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MGT602 - Entrepreneurship - Lecture Handout 41

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DECISIONS (Continued….)


The entrepreneur may need to borrow funds to finance assets and meet cash needs. Fixed assets are usually financed by long-term debt borrowed from a bank. Alternatives include borrowing from family members, having partners contribute more funds or selling corporate stock. Many of these options require the entrepreneur to give up some equity.


An interim income statement helps to compare the actual with the budgeted amount for that period. The most effective use of the interim income statement is to establish cost standards and compare the actual with the budgeted amount for that time period. Costs are budgeted based on percentages of net sales. These percentages can be compared with actual percentages to see where tighter cost controls may be necessary. This lets the entrepreneur manage and control costs before it is too late. In later years, it is also helpful to look back on the first year of operation and make comparisons month-to-month. When expenses or costs are much higher than budgeted, the entrepreneur may need to determine the exact cause. Comparison of actual and budgeted expenses can be misleading for ventures with multiple products or services. For financial reporting purposes, the income statement summarizes expenses across all products and services.
This does not indicate the marketing cost for each product nor should the most profitable product. Allocating expenses over product lines be done as effectively as possible to avoid arbitrary allocation of costs.


The entrepreneur will be required to withhold federal and state taxes for employees and make deposits to the appropriate agency. Federal taxes, state taxes, social security, and Medicare are withheld from employees’ salaries and are deposited later. The entrepreneur should be careful not to use these funds. The new venture may also be required to pay state and federal unemployment taxes. Federal and state governments will require the entrepreneur to file end-ofthe-
year returns of the business.

RATIO ANALYSIS Calculations of financial ratios can also be valuable as an analytical and control mechanism. These ratios serve as a measure of the financial strengths and weaknesses of the venture, but should be used with caution. There are industry rules of thumb that the entrepreneur can use to interpret the financial data.

Liquidity Ratios Current ratio is commonly used to measure the short-term solvency of the venture or its ability to meet its short-term debts. The current liabilities must be covered from cash or its equivalent. The formula is:

Current ratio

While a ratio of 2:1 is generally considered favorable the entrepreneur should also compare this ratio with industry standards.

Acid test ratio is a more rigorous test of the short-term liquidity of the venture.

It eliminates inventory, which is the least liquid current asset.
The formula is:

Acid test

Usually a 1:1 ratio would be considered favorable.

Activity Ratios

Average collection period indicates the average number of days it takes to convert accounts receivable into cash.
This ratio helps gauge the liquidity of accounts receivable or the ability of the venture to collect from its customers.
The formula:

Average collection

This result needs to be compared to industry standards.

Inventory turnover measures the efficiency of the venture in managing and selling its inventory. A high turnover is a favorable sign indicating the venture is able to sell its inventory quickly.


Debt ratio helps the entrepreneur assess the firm’s ability to meet all its obligations. It is also a measure of risk because debt also consists of a fixed commitment. The calculation:

Debt ratio

Debt to equity ratio assesses the firm’s capital structure. It provides a measure of risk by considering the funds invested by creditors and investors. The higher the percentage of debt, the greater the degree of risk to any of the creditors the calculation:

Debt to

Profitability Ratios Net profit margin represents the venture’s ability to translate sales into profits. You can also use gross profit as another measure of profitability. It is important to know what is reasonable in the particular industry as well as to measure these ratios over time. The calculation:

Net profit

Return on investment measures the ability of the venture to manage its total investment in assets. By substituting stockholders’ equity for assets, you can also calculate a return on equity.

The calculation:

Return on

The result of this calculation will also need to be compared to industry data. As the firm grows it will be important to use these ratios in conjunction with all other financial statements to provide an understanding of how the firm is performing.


Rapid growth may result in management problems. Before rapid growth occurs, the new venture is usually operating with a small staff and limited budget. Rapid growth may also dilute the leadership abilities of the entrepreneur. The entrepreneur’s unwillingness to delegate responsibility can lead to delays in decision-making. The entrepreneur can avoid these problems through preparation and sensitivity. It may be necessary to limit the venture’s growth if the future financial well being of the venture means a more controlled growth rate. The limits to the growth of any venture will depend on the availability of a market, capital, and management talent. Too rapid growth can stretch these limits and lead to serious financial problems.


In the early stages, the entrepreneur should focus on developing awareness of the products offered through:

  1. Publicity
  2. Internet Advertising
  3. Trade Shows
  4. Selecting an Advertising Agency

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