CH-11-12 Creating a Successful Financial Plan – Essentials of Entrepreneurship and Small Business Management : Exam Guide

This Document Contains Chapters 11 to 12 Chapter 11 Creating a Successful Financial Plan 1) In order to reach profit objectives, entrepreneurs must be aware of their firms': A) current ratio and liabilities. B) fixed assets and owner's equity. C) assets and liabilities. D) overall financial position and any changes in the financial status. Answer: D 2) The ________ shows what assets the business owns and what claims creditors and owners have against those assets, and is built on the basic accounting equation: Assets = Liabilities + Owner's Equity. A) income statement B) sources and uses of funds statement C) balance sheet D) cash budget Answer: C 3) The ________ represents a "snapshot" of a business, showing an estimate of its value on a given date, while the ________ is a "moving picture" of the firm's profitability over time. A) balance sheet; income statement B) income statement; balance sheet C) statement of cash flows; income statement D) balance sheet; statement of cash flows Answer: A 4) Which of the following associations is correct? A) Balance sheet - cost of goods sold B) Income statement - owner's equity C) Current assets - inventory D) Long-term liabilities - accounts payable Answer: C 5) The first section of a balance sheet lists: A) assets. B) liabilities. C) claims creditors have against the firm's assets payable within one year. D) the owner's equity in terms of initial capital invested and retained earnings. Answer: A 6) Which of the following items would not be listed as a current asset in a company's financial reports? A) Cash B) Accounts receivable C) Fixtures D) Inventory Answer: C 7) ________ are those items of value the business owns; ________ are those things the business owes. A) Assets; liabilities B) Liabilities; assets C) Ratios; equities D) Equities; liabilities Answer: A 8) Cost of goods sold is located on which financial statement? A) Income statement B) Balance sheet C) Statement of cash flows D) All of the above Answer: A 9) Which of the following is not true regarding the components of the income statement? A) Cost of goods sold represents the total cost, excluding shipping, of the merchandise sold during the accounting period. B) Gross profit margin is calculated by dividing gross profit by net sales revenue. C) Operating expenses include those costs that contribute directly to the manufacture and distribution of goods. D) A and B above Answer: A 10) The statement of cash flows: A) compares costs and expenses against a firm's net profits. B) is built on the basic accounting equation: Assets = Liabilities + Capital. C) shows what assets the business owns and what claims creditors and owners have against those assets. D) shows changes in working capital by listing sources and uses of funds. Answer: D 11) On a company's statement of cash flows, depreciation is: A) the difference between the total sources available to the owner and the total uses of those assets. B) listed as a source of funds because it is a noncash expense, already deducted as a cost of doing business. C) the owner's total investment at the company's inception plus retained earnings. D) creditors' total claims against the firm's assets. Answer: B 12) Creating projected (pro forma) financial statements would allow a business owner to answer which of the following questions? A) What profit can my business expect to achieve? B) What sales level must my business reach if our targeted profit is × dollars? C) What fixed and variable expenses can my business expect to incur at our targeted sales level? D) All of the above Answer: D 13) On a projected income statement, a business owner's target income is: A) the sum of a reasonable salary for the time spent running the business and a normal return on the amount invested in it. B) the income at which the company's total revenues and its total expenses are equal. C) the income that will produce a 10 percent return on the owner's financial investment in the business. D) the income that the owner could earn working for someone else. Answer: A 14) You are to prepare a projected income statement for a proposed business venture. Your desired income is $28,000 and you have the following published statistics: Costs of goods sold = 56.9 percent of net sales Operating expenses = 37.1 percent of net sales Gross profit margin = 43.1 percent of net sales This information indicates the net sales on your pro forma "P & L" (income statement) would be: A) $466,667. B) $491,228. C) $500,000. D) None of the above Answer: A 15) Gaither Mack is preparing projected financial statements to include in the business plan he is preparing for the launch of a specialty retail store. Using published financial statistics, Mack finds that the typical net profit margin for a store like his is 7.3 percent. If Mack's target income for his first year of operation is $32,000, what level of sales must he achieve to reach it? A) $233,600 B) $438,356 C) $2,966,400 D) Cannot be determined from the information provided Answer: B 16) Michelle Becker's target income in her business for the upcoming year is $78,500. The company's gross profit margin averages 32.6 percent of sales, and its total operating expenses run 24.7 percent of sales. To achieve her target income, sales of Michelle's company should be: A) $148,773. B) $993,671. C) $317,814. D) $1,271,348. Answer: B Refer to the following information to answer the question(s) regarding Anita Lupino's toy and game shop: Anita Lupino is planning to open her own toy and game shop. She has conducted a great deal of research at the local library, contacted the industry trade association, and has set up a meeting with a consultant at the SBDC next week. Before she goes to the SBDC, she wants to sketch out an estimated income statement. She reviews the following data from RMA's Annual Statement Studies: Costs of goods sold 57.3 percent of net sales Operating expenses 32.9 percent of net sales Gross profit 42.7 percent of net sales 17) If Anita's research suggests that she can expect net sales of $475,000, what net profit could she expect? A) $202,825 B) $46,550 C) $69,350 D) $156,275 Answer: B 18) If Anita's net profit target is $32,000, what level of net sales must she achieve? A) $74,941 B) $97,264 C) $326,531 D) $219,178 Answer: C 19) Cash requirements can be determined by dividing cash expenses by: A) liabilities. B) accounts receivables. C) total assets. D) the average inventory turnover. Answer: D 20) A technique that allows the small business owner to perform financial analysis by understanding the relationship between two accounting elements is called: A) creating the pro forma. B) budgeting. C) break-even analysis. D) ratio analysis. Answer: D 21) Analyzing financial ratios could alert a business owner to which of these problems? A) Excessive inventory B) Overextending credit C) Too much debt D) All of the above Answer: D 22) Which of the following is not a liquidity ratio? A) Current ratio B) Total asset turnover ratio C) Quick ratio D) None of the above Answer: B 23) The ________ ratio is a measure of the small company's ability to pay current debts from current assets and is the liquidity ratio most commonly used as a measure of short-term solvency. A) quick B) debt-to-net worth C) current D) debt-to-assets Answer: C 24) ________ ratios tell whether or not the small company will be able to meet its short-term obligations. A) Leverage B) Profitability C) Liquidity D) Operating Answer: C 25) Financial analysts suggest that a small business should maintain a current ratio of at least: A) 1:1. B) 2:1. C) 3:1. D) 4:1. Answer: B 26) The ________ ratio is a conservative measure of a firm's liquidity and shows the extent to which a firm's most liquid assets cover its current liabilities. A) current B) quick C) turnover D) net profit Answer: B 27) Bettina has just calculated her company's current ratio. To calculate the quick ratio, she should: A) subtract current liabilities from current assets before dividing by total liabilities. B) subtract total liabilities from current assets before dividing by current liabilities. C) subtract inventory from current assets before dividing by current liabilities. D) subtract depreciation expense from current assets before dividing by current liabilities. Answer: C 28) When a company is forced into liquidation, owners are most likely to incur a loss when selling: A) accounts receivable. B) inventory. C) marketable securities. D) real estate. Answer: B 29) ________ ratios measure the extent to which an entrepreneur relies on debt capital rather than equity capital to finance a business. A) Liquidity B) Leverage C) Operating D) Profitability Answer: B 30) Which of the following combinations of ratios would indicate that a company is financially mismanaged and is not a good credit risk? A) High liquidity; high leverage B) Low liquidity; high leverage C) High liquidity; low leverage D) Low liquidity; low leverage Answer: B 31) The ________ ratio measures the percentage of total assets financed by a small company's creditors compared to its owners. A) debt B) times-interest-earned C) net sales to total assets D) total asset turnover Answer: A 32) A high debt ratio: A) means that creditors provide a large percentage of the company's total financing. B) gives a small business more borrowing capacity. C) decreases the chances that creditors will lose money if the business is liquidated. D) represents a lower risk to potential lenders and creditors. Answer: A 33) Which ratio would best give an owner an indication that the business is undercapitalized? A) Debt-to-net worth B) Net sales to total assets C) Average inventory turnover D) Quick Answer: A 34) The higher the ________ ratio, the lower the degree of protection afforded creditors, and the closer creditors' interest approaches the owner's interest. A) debt-to-net worth B) quick C) asset turnover D) current Answer: A 35) ________ is one indication that a small business may be undercapitalized. A) A current ratio below 1:1 B) A quick ratio above 2:1 C) A debt-to-net worth ratio above 1:1 D) A net sales-to-working capital ratio equal to 3:1 Answer: C 36) The ________ ratio tells how many times the company's earnings cover the interest payments on the debt it is carrying. A) debt B) debt-to-net worth C) times-interest-earned D) net sales-to-working capital Answer: C 37) ________ ratios help a business owner evaluate the company's performance and indicate how effectively the business employs its resources. A) Liquidity B) Leverage C) Operating D) Profitability Answer: C 38) The average inventory turnover ratio: A) measures the number of times a company's inventory is sold out during the accounting period. B) tells a business owner whether she is managing the company's inventory properly. C) tells a business owner how fast the merchandise is moving through the business. D) All of the above Answer: D 39) Sarah's Smart Shop has an inventory turnover ratio of 3 times per year and an average inventory of $156,000. If Sarah could manage her inventory better and increase the number of turnovers to the industry average of 6 times per year, what average inventory would she need to generate the same level of sales? A) $78,000 B) $52,000 C) $468,000 D) $312,000 Answer: A 40) A business that turns over its receivables 5.9 times a year would have an average collection period of about: A) 30 days. B) 2/10, net 30. C) 71 days. D) 62 days. Answer: D 41) If the accounting period is one year with credit sales totaling $2,500,000 and accounts receivable totaling $200,000, what is the average collection period ratio? A) 29.2 days B) 365 days C) 119.3 days D) Cannot be determined from the information provided Answer: A 42) For the most meaningful interpretation, the small business owner should compare his firm's average collection period to: A) other businesses in the same geographic area. B) a direct competitor. C) the universal standard of 25 days. D) the average for the industry and the firm's credit terms. Answer: D 43) A business with a payables turnover ratio of 10.4 times a year would have an average payable period of about: A) 3 days. B) 30 days. C) 35 days. D) 62 days. Answer: C 44) An excessively high average payable period ratio: A) suggests that the company is making the best use of its available cash balance. B) indicates that the company is doing a poor job of collecting its accounts receivable. C) indicates the presence of a significant amount of past-due accounts payable. D) suggests that the company is highly liquid. Answer: C 45) The ________ ratio measures a company's ability to generate sales in relation to its assets. A) net sales-to-working capital B) net sales to total assets C) average collection period D) average inventory turnover Answer: B 46) ________ ratios indicate how efficiently the small firm is being managed. A) Liquidity B) Profitability C) Leverage D) Operating Answer: B 47) Which ratio would be most helpful to a business owner to measure the profit per dollar of sales? A) Net sales to total assets B) Net sales to working capital C) Net profit on sales D) Net profit to equity Answer: C 48) The ________ ratio shows the portion of each sales dollar remaining after deducting all expenses. A) net profit on sales B) net profit to equity C) net sales to total assets D) net sales to working capital Answer: A Refer to the following information to answer the question(s) regarding Port Royal: Net sales $927,641 Gross profit $301,483 Net profit $48,457 Total assets $203,869 Total liabilities $74,325 49) Port Royal's debt-to-net worth ratio is: A) 0.36:1. B) 0.08:1. C) 1.57:1. D) 0.57:1. Answer: D 50) Port Royal's profit margin on sales is: A) 5.2 percent. B) 32.5 percent. C) 16.1 percent. D) 8.0 percent. Answer: A 51) Port Royal's net profit-to-equity ratio is: A) 23.8 percent. B) 37.4 percent. C) 16.1 percent. D) 232.7 percent. Answer: B 52) A business should provide the owner with a reasonable rate of return based upon: A) the time and money invested in the business. B) industry averages. C) the capital borrowed from the bank. D) an acceptable annual salary. Answer: A 53) Ideally, a company reaches a point where increases in operating efficiency mean that expenses as a percentage of sales revenue flatten or even decline. This is referred to as: A) net profit to assets ratio. B) profitability ratio. C) net profit to equity. D) operating leverage. Answer: D 54) The ________ ratio measures the owner's rate of return on the investment in the business. A) net profit to equity B) net profit on sales C) quick profit D) net sales to working capital Answer: A 55) The net profit to asset ratio measures: A) the owner's rate of return on investment. B) how much profit a company generates for each dollar of assets that it owns. C) a company's profit per dollar of sales. D) a company's ability to generate sales in relation to its asset base. Answer: B 56) You are provided this information about a retail store called "BoardSports:" What can you reasonably assess about the current financial status of this company? A) The company is in excellent financial condition with no changes required. B) The company is in respectable financial condition with no changes required. C) The company is in questionable financial condition with minor changes required. D) The company is in poor financial condition with significant changes required. Answer: D 57) The break-even point: A) occurs where a company's total revenue equals its total expenses. B) is the point at which a company neither earns a profit nor incurs a loss. C) tells a business owner the minimum level of activity needed to keep her company in operation. D) All of the above Answer: D 58) Which of the following is an assumption of break-even analysis? A) Fixed expenses remain constant for all levels of sales volume. B) Variable expenses change in direct proportion to changes in sales volume. C) Changes in sales volume have no effect on unit sales price. D) All of the above Answer: D 59) Refer to the following information Which of the following statements is most likely false? A) Smith relies heavily on inventory to meet its debt obligations. B) Smith is sufficiently capitalized. C) Smith's sales are inadequate. D) Smith's prices may be too high and/or the inventory too "stale." Answer: B For Meters, Inc., refer to the following information to answer the question(s) below: Meters, Inc., reported net sales of $874,916 and a net profit of $74,563 on its most recent income statement. The company's balance sheet shows total assets of $342,742 and total liabilities of $88,367. 60) What is the net profit margin for Meters, Inc.? A) 8.5 percent B) 1.91:1 C) 21.8 percent D) 29.3 percent Answer: A 61) What is the return on net worth ratio for Meters, Inc.? A) 8.5 percent B) 1.91:1 C) 21.8 percent D) 29.3 percent Answer: D Regarding Gunther's Emporium, refer to the following to answer the question(s) below : Gunther's Emporium expects net sales of $2,396,919 for the upcoming year, with variable expenses totaling $1,813,443 and fixed expenses of $412,190. 62) Using break-even analysis, what is Gunther's contribution margin? A) 4 percent B) 32 percent C) 24 percent D) 12 percent Answer: C 63) Gunther's Emporium expects net sales of $2,396,919 for the upcoming year, with variable expenses totaling $1,813,443 and fixed expenses of $412,190. What is Gunther's break-even point? A) $1,876,324 B) $1,693,276 C) $5,667,009 D) Insufficient information given to determine Answer: B 64) If Gunther's net profit target for the year is $190,000, what sales level must he achieve? A) $2,473,796 B) $1,876,324 C) $5,667,009 D) None of the above Answer: A Refer to the following break-even Chart to answer the question(s) below: 65) Line T is the ________ line, while Line S is the ________ line. A) total revenue; total expense B) total expense; total revenue C) fixed cost; variable cost D) variable cost; fixed cost Answer: B 66) The area labeled ________ represents the firm's fixed expenses, while ________ represents its variable expenses. A) Z; W B) X; Y C) Y; X D) W; Z Answer: B 67) The area labeled ________ is the "profit area." A) W B) X C) Y D) Z Answer: D 68) The area labeled ________ is the "loss area." A) W B) X C) Y D) Z Answer: A 69) According to one study, 23 percent of small business owners lack financial literacy to identify the cost that has the greatest impact on their companies. Answer: True 70) The balance sheet provides owners with an estimate of the firm's worth for a specific moment in time, while the income statement presents a "moving picture" of its profitability over a period of time. Answer: True 71) Assets represent what a business owns, while liabilities represent the claims creditors have against a company's assets. Answer: True 72) The income statement is based on the fundamental accounting equation: Assets = Liabilities + Owner's Equity. Answer: False 73) On the income statement, the cost of goods sold represents the total cost, excluding shipping, of the merchandise sold during the year. Answer: False 74) To determine net profit, the owner records sales revenue for the year and subtracts liabilities. Answer: False 75) Service companies spend the greatest percentage of their sales revenue on cost of goods sold. Answer: False 76) Comparing a company's current income statement to those of prior accounting periods rarely reveals valuable information about key trends. Answer: False 77) The difference between the total sources of funds and the total uses of funds represents the increase or decrease in a firm's working capital. Answer: True 78) The most common mistake entrepreneurs make when preparing pro forma (projected) financial statements for their companies is being overly pessimistic in their financial plans. Answer: False 79) Pro forma financial statements show a company's most recent financial position. Answer: False 80) On a projected income statement, a business owner's target income is the sum of a reasonable salary for the time spent running the business and a normal return on the amount the owner has invested in it. Answer: True 81) In start-up firms, one guideline is for the owner to draw a salary 25-30 percent below the market rate for a similar position. Answer: True 82) Concerning how much cash to have at startup, one rule of thumb is to have enough to cover operating expenses (less depreciation) for two inventory turnover periods. Answer: False 83) Ratio analysis allows a business owner to identify potential problem areas in her business before they become business-threatening crises. Answer: True 84) Ratio analysis is a useful managerial tool that can help business owners maintain financial control over their businesses, but it is of no use to a business owner trying to obtain a bank loan. Answer: False 85) Liquidity ratios, such as the current ratio and the quick ratio, tell whether a small business will be able to meet its short-term obligations as they come due. Answer: True 86) Liquidity ratios help a business owner evaluate a small company's performance and indicate how effectively it employs its resources. Answer: False 87) A current ratio of 2.4:1 means that a small company has $2.40 in current liabilities for every $1 has in current assets. Answer: False 88) A high current ratio guarantees that the small firm's assets are being used in the most profitable manner. Answer: False 89) Generally, the higher the current ratio, the stronger the small firm's financial position. Answer: True 90) Most firms calculate their quick assets by subtracting the value of their inventory from their current asset total. Answer: True 91) A quick ratio of more than 1:1 suggests that a small company is overly dependent on inventory and future sales to satisfy its short-term debt. Answer: False 92) Leverage ratios measure the financing supplied by the firm's owner against that supplied by his creditors. Answer: True 93) Small businesses with high leverage ratios are more vulnerable to economic downturns, but they have greater potential for large profits. Answer: True 94) Taking on debt destroys a business; therefore, small business owners should avoid it at all costs. Answer: False 95) The small business with a high debt-to-net worth ratio has more borrowing capacity than a firm with a low ratio. Answer: False 96) As a company's debt-to-net worth ratio approaches 1:1, its creditors' interest in that business approaches that of the owners. Answer: True 97) A company with a low debt-to-net worth ratio has less capacity to borrow than a company with a high debt-to-net worth ratio. Answer: False 98) The times-interest-earned ratio tells how many times the company's earnings cover the interest payments on the debt it is carrying. Answer: True 99) A company with a times-interest-earned ratio that is well above the industry average would likely have difficulty making the interest payments on its loans, as creditors would see that it was overextended in its debts. Answer: False 100) Creditors often look for a times-interest-earned ratio of at least 4:1 to 6:1 before pronouncing a company a good credit risk. Answer: True 101) Operating ratios measure the extent to which an entrepreneur relies on debt capital rather than equity capital to finance the business. Answer: False 102) The average inventory turnover ratio measures the number of times a company's inventory is sold out during the accounting period. Answer: True 103) An inventory turnover ratio above the industry average suggests that a business is overstocked with obsolete, stale, overpriced, or unpopular merchandise. Answer: False 104) A high inventory turnover ratio relative to the industry average could mean that a business has too little inventory and is experiencing stockouts. Answer: True 105) A company's average collection period ratio tells the average number of days it takes to collect its accounts receivable. Answer: True 106) Generally, the higher the small firm's average collection period ratio, the greater the chance of bad debt losses. Answer: True 107) Slow accounts receivable are a real danger to a small business because they often lead to cash crises. Answer: True 108) If a company's average payable period ratio is significantly lower than the credit terms vendors offer, it may be a sign that the company is not using its cash most effectively. Answer: True 109) An excessively high average payable period ratio indicates the possibility of the presence of a significant amount of past-due accounts payable. Answer: True 110) Although sound cash management principles call for a business owner to keep her cash as long as possible, slowing accounts payable too drastically can severely damage a company's credit rating. Answer: True 111) The net-sales-to-total assets ratio is also referred to as the total asset turnover. Answer: True 112) The net-sales-to-total assets ratio measures a company's ability to generate sales in relation to its asset base. Answer: True 113) Float is the net number of days of cash flowing into or out of a company. Answer: True 114) The net profit on sales ratio measures the owner's rate of return on the investment in the business. Answer: False 115) The net profit to equity ratio reports the percentage of the owners' investment in the business that is being returned through profits annually. Answer: True 116) Ratio analysis provides an owner with a "snapshot" of the company's financial picture at a single instant; therefore, she should track these ratios over time, looking for trends that otherwise might go undetected. Answer: True 117) The break-even point is the level of operation at which a business neither earns a profit nor incurs a loss, and lets the business owner know the minimum level of activity required to keep the firm in operation. Answer: True 118) Fixed expenses are those that do not vary with changes in the volume of sales, but do vary with production. Answer: False 119) On a break-even chart, the break-even point occurs at the intersection of the fixed expense line and the total revenue line. Answer: False 120) Explain the three basic financial reports that a small business uses in building a financial plan: the balance sheet, the income statement, and the statement of cash flows. What information is contained in each, and of what value is it to the small business owner? Answer: The balance sheet: This statement takes a "snapshot" of a business, providing owners with an estimate of its worth on a given date. It is built on this fundamental accounting equation: Assets = Liabilities + Owner's Equity. The balance sheet provides a baseline from which to measure future changes in assets, liability, and equity. Balance sheet components include assets (current and long term), liabilities (current and long term), and owner's equity. The income statement: This statement compares expenses against revenue over a certain period of time to show the firm's net profit (or loss). It is a "moving picture" of the firm's profit over a period of time and provides "the bottom line" figure for the small business owner. It is also known as the profit and loss statement or P & L. Income statement components include various categories of revenues and expenses. Statement of cash flows: This statement shows the changes in the firm's working capital since the beginning of the year by listing the sources of funds and the use of these funds. Although many small business owners never create them, IRS, creditors, investors, and new owners may require them when investigating the changes in a firm's working capital. Statement of cash flow components include categories of sources and uses of funds. 121) Define what a pro forma financial statement is. What are the two types a small business owner uses, and how are they created? Answer: Pro forma statements are vital elements in a small business financial plan. They estimate the firm's future profitability and overall financial condition. These statements help the owner determine the funds required to launch the business and sustain it. The basic pro forma financial statements are: The income statement-Most entrepreneurs select a target income and build a pro forma income statement from the bottom up. The target income includes a reasonable salary and a normal return on the amount invested in the firm. The owner computes target sales from his target income by: Next, using published statistics, the owner computes the remaining entries by multiplying the proper statistic by the net sales figure. After the owner determines that the targeted net sales figure is reasonable, expenses are listed accordingly. The balance sheet-Creating a pro forma balance sheet begins with a statement of assets. One rule of thumb suggests that the company's cash balance should cover its operating expenses (less depreciation, a noncash expense) for one inventory turnover period. The method of determining the firm's cash requirement is: The inventory level is computed from published statistics and the cost of goods sold figure from the income statement: To complete the projected balance sheet, the owner must record the firm's other assets, and liabilities, the claims against its assets. Using the accounting equation of Assets = Liabilities + Owner Equity, he calculates the final component-owner's equity. 122) Explain what ratio analysis is. Name the four categories of ratios and describe the type of information each group provides the small business owner. Answer: Ratios help measure the small firm's performance and can point out potential problem areas before they become business crises. They use accounts from both the balance sheet and income statement and provide relevant information to the overall financial plan. One way to use ratios is to compare those of the small business to other businesses in the same industry through a number of published industry averages and standards. It is also helpful for the owner to analyze the firm's financial ratios over time. The four ratio categories are: 1. Liquidity ratios-Tell whether a firm will be able to meet its short-term financial obligations as they come due. These ratios can forewarn a business owner of impending cash flow problems. A firm with a solid liquidity is able to pay bills on time and take advantage of attractive opportunities as they arrive. 2. Leverage ratios-Measure the financing supplied by the firm's owners against that supplied by its creditors. The ratios are a gauge of the depth of a firm's debt. These ratios show the extent to which a business relies on debt capital (rather than equity) to finance operating expenses, capital expenditures, and expansion costs. In a sense, they measure the degree of financial risk in a company. Generally, small businesses with low leverage ratios are affected less by economic downturns, but the returns are lower during economic booms. Firms with higher ratios are more vulnerable during economic downturns because of their debt loads, but have a greater potential for large profits in economic booms. 3. Operating ratios-Evaluate a firm's overall performance and indicate how effectively the business employs its resources. The more effectively its resources are used, the less capital a small business will require. 4. Profitability ratios-Indicate how efficiently a small business is being managed. These ratios provide information on the company's bottom line. Profitability ratios assess how successfully the firm is using its available resources to generate a profit. 123) List the 12 key ratios outlined in the text and explain the type of information they provide the small business owner. Answer: Students should select from the following 12 Key Ratios: 1. Current ratio-Firm's ability to pay current debts out of current assets. The rule of thumb for the current ratio is 2:1. 2. Quick ratio-Extent to which firm's most liquid assets cover its current liabilities. The rule of thumb for the quick ratio is 1:1. 3. Debt ratio-Measure the financing supplied by business owners and that supplied by business creditors. 4. Debt-to-net-worth ratio-Compares what the business owes to what it "owns." 5. Times interest earned-A measure of the firm's ability to make the interest payments on its debt. 6. Average inventory turnover ratio-Measures the average number of times its inventory is "turned over" during the year. 7. Average collection period ratio-Tells the average number of days it takes to collect accounts receivable. 8. Average payable period ratio-Tells the average number of days it takes a company to pay its accounts payable. 9. Net sales to total assets ratio-A general measure of firm's ability to generate sales in relation to its assets. 10. Net profit on sales ratio-Measures firm's profit per dollar of sales. 11. Net profit to asset ratio-Measures how much profit a company generates for each dollar of assets that it owns. 12. Net profit to equity ratio-Measures owner's rate of return on investment (ROI). The 12 key ratios outlined in the text are: • Current Ratio - measures liquidity and ability to pay short-term obligations. • Quick Ratio - assesses immediate liquidity excluding inventory. • Debt to Equity Ratio - indicates financial leverage and risk level. • Gross Margin Ratio - shows profitability from core business activities. • Net Profit Margin - reflects overall profitability after all expenses. • Return on Assets (ROA) - gauges efficiency in using assets to generate profit. • Return on Equity (ROE) - evaluates profitability from shareholders' equity. • Inventory Turnover - measures inventory management efficiency. • Accounts Receivable Turnover - indicates efficiency in collecting receivables. • Accounts Payable Turnover - shows the speed of paying off suppliers. • Fixed Asset Turnover - assesses the efficiency of using fixed assets. • Sales to Working Capital Ratio - measures the effectiveness of using working capital to generate sales. These ratios provide small business owners insights into liquidity, profitability, leverage, and operational efficiency, aiding in informed decision-making. 124) Why is it important for an entrepreneur, about to launch a business, to perform a break-even analysis? Describe the steps in calculating it. Answer: Break-even analysis is important because it helps the entrepreneur understand what sales volume he/she must achieve to "break-even"-neither earning a profit nor incurring a loss. It shows the minimum level of sales required to stay in business and what minimum level of sales is required to cover expenses. The formula can be adapted to figure the minimum level of sales needed to support a certain profit margin or dollar amount. The steps in calculating break-even include: A. Determining variable and fixed expenses: 1. Fixed expenses-costs that do not vary with changes in the volume of sales or production. 2. Variable expenses-costs that vary directly with changes in the volume of sales or production. B. Calculating the break-even point: Step 1: Determine the expenses the business can expect to incur. Step 2: Categorize the expenses estimated in step 1 into fixed expenses and variable expenses. Step 3: Calculate the ratio of variable expenses to net sales. Step 4: Compute the break-even point by inserting this information into the following formula: C. Including desired net income in break-even analysis: D. Break-even point in units: 125) Explain the procedure for constructing a graph that visually portrays the firm's break-even point (the point where revenues equal expenses). Answer: • Step 1: On the horizontal axis, mark a scale measuring sales volume in dollars (or in units sold or some other measure of volume). • Step 2: On the vertical axis, mark a scale measuring income and expenses in dollars. • Step 3: Draw a fixed expense line intersecting the vertical axis at the proper dollar level parallel to the horizontal axis. The area between this line and the horizontal axis represents the firm's fixed expenses. • Step 4: Draw a total expense line that slopes upward beginning at the point where the fixed cost line intersects the vertical axis. The precise location of the total expenses line is determined by plotting the total cost incurred at a particular sales volume. The total cost for a given sales level is determined by: Total Expenses = (Fixed expenses + Variable expenses expressed as a percent of sales) × Sales level • Step 5: Beginning at the graph's origin, draw a 45-degree line showing where total sales volume equals total income. • Step 6: Locate the break-even point by finding the intersection of the total expense line and the revenue line. If the company operates at a sales volume to the left of the break-even point, it will incur a loss because the expense line is higher than the revenue line. On the other hand, if the firm operates at a sales volume to the right of the break-even point, it will earn a profit because the revenue line lies above the expense line. 126) What are the advantages and the disadvantages of using break-even analysis? Answer: As a key component in a sound financial plan, the advantages of break-even analysis include its ability to analyze costs and expenses so an entrepreneur can calculate the minimum level of activity required to keep the firm in operation. These techniques can then be refined to project the sales needed to generate the desired profit. Break-even analysis is a simple and useful screening device. Business owners can also employ nonlinear break-even analysis using a graphical approach. Disadvantages of break-even analysis include limitations such as the analysis can be too simple to use as a final screening device because it ignores the importance of cash flows. In addition, the accuracy of the analysis depends on the accuracy of the revenue and expense estimates, and the basic assumptions pertaining to break-even analysis may not be realistic for some businesses. These assumptions include: that fixed expenses remain constant for all levels of sales volume; variable expenses change in direct proportion to changes in sales volume; and changes in sales volume have no effect on unit sales price. In addition, break-even analysis does not take into consideration the time value of money. Mini-Case 11-1: Bowden Brake Service (Part A) Jim Bowden, owner of Bowden Brake Service, is planning to expand his six-year-old brake service to include tune-ups and tire services. Based on budget estimates for the upcoming year, Jim expects net sales to be $825,000 with a cost of goods sold of $530,000 and total operating expenses of $210,000. From the budget he created, Jim computes fixed expenses to be $168,000, while variable expenses (including cost of goods sold) are $572,000. Jim is concerned that the new cost structure may damage his ability to produce a profit and he wants to perform a break-even analysis for the upcoming year to gain insight. 127) If Jim were to reduce his fixed costs by 10 percent by reducing a middle management position, what benefit would that be to him and the company? What would his new contribution margin be? Answer: By reducing his fixed costs, Jim improves his contribution margin. If fixed costs are reduced by 10 percent Then: $572,000 × 90% = $514,800 To calculate the new contribution margin: 1 - .62 = .38 or a contribution margin of 38% Since middle managers are normally salaried employees that constitutes a fixed cost, it is easy to appreciate why middle management positions have been significantly reduced in recent years. 128) Help Jim compute the break-even point for his brake service. Answer: Contribution margin: 1 - .6933 = .3067 break-even sales: Mini-Case 11-2: Bowden Brake Service (Part B) One day while you are in Bowden Brake Service getting your brakes repaired, Jim storms into his office, slamming doors and shouting about the local financial institutions. After a few minutes of building your courage, you approach Jim and ask him what the problem is. He shouts, "It's the financial institutions in this town! Not one of them will lend me the money I need to expand my business. They all said I needed to take a closer look at my financial position before I consider expanding. One of them said something about ratio analysis. I know a lot about cars and brakes, but what is ratio analysis?" You tell Jim you will perform a ratio analysis for the business if he gives you a free brake job. Jim provides you with the following financial statements. 129) Refer to the income statement and balance sheet. Prepare a ratio analysis for Bowden Brake Service. In addition, use the following industry statistics for firms like Jim's to explain and interpret what these ratios mean. Answer: Bowden has $2.61 in current assets for every $1 in current liabilities. This surpasses both the 2:1 "rule of thumb" and the 1.4 industry median. Bowden has .53 in quick assets for every $1 in current liabilities. This is below both the 1:1 rule of thumb and the .7 industry median. Bowden apparently relies heavily on inventory to help satisfy its short-term debt. Compared to the industry median of 1.80, Bowden is not overburdened with debt. Creditors have contributed three times as much to the business as Jim Bowden. Creditors are likely to see Bowden as being "borrowed up," especially since the industry median is 1.90. Bowden turns over its inventory about 4.17 times per year. A comparison is difficult since industry figures are unavailable. With credit sales of $780,000, Bowden's accounts and notes receivable are outstanding for an average of 7.02 days, while the industry median is 21.22 days. Bowden generates $1.5 in sales for every $1 in total assets. The industry median is 2.8. Bowden is not producing enough sales in relation to its asset size. Bowden is not using working capital efficiently to produce sales. With an industry median of 17.2, the implication is that Bowden must increase sales. Each dollar of sales yields 7.7 cents in profit for Bowden, below the industry median of 9.0 cents. Bowden's rate of return on his investments in the business is 46.2 percent, well above the industry median of 22.2 percent. This reflects Bowden's low investment in the business. 130) Were the bankers correct? Do you think Jim should expand the business? Answer: Bowden needs to increase sales, and expanding the business could help. However, Jim may have a problem obtaining a loan since creditors have provided three times as much capital as he has. In addition, Jim seems to rely on inventory to meet short-term debt. Still, with a sound business plan explaining how the additional funds would be used, Jim could probably obtain the financing he needs. Mini-Case 11-3: Birmingham's Stereo Shop Birmingham's Stereo Shop expects net sales of $280,000 in the upcoming year, with a cost of goods sold of $173,600 and total expenses of $76,200. Birmingham expects variable expenses (including cost of goods sold) to be $195,700 and fixed expenses to be $54,100. 131) What level of sales would Birmingham's have to achieve if it wanted to make a $25,000 profit? Answer: Sales needed to generate a profit of $25,000. Therefore: 132) Construct a break-even chart for Birmingham's. Answer: 133) Compute a break-even point in dollars. Answer: Mini-Case 11-4: Calculating the Break-even Point A small manufacturer plans to sell tents for $120 each. The variable cost for each tent is $90. Fixed costs for the process are estimated to be $36,000. How many tents must the company sell to break-even? 134) Suppose that the manufacturer desires a profit of $9,000 on this product. How many units must be sold? Answer: Price/unit $120 Variable cost/unit $90 Fixed cost $36,000 Sales required to earn a $9,000 profit: Contribution Margin: $120 - $90 = $30 Use break-even formula and add desired profit: Mini-Case 11-5: A Projected Income Statement You want to start your own retail furniture store, and you have already gathered a great deal of information on location, layout, form of ownership, business failure rates, etc. In applying for a loan, you notice that a projected income statement is required. Your problem is to complete this projected "P&L," given a desired income of $23,000 and the following published statistics. Show and clearly label all of your work! 135) If a market survey indicates that your firm's sales would be $620,000, what net profit would you expect to earn? Answer: First, find net profit margin percentage Therefore, if net sales equals $696,970, then net profit is: $696,970 × 3.3% = $23,000 Net profit can also be calculated by using dollar values: Mini-Case 11-6: Crazy Harry's The following is a pro forma income statement for Crazy Harry's. 136) Calculate Harry's break-even point. Answer: Break-even Point: 137) Create a break-even chart for Harry. Answer: 138) If Harry's profit target is $15,000, what level of sales must be achieved? Answer: Sales required to earn a $15,000 profit: Mini-Case 11-7: Sharps and Flats Anthony Gray has been interested in music since he was old enough to sit at the piano. He literally grew up with music, and he used his talent to earn his way through college. Anthony has grown tired of his job at a large music house in Houston and is seriously considering moving back to his hometown in Massachusetts to open his own small music shop. In researching this venture, Anthony notices that he must include a projected income statement in his loan application. Use the following statistics from Robert Morris Associates' Annual Statement Studies to answer the following question(s). 139) Suppose that a market survey indicates that Anthony's proposed business is likely to generate only $190,000 in sales. What net profit should Anthony expect to earn? Answer: If expected sales are $190,000, then Anthony's expected profit is: $190,000 × .089 = $16,910 140) Using Anthony's target income of $23,000, construct a pro forma income statement for Anthony's proposed music shop. Answer: To compute net sales: Chapter 12 Managing Cash Flow 1) Solid cash management enables a business owner to: A) adequately meet the cash demands of the business. B) avoid retaining unnecessarily large cash balances. C) stretch the profit-generating power of each dollar the business owns. D) All of the above Answer: D 2) ________ is the most important, yet least productive, asset that a small business owns. A) Profit B) Cash C) Inventory D) Accounts receivable Answer: B 3) Which of the following statements concerning cash management is false? A) Cash is the most important, yet least productive, asset a small business owns. B) Young companies tend to be "cash sponges," soaking up every available dollar of cash. C) Fast-growing businesses are least likely to experience shortages. D) Cash management involves forecasting, collecting, disbursing, investing, and planning for a company's cash needs. Answer: C 4) The first step in managing cash more effectively is: A) having an adequate cash reserve for emergency expenditures. B) rapid payment of accounts payable. C) speeding up payment of accounts receivable. D) understanding the company's cash flow cycle. Answer: D 5) More companies fail for the lack of ________ than for the lack of ________. A) cash; profit B) profit; cash C) net revenue; gross revenue D) vision; profit Answer: A 6) Which of the following measures a company's liquidity and its ability to pay its bills and other financial obligations on time? A) Cash budget B) Cash flow C) Cash management D) All of the above Answer: B 7) ________ typically lead(s) sales; ________ typically lag(s) sales. A) Production; receivables B) Collections; purchases C) Receipts; production D) Purchases; collections Answer: D 8) A cash budget reveals important clues about how well a company ________. A) balances its accounts receivable and accounts payable B) controls inventory C) finances its growth D) All of the above Answer: D 9) A firm's cash budget should: A) be prepared on a monthly basis for at least one year in advance and cover all seasonal fluctuations. B) cover a longer planning horizon when a firm's pattern is highly variable. C) show the amount and timing of cash receipts and cash disbursements on an annual basis. D) show the amount and timing of cash receipts and cash disbursements on a quarterly basis. Answer: D 10) A cash budget: A) is based on the cash method of accounting. B) is a "cash map," showing the amount and the timing of cash flowing into and out of the business over a given period of time. C) will never be completely accurate since it is based on forecasts. D) All of the above Answer: D 11) Which of the following is not a step in creating a cash budget? A) Determining an adequate minimum cash balance B) Forecasting profits C) Forecasting cash receipts D) Forecasting cash disbursements Answer: B 12) A cash budget is based on the cash method of accounting, meaning that cash receipts and cash disbursements are recorded in the forecast only when ________ is expected to take place. A) the transaction is predicted B) a credit sale C) the cash transaction D) projections are Answer: C 13) On March 10th, a business owner receives an invoice from a supplier for $416.27 with "net 30" credit terms marked on it. On April 7th, the owner writes the supplier a check for $416.27 and mails it. When would this cash disbursement show up on the company's cash budget? A) March 10th B) March 30th C) April 7th D) April 10th Answer: C 14) Jane is arguing with Joan about how much cash their small retail outlet needs as they prepare their cash budget. Jane feels that with the Christmas season coming, their busiest time, they need more cash available while Joan feels they do not because their sales volume will be up significantly. Jane and Joan are discussing which step of the cash budgeting process? A) Determining an adequate minimum cash balance B) Forecasting sales C) Forecasting cash receipts D) Forecasting cash disbursements Answer: A 15) A cash budget is only as accurate as the ________ forecast from which it is derived. A) profit B) receivables C) income D) sales Answer: D 16) What factors can drastically affect a company's cash flow? A) Increased competition B) Economic swings C) Normal seasonal variations D) All of the above Answer: D 17) Which of the following would be a potential source of information for preparing a sales forecast? A) Past records B) Trade associations and the Chamber of Commerce C) Similar firms D) All of the above Answer: D 18) When a firm sells goods or services on credit, the owner needs to remember that for cash budgeting purposes: A) the sale may be immediately posted as if it has been collected. B) the sale should be recorded in the month it was made. C) she must account for a delay between the sale and the actual collection of the proceeds. D) such a transaction counts as a cash disbursement. Answer: C 19) It is recommended that new business owners estimate cash disbursements as best they can and then add on another ________. A) 3-4 percent B) 5-10 percent C) 10-25 percent D) 25-35 percent Answer: C 20) When estimating the firm's end-of-month cash balance, the owner should first: A) determine the cash balance at the beginning of the month. B) add up total cash receipts and subtract cash on hand. C) review the accounts receivable. D) make a daily list of cash disbursements. Answer: A 21) The fact that the cash budget illustrates the flow of cash in a business helps the owner to: A) accelerate accounts payable payments. B) get a seasonal line of credit rather than an annual line of credit. C) slow accounts receivable payments. D) track the effects of depreciation and bad debts. Answer: B 22) By planning cash needs ahead of time, a small business is able to achieve all but which of the following? A) Make the most efficient use of available cash. B) Provide the opportunity to forgo quantity and cash discounts. C) Finance seasonal business needs. D) Provide funds for expansion. Answer: B 23) The "big three" of cash management include: A) accounts receivable, overhead, and inventory. B) accounts payable, accounts receivable, and taxes. C) accounts receivable, accounts payable, and inventory. D) accounts receivable, prices, and expenses. Answer: C 24) Experts estimate that ________ percent of industrial and wholesale sales are on credit, while ________ percent of retail sales are on credit. A) 20; 40 B) 40; 20 C) 60; 30 D) 90, 40 Answer: D 25) Small businesses selling on credit find that: A) it is relatively inexpensive and it is simple. B) it is expensive, requires a great deal of effort, and it is risky. C) it is essentially borrowing money from the customer. D) many can get by without selling on credit because their business customers do not expect to use credit. Answer: B 26) The cost to check a potential customer's credit at a reporting service starts at: A) $5. B) $85. C) $119. D) $499. Answer: B 27) ________ small businesses take the time to conduct a credit check. A) All B) Most C) Few D) None of the above Answer: C 28) An important source of credit information that collects information on small businesses that other reporting services ignore is: A) National Association of Credit Management. B) TRW. C) Dun & Bradstreet. D) National Association of Small Business Owners. Answer: A 29) According to the American Collectors Association, if a business is writing off more than ________ of its sales as bad debts, it needs to tighten its credit and collection policies. A) 3 percent B) 5 percent C) 10 percent D) 25 percent Answer: B 30) A collection agency typically takes ________ percent of the amounts they collect on past due accounts. A) 5 to 10 B) 10 to 20 C) 25 to 30 D) 30 to 50 Answer: C 31) To encourage credit customers to pay invoices promptly, a business owner should: A) ensure that all invoices are clear, accurate, and timely. B) state clearly a description of the goods or services purchased and an account number. C) include a telephone number and a contact person in case the customer has a question or a dispute. D) All of the above Answer: D 32) Once a small business has established a firm written credit policy and has clearly communicated it, the next step in building an effective credit policy is to: A) send invoices promptly. B) determine what percentage of sales are being written off as bad debt. C) create a simple credit application. D) create a "tracking file" of events. Answer: A 33) Once a credit account becomes past due, a small business owner should: A) wait patiently; the customer will most likely pay the bill eventually. B) turn the account over to a collection agency the day it becomes past due. C) send a "second notice" letter requesting immediate payment. D) call the "deadbeat" in the middle of the night and make harassing and threatening remarks until he pays. Answer: C 34) According to the American Collector's Association, only ________ of accounts more than 90 days delinquent will be paid voluntarily. A) 5 percent B) 20 percent C) 45 percent D) 65 percent Answer: A 35) The Fair Debt Collection Practices Act prohibits business owners from: A) harassing people who are past due. B) sending invoices the same day product is shipped. C) hiring debt collection attorneys. D) referring past due bills to collection agencies. Answer: A 36) An effective approach to successful collections includes: A) an abrupt, in-your-face style of communication once a payment is late. B) waiting to invoice and communicate with the customer once a payment problem clearly exists. C) setting up an automated collection system to generate "Past Due" notices that does not require personal intervention. D) timely, well-communicated payment expectations with well-documented records. Answer: D 37) A contract in which a business selling an asset on credit gets a security interest in that asset (the collateral), protecting its legal rights in case the buyer fails to pay, is a: A) lockbox. B) classic collection blunder. C) way to protect the buyer. D) security agreement. Answer: D 38) An entrepreneur can potentially improve collections by: A) contacting the customer once the bill becomes past due to verify they have received the bill and that it is accurate. B) negotiate payment if the customer is unable to pay the full amount on time. C) developing a rapport with the customer that will lead to prompt payment. D) all the above Answer: D 39) Patel Industries recently filled an order from one of its customers, Oxmoor Gardens, a small garden supply store. Oxmoor's owner recently received an invoice from Patel for $1,278.64 with selling terms of "2/10, net 30." Therefore: A) the selling terms indicate that Oxmoor must pay 2 percent of the invoice by the 10th day of the month with the balance due in 30 days. B) the selling terms are offering Oxmoor a 2 percent discount if the bill is paid within 10 days; otherwise the full amount of the invoice is due in 30 days. C) the selling terms indicate that the full amount of the invoice is due within 30 days and Oxmoor will be subject to a 2 percent finance charge for every 10 days that the bill is past due. D) the selling terms indicate that Oxmoor has not yet qualified for a quantity discount and must pay the full amount of the invoice within 30 days. Answer: B 40) Efficient cash managers: A) disregard trade discounts because of their hidden costs. B) avoid the use of credit cards to stretch their firm's cash balances. C) set up a payment calendar in order to both pay on time and take advantage of cash discounts for early payment. D) use expressions like "the check is in the mail" to mollify creditors when short on cash. Answer: C 41) For product-based businesses, ________ often represents their largest capital investment. A) account receivables B) inventory C) plant and equipment D) real estate Answer: B 42) Which of the following is true about inventory management for the small business owner? A) Most small business owners have turned to technology and computer spreadsheets to achieve maximum efficiency in managing it. B) Inventory is the largest capital investment for most businesses but few owners use any formal means for managing it. C) Inventory is generally highly liquid and can be easily mortgaged to a bank for immediate cash if needed. D) Inventory yields a return of about 25 percent for manufacturing firms but nothing for service companies. Answer: B 43) Only about ________ percent of a typical business' inventory turns over quickly. A) 20 B) 40 C) 60 D) 80 Answer: A 44) Which of the following inventory management techniques would help a business owner make the best use of his company's cash? A) Avoid overbuying inventory. B) Schedule inventory deliveries at the latest possible date. C) Purchase goods from the fastest suppliers who can meet quality standards to keep inventory levels low. D) All of the above Answer: D 45) Exchanging goods and services for other goods and services, or ________, is an effective way for a small business to conserve cash. A) leasing B) bartering C) arbitrating D) credit sales Answer: B 46) It is estimated that approximately ________ companies, most of them small, engage in barter exchanges every year. A) 50,000 B) 100,000 C) 350,000 D) 500,000 Answer: C 47) The real benefit of barter for the entrepreneur is that: A) it is essentially without cost to the business owner. B) it is considered a depreciable item for tax purposes rather than as income. C) it saves the small business owner between $100,000 and $150,000 a year on the average. D) it is "paid" for at the wholesale cost of doing business, yet it is credited at the retail price. Answer: D 48) Barter offers business owners the benefit of: A) buying materials, equipment, and supplies without spending valuable cash on them. B) transforming slow-moving inventory into much-needed goods and services. C) "paying" for goods and services at wholesale cost and getting credit for retail price. D) All of the above Answer: D 49) Which of the following is an effective way to trim overhead? A) When able, buy instead of leasing. B) Hire more full-time employees; reduce the number of part-timers. C) Eliminate zero-based budgeting. D) Negotiate fixed loan payments to coincide with company cash flow. Answer: D 50) Which of the following statements concerning leasing is true? A) Leasing is an "off-the-balance-sheet" method of financing assets. B) Although total lease payments for an asset are greater than those on a conventional loan, most leases do not require large capital outlays as down payments. C) Leasing gives business owners access to equipment even when they cannot borrow the money to buy it. D) All of the above Answer: D 51) Leasing allows business owners to forecast cash flows more ________ because lease payments are ________ amounts paid over a particular time period. A) often; fixed B) accurately; variable C) accurately; fixed D) often; variable Answer: C 52) "Stick to what you are good at and ________ everything else" is an approach to reduce overhead costs. A) make B) sell C) leverage D) out source Answer: D 53) Rather than build the current year budget on increases from the previous year's budget, ________ evaluates the necessity of every item. A) zero-based budgeting B) zero-based accounting C) ground-up budgeting D) year-one budgeting Answer: A 54) When investing surplus cash, the small business owner's key objectives should be on the ________ of the investment. A) high yields B) current income C) liquidity and safety D) long-term yield Answer: C 55) A checking account that never has idle funds-because it draws funds from an interest-bearing master account to cover checks written-is called a: A) zero-balance account. B) money market account. C) deficit account. D) sweep account. Answer: A 56) A sweep account is a checking account that: A) bears interest, allowing depositors to write checks without tying up money for a specific period of time. B) never has funds as they are drawn from a master account. C) automatically moves all funds in a company's checking account above a predetermined minimum into an interest-bearing account. D) need to be reviewed and updated on a regular basis. Answer: C 57) Cash is the most important, yet least productive, asset a small business owns. Answer: True 58) A common cause of business failures is that owners neglect to forecast how much cash their companies will need until they reach the point of generating positive cash flow. Answer: True 59) The objectives of cash management are to adequately meet the cash demands of the business, to avoid retaining unnecessarily large cash balances, and to stretch the profit-generating power of each dollar the business owns. Answer: True 60) The goal of cash management is to maintain as much cash as possible on hand to meet any unexpected circumstances that might arise. Answer: False 61) It is likely that young companies and rapidly growing companies will experience cash flow difficulties. Answer: True 62) The shorter a company's cash flow cycle, the more likely it is to encounter a cash crisis. Answer: False 63) A highly profitable company rarely experiences cash flow problems. Answer: False 64) Developing a cash forecast is essential for new businesses because early profit levels usually do not generate sufficient cash to keep the company afloat. Answer: True 65) A highly profitable business is a highly liquid business. Answer: False 66) Profit is the difference between a company's total revenue and its total expenses. Answer: True 67) Compiling the total cash on hand, bank balance, summary of the day's sales, summary of the day's cash receipts, and a summary of accounts receivables collections into monthly summaries provides the basis for making reliable cash forecasts. Answer: True 68) A small company's cash balance is the difference between total revenue and total expenses. Answer: False 69) A cash budget allows a small business owner to anticipate cash shortages and cash surpluses and gives him time to handle, or even avoid, approaching problems. Answer: True 70) Typically, small business owners should prepare a projected weekly cash budget for at least six months and quarterly estimates for the remainder of the year, being careful to cover all seasonal sales fluctuations. Answer: False 71) A small business whose sales are highly variable, such as a seasonal business, should use a short cash planning horizon. Answer: True 72) The primary problem with cash management tools is that they are too complex and time consuming for small business owners to use practically. Answer: False 73) In a cash budget, credit sales to customers are recorded at the time the sale is made. Answer: False 74) Depreciation and debt expenses are often left off the cash budget but need to be included to accurately forecast cash requirements for running the business. Answer: False 75) The cash budget is nothing more than a forecast of the firm's cash inflows and outflows for a specific time period, and it will never be completely accurate. Answer: True 76) The first step in preparing a cash budget is to forecast sales. Answer: False 77) The most reliable method of determining an adequate minimum cash balance is using estimates of similar businesses from trade literature. Answer: False 78) A small firm's minimum cash balance should be two times its average weekly sales. Answer: False 79) A small company's ideal minimum cash balance is one month's sales. Answer: False 80) Because the heart of the cash budget is the sales forecast, the cash budget is only as accurate as the sales forecast on which it is based. Answer: True 81) Since even the best sales forecast will be wrong, the small business owner should prepare three forecasts-optimistic, pessimistic, and most likely. Answer: True 82) A sale to a customer is not really a sale until the business owner actually collects the money from it. Answer: True 83) To project cash receipts, an entrepreneur must analyze accounts receivable to determine the company's collection pattern. Answer: True 84) The key factor in forecasting cash disbursements for a cash budget is to record them in the month when they are incurred, not when they are paid. Answer: False 85) Some financial analysts recommend that new owners estimate cash disbursements as best they can and then add another 25 to 50 percent of the total! Answer: True 86) Difficulty in collecting accounts receivable is the primary cause of cash flow problems, according to small business owners. Answer: True 87) The longer an accounts receivable is outstanding, the lower its probability of collection. Answer: True 88) For cash planning purposes, it is better to underestimate cash disbursements than to overestimate them. Answer: False 89) Seasonal sales patterns cause cash balances to fluctuate dramatically, creating the need for cash forecasts. Answer: True 90) To manage cash efficiently, business owners should strive to accelerate their accounts payable and stretch out their accounts receivable. Answer: False 91) Forty percent of industrial and wholesale sales are on credit, and 90 percent of retail sales are on account. Answer: False 92) Most small businesses conduct a thorough credit investigation before selling to a new customer. Answer: False 93) The first line of defense against bad debt losses is to have a financial institution extend loans to credit-seeking customers. Answer: False 94) One effective technique for improving cash management is to establish a firm credit policy in writing and let customers know in advance what it is. Answer: True 95) Some businesses use cycle billing, in which a company bills a portion of its credit customers each day of the month to smooth out uneven cash receipts. Answer: True 96) As soon as an account receivable becomes past due, a business owner should turn it over to a collection agency. Answer: False 97) If an account receivable becomes past due, the best strategy is simply to wait; statistics show that customers eventually pay their bills if business owners do not bother them with repeated collection attempts. Answer: False 98) Small business owners should not press customers for payment of their past due accounts for fear of losing them as customers altogether. Answer: False 99) A small business owner should concentrate collection efforts on the top 20 percent of the company's customers since they typically account for 80 percent of all accounts receivable. Answer: True 100) A security agreement is a contract in which a business selling an asset on credit gets a security interest in that asset, protecting its legal rights in case the buyer fails to pay. Answer: True 101) Communication in a timely and professional manner is key to effective collection activities. Answer: True 102) Proper cash management techniques call for a small business owner to pay invoices as soon the invoices arrive. Answer: False 103) Efficient cash managers set up a payment calendar each month, which allows them to pay their bills on time and to take advantage of cash discounts for early payment. Answer: True 104) A basic principle of cash management is verifying all invoices before paying them. Answer: True 105) A cash discount offers a price reduction if the owner pays an invoice on time. Answer: False 106) Small business owners generally should not take advantage of cash discounts vendors offer, choosing instead to maintain control of their cash for as long as possible. Answer: False 107) It is considered unethical for small business owners to regulate payments to their companies' advantage. Answer: False 108) Because inventory is not a liquid asset, cash invested there is tied up and cannot be used for other purposes. Answer: True 109) Only about 20 percent of a typical business' inventory turns over quickly. Answer: True 110) Roughly 80 percent of the typical business' inventory turns over quickly. Answer: False 111) It is much wiser to carry too little inventory rather than too much because there are no costs associated with carrying too little inventory. Answer: False 112) Cash and quantity discounts allow business owners to receive a price break in the goods they purchase. Answer: True 113) Bartering-exchanging goods and services for other goods and services, is an effective way for small business owners to conserve cash. Answer: True 114) Bartering is an opportunity to transform slow-moving inventory into much-needed products and services. Answer: True 115) The real benefit to a business owner engaging in barter is the ability to "pay" for goods and services at her wholesale cost and to get credit for the retail price. Answer: True 116) Most business owners should avoid leasing as a cash management strategy because it requires large capital outlays as down payments, and total lease payments typically are greater than those for conventional loans. Answer: False 117) Important advantages of leasing include the flexibility of the lease agreement and protection against obsolescence. Answer: True 118) When a small business encounters a sales slowdown, the first thing the owner should do is cut marketing and advertising expenditures to conserve cash. Answer: False 119) Many banks allow entrepreneurs to schedule their loan payments to fit their company's cash flow cycles. Answer: True 120) Changing your firm's shipping terms from "F.O.B. buyer" to "F.O.B. seller" can improve your cash flow, as it switches the cost of shipping from you to your buyer. Answer: True 121) Companies lose billions of dollars each year due to employee theft. Answer: True 122) Rather than build the current year's budget on increases from the previous year's budget, zero-based budgeting starts from a budget of zero and evaluates the necessity of every item. Answer: True 123) In order to deter employee theft, it is best to separate cash management duties between at least two different employees. Answer: True 124) When trying to prevent employee theft, business owners should create a "police state" environment and trust no one. Answer: False 125) Because small business owners often rely on informal procedures for managing cash, they are most likely to become victims of embezzlement and fraud by their employees. Answer: True 126) A sweep account is a checking account that automatically "sweeps" all funds in a company's checking account above a predetermined minimum into an interest-bearing account. Answer: True 127) Small business managers need not be concerned about investing surplus cash since small amounts of cash sitting around for a few days or weeks are not worth investing. Answer: False 128) When investing surplus cash, the small business owner should seek the highest returns possible on the money. Answer: False 129) When investing surplus cash, an owner's primary objective should be on the safety and liquidity of the investments. Answer: True 130) A sweep account automatically "sweeps" all funds in a company's checking account above a predetermined minimum into an interest-bearing account, enabling it to keep otherwise idle cash invested until it is needed to cover checks. Answer: False 131) Revising business plans annually forces owners to focus on managing the business more effectively. Answer: True 132) Why is cash a unique asset? What are the advantages of efficient cash management? Answer: Cash is the most important, yet least productive, asset that a small business owns. A business must have enough cash to meet its obligations, or it will go bankrupt. Creditors, employees, and lenders expect to be paid on time, and cash is the required medium of exchange. Cash is the lifeblood of any small business. Proper cash management permits the owner to adequately meet the cash demands of the business, to avoid retaining unnecessarily large cash balances, and to stretch the profit-generating power of each dollar the business owns. In addition, more businesses fail for lack of cash than for lack of profit. 133) Your friend Jake owns a business that is achieving phenomenal growth. Explain why it is said that: "Fast-growing companies are most likely to experience cash shortages." Answer: Many successful, growing, and profitable businesses fail because they become insolvent; they do not have adequate cash to meet the needs of a growing business with a booming sales volume. If a company's sales are up, its owner must also hire more employees, expand plant capacity, increase the sales force, build inventory, and incur other drains on the firm's cash supply. During rapid growth, cash collections often fall behind, compounding the problem. Inventory and receivables often increase faster than profits can fund them. 134) The profits your small business is generating are high; however, you never seem to have enough cash to pay your bills on time. Are cash and profit the same thing? Why or why not? Answer: Cash and profit are not the same thing. Cash is the money-the actual receipt of money-that flows through the business in a continuous cycle. It is the money that is free and readily available to use in the business. Profit is the difference between the company's total revenue and total expenses. It is the net increase over a period of time in capital cycled through the business, and it tells how effectively the firm is being managed. A business cannot spend profits or pay bills with profits; these require cash. Businesses sometimes fail not because they are not making a profit, but because they simply run out of cash. 135) What are the basic steps in preparing a cash budget? Which forecast is the "heart" of the cash budget? Answer: Five basic steps to preparing a cash budget include: 1. Determining an adequate minimum cash balance-Some suggest it should be at least one-fourth of a firm's current debts. Be sure to account for seasonal fluctuations and add extra for "cushion." The most reliable method involves past operating records. 2. Forecasting sales-which ultimately are transformed into cash receipts and cash disbursements. Be careful not to be excessively optimistic; consider economic swings, increased competition, fluctuations in demand, normal seasonal variations, and other factors that can have a dramatic effect on sales. A cash budget is only as accurate as the sales forecast from which it is derived. 3. Forecasting cash receipts-Includes accounting for the delay between the sale and the actual collection of the proceeds. To predict accurately the firm's cash receipts, the owner must analyze the accounts receivable to determine the collection pattern. 4. Forecasting cash disbursements-Many cash payments are fixed amounts due on specified dates. The key is to record them in the month in which they will be paid, not when the obligation is incurred. 5. Determining the end-of-month cash balance-Add total cash receipts to, and subtract total cash disbursements from, the beginning cash balance for the month. The cash balance at the end of a month becomes the beginning balance for the following month. The heart of the cash budget is the sales forecast. As mentioned above, a cash budget is only as accurate as the sales forecast from which it was derived. 136) How are sales forecasts developed for an established business? How are sales forecasts developed for a new business enterprise? Answer: For an established business, a sales forecast can be derived from past sales data, using quantitative techniques like linear or multiple regression, time series analysis, and others. The business owner must be aware that economic swings, increased competition, fluctuations in demand, normal seasonal variations, and other factors that can have a dramatic effect on sales. The task of forecasting sales for the new firm is more difficult, but not impossible. The founder of a new business might rely on similar firms and their first-year sales patterns, published statistics, market surveys, and experts' opinions to derive a sales forecast. The local Chamber of Commerce and trade associations may be able to provide helpful statistics. Marketing research using census data, government statistics, polls, surveys, etc., is also a potential source of data for forecasting sales. 137) Identify the "big three" of cash management. As a small business consultant, what would you recommend your clients do to control the "big three" more effectively? Answer: The "big three" primary causes of cash flow problems are: 1. Accounts receivable 2. Accounts payable 3. Inventory Selling on credit is a common practice in business. It is essential that business owners establish a workable credit policy before granting credit. It should include a detailed credit application and a firm written credit policy issued to every customer in advance. Other techniques for accelerating accounts receivable include sending invoices promptly, indicating due date and late payment penalties, and tracking the results of collection efforts. Although a firm should try to accelerate its receivables, it should strive to stretch out its payables as long as possible without damaging its credit rating. Businesses should always verify invoices before paying them and should strongly consider taking advantage of cash discount opportunities offered by their vendors. Wise use of credit cards may also be considered. Because inventory is a significant investment for many small businesses, it can create a severe strain on cash flow. Inventory should be carefully managed to reduce the possibilities of carrying the wrong type, too much, or failing to meet customer demand/stock-outs. Scheduling inventory deliveries at the latest possible date will prevent premature cash distributions. 138) What steps can a small business owner take to minimize bad debt losses? Answer: A credit policy that is too lenient can destroy a business' cash flow, attracting nothing but slow paying or "deadbeat" customers. However, extending a carefully designed credit policy to customers can boost sales and cash flow. Establishing a credit and collection policy involves these actions: • Screen customers carefully by requiring that they submit a detailed credit application. • Establish a firm written credit policy and let every customer know in advance the company's credit terms. • Send invoices promptly. • When an account becomes overdue, take immediate action. Steps to encourage prompt payment of invoices includes: • Ensure that all invoices are clear, accurate, and timely. • State clearly a description of the goods or services purchased and an account number. • Ensure that prices on invoices agree with price quotations on purchase orders or contracts. • Highlight the terms of sale (e.g., "net 30") on all invoices and reinforce them. • Include a telephone number and a contact person in your organization in case the customer has a question or a dispute. 139) What steps can a small business owner take to avoid the cash "crunch"? Answer: Techniques that allow small business owners to get the maximum benefit from their companies' pool of available cash include: • Barter: The exchange of goods and services for other goods and services rather than for cash is an effective way to conserve cash. The owner can get the goods and services he needs without having to spend valuable cash. The business gets credit for the retail value of the goods or services, but the real cost to him is less, depending on the gross profit margin. In addition, the owner may be able to collect otherwise uncollectible accounts. • Trim overhead costs: High overhead expenses can strain a small firm's cash supply. Ways to trim overhead costs include: • Periodically, evaluate expenses. • When practical, lease instead of buy. • Avoid nonessential outlays. • Negotiate fixed loan payments to coincide with your company's cash flow cycle. • Buy used or reconditioned equipment, especially if it is "behind-the-scenes" machinery. • Hire part-time employees and freelance specialists whenever possible. • Control employee advances and loans. • Establish an internal security and control system. • Develop a system to battle check fraud. • Change your shipping terms. • Switch to zero-based budgeting. • Prevent theft: Be on the lookout for employee theft. • Keep your business plan current: Keep your business plan up to date with annual revisions. • Invest surplus cash: If a small business has a surplus of cash, a significant amount can be earned by investing to improve cash flow. Mini-Case 12-1: The Golden Company This is a summary of the monthly cash budget for the next quarter (October through December) for the Golden Company. 140) From the information provided, prepare a monthly cash budget for the next quarter (October-December) for the Golden Company. Answer: Golden Company expects 25 percent of its sales to be in cash, and of the accounts receivable, $705 will be collected within the next month. Depreciation, insurance, and property taxes comprise $25,000 of monthly manufacturing costs and $10,000 of the operating expenses. Insurance and property taxes are paid in February, June, and September. The rest of the manufacturing costs and operating expenses will be paid off, one-half in the month incurred and the rest in the following month. The current assets as of October 1st are made up of: • Cash: $70,000 • Marketable securities: $50,000 • Accounts receivable: $600,000 ($450,000 from September, $150,000 from August) and current liabilities include a 90-day note for $60,000 at 9 percent due October 18th • Accounts payable: $200,000 for September manufacturing expenses • Accrued liabilities: $100,000 for September operating expenses Dividends of $1,000 should be received in November and an income tax payment of $50,000 will be made in November as well. The firm's minimum cash balance is $20,000. Calculations: October 18th notes payable: $60,000 principal + $60,000 × .09 × ¼ of a year = $61,350 Manufacturing Costs: Because depreciation (a noncash expense) is a component of manufacturing costs and because insurance and property taxes (cash expenses, which are included on a cash budget) are paid only in February, June, and September, we must subtract out $25,000 of monthly manufacturing costs as follows: Now we can show the actual cash outflow of these expenses, which is 50 percent in the current month and 50 percent in the following month. October: 450,000/2 = 225,000 PLUS the half from September, 200,000 accounts payable. So cash outflow for manufacturing in October are: 225,000 + 200,000 = 425,000 November: 495,000/2 = 247,500 PLUS the half from October, 225,000. So cash outflow for manufacturing expenses for November are: 247,500 + 225,000 = 472,500 And this same monthly progression continues in the future. Mini-Case 12-2: The Laurens Corporation In past years, Sue Salgado, owner of the Laurens Corporation, has been plagued by unexpected cash flow problems. Her banker, worried about her lack of cash flow management, has suggested that Sue create a cash budget for the upcoming quarter. Sue does this, using the following information: Laurens Corporation expects 35 percent of its sales to be in cash, and that of the accounts receivable, 70 percent will be collected within the next month, and 25 percent in the second month after sale. Depreciation, insurance, and property taxes comprise $25,000 of monthly manufacturing costs and $12,000 of operating expenses. Insurance and property taxes are paid in February, June and September. One-half of the remaining manufacturing costs and operating expenses will be paid in the month in which incurred, and the rest in the following month. As of October 1st, the following facts are relevant: • Current assets consist of $50,000 in cash, $50,000 in securities • Credit sales for August and September were $500,000 and $450,000 respectively • The firm has a line of credit with a local bank at 18 percent APR, and loan is due the following month • Accounts payable of $200,000 for September manufacturing expenses • Accrued liabilities of $100,000 for September operating expenses Dividends of $1,000 should be received in November and an income tax payment of $20,000 will be made in November. The firm's minimum cash balance is $10,000. 141) From the information given, prepare a monthly cash budget for the next quarter (October through December) for the Laurens Corporation. Answer: Laurens Corporation's cash balance never dips below the minimum cash balance so the firm does not need to borrow on its line of credit. Mini-Case 12-3: Rent-A-Nerd Computer Consultants The owners of Rent-A-Nerd Computer Consultants have prepared the partial cash budget for the upcoming quarter: Calculate the final end-of-month balance for months 1-3 and answer the following questions. 142) How much would Rent-A-Nerd have to borrow if its desired minimum cash balance is $4,000? a. $2,224 in Month 3 b. Nothing. Rent-A-Nerd's end of the month cash balance is below $4,000. c. $2,598 in Month 3 d. $20,771 in Month 3 Answer: C 143) Total cash receipts for months 1, 2, and 3, respectively are: a. $42,650, $45,400, and $47,000. b. $25,590, $27,300, and $28,200. c. $68,240, $72,800, and $75,200. d. $41,424, $43,396, and $45,508. Answer: D 144) The end-of-the-month balances for months 1, 2, and 3, respectively are: a. $5,293, $4,865, and $1,402. b. $6,519, $8,195, and $6,224. c. -$10,541, -$12,524, and -$16,771. d. $32,109, $61,085, and $87,314. Answer: A Test Bank for Essentials of Entrepreneurship and Small Business Management Norman M. Scarborough 9780132666794, 9780273787129, 9780134741086, 9780136109594, 9780133930382