Small Business Management: A Planning Approach

Small Business Management:A Planning Approach Joel Corman Suffolk University, Emeritus Robert Lussier Springfield College Lori Pennel Bunker Hill Community College

PART 4Controlling and Evaluating Performance CHAPTER 13Financial Analysis and Taxation

13-1 The Interrelationship between Financial Analysis Taxation and the Other Business Plan Components • Financial analysis analyzes company’s performance in all functional areas and determines if corrective measures are required. • Federal or state government demand taxes, which in turn can affect profitability. • Organizations need to plan as tax components change and vary on the basis of the following: • Equipment purchased and depreciation • Manpower • Sales of goods • Organization form

13-2Taxation • Government provides for certain societal benefits: • Roads • Defense • Social Security • Unemployment benefits • These benefits are provided by deducting money from wealth created by producers (business organizations) and redistributing it elsewhere. • There are volumes published that define and enumerate: • Proper size of the benefit package • Amount that should be taken from the economy in taxes • Who should benefit from the taxes

13-2Taxation (contd.) • There are two sources of tax revenue, individuals and business. • Imposition of taxes may reduce individual and organizational spending. • Organizations that pay higher taxes have less budget for: • Equipment • Research • Personnel • General expenditure • Investments • Savings • Taxes affect the survival, growth and viability of organizations. • Taxes are payable at three levels: • Federal • State • Local

13-2Taxation (contd.) • Income taxes • Tax levied on the net income of business. • A percentage of the net income determined by the taxing agency. • Social Security taxes • Levied on employers and employees to provide for individual retirement • Currently, 7.65% each is contributed by employees and employers. • Self-employed individuals need to contribute for both the portions. • 1.45% of the social security tax goes to the Medicaid fund and is accounted separately. • Unemployment Taxes • Collected from employers, normally a portion of the payroll • This amount is used to insure the individuals who lose their jobs.

13-2Taxation (contd.) • Amount a person receives and duration differs from state to state. • Sales Taxes • Tax paid by the customers • Certain percentage of the price of goods/services. • Attempts are being made to standardize and simplify tax of goods purchased through Internet. • Property and Excise taxes • Levied based on ownership and a percentage of the assessed value • Levied on personal or real property: • Land • Automobiles/boats • Inventories • Gasoline

13-3Budgets • One of the most powerful and common method to control future expenditure • A preliminary written plan for future specific application that controls future company activities. • There are rational limits to budgets as it is a statement of funds to be expended. • The limits are provided by estimated sales income. • Expenses can’t exceed income unless there’s cash in reserve to draw from.

13-3Budgets (contd.) • Budget is a planning mechanism to forecast source of cash flow and the allocation of expenses. • Budgets are still only a guide to measuring progress. • The normal phenomenon of change may cause actual dollars to deviate from the plan. • Planning: • Determining expense categories • Allocating relative amount of dollars for each category • In a large organization every department may have its own budget. • Yearly budget can be broken into smaller time limits.

13-3aBudgetary Variance • Deviation from the established budgetary amount • Control function of the budgetary process between actual and planned expenditure. • Departmental budget should be simple: • Significant variations can be identified. • Corrective measures can be taken. • Variable budgeting: • A flexible budget that allows changes in environment. • Allows variable expenditure pattern according to changing sales pattern

13-3bVariable Budgeting • Transforms the budget from a passive tool to one that is able to respond to forecasted changes. • Used to plan and control variable interpretations of the future. • Helps managers adjust and cope to anticipated future changes. • A firm does not delegate the task of deciding upon fiscal matters to lower level employees. • The owner is responsible for raising funds and is hesitant to let others spend it. • A budget can either be created for a fixed time (next year) or devise a rolling budget that can be updated as time passes.

13-3bVariable Budgeting (contd.)

13-3cStandard Costs • Costs that should be incurred in the production process if all goes according to plan and definition. • Standard cost calculation • Standard cost figure is used as a control device. • Departmental Manager predicts in advance what his cost will be. • Cost Variance is the difference between actual costs and what they should have been. • A significant difference calls for corrective measures: • Root cause analysis • Permanent improvement of the process

13-3cStandard Costs (contd.) Cost variance

13-4Ratios • A ratio is the relationship between any two numbers derived from a firm’s financial statements. • Two major descriptive tools that businesses must use to function profitably are balance sheet and profit-and-loss statement. • Balance sheet is a statement at a point in time that reflects a company’s financial status. • What the organization owns. • What the organization owes. • What the stockholders own in dollar term. • The value of retained earnings. • An equality results from the statement, that Assets = liabilities and net worth.

13-4aProfit-and-Loss Statement • Over the considered period of time how much money was generated by sales, how much money was spent to support these sales, and what is left. • The remainder is profit. • Profit and loss statement is a flow concept that shows the result of movement over time. • Ratios are the relationships of the firm’s financial figures using a balance sheet and income statement information and can be compared to industry averages and previous periods. • Ratios provide analysts a comprehensive understanding of the company’s financial health. • Ratios are control devices to ensure that the organizations performance is in line with its goals and objectives.

13-4bLiquidity Ratios • Ratios that indicate if the business can meet its cash obligations as they become due. • Current ratio measures the ability of the business to readily convert current assets into cash to meet current liabilities, that is, the ability to pay its debts. • Assets are divided into fixed assets and current assets. • Current assets can be converted into cash within one year. • Creditors would not be pleased if this ratio falls below 2 to 1.

13-4bLiquidity Ratios (contd.) • Previously 2 to 1 indicates inefficient usage of money available, thereby displeasing stockholders. • The ratio for Brown Corporation and the RMA industry standard are:

13-4bLiquidity Ratios (contd.) • Quick ratio shows the relationship between assets (cash accounts, notes receivable, market securities) and current liabilities—also known as acid test ratio. • Quick ratio shows how much cash (or near cash) is instantly available to pay bills.

13-4bLiquidity Ratios (contd.) • The existence of the proper ratio does not signify that the business is healthy. • A high quick ratio can mean everything is all right or that dividends were being held back for the purposes of beefing up the ratio.

13-4bLiquidity Ratios (contd.) • Asset coverage ratio shows how much of debt is covered by assets. • There is no fixed value for this ratio since the desired value depends upon the industry average and how secure the creditors are. • Relationship is different for different industries.

13-4cLeveraging Ratios • Leveraging ratios measure financing by a firm’s owners against that supplied by creditors. • A low-leverage ratio means the owners supply less funds and the creditors supply more of it. • Safe against poor economic times • Lowers profit potential in good times • Highly leveraged firms • More susceptible to downturns • Return greater profits as a percentage of investment in good times

13-4cLeveraging Ratios (contd.) • In the event of liquidation this ratio indicates the ability of a firm to meet its obligations to owners and creditors. • A low ratio provides greater financial security and potential to borrow more funds.

13-4cLeveraging Ratios (contd.) • Reveals how much of net worth is represented by fixed assets • A high ratio sends a danger signal • May not be enough money to pay current bills • Less money recovery in hard times

13-4cLeveraging Ratios (contd.) • Debt ratio measures the percentage of total funds in the business that are provided by creditors. • A high ratio would mean the business is highly leveraged. • Owners would want the ratio high. • Creditors favor a lower ratio.

13-4d Operating Ratios • Enables evaluation of business performance and how efficiently the firm is operating

13-4dOperating Ratios (contd.) • The inventory turnover ratio measures the number of times the inventory is turned over during the accounting period. • Both the ratios indicate how long the inventory remains on the corporate shelves. • The longer the inventory sits on the shelves, the higher the price it must return in the market.

13-4dOperating Ratios (contd.)

13-4dOperating Ratios (contd.) • A pair of ratios that measure the number of times receivables turn over during the year. • The higher the turnover, the faster your money turns over, the shorter the time between the sale of goods and receipt of cash. • The higher the number, the less cash needed in reserve.

13-4dOperating Ratios (contd.) • A good measure of the ability of a company to generate sales in relation to the assets it owns. • A ratio below the industry average indicates that you must take some action to generate sales.

13-4dOperating Ratios (contd.) • A measure of the efficiency of use of working capital. • A high number indicates inadequate working capital, while a low number indicates inefficiency.

13-4dOperating Ratios (contd.) • The relationship between what the owner has invested in the firm and the total assets being used by the firm. • Many other ratios can be used to analyze a firm’s operation. • Specific ratios can enable you to gauge the health of the business and indicate corrective action needs.

13-4eProfitability Ratios • Describes the profitability of a firm, measures the bottom line, that is a measure of success • The higher the profit, the more efficiently and successfully you are managing the company. • Profit to net worth ratio measures the return on sales.

13-4eProfitability Ratios (contd.) • This percentage indicates the amount of profit per dollar of sales after all expenses have been paid. • If industry average is higher than yours, it indicates that your prices are too low and/or costs are too high. • Must be used in conjunction with other information like assets, inventory turnover, and capital ratios.

13-4eProfitability Ratios (contd.) • This ratio measures the rate of return of assets. • Represents the percentage of your investment being returned to you annually as generated by your assets • Results should be compared with the industry averages.

13-4eProfitability Ratios (contd.) • Industry averages are published by: • Dun & Bradstreet • Risk Management Associates • Bank of America • Government agencies • Trade associations • Strive to equal or exceed the industry averages.

13-5 Tax Considerations and Record Keeping • Record keeping • The taxes you pay are based on the records you maintain. • Companies must maintain accurate and detailed records. • IRS may demand records for authenticating tax bills. • Records can help a manager to a large extent. • On need for credit, records become essential. • Tax considerations • Business decisions may be impacted by taxation. • Tax laws and rules are subject to changes. • Taxes and Profitability • Profit or loss = Sales – (Cost of goods sold + Operating expenses). • Taxes are based on the profits of your operation. • Certain classes of expenditure will be allowed for deduction. • Understanding allowable business expenses help to reduce tax bills.

13-5dAllowable Business Expenses • Cost of goods sold • All costs in making or buying the goods or services you sell • Salaries • Compensation paid to employees, should be ordinary, necessary, and reasonable. • Rent • Depreciation • The yearly cost of the use of an asset with a life longer than one year. • Straight line method • Accelerated depreciation (Higher depreciation = lower tax).

13-5d Allowable Business Expenses (contd.) • Automobile expenses • Only business related expenses may be deducted. • Bad debts • Loss must be real and must be able to demonstrate efforts taken to collect the debt. • Travel and entertainment • Travel costs must be reasonable. • Some costs are not fully deductible. • Interest • Taxes • Miscellaneous expenses

13-5e Effects of Taxes on the Form of Ownership • The S/LLC possesses tax benefits worth examining. • The S/LLC allows you to bypass double taxation. • The Economic Tax Relief Reconciliation Act of 2001 Difference in taxes between C and S Corporations

Small Business Management: A Planning Approach