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decreased?

â€¢ What is the ownerâ€™s equity of your business? Has it increased?
Do you have a goal for how much you would like your business to
be worth?
71
Creating a Budget Everyone Can Use and Understand

BREAK-EVEN ANALYSIS

Worksheet 2.8 determines the sales level at which the company neither
makes a profit nor suffers a loss. Break-even analysis can help to identify
problems and avoid or lessen losses by acting proactively rather than re-
actively. Obviously, the sooner you recognize that the company is operat-
ing at less than break-even operations, the sooner you can begin to cut
fixed costs and take other measures to restore profitability.

Some companies use break-even analysis to evaluate their overall profit
goal. It is a simple-to-use tool to relate sales to profit. Break-even analysis
is driven by the relationship of costs, volumes, and profits.

Break-even analysis offers a consistent way to test proposed transactions,
consider alternatives, or make decisions. Most of the information required

Making It Happen

Use the previous Income Statement Projections Worksheet (2.7) to deter-
mine which costs are fixed and which are variable. For Part I of Work-
sheet 2.8, determine the variable cost percentage by one of two ways:

1. Divide the total variable costs by projected sales.

Variable cost
= Variable cost percentage
Sales

2. Using historical financial statements, divide all variable costs
by sales to derive each variable cost as a percentage of sales.
Then add all of these percentages to obtain a total variable cost
percentage.

Example:
Materials: 50 percent

Production: 10 percent

Direct labor: 10 percent

Sales salaries: 15 percent

Total variable cost: 75 percent
72 Set High Standards

Worksheet 2.8
Break-Even Analysis
Part I
% of Salesa
Variable Expenses
Materials purchased
Production supplies
Shipping supplies
Mailing & shipping
Sales commissions
%
Total Variable Cost %
Contribution Margin Ratio
(100% minus the total variable cost %) %
Fixed Costs
Monthly \$
Annual \$
Break-Even Sales Level
Monthly \$
Annual \$

Part II
Annualb Monthlyc
\$ \$
Fixed Expenses
Personnel
Salaries & wages âˆ’ Cost of sales
Bonuses
Payroll taxes
Group life & health insurance
Workers compensation insurance
Employee benefit plans
Officersâ€™ salaries
Employment expense
Training
Temporary help
Total Personnel Costs \$ \$
73
Creating a Budget Everyone Can Use and Understand

Worksheet 2.8 (Continued)
Annualb Monthlyc
Sales & Marketing Expenses
Salaries
Sales commissions
Direct mail
Publicity
Consulting
Other sales & marketing expenses
Total Sales & Marketing Expenses \$ \$
Facilities
Rents
Property tax
Repairs & maintenance
Utilities
Property & liability insurance
Total Facilities \$ \$
Accounting services
Automobiles
Bank charges
Computer supplies
Charitable contributions
Depreciation & amortization
Dues & subscriptions
Interest expense
Legal services
Miscellaneous
Office supplies
Other professional services
Telephone
Travel
Total Fixed Expenses \$ \$
a
From Income Statement Projections worksheet (2.7), current year projection, % of sales column for vari-
able expenses only.
b
From Income Statement Projections worksheet (2.7), current year projections column.
c
Current year projections divided by 12.
74 Set High Standards

The goal of Part II is to determine the contribution margin ratio to add
back into Part I. This ratio is calculated by taking the complement of the
variable cost percentage or simply by subtracting the variable cost per-
centage from 100 percent.

Contribution margin ratio = 100 percent âˆ’ Variable cost percent

Now you are ready to calculate sales break-even level. To do this, divide
total fixed costs by the contribution margin ratio.

Total fixed costs
Sales break-even level =
Contribution margin ratio

Reality Check

â€¢ If sales begin to decline, at what level will you start to lose
money?

â€¢ If you increase fixed costs by \$X, how much additional sales will
you need to generate to cover these costs?

â€¢ If you lower the variable cost percentage, what impact will it have
on profits?

â€¢ If you want a profit of \$X, what level of sales will you have to
achieve?

â€¢ Are there months where your projections are less than break-
even on sales?

W H AT â€™ S N E X T

In the next chapter, I cover how to look at what really happens after
you complete the budget and go back to business. I discuss how you
can interpret financial data to ensure your company is on the right
track. I also cover how to share financial information and budget re-
quirements with your employees and how to make this information
relevant and useful to them.
3
UNDERSTANDING
THE NUMBERS

The expectations of life depend upon diligence; the
mechanic that would perfect his work must first
sharpen his tools.
â€”Confucious

A primary goal of every business is to make enough money to stay in
business. Making money can be defined in two ways: making a
profit and generating cash. Profitable businesses usually generate cash,
but not always. Unprofitable businesses sometimes generate cash, but
not often.

Either way, in reviewing your finances, you look at both profits and cash.
This chapter takes you through this review by stressing three points:

1. The importance of tracking variances from budgeted amounts.

2. The importance of cash in running any business.

3. The central role of developing key financial indicators and com-
municating them to coworkers.

you run and whether your company is young or mature. As a rule, cash is
king for a young company; many start-up owners fear running out of
cash more than anything else. In a mature company, sales and growth
may become the main concern. When a company goes public, showing a
good return on assets may become paramount.

75
76 Set High Standards

FLYING BLIND

The owners of many new businesses fly blind, concentrating on the day-
to-day essentials at the expense of reviewing the numbers and planning
ahead. Once they start reviewing and planning, they discover that the
process brings unexpected payoffs in reaching their goals because it
forces them to identify what they want and to determine the means by
which to get there. Effective managers develop their own methods for
gauging performance, and they define performance in accordance with
their short- and long-term goals. They may consider daily revenues, for
example, or catalogs mailed, cash balance, and payroll.

The small business owner must become intimately involved in the daily
dynamics of the business. This familiarity provides a long-term blue-
print for keeping the company vital because the key to implementation is
in the details.

Essential Financial Measurements

The following are six essential measurements of financial well-being for

1. Revenue dollars. Are total sales up or down for the period?

2. Gross profit margin percentage. One of the profit indicators you
look at first, this measurement takes into account only the costs
directly related to the product manufactured.

3. Net income. Always a key indicator of financial performance, net
income reflects sales and costs, profit and lossâ€”the best places
to start any analysis.

4. Cash position. Especially in the early years of a companyâ€™s his-
tory, liquidity has more importance than any other financial
benchmark. But whatever the maturity of your company, it pays
to watch how much money you have in the bank at least weekly
and maybe even daily. If you have a line of credit, how much of
the line is in use and how much is available becomes an impor-
tant part of your available cash calculation.

5. Net worth. This indicator, which tells the ownerâ€™s equity (or in
publicly traded companies, shareholdersâ€™ equity), is simply assets
minus liabilities. It includes equity put into the business through
77
Understanding the Numbers

the sale of stock or retained earnings. It helps you consider the
best ways to allocate equity and assets to reach your goals.

6. Accounts payable days and accounts receivable days. Many experts
call these leading indicators because they give you a read on what
your cash position will be next month. However, accounts re-
ceivable are sometimes collected more slowly than payables
come due, in which case your cash position might become tight.

Your management of receivables and payables profoundly affects cash
flow. Poor management here can kill almost any company, no matter
what the size, and good management pays big dividends.

Just by managing receivables well, even in a small company, you can gen-
erate tremendous amounts of cashâ€”in todayâ€™s volatile economyâ€”and this
is essential.

Another way to look at the receivables/payables ratio is as a measure of
make sure the company pays its bills and collects its receivables on time.

The traditional financial statement has two componentsâ€”the income
statement and the balance sheet. The income statement shows your
sales and expenses and profit and loss for a given period, usually the
month, quarter, or year. The balance sheet shows net worth; it also details
items such as inventory, fixed assets, accounts payable, and accounts
receivable.

Another important financial statement, not always prepared by small
companies, is a statement of cash f lows. This statement shows the details of
how cash increased or decreased during the period and where it went.

Make sure financials are prepared monthly, preferably by the tenth of the
following month at the latest. Learn which pieces of information in them
are relevant to your business and concentrate on those. Donâ€™t ignore what
the numbers tell you and, above all, believe them; good or bad, the num-
bers are important. In addition, donâ€™t hesitate to shape the reports you get
to suit your ends. Accountants tend to work by habit, and they sometimes
prepare numbers for business managers without giving much thought to
78 Set High Standards

making them truly useful. You need to make sure the reports you get are

In all cases, your financial statements look backward to show the pres-
entâ€”namely, your position as of their date of preparation. Finally, donâ€™t
forget, if you have a bank loan, the bankers will be looking at these num-
bers as well to make sure you can pay off your debt.

Implicit in this discussion is the fact that your concentration on the fi-
nancial statements may blind you to opportunity. Budgets set cost tar-
gets, leading some managers to spend their time controlling how much
the operation spends and ignoring how much it earns now or might
make in the future. They monitor money going out, and they donâ€™t take
into account issues such as trends, the big picture, or the business under-
lying the profit and loss statement, which shows results. Worse, they ig-
nore the balance sheet, which shows your financial position.

tion inward, values rule above initiative, and lead managers to query
trivial variances while they ignore harder-to-identify, companywide prob-
lems or opportunities.

Therefore, financial measurements must always be balanced against
measures of operations, product development, and marketing.

One way to counteract this is to develop specific key indicators for your
business. A key indicator answers the questions: How well are we really
doing? If you were managing the business in crisis mode and you had to
focus only on the essentials, what would you need to know? What num-
bers or other data would you want on your desk every morning? It is
dicators and making sure you have that data available to you consistently.

CASH FLOW IS CRITICAL

Many small business owners donâ€™t think about all the strategies and tools
available to them when they run into cash flow problems. Instead, they
react by trying to boost sales. They chase revenue, and cost is damned. In
79
Understanding the Numbers

so doing, they overextend themselves seeking new business and fail to
serve their best customers. This can harm cash flowâ€”the last thing a
company needs if liquidity is already a problem.

There are several strategies for maximizing cash flow. Controlling ex-
penses is chief among them.

Many business owners see expense controls as a sign of trouble, but they
arenâ€™t. The absence of cost controls is a sign of trouble.

study receivables and inventory, both of which are common drains on
cash flow.