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05 12th, 2009| 
Scott was clueless when it came to financials and forecasting. Scott knew how to make money at his video production studio, but keeping it was another matter. He was considered one of the best studios in town for video, audio, and mixing. He even produced quality still photography shots from videos for publicity purposes. But Scott sensed he was slipping. He grudgingly knew he needed to expand his operations to keep up with the market. But he was having so much trouble tracking his money, how could he? He was overwhelmed when it came to accounting and bookkeeping and finances in general.
Then one day, two things happened that dramatically changed his course. First, he lost a significant job to a company he considered to be a lesser production house. When he called to find out why he had lost the work, Scott learned that his lowly competitor had expanded its services offered and had upgraded all of its equipment. It could now produce a higher-quality video at a lower cost. Second, several employee checks had bounced. The employees were not happy. Their NSF payroll checks caused a cascade of late fees and penalties on mortgage, credit card, and other payments. One employee quit over it. Scott’s valued assistant warned him that such a thing could never happen again.
That was it for Scott. He knew he had to get a handle on his books and then prepare a business plan so he could catch up with the competition. He asked his lawyer for advice on how to proceed. The attorney gave him the name of a consultant who had helped out another client recently.
Shortly thereafter, the consultant, Ron, visited Scott at his studio. He listened to Scott talk of his frustrations with his accounting and his need for a bank loan to acquire new equipment to keep up with his competitors. Scott was very worried he could never get a bank loan because he didn’t have the systems in place to prove that he’d ever be able to repay a loan. At this moment, he wasn’t even sure whether he could repay a loan or not.
Ron told Scott not to worry. There were plenty of entrepreneurs in his
they’d been able to pull it together, obtain
exact situation. With a little help,
a bank loan, and thrive. He would, too.
That was fine, Scott said. But the accounting had become such a problem that he had developed a mental block to it all. When he heard all the financial terms, he just tuned them out. He was stressed that he could never comprehend it well enough to talk to a banker.
Ron had the solution to Scott’s mental block. They would go through the four main accounting reports and relate them to Scott’s business. This way when Scott heard the term, he could equate it to an aspect of his business and be able to talk about it. Scott agreed to give it a try. Ron identified the four main reports they would be discussing as income statement, cash flow statement, balance sheet, and break-even analysis.
Ron could sense Scott’s frustration at the mere mention of these terms. So he asked Scott a production question: “What is a snapshot?” After several questions as to why this was relevant to anything at all, Ron got Scott to answer that a snapshot, as in a photograph, is an image in time. Ron then told Scott that was also what an income statement is: a snapshot of your business at one point in time. If an income statement is prepared on June 30, then like a photograph taken on June 30, it will show you if you are making any money as of June 30. Scott slowly nodded.
Ron also pointed out that in an income statement you bring all of your revenue from sales and other sources into the picture, take out all of your costs, and end up with a snapshot of net income. This is your photo of the amount of profit or loss you have on, for example, June 30.
Ron went on to say that income statements are also called earning statements or profit and loss statements (P&Ls) and that they all provide the same thing: a snapshot of the business on a fixed date in time.
Scott said he was getting the picture, so to speak. Ron laughed and said next was the cash flow statement.
A cash flow statement is movement, he said. It shows where the money comes from and where it goes. It is different from an income statement, which takes a still picture of sales and profits. Instead. Ron said, the cash flow statement tells you where the cash comes from, how it is being used in the company, and how it is going out of the company. There is movement to a cash flow statement, Ron explained. It is a video. Scott’s eyes lit up. He could visualize the movement.
Ron went on to explain there are two parts to this video. One is called the sources of funds, which tracks not only sales but also loans, line of credit drawdowns, and equity investments from investors. It records the movement of money into the company. Part two of the video shows the uses of funds—the movement of money within the company. This includes the cost of goods sold, administrative expenses, loan and interest payments, equipment purchases, and dividends or draws paid to the owners.
The result of this movement of cash into the company, around the company, and out of the company is called the net change in cash. It is the difference between total funds in and total funds out.
Ron noted that a happy ending to this video would show a positive number and an upward trend. Scott said he was on the edge of his chair to see how his cash flow video ended. Ron agreed but reminded Scott that the cash flow statement doesn’t have a finite end. Instead, it is a measuring tool, a means for improving performance over time. A never-ending video. Scott liked that idea.
A balance sheet was the third report he needed to understand. This matches your assets (the things you own) with your liabilities (the items you owe on). The result is your total assets.
Scott didn’t see how this related to video production. Ron asked him to think about a mixing job, where you lay the audio (the sound) with the video Ron said this was how Scott should remember a balance sheet: the mix of audio and video into one valuable asset. Or, in accounting terms, the mix of assets with liabilities to equal net worth. Scott saw it, and Ron went on to clarify that just as an income statement is a snapshot of the business, and a cash flow statement is the movement of money, a balance sheet is used to get at the owner’s equity or net worth of the business.
The key element of the balance sheet is that it has to balance. In video terms, it can’t look like the English translation of a Japanese movie where the spoken words don’t match the movement of the actor’s lips. Instead, the assets on one side and the liabilities on the other side have to be equal and have to balance.
Ron noted that if you had more assets than liabilities (and hopefully he did), the difference was the net worth of the business. By tracking this regu- larly, you could see if you were getting richer or poorer. Scott understood, and Ron moved on to the break-even analysis.
Ron guessed that Scott, like almost every other video guy he’d ever met, would love to someday make a big-budget Hollywood movie. When Ron asked the question, Scott perked up at the thought. Ron then explained that break-even analysis is like opening night. The movie has been made. Now, how many tickets do you have to sell to break even? Scott understood but asked about the distributors and movie houses. TheN, got a cut of every ticket sold.
Ron explained that was factored into the equation. With a movie, you know on opening night what the fixed costs to make it were. And you know how much the distributor took out of each ticket—for example, 60 percent. Similarly, in a business you have fixed costs such as rent, insurance, and office costs each month, and you have an average gross profit margin on each sale.
Continuing with the movie example, suppose it cost $1 million to make a low-budget thriller. That was the fixed cost. The distributor and movie houses were going to keep 60 percent of each $7 ticket sold. Your gross profit margin was 40 percent. By T dividing the $1 million film cost by the 40 percent you get from each ticket, you learn that you need to sell $2.5 million in tickets to bring in the $1 million needed to break even. Scott clearly understood this and began talking about a script he’d been working on with a friend. Ron brought him back to reality
Just as you had opening night for a film, you have the first of the month for your business. You know what your rent and other fixed expenses are. From there, you have to figure how many things—be it tickets, products, or services—you would have to sell and at what percentage of profit to break even for the month.
Ron got Scott to focus on his own business. With rent and all the other fixed expenses, it cost him $12,000 a month to keep the doors open. A video production job, after paying for film and supplies, netted him 50% percent of the monies paid by the client. So, using the break-even equation, Ron told Scott that he needed to bring in $24,000 a month just to break even.
Scott shook his head. There were some months when he came nowhere near that amount. Ron said he needed this tool for bidding on jobs and taking on new business. You needed to know where you were every month, and you had to hold your margins to reach your break-even point before moving into profitability.
Ron summarized the discussion by writing it down on a piece of paper for Scott to remember:
Accounting Term Production Term Answers the question
Income statement Snapshot Am I making money?
Cash flow statement Video Where did the money move?
Balance sheet Audio/video mix What is this worth?
Break-even analysis Opening night When do I start making money?
Scott appreciated the assistance. His mental block was removed. With Ron’s help, the financials were brought into order, reasonable income projections were crafted, and a bank loan was obtained. Scott went on to profitability and eventually made his movie.
The Importance of Forecasts
Bankers and investors will be looking at your plan to see if your business is a good risk. In other words, will your business income allow for timely repayment of borrowed money? One of the ways this risk is analyzed is by reviewing your income projections, which is also known as a pro forma profit and loss forecast. Your income projections report is based on the other four reports we’ve just discussed. If you are a start-up and don’t have a prior history, you’ll be making all five reports up out of thin air. In which case we must favor reality over creativity.
The income projection is a way for bankers and/or investors to get an idea of what the near future (usually three years, seldom more than five) will hold in terms of income and expenses based on reasonable assumptions of costs and sales. Your assumptions should be based on prior experience and real-world numbers. Don’t try to predict the future with a cracked crystal ball, Be realistic.
Obviously, a three-year income projection is a pro forma statement and must be backed up by sound reasoning and expertise—both of which you should have after all your research on industry standards and trends. If you are basing your projections on past performance, be clear about it. But don’t just take last year’s numbers and shove them into next year’s projec-
tions. ections. Be sure to take into account changes in the industry, the economy
marketing, competition, efficiency, costs, and the like. If you are basing projections on standards and trends, state where you got your information. Again, be realistic. The people you’ll be dealing with will know when you’re blowing smoke.
Whereas the cash flow statement records the movement of all cash going in and all cash going out, the income projection looks only at income and deductible expenses. But all parts of your business plan build on each other. The cash flow statement will contain some of the information you need for income projection.
Forecasting Timelines
The timeline for an income projection can vary depending on how you are using the plan and what you want to accomplish. Three to five years is the average. But remember that the art of prognostication blurs with distance. Three years is certainly a reasonable timeline because it gives a glimpse of the future without risking too much inaccuracy. But note that different funding entities may prefer other timelines. Don’t be put off if someone asks for five years and you’ve only got three. If you want their money, go back and do five.
As with the overall timeline, the time breakdown of your forecast can vary as well. If you are preparing your plan for management purposes, you may want to show your projections by year. If you are preparing your plan to attract funding, projections by month may work well. But different entities have different preferences, so it is a good idea to check with your target entities ahead of time to find out how they would like your financials laid out.
The basic categories for an income projection are the same as those for the income statement:
Income
Net Sales [account for returns, allowances, and markdowns] Cost of Sales [such as inventory, purchases, and cost of goods available for sale]
Gross Profit [Cost of Sales subtracted from Net Sales] Expenses
Variable [such as advertising, professional fees, packaging costs, freight, supplies and parts, payroll—including overtime and benefits—repair and maintenance, travel]
Fixed [such as rent, leases, utilities, loan repayment and interest, insurance, depreciation of capital assets, workers' compensation, taxes and licenses, and office salaries]
Total
Income from Operations [Expenses subtracted from Gross Profit] Other Income (such as interest income)
Other Expenses
Net Profit or Loss Before Taxes
Taxes [such as sales, real estate, income, inventory, and excise] Net Profit or Loss After Income Taxes • If you want to take the exercise one step further, include a column for industry standards so that anyone reading your plan can quickly see how your company stacks up against industry averages.
• As time goes on, you can compare your projections to your real income and expenses and adjust accordingly. Even projections are a good management tool.
• Financial projections require a high level of financial literacy. If you don’t have great expertise, use the creation of your financial projections as a learning experience and hire a CPA or accountant who will teach you the fundamentals of the statements while you prepare them together.
• There are several user friendly accounting programs for small businesses that are great resources for both the financially astute as well as the new business owner. Research the Internet for what others have to say about affordable software such as QuickBooks from Intuit.
Forecasting
Forecasting numbers for the future should not be an exercise in wishful thinking. Rather, your forecasts should be based on realistic expectations and real-world experience. However, not all that experience needs to come from you. If you are a brand-new business owner, it is a good idea to talk to others or even hire some professionals to help you get the numbers right. If you are an owner of an existing business, try including your managers and department heads in planning for the future. This is called bottom-up forecasting.
Bottom-up forecasting uses the knowledge of the front lines to predict as accurately as possible the future needs of your business. Managers and department heads can plan ahead for the needs of their teams and give the data to you to approve and compile. These front liners know what equipment will need to be replaced next year, what positions will need to be added, and how many training programs need to be added. Your sales team should have a good idea as to where sales are going and what trends might change the path you are currently on, and the like. Each manager or department head can look at the next few years month by month and come up with a realistic forecast. You can add all those forecasts together to prepare a picture of the future of your business as a whole. Of course, your front liners cannot accurately predict everything that will be needed in the coming three years, but they might have insights you don’t.
Top-down forecasting is planning for the future with the end in mind. It starts with your goals for three years out and backtracks the steps it will take to get there. You start with the big picture—the industry—and your goals within it. With your market share goal, you can figure your projected revenue. From there, you work your way down the table, filling in exact numbers where you can and making your best predictions where you can’t. Still, these are not guesses. Even the advertising section (one of the most variable sections of your projection) can be worked out logically. You know where you stand with the competition and the industry norms. So you know if you will need to spend more or less than the norm in order to increase your piece of the pie. How much more is a little murkier, but your marketing section analysis should be able to guide you.
Top-down forecasting allows you to work your goals into your company’s expectations of the future. It also allows for some spin, but keep it real.
Now to drive home the financials and forecasting of financials, we’re going to review the four reports again and look at some new beneficial ratios to use. If you feel like you’ve had enough of all the numbers, feel free to go on to the next chapter.
Cash Flow Statement: Cash Is King!
Money comes in; money goes out. The difference between the two is your profit or loss. Put it all on paper along with a timeline, and you have a basic cash flow statement (or budget). This means you put down how much money you expect from whom (by category—sales, loans, etc.) and when (by date, week, month, or quarter), and how much money you will need to pay out (bills, debts, and expenses) to whom and when,
In Rich Dad’s Guide to Investing, Robert Kyosaki and Sharon Lechter wrote: “Cash flow management is a fundamental and essential skill if a person truly wants to be successful in the B quadrant. Many small business owners fail because they do not know the difference between profit and cash flow.”If preparation of the report seems daunting, try breaking it down into easily digestible pieces. Create separate budgets for revenues (real and/or projected), cost of sales, fixed expenses, and variable expenses. You may also want to create a table of all your sources of incoming cash as well as one for all outgoing cash. You don’t have to include all this information in your plan (the table may contain detail better left under wraps). Then you can use these tables to figure out where the money is going to come from to pay the bills each month if cash in and cash out don’t exactly coincide. And there’s your timeline.
Your table or spreadsheet for cash flowing into your business can include categories such as:
• Amount of cash you have available for the business
• Sale revenues (broken out by sales, service, accounts receivable, collections, and deposits)
• Interest income
• Any sales of long-term assets
• Liabilities (such as loans)
• Equity (such as owner investments, sales of stock, or venture capital)
Your table or spreadsheet for cash flowing out of your business can include categories such as:
• Start-up costs (including business licenses)
• Inventory purchases
• Controllable expenses (such as freight, packaging, and advertising)
• Fixed expenses (such as rent, utilities, and insurance)
• Long-term purchase assets
• Liabilities (such as paying back Loans)
• Owner equity (money you take out as an owner)
You can prepare a statement for any stretch of time you want, but remember that the further out you project, the more you risk losing accuracy. It is best to stick to one fiscal year, beginning with the start of the current fiscal year and stepping month to month to the end of that same fiscal year. To improve accuracy, keep revising the statement (monthly is ideal) to reflect reality, and your ever-increasing expertise.
The timeline will help you plan for the time lag often involved with collection of receivables and will allow you to time collections so that you are not caught short when bills come due. For example, your office supply store likely experiences an influx of cash during August and September because of the back-to-school frenzy. your big bills may come significantly later in the year. Plan accordingly.
The cash flow statement (like most budgets) only includes real money (cash in, cash out). It does not include noncash transactions (such as amortization or depreciation).
The traditional format of a cash flow statement has the total for the year and the subtotals for each month in thirteen columns (vertical) with column labels across the top. The rows (horizontal) show the beginning balance and the amount of cash in and cash out by source, with the sources listed on the far left. The table (or spreadsheet) will be easier to understand if you break categories into subcategories when you can. Here is an example of a detailed cash flow statement:
Total [this row is the total for each category by column] Beginning Cash Balance [enter under month 1]
Cash Receipts
Sales Revenues
Cash Sales
Receivables
Sale of Long-Term Assets
Interest Income
Total Cash Available [add the Beginning Cash Balance to all Cash Receipts]
Cash Payments Cost of Sales Material
Labor
Purchases
Controllable Expenses
Supplies
Salaries
Freight
Packaging
Advertising
Miscellaneous Fixed Expenses Rent/Lease
Utilities
Office Salaries Licenses/Permits Insurance
Advertising
Miscellaneous Loan Payments Interest Payments Long-Term Asset Payments
Taxes
Federal Income Tax
Other Taxes Owner Draws
Total Cash Paid Out [add Cost of Sales, Controllable Expenses, Fixed Expenses, Loan Payments, Interest Payments, Long-Term Asset Payments, Taxes, and Owner Draws]
Balance [subtract Total Cash Paid Out from Total Cash Available; put negatives in brackets]
Incoming Loans [loan money coming in]
Equity Deposits [deposits to be made]
Ending Balance [add the numbers for each month; this number should be the same as the total for month 12]
An example of a pro forma cash flow statement is found in the appendix; the following is an example of a simplified Cash Flow Statement:
f you don’t, or if you find it difficult to prepare a reasonable projection, you may want to rethink your other sections and go back to researching.
Balance Sheets
A balance sheet (also known as a statement of financial position) is a balance of your company’s finances. It presents data on assets, liabilities, and net worth. Assets are anything of monetary value owned by the business. Liabilities are company debts. Net worth is capital—the worth of your equity as owner. When you add liabilities and net worth, you get a total for assets. Generally accepted accounting principles link these three factors because of their mathematical relationship. A positive net worth means assets outweigh liabilities; a negative net worth means liabilities outweigh assets.
No matter the business, no matter the use, balance sheets share the same format. All professionals expect this format. Anyone can read them and easily compare one to another. Due to the ease of interpretation of this format, balance sheets are relatively simple to create.
Assets are anything of value owned by or legally due to the company and fall into four categories:
1. Current: those that can be converted to cash within a year (such as cash, checking and savings accounts, accounts receivable, short-term investments, prepaid expenses, and inventory from raw materials to finished products)
2. Long-term: investments such as stocks, bonds, and special savings accounts to be kept for at least a year
3. Fixed: resources not meant for resale (such as land, buildings, improvements, equipment, vehicles, and furniture)
4. Other: assorted assets that typically are unique to a business’s circumstances.
Liabilities fall into two categories:
1. Current: payable within one operating cycle (such as notes, taxes, interest, payroll accrual, and accounts payable)
2. Long-term: mortgages, vehicles, notes, and the like (take the current payment due subtracted from the remaining balance)
Net worth or owner equity is given according to the legal structure of your business. Corporations use the total invested by owners or stockholders added to retained earnings (after dividends are paid). Partnerships, LLC’s, and sole proprietorships use the original investment of owners added to earnings after withdrawals.
A sample projected balance sheet is round in the appendix.
Balance sheets should be prepared on a regular basis, not just when you are preparing a business plan. The balance sheet can help you ou spot trends and plug cash leaks before they sink your company.
If you are preparing your plan fora new business, you might want to include a balance sheet of your personal finances instead of a business balance sheet, to show your ability to handle money. Then again, you might not want to do so, in order to show that you value your privacy.
Income Statement
The income statement (also known as a profit and loss statement or statement of operations) reveals your business profitability at a set point in time. What your business has spent (and what it was spent on) is combined with what your business has brought in (and from where) to tell you whether you made money or not.
Preparation of the income statement is best done on a monthly as well as yearly basis. You really don’t want to wait a year to see if you are making money. The data for your income statement should be readily available from your company records.
Again, there is a standard, expected format for your financial data. The income statement should include:
Income
Net Sales [returns and allowances subtracted from gross sales] Cost of Goods Sold
Gross Profit [Cost of Goods Sold subtracted from Net Sales]
Other Expenses
Direct, controllable, variable [those associated with sales]
Indirect, fixed, office, overhead [those associated with administration] Other
Net Profit/Loss Before Income Taxes
Income Taxes
Net Profit/Loss After Income Taxes
A sample of a detailed income statement is shown on page 147. Here is an example of a simplified income statement:
Income Statement for 2008
Gross Sales
Cost of Goods Sold Gross Profit
Expenses
Net Profit Before Taxes Taxes
Net Profit/Loss
The income statement can help you track the effectiveness of ,your plans by showing how expenses and sales are affecting profits or losses. It will also help you plan for variations in sales volumes from month to month. Though you only need one year’s worth of info for the business plan, a comparison of income statements over a period of years can help you see longer-term trends and therefore can help you plan accordingly. Break-Even Analysis
As discussed, a break-even analysis answers the question of how much your business will need to sell in order to cover its costs. For example, if you sell copy machines, the break-even analysis enables you to figure out exactly how many copiers you need to sell in order to pay all your bills. Add one more copier to the mix and you suddenly see profit.
The analysis is a good one for entrepreneurs because it encourages an in-depth understanding of costs. The analysis is a good one for lenders and investors because it says a lot about whether or not you, as writer of the plan, are realistic in your assumptions.
The break-even point is the dream of any entrepreneur. It is that point at which you can start to breathe a little easier. It is the point when you start to think maybe going into business for yourself was a good decision. It is the beginning of stability. It is the point too many businesses never reach. But numerically, it is the point at which your fixed and variable expenses (including cost of sales) are met by your product and/or service sales. You won’t be making a profit, but you will no longer be taking a loss either.
You can display this point in a number of ways in your business plan. In either graph h or table form, you can show dollars of expense compared to dollars of revenue or even dollars of expense compared to units of production (in either products or services). Your income projection can be the source for either way of showing the information.
If you decide to use a mathematical presentation, you can find the exact break-even point with a simple formula:
break-even = fixed expenses + (1 – variable expenses/sales) come that increases as sales increase, your revenue line will be drawn at a forty-five-degree angle on the chart. The point at which your revenue line and your total cost line meet is marked as your break-even point.
Break Even Analysis Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7
Sales 20000 22000 24000 26000 280000 30000 32000
Variable Costs 12000 13000 14000 14000 150000 16000 17000
Fixed Costs 10000 10000 10000 10000 100000 10000 10000
Fixed + Variable Costs 22000 23000 24000 24000 250000 26000 27000
Net –2000 –1000 0 2000 3000 4000 5000
Because the graphic presentation is such a great way to express complicated data for a visually focused society and the numerical presentation is so great for bankers and other number-focused types, you may choose to present Your data in both formats (might as well cover your bases) or pick and choose and customize for your particular audience.
Ratios
When potential investors begin their task of analyzing your business for risk and feasibility, they bring experience and expertise to bear on your business plan. It’s not simply a matter of whether or not they like your idea or whether or not they have the money to give. Nor is it a matter of how personally persuasive you are. What it comes down to is whether or not they think your business proposal, as presented in your business plan, is feasible. In other words, can your business make money?
40000
30000
Costs 20000
10000
0
(sales) Break-Even
(variable costs)
(fixed cost)
Sales Over Time
To create your own break-even diagram, you must first plot your fixed costs and variable costs. Label your vertical axis as costs (in dollars). Then label the horizontal axis as sales (in dollars). Your fixed costs will form a straight horizontal line across the graph because your fixed costs will stay constant even as your sales increase. Your variable costs line will increase as sales increase. The line formed by plotting variable costs on top of fixed costs will create your total cost line. Now you must add your revenue. Because revenue is in-come that increases as sales increase, your revenue line will be drawn at a forty-five-degree angle on the chart. The point at which your revenue line and your total cost line meet is marked as your break-even point.
Break Even Analysis Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7
Sales 20000 22000 24000 26000 280000 30000 32000
Variable Costs 12000 13000 14000 14000 150000 16000 17000
Fixed Costs 10000 10000 10000 10000 100000 10000 10000
Fixed + Variable Costs 22000 23000 24000 24000 250000 26000 27000
Net –2000 –1000 0 2000 3000 4000 5000
Because the graphic presentation is such a great way to express complicated data for a visually focused society and the numerical presentation is so great for bankers and other number-focused types, you may choose to present Your data in both formats (might as well cover your bases) or pick and choose and customize for your particular audience.
Ratios
When potential investors begin their task of analyzing your business for risk and feasibility, they bring experience and expertise to bear on your business plan. It’s not simply a matter of whether or not they like your idea or whether or not they have the money to give. Nor is it a matter of how personally persuasive you are. What it comes down to is whether or not they think your business proposal, as presented in your business plan, is feasible. In other words, can your business make money?
40000
30000
Costs 20000
10000
0
(sales) Break-Even
(variable costs)
(fixed cost)
Sales Over Time
One of the ways experienced financial decision makers make their decisions is through the analysis of ratios. just as the term implies, ratio analysis involves taking numbers from the financial tables and comparing one to another. Which numbers are chosen and how they are combined tell a lot about different aspects of the business under scrutiny.
Most ratios are not analyzed in a vacuum either. Ratios are commonly compared to one another in a historical, competitive, and/or budgetary context. By comparing current figures with those of the past, decision makers can get a feeling for mobility and trends within the company. By comparing figures for one company to those of competing companies, decision makers can get a feeling for where the company stands in the competitive hierarchy of its industry By comparing real figures to budgeted figures, decision makers can see how well you have budgeted. This last comparison usually comes into play after funding has been granted. It is a good way for investors to stay on top of a company’s promises. It is also a great way for you or your management team to learn to refine your budgeting abilities.
Knowledge of ratios on your part is akin to learning to speak the language of potential investors. It gives you a chance to see what impressions your financials will make on decision makers. It alsoives you a valuable management
tool. By tracking your ratios, you can spot trends, strengths, weaknesses, and potential roadblocks. Following are some of the most commonly used ratios.
Liquidity Ratios
The current ratio and the quick ratio are two examples of liquidity ratios. The current ratio is used to determine liquidity of an existing business by dividing current assets by current liabilities. If the current ratio is greater than 1.0, then the business has a chance of being able to pay its short-term bills. The larger the number, the better the chance of paying the bills. If that number is less than 1.0, the business may be in rough water. However, decision makers will also take into account industry norms. If a ratio of 4.0 is the average for an industry, that current ratio of 1.0 is not nearly as good as it would be in an industry with an average of, say, 1.5.
The quick ratio (also called the acid test) is a measurement of liquidity without inventory being calculated in. It is current assets (not including inventory) divided by current liabilities. Comparing the quick ratio to the cur-rent ratio gives decision makers an idea of how dependent liquidity is upon inventory.
Debt Management Ratios
Debt management ratios include the debt ratio and the times interest earned ratio (TIE). The debt ratio is a measure of risk in that it shows how well the company’s assets support its monetary obligations. The debt ratio is found by dividing total debt (including long-term debt, short-term debt, and current liabilities) by total assets. A high debt ratio means high risk to potential investors.
The TIE measures how well earnings cover interest and can be found by dividing earnings before interest and taxes by interest. The higher the number, the more times earnings can cover interest, thus the safer the investment.
Asset Management Ratios
Inventory turnover and average collection period (ACP) are both examples of asset management ratios. The inventory turnover ratio measures how often your company gets rid of and restocks an average-sized inventory It is measured by dividing costs of goods sold by inventory. A higher number is better because higher numbers mean you are more quickly going through your inventory. This means fewer of your business dollars are tied up in inventory. Inventory can cost you in storage, taxes, insurance, and interest as well as time. Inventory and time are not friends. As time passes, inventory can become outdated, unpopular, or even unsafe.
ACP measures how long it takes to collect on sales on credit. When you sell on credit, there will be a lag time. That lag time is measured by the ACP
9 by
(also known as days sales outstanding and the receivables cycle) and is found by dividing accounts receivable by sales and multiplying the total by 360. Obviously, you want that number to be as small as possible. Ideally you want it as close to your company’s terms of sale as you can get it. If the number exceeds your terms of sale significantly T (greater than 30 percent is usually a problem), you show that you are not being as strict with your credit choices as you should be or there is significant customer dissatisfaction. Neither is going to endear you to potential investors. While you may have most
T very
of your receivables paid promptly, a few very old accounts can skew this ra-tio. Take into account the odds of ever getting payment from those very old accounts and decide whether or not to write them off.
Profitability Ratios
Profitability ratios include return on sales (ROS), return on assets (ROA), and return on equity (ROE). The ROS ratio is the most basic measurement of profitability and says something about how well you can keep down costs and expenses. Divide net income by sales and, voila, you have profitability (at least on paper).
The ROA ratio similarly says something about how well you use invested assets and is found by dividing net income by total assets.
The ROE ratio builds on the ROA by taking leverage into account and is found by dividing net income by equity. Debt affects ROA and ROE in that the two will be close if debt is small. But when debt grows large, ROE is higher than ROA when the company is doing well and lower when the company is doing poorly.
Financial History/Loan Application
A good indicator of where you’re going in business is where you’ve been. One of the best ways to reassure investors of future success is through showing past success. If you are writing your plan for an existing business, you will include information on your business from start-up to present. Put this first in the financials section; it is your loan application. But prepare it last. Preparation of all the other financial documents will greatly help you in preparation of the financial history.
Even if you are not preparing your plan for investment purposes, this exercise will help in your management practices by helping you look at your business from a big-picture perspective.
The financial history subsection is a summary. Summarize the data from the other sections and reference those sections accordingly. The following are some of the categories usually summarized in this section:
Assets
Liabilities Net worth
Contingent liabilities
Inventory detail
Revenues Expenses
Real estate holdings
Stocks
Bonds
Legal structure
Insurance
Audit information
If you are writing your plan for a new business, you may want to include information on your personal financial history and status, including a personal finance balance sheet with information on assets (cash, life insurance cash value, trust deeds, personal property, mortgages, real estate, stocks, bonds, mutual funds, accounts receivable, notes receivable), liabilities (unsecured loans, credit card debt, revolving credit debt, notes and deeds, loans secured by personal property, loans against life insurance), net worth, annual income, and annual living expenses. This information will help potential investors see how well you handle money. But remember also that in this era of identity theft, the less information you give out the better.
Keep in mind that the personal financial history combined with the information you include in your loan application (provided by institutions upon request) needs to be verifiable and accurate, just as it would if you were providing information on an existing business’s financial history.
Uses of Funds
It would be nice if your promise to pay someone back was all it took to get funding for your business. It would be nice if there were institutions or individuals who would write you a blank check to pursue your dreams. But it’s not likely. Most institutions and individuals want to know exactly what you plan on doing with their money. And keep that straight: It is their money.
The best place to start with how you will use the funds you are requesting (if that is the purpose of the plan) is to provide a summary of your business’s financial needs. If you are preparing the plan for management purposes only, you will want to skip this section.
The summary of financial needs and the uses of funds can both be short and to the point. An example is found in the appendix. The summary is a simple statement of what you need. Working capital, growth capital, and equity capital are the three broad categories of funds. The main difference between the three is in how quickly you will be expected to repay the money. Working capital loans are usually for only a year, growth capital loans are for a few years (usually no more than seven), and equity capital is usually repaid through a stake in the business (which means the payback could be slow in coming, but it may continue to pay over the long haul above and beyond the initial investment),
Be specific as to what you need the funds for. Are you looking for a loan to buy equipment or pay for training? Are you looking for an investor to take on a significant portion of start-up costs?
Also be specific as to how much you need and how it will be disbursed. If you are buying equipment, for example, list how much that equipment will cost, along with the exact make and model. If you are investing in training, list how much it will cost, how long it will take, and who will be doing the training. Give the details it will take for a lender to determine whether or not the investment will increase profit. In fact, if you have data on how profit will be increased (and you should), include that in this section as well.
Assumptions
Not even numbers are concrete in today’s world. There is always a bias, whether conscious or not. The purpose of the assumptions subsection is to explain to readers how you chose your numbers. It is the section readers turn to in order to interpret the biases of the preparer. Assumptions answer the all-important question “Why?” Why did you decide, for example, that you could double your sales in two years? If readers don’t know your reasoning, they cannot make an educated decision as to the validity of your numbers. Your assumptions are yet another chance to convince your readers.
If you are preparing your business plan in order to attract investment, you definitely need this section. If you are preparing your plan for manage-meet purposes, you might leave it out if it’s only for your own use. However, if the plan will be used by others or if you are preparing it for the edification of others in your business, you might want to keep it in. With your assumptions in mind, others within your company are better able to meet goals because they know what is behind those goals. For example, if your income projection states that you plan to double your sales within two years, it would be nice for your sales staff to know how you think that is possible. Is there new technology in the offing? Is a piece of proprietary information finally snaking its way through the approval process? Do you plan an expansion? All good information for your staff to know
As for format, some plans include the assumptions as footnotes at the bottom of each of the financial tables, some include them as a separate page within each table’s subsection, and yet others have one separate subsection devoted to explaining all the assumptions that went into all the financials. Choose the format that works best for your business.
Don’t get lazy with this subsection and never assume that any of the numbers are self-explanatory. Discussions about your plan may occur months after you have prepared your numbers, and you might actually forget why, for example, you thought you could double sales within two years. Don’t get stuck fumbling for explanations in a loan or investment meeting. If the assumptions are on paper, you can refer to them. If they aren’t, you could end up losing the trust of those whose money you are trying to obtain. Why risk it?
• As final points on the financials, know that your investors want to see how much “skin in the game” you have. Keep your salaries as low as possible to show that you are investing “sweat equity”
• Also know that your investors will want your overhead kept low. They want to see their money spent on the business, not on the office surroundings.
