Sustainable Business/Finance

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The financial part of your business plan is where you pull together all of the various elements of your business and express them in a common denominator: dollars. It is the part of the exercise where you see whether all your efforts and plans will result in you making a profit or not.

It should particularly highlight the timing of any required cash injections (borrowings or investment), by answering questions such as: How much money is needed? When is it needed? What for? Where is the money to come from?

Three key documents

A good finance section should include three key interrelated documents.

Profit and loss forecast (sometimes called the income and expenditure statement)
Cashflow forecast
Balance sheet forecast

These three documents collectively and separately depict the impacts of profitability, liquidity and growth on your business over the planning horizon you have chosen. These financial statements are essential. Not only do potential lenders and investors want to see them, but research shows that small business owners with a good grasp of the financial side of their business are much more likely to succeed.

Managing your finances

In order to keep your finger on the pulse of your business you should try to gain a working understanding of these financial management tools and the way they interact. However, you should also recognise that in many cases you will need the advice and support of your accountant or business adviser to compile and interpret the information these statements contain.

You will use the financial forecasts as an important yardstick for measuring the performance of your business over the life of your business plan. In addition, your financial section is a key component of your business plan when you present a case to investors or lenders.

Such people will be keen to gain an understanding of your business from your description of the market, your Competition, products and services, the skills and experience of you and your staff and the various productive resources you have assembled, or intend to assemble, to achieve your production targets.

They will ultimately, however, be most interested to see clear statements of the projected financial health of the business. They will also hope to draw comfort from the soundness and sustainability of the assumptions behind the numbers.

Specific points of interest to lenders or investors

In particular, they will be looking to see that:

The profitability of the business reflects a sound relationship between market-driven sales projections and accurately based costs of production and overhead costs
You have planned to have enough cash to meet both your regular bills and also non-regular items (such as once-yearly insurance payments)
The financial position of the business continues to remain sound as growth takes place
You maintain a sensible balance of debt and equity finance
Your short and long-term obligations are matched with relevant finance options
The key business ratios (see Glossary) remain within sensible bounds.

Goods and Services Tax (GST)

Financial accounts for all businesses are prepared exclusive of GST (because the GST isn’t retained by the business). So your Profit and Loss Statement and Balance Sheet always show the net amounts (GST exclusive).

Your cashflow projections should be prepared GST inclusive, however, as this document projects what happens to your cash each month.

Preparing your financial forecasts

So how do you go about preparing your financial forecasts? Clearly it will be easier for you to forecast the future performance of your business if it is already up and running. You will have your past trading results to act as a guide in terms of sales and the relationship of sales to costs. In the case of a new business you will to some degree be flying blind, but this should not be used as an excuse to skimp on your planning.

The profit and loss forecast

The profit and loss forecast is the starting point for your financial planning exercise. It is the document that pulls together key elements of information from your business plan. Because it is impossible to accurately predict the future, it is a good idea to prepare three variations of your profit and loss forecast:

An optimistic option: what would eventuate if everything goes right?
A pessimistic option: what would the results look like in a worst case scenario?
The most realistic: your best estimate of sales and costs

By completing these alternatives you gain a valuable insight into the various risks associated with your business. Avoid the temptation to prepare more than three alternatives. Computergenerated spreadsheet programs make it easy to produce multiple scenarios by varying any number of factors. But masses of printouts will only confuse you and possibly annoy other readers of your finished business plan.

Remember, three-year forecasts are acceptable for most businesses, but you should prepare a five-year forecast if you want to challenge your thinking.

Step 1, your sales forecast

Start with your sales forecast, simply because the level of sales is, in the overwhelming majority of businesses, the dominant influence on the performance of the business and because most cost items are directly or indirectly linked to the level of sales.

For most existing businesses the past sales levels are the best indicator of future levels of market penetration. For new businesses it is less simple, but you will find that the accuracy of your sales forecasts will improve with time as you gain a better understanding of the relationship of your products and their markets. You must keep detailed records of all aspects of sales; as it is these records that provide you with the growing ability to forecast income levels.

If you have a new business with no past sales history, or an existing business facing a changing market, it may still be possible to get some useful information by doing the Following:

Talk to industry experts

Suppliers (those who supply your competitors and would like to supply to you too), industry associations, and others in the industry familiar with products or services like yours.

Talk to potential customers

Observe the activity of your competitors and any customer buying patterns, and talk to customers about what they need, how much, and when.

Remember your capacity limits

Determine your ability to meet demand and how many units you can produce per month.

Forecasting sales should be undertaken in two steps.

1. First, forecast the number of units you expect to sell during the period.

Begin with an analysis of current performance (if available)
Divide sales into appropriate categories

Consider factors that affect each category:

Internal factors might include staffing changes, profit expectations, promotional plans, capacity restrictions, etc.
External factors might include the impact of inflation, unemployment, competition, business trends, government policies, etc.
Now attempt to forecast unit sales in each category for the future period (note that this may require breaking the period down into weeks or days to produce a total).

Remember that considering first a best case scenario, then a worst case scenario, will help you to determine the most likely unit sales forecast.

2. Then multiply by price (excluding any GST you add if GST registered) to calculate the expected dollar value of sales. In estimating sales figures for the coming period use past figures to see any trends.

Examine your annual totals for the last five years to help estimate this year’s total sales
Examine monthly totals for the last two years to see monthly variances and seasons.
Take into account new sales opportunities you expect to achieve in the forecast period.

Step 2, your direct costs

On the expenditure side the first section to address relates to the ‘direct costs of sales’.

These are costs that generally move or change consistently with the level of sales; they are said to be ‘variable’ or ‘directly’ related to the level of sales.

Some examples of direct costs of sales:

A retail store: the price you paid to purchase the products sold
A manufacturing business: raw materials, factory wages, packaging
A restaurant: the cost of food, wages of kitchen and waiting staff
A painter and decorator: the cost of material, painters’ wages.

The amount left over after deducting direct costs from sales revenue is usually called the gross profit or gross margin of the business.

Step 3, your overhead expenses

From your gross profit you then deduct the ‘overhead’ costs or ‘fixed’ costs to calculate the final net profit of the business.

Overhead costs are sometimes listed alphabetically in the profit and loss statement but it is probably more useful to group them by type. For example:

Selling: costs associated with marketing your products and services and generating sales
Administration: costs involved in administrating the business and running the office
Finance: costs of funding the business and other financial losses.

These overheads or fixed costs are generally the expenses that do not vary (in the short term) with the volume of activity. For example your rent and insurance premiums do not reduce if you sell fewer goods this year. Fixed costs can therefore be estimated in advance with some accuracy because they do not change if your business is busy or quiet.

As you prepare your cost figures remember to give consideration to any other relevant influences. For example:

Internal factors might include a planned change in staff numbers, anticipated wage increases, commitments to new leases, etc.
External factors might include the impact of inflation over the next year, anticipated changes to supplier prices, changes in tax rates, changes to power and telephone prices, etc.

Remember again that if you are GST registered your profit and loss statements are prepared GST exclusive (as the GST component of all revenues and expenses is merely passed on to the IRD). If you are not GST registered then simply record the sales you expect to make and the full value of expenses you will incur (including GST as you are deemed an end user and cannot claim it back).

Cashflow budget

Once you have completed your profit and loss forecast, which reflects the likely profit performance of your business, you need to convert the information it contains into a cashflow budget. As the name suggests, what you are endeavouring to do here is identify, usually on a monthly basis, the inward and outward flows of cash for your business.

This is important, because profit is not the same thing as cash in the bank. In the short term a business needs liquidity, which means having enough cashflow to pay the bills as they become due.

If the cash flowing into your business exceeds the cash flowing out, you can continue to operate.
If the cash flowing out of your business exceeds the cash flowing in, you eventually run out of cash and creditors may seek to have the business liquidated in order to recover their losses.

Capital expenditure budget

Many businesses will have to plan for capital expenditure, such as replacing or updating old or obsolete equipment, or buying new equipment. This includes the upgrading of computers and software. Capital expenditure has a massive impact on cashflow, especially for those businesses that use expensive equipment.

To avoid liquidity problems it is important to anticipate and plan the cashflow for your business.

A cashflow forecast anticipates the flow of cash in and out of the business on a monthly basis, in an attempt to ensure that there is sufficient cash coming in to pay bills as they fall due.

The first step is to ensure you are able to break down your profit and loss forecast into monthly sections.

Having achieved this, you need to convert the information to reflect when the actual cash from a sale is received and when you actually pay the cash for an item of expenditure.

The key here is to remember that in many cases some of the cash coming in will arrive in a month other than that of the actual sale, and some of the cash going out will be in a month other than when you received the goods or services.

Your business policies regarding the credit you offer your customers and when you pay your bills will dictate when cash flows into and out of your business.

It is therefore vital that you make sure the policies you set in these areas are followed as closely as possible. For example, if you offer customers the usual ‘payment by 20th of the month following invoice’ credit terms, but then fail to collect until two months later, you will run into serious cashflow difficulties.

GST

If you are GST registered your financial accounts are prepared exclusive of GST , but your bank records aren’t. They show the total cash in and out, including the GST component. You should use GST inclusive figures just like your bank records (to make a comparison with your bank statements easier). Simply use the estimates you’ve prepared for your profit and loss forecast and add GST to all figures (except items like wages and interest that don’t attract GST ).

But you must remember to include also your regular GST returns (i.e., GST to pay and GST refunds).

If you are not GST registered just use the sales and expenses figures you incur.

Steps in preparing a cash budget

1. Prepare sales forecasts

Use the sales projections from your profit and loss, but remember to include GST in your cashflow sales forecasts if necessary.

2. Identify the cash inflows that form a part of each month’s operations.

The principle sources of cash coming in will be:

cash from cash sales (received in the month you sell)
cash from debtors who are paying for a past month’s credit sales (so the cash receipts will be staggered over the month or two following the sale)
any other sources of cash revenue (e.g. interest, commission, tax refunds).

Note that the sale of assets and new injections of capital will produce cash inflows also, but these do not occur regularly. Include them when relevant.

3. Identify cash outflows

The principle sources of cash going out will be:

cash payments for stock purchases (note that if you buy on credit you will need to stagger the cash payments to the months that you pay the bills)
all other cash expenses (e.g. wages, rent, power, drawings, taxes paid, etc.).

Note that depreciation is not a cash expense and is ignored in the cashflow forecast.

4. Calculate net cashflow

Subtract the cash outflows from the cash inflows.

5. A djust the bank balance each month

By adding the net cashflow for the month to the month’s opening bank balance you can estimate the bank balance at the end of the month.

Repeat for subsequent months.

Special points

It is important to note the following:

Some expenses do not occur regularly each month—for example, insurance, ACC, Provisional Tax, FBT and GST payments—so you have to reflect the timing of such irregular payments in your cashflow forecast.
Some cash items do not appear in your profit and loss forecast but, because they involve cash going out, they must be included in your cashflow forecast. Examples are any principal repayments on a loan, capital expenditure, or tax payments.
Some profit and loss items are not included in the cashflow budget. Depreciation is not a cash item so it is not included.

Remember the purpose of your cashflow budget is to provide you with an estimate of your cash position at the end of each month. As such it must account for all cash coming into the business from all sources (sales, investments, loans, collections), as well as all the cash going out of the business in the same period.

The difference between the two totals, inwards and outwards, will leave you with either a surplus or deficit of cash. A surplus you manage by investing or holding the credit in an interest-bearing account. A deficit you have to cover by a loan, increasing your overdraft, or delaying payment to certain creditors.

Cash is king in your business—without it your business will likely fail—even when underlying profitability is sound. Like a car engine without oil, your business will cease to function if there is insufficient cash on hand to meet commitments. It is therefore vital that you continually monitor your cash position via your cashflow budget.

The balance sheet

The balance sheet of your business provides a snapshot of its financial status at a particular point in time. For most businesses this is generally at the end of the financial year where the balance sheet gives a summary of how the previous year’s trading has affected the business.

For example, a year of sales growth would have led to greater investment in current assets to support the extra sales (for example, increased stock levels and an increase in debtors).

This would have required additional finance, either from yourself or your partners in the form of extra equity, increased creditors (who supplied your stock on credit), or greater short-term borrowing in the form of an increased overdraft.

Growth in sales may also require cash reserves and borrowing to be committed to new plant and equipment, which in turn may leave the business short of cash.

Curiously, periods of sales growth can result in cash shortfalls that threaten your ability to pay immediate debts. It’s important to monitor this in your cashflow forecast.

Balanced relationship

The balance sheet highlights problems associated with growth and allows the prudent business owner to keep growth in balance.

Controlled growth, in which the rate of growth is balanced against the objectives of liquidity and profitability, brings these three business objectives into a sustainable, balanced relationship.

Key points

Key points highlighted in a balance sheet should include:

That the balance of types of funding (debt versus equity, long term versus short term) is appropriate for the business
That there are sufficient current assets to cover short-term liabilities
That profits are being retained or distributed
The extent to which the business can grow under its existing financial structure.

The average small businessperson should not expect to understand the intricacies of the balance sheet and how it acts as a regulator of business growth. Your accountant should alert you to problems in this area.

If by this stage you have come to recognise that planning and managing a business is a continual juggling act between liquidity, profitability and growth, then you have gained a basic understanding of the importance of a comprehensive approach to financial planning.

Break-even calculation

Using different scenarios to forecast the financial performance of the business will give you an idea of the level of risks involved. A more precise way to gauge both the risks and potential of your business is to complete a break-even analysis. This involves working out how much business you have to do to achieve the desired profit.

Calculate the break-even point for your business and compare this level of sales with your best estimate of the level of business activity.

A. Sales last year $
B. Gross Profit last year $
C. Gross Profit percentage %
D. Total fixed expenses $
E. Desired profit $ (if not already included as owner’s wages in fixed expenses)
F. Required sales level $ D + E divided by C%
G. Required sales level – units per year Units F divided by average unit price (divide by 52 for weekly)

An example:

Let’s presume your sales total last year was $180,000, and your gross profit was $90,000. Your gross profit percentage was 50%.

This year your fixed expenses are expected to be $60,000 and you are seeking a profit of $50,000. Your average price is $10.

Step 1. Work out your Gross Profit percentage

Divide your Gross Profit $90,000 by your Sales – and then multiply by 100

$180,000 Gross Profit percentage 50%

Step 2. Fixed overheads

Add fixed expense costs $60,000 and your desired profit $50,000

Minimum needed $110,000

Step 3. Now you can work out the target sales figure

Minimum needed to cover fixed overheads $110,000

Divided by Gross Profit percentage 50%

Required sales level $220,000

Step 4. Finally, you can work out how many units you must sell

Target sales $220,000

Divided by average unit cost 10%

Number of units per year (required sales level) 22,000
(Note: you can leave out the profit estimate if you want a true break even).

Your business idea: a quick test

Use a trial income and expenditure statement to scope the potential of your business idea

We’ve said that it’s accepted practice to complete the financial section after you’ve completed the other key elements of your business plan. However, it can be very useful to ‘scope’ an approximate income and expenditure statement right at the start of your business planning exercise. You can do this when you are still considering whether a new idea has the potential to form the basis of a business that will meet your personal goals.

In such circumstances it is often very difficult to get your head around the market potential of your idea, so why not work in reverse? Start with your financial goal and, by using the income and expenditure format in a ‘bottom up’ way, work out the necessary dollar sale levels you will need to achieve and what this represents in unit sales in the context of the market for your product. Are you confident you can produce the required units? Where and to whom will you sell this volume?

A step-by-step approach can be followed.

1. Set your financial goal

Let’s say you are earning $50,000 at your current job and feel your business idea needs to give you the ability to earn $80,000 per year to compensate for the loss of income security and to offer you a return on your investment.

2. Determine overhead costs

To this $80,000 you have to add the expected level of overhead costs your business will incur. Roughly calculate your likely costs. Let’s say these costs total $60,000 per year.

3. Calculate gross margin

Adding these two amounts together gives the amount of gross margin you will have to earn from sales after you have paid for the direct inputs that go into your product.

4. Calculate cost

Let’s assume you intend to make garden bench chairs and have established that you can sell these for $560. Your trial production has shown that each unit takes four hours to make at a labour rate of $30/hr (total $120) and uses $180 of materials (timber, screws, paint, etc.). Grand cost total, therefore, is $300.

When you combine all this information you are able to gain a ‘ball park’ insight into the level of sales you will require to meet your personal financial goals from the operation of the business:

Desired financial return	$80,000
Level of overheads (list by item)	$60,000
Gross margin required	$140,000
Sales: price per unit	$560
Cost of goods sold: labour	$120
Cost of goods sold: material	$180
Total cost per unit (labour plus materials)	$300

Gross margin/unit ($560-$300)	$260
Number of units to be sold to reach target: $140,000/260 =	538 units
Total sales 538 units x $560 =	$301,280
Cost of goods sold 538 x $300 =	$161,400
Gross margin (approximately)	$140,000

You have learned a number of things from this simple scoping exercise.

You need to sell 538 units per year or between 10 and 11 per week to meet your personal financial goal from the business.

This has allowed you to put your business potential into a market-sized context and develop a marketing strategy.

The exercise may have provided you with an early warning that the business will have difficulty obtaining sufficient sales to meet its goals.

It gives an indication of the level of production required to achieve market and finance targets. For instance 10 -11 units/week at four hours per unit mean that a full 40-hour week needs to be devoted to production. With marketing, sales and administration also to be taken care of, clearly a large proportion of the production will need to be undertaken by hired labour or contracted out if you are to have time for these other important activities.

Clearly you can use this ‘scoping’ exercise to play around with options such as how many units you would need to make and sell if you were happy to take a lower return in the first two years while getting the business established. Try increasing the price, or lowering your costs to see what difference this makes to how many units you have to sell.

The Four Fives Rule

Often when you have completed your financial planning exercise you may want to do some fine-tuning to see whether, by your good management, you can enhance the future performance of the business. Improved performance is often the result of many small gains rather than major breakthroughs. This is where the Four Fives rule can offer a useful guide.

The four major areas where you can improve the financial performance of your business are the:

level of sales
average price of sales
cost of sales
level of overheads

A target of increasing the first two areas by five percent each and reducing the second two areas by five percent each can collectively result in amazing performance improvements for a business. An example will serve to illustrate.

Projected performance		Enhanced performance
As per original budget		The goal is to sell 5% more units at 5% higher price
We plan to sell 10,000 units @ $20	= $200,000	We now plan to sell 10,500 units @ $21	= $220,500
They cost 10,000 @$3 per unit	= $30,000	If we reduce the cost per unit by 5% and sell the 5% extra units, we have 10,500 units @ $2.85 per unit	= $29,925
Thus the Gross Margin will be 85%	= $170,000	Therefore the enhanced Gross margin	= $190,575
Subtract the 50% overhead costs	= $100,000	Reduce overhead costs by 5%, they become	= $95,000
Giving a Net Margin of 35%	= $70,000	Giving an enhanced Net Margin of	= $95,575

The result of following the Four Fives Rule is a 36.5 percent improvement in pre-tax profit.

Notice that this improvement was brought about by making relatively small changes in a number of key areas, rather than attempting a large change in only one area.

To calculate the necessary level of sales for your business, use the information developed in your Profit and Loss Forecast

A. Sales last year $
B. Gross Profit last year $
C. Gross Profit percentage %
D. Total fixed expenses $
E. Desired profit $ (if not already included as owner’s wages in fixed expenses)
F. Required sales level $ D + E divided by C%
G. Required sales level – units per year Units F divided by average unit price (divide by 52 for weekly)