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3/21/10 The Financial Forecasts for the Business Plan


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3/21/10 The Financial Forecasts for the Business Plan

  1. 1. The Financial Forecasts for the Business Plan Shad Valley 2007
  2. 2. Contact Info <ul><li>Ken Hartviksen </li></ul><ul><ul><ul><li>[email_address] </li></ul></ul></ul><ul><ul><ul><li>Office: RB 1043 </li></ul></ul></ul><ul><ul><ul><li>343-8497 </li></ul></ul></ul><ul><li>Web links: </li></ul><ul><ul><li> </li></ul></ul><ul><ul><li> </li></ul></ul>
  3. 3. Today’s Agenda <ul><li>Contact Info </li></ul><ul><li>Purpose of Financial Forecasts </li></ul><ul><li>Characteristics of Good Financial Forecasts </li></ul><ul><li>How to forecast and how to recognize assumptions </li></ul><ul><li>A tour of the financial forecasts required </li></ul><ul><li>Break even analysis </li></ul><ul><li>Purpose of each forecast and their interrelationships </li></ul><ul><li>Data requirements and how they are generated </li></ul><ul><li>Annual Sales Forecast </li></ul><ul><li>Monthly Sales Forecast </li></ul><ul><li>Monthly Cash Budget </li></ul><ul><li>Pro forma Financial Statements </li></ul>
  4. 4. What we Hope to Accomplish <ul><li>Understand the importance and use of: </li></ul><ul><ul><li>Cash flow </li></ul></ul><ul><ul><li>Financial forecasts </li></ul></ul><ul><li>Learn how to develop loan amortization schedules and CCA schedules </li></ul><ul><li>Learn how to incorporate this forecast information into financial forecasts </li></ul><ul><li>Get you started on your own forecasts </li></ul><ul><li>Develop some skills in the use of Excel spreadsheets </li></ul>
  5. 5. The Purpose of Financial Forecasts <ul><li>To: </li></ul><ul><ul><li>Predict the financial consequences of our business plan </li></ul></ul><ul><ul><li>Allow us to change our plans in advance to optimize the real financial results after analyzing the forecast financial statements. </li></ul></ul><ul><ul><li>To demonstrate to financial partners the ability of the business to give them an adequate return on investment. </li></ul></ul>
  6. 6. The Purpose of Financial Forecasts – What do Investors Look For? <ul><li>Ability to generate cash flow early enough and in sufficient quantity to ensure on-going financial solvency </li></ul><ul><li>Time to break even </li></ul><ul><li>Time to positive cash flow </li></ul><ul><li>Time to profitability </li></ul><ul><li>Return on investment </li></ul>
  7. 7. Characteristics of Good Forecasts <ul><li>Reasonable/plausible </li></ul><ul><li>Based upon good primary and secondary research </li></ul><ul><li>Congruent with operating and marketing plans </li></ul><ul><li>Can withstand stress testing </li></ul><ul><li>Conservative/achievable </li></ul>
  8. 8. Where do you Start? <ul><li>When generating integrated financial statements you start with: </li></ul><ul><ul><li>Sales forecast </li></ul></ul><ul><li>You will modify the annual sales forecast to a monthly sales forecast for the first year </li></ul><ul><li>Make projections of all expenses for the first year. </li></ul><ul><li>Start with a guess about the amount of initial financing required and where it is likely to be invested. </li></ul><ul><li>Remember: </li></ul><ul><ul><ul><li>The big difference between the cash budget and the pro forma Income Statement is that you include depreciation in the Income Statement and ignore it in the cash budget. </li></ul></ul></ul><ul><ul><ul><li>The other big difference is that you use total interest expense for the year in the income statement, but you use the total payments in the cash budget. </li></ul></ul></ul>
  9. 9. Integrated Financial Forecasts Analyze forecasts, adjust inputs and forecast again. Sales Forecast Cash Budget Initial Investment Schedule Pro Forma Income Statement Pro Forma Balance Sheet Detailed Expense Forecasts Loan Amortization Schedule Capital Cost Allowance Schedule
  10. 10. Before we Get Started Let’s Review Some Things about Business Plans <ul><li>A Business Plan … is a forecast of what you hope to do….and how and when you hope to do it! </li></ul>
  11. 11. Characteristics of a Good Plan <ul><li>readable </li></ul><ul><li>organized </li></ul><ul><li>targeted to the audience </li></ul><ul><li>integrated </li></ul><ul><li>complete </li></ul><ul><li>short </li></ul>
  12. 12. Uses of A Business Plan <ul><li>Helps you understand the steps to implementing your idea and what key factors you must monitor to ensure success. </li></ul><ul><li>Support an application for financing </li></ul><ul><li>Solicit potential financial partners </li></ul>
  13. 13. How a Business Plan is Read <ul><li>Determine the characteristics of the company and industry </li></ul><ul><li>Determine the terms of the deal </li></ul><ul><li>Read the latest balance sheet </li></ul><ul><li>Determine the caliber of the people in the deal </li></ul><ul><li>Determine what is different about this deal </li></ul><ul><li>Give the plan a once-over lightly </li></ul>
  14. 14. Abbreviated Contents <ul><li>Title Page (with disclaimer) </li></ul><ul><li>Executive Summary </li></ul><ul><li>Table of Contents </li></ul><ul><li>Business Idea </li></ul><ul><li>Industry/Company </li></ul><ul><li>Market Research and Analysis </li></ul><ul><li>Economics of the Business </li></ul><ul><li>Marketing Plan </li></ul><ul><li>Design and Development Plans </li></ul><ul><li>Manufacturing and Operations Plan </li></ul><ul><li>Management Team </li></ul><ul><li>Overall Schedule </li></ul><ul><li>Critical Risk, Problems and Assumptions </li></ul><ul><li>The Financial Plan </li></ul><ul><li>Financing </li></ul><ul><li>Appendices </li></ul>NOTE the location of the financial documents
  15. 15. IV. Economics of the Business <ul><li>Gross and operating margins </li></ul><ul><li>Profit potential and durability </li></ul><ul><li>Fixed, variable and semi-variable costs </li></ul><ul><li>Months to Break even </li></ul><ul><li>Months to reach positive cash flow </li></ul>
  16. 16. XI. The Financial Plan <ul><li>Actual financial statements (if an already established business) </li></ul><ul><li>initial investment required </li></ul><ul><li>cash budget </li></ul><ul><li>pro forma balance sheet </li></ul><ul><li>pro forma income state </li></ul><ul><li>break even chart </li></ul><ul><li>cost control </li></ul>
  17. 17. XII. Financing <ul><li>Proposed sources of financing </li></ul><ul><li>use of funds </li></ul><ul><li>investor’s forecast rate of return on invested capital </li></ul>
  18. 18. The Basic Financial Forecasts Shad Valley Lakehead
  19. 19. Types of Financial Forecasts <ul><li>Break Even Analysis </li></ul><ul><li>Initial Investment Schedule </li></ul><ul><li>Monthly Cash Budget </li></ul><ul><li>Pro forma Income Statements </li></ul><ul><li>Pro forma Balance Sheets </li></ul><ul><li>Subsidiary forecasts </li></ul><ul><ul><li>Loan Amortization schedule </li></ul></ul><ul><ul><li>CCA schedule </li></ul></ul><ul><li>Statement of Forecast Assumptions </li></ul>
  20. 20. Break-even Analysis Shad Valley 2007
  21. 21. Break - Even Analysis (Cost/Volume/Profit Analysis) <ul><li>This is a planning and control technique. </li></ul><ul><li>PLANNING: </li></ul><ul><ul><li>make informed decisions about pricing your product or service and the cost to produce it. </li></ul></ul><ul><li>CONTROL: </li></ul><ul><ul><li>compare your actual results with those that you have forecast. (For example, your restaurant may require you to sell 10,000 meals at $10.00 per meal = $100,000 in order to break even annually. This works out to 192 meals a week or 28 per day. If on the first day of operation you sell 30 meals…you are on track to break even!) </li></ul></ul>
  22. 22. Break - Even Analysis (Cost/Volume/Profit Analysis) <ul><li>The break-even point can be found using the following equation: </li></ul><ul><li>B.E. Point = Fixed Costs </li></ul><ul><li>Contribution Margin </li></ul><ul><li>= Fixed Costs </li></ul><ul><li>Selling price/unit - Variable Cost/unit </li></ul>
  23. 23. Cost Behaviour <ul><li>You can classify fixed and variable costs according to how they change in response to changes in sales volume. </li></ul><ul><li>Fixed Costs </li></ul><ul><ul><li>are costs that (within the relevant range) don’t change in response to changes in sales volume. </li></ul></ul><ul><ul><li>Examples include depreciation expense, rent, salaries and other overhead costs. </li></ul></ul><ul><li>Variable Costs </li></ul><ul><ul><li>are costs that (within the relevant range) change in response to changes in sales volume. </li></ul></ul><ul><ul><li>Examples include direct materials and direct labour costs (wages paid by hour). </li></ul></ul>
  24. 24. Relevant Range <ul><li>The relevant range is the range of output (units produced and sold) that the cost and pricing assumptions can reasonably be expected to hold. </li></ul>$ of Sales and Costs # of units produced and sold Total Revenue Total Costs Fixed Costs Relevant Range
  25. 25. Relevant Range <ul><li>If sales are expected to push the firm beyond its current physical capacity, (beyond the relevant range) cost behaviour assumptions must be revised. </li></ul>$ of Sales and Costs # of units produced and sold Total Revenue Total Costs Fixed Costs Relevant Range
  26. 26. Break - Even Analysis (Cost/Volume/Profit Analysis) Number of units produced and sold $ of Sales and Costs Total Revenue Line 1 2 $20 $10 The slope of the revenue line is determined by the price that you set for your product or service. Sales revenue when price per unit is $10.00.
  27. 27. Break - Even Analysis (Cost/Volume/Profit Analysis) Number of units produced and sold $ of Sales and Costs Total Revenue Line 1 2 $20 $10 The slope of the revenue line is determined by the price that you set for your product or service. Sales revenue when price per unit is $5.00.
  28. 28. Break - Even Analysis (Cost/Volume/Profit Analysis) Number of units produced and sold Total Revenue Line $7.50 $10 Total Variable Cost Contribution Margin per unit = $2.50 The slope of the revenue line is determined by the price that you set for your product or service. $ of Sales and Costs 1 2 If variable cost per unit is less than price per unit, there is a positive contribution margin.
  29. 29. Contribution Margin <ul><li>For most small businesses, it is relatively easy to determine the variable cost per unit. </li></ul><ul><li>What you want to determine is how much it costs you in terms of direct material and direct labour to produce your product or service. </li></ul><ul><li>Once you know the variable cost per unit, this becomes a good guide to you in the pricing decision. Obviously, if you price your product under your variable cost per unit, you will lose money each time you sell one unit. The more you sell, the more money you lose. </li></ul><ul><li>Look at the following example….. </li></ul>
  30. 30. Contribution Margin Example <ul><li>You plan to start a bagel shop. </li></ul><ul><li>The average customer will purchase a dozen bagels, some cream cheese and a coke. </li></ul><ul><li>You have determined that your variable costs to produce this ‘average customer purchase’ as follows: </li></ul><ul><li>Variable Cost per unit </li></ul><ul><li>Coke and cup $0.85 </li></ul><ul><li>12 Bagels cooked (materials and electricity) 2.99 </li></ul><ul><li>Cream cheese and container 1.65 </li></ul><ul><li>Straw/napkins/bag and other condiments 0.75 </li></ul><ul><li>Direct labour costs (counter help & cook) 2.75 </li></ul><ul><li>Total variable cost per unit $8.99 </li></ul><ul><li>Given your analysis you initially price coke at $2.00 and a dozen bagels with cheese for $8.50 giving you a contribution margin of $1.51 per unit. Total cost to the customer is $10.50 plus PST and GST or $12.08 </li></ul>
  31. 31. Contribution Margin …. <ul><li>You now find out that the Great Canadian Bagel sells coke for $1.75 and a dozen bagels with cheese for $6.50 for a total cost to the customer of $9.49 (including Gst and Pst)…this is below your estimated variable cost per unit! </li></ul><ul><li>The Great Canadian Bagel is a franchise that benefits by the fact that the franchisor has tremendous buying power (centrally negotiates purchases and prices with suppliers for flour, cream cheese and coke). This gives them a competitive advantage over you... </li></ul><ul><li>Variable Cost per unit Great Canadian Bagel </li></ul><ul><li>Coke and cup $0.85 $0.45 </li></ul><ul><li>12 Bagels cooked (materials and electricity) 2.99 1.50 </li></ul><ul><li>Cream cheese and container 1.65 1.20 </li></ul><ul><li>Straw/napkins/bag and other condiments 0.75 0.50 </li></ul><ul><li>Direct labour costs (counter help & cook) 2.75 2.75 </li></ul><ul><li>Total variable cost per unit $8.99 $6.40 </li></ul>
  32. 32. Contribution Margin …. <ul><li>Conclusion: if you are to compete with the Great Canadian Bagel purely on price, you will fail. </li></ul><ul><li>Variable Cost per unit Great Canadian Bagel </li></ul><ul><li>Coke and cup $0.85 $0.45 </li></ul><ul><li>12 Bagels cooked (materials and electricity) 2.99 1.50 </li></ul><ul><li>Cream cheese and container 1.65 1.20 </li></ul><ul><li>Straw/napkins/bag and other condiments 0.75 0.50 </li></ul><ul><li>Direct labour costs (counter help & cook) 2.75 2.75 </li></ul><ul><li>Total variable cost per unit $8.99 $6.40 </li></ul><ul><li>Selling Price to the Public per unit $10.50 $8.25 </li></ul><ul><li>Contribution margin per unit $1.51 $1.85 </li></ul><ul><li>Your variable cost per unit is higher than the Great Canadian Bagels variable cost per unit. </li></ul><ul><li>Your proposed selling price is 27% higher than your competition yet your proposed contribution margin is 18% lower. </li></ul>
  33. 33. Contribution Margin Analysis <ul><li>Faced with this pricing and costing analysis, you have some choices: </li></ul><ul><ul><li>forget about going into this business </li></ul></ul><ul><ul><li>seek to negotiate arrangements where your direct operating costs can be lowered </li></ul></ul><ul><ul><li>devise a product or marketing strategy that would induce consumers to purchase your products over the Great Canadian Bagel product (higher quality product, perceived greater value that justifies the higher price) </li></ul></ul><ul><ul><li>seek to locate your business somewhere there is no direct competition. (Nipigon, Marathon, Atikokan, Sioux Lookout) </li></ul></ul><ul><li>Of course, further analysis will be required (before proceeding) to determine whether you could actually make a profit at the business. </li></ul>
  34. 34. Contribution Margin <ul><li>The contribution margin is the amount of money that is available from the sale of each unit to cover the fixed costs of the firm. </li></ul><ul><li>Once those fixed costs are covered, any further units that are sold will result in profit…. </li></ul>
  35. 35. Break Even Point <ul><li>Is the point where total revenue equals to total costs </li></ul><ul><li>Variable and Fixed costs are summed to equal total costs. </li></ul><ul><li>Break even point in units = Annual Fixed Costs / contribution margin </li></ul>
  36. 36. Break Even Chart $ of Sales and Costs # of units produced and sold Total Revenue Total Costs Fixed Costs Break Even Point in Units TR = TC
  37. 37. Annual Fixed Costs of the Bagel Business <ul><li>Let us assume for a moment that you have decided to locate your proposed business in Nipigon where you are sure that there is no competition, and it is unlikely competition would enter the market after you arrive. </li></ul><ul><li>You estimate that once established, you will face the following fixed costs each year to run the business: </li></ul><ul><li>Annual building lease costs (12 months @ $2,000/month) $24,000 </li></ul><ul><li>Office expenses (bank charges, accountant etc.) 8,000 </li></ul><ul><li>Depreciation of equipment (ovens, microwave, etc.) 4,400 </li></ul><ul><li>Gross Salary for the manager 34,000 </li></ul><ul><li>Employer contribution to CPP/EI and employer health tax 9,520 </li></ul><ul><li>Other fixed costs (advertising and promotion) 2,000 </li></ul><ul><li>TOTAL ANNUAL FIXED COSTS $81,650 </li></ul>
  38. 38. Break Even Point of the Bagel Business <ul><li>The breakeven point, given your analysis to this point is: </li></ul><ul><li>Break-even point in #’s of meals annually = Annual Fixed Costs </li></ul><ul><li>Contribution Margin </li></ul><ul><li>= $81,650 </li></ul><ul><li> $1.51 </li></ul><ul><li>= 54,073 meals </li></ul><ul><li>This works out to 4,507 meals per month or 149 meals per day. </li></ul>
  39. 39. Break Even Point of the Bagel Business <ul><li>Break-even point = 54,073 meals </li></ul><ul><li>This works out to 4,507 meals per month or 149 meals per day. </li></ul><ul><li>This implies baking and selling 1,788 bagels per day with no wastage. </li></ul><ul><ul><li>Do your oven’s and facilities have the capacity to produce this volume each day? </li></ul></ul><ul><ul><li>If you are closed on Christmas, New Year’s or any other day…you will have to sell more on the other days on average. </li></ul></ul><ul><ul><li>NOW - the big question….what is the market for your product in that location…who would buy bagels? How frequently? What is their purchasing behaviour? Attitudes toward price? </li></ul></ul>
  40. 40. Break Even Point of the Bagel Business <ul><li>Break-even point = 54,073 meals </li></ul><ul><li>At an average price per sale of $10.50, that volume of meals means annual sales revenue of: </li></ul><ul><li>Annual Sales Revenue = Price per meal times # of meals </li></ul><ul><li>= $10.50 * 54,073 </li></ul><ul><li>= $567,766.50 </li></ul>
  41. 41. Initial Investment Schedule
  42. 42. Initial Investment Schedule <ul><li>The purpose of the initial investment schedule: </li></ul><ul><ul><ul><li>Identify proposed sources of capital </li></ul></ul></ul><ul><ul><ul><li>Identify proposed initial uses of capital </li></ul></ul></ul>
  43. 43. The Monthly Cash Budget
  44. 44. The Monthly Cash Budget <ul><li>The purposes of the monthly cash budget: </li></ul><ul><ul><ul><li>Illustrate projected sources of cash – timing and magnitude </li></ul></ul></ul><ul><ul><ul><li>Illustrated projected uses of cash – timing and magnitude </li></ul></ul></ul><ul><ul><ul><li>Demonstrate the time to producing a positive cash flow </li></ul></ul></ul>
  45. 45. The Pro Forma Income Statement
  46. 46. The Pro Forma Balance Sheet
  47. 47. Subsidiary Forecasts <ul><li>You will need to make a series of forecasts that will be incorporated into your overall financial forecasts. </li></ul><ul><li>Some of it will require outside data gathering for example: </li></ul><ul><ul><li>Employer contributions to CPP and EI </li></ul></ul><ul><ul><li>WSIB premiums </li></ul></ul><ul><li>The most common subsidiary forecasts are: </li></ul><ul><ul><ul><li>Loan amortization schedule </li></ul></ul></ul><ul><ul><ul><li>Capital Cost Allowance Schedule </li></ul></ul></ul>
  48. 48. Types of Small Business Loans <ul><li>Standard Bank Financing: </li></ul><ul><ul><li>Fixed term </li></ul></ul><ul><ul><ul><li>Fixed rate </li></ul></ul></ul><ul><ul><ul><li>Variable rate </li></ul></ul></ul><ul><ul><li>Operating Line of Credit </li></ul></ul><ul><li>Government Financing: </li></ul><ul><ul><li>Northwestern Ontario </li></ul></ul><ul><ul><ul><li>FedNor </li></ul></ul></ul><ul><ul><ul><li>Thunder Bay Ventures </li></ul></ul></ul><ul><ul><li>Business Development Bank of Canada </li></ul></ul>
  49. 49. Fixed Term Blended Payment Loans This is a diagram of the cash flows involved $10,000 Monthly fixed payments
  50. 50. Effective Annual Rate Calculations <ul><li>You wish to borrow $10,000 </li></ul><ul><li>Assume you are quoted a fixed term, fixed payment loan at 2.5 percent above the prime lending rate </li></ul><ul><li>The prime lending rate is currently 4.5% </li></ul><ul><li>The loan amortization period is 1 year </li></ul>
  51. 51. Calculating an Effective Monthly Rate <ul><li>Since most loans require monthly payments, it is necessary to determine the monthly rate that would equal the effective annual rate: </li></ul>
  52. 52. Calculating the Monthly Loan Payment <ul><li>Now we know all of the variables: </li></ul><ul><ul><li>$10,000 loan </li></ul></ul><ul><ul><li>7% APR 1-year term loan </li></ul></ul><ul><ul><li>We can calculate the loan payment: </li></ul></ul>
  53. 53. Preparing a Loan Amortization Schedule
  54. 54. Use of the Loan Amortization Schedule <ul><li>The loan payment each month is a cash outflow that must be included in your cash monthly cash budget. </li></ul><ul><li>The total interest expense for the year is included in the pro forma income statement. </li></ul><ul><li>NOTE: - repayment of principal is not a tax deductible expense. </li></ul><ul><li>- the total payment is a cashflow burden borne by the firm </li></ul>
  55. 55. Effective Annual Rates of Return <ul><li>Most loan rates are quoted in APR terms (annual percentage rate) </li></ul><ul><li>However, APR financing does not take into account the effects of compounding </li></ul><ul><li>Most loans are compounded semi-annually. (ie. Interest is calculated and credited every six months). This effectively increases the rate of interest that the consumer faces. </li></ul>
  56. 56. The Nature of Depreciation <ul><li>Capital assets such as buildings and equipment and land are very costly, but usually have a useful life of greater than one year. </li></ul><ul><li>Buildings and equipment tend to wear out over time (ie. They have a useful life of perhaps 10, 20 or 30 years) </li></ul><ul><li>Land doesn’t wear out. </li></ul><ul><li>The cost of the buildings and equipment is spread out over their useful lives, and only the amount of wastage (wear and tear) is deductible from income in that year for the purposes of calculating taxes. </li></ul><ul><li>CCRA predominantly uses one method of depreciation…it is known as Capital Cost Allowance. </li></ul>
  57. 57. CCA gives rise to a ‘Tax Shield Benefit’ to the Company <ul><li>CCA is a non-cash deduction from income that would otherwise be subject to income taxation. </li></ul><ul><li>As a result of the CCA deduction, taxable income is reduced. </li></ul><ul><li>This results in a savings in tax payable. </li></ul><ul><li>The tax shield benefits is equal to: T(CCA) </li></ul><ul><li>t = corporate tax rate </li></ul><ul><li>CCA = the dollar amount of CCA claimed </li></ul><ul><li>A firm with a 40% corporate tax rate and a $2,000 CCA deduction will save $800 in taxes. </li></ul>4 K. Hartviksen
  58. 58. Example: Consider two firms that report $10,000 in earnings before CCA and taxes, face a 40% tax rate. One firm has no CCA to claim, the other can claim $2,000 in CCA <ul><li>Company A Company B </li></ul><ul><li>Earnings Before CCA & Tax $10,000 $10,000 </li></ul><ul><li>CCA 2,000 0 </li></ul><ul><li>Taxable Income $ 8,000 $ 10,000 </li></ul><ul><li>Taxes @ 40% 3,200 4,000 </li></ul><ul><li>Net Income $ 4,800 $ 6,000 </li></ul><ul><li>Add back non-cash expense 2,000 0 </li></ul><ul><li>Cash flow from Operations $ 6,800 $ 6,000 </li></ul>5 K. Hartviksen Note that company A is better off by $800 because of the $2,000 non-cash deduction of CCA. That is the amount of taxes saved.
  59. 59. CCA Rules <ul><li>Assets are grouped into pools or classes and depreciated as a group </li></ul><ul><li>CCA rates are found in the regulations to the Income Tax Act and can be changed by Order-in-Council </li></ul><ul><li>There is no need for an estimate of salvage value or useful life </li></ul><ul><li>1/2 of the regular CCA rate for the class applies to the net additions to the pool for that year. </li></ul><ul><li>CCA cannot be used to create a tax loss. </li></ul>7 K. Hartviksen
  60. 60. CCA Over Time - A Simple Example Assume you acquire a depreciable asset with a cost base of $100,000 and there are no other assets in this pool. The CCA rate for the pool is 10%. Note you are allowed only 1/2 the regular CCA rate on the net additions to the pool in the year of acquisition. 8 K. Hartviksen
  61. 61. CCRA Form
  62. 62. CCRA Form forecasting CCA out three years for one asset class
  63. 63. NOTE Regarding Depreciation in your Financial Forecasts: <ul><li>You never include depreciation (CCA) on a cash flow (cash budget) forecast </li></ul><ul><li>You use depreciation only in your pro forma income statement, and on your pro forma balance sheet. </li></ul>
  64. 64. Initial Startup Capital Required <ul><li>The initial estimate can and probably will be revised depending on your first iteration of the forecasts. </li></ul><ul><li>Separate the estimate into two categories: </li></ul><ul><ul><li>Working capital </li></ul></ul><ul><ul><li>Fixed assets (plant and equipment) </li></ul></ul><ul><li>You do this because when you look for financing for these investments, the fixed assets can usually be pledged as collateral for any borrowing, whereas the working capital needs usually has to be financed out of the owner’s equity. </li></ul>
  65. 65. Initial Investment <ul><li>In your business plan you will have to prepare a schedule that details the initial financial investment that is required to make your business a success. </li></ul><ul><li>It is best is you divide the schedule up into two components: </li></ul><ul><ul><li>Working capital requirements </li></ul></ul><ul><ul><li>Capital Equipment </li></ul></ul>
  66. 66. Initial Investment Required Example
  67. 67. The Cash Budget <ul><li>Incorporates your startup capital estimates </li></ul><ul><li>Is strongly a function of your sales forecasts (that are predicated on your market research and some assumptions about your market penetration strategy) </li></ul>
  68. 68. Importance of Cash Flow <ul><li>Planning to have cash available to pay bills of the business as they become due is a critical aspect of business survival…it is a management skill. </li></ul><ul><li>Understanding the cash flow cycle of a firm can help you manage those elements that are critical to ensuring you can pay your bills. </li></ul><ul><li>Cash flow forecasting through a cash budget provides important information to you and to your potential funding partners about your operating financial needs and most particularly, the timing and magnitude of any projected cash deficits or surpluses. </li></ul>
  69. 69. Cash and Materials Flow Shareholders’ equity Debt Cash Taxes Cash Sales Raw Materials Inventory Finished Goods Inventory Work-in-process Inventory
  70. 70. The Cash Budget <ul><li>Cash budgets are most often prepared on a monthly basis. </li></ul><ul><li>Most funding partners expect to see three years of projects. Some may require as many as seven years. </li></ul><ul><li>If your business expects to encounter any seasonality in the sales cycle, you will find some ‘interesting’ effects that may dramatically affect the amount of start-up financing that you require. </li></ul><ul><li>If there is seasonality effects, you will have to carefully manage your cash flows, inventories and accounts receivable to remain solvent. </li></ul>
  71. 71. Cash Budgets <ul><li>allow us to forecast the cash flows of a firm over time (between balance sheet dates). </li></ul><ul><li>identifies the timing and magnitude of expected cash surpluses and deficits - thereby providing the manager with the opportunity to prepare, in advance, to finance expected deficits, or to invest surpluses. </li></ul><ul><li>may be used as the basis for pro forma financial statements. </li></ul>
  72. 72. General Form - Cash Budget
  73. 73. Assumptions of Cash Budgets <ul><li>that cash inflows and outflows occur evenly throughout the month. </li></ul><ul><ul><li>this is rarely the case </li></ul></ul><ul><ul><li>disbursements often are predictable </li></ul></ul><ul><ul><ul><li>wages/salaries due on 15th and 30th </li></ul></ul></ul><ul><ul><ul><li>payments to suppliers on 15th or 30th, etc. </li></ul></ul></ul><ul><ul><li>cash receipts depend on how we manage accounts receivable....depending on how we do this they may largely occur between the 20th and 30th of the month... </li></ul></ul><ul><ul><li>what is the impact of the foregoing? </li></ul></ul><ul><ul><li>how can we overcome this? </li></ul></ul>
  74. 74. General Form - Cash Budget
  75. 75. General Form - Cash Budget
  76. 76. Cash Balance $ Cash Jan Feb Mar Apr May Jun Jul Aug
  77. 77. Analyzing your financial forecasts Lakehead Shad Valley
  78. 78. Ratio Analysis <ul><li>This is a technique used by investors and bankers (lenders) alike to assess the financial strength of your proposed business. </li></ul><ul><li>Once your business begins, ratios will be used to examine how well you are managing your business. </li></ul>
  79. 79. Ratio <ul><li>Is one number divided by another! </li></ul><ul><li>Purpose is the provide some insight into the complexity of financial information. </li></ul><ul><li>Example: </li></ul><ul><li>Current Ratio = Current Assets </li></ul><ul><li>Current Liabilities </li></ul>
  80. 80. Categories of Ratios <ul><li>Liquidity </li></ul><ul><li>Asset Management </li></ul><ul><li>Debt Management </li></ul><ul><li>Profitability </li></ul>
  81. 81. Liquidity Ratios <ul><li>Purpose: </li></ul><ul><ul><ul><li>to examine the ability of the business to pay it’s bills on time. </li></ul></ul></ul><ul><li>A firm that can’t survive in the short-term won’t have to worry about the long-term! </li></ul>
  82. 82. Liquidity Ratios <ul><li>Examples: </li></ul><ul><li>Current Ratio = Current Assets </li></ul><ul><li>Current Liabilities </li></ul><ul><li>Quick Ratio = Current Assets - Inventories </li></ul><ul><li>Current Liabilities </li></ul>
  83. 83. Asset Management Ratios <ul><li>Purpose: </li></ul><ul><ul><ul><li>to give some insight into how well the business is being managed. </li></ul></ul></ul>
  84. 84. Asset Management Ratios <ul><li>Examples: </li></ul><ul><li>Inventory Turnover = Sales </li></ul><ul><li>Inventory </li></ul><ul><li>Average Collection </li></ul><ul><li>Period = Receivables </li></ul><ul><li>Sales/365 </li></ul>
  85. 85. Asset Management Ratios <ul><li>Examples: </li></ul><ul><li>Fixed Asset </li></ul><ul><li>Turnover = Sales </li></ul><ul><li>Fixed Assets </li></ul><ul><li>Total Asset </li></ul><ul><li>Turnover = Sales </li></ul><ul><li>Total Assets </li></ul>
  86. 86. Debt Management Ratios <ul><li>Purpose: </li></ul><ul><ul><ul><li>to examine the impact that the chosen methods of financing are having (likely to have) on the financial health of the business. </li></ul></ul></ul><ul><ul><ul><li>Lenders will also be concerned with your liquidity ratios because those ratios assess your firm’s ability to pay the bills when they come due. </li></ul></ul></ul>
  87. 87. Debt Management Ratios <ul><li>Examples: </li></ul><ul><li>Debt to </li></ul><ul><li>Total Assets = Total Debt </li></ul><ul><li>Total Assets </li></ul><ul><li>Times interest </li></ul><ul><li>earned = Operating Income </li></ul><ul><li>Interest Charges </li></ul>
  88. 88. Profitability Ratios <ul><li>Purpose: </li></ul><ul><ul><ul><li>to examine the historical (or prospective rate of return in the case of pro forma financial statements) rates of return earned on invested capital. </li></ul></ul></ul>
  89. 89. Profitability Ratios <ul><li>Examples: </li></ul><ul><li>Profit margin </li></ul><ul><li>on sales = Net income </li></ul><ul><li>Sales </li></ul><ul><li>Return on </li></ul><ul><li>Equity = Net income </li></ul><ul><li>Common Equity </li></ul>
  90. 90. Profitability Ratios <ul><li>Examples: </li></ul><ul><li>Return on </li></ul><ul><li>Assets = Net income </li></ul><ul><li>Total Assets </li></ul>
  91. 91. Seasonality of Sales <ul><li>most firms experience a seasonal variation in sales volume...times of the year when sales increase, and times of the year when sales volumes are low or non-existent. </li></ul><ul><li>there are financial implications for firms that experience a marked seasonal sales cycle </li></ul><ul><ul><li>what is the best time in the seasonal sales cycle to have the fiscal year end? </li></ul></ul><ul><ul><li>how do we finance the seasonal build-up in inventory levels? </li></ul></ul><ul><ul><li>what happens to the balance sheet accounts at different points in the seasonal sales cycle? </li></ul></ul><ul><ul><li>how comparable are two firms in an industry with a marked seasonal sales cycle if they have differ fiscal year ends? </li></ul></ul>
  92. 92. Balance Sheet Accounts over time
  93. 93. Selecting the Fiscal Year End <ul><li>tax considerations </li></ul><ul><ul><li>for smaller, owner/managed enterprises, there are greater tax-planning opportunities if the corporate fiscal year end is set sometime after the calendar year end </li></ul></ul><ul><ul><li>the firm’s financial position </li></ul></ul><ul><ul><li>firms will look most healthy if the fiscal year end is set sometime after the seasonal sales peak....long enough afterward to see receivables collected. </li></ul></ul><ul><ul><li>auditors preferences </li></ul></ul><ul><ul><li>auditors are busy around the calendar year end...with firms and individuals that have selected Dec 31 as their year end. </li></ul></ul><ul><ul><li>auditors are busy from February through May with income tax </li></ul></ul>
  94. 94. Ratio Analysis <ul><li>a ratio is just one number over another number. If the ratio is ‘poor’ when compared to something else, it could be a result of the numerator, or the denominator, or both. </li></ul><ul><li>a ratio is just a number. It must be compared to something else if it is to begin to take on some meaning. Common comparators include: </li></ul><ul><ul><li>industry average ratios </li></ul></ul><ul><ul><li>historical ratios for the firm itself </li></ul></ul><ul><ul><li>other current ratios for the same firm </li></ul></ul><ul><li>it is important to take the ‘context’ into account when interpreting the financial performance of the firm...what industry is the firm in? how rapidly has the firm been growing? what is happening in the industry? </li></ul><ul><li>ratio analysis is a starting point in analyzing the firm. It must be supplemented by analysis of the overall economy, the industry, etc. </li></ul>
  95. 95. Income Statement Ratios <ul><li>Absolute Common Size Industry Avg. </li></ul><ul><li>Sales $250,000 100.0% 100% </li></ul><ul><li>Cost of Goods Sold 173,000 69.2% 70% </li></ul><ul><li>Gross Margin 77,000 30.8% 30% </li></ul><ul><li>Admin Expenses 50,000 20.0% 10% </li></ul><ul><li>EBIT 27,000 10.8% 20% </li></ul><ul><li>Interest Expense 5,000 2.0% 5% </li></ul><ul><li>Net Income $22,000 8.8% 15% </li></ul><ul><li>Profit Margin on Sales 8.8% 15% </li></ul><ul><li>You can see from the common size data, that this firm differs from the industry in overhead costs and in interest expense. Without further information it is difficult to draw any specific conclusions, however, you should note, that direct operating costs are in line with the industry. Why is selling and admin. expenses double that of the industry? The firm’s fixed financing costs are it just low cost or are they using less debt than others in the industry? </li></ul>
  96. 96. Use of Ratios <ul><li>Evaluate your past financial performance </li></ul><ul><li>Evaluate your financial forecasts </li></ul>
  97. 97. Role of Ratios in Your Business Plan <ul><li>Your business plan forecasts your firm’s future financial performance. </li></ul><ul><ul><li>Conduct ratio analysis on your forecast position </li></ul></ul><ul><ul><li>determine whether you should pursue your plans </li></ul></ul><ul><ul><li>revise your plans…. </li></ul></ul>
  98. 98. Role of Ratios in Your Business Plan Prepare Pro Forma Financial Statements based on your business plans Analyze your forecasts using ratio analysis Once you are satisfied with your forecasts…proceed to raise the capital and implement the plan Revise plan if necessary
  99. 99. The Articulation of forecast Income Statements and Balance Sheets <ul><li>Articulation refers to the fact that the forecast income statements and balance sheets are integrally linked. </li></ul><ul><li>For example: </li></ul><ul><ul><li>Assets like building and equipment are stated on the balance sheet at their net value (net of depreciation) </li></ul></ul><ul><ul><li>The retained earnings account on the balance sheet will be the accumulated retained earnings over time as found historically on the income statements. (The difference between last year’s R/E balance and next years, is the amount of income after tax that is retained in the firm.) </li></ul></ul>
  100. 100. Questions? Good Luck