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What should be included within the Financials portion of the business plan?
It depends upon the intended use of the business plan. The financial portion of the business plan may be surprisingly unique depending on the business. As previously discussed, the business plan serves two primary functions:
- Use by owners/managers in planning the business, and
- Obtaining business financing (loans and investors).
Developing the financials section will give the business founder/managers a plan for budgeting, estimating future expenses and revenues, and business projections. Likewise, a lender or outside investor will depend greatly upon the financials in evaluating the appeal/risk of investing in the business.
Below we go through multiple sections of the business plan that meet the above purposes. Note: Depending on the use of the business plan, it may be advisable to remove certain sections for a specific purpose. For example, when presenting the business plan to equity investors, it may be advisable to remove the portion regarding the financial status of the founders. Likewise, as the business develops the financial condition of the owners may be less relevant than the corporate fiscal health.
Personal Finances of Founders
Disclose the personal net worth, assets, obligations, outside investments, and sources of income of each individual. This information can be rather personal, but it serves multiple purposes. Demonstrating the financial status of the founders, owners, or major stockholders gives an indication of the ability of these individuals to supply necessary capital to the business. The partners, members, shareholders, etc., will have more confidence if the other owners have the financial ability to meet the capital needs of the business.
This information serves the dual purpose of satisfying the requirements of lenders and investors. Potential investors will want assurance about the owner’s ability to meet the financial needs of the business. Likewise, lenders will take the resources of these individuals into consideration when making the determination of whether to extend credit. Unless the company has considerable assets to post as collateral, lenders will require founders/owners to sign personal guarantees for the debts of the business.
Seed Capital and Startup Funds
Every business begins with a combination of effort and assets. The initial funds to obtain the assets or services necessary to start a business are known as seed funds. This initial amount of capital generally comes from the personal assets of the owner(s), family members, or friends. It may be the case that the owners use personal debt, such as credit cards, home loans, etc., to fund the startup. In other cases, friends and family members either invest the necessary cash or make a loan to the entrepreneur.
Regardless of the source, seed capital is essential to starting the business. Many entrepreneurs depend too much on their own time and efforts to carry out business functions. While this may be necessary, it pulls the entrepreneur from his/her primary tasks – planning and organizing resources to develop the business. For this reason, I recommend that you invest considerable time in mapping out the potential startup costs.
When preparing a list of startup expenses, it is best to overestimate the amount. You should conduct secondary and primary research to determine the costs associated with startup. Secondary research would be to read material from secondary sources on the cost of assets or services. Primary research includes contacting providers of venders of the necessary assets/services. Overestimating the stated costs will give you some room for accommodating unforeseen costs. Another approach would be to allocate a set an additional amount of money entitled contingencies. This should generally be 15-25 percent of the total startup expenses.
You will need to itemize your expenses in a readily usable and modifiable format. I recommend using excel in the beginning and later moving to a customized accounting system (like Intuit or Quickbooks). You will need to explain all of your expenses, the amounts, the necessity of the expense, etc. This will be important in obtaining a business loan or justifying the required capital contribution and ownership interest of each owner.
The Financial Plan (Financials)
The financial plan lays out the entirety of revenue, expenses, profit or loss for the company. All of the figures estimated in prior portions of the business plan come together here. The financials are so comprehensive, most potential investors read the business summary, the founder bios, and the financials to determine whether they are interested in the business. These statements constitute the projected financial future of your business.
The financial plan consists of a 12‐month profit and loss projection, Three‐year profit and loss projections, a cash‐flow projection, a projected balance sheet, and a break‐even calculation. If you are approach investors you will want to include a projection for internal rate of return and pay-back.
12 – Month Financial Projections
The first part of the financials is a detailed 12-month profit and loss projection. The profit and loss projection includes all sources of revenue (including the capital contributions of owners) and all costs/expenses associated with the business.
- The top portion should show all sources of revenue and contributed capital, including the injection of cash from the owner’s capital, loans or lines of credit, and any equity investment. Your estimation of revenue from sales should be illustrated within your sales projections. You will draw from your marketing research to estimate sales and the average price of goods or services sold.
- The middle portion should give a breakdown of all costs and expenses of startup and operations, including the cost of capital (i.e., interest on loans). You should allocate a percentage of any contingency funds to miscellaneous expenses of the 12-month period. Your sales cost should include the costs of goods sold, service-related expenses. Profit projections should be accompanied by a narrative explaining the major assumptions used to estimate company income and expenses.
- Profit/Loss projections should be laid out month-by-month for the twelve-month period. The 12-month projections should be accompanied by a narrative explaining the major assumptions used to estimate company income and expenses. You will want to carefully document your presumptions for use in future planning.
The 12-month projections should be as detailed as possible. While the revenue portion will generally be very simple in comparison to the expenses portion. The important point about the revenue portion is to make certain that your revenue projections are realistic. Too many business plans over-estimate revenue from sales early in the Startup’s life. Remember, the number one reason why businesses fail is a lack of sales. This leads to inevitable cash flow problems.
Three-Year Financial Projections
Now that you have a 12-month plan, you should start working on your 3-year Financial Projections. The 3-Year projections should contain all of the same elements as the 12-month projections. There should also be additional elements to the Revenue section (to account for increased sales, new infusions of equity, or additional debt). The expenses section must account for the projected growth in COGS, personnel expenses, cost of capital, etc.
The 3-year Financial Projections serves two purposes:
- A strategic and financial planning tool for the founders, and
- The business proposal to potential investors.
At this point, it is important to remember the difference between a small business and a startup venture. The small business hopes to exist, grow, and provide a continued livelihood or employment for the owners. Startup ventures are growth-based projects. The entrepreneur, along with any investors, look to capitalize upon the sale or exit of the business venture. Investors in the business will want to see a detailed 3-5 year projection showing the intended growth path of the business. The growth of the business (i.e., the increased revenue) will be the metric by which the sale price is determined. The sale price gives the investor a target rate of return on their investment.
Projected Cash Flow
Cash flow is generally considered the absolute most important component of business operations. As stated above, the number one reason businesses fail is a lack of sales. Failing to meet the intended sales projections often gives rise to cash flow problems. The cash flow projections allow you to visualize the movement of money in and out of your business. This is critical in planning the use in the budgeting process.
You can think of the cash flow statement as your checkbook. You start out with an amount in your bank account. The amount each month is based on your budget projections. This amount will be adjusted each month, based on the actual result of cash flow for the prior month. You will subject from the budget amount for every expense paid and add to the amount for every dollar received.
Basically, the cash flow statement breaks down the revenue and expense component of the financial projections into individual transactions over a stated time period. You will define individual sources and amounts of revenue on a week-by-week or month-by-month basis. Remember, the cash flow projections deals with the period in which money comes in and goes out. Just because goods are bought or sold in a given month, that does not mean that cash changes hands.
You should record every transaction based on the actual receipt or amount paid at the time of payment. These projections should be updated weekly as the number of payments made may vary throughout the week or month. Further, your expenses projection should be based on the same time period as the revenue projection, so that you can easily compare the two.
Revenue of the organization tends to vary more than expenses. Revenue is based upon sales projections, which are subject to the whim of the consumers. Many of the organization’s expenses are fixed – such as payroll expenses. These payments will remain constant each week or month. Variable expenses, such as materials associated with sales or other incidentals will vary. Try to use any prior historical references you can to estimate these amounts.
Your underlying purpose of the cash flow projections is to actively plan for the allocation of resources throughout the year. You certainly don’t want to have a cash deficit, but you equally do not want to have a surplus of unused cash. A deficit can ruin the business, while a surplus indicates inefficient use of funds.
The Balance Sheet
The balance sheet is a statement of your business’ assets, liabilities, and equity invested in the business. The owner’s equity is simply the assets (or asset value) minus the total liabilities of the business. This statement is important because it gives an overview of the company’s overall solvency.
You will begin your balance sheet by accounting for all of the assets of the business. You will categorize these assets into broad categories for accounting purposes, such as cash, equipment, real estate, inventory, investment assets, prepaid expenses (such as insurance or rent), etc. You will want to break these assets into current assets (i.e., assets that are easily converted to cash) and long-term assets (which are far less liquid). It’s not likely that you will have too many categories of assets at the very beginning.
On the liabilities side, you will outline all of the obligations of the business. You can look back on your expenses calculations to re-check all of your existing liabilities. Like the assets, you should categorize the liability and group them into short-term liabilities and long-term liabilities. For example, the accounts payable would be a short-term liability, where the mortgage obligation would be a long-term liability.
You may want to develop an end-of-year projected balance sheet. You will draw these projections from your expected growth path. If you plan to reinvest cash flow to purchase additional equipment, then you would adjust your assets and owner’s equity accordingly. Likewise, if your growth path calls for increasing your debt or accounts payable, then you can project this in your accounts payable.
A break-even analysis is a projection demonstrating the level of sales at which you break even. This statement takes into account the total expenses of the business for a given time period (week, month, year). There are a number of ways to arrange the formula to calculate the break-even point. Here is a basic formula:
- Your Total Costs (TC) have to equal your Total Revenue (TR); TC =TR
- Your Total Costs (TC) equals your Fixed Costs (FC) plus Variable Costs (VC): TC = FC + VC
- Total Revenue (TR) equals Avg. Price (P) times the Number of items Sold (N); TR = P x N
Calculate the fixed cost associated with doing business during this time. When the TR from sales equals the Total Cost of operations for that period, that is your break-even point. You know what your fixed costs are. These do not vary each period unless you purchase more equipment or hire more people. Your variable costs change depending on the number of resources used to produce and sell the product or service. These calculations are taken from your original expense calculations. Now, given the price of goods/service (or the average price of a combination of goods/service) what is the volume of sales (N) that you will need to achieve this revenue break-even point.
Calculations for Investors
Remember, one of the key purposes of the business plan is to attract investors. Two calculations that an investor will want to see is the Rate of Return on money invested and the PayBack period for money invested.
Calculating the Internal Rate of Return and Payback period is explained in a separate section.