Financial Plan

Your financial plan deals with risk and reality. It lets you establish how much money will be at risk as you launch the business and operate it, and it translates numbers such as sales forecasts and expense breakdowns into the reality of whether you'll be making a profit, and when.

First, establish the administration side of financial matters. Who will look after your day-to-day bookkeeping and how? Accounting software now makes this much easier than the steam-powered days of huge account ledger books, but you still need to keep up with entering in your receipts and creating your invoices. At the end of the year, who will use the bookkeeping records to create your financial statements, and who will prepare your income tax returns? You can certainly do some or even all of these tasks, especially if you're a sole proprietor. More complex business structures, however, will usually need expert assistance.

Much of the information in your financial plan can take the form of financial statements: sales and expense predictions, cash flow statements, income statements, and balance sheets, for example. For a small operation, you might just need to look at income, expenses, and cash flow. If you're looking for outside funding, however, you need the full package.

Your financial plan needs to explain how much money the business needs, how much money you have now, your predictions for revenue and expenses, and the assumptions that you've made to arrive at those assumptions. You'll be looking specifically for your break-even point (where revenues begin to cover expenses). Along the way, there are key ratios that financial investors will use to assess the financial health of your business, including turnover, debt-to-equity, and assets-to-liabilities calculations.

It's okay to be wrong when you're making estimates and educated guesses within your business plan. That's why businesspeople often create three projections: one best case scenario, one worst case scenario, and one scenario that's in the middle — they'll be prepared, no matter what happens.

Funding Needs

Assessing your financial needs in three different areas — capital, operating, and reserve — will establish how much funding your business will need to launch and then to operate. Although it can be difficult to estimate figures before you begin running the business, this will at least provide you with a start point: You can always go back and revise your figures later if you find that your estimates weren't accurate.

Capital Costs

“Capital” refers to items such as real estate, furniture, equipment, and vehicles. These items are sometimes called “nonconsumables” because their lifetime is generally more than a year, and these materials are not “used up” quickly the way that other items are, such as office supplies. Will you need to invest in any equipment to get your business up and running? If you want to open a catering business, for example, will you need new refrigerators or a delivery van? You can estimate costs by calling equipment vendors, checking trade catalogs, or calling in a contractor (to quote on renovations).

Operating Costs

Make a list of your operating expenses: payroll (you and for any employees); insurance (business and health); taxes; utilities (electric, telephone, water, Internet access), cost of goods (inventory for resale, supplies for making a product); transportation (cost of a vehicle, gas, maintenance), and anything else that comes to mind. You need your list of expenses to be as complete as possible here, so include one-time or annual operating expenses (such as licenses) in your first month of operation.

It's best to estimate higher rather than lower, so that you won't be taken by surprise if your costs are higher than you anticipate (and this isn't unusual in a start-up). Once you total up your expenses, you'll have an idea of the funds you'll need each month to cover your operating costs during your start-up phase.

Cash Reserve

You've estimated your foreseeable expenses; now you need to estimate how much might be reasonable to cover unforeseeable costs. You should have insurance to cover catastrophic problems (the theft of all your equipment), but what if it takes you twice as long as you expect to build your revenue base? What if your vehicle breaks down? Having at least a modest cash reserve can give you great peace of mind. If a cash reserve isn't possible, try to have a source of reasonably priced credit available, such as a line of credit.

Financial Statements

The easiest way to show all of the figures that you're working with is to break them down into the financial statements that will provide you — and your lending institutions — with clear, easy-to-read information. First, an Income Statement shows your revenue and your expenses for a particular time period (often a month or a year), and it is also known as a profit and loss statement or an operating statement. It can be helpful to show several time periods along with a total for the entire time: You can use a column for each of twelve months, for example, and a final column that reflects the annual totals.

Sample Income Statement: Gift Baskets Galore Year 1

Item

Total

Sales

Baskets

15,500

Total Sales

15,500

Cost of Goods Sold

Materials Cost

6,540

Freight

327

Delivery Cost

981

Total Cost of Goods Sold

7,848

Gross Profit

7,652

Operating Expenses

Advertising

1,000

Utilities

600

Office Supplies

300

Insurance

900

Accounting

600

Depreciation

800

Misc.

300

Total Operating Expenses

4,500

Net Profit (Loss)

3,152

A Cash Flow Projection is very similar to a budget: it takes a particular time period (say, a year) and breaks it down into manageable parts (months, for example) so that you can see when the revenue is coming in and when the expenses are flowing out. This is important, because it shows you exactly when you might be short of funds.

Sample Cash Flow Projection: Gift Baskets Galore First Quarter

Summary

Jan.

Feb.

Mar.

Total

Opening Balance

3,000

2,110

1,675

Receipts

Cash Revenues

500

500

600

1,600

Accounts Receivable

0

250

400

650

Loans

Other

Total Receipts

500

750

1,000

2,250

Disbursements

Material

600

600

400

1,600

Freight

60

60

40

160

Vehicle

30

250

40

320

Advertising

500

100

100

700

Utilities

50

50

50

150

Office Supplies

25

25

25

75

Insurance

75

75

75

225

Accounting

Misc.

50

25

10

85

Loan Payments

Total Disbursements

1,390

1,185

740

3,315

Total Cash Flow

(890)

(435)

260

(1,065)

Ending Balance

2,110

1,675

1,935

Balance Sheets show how much your business is worth at one point in time, and are often used by lending institutions. The entire sheet is designed around this equation: assets = liabilities + equity. Your total assets on the left-hand side must equal the sum of your liabilities and equity on the right-hand side — hence the “balance.”

Sample Balance Sheet: Gift Baskets Galore March 31

Assets

Liabilities and Equity

Current Assets

Liabilities

Cash

1,935

Accounts Payable

85

Accounts Receivable

200

Debt

3,000

Inventory

950

TOTAL LIABILITIES

3,085

TOTAL CURRENT ASSETS

3,085

Equity

Fixed Assets

Start-up Funding

5,000

Vehicle…Furniture

5,000

Retained Earnings

0

Total Fixed Assets

5,000

Total Equity

5,000

TOTAL ASSETS

8,085

TOTAL LIABILITIES AND EQUITY

8,085

Financial Analysis

Many lending institutions will analyze your financial statements using key financial ratios or other calculations to determine your business's fiscal fitness. These figures, including break-even point, turnover, debt-to-equity, and debt-to-assets can also provide you with a guide to how you're progressing.

Break-Even Point

You can calculate how many items you need to sell in order to break even (cover your costs) if you know some key figures, including the item's selling price, its cost of goods sold, and your other expenses during the sales period.

First, subtract the item's cost of goods sold from its selling price. This gives you what's known as the contribution margin. Then divide your other expenses (operating costs) over the specific period of time by the contribution margin.

In this case, the calculation is the year's operating costs ($4,500) divided by the contribution margin (which is the unit selling price [assume an average of $60] minus the cost of goods sold [51% or $30.60]). This gives you how many units you need to sell to reach the break-even point (153.1 units).

Turnover

This is important to any inventory-based business, whether you're producing the product that you're selling or you're buying it for resale. The greater the turnover, the better, because it indicates that the business is more efficient — that it's generating greater sales. To calculate turnover, divide your total sales for a period of time (say, a year) by your average inventory during that time (this is one reason why retail stores conduct periodic inventory counts).

Be sure that you're using the same valuation method for each part of the turnover calculation. Value both the inventory and the sales at cost, for example, or at what they're worth at your selling price. If you use inventory at cost and sales at retail price, you'll throw the calculation off completely.

Debt-to-Equity

This looks at how much financing you're using to fund the company compared to how much you've put in yourself (or how much your shareholders have put in). Divide your total debt (the total, not the monthly payments) by your total equity. If the ratio decreases over time, it means that you're successfully reducing your reliance on debt financing. If the ratio is greater than one, it means that you're financing the business more through debt than you are through equity, which can indicate a riskier venture.

Debt-to-Assets

This ratio indicates the relative health of your business when it comes to your debt. To figure it out, divide your total debt (the total, not the monthly payments) by your total assets (from cash in the bank to accounts receivable to furniture and tools). Generally, you want to see the ratio decreasing over time: Whenever it's less than one, it indicates that your assets are greater than your debt (which is a good thing).

Funding Sources

You may have savings on hand that you're planning to invest in the business. This is the place to list money that you already have and also sources of outside funding that you need. For outside funding, itemize how much you need and whether it's for capital, operating, or cash reserve needs. (You'll usually receive a better interest rate on loans for capital expenses, because the loan can be secured by the asset that it's paying for, such as a vehicle.)

Then list your potential sources for that money, being as specific as possible. Perhaps you believe that your bank, with which you've had a long and positive relationship, is your best source of funds. Look at their financial products and decide which one best fits your situation. If your home needs renovations to accommodate your office, for example, a home improvement loan or line of credit that's based on the equity in your home might be the best option. If you don't believe that local financial institutions are the answer for your needs, identify other sources, such as the SBA or Industry Canada small business programs (see Chapter 7).

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