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ChapterChapter1010

The Financial PlanThe Financial Plan

References:References:Hisrich, Peters and Shepherd, Hisrich, Peters and Shepherd, Entrepreneurship, Entrepreneurship, 66thth Edition, Edition, McGraw-Hill, 2005.McGraw-Hill, 2005.Cornwall, Vang and Hartman, Cornwall, Vang and Hartman, Entrepreneurial Entrepreneurial Financial Management: An Applied Approach, Financial Management: An Applied Approach, PearsonPearson Prentice-Hall, 2004.Prentice-Hall, 2004.

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Learning ObjectivesLearning Objectives

To understand financial statementsTo understand financial statements To understand why positive profits can To understand why positive profits can

still result in negative cash flows still result in negative cash flows To understand the role of budgets To understand the role of budgets To learn to prepare pro forma cash flow, To learn to prepare pro forma cash flow,

income, balance sheet, and sources and income, balance sheet, and sources and uses of funds statementsuses of funds statements

To understand and calculate the To understand and calculate the breakeven point for new venturesbreakeven point for new ventures

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The Financial PlanThe Financial Plan

Provides a complete picture of:Provides a complete picture of: How much and where the funds are coming into the How much and where the funds are coming into the

organisationorganisation Where the funds are goingWhere the funds are going How much cash is availableHow much cash is available The projected financial position of the firmThe projected financial position of the firm

Provides short-term basis for budgeting Provides short-term basis for budgeting and help prevent and help prevent (negative)(negative) cash flow cash flow problems.problems.

Explain how the entrepreneur will meet all Explain how the entrepreneur will meet all financial obligations and maintain liquidity, financial obligations and maintain liquidity, especially in the first three years.especially in the first three years.

Before developing the pro forma financials:1 Prepare operating and capital budgets.

2 Develop a sales budget.

3 Production or manufacturing budgets will provide a basis for projecting cash flows. flows. Note that:Note that:

Operating budgets focus on operating costs Operating budgets focus on operating costs ((Short termShort term). ). Capital budgets evaluate expenditures that will Capital budgets evaluate expenditures that will

impact the business for more than one year impact the business for more than one year ((Long termLong term).).

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McGraw-Hill/Irwin © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Sales BudgetSales BudgetCalculate Sales Expectations In UnitsCalculate Sales Expectations In UnitsUtilizeUtilize

Marketing ResearchMarketing Research Industry SalesIndustry Sales ExperienceExperience

Forecasting TechniquesForecasting Techniques Survey of BuyersSurvey of Buyers Sales Force OpinionsSales Force Opinions Expert OpinionsExpert Opinions Time Series AnalysisTime Series Analysis

Estimates revenue and costs of these Estimates revenue and costs of these sales, and ending inventorysales, and ending inventory

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Production/Manufacturing Production/Manufacturing BudgetBudget

Basis for projecting cash flows for cost Basis for projecting cash flows for cost of goods producedof goods produced

Includes actual production required each Includes actual production required each month and needed inventory month and needed inventory to respond to respond to changes in demand to changes in demand

reflects seasonal demand or marketing reflects seasonal demand or marketing programs which increases demand and programs which increases demand and needed inventoryneeded inventory

Important!Important! Since pro forma income Since pro forma income statement only reflect the actual costs of statement only reflect the actual costs of goods sold, but not timing of cash goods sold, but not timing of cash receipts or expenses.receipts or expenses.

Operating and Capital BudgetsOperating and Capital Budgets

Operating BudgetOperating Budget Fixed expensesFixed expenses (incurred regardless of sales (incurred regardless of sales

volume) include rent, utilities, salaries, volume) include rent, utilities, salaries, interest payments, depreciation and interest payments, depreciation and insurance.insurance.

Variable expensesVariable expenses (changes depending on (changes depending on sales volume) e.g. advertising and selling sales volume) e.g. advertising and selling expensesexpenses

Capital BudgetCapital Budget Expenditures that impact the business Expenditures that impact the business long-long-

term,term, e.g. for more than one year e.g. for more than one year Expenditures for new equipment, vehicles, Expenditures for new equipment, vehicles,

new facilitiesnew facilities May include cost of capital and return on May include cost of capital and return on

investments (using present value methods)investments (using present value methods)

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Pro Forma StatementsPro Forma Statements

Pro Forma IncomePro Forma Income Sales Budget By MonthSales Budget By Month Expenses Are Function Of Sales LevelExpenses Are Function Of Sales Level

Pro Forma Cash FlowPro Forma Cash Flow Cash ReceiptsCash Receipts Cash PaymentsCash Payments

Pro Forma Balance SheetPro Forma Balance SheetPro Forma Sources & Applications of Pro Forma Sources & Applications of

FundsFunds

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Daily KnowledgeDaily Knowledge On Financial PositionOn Financial Position

Cash Balance On HandCash Balance On HandBank BalanceBank BalanceDaily Summaries Of Daily Summaries Of Sales/Cash ReceiptsSales/Cash Receipts

Problems In Credit Problems In Credit CollectionsCollections

Record Of Money Paid OutRecord Of Money Paid Out

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Slow-Paying Accounts Slow-Paying Accounts ReceivableReceivable

Discounts Offered On Accounts Discounts Offered On Accounts PayablePayable

Payroll- Hours Worked & Payroll Payroll- Hours Worked & Payroll OwedOwed

Taxes- When Taxes Due & Taxes- When Taxes Due & Reports RequiredReports Required

Weekly KnowledgeWeekly Knowledge On Financial PositionOn Financial Position

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Monthly KnowledgeMonthly Knowledge On Financial PositionOn Financial Position

Provide RecordsProvide Records ReceiptsReceipts DisbursementsDisbursements Bank AccountsBank Accounts JournalsJournals

ReviewReview Income StatementIncome Statement Balance SheetBalance Sheet

Reconcile Checking Reconcile Checking AccountAccount

Balance Petty Cash Balance Petty Cash AccountAccount

Review Tax Review Tax Requirements & Make Requirements & Make DepositsDeposits

Review/Age Accounts Review/Age Accounts ReceivableReceivable

To prepare a pro forma income statement:1 Calculate sales by month

(main revenue source). Based on market research, industry

sales, forecasting by surveys, etc.

2 Project operating expenses for each month of the 1st year.

3 Reference unusual expenses (e.g. trade shows) with an explanation at the bottom.

4 Be conservative especially regarding sales. Many Internet start-ups have not earned a profit!

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MPP Plastics, Inc.: Pro Forma Income Statement, 1st Year by Month ($000s)

　 July Aug Sept Oct Nov Dec Jan Feb Mar Apr May June

Sales 40.0 50.0 60.0 80.0 80.0 80.0 90.0 95.0 95.0 100.

0 110.

0 115.

0

Less: cost of goods sold

26.0 34.0 40.0 54.0 50.0 50.0 58.0 61.0 60.0 64.0 72.0 76.0

Gross profit 14.0 16.0 20.0 26.0 30.0 30.0 32.0 34.0 35.0 36.0 38.0 39.0

Operating expenses 　

Selling expenses

3.0 4.1 4.6 6.0 6.0 6.0 7.5 7.8 7.8 8.3 9.0 9.5

Advertising 1.5 1.8 1.9 2.5 2.5 2.5 3.0 7.0* 3.0 3.5 4.0 4.5

Salaries and wages

6.5 6.5 6.8 6.8 6.8 6.8 8.0 8.0 8.0 8.3 9.5 10.0

Office supplies 0.6 0.6 0.7 0.8 0.8 0.8 0.9 1.0 1.0 1.2 1.4 1.5

Rent 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 3.0 3.0

Utilities 0.3 0.3 0.4 0.4 0.6 0.6 0.7 0.7 0.7 0.8 0.9 1.1

Insurance 0.2 0.2 0.2 0.2 0.3 0.3 0.3 0.3 0.3 0.3 0.6 0.6

Taxes 1.1 1.1 1.2 1.2 1.2 1.2 1.6 1.6 1.6 1.7 1.9 2.0

Interest 1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.5 1.5 1.5 1.5 1.5

Depreciation 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.3

Miscellaneous 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.2 0.2 0.2 0.2 0.2

Total operating expenses

19.8 21.1 22.4 24.5 24.8 24.8 28.6 33.4 29.4 31.1 35.3 37.2

Profit (loss) before taxes

(5.8) (5.2) (2.4) 1.5 5.2 5.2 3.4 0.6 5.6 4.9 2.7 1.8

Taxes 0.0 0.0 0.0 0.75 2.6 2.6 1.7 0.3 2.8 2.45 1.35 0.9

Net profit (loss) (5.8) (5.2) (2.4) 0.75 2.6 2.6 1.7 0.3 2.8 2.45 1.35 0.9

*Trade show

Revenue Forecasting

• Important since many key decisions based on revenue forecasts– Bank loans, inventory and production decisions, staffing

and space requirements, venture capitalists• Important to link revenue forecasts to marketing

plan– Sales of innovative and/or Internet products may be

difficult to project• Revenue Forecast and Cash Flow Forecast

– Determine if credit is to be extended to customers – Estimate the percentage of the sales that will be on

credit – Determine how long it will take to collect credit sales

Marketing Plan and Revenue Forecasting

1. Identifying industry and market trends

2. Market research

3. Competitive analysis

Marketing Plan Revenue ForecastsBackbone

Figure 4.3

Sample Competitive Grid Cleanliness of Facilities

Hours of Operation

Selection Price

Joe’s Inc. Good 8:00 – 6:00 Moderate Moderate

Jane’s Inc. Excellent 8:00 – 8:00 Large High

Sally & Jim’s Shop

Fair 9:00 – 4:00 Limited Low

Your Own Business

Excellent 7:00 – 9:00 The Largest Moderate

Common Forecasting Mistakes

1. The linear forecast mistake

2. The hockey stick forecast mistake

3. The 20/80 vs. 80/20 mistake

Basic Guidelines for Revenue ForecastsRevenue/Sales estimated using market research, industry sales,

trial experience, survey of buyers’ intention or expert opinion

• Market research to assure the quality of the assumptions behind the revenue forecasts

• Validate assumptions with more than one source of data • Plan based on more conservative assumptions

Creating scenarios Make Three Forecasts1. Best-case2. Worst-case3. Most likely case

Track Key Assumptions

Impact of Business Type on Revenues • Manufacturing firms

– Revenues limited by production capacities– Time lag between expenses for raw materials and production and cash

receivable from goods sold• Service firms

– Specialist service often billed by the hour or by job – No employee can physically be 100% involved in billable time– Specialised skills not easily transferable, thus limiting “capacity” expansion

• Recurring Revenue firms– Provides service that is used repeatedly, e.g. paging service, Internet access.– Customer usually signs a term contract, but customer can renege, so full-

contract revenues may not be collected (Disconnect rate)• Commission-based Selling firms

– Salesperson required to sell a minimum (base) number of units, and receives commission on units sold above the base

Cyclical/seasonal sales means revenue not sustainable during months with no or low sales!

Cost behavior

Variable Costs Type of Expense Activity BaseSales commissions SalesMaterials cost Units producedHealth insurance No. of

employeesWages expense No. of hours

workedPayroll tax expense Dollars of wages

paid

Fixed Costs

Total Variable Cost Line

Total Units Produced

$

Total Fixed Costs

Total Units Produced

$

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Impact of Business Type on ExpensesImpact of Business Type on Expenses

Manufacturing firmsManufacturing firms Typical expenses include raw materials, direct labour, overhead, Typical expenses include raw materials, direct labour, overhead,

selling and distribution costs selling and distribution costs (Fixed vs. variable?)(Fixed vs. variable?) Selling expenses for achieving sales may be high at start-upSelling expenses for achieving sales may be high at start-up

Service firmsService firms Salaries and wages one of the most significant expensesSalaries and wages one of the most significant expenses Standard practice is to pay a fixed salary plus a annual bonus (based Standard practice is to pay a fixed salary plus a annual bonus (based

on profit!)on profit!) Recurring Revenue firmsRecurring Revenue firms

Usually have relatively large expenses at the initialisation of service Usually have relatively large expenses at the initialisation of service and somewhat lower recurring expenses as service is providedand somewhat lower recurring expenses as service is provided

When pursuing growth of customer base, company may experience When pursuing growth of customer base, company may experience negative cash flow! High disconnect rate may lead to losses.negative cash flow! High disconnect rate may lead to losses.

Commission-based Selling firmsCommission-based Selling firms Commission must be set carefully to attract salespersons but still be Commission must be set carefully to attract salespersons but still be

profitable for companyprofitable for company

Cash flow is not the same as profit.Cash flow results from the difference between the actual cash receipts and cash payments. Cash flows only when actual payments are received or made. Sales may or may not result in immediate cash.

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Pro forma cash flowPro forma cash flow

Profit is the result of subtracting expenses from salesProfit is the result of subtracting expenses from sales For credit card sales, a percentage would be paid as For credit card sales, a percentage would be paid as

fees to credit card companyfees to credit card company Two standard methods for projecting cash flow:Two standard methods for projecting cash flow:1.1. Indirect methodIndirect method – adjustments made to net income – adjustments made to net income

(based on sales) to reflect that actual cash may not (based on sales) to reflect that actual cash may not have been received or disbursed.have been received or disbursed.

2.2. Direct methodDirect method – simple determination of cash in less – simple determination of cash in less cash out; gives fast indication of the cash position at cash out; gives fast indication of the cash position at a point in timea point in time

Important to make monthly projections of cashImportant to make monthly projections of cash Usually the first few months of start-up will require Usually the first few months of start-up will require

external cash in order to cover cash outlays.external cash in order to cover cash outlays.

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Cash Flow:Cash Flow: (Cash Flow From Operating Activities)(Cash Flow From Operating Activities)

Net IncomeNet Income XXXXXX

Adjustments to NIAdjustments to NI

Noncash/Nonoperating ItemsNoncash/Nonoperating Items

+Depreciation+Depreciation XXXXXX

Cash Changes in Current Assets/LiabilitiesCash Changes in Current Assets/Liabilities

+/- Accounts Receivable+/- Accounts Receivable XXXXXX

+/- Inventory+/- Inventory XXXXXX

+/- Prepaid Expenses+/- Prepaid Expenses XXXXXX

+/- Accounts Payable+/- Accounts Payable XXXXXX

Net Cash From OperationsNet Cash From Operations XX,XXX XX,XXX

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Cash Flow:Cash Flow: (Cash Flow From Other Activities)(Cash Flow From Other Activities)

Capital Expenditures (-)Capital Expenditures (-) (XXX)(XXX)

Payments of Debt (-)Payments of Debt (-) (XXX)(XXX)

Dividends Paid (-)Dividends Paid (-) (XXX)(XXX)

Sale of StockSale of Stock XXX XXX

Net Cash From Other ActivitiesNet Cash From Other Activities (XXX)(XXX)

Net Cash From OperationsNet Cash From Operations XXX XXX

Net Cash From Other ActivitiesNet Cash From Other Activities (XXX)(XXX)

Increase/(Decrease) in CashIncrease/(Decrease) in Cash XXX XXX

MPP Plastics, Inc.: Pro forma cash flow, 1st Year by Month ($000s)

　 July Aug Sept Oct Nov Dec Jan Feb Mar Apr May June

Receipts 　

Sales 24.0 46.0 56.0 72.0 80.0 80.0 86.0 93.0 95.0 98.0 106.0 113.

0

Disbursements 　

Equipment 100.0 100.0 40.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Cost of goods 20.8 32.4 40.8 51.2 50.8 50.0 55.4 61.4 60.2 63.2 70.4 75.2

Selling expenses 1.5 3.55 5.35 5.3 6.0 6.0 6.75 7.65 7.8 8.05 8.55 9.25

Salaries 6.5 6.5 6.8 6.8 6.8 6.8 8.0 8.0 8.0 8.3 9.5 10.0

Advertising 1.5 1.8 1.9 2.5 2.5 2.5 3.0 7.0 3.0 3.5 4.0 4.5

Office supplies 0.3 0.6 0.65 0.75 0.8 0.8 0.85 0.95 1.0 1.1 1.3 1.45

Rent 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 3.0 3.0

Utilities 0.3 0.3 0.4 0.4 0.6 0.6 0.7 0.7 0.7 0.8 0.9 1.1

Insurance 0.8 0.8 0.8 0.0 0.4 0.0 0.0 0.5 0.0 0.0 0.0 0.0

Taxes 0.8 0.8 0.9 1.8 0.9 0.9 2.2 1.3 1.3 2.3 1.5 1.6

Loan principal and interest

2.6 2.6 2.6 2.6 2.6 2.6 2.6 2.9 2.9 2.9 2.9 2.9

Total disbursements 137.1 151.4 112.

2

73.4 73.4 72.2 81.5 92.4 86.9 92.1

5

102.05

109.0

Cash flow(113.

1)

(105.35)

(46.2)

(1.35)

6.6 7.8 4.5 0.6 8.1 5.9 4.0 4.0

Beginning balance 275.0 161.9 56.5

5

10.35

9.0 15.6 23.4 27.9 28.5 36.6 42.45 46.4

Ending balance 161.9 56.55 10.4 9.0 15.6 23.4 27.9 28.5 36.6 42.4

5

46.4 50.5

Because many of the businesses that fail run out of cash, it is important for the

entrepreneur to develop a realistic, pro forma cash flow statement.

If disbursements exceed receipts, plan to either borrow funds or tap cash reserves.

Invest positive cash flows in short term sources.Provide different scenarios based on

different levels of success.

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Pro forma balance sheetPro forma balance sheet

Summarizes the assets, liabilities and net Summarizes the assets, liabilities and net worth of the enterprise worth of the enterprise ---“Snap-shot” view---“Snap-shot” view

Assets:Assets: Liabilities:Liabilities: Owners’ equityOwners’ equity::

Represents the excess of all assets over all liabilitiesRepresents the excess of all assets over all liabilities Represents the net worth of the companyRepresents the net worth of the company Any profit from the business will also be included in the Any profit from the business will also be included in the

net worth of the company as retained earningsnet worth of the company as retained earnings

The entrepreneur should prepare a projected The entrepreneur should prepare a projected balance sheet depicting the condition of the balance sheet depicting the condition of the business at the end of the first year.business at the end of the first year.

Assets• Represents everything of value owned by the business• Value is not necessarily replacement costs, but actual cost

expended for the asset• Current assets include cash and anything that will be converted

into cash within one year (e.g. marketable securities maturing within 90 days)

• Fixed assets are those to be used over a long period of time– Depreciation is a systematic method of allocating the original cost of a

long-term asset to expense over the asset’s expected life.

• Inventory is recorded as an asset until sold– Upon a sale, inventory account is reduced and expense account (cost of

goods sold) is increased. (FIFO, LIFO and average cost)

• Management of receivables (money owed by customers) is important to cash flow

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Pro Forma Balance SheetPro Forma Balance Sheet

AssetsAssets Current AssetsCurrent Assets

CashCash $50,400$50,400Accounts ReceivableAccounts Receivable 46,000 46,000Merchandise InventoryMerchandise Inventory 10,450 10,450SuppliesSupplies 1,200 1,200

Total Current AssetsTotal Current Assets $108,050 $108,050

Fixed AssetsFixed AssetsEquipmentEquipment $240,000 $240,000Less DepreciationLess Depreciation 39,600 39,600Total Fixed AssetsTotal Fixed Assets $200,400 $200,400

Total AssetsTotal Assets $308,450 $308,450 ==============

Liabilities• Represent everything owed to creditors• Current liabilities are due within one year

– working capital loan to finance inventory build-up in a seasonal business

– Current maturities of long-term debt represent principal payment due within the next year

– Accounts payable are amounts owed to suppliers for goods and services

– Deferred revenues occur when customers pay in advance (products or services are owed the customer)

• Long-term liabilities include long-term bank loans or other debts, bond issues, etc.

• May need to delay payment of bills to effectively manage cash flow

• Working capital refers to the difference between current assets and current liabilities.

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Total Liabilities & Owners’ EquityTotal Liabilities & Owners’ Equity Current LiabilitiesCurrent Liabilities

Accounts PayableAccounts Payable $23,700$23,700Current Portion of Long Term DebtCurrent Portion of Long Term Debt 16,800 16,800

Total Current LiabilitiesTotal Current Liabilities $40,500$40,500

Long-Term LiabilitiesLong-Term LiabilitiesNotes PayableNotes Payable $209,200 $209,200

Total LiabilitiesTotal Liabilities $249,700 $249,700

Pro FormaPro Forma Balance Sheet (cont’d)Balance Sheet (cont’d)

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Owners’ EquityOwners’ Equity

C. Peters, CapitalC. Peters, Capital $25,000$25,000

K. Peters, CapitalK. Peters, Capital 25,000 25,000

Retained EarningsRetained Earnings 8,700 8,700

Total Owners’ EquityTotal Owners’ Equity $58,750 $58,750

Total Liabilities & Owners’ Equity $308,450Total Liabilities & Owners’ Equity $308,450 ==============

Pro FormaPro Forma Balance Sheet (cont’d)Balance Sheet (cont’d)

MPP Plastics, Inc.: Pro forma balance sheet, End of 1st year

AssetsCurrent assets

Cash $50,400Accounts receivable 46,000Merchandise inventory 10,450Supplies 1,200

Total current assets $108,050Fixed assets

Equipment 240,000Less depreciation 39,600

Total fixed assets 200,400Total assets $308,450Liabilities and Owners' EquityCurrent liabilities

Accounts payable $23,700Current portion of long-term debt 16,800

Total current liabilities $40,500Long-term liabilities

Notes payable 209,200Total liabilities 249,700

Owner' equityC. Peter, capital 25,000K. Peters, capital 25,000Retained earnings 8,750

Total owners' equity 58,750Total liabilities and owners' equity $308,450

Accounting methods• Cash basis accounting

– Recognises revenue for goods/services in period when cash is received

– Reports expenses in periods when paid– Does not adequately match the costs of effort in

generating revenues with revenues so generated– May postpone time when sales recognised

• Accrual basis accounting– Recognises revenue when goods/services sold, and

costs incurred in generating the goods/services expensed in period when revenue recognised

– Better measure of operating performance, since revenues more accurately reflect sales in the period and expenses more closely match revenues generated

Pro forma sources and uses of funds statement

• Illustrates the disposition of earnings from operations and from financing

• Purpose is to show how income was used• Typical sources of funds are from operations, new

investments, long-term borrowing and sale of assets

• Major use of funds are to increase assets, retire long-term liabilities, reduce owner equity and pay dividends.

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Pro Forma Sources &Pro Forma Sources & Applications of FundsApplications of Funds

Sources of FundsSources of Funds

Mortgage LoanMortgage Loan $150,000$150,000

Term LoanTerm Loan 75,000 75,000

Personal FundsPersonal Funds 50,000 50,000

Net Income From OperationsNet Income From Operations 8,750 8,750

Add DepreciationAdd Depreciation 39,600 39,600

Total Funds ProvidedTotal Funds Provided $323,350 $323,350

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Applications of FundsApplications of FundsPurchase of EquipmentPurchase of Equipment $240,000$240,000

InventoryInventory 10,450 10,450 Loan RepaymentLoan Repayment 16,800 16,800

Total Funds ExpendedTotal Funds Expended $267,250 $267,250

Total Funds ProvidedTotal Funds Provided $323,350$323,350Total Funds ExpendedTotal Funds Expended 267,250 267,250Net Increase in Working Capital $56,100Net Increase in Working Capital $56,100

============

Pro Forma Sources &Pro Forma Sources & Applications of Funds(cont’d)Applications of Funds(cont’d)

Break-even analysis is a technique for determining how many units must be

sold in order to break-even.The break-even formula is:

Break-even is the volume of sales needed to cover

total variable and fixed expenses.

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B/E(Q) =B/E(Q) = Total Fixed Cost . Total Fixed Cost .

Selling Price per Unit – Variable Cost per UnitSelling Price per Unit – Variable Cost per Unit

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Break-Even GraphBreak-Even Graph

0

200

400

600

800

1000

1200

0 20 40 60 80 100

Fixed Cost

Total Cost

Total Revenue

Break-EvenBreak-Even

TR = TCTR = TC

Spreadsheet programs can be used for break-even analysis, constructing pro form financial statements, check writing, payroll, invoicing, inventory management, bill paying, credit management and taxes.• Popular packages include

“Quickbooks,” “Peachtree First Accounting,” “MS Financial Manager” and “Managing Your Money.”

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