3.3 (most liquid assets/current liabilities = $10,000/$3,000). As noted in the text, as a rule of thumb, this ratio should be greater than 1. The quick ratio for DISCovery is above average, which reflects a rather healthy position. SME Benchmarking Tool provides no cash estimates, so this source cannot provide us with an industry yardstick. However, we do know that based on the current ratio, liquidity (of which cash is an important component) is low. This should be a danger signal, for DISCovery owners. The owner(s) are proposing to start a business where the industry liquidity is low. Debt-to-equity ratio. The debt to equity ratio is .44 (debt/equity = $35,000/ $80,000). According to the text, as a rule of thumb, this ratio should be less than 1. This implies a rather healthy position for DISCovery. According to Performance Plus, the industry ratio is -10 (incorporated businesses, average sales of 147,000). Again note that the industry debt/equity ratio is negative and quite unhealthy. This should be a danger signal, for DISCovery owners. Debt-equity is a solvency ratio that indicates a firm's ability to pay its long-term debts. The owner(s) are proposing to start a business where the industry is showing difficulty paying its long-term debt obligations. 3. Cash flow a. Review the DISCovery cash flow in the text (Table 10.6, pages 256–257). Suppose the owners wanted to “save on interest costs” and decided that they wanted to pay off their loan of $35,000 in the first year at an interest rate of 6%. Calculate the revised total cash balance at the end of the first year. Would you advise the owners to pay off their loan over this one-year period? Note: We suggest you encourage students to go online and use one of the loan calculators such as: Bankrate.ca: http://www.bankrate.com/can/popcalc2.asp or CIBC loan calculator: http://www.cibc.com/ca/loans/personal-loan.html). Answer: Step 1—Calculate total cash available to pay its loan obligations. Cash at the end of the 12 months for DISCovery is $27,395 (line 39, column 14). Add this $27,395 to DISCovery’s current bank payments of $6,600 (interest—$3,600 + principal—$3,000) that equals $33,395 ($27,395 + $6,600). This $33,995 is the total cash available to pay bank loans. Step 2—Calculate the monthly payments for $35,000 loan @ 6%. Give an interest rate of 6%, and using the Bankrate.ca loan calculator (http://www.bankrate.com/can/popcalc2.asp), DISCovery will be required to pay $3012 per month for a total of $36,144 (total principal payments will equal $35,000 and total interest paid will be $1,144). Step 3—Calculate the revised bank balance at the end of the year DISCovery has $33,995 cash available to pay its loan. But the total loan cost will be $36,144. The revised bank balance at the end of the year is -$2,149 ($36,144 – 33,395). DISCovery does not have enough cash from its business operations to pay for its loan. Thus, it would not be advisable to try and pay off its debt obligations in such a short period of time. b. If the owners of DISCovery decided they wanted to pay off their entire loan in the first year, how would this decision affect the opening balance sheet and the first-year income statement? Answer: Opening Balance Sheet. This new policy would not affect the total assets, liabilities, or equity. However, it will affect the long-term loans (current portion), short-term loans, total current liabilities, long-term loans (minus current portion), and the long-term liabilities. DISCovery will no longer have a long-term debt. Its short-term debt will be $35,000. But its total liabilities will remain at $35,000. -Long-term loans (current portion) = 0 -Short-term loans = $35,000 -Total current liabilities = $35,000 -Long-term loans (minus current portion) = 0 -Long-term liabilities = 0 -Total Liabilities = $35,000 (no change) Note to Instructor: You may want students to go back and now calculate and review the new liquidity and solvency ratios. c. Suppose that DISCovery offered very liberal credit terms and received cash payments two months after they made a sale. Show how this would affect the closing bank balance. How would this decision affect the opening balance sheet and the income statement? Answer: The closing bank balance of DISCovery’s cash flow was originally $27,395. These new credit terms mean that DISCovery, at the end of the period, would have $24,000 less in cash—(May ($12,000) + June ($12,000) = $24,000. Its ending cash balance would now be $3,395 ($27,395 – $24,000). This credit decision would have no affect on the opening balance sheet or the income statement. Note: Although the ending balance on the cash flow still remains positive with these new credit terms, this decision could still cause serious problems in the monthly operations—particularly in the early months. In month 2, for example, the closing bank balance would be -$13,935 ($5,565 - $9,000 - 10,500). In the second month, DISCovery would not be able to pay its bills which may even cause it to close its doors. 4. Income Statement a. Up until this point, the financials of DISCovery look fairly healthy. Evaluate DISCovery’s projected income statement (Table 10.8) based on its gross profit margin, profit margin, turnover, and gross margin return on inventory investment (GMROI). One set of industry averages is provided by Industry Canada, Performance Plus: (http://strategis.ic.gc.ca/epic/internet/inpp-pp.nsf/en/h_pm00059e.html) for incorporated businesses (NAICS 45121), lower half category (average sales of $147,000). Answer: Gross profit margin (DISCovery) = gross profit/total sales = $60,000/ $150,000 = 40%. Industry ratio (based on Performance Plus). For incorporated businesses with average sales of $147,000 (lower half of all incorporated businesses), the gross profit margin is 40%, which is the same as DISCovery’s ratio. DISCovery’s gross profit margin is in line with industry averages—according to this one source (as discussed in the text, page 259). Profit margin (DISCovery) = net profit (before taxes)/sales = $8450/$150,000 = 6% Industry ratio (based on Performance Plus). Incorporated businesses with average sales of $147,000 (lower half of all incorporated businesses), showed a –5% profit margin. Book and magazine stores with average sales of about $150,000 lost money. This means that DISCovery had better double check all of its operating costs and make sure they are right. The industry—according to Performance Plus—is showing a loss (as discussed in the text, page 260). Turnover (DISCovery) = cost of goods sold/average¬ inventory* = $90,000/$46,028 = 2 (page 260) *Average inventory (page 260) = (opening inventory + closing inventory)/2 = ($50,000 + $42,055)/2 = $46,028 Industry ratio (based on Performance Plus). For incorporated businesses with average sales of $147,000 (lower half of all incorporated businesses), the turnover is about 3 (87.7/31.6). So it seems that DISCovery’s turnover rate is a little low relative to industry standards (page 261). Gross margin return on inventory investment (GMROI) for DISCovery = Gross Profit Margin (%) x sales to stock ratio = 40 x 3.26 = 130 Industry ratio (based on Performance Plus). For incorporated businesses with average sales of $147,000 (lower half of all incorporated businesses), the GMROI is 185 (40.2 x 4.6). DISCovery has a lower than average GMROI. It might now want to check out which products have the highest GMROI and promote these products (as discussed in the text, pages 261 and 262). b. After doing your analysis in 4(a) above, what advice would you give the owners of DISCovery? Answer: The major income statement ratio for DISCovery, which seems out of line (relative to the industry) is the profit margin. The industry ratio is showing a negative 5 percent. It is very likely that DISCovery has underestimated some of its operating costs—especially the labour costs. Probably, the best advice is to have the owners go back to the industry income statement and double check the DISCovery numbers with the industry numbers. Note that DISCovery’s turnover is low and its GMROI is also low. Owners of DISCovery should think about ways to improve their turnover and think about promoting products with a high turnover and profit margin. 5. Closing Balance Sheet a. Given the opening balance sheet (question 2); the cash flow (Table 10.6, page 250) and the income statement (Table 10.8, page 256), create an ending balance sheet for DISCovery. Remember, if you have made no arithmetic or accounting errors, your total assets will equal total liabilities plus equity—CONGRATULATIONS! Answer: The closing balance sheet for DISCovery is shown in Table 10.14 below. Note that it balances: Total Assets ($120,450) = Total Liabilities ($32,000) + Equity ($88,450) Notes: -Cash ($27,395)—taken from cash flow, total column line 39. -Inventory ($42,055)—taken from income statement, closing inventory. -Prepaid expenses ($9,575)—taken from opening balance sheet. -Equipment ($22,825)—taken from opening balance sheet. -Leasehold improvements ($19,800)—taken from opening balance sheet. -Depreciation ($4000) —taken from the income statement. Note that the value of depreciation must be subtracted from the value of the fixed assets. -Organizational costs ($2,800)—taken from opening balance sheet. -Total liabilities ($32,000)—total liabilities from opening balance sheet ($35,000) minus the principal payments on the loan ($3,000) from the cash flow. After the first year, DISCovery will now owe $32,000 since it has paid the lender $3,000 over the first year. -Long-term loans (current portion) ($3000)—here we have assumed that DISCovery will pay the same amount in principal over the second year as they did in the first year. We could alternatively go to a loan calculator and get the exact amount. -Long-term liabilities (minus current portion) ($29,000)—total liabilities ($32,000) minus current portion ($3000). -Equity at start of period ($80,000)—from the opening balance sheet. -Profit ($8,450)—from the income statement. b. Suppose that at the end of the year, DISCovery decides to pay an extra $10,000 off the principal payment (for the loan). How would this transaction affect the projected cash flow, income statement, and closing balance sheet? Answer: Cash flow: The projected cash flow would be reduced by $10,000 from $27,395 to $17,395. Income statement: This would not affect the income statement. Profit, for example, would still remain the same at $8,450. Closing balance sheet: -Cash ($17,395)—cash would be reduced by $10,000 from $27,395 to $17,395. -Total current assets ($69,025)—would be reduced by $10,000 to $69,025. -Total assets ($110,450)—would be reduced by $10,000 to $110,450. -Total liabilities ($22,000)—total liabilities would be reduced from $32,000 to $22,000 since DISCovery would have reduced its loan by $10,000. -Long-term loans (current portion) ($13,000)—a $10,000 increase from $3,000. -Long-term liabilities (minus current portion)—Total liabilities ($22,000) – long-term loans (current portion) ($13,000) = $9,000. Total assets ($110,450) = total liabilities ($22,000) + equity ($88,450) c. DISCovery was an incorporated business. On the income statement and cash flow, the owners of DISCovery paid themselves a wage ($19,200). Suppose DISCovery were not incorporated and the owners paid themselves in terms of an owner’s draw. How would this affect the projected cash flow, income statement, and ending balance sheet? Answer: Cash flow The cash will be withdrawn and recorded as owner’s or principal draw instead of management salaries. The numerical values of the cash flow will remain the same. Line 26 of the cash flow would remain the same. Income statement -Salaries as an operating expense will be reduced to $0 from $19,200. An owners’ draw is not a salary expense. -Total operating expenses ($28,750)—operating expenses will be reduced by $19,200 from $47,950 to $28,750. -Net profit ($27,650)—Net profit will increase by $19,200 from $8,450 to $27,650. Note: profit actually increases. Ending balance sheet -Plus profit over the period ($27,650)—profit will increase by $19,200 from $8,450 to $27,650. -Minus owner’s draw ($19,200)—owner’s draw will increase by $19,200. -Total equity ($88,450)—total equity will remain the same. d. Calculate DISCovery’s Return on investment (ROI) and return on owner investment. Answer: Return on investment (ROI) = net profit (before taxes)/total assets = $8,450/$120,450 = 7% Return on owner investment = net profit (before taxes)/owner investment = $8,450/$80,000 = 11% Solution Manual for Small Business: An Entrepreneurs Plan Ron Knowles, Chris Castillo 9780176501808, 9780176252403