Preparing and Using Financial Statements

Chapter 4
Preparing and Using Financial

Statements
Leach & Melicher, Entrepreneurial Finance, 7th Edition. © 2021 Cengage. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 4: Learning Objectives
• Describe the process for obtaining and recording resources needed for an
early-stage venture
• Describe and prepare a basic balance sheet
• Describe and prepare a basic income statement
• Briefly describe two important internal operating schedules: the cost of
production schedule and the inventories schedule
• Prepare a cash flow statement and explain how it helps monitor a venture’s
cash position
• Describe operating breakeven analysis in terms of survival revenues and
identify major drivers on the amount of revenues needed to survive
• Describe operating breakeven analysis in terms of NOPAT breakeven
revenues (Appendix A)
Basic Accounting Concepts (1 of 2)
Generally Accepted Accounting Principles (GAAP):

guidelines that set out the manner and form for presenting accounting information
Accrual Accounting:
the practice of recording economic activity when recognized rather than waiting
until realized
Basic Accounting Concepts (2 of 2)
Depreciation:
reduction in value of a fixed asset over its expected life intended to reflect the
usage of wearing out of the asset
Accumulated Depreciation:
sum of all previous depreciation amounts charged to fixed assets
Basic Balance Sheet Terms & Concepts (1 of 2)
Balance Sheet:
financial statement that provides a snapshot of a venture’s financial position as of
a specific date
Balance Sheet Equation:
Total Assets = Total Liabilities + Owners’ Equity
Assets:
financial, physical and intangible items owned or controlled by the business
Basic Balance Sheet Terms & Concepts (2 of 2)
Listing Order of Assets:

assets are listed in declining order of liquidity, or how quickly the asset can be
converted into cash
Liabilities:
short-term liabilities are listed first followed by long-term debts owed by the
venture
Owners’ Equity:
equity capital contributed by the owners of the venture is shown after listing all
liabilities
Types of Balance Sheet Assets
Current Assets:
cash & other assets that are expected to be converted into cash in less than one
year
Fixed Assets:
assets with expected lives of greater than one year
Types of Current Assets
Cash:
amount of coin, currency, and checking account balances
Receivables:
credit sales made to customers
Inventories:
raw materials, work-in-process, and finished products which the venture hopes to
sell
Types of Current Liabilities
Payables:
short-term liabilities owed to suppliers for purchases made on credit
Accrued Wages:
liabilities owned to employees for previously completed work
Bank Loan:
interest-bearing loan of one year or less from a commercial bank
Types of Long-Term Liabilities
Long-Term Debts:
loans that have maturities of longer than one year
Capital Leases:
long-term, noncancelable leases whereby the owner receives payments that
cover the cost of the equipment plus a return on investment in the equipment
Off-Balance-Sheet Financing: Operating Leases
Operating Leases:
provide maintenance in addition to financing and are also usually cancelable
• Computers, copiers, and automobiles are often financed through operating
leases
• Balance sheet impact: for operating leases, no assets or lease liabilities are
recorded on the balance sheet
Basic Income Statement Terms and Concepts (1 of 2)
Income Statement:
financial statement that reports the revenues generated and expenses incurred
over an accounting period
Sales or Revenues:
funds earned from selling a product or providing a service
Gross Earnings:
net sales (after deducting returns and allowances) minus the cost of production
Basic Income Statement Terms and Concepts (2 of 2)
Operating Income or Earnings Before Interest and Taxes (EBIT):

indicates a firm’s profit after operating expenses, excluding financing costs, have
been deducted from net sales
Net Income (or Profit):
bottom line measure after all operating expenses, financing costs, and taxes
have been deducted from net sales
Internal Operating Schedules
Cost of Production Schedule

important for preparing the income statement
Cost of Goods Sold Schedule
important for preparing the income statement
Inventories Schedule
important for preparing the balance sheet
Statement of Cash Flows: Definition and Use
Statement of Cash Flows:

shows how cash, reflected in accrual accounting, flowed into and out of a firm
during a specific period of operation
Can be used to determine if a venture has been building or burning cash
“Net Cash Burn” occurs when the sum of cash flows from “operations” and
“investing” is negative
MPC Income Statements
Table 5.1 MPC Income Statements for Years Ended 2018 and 2019
2018 2019
Net sales $438,000 $575,000
−Cost of goods sold −285,000 −380,000
Gross profit 153,000 195,000
−Administrative expenses −45,000 −65,000
−Marketing expenses −32,000 −39,000
−Research and development −20,000 −27,000
−Depreciation − 14,000 −17,000
EBIT 42,000 47,000
−Interest expense − 12,000 −20,000
Income before taxes 30,000 27,000
−Income taxes (30% rate) −9,000 −8,000
Net income $ 21,000 $ 19,000
MPC Balance Sheets
Table 5.2 MPC Balance Sheets for Years Ended 2017, 2018 and 2019
2017 2018 2019
Assets
Cash and marketable securities $ 10,000 $ 10,000 $ 5,000
Receivables 60,000 75,000 105,000
Inventories 70,000 95,000 140,000
Total current assets 140,000 180,000 250,000
Gross plant and equipment 205,000 205,000 255,000
Less: accumulated depreciation −28,000 −42,000 −59,000
Net plant and equipment 177,000 163,000 196,000
Total assets $317,000 $343,000 $446,000
Liabilities and Equity
Payables 47,000 57,000 84,000
Short-term bank loan 40,000 44,000 110,000
Accrued liabilities 8,000 9,000 10,000
Total current liabilities 95,000 110,000 204,000
Long-term debt 100,000 90,000 80,000
Owners’ equity 122,000 143,000 162,000
Total liabilities and equity $317,000 $343,000 $446,000
MPC Statements Of Cash Flow
Table 5.1 MPC Income Statements for Years Ended 2018 and 2019
2018 2019
Cash Flow from Operating Activities
Net Income $21,000 $19,000
+ Depreciation 14,000 17,000
− Increase in receivables −15,000 −30,000
− Increase in inventories −25,000 −45,000
+ Increase in payables 10,000 27,000
+ Increase in accrued liabilities 1,000 1,000
Net Cash Flow from Operations 6,000 −11,000
Cash Flow from Investing Activities
− Increase in gross equipment 0 −50,000
Net Cash Flow from Investing Activities 0 −50,000
Cash Flow from Financing Activities
+ Increase in short-term bank loan 4,000 66,000
− Decrease in long-term debt −10,000 −10,000
Net Cash Flow from Financing −6,000 56,000
Net Change Excluding Cash Account 0 −5,000
Beginning Cash and Marketable Securities 10,000 10,000
Ending Cash and Marketable Securities $10,000 $ 5,000
Operating Breakeven Analysis: Basic Terms (1 of 2)
Variable Expenses:
costs or expenses that vary directly with revenues
Fixed Expenses:
costs that are expected to remain constant over a range of revenues for a
specific time period
EBITDA:
earnings before interest, taxes, and depreciation & amortization
Operating Breakeven Analysis: Basic Terms (2 of 2)
EBDAT:
earnings before depreciation, amortization, & taxes
EBDAT Breakeven:
amount of revenues (survival) needed to cover cash operating expenses
Cash Flow Breakeven:
cash flow at zero for a specific period (EBDAT = 0)
Survival Breakeven Analysis: Some Basics
Basic Equation:
EBDAT = Revenues (R) − Variable Costs (VC) − Cash Fixed Costs (CFC)
Where:
CFC includes both fixed operating (e.g., general and administrative, and possibly
marketing expenses) and fixed financing (interest) costs
When EBDAT is Zero:
R = VC + CFC
Solving for Breakeven Level of Survival Revenues
Starting Point:
Ratio of variable costs (VC) to revenues (R) is a constant (VC/R) and is called
the Variable Cost Revenue Ratio (VCRR)
Survival Revenues (SR) = VC + CFC
Rewriting, CFC = SR − VC
By substitution, CFC = SR[1 − (VCRR)]
Solving for SR,
Survival Revenues Breakeven: An Example (1 of 3)
If the PSA venture were expecting:
Revenues = $1,000,000
Cost of Goods Sold = $650,000
Administrative Expenses = $200,000
Marketing Expenses = $180,000
Depreciation Expenses = $100,000
Interest Expenses = $20,000
Tax Rate = 33%
Note: only Cost of Goods Sold is expected to vary directly with Sales
Check:
Survival Revenues $1,143,000
Cost of Goods Sold (65%) −743,000
Gross Profit 400,000
Administrative Expenses −200,000
Marketing Expenses −180,000
Interest Expenses −20,000
EBDAT $0
Graphically
FIGURE 4.2 EBDAT Breakeven Chart for PAS Corporation (Where Variable
Costs Are 65 Percent of Revenues)
Variable Costs at 60% of Revenues
FIGURE 4.3 EBDAT Breakeven Chart for PAS Corporation (Where Variable
Costs Are 60 Percent of Revenues)
Identifying Breakeven Drivers in Revenue
Projections (1 of 2)
1. Contribution Profit Margin = 1 − VCRR
higher contribution profit margins mean lower levels of survival revenues are
needed to break even (EBDAT = 0)
Example:
Assume cash fixed costs are $400,000 & the VCRR declines from 65% to 60%
 A  : SR = $400,000 (1 − .65 ) = $1,143,000
B : SR = $400,000 (1 − .60 ) = $1,000,000
Identifying Breakeven Drivers in Revenue
Projections (2 of 2)
2. Amount of Cash Fixed Costs
lower cash fixed costs result in lower levels of survival revenues needed to
breakeven (EBDAT = 0)
Example:
Assume cash fixed costs decline from $400,000 to $350,000 and the VCRR is
65%
 A  : SR = $400,000 (1 − .65 ) = $1,143,000
B: SR = $350,000 (1 − .65 ) = $1,000,000
NOPAT Breakeven: Terms & Concepts (1 of 2)
Economic Value Added (EVA):

measure of a firm’s economic profit over a specified time period
NOPAT:
net operating profit after taxes or EBIT times one minus the firm’s tax rate
NOPAT Breakeven Revenues (NR):
amount of revenues needed to cover a venture’s total operating costs
NOPAT Breakeven: Terms & Concepts (2 of 2)
Basic Equation:
NR = TOFC (1 − VCRR )
Where:
TOFC is the total operating fixed costs which consist of cash operating fixed
costs (excluding interest expenses) plus noncash fixed costs (e.g., depreciation)
NOPAT Breakeven: An Example (1 of 2)
Note: Find the NOPAT Breakeven Revenues (NR) for the PSA venture example
NR = ( $200,000 + $180,000 + $100,000 ) (1 − $650,000 / $1,000,000 ) = $480,000 .35 = $1,371,000 rounded
NOPAT Breakeven: An Example (2 of 2)
Check:
Revenues $1,371,000
Cost of Goods Sold (65%) −891,000
Administrative Expenses −200,000
Marketing Expenses −180,000
Depreciation −100,000
EBIT $0
NOPAT = [$0 × (1 − .33)] = $0

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Chapter 4

Preparing and Using Financial

Generally Accepted Accounting Principles (GAAP):

Listing Order of Assets:

Operating Income or Earnings Before Interest and Taxes (EBIT):

Cost of Production Schedule

Statement of Cash Flows:

If the PSA venture were expecting:

Economic Value Added (EVA):

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