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How To Prepare Financial Projections and Financial Plan for a Business Start Up
Let me start off by saying that anyone can put together a great financial plan.
There's a misconception out there that the only people who can put together a complete financial plan are accountants and math people. Not true. Believe me, I'm not a math person or an accountant by any means, in fact, I hated math and was scared to death of numbers.
In my mind, I was not qualified to put together a financial plan and this was the number one reason why I was so scared of the numbers game, I felt defeated even before I tried.
I think this is the number one reason why people are so intimidated by the financial part of a business plan, they've been told they can't do it so why bother. Believe me, once you understand where the numbers should go, it will all seem so easy.
And no, you don't have to be a math wizard. You simply have to understand the system that goes behind the numbers. Once you understand the system and how it fits into the overall business plan, the numbers part of the plan become so much easier.
The problem is that most people look at the financial plan as a separate entity within the business plan.
The financial plan is simply a reflection of the plan as a whole . The plan is a reflection of all the decisions you've made in your business plan. For example, all of your ongoing operational costs taken from the operations plan will be reflected in the income statement as expenses.
The revenue portion of the income statement will all be reflective of the market and pricing structure of your marketing plan and strategy.
You see, the financial plan is not a stand alone section, it flows within the plan and is simply a reflection of the whole business proposal. A lot of entrepreneurs fail to realize this and see the numbers as being on there own.
It's a lot harder to come up with numbers when you don't know where there coming from. It also makes for a very confusing task because your numbers simply won't match up.
How Important Is The Financial Plan?
Let's put it this way, the financial plan will give you an idea of whether or not your business is a viable operation. Business plan reviewers know this and will immediately go to this section. The financial plan will give an indication to the reviewer whether this operation will make money or lose money. The reviewer will take a look at the plan and from there, go to the corresponding sections. For example, if the income statement is showing a gross revenue of $87,000, the reviewer will immediately go to the marketing section and match the pricing structure with market size.
The reviewer wants to know where you got your numbers from and do they make sense with your overall market.
To the entrepreneur, numbers represent your decisions . The numbers reflect the decisions you have made previously in your business plan. For example, if you decide to advertise each week on your local radio station, there's a number attached to this decision and it will be reflected in your financial plan.
If you project a certain level of sales in your marketing plan, there will be a number attached to that decision.
Every business decision you make in your business plan leads to a number, and taken together, will form the basis for your financial plan. This is the core of any financial plan in a business plan and it is this relationship that most entrepreneurs fail to see.
Once you understand this relationship, the financial plan will become a lot easier. Just remember, you cannot pull numbers out of thin air because you need to fill in a certain space in the financial plan. Rather, your numbers should always be the result of careful planning.
With that in mind, lets' get started on your...
There are certain types of financial forms that you will be using in your financial plan. The three most important ones are:
- Income Statement or Profit and Loss - Shows whether your company is making a profit
- Cash Flow Projection - Cash incoming to your business and cash out. Shows whether or not your company has enough cash to pay its bills.
- Balance Sheet - Basically a summation of your company's worth.
These are the main forms you will be interested in using for your financial plan.
However, there are other financial forms that we will cover that are quite important in your plan. These forms are as follows:
- Break Even Point - The break even point tells you at which point sales exceeds cost and when you begin to make a profit. A great little profitability indicator.
- Cost and Financing / Start Up Costs - This will tell you what you need to start up your business. If you are looking for financing, this will outline to the investor what you are asking for.
- Assumptions - It is important to always explain your numbers. Your assumptions will show those reading your plan how you determined the figures used.
- Pertinent Ratios - These will be used to analyze the condition of your company and make some sense of your numbers.
When you are completing your financial plan, you will want to remember the time frames involved. Generally, investors want to see financial projections for three to five years.
I think 3 years is plenty unless your business is very high capital and will not see a profit for 5 years, such as a mining operation.
As such, we'll stick to 3 years of project financial information. Here are the time frames you'll want to cover in your project financial statements.
Income Statement - First year: monthly. Years two and three: Yearly.
Cash Flow - First year: monthly. Years two and three. Yearly.
Balance Sheet - Years one, two and three: Yearly.
Here are some guidelines you will want to remember when you are preparing your financial plan.
Honest Projections. You will always have to justify your numbers. Don't over inflate your numbers to impress the reader. An experienced business plan analyst can sense dishonest figures and will always want to know where you got your numbers from. Keep your figures honest!
Here's an example. I had this one client who was a brand new start up. His business was window washing. In his first year, he projected $700,000 in sales. This figure was simply outrages since his market didn't justify anywhere near this number.
Based on his market size and competition, he would be lucky to make $60,000 the first year. The only way he might have attained the $700,000 revenue was with huge, guaranteed contracts. He was new to the market and didn't know anyone!
When I asked him how he got this number, he replied that he could get over 50% of the market in his first year. The plan didn't justify this statement and I knew his projections were a myth. His false projections stalled the project for months because he refused to adjust his figures based on the current market.
Be Conservative. Always go with the conservative approach. Don't be tempted to paint too much of a rosy picture for your business. Tell it like it is and you'll gain more credibility from the reader.
Use Standardized Financial Sheets. Don't get fancy when you are preparing your financial plan. Don't use shades or pretty colours. Use standardized forms and avoid clutter. Your financial statements must be clear and easy to read.
Make Sure You Choose The Appropriate Accounting Method. Decide which method of accounting you want to use; Cash or Accrual.
Cash accounting is exactly what it means. You record the transaction when you get the cash. For example, if you made a sale for $500 in January and you get paid in March, you would record that transaction for March.
Accrual accounting is when you record income and expenses when they were originally transacted. For example, If you made a sale for $500 in January, you would record it in January regardless of when you received the cash.
Personally, I prefer the accrual method of accounting. I find it a little easier to work with.
Be Consistent. Use one method for all of your accounts, otherwise you might end up comparing apples and oranges. Trust me, it will make your life a lot easier later on.
The real key to making a financial forecast is to get as much factual information as possible on the market potential and total costs of your proposed product or service. Remember, always be realistic in making your assumptions.
The purpose of the financial section of a business plan is to formulate a credible, comprehensive set of projections reflecting the company's anticipated financial performance. If these projections are carefully prepared and convincingly supported, they become one of the most critical yardsticks by which the business's attractiveness is measured.
While the rest of the business plan communicates a basic understanding of the nature of the operation, projected financial statements addresses bottom line interest. It is here that the investor discovers what sort of return he or she should anticipate, and the lender learns about the borrower's capacity to service debt.
The first thing you have to remember is the importance of reliable data. The quality of research is directly reflected in the accuracy of the projections. It will also make your job at projecting your financial data much, much easier.
Further, the reviewer will likely do his or her own investigation and evaluation in order to assess the validity of these projections.
Yes, the reviewer will do their own calculations to see if your projections are accurate. So, make sure you have sound explanations in your assumptions to back up all of your numbers.
The financial plan, properly prepared, can be used to assess performance after the business actually starts. In some cases, the financial plan may be the basis for a detailed operating budget.
Ok, let's go over the basics of your financial plan.
The Projected Income Statement
The income statement is also called the profit and loss statement or income and expense statement. This statement shows how profitable your company is. That is, how much money your business will make after all expenses are accounted for.
An income statement shows the profit and loss performance of a business over a given time period, usually a year. Remember that the income statement does not give a total picture of what your company is worth overall or it's cash position. For example, a company can be profitable but still not have enough cash to pay its bills.
An income statement is read from top to bottom. The first line accountants for sales. Each line thereafter represents deductions from sales. The result is a profit or loss.
To prepare an income statement, you will need to gather detailed information about your sales and expenses. Your income statement will detail the business's revenues and expenses on the following topics:
- What is your projected sales growth? This is the total sales from all products or services. Consider seasonal trends;
- What about additional expenses, overheads and production costs associated with a projected increase in sales? Examples: High sales commissions, increased labour costs, rent for storage space to handle increased inventory;
- Have you considered other costs associated with the purchase of any new equipment in addition to the purchase price? Examples: Installation, financing, production, business interruption and depreciation;
- If new loans are part of your plan, have you considered the added interest expense? Is the projected interest rate reasonable?
I've included an example of an income statement using our fictional company: Terra Engineering.
The Cash Flow Statement
The cash flow analysis will probably be the most important financial assessment you can do. Yes, it's that important. After all, if you can't pay your bills and employees, you're not going to be around very long.
It's important that you understand that the cash flow statement is not about profit. It's about how much cash you have in the bank. The cash flow statement can be boiled down to one statement:
How Much Cash Is Going In And How Much Cash Is Going Out
It doesn't tell you whether your company will show an overall profit at the end of the year or how many orders you place, but instead gives you an actual picture of the money going in and out of your business.
Cash Flow Statement vs The Income Statement
There is a basic distinction between a projected monthly cash flow and monthly income statement. The monthly cash flow shows all cash receipts (incoming cash) the business expects to receive from every source and all cash payment (outgoing cash) the business expects to make.
The monthly income statement shows sales made and expenses to be incurred over a period of time. In many cases the monthly and annual income statement will record income before cash has actually been received.
It does not show a change in the cash position of the business, and does not necessarily show all cash transactions, such as additional investment by the owner, dividends or payment on long term debt.
The following example shows the difference between these two financial tools:
If you expect to sell $100 worth of goods in March and receive payment in cash at the time of sale, the $100 will appear as a sales receipt in your cash flow for March.
However, if you expect to sell $100 worth of goods in March on 30 day terms and collect the $100 in April, the $100 will appear as a sale in your March income statement but will not appear as a cash receipt in your cash flow until April.
In summary, the monthly income statement will
provide an estimate of the profitability over a period of time. It
cannot indicate what form that profitability will take.
Specifically, will the profit show up in cash? Or in receivables? The monthly income statement will not indicate whether there will be sufficient cash during the period to meet the obligations of the business.
The purpose of a cash flow is to determine, as closely as possible, just how much cash is needed to meet obligations.
Since only cash payments and receipts are recorded, not promises, and not ultimate profitability, the cash flow budget will show the actual flow of cash through the business.
With this information you will be in a position to know whether you have enough funds to make planned capital expenditures and to pay suppliers when bills are due; whether extended credit terms are necessary, or whether you need a new or increased line of credit.
You will probably be using these items in your projected cash flow:
Cash Sales. Sales made for immediate payment or prepayments.
Collections. Income collected from sales made in previous periods.
Loans and Funding Sources. Some sources will not tell you to include these items but I prefer to see them and it gives a true sense of incoming cash. Include bank loans and other interest bearing items.
Other Incoming Cash Items. This can include interest income, payment for travel, share purchases etc.
Cost of Sales. Actual payments made on items in this category.
Operating Expenses. Usually items taken from the income statement. Remember that depreciation is not an actual cash payment and should not be included here. Actual payments made on items in this category, minus depreciation.
Reserve. Money put into accounts for the future. A sort of contingency fund.
Drawings. Money paid to owner in lieu of a salary in a proprietorship. If it is a corporation it will be called a dividend.
Net Cash Flow. Money left over after all disbursements have been deducted from all cash received.
Opening Cash Balance. Amount of money in the bank at the beginning of the month being evaluated; should be the same as the previous months ending cash balance.
When you are preparing your projected cash flow statement, make sure that your first year is broken down monthly. Years 2 and 3 can be done yearly. The following example is broken down firstly by the month and than yearly after that.
Once you've finished looking at the monthly cash flow for year 1, click the line called "projected yearly cash flow statement of the sources and uses of funds".
I've included an example of the cash flow statement using our fictional company: Terra Engineering:
Let's move onto the balance sheet...
Preparing The Balance Sheet
The balance sheet is probably the least understood of the financial statements. For those of you who have no clue what the balance sheet means, don't worry, it's not as confusing as it's made out to be.
Basically, the balance sheet gives a snapshot of the overall financial worth of the company including the value of all its various components and the extent of it's obligations. It is an overall look at the financial position of a business at a particular point in time.
The balance sheet shows what the company owns, what it owes and its net worth on the date when the balance sheet was prepared. It accounts for all the company's assets minus all the company's liabilities. The remaining amount is figured to be the net worth of the company.
Most entrepreneurs rarely view the balance sheet as a planning document, however, bankers and investors rely on the balance sheet to give them a fuller picture of the company's value. Only on the balance sheet can one see the worth of existing property and equipment.
Some companies own valuable land or buildings that far exceed the income of the business; others own costly equipment. Other companies may be very profitable but heavily in debt.
To the reviewer, the balance sheet provides him
or her with answers as to how your company is going to look now and in
the future. How much debt are you handling? Can you service the debt?
How fast can you liquidate assets? Are you making a good return on all
of your investments?
These are just some of the questions that a reviewer will have and the balance sheet will serve to answer.
When you prepare the balance sheet statement, consider the assumptions underlying your financial plans and their effect on assets, liabilities and owners' and shareholders equity (your investment plus accumulated profits).
- Do accounts receivable reflect your current
policy? For example, if your terms are net 30 days, are your customers
paying within 30 days? Should you be allowing for 45 days in your plan
to reflect real experience?
- Do you have enough inventory to fill planned orders?
- Have you adjusted figures for fixed assets and accumulated
depreciation to reflect any plans for adding equipment or leaseholds?
- For long term debt, such as mortgages or debentures, what is the current portion of the principle to pay each month?
- Do trade payables reflect your established arrangements with suppliers? For example, do you usually pay within 35 days?
- Have retained earnings been adjusted monthly to reflect planned profits or losses carried forward from the income statement?
- Are there any hidden values in your balance sheet? Be sure to inform your banker of market values of assets such as land, stocks, bonds, and licenses.
I've included an example of the balance sheet statement using our fictional company: Terra Engineering.