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Chapter 4: Preparing and Using Financial Statements

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Chapter 4 PREPARING AND USING FINANCIAL STATEMENTS

DISCUSSION QUESTIONS AND ANSWERS 1. Describe the types of resources (assets) needed for a new product venture during its development and startup stages. Comment on the likely revenues and expenses during these early life cycle stages. Refer to: Figure 4.1 Obtaining and Recording the Resources Necessary to Start and Build a New Venture Development Stage in Life Cycle: Assets: acquire initial assets (e.g., initial cash, office furniture, computer, etc.) Revenues: no sales (consequently no money is coming in) Expenses: e.g., rent, utilities, subsistence salary for entrepreneur Startup Stage in Life Cycle: Assets: acquire production assets (e.g., inventories and equipment to produce products and give credit to customers) Revenues: making sales (money begins flowing in) Expenses: additional expenses to produce and market products and to record business transactions 2. What is accrual accounting? What are generally accepted accounting principles (GAAP)?

Accrual accounting is the practice of recording economic activity when it is recognized  rather than waiting until it is realized.       Generally accepted accounting principles (GAAP) are guidelines that set out the manner  and form for presenting accounting information. 3. What is meant by the statement that a balance sheet provides a “snapshot” of a venture’s financial position as of a point in time? Why must a balance sheet be in “balance?” A balance sheet is known as a “snapshot” because it is the value of all the accounts at a certain point in time. A balance sheet must be in balance because the amount of total assets must be equivalent to the sum of the firm’s total liabilities and the owner’s equity. 4. Briefly describe the typical types of accounts that are found in the current assets of a new venture. Typical current asset accounts are cash, which includes cash accounts and marketable securities, accounts receivable, inventory and other current assts.

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5. What is meant by the terms “depreciation” and “accumulated depreciation”? Depreciation refers to the amount of decrease in value of the firm’s long-term depreciable assets based on a preset schedule of the individual assets. Accumulated depreciation is the accrued amount of depreciation the firm has on its existing assets. 6. What types of liabilities might show up on a venture’s balance sheet? Liabilities might include: payables, accrued wages, bank loan, other current liabilities, long-term debts, and capital leases. 7. What does an income statement measure or track over time? The income statement is a performance measure of a firm’s operations over a period of time. Many different accounts that make up the income statement are used to determine trends in costs and revenues. 8. Define the term “EBIT.” How does EBIT differ from a firm’s net income or net profit? EBIT is defined as the earnings of a company before accounting for any interest expense/income and the taxes to be paid. Net income results from subtracting interest expense and taxes from EBIT. 9. What are the three internal operating schedules that most firms must prepare? The three internal operating schedules prepared by most firms are the “cost of production schedule”, the “cost of goods sold schedule” and the “inventories schedule.” 10. Briefly describe what is meant by a statement of cash flows. A statement of cash flows shows how cash, as reflected in accrual accounting, flowed into and out of a company during a specific period of operation. 11. What is meant by net cash build and net cash burn? Net Cash Build: exists when the sum of cash flows from operations and investing is positive Net Cash Burn: occurs when the sum of cash flows from operations and investing is negative 12. Describe the differences between variable expenses and fixed expenses. Variable expenses depend upon the level of production while fixed expenses are items that are independent from production levels and will be incurred regardless.

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13. Define the term EBITDA. The acronym EBITDA stands for earnings before interest, taxes, depreciation, and amortization. 14. What is a venture’s contribution profit margin? Contribution profit margin is the portion of the sale of a product that contributes to covering the fixed costs. 15. Define the term EBDAT. EBDAT is a firm’s earnings before taxes, depreciation and amortization. 16. Describe the meaning of EBDAT breakeven and survival revenues. EBDAT breakeven occurs when the firm’s survival revenues cover all of its cash expenses. 17. Describe and illustrate how an EBDAT (survival) breakeven chart is constructed. Refer to Figure 4.2. Costs and revenues are plotted on the vertical axis and revenues (in dollars and/or units) are plotted on the horizontal axis. Breakeven (in dollars or unit sales) exists when the total costs curve and the total revenues curve intersect or cross. 18. What is meant by breakeven drivers? Identify two important drivers affecting the amount of revenues needed for ventures to break even. Breakeven drivers are key elements of the firm’s financial statements that affect breakeven. Two important drivers are the VCRR/contribution profit margin and the amount of fixed costs.

19. From the Headlines -- “Competing to Let the Light Shine”: Describe three financial performance measures that d.light’s venture investors might use to examine whether d.light is measuring up financially as it achieves its “lives touched” goals. Answers will vary widely: Margins (revenues vs. costs) will be critical in providing the necessary internal capital to fund d.light’s growth. In terms of overall efficiency, d.light will need to monitor its inventory levels and breakeven levels as it introduces new products or enhances the functionality of existing ones. With venture capital backers, d.light has no choice other than to watch all of the usual financial return measures (Net Income, growth of Net Income, and returns to investors). EXERCISES/PROBLEMS

59 1.

Chapter 4: Preparing and Using Financial Statements [Stockholders’ equity] The owners of a new venture have decided to organize as a corporation. The initial equity investment is valued at $100,000 reflecting contributions of the entrepreneur and her family and friends. One hundred thousand shares of stock were initially issued. A. What dollar amount would initially be recorded in the common stock account? Common stock (initial investment)

$100,000

B. If a par value on the common stock was set at $.01 per share, show how the initial equity investment would be recorded. Common stock ($.01 par value) Additional paid-in-capital Total stockholders’ equity

$1,000 $99,000 $100,000

(100,000 shares times $.01)

C. Now assume that 20,000 additional shares of stock are sold to an angel investor at $5 per share six months after the initial incorporation. Show how your answer in Part A would change if the common stock did not have a par value. Also show how your answer in Part B would change given a par value of $.01 per share. Assumption (no par value): Common stock initial investment Common stock additional investment Total stockholders’ equity

$100,000 $100,000 $200,000

Assumption (with par value): Common stock ($.01 par value) Additional paid-in-capital Total stockholders’ equity

$1,200 $198,800 $200,000

(20,000 shares times $5)

(120,000 shares times $.01)

D. At the end of the first year of operation, the venture recorded an operating loss of $80,000. Show the dollar amounts in the common stock account, the additional paid-incapital account, and the retained earnings account at the end of one year. Also indicate the cumulative amount in stockholders’ equity at the end of one year. Common stock ($.01 par value) Additional paid-in-capital Retained Earnings Total stockholders’ equity

$1,200 $198,800 -$80,000 $120,000

2. [Internal Operating Schedules] Assume you have developed and tested a prototype electronic product and are about to start your new business. You purchase pre-programmed computer chips at $70 per unit. Other component costs include: plastic casings at $15 per unit and assembly hardware at $5 per unit. Direct labor costs are $15 per hour and three units can

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be produced per hour. You intend to sell each unit at a 50 percent mark-up over the total costs of producing each unit. The plan is to produce 500 product units per month in January, February, and March. Sales are expected to be: 200 units in January, 400 units in February, and 800 units in March. A. Calculate the dollar amount of sales revenue expected in each month (i.e., January, February, and March) and for the first quarter of the year. Computer chips $70 Plastic casings 15 Assembly hardware 5 Direct labor ($15/3) 5 Total costs $95 Mark-up = $95(1.5) = $142.50 Dollar Sales: January: 200 units x $142.50 = $28,500 February: 400 units x $142.50 = $57,000 March: 800 units x $142.50 = $114,000 First Quarter $199,500 B.

Prepare a cost of production schedule for January, February, and March. Cost of Production Schedule: Cost Per Unit Production (units) Production costs Computer chips $70 Plastic casings 15 Assembly hardware 5 Direct labor 5 Total costs $95

C.

January 500

February 500

$35,000 7,500 2,500 2,500 $47,500

$35,000 7,500 2,500 2,500 $47,500

March 500 $35,000 7,500 2,500 2,500 $47,500

Prepare a cost of goods sold schedule for each of the three months and for the first quarter of the year. Using your cost of goods sold estimates and the sales revenues expected in Part A, calculate the gross earnings for January, February, and March, as well as for the first quarter of the year. Cost of Goods Sold Schedule: January Sales (units) 200 Costs @ $95/unit $19,000

February 400 $38,000

Gross Earnings Estimate: Sales (dollars) Less: cost of goods sold

$57,000 38,000

$28,500 19,000

March 800 $76,000

Total 1,400 $133,000

$114,000 76,000

$199,500 133,000

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Chapter 4: Preparing and Using Financial Statements Gross earnings

D.

$9,500

$19,000

$38,000

$66,500

Prepare an inventories schedule for January, February, and March. Inventories Schedule: Beginning finished goods Production Materials Direct labor Additions Total (beg. + additions) Less: cost of goods sold Ending finished goods

3.

January $0

February $28,500

March $38,000

$45,000 $45,000 $45,000 2,500 2,500 2,500 47,500 47,500 47,500 47,500 76,000 85,500 19,000 38,000 76,000 $28,500 $38,000 $9,500

[Internal Operating Schedules] This problem is a continuation of Problem 3. Assume you ramp up production to 1,000 units per month in April, May, and June. Sales are expected to be 800 units in April and 1,100 units in each of May and June. Repeat the calculations requested in Problem 3 for the second quarter of the year (April, May, and June). A.

Calculate the dollar amount of sales revenue expected in each month (i.e., April, May, and June) and for the second quarter of the year. Computer chips Plastic casings Assembly hardware Direct labor ($15/3) Total costs

$70 15 5 5 $95

Mark-up = $95(1.5) = $142.50 Dollar Sales: April : 800 units x $142.50 = May : 1,100 units x $142.50 = June: 1,100 units x $142.50 = Second Quarter B.

$114,000 $156,750 $156,750 $427,500

Prepare a cost of production schedule for April, May, and June. Cost of Production Schedule: Cost Per Unit Production (units) Production costs Computer chips $70 Plastic casings 15 Assembly hardware 5

April 1,000

May 1,000

June 1,000

$70,000 15,000 5,000

$70,000 15,000 5,000

$70,000 15,000 5,000

Chapter 4: Preparing and Using Financial Statements Direct labor Total costs C.

5 $95

5,000 $95,000

5,000 $95,000

62 5,000 $95,000

Prepare a cost of goods sold schedule for each of the three months and for the second quarter of the year. Using your cost of goods sold estimates and the sales revenues expected in Part A, calculate the gross earnings for April, May, and June, as well as for the second quarter of the year. Cost of Goods Sold Schedule: April 800 $76,000

May 1,100 $104,500

June 1,100 $104,500

Total 3,000 $285,000

Gross Earnings Estimate: Sales (dollars) $114,000 Less: cost of goods sold 76,000 Gross earnings $38,000

$156,750 104,500 $52,250

$156,750 104,500 $52,250

$427,500 285,000 $142,500

Sales (units) Costs @ $95/unit

D.

Prepare an inventories schedule for April, May, and June. Inventories Schedule: Beginning finished goods Production Materials Direct labor Additions Total (beg. + additions) Less: cost of goods sold Ending finished goods

4.

April $9,500

May $28,500

June $19,000

$90,000 $90,000 $90,000 5,000 5,000 5,000 95,000 95,000 95,000 104,500 123,500 114,000 76,000 104,500 104,500 $28,500 $19,000 $9,500

[Survival Revenues Breakeven] During its first year of operations, the SubRay Corporation produced the following income statement results: Net Sales Cost of Goods Sold Gross Profit General & Administrative Marketing expenses Depreciation EBIT Interest expenses Earnings before taxes Income taxes Net earnings (loss)

$300,000 -180,000 120,000 -60,000 -60,000 -20,000 -20,000 -10,000 -30,000 -0 $-30,000

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Costs of goods sold are expected to vary with sales and be a constant percentage of sales. The general and administrative employees have been hired and are expected to remain a fixed cost. Marketing expenses are also expected to remain fixed since the current sales staff members are expected to remain on fixed salaries and no new hires are planned. The effective tax rate is expected to be 30 percent for a profitable firm. A. Estimate the survival or EBDAT breakeven amount in terms of survival revenues necessary for the SubRay Corporation to breakeven next year. Survival revenues (SR), when EBDAT = 0, are calculated as: VCRR = (VC/R) = $180,000/$300,000 = .60 CFC = general and administrative + marketing + interest expense = $60,000 + $60,000 + $10,000 = $130,000 SR = [$130,000/(1 - .60)] = $130,000/.40 = $325,000 Check: Survival revenues Cost of goods sold (60%) Gross Profit General and administrative Marketing Interest expenses EBDAT B.

$325,000 -195,000 130,000 -60,000 -60,000 -10,000 $0

Assume that the product selling price is $50 per unit. Calculate the EBDAT breakeven point in terms of the number of units that will have to be sold next year. Survival revenues (SR) for a zero EBDAT from Part A = $325,000 $325,000/ $50 = 6,500 units

5. [Statement of Cash Flows and Cash Burn or Build] Cindy and Robert (Rob) Castillo founded the Castillo Products Company in 2015. The company manufactures components for personal decision assistant (PDA) products and for other hand-held electronic products. Year 2015 proved to be a test of the Castillo Products Company’s ability to survive. However, sales increased rapidly in 2016 and the firm reported a net income after taxes of $75,000. Depreciation expenses were $40,000 in 2016. Following are the Castillo Products Company’s balance sheets for 2015 and 2016. CASTILLO PRODUCTS COMPANY 2015 Cash Accounts Receivables

$50,000 200,000

2016 $20,000 280,000

Chapter 4: Preparing and Using Financial Statements Inventories Total Current Assets Gross Fixed Assets Accumulated Depreciation Net Fixed Assets Total Assets

400,000 650,000 450,000 -100,000 350,000 $1,000,000

500,000 800,000 540,000 -140,000 400,000 $1,200,000

Accounts Payable Accruals Bank Loan Total Current Liabilities Long-Term Debt Common Stock ($.01 par) Additional Paid-in-Capital Retained Earnings Total Liabilities & Equity

$130,000 50,000 90,000 270,000 300,000 150,000 200,000 80,000 $1,000,000

$160,000 70,000 100,000 330,000 400,000 150,000 200,000 120,000 $1,200,000

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A. Calculate Castillo’s cash flow from operating activities for 2016. See spreadsheet calculations below. B. Calculate Castillo’s cash flow from investing activities for 2016. See spreadsheet calculations below. C. Calculate Castillo’s cash flow from financing activities for 2016. See spreadsheet calculations below. D. Prepare a formal statement of cash flows for 2016 and identify the major cash inflows and outflows that were generated by the Castillo Company. See spreadsheet calculations below. E. Use your calculation results from Parts A and B above to determine whether Castillo was building or burning cash during 2016 and indicate the dollar amount of the cash build or burn. See spreadsheet calculations below. F. If Castillo had a net cash burn from operating and investing activities in 2016 divide the amount of burn by 12 to calculate an average monthly burn amount. If the 2017 monthly cash burn continues at the 2016 rate, indicate how long in months it will be before the firm runs out of cash if there are no changes in financing activities. CASTILLO PRODUCTS COMPANY

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Chapter 4: Preparing and Using Financial Statements Note: Because Retained Earnings increased by only $40,000 and Net Income was $75,000, Cash Dividends paid must have been $35,000. Parts A-D: Statement of Cash Flows ($ Thousands) 2016 Cash from Operating Activities: Net income 75 Depreciation 40 Increase in accounts receivable -80 Increase in inventories -100 Increase in accounts payable 30 Increase in accrued liabilities 20 Net from Operating Activities -15 Cash from Investing Activities: Increase in gross fixed assets Net from Investing Activities

-90 -90

Cash from Financing Activities: Increase in bank loan Increase in long-term debt Cash dividends paid Net from Financing Activities Total net cash increase (decrease)

10 100 -35 75 -30

Cash at beginning of period Total net cash increase (decrease) Cash at end of period

50 -30 20

Part E: Operating activities (-15) + Investing activities (-90) = -105 (annual net cash burn) Part F: per Monthly burn rate = annual burn/12 -8.75 month Time to Out of Cash = Cash/Mthly Burn 2.3 months

6. [Variable Expenses and Survival Revenues Breakeven] The Castillo Products Company described in Problem 6 had a very difficult operating year in 2015 resulting in a net loss of $65,000 on sales of $900,000. In 2016, sales jumped to $1,500,000 and a net profit after taxes was earned. The firm’s income statements are below. CASTILLO PRODUCTS COMPANY 2015 Net Sales $900,000 Cost of Goods Sold -540,000 Gross Profit 360,000 Marketing -90,000 General & Administrative -250,000

2016 $1,500,000 -900,000 600,000 -150,000 -250,000

Chapter 4: Preparing and Using Financial Statements Depreciation EBIT Interest Earnings Before Taxes Income Taxes Net Income (Loss)

-40,000 -20,000 -45,000 -65,000 0 -$65,000

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-40,000 160,000 -60,000 100,000 -25,000* $75,000

*Includes tax loss carryforward from 2015. A. Calculate each income statement item for 2015 as a percent of the 2015 sales level. Make the same calculations for 2016. Determine which cost or expense items varied directly with sales for the two-year period? See spreadsheet calculations below. B. Use the information in Part A to classify specific expense items as being either variable or fixed expenses. Then estimate Castillo’s EBDAT breakeven in terms of survival revenues if interest expenses had remained at the 2015 level ($45,000) in 2016. See spreadsheet calculations below. C. Estimate the dollar amount of survival revenues actually needed by the Castillo Products Company to reach EBDAT breakeven in 2016 given that more debt was obtained and interest expenses increased to $60,000. See spreadsheet calculations below.

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CASTILLO PRODUCTS COMPANY Part A: Income Statements ($ Thousands) 2015 Net sales 900 Less: Cost of goods sold 540 Gross profit 360 Less: Marketing 90 Less: General & Administrative 250 Less: Depreciation 40 EBIT -20 Less: Interest 45 Income before taxes -65 Less: Income taxes 0 Net income -65

% of Net Sales: 2016 2015 2016 1500 100.0% 100.0% 900 60.0% 60.0% 600 40.0% 40.0% 150 10.0% 10.0% 250 27.8% 16.7% 40 4.4% 2.7% 160 -2.2% 10.7% 5.0% 60 4.0% 100 -7.2% 6.7% 25 0.0% 1.7% 75 -7.2% 5.0%

Part B: Cash Fixed Costs: General & Administrative Interest Expenses Total Cash Fixed Costs

250 45 295

Variable Expenses: Cost of Goods Sold Marketing Total Operating Variable Expenses

60.0% of NS 10.0% of NS 70.0% of NS

EBDAT Breakeven (interest = 45):(250 + 45)/(1 - .7) = 983.333 Part C: EBDAT Breakeven (interest = 60):(250 + 60)/(1 - .7) = 1033.333