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Chapter 4: Preparing and Using Financial Statements 56

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.
57 Chapter 4: Preparing and Using Financial Statements

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.
Chapter 4: Preparing and Using Financial Statements 58

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 Chapter 4: Preparing and Using Financial Statements

1. [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) $1,000 (100,000 shares times $.01)
Additional paid-in-capital $99,000
Total stockholders’ equity $100,000

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 $100,000
Common stock additional investment $100,000 (20,000 shares times $5)
Total stockholders’ equity $200,000

Assumption (with par value):


Common stock ($.01 par value) $1,200 (120,000 shares times $.01)
Additional paid-in-capital $198,800
Total stockholders’ equity $200,000

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-in-
capital 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) $1,200


Additional paid-in-capital $198,800
Retained Earnings -$80,000
Total stockholders’ equity $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
Chapter 4: Preparing and Using Financial Statements 60

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 January February March
Production (units) 500 500 500
Production costs
Computer chips $70 $35,000 $35,000 $35,000
Plastic casings 15 7,500 7,500 7,500
Assembly hardware 5 2,500 2,500 2,500
Direct labor 5 2,500 2,500 2,500
Total costs $95 $47,500 $47,500 $47,500

C. 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 February March Total
Sales (units) 200 400 800 1,400
Costs @ $95/unit $19,000 $38,000 $76,000 $133,000

Gross Earnings Estimate:


Sales (dollars) $28,500 $57,000 $114,000 $199,500
Less: cost of goods sold 19,000 38,000 76,000 133,000
61 Chapter 4: Preparing and Using Financial Statements

Gross earnings $9,500 $19,000 $38,000 $66,500

D. Prepare an inventories schedule for January, February, and March.

Inventories Schedule:
January February March
Beginning finished goods $0 $28,500 $38,000
Production
Materials $45,000 $45,000 $45,000
Direct labor 2,500 2,500 2,500
Additions 47,500 47,500 47,500
Total (beg. + additions) 47,500 76,000 85,500
Less: cost of goods sold 19,000 38,000 76,000
Ending finished goods $28,500 $38,000 $9,500

3. [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 $70


Plastic casings 15
Assembly hardware 5
Direct labor ($15/3) 5
Total costs $95

Mark-up = $95(1.5) = $142.50


Dollar Sales:
April : 800 units x $142.50 = $114,000
May : 1,100 units x $142.50 = $156,750
June: 1,100 units x $142.50 = $156,750
Second Quarter $427,500

B. Prepare a cost of production schedule for April, May, and June.

Cost of Production Schedule:


Cost
Per Unit April May June
Production (units) 1,000 1,000 1,000
Production costs
Computer chips $70 $70,000 $70,000 $70,000
Plastic casings 15 15,000 15,000 15,000
Assembly hardware 5 5,000 5,000 5,000
Chapter 4: Preparing and Using Financial Statements 62

Direct labor 5 5,000 5,000 5,000


Total costs $95 $95,000 $95,000 $95,000

C. 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 May June Total
Sales (units) 800 1,100 1,100 3,000
Costs @ $95/unit $76,000 $104,500 $104,500 $285,000

Gross Earnings Estimate:


Sales (dollars) $114,000 $156,750 $156,750 $427,500
Less: cost of goods sold 76,000 104,500 104,500 285,000
Gross earnings $38,000 $52,250 $52,250 $142,500

D. Prepare an inventories schedule for April, May, and June.

Inventories Schedule:
April May June
Beginning finished goods $9,500 $28,500 $19,000
Production
Materials $90,000 $90,000 $90,000
Direct labor 5,000 5,000 5,000
Additions 95,000 95,000 95,000
Total (beg. + additions) 104,500 123,500 114,000
Less: cost of goods sold 76,000 104,500 104,500
Ending finished goods $28,500 $19,000 $9,500

4. [Survival Revenues Breakeven] During its first year of operations, the SubRay Corporation
produced the following income statement results:

Net Sales $300,000


Cost of Goods Sold -180,000
Gross Profit 120,000
General & Administrative -60,000
Marketing expenses -60,000
Depreciation -20,000
EBIT -20,000
Interest expenses -10,000
Earnings before taxes -30,000
Income taxes -0
Net earnings (loss) $-30,000
63 Chapter 4: Preparing and Using Financial Statements

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 $325,000
Cost of goods sold (60%) -195,000
Gross Profit 130,000
General and administrative -60,000
Marketing -60,000
Interest expenses -10,000
EBDAT $0

B. 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 2016

Cash $50,000 $20,000


Accounts Receivables 200,000 280,000
Chapter 4: Preparing and Using Financial Statements 64

Inventories 400,000 500,000


Total Current Assets 650,000 800,000
Gross Fixed Assets 450,000 540,000
Accumulated Depreciation -100,000 -140,000
Net Fixed Assets 350,000 400,000
Total Assets $1,000,000 $1,200,000

Accounts Payable $130,000 $160,000


Accruals 50,000 70,000
Bank Loan 90,000 100,000
Total Current Liabilities 270,000 330,000
Long-Term Debt 300,000 400,000
Common Stock ($.01 par) 150,000 150,000
Additional Paid-in-Capital 200,000 200,000
Retained Earnings 80,000 120,000
Total Liabilities & Equity $1,000,000 $1,200,000

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


65 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 -90
Net from Investing Activities -90

Cash from Financing Activities:


Increase in bank loan 10
Increase in long-term debt 100
Cash dividends paid -35
Net from Financing Activities 75
Total net cash increase (decrease) -30

Cash at beginning of period 50


Total net cash increase (decrease) -30
Cash at end of period 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 2016
Net Sales $900,000 $1,500,000
Cost of Goods Sold -540,000 -900,000
Gross Profit 360,000 600,000
Marketing -90,000 -150,000
General & Administrative -250,000 -250,000
Chapter 4: Preparing and Using Financial Statements 66

Depreciation -40,000 -40,000


EBIT -20,000 160,000
Interest -45,000 -60,000
Earnings Before Taxes -65,000 100,000
Income Taxes 0 -25,000*
Net Income (Loss) -$65,000 $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.


67 Chapter 4: Preparing and Using Financial Statements

CASTILLO PRODUCTS COMPANY


Part A: % of Net Sales:
Income Statements ($ Thousands) 2015 2016 2015 2016
Net sales 900 1500 100.0% 100.0%
Less: Cost of goods sold 540 900 60.0% 60.0%
Gross profit 360 600 40.0% 40.0%
Less: Marketing 90 150 10.0% 10.0%
Less: General & Administrative 250 250 27.8% 16.7%
Less: Depreciation 40 40 4.4% 2.7%
EBIT -20 160 -2.2% 10.7%
Less: Interest 45 60 5.0% 4.0%
Income before taxes -65 100 -7.2% 6.7%
Less: Income taxes 0 25 0.0% 1.7%
Net income -65 75 -7.2% 5.0%
Part B:
Cash Fixed Costs:
General & Administrative 250
Interest Expenses 45
Total Cash Fixed Costs 295
Variable Expenses:
Cost of Goods Sold 60.0% of NS
Marketing 10.0% of NS
Total Operating Variable Expenses 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