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Tennessee Business Center - Getting Started
<< Go BackThe Business Plan
The Business Plan is your guide. It is an outline that can be altered as your business grows and changes over time. Below is an outline for a basic business plan.
- Brief Summary
Indentification
Introduction
Business Description
Market Analysis
Management Description - The Business
Business Description
Market Analysis
Key Personnel
Financing Requirements - Financial Data
Financial Projections - Start-Up Costs
Financial Documents - Papers to Prepare
- Sources and Application of Funds
- Capital Equipment List
- Operating Statement
- Cash Flow Statement
- Balance Sheet
- Break-Even Analysis
- Supporting Documents
Personal Financial Statements of Owners
Resumes of Principals
Signed Contracts
Additional Information
This is important when requesting a loan. Simplify the understanding of your proposals with a one-page summary. This serves to route the request to the appropriate loan officer. It then gives the loan officer a thumbnail sketch of the proposal to frame a subsequent examination of the business plan. The brief summary should include:
Identification. Designate your company or entrepreneur name, address and phone number, as well as contact person, position and phone number if different from the company’s number.
Introduction. The introduction tells the lender up front why there is so much documentation/paperwork on his or her desk. It helps put the lender in the proper frame of reference to read the rest of your proposal. Remember, this is a brief description. Save the details of loan structure and maturity for the body of the proposal.
Business Description. Include a paragraph on the nature of the business operations, market served and whether it is a start-up or expansion of current operations.
Market Analysis. Write a one- or two-paragraph description of the market you plan to reach, including size, capacity and/or cyclical nature.
Management Description. Include one or two sentences about your management team. Concentrate on the team’s industry experience.
In this section you include the details of your business. This section should include:
Business Description. Describe the company’s organization, operations, primary market, background and eventual goals.
Market Analysis. This is one of the crucial aspects of your business plan. It identifies the environment in which the business will operate. It describes competitors who may impact the operations of the business, and identifies pricing or technical innovation strategies which give your business a competitive advantage in the market. It should review business cycles and practices that may be unique to the industry. It identifies key features of the product or service offered; that is, those features product buyers consider important.
If relying on industry experience, you may have decided upon a product or service that the business can furnish to a specific group of buyers you have already identified. If new to an industry, you will have to do some extensive work in both product and buyer identification.
- Which specific products or services do you intend to furnish?
- To which specific buyers do you intend to sell your products or services?
- What is the buying cycle? Steady? Seasonal?
- What are the pricing practices?
- What are the payment practices?
- What are the characteristics of the market? Growing, steady, declining?
- Aging?
- Relocating?
- What are the external influences on the market?
- Regulatory?
- Fad or fashion conscious?
- Hurt or helped by government or industry changes?
- What is your differential advantage or your unique selling point (USP)?
- Why should consumers purchase from you instead of the competition?
This is just a brief list of marketing information you must consider. Depending on the product and market selected, you can look forward to spending much time, energy and money to develop answers to the above questions. This section establishes the base upon which the business will be constructed. All other parts of the business plan should support your plan to service the selected market.
Key Personnel. Here you will need to include a list of the people involved with your business and the costs associated with their employment.
- Directors and Officers. List names and positions of all directors, officers and key employees in your firm.
- Personal Information. Enclose a resumé and personal financial statement for each principal in your business. If you seek a loan through the Small Business Administration, you will be required to complete personal history and personal financial statements.
- Labor Costs. Make a table showing the name of each person who will be paid by your business, from owner/directors through hourly employees. Indicate their position with the firm and the total cost associated with each one (salary, fringes, director’s fees, bonuses, commissions, etc.).
- Owner/Investors. Describe your financing to date as it relates to the people involved. Indicate the name, amount of investment and percent of ownership for each investor. If you offered shares to investors, indicate the number under option and the number exercised. If shares were offered in exchange for services, state this as well. If your firm signed employment agreements with any director, manager, or employee, enclose a copy here. If you seek financing, you should explain why these agreements were necessary and how they will benefit the business.
- Professional Help. List names of all professionals you have consulted or plan to consult in connection with your business. Lenders and investors will want to know the amount you have paid consultants and whether part of the money you are requesting now will go toward their fees.
Financing Requirements. Most entrepreneurs require supplemental financing to begin operations. This is the area where you need to be realistic and conservative. Calculate the amount required to start and operate your venture until cash flow supports the operation. Most financial problems experienced by entrepreneurs can be traced to lack of capital caused by underestimating expenses.
Working capital is one requirement that all businesses must meet. Include a breakdown of working capital under major components such as inventory and salaries. Most commercial banks have copies of the Robert Morris Associates books. These books provide average business ratios for businesses of similar size and industry. You would be wise to consult these books in preparing this portion of your business plans.
The financial portion of your business plan consists of documents that support your loan request and indicate the expected financial posture of your firm at different time periods. Listed below are suggested statements for start-up companies.
Financial Projections — Start-Up Costs. Entrepreneurs say the most common mistake in starting a business is underestimating start-up costs and the time required to generate positive cash flow. Your initial goal as an entrepreneur is to reach positive cash flow. If you make positive cash flow, profit should follow. This is the area where you should be realistic or at least conservative.
Using standard cost accounting procedures, start-up costs can be divided into two categories: fixed and variable. This information should be included in your operating costs documents.
Fixed Costs. Fixed costs are those incurred by the purchase or lease of equipment, supplies, utility deposits, furniture, fixtures and vehicles, real estate rent or mortgage. They can be tabulated and will be the same regardless of the volume of business generated. Advertising costs can be considered fixed if planned for.
Variable Costs. Variable costs are those most often underestimated by entrepreneurs. Variable costs in this case include not only costs associated with the volume of operations, but also any unplanned costs. Variable costs include those expenses associated with operating the business until the point of positive cash flow. While various mechanisms are available to cover fixed initial costs, most lenders expect the entrepreneur to provide the working capital necessary to operate the business to the point of positive cash flow. Variable costs also include payrolls, inventory, utility bills and unplanned expenses such as production waste costs (applies to manufacturing and service businesses), unanticipated production costs such as bonds or insurance premiums, underestimated job quotes and the like. It is usually a good idea to add 10–20% of variable costs as unanticipated expenses.
Financial Documents — Papers to Prepare.
- Sources and Application of Funds. Borrowers should list the amount of money they have spent or are prepared to spend on the project for which they are preparing the business plan. This document should include funds raised, the source of those funds (owner’s cash, loans from friends or investors) and how the funds were spent.
- Capital Equipment List. If you, the borrower, have purchased equipment in the past, you should provide a list of such equipment, date purchased and appraised value.
- Operating Statement. The operating statement is a projection of the costs of doing business. These figures form the basis of the cash flow projection. The foundation of an accurate operating estimate is a good cost accounting system.
Note: Operating Statements are calculated using the Accrual Method; that is, sales and expenses are recognized at the time they occur, not when they are paid or accounts are collected. The CASH FLOW statement accounts for the actual time periods in which bills are paid and receipts are collected. - Cash Flow Statement. Cash flow projections demonstrate the inflow and outflow of cash over a period of time. They project increases and decreases in the cash accounts of your company. Therefore, the cash flow statement projects your firm’s ability to pay bills, cover payrolls and service bank debt from one period to the next (usually per month). It shows the source of cash and the uses of cash. Entries for the cash flow statement should flow from the operating statement. The difference is:
An operating statement recognizes sales and expenses when they are incurred.
A cash flow statement recognizes sales and expenses when they are actually paid for. - Balance Sheet. The balance sheet describes the condition of your business on a particular day, usually the last day of the month, quarter, or year. This makes it different from other financial statements, most of which cover a period of time. Another difference between the balance sheet and other statements is that it must balance the assets and liabilities of your business. The headings used in the balance sheet are described below:
Assets—Anything the business owns that has money value. The assets of a small business commonly include cash, notes receivable, accounts receivable, inventories, land, buildings, machinery, equipment and other investments.
Current Assets—Cash and assets that are expected to be converted into cash during the normal operating cycle of the business (generally within a year).
Fixed Assets—Those assets acquired for long-term use in the business. They include land, buildings, plant, machinery, equipment, furniture, fixtures and so on.
Other Assets—Those assets which constitute value but are not directly used to generate cash such as consumable office supplies and vehicles.
Liabilities—The claims of creditors against the assets of the business. In other words, debts owed by the business.
Current Liabilities—Those due for payment within a year. They include trade payable, vehicle installment loans, salaries and especially employer taxes such as unemployment insurance and workers compensation insurance.
Long-term (or Fixed) Liabilities—Debts or parts of debts that are not due for payment within a year. The allowance for future income taxes represents the taxes that will have to be paid on the profits of the current year, but that are not due for payment until later. Accrued liabilities are similar to the allowance for future income taxes in that the expenses are charged against profits of the current year, although payment will not be made until later.
Equity—Consists of the assets of your business minus its liabilities. This equity is the investment of the owner or owners plus any profits (or minus any losses) that have been left to accumulate in the business. If your business is incorporated, its books will show a capital stock account. This account represents the paid-in value of the shares issued to the owners of the business.
Undistributed Profits—Are recorded in an earned-surplus account. If your business is a proprietorship or a partnership, the capital accounts appear under the name or names of the owners. Increases in equity as a result of undistributed earnings are also recorded here, as are decreases in equity if the business shows a loss instead of a profit.
A new business should prepare projected annual balance sheets for three years. An existing firm should include historical balance sheets from the three previous years (or for however long it has been in existence if fewer than three), as well as three years of annual projections. Why is estimating your projects so important? Because it demonstrates your increase in operations and subsequent ability to repay the loan from increased cash flows. - Break-Even Analysis. You need to calculate a break-even point to determine the volume of sales necessary to reach that minimum point where you can cover both fixed and variable costs. This point of no loss and no profit is called the break-even point.
If you are going to use your business plan to support a loan request, be prepared. Include these supporting documents:
Personal Financial Statements. Obtain signed, personal financial statements on any persons guaranteeing a debt.
Resumés of Principals. Include the name, address and telephone number of each principal.
Relevant work or industry experience. The purpose of this section is to acquaint loan officers with the principals’ industry experience which demonstrates their ability to operate a company. Unlike a job-seeking resumé that concentrates on accomplishments, this resumé should outline learned skills and experiences that facilitate the operation of a company.
Principals should list companies worked for, dates of employment, job titles and responsibilities.
List the high school, community college or university the principals graduated from, along with graduation date and type of degree or diploma.
Additional Information. Here is a good place to include any other information you feel is relevant to the business plan or loan request. Entrepreneurs should find the above outline useful in planning their business operations and requesting financing. This outline is designed for a start-up operation; however, a good business plan is helpful when considering alternative approaches to owning a business. Read the next section, 1.3 Business Options, to find out more about the main types of businesses available.
There are three main types of businesses to consider. Each option has unique benefits and specific concerns to consider. You can:
You may save time and trouble by purchasing an existing business. If you are considering purchasing a business that is a sole proprietorship or general partnership, you are buying assets from the owner. You are not assuming liabilities unless you specifically agree to.
Advantages/Disadvantages. The advantages of buying a business are avoidance of start-up costs, usually, no downtime in acquiring customers, established vendor relations, and some kind of financial history on which you can base your decision. The disadvantages may be the flip side of the advantages. There may be few customers to acquire, vendor relations may be terrible because of unpaid bills, and the financial history may not be as rosy as the owner projects.
Steps to Take. Decide what you want the business to accomplish. Do you want to make a living; provide employment for you, a spouse, children and their spouses? Do you want to operate a business at a certain volume or to grow a business to a Fortune 500 status?
- Locate an existing business that is for sale. Entrepreneurs may use business brokers who advertise in the classified section in newspapers, trade journals and the Yellow Pages. You may learn of businesses for sale from salesmen, vendors and other contacts in the industry. Chambers of Commerce may know of businesses for sale.
- Determine the value of the business you plan to buy. This is as much art as science. What is the business worth? When asked its value, buyers typically begin listing real estate and equipment. A business is not valued for the worth of its assets. It is valued for its ability to generate cash and subsequent profits for the owner — you!
An analysis of the company’s profit-and-loss statements from three years should help you determine trends, a rough cash flow and profitability of the business. The results will enable you, the prospective buyer, to forecast funds available to service new debt as well as monies left for distribution to the owner. There are no hard and fast rules of pricing such as "value equals X times earnings." Much will depend on the amount of financing required. - Purchase the business. Most entrepreneurs are compelled to seek outside financing to close the deal. In these cases, most lenders will require some owner financing. This serves to reduce their risk as well as keep some owner involvement or at least interest in the continued success of the venture.
Administrative Matters. When purchasing a sole proprietorship or general partnership, the following administrative matters must be addressed:
- Business License. The current owner must close out his or her business license. You must obtain one in your name.
- State Taxes. The owner must close out the current tax accounts. You must apply for and establish new accounts.
- Unemployment Insurance. Again, the current owner closes out existing accounts while you must open new accounts.
- Bulk Transfer Law. Tennessee has a bulk transfer law designed to protect creditors from:
"The merchant owing debts, who sells out his stock in trade to anyone for any price, pockets the proceeds, and disappears leaving his creditors unpaid. The ... form of fraud suggested above represents the major bulk sales risk, and its prevention is the central purpose of the existing bulk sales laws ..."
This provision, Uniform Commercial Code — Bulk Transfers (TN Code Annotated 47-6-101-111), requires certain notices be given a business’s creditors, requires a complete list of creditors of a proprietor’s business operations, and requires certain actions of a buyer in regard to the distribution of his or her proceeds to creditors.
The purchase of a business is complicated by the firm’s own business practice history. Legal advice from a lawyer experienced in business law can prevent litigation or a damaged reputation.
The bottom line is that after careful and knowledgeable analysis, you can purchase a business that can help you realize your dreams. However, without a careful and knowledgeable analysis, the purchase can turn into a nightmare of bankruptcy and strained relationships.
Another option is to consider purchasing a franchise. The franchise industry can offer a package of assistance, marketing data, proven products and/or services. Depending on the franchise purchased, your risk may be considerably less than starting a venture from scratch. (For your information, 72% of all mall stores are franchise operations). The nation’s 533,000 franchises produce more than $700 billion in sales annually for roughly 35% of all goods and services sold.
Advantages/Disadvantages
- A successful franchise may offer a known product or service.
- A certain level of demand and pricing has been established.
- Data about the target market has been gathered, reducing much of the industry risk.
- Many franchisers perform marketing studies and surveys which small business owners could not afford.
- Marketing information, including analysis of competitors’ products and pricing, trends, estimated sales projections, product design and delivery are some of the key benefits of a franchise relation.
- Franchisers can help manage industry risk with legislative lobbyists, consultants and corporate headquarters staff who can do future planning. This gives you the benefit of a large corporate support staff for minimum cost.
- Some franchisers offer direct financing or referrals to investment institutions specializing in franchise financing. Be prepared to furnish 25–35% in personal equity.
How a Franchise Works. Basically, a franchisee (that’s you) purchases the right or license to sell the franchiser’s products or services within an exclusive territory. These territories may encompass entire states or countries, or may include only a few square blocks of metropolitan areas. As the franchisee, you usually pay an up-front fee plus periodic franchise fees for corporate overhead (management, advertising, etc.). Fees may be fixed or based on performance of the franchise.
Franchises may be purchased or leased. Franchisees may be required to purchase inventory from approved vendors or from the corporate office exclusively. The conditions surrounding the relationship are spelled out in the franchise contract. Some franchisers require a minimum level of sales or profitability for continuation of the relationship.
Franchise Choices
- Business Format Franchising. This includes ongoing operational interface with the franchise. Franchisees (that’s you, the local business owner) may purchase inventory, trademark goods, take advantage of national or regional advertising and receive bookkeeping and training assistance from the franchiser (corporate headquarters). Most fast-food franchises fall into this category, as well as pest control, tax services and the like.
- Product and Trade Name Franchising. This involves buying one product line for resale and using the franchiser’s name. Automobile dealerships, retail service stations and many soft drink bottlers fall under this category.
Selecting a Franchise. There are many franchise opportunities from which to choose. Two important criteria in selecting a franchise are your experience and your bank account.
- Your Experience. You, as an entrepreneur, can better manage a company when you possess experience in the industry. Regardless of franchise sponsored training, there is no substitute for experience. Franchisers do not manage businesses. Whether it is staffing a fast-food outlet on slow nights or working with local codes and ordinances in the area of termite and pest control, industry experience can help the business owner avoid costly mistakes and poor management practices.
- Your Bank Account. Your bank account is a key component in acquiring and operating a franchise. An advantage to buying a franchise is that initial costs and operating expenses can be projected with more certainty. A disadvantage is that this knowledge is often paid for with up-front franchise fees. Many franchise owners consider this cost well worth the money.
Additional Benefits of Buying a Franchise
- Training. Many franchisers offer (or require) training courses in the business, providing shortcuts to experience and knowledge which would normally take you years to acquire. In addition to business practices, they may provide standardized bookkeeping services, further streamlining operations.
- Right of First Refusal. Some franchisers offer the right of first refusal. That is, if market conditions indicate, a franchiser may expand operations in an area adjacent to a current franchisee. Some franchisers offer current operators the opportunity to run the second franchise. This gives the entrepreneur a chance to expand to multiple locations as the market and owner’s expertise increase.
Before Buying a Franchise
- Talk with Other Owners. A franchiser should provide names of current operators for you to meet with while investigating a franchise opportunity. These other franchise owners will provide invaluable insight into their particular business and their view of franchiser support. You should never consider investing until speaking with several operators.
- Do Your Research. There are several sources of information on more than 3,000 U.S. franchisers: Entrepreneur magazine, Franchise Opportunities Handbook (published by the U.S. Dept. of Commerce and found in many libraries) and Inc. magazine. Highly recommended is Enterprise magazine’s annual franchise issue (each January) as a primer on franchise operations and for its ranking of 500 franchise opportunities.
What to Do after Selecting a Franchise
- Make the Contact. You must make the initial contact either in writing or by phone. The object of the initial contact is to obtain the franchiser’s Uniform Franchise Offering Circular (UFOC). Franchisers may mail this document; however, by law they are required to furnish this prospectus at the first “personal” meeting, 10 business days prior to signing a franchise contract or 10 business days prior to any payments.
- Double Check the UFOC. The UFOC will provide enough information to enable you to make an informed decision. The circular must meet the requirements of the Federal Trade Commission’s Franchise Rule. In Tennessee, there are no other disclosure documents required. However, there are additional laws governing package alcoholic beverages and petroleum-based fuels (TCA 47-25-1000-1300). In addition, there are several laws covering termination of franchises.
- The UFOC has 23 separate sections covering franchiser financial information, projected franchise costs, all franchiser fees and charges, territories, termination of franchise, lease agreements and the like. An entrepreneur cannot make an informed decision without this information.
- Be aware that the UFOC does not decide the issue. The prospective business owner must use the information to decide if the venture meets expected goals, experience and bank account. This is the first decision you make and may very well be the most important one.
Word of Caution: Many unscrupulous operators set up fraudulent schemes under the guise of franchising. These pyramid schemes have been around a long time but continue to cost people their life’s savings every year.
A pyramid scheme is a business in which you are recruited to supposedly sell a product or service. For several thousand dollars, you are coached on how to recruit even more sellers. You make your money from the network of sellers. A rule of thumb: if the company emphasizes recruitment of salespeople over the need to sell products or services, be very cautious. Such schemes are against the Consumer Protection Act.
Several years ago, 14 states, Tennessee included, took Glen Turner’s company, Dare to Be Great, to court and succeeded in shutting it down. While the company had products, its main emphasis was recruiting investors who would in turn recruit more investors. The company’s profits rested on recruiting an increasing number of investors rather than increasing sale of product.
Should you find yourself dealing with a questionable franchiser, contact the Consumer Affairs Division within the Tennessee Department of Commerce and Insurance in Nashville at 615-741-4737. They may have information that could preserve your life savings.
Nearly 9 million people in the United States are self-employed, and the majority of them work out of their home. These include consultants, manufacturers representatives and a variety of freelancers: data entry personnel, writers, designers, artists, craft people, photographers — virtually any business not requiring a "corporate" setting.
Advantages/Disadvantages
The advantages of starting a business in your home are freedom, flexible hours, being your own boss, getting away from a corporate setting and having no limit to your income. The disadvantages are the reverse of the advantages.
Working Part-Time vs. Full-Time
- A part-time home-based business can add income to increase the household budget.
- Part-time can act as a stepping stone to a full-time business.
- Starting part-time, you can learn valuable lessons in business management, especially time management.
- Part-time means partial profits. Many part-time businesses are limited by either selected hours of operation or seasonal sales. For example, an afterschool child care business may be profitable because it operates only three hours a day, five days a week; a crafts business specializing in Christmas decorations may be profitable only from Thanksgiving through Christmas.
- Entrepreneurs considering converting a part-time business to full-time should go through one or more annual business cycles to better gauge the prospects of a sustained level of sales.
How to Select the Right Business for You.
- Do your research. Check your local bookstore and/or public library. There are literally hundreds of different books filled with ideas for a home-based business.
- Recognize that the most important ingredient in any small business is you. Know your personality, interests, abilities, drive, commitment, relationships, priorities and dreams.
- Ask yourself these questions:
Does the business you are thinking of starting require learning new skills or does it complement skills already developed? (It may be harder to develop skills on your own than in a corporate setting that offers training as well as colleagues to help the learning process.)
What is the level of business management skills needed? Do you have the required experience in marketing, pricing, financial projections and bookkeeping? (Remember, businesses, home-based or otherwise, do not operate by producing goods or services. They operate by selling those goods and services at a profit. They make profits by controlling costs to produce goods and services at a lower cost than they sell them.)
Before You Make Your Final Decision. Having thought through the different business options that are available, you might do well to look at some of the decision processes that lenders and investors use in judging the feasibility of a plan.
Entrepreneurs submit thousands of business plans annually to many different sources of financing. Only a relative few seem to enjoy success. It is important to understand what goes on within the lenders’ or investors’ offices once a proposal is made. Read the next section, 1.4 “Dealing With the Bank,” to find out how you can receive successful financial support.
The financial package you have just prepared and presented now goes to the lender’s “in box.” After you leave, the loan officer or credit standards group performs an analysis. Now you can see the importance of a concise yet descriptive business plan. Your request for funding may be analyzed and decided upon by complete strangers who did not sit in on your loan presentation.
Types of Commercial Loans
Lenders offer two types of commercial loans to small businesses. For most bank loans you may be asked to pledge personal assets (including your house) and furnish signed guaranties from all principles.
Term Loans. Term loans are generally for fixed asset loans; that is, they are used to purchase real estate and equipment. The loans are collateralized with the assets purchased. As such, lenders generally extend a loan for a percentage of the value rather than full value for the goods. Such loans usually take the form of installment loans with monthly payments.
Seasonal Lines of Credit. Seasonal lines of credit are extended to satisfy the working capital needs of a firm. Proceeds may be used to purchase inventory, take purchase discounts and make payrolls. While some lenders may take accounts receivable and inventory as collateral, be prepared to use all assets of the company to secure these loans. Borrowers are expected to pay off seasonal lines of credit at least once a year. Small business borrowers generally draw down and pay off seasonal lines of credit several times a year.
Bank Analysis
As a prudent entrepreneur, you will want to be aware of the accepted standards a bank uses to determine loans. Be sure your projections match these standards. One of the first analyses done is a comparison of financial ratios to historical standards found in such books as the Robert Morris Associates books.
Key financial ratios fall into four categories:
Liquidity Ratios—measure a firm’s ability to meet its short-term bills.
Leverage Ratios—measure the portion of the business financed by credit.
Activity Ratios—measure how efficiently management is using the assets of the business.
Profitability Ratios—measure management’s ability to turn a profit on operations and investments.
Using an information service such as Robert Morris Associates or Dunn & Bradstreet, lenders compare your ratios to industry averages. The ranges represent historical data compiled from many companies. The ratios are, therefore, actual comparisons with other companies of like size in the industry. A ratio outside the low range is not necessarily a deal killer if there is a reasonable explanation.
Liquidity Ratios. These measure your firm’s ability to pay trade bills, the current portion of bank debt and any other immediate obligations your firm has by converting current assets such as inventory and accounts receivable to cash. Current is defined as due within 12 months.
| Current Ratio |
| Current Assets Current Liabilities |
A ratio of 1 or greater indicates sufficient assets to cover debt. A better ratio would be 1.3 or 1.5 because of inventory markdowns and noncollectable receivables. A sustained ratio below 1 indicates an insufficient cushion to pay short-term bills and generally requires more owner capital for a loan.
| Quick Ratio |
| Current Assets (inventories) Current Liabilities |
This ratio measures your firm’s abilities to honor its obligations with accounts receivable and cash. This ratio is important because firms are more likely to take losses on inventories or suffer sales slowdowns. This ratio will probably fall below 1. The greater the value, the greater the cushion to pay debts.
Leverage Ratios. Gaining fame and, in some cases, notoriety in the 1980s, leverage is the ratio of debt to assets. The term “leveraged buyout” means the purchase of a business with little owner equity and much bank debt. Those days are over for large businesses and never existed for small businesses.
| Debt to Assets Ratio |
| Total Debt Total Assets |
This ratio measures the amount of total funds provided by creditors (including trade creditors). A high debt ratio is a danger signal in that you may have the most to lose if the venture fails. In addition, the higher the ratio, the less cushion there is to pay obligations. A ratio of 1:1 reflects an equal stake in the venture. Above 1:1 (such as 1.5:1) indicates creditors have a greater stake than you do. This is a danger signal to lenders.
Activity Ratios. These ratios show how effectively management turns assets such as inventory into cash.
| Inventory Turnover |
| Cost of Sales Average Inventory |
Average inventory is beginning plus ending inventory divided by 2. This ratio measures the number of times a firm’s inventory is sold. A high ratio generally indicates brisk sales; a low ratio indicating slower sales. Product, pricing and markets determine the level of sales. A retail outlet should reflect a high inventory turnover of several times per year, wholesalers and manufacturers somewhat less.
| Accounts Receivable Turnover |
| Net Sales Net Trade Receivable |
Those firms that offer credit terms must manage their accounts receivable to generate cash for operations (so they can pay their bills). This ratio measures how often receivables are collected.
The higher the ratio, the more frequently receivables convert to cash and correspondingly, the less risk of bad debts. Retailers and wholesalers should turn receivables frequently; 12 times per year reflects a standard 30-day billing cycle.
Some small businesses may bill all accounts the last week of the month resulting in as much as a 60-day cycle or six times per year. This should be explained and accounted for in the cash flow projection. The lower number reflects a longer cash collection period (or debtors’ inability to pay their bills) and therefore more need for a credit line.
Depending on the bank’s credit policy, loan officers may assign limited or no value to A/Rs 60 and 90 days past due.
| Accounts Payable Turnover |
| Cost of Sales Average Trade Payable |
This ratio shows how frequently your company pays its bills. This ratio reflects the efficient operation of the firm’s bill-paying procedures. In times of low interest rates, businesses should take advantage of prompt payment discounts. Such practices will be reflected here. Note: If you experience slow accounts receivable turnover as in the preceding paragraph, this ratio will reflect in slower payment of bills.
| Sales to Fixed Assets Ratio |
| Sales Fixed Assets (less depreciation) |
This ratio can be used to determine if you have too much capital tied up in fixed assets. Frequently, entrepreneurs request assistance to purchase a building for their business. They become blinded by real estate prices, especially bargains. They view this acquisition as they would a home purchase: based on the value of the building. Instead, they should analyze the impact of the purchase on the operations of the business. Too much floor space or too great a price may sink a viable business. A high sales to fixed assets ratio such as 25:1 represents a more affordable position than a low ratio of 10:1.
Profitability Ratio
| Profit Before Tax Ratio |
| Profit Before Taxes Total Assets |
This ratio shows you the percentage of profit gained from assets employed. As above, an analysis of this ratio may reveal high-cost fixed assets that act as a drain on profits. Profitability should range from 0% (a break-even level) to higher ratios. Note: this ratio frequently equals zero for small businesses as owners take all surpluses for compensation, for tax advantages. Be prepared to add compensation back in to render a more accurate account of the firm’s profitability.
