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

1. The Financial Forecasts for the Business Plan Shad Valley 2007

Ken Hartviksen

[email_address]

Office:RB 1043

343-8497

Web links:

http://foba.lakeheadu.ca/hartviksen

http://www.scotiabank.com/businessplan

Contact Info

Purpose of Financial Forecasts

Characteristics of Good Financial Forecasts

How to forecast and how to recognize assumptions

A tour of the financial forecasts required

Break even analysis

Purpose of each forecast and their interrelationships

Data requirements and how they are generated

Annual Sales Forecast

Monthly Sales Forecast

Monthly Cash Budget

Pro forma Financial Statements

Understand the importance and use of:

Cash flow

Financial forecasts

Learn how to develop loan amortization schedules and CCA schedules

Learn how to incorporate this forecast information into financial forecasts

Get you started on your own forecasts

Develop some skills in the use of Excel spreadsheets

Predict the financial consequences of our business plan

Allow us to change our plans in advance to optimize the real financial results after analyzing the forecast financial statements.

To demonstrate to financial partners the ability of the business to give them an adequate return on investment.

Ability to generate cash flow early enough and in sufficient quantity to ensure on-going financial solvency

Time to break even

Time to positive cash flow

Time to profitability

Return on investment

Reasonable/plausible

Based upon good primary and secondary research

Congruent with operating and marketing plans

Can withstand stress testing

Conservative/achievable

When generating integrated financial statements you start with:

Sales forecast

You will modify the annual sales forecast to a monthly sales forecast for the first year

Make projections of all expenses for the first year.

Start with a guess about the amount of initial financing required and where it is likely to be invested.

Remember:

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.

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.

A Business Plan is a forecast of what you hope to do.and how and when you hope to do it!

readable

organized

targeted to the audience

integrated

complete

Helps you understand the steps to implementing your idea and what key factors you must monitor to ensure success.

Support an application for financing

Solicit potential financial partners

Determine the characteristics of the company and industry

Determine the terms of the deal

Read the latest balance sheet

Determine the caliber of the people in the deal

Determine what is different about this deal

Give the plan a once-over lightly

Title Page (with disclaimer)

Executive Summary

Table of Contents

Business Idea

Industry/Company

Market Research and Analysis

Economics of the Business

Marketing Plan

Design and Development Plans

Manufacturing and Operations Plan

Management Team

Overall Schedule

Critical Risk, Problems and Assumptions

The Financial Plan

Financing

Appendices

Gross and operating margins

Profit potential and durability

Fixed, variable and semi-variable costs

Months to Break even

Months to reach positive cash flow

Actual financial statements (if an already established business)

initial investment required

cash budget

pro forma balance sheet

pro forma income state

break even chart

cost control

Proposed sources of financing

use of funds

investors forecast rate of return on invested capital

Break Even Analysis

Initial Investment Schedule

Monthly Cash Budget

Pro forma Income Statements

Pro forma Balance Sheets

Subsidiary forecasts

Loan Amortization schedule

CCA schedule

Statement of Forecast Assumptions

This is a planning and control technique.

PLANNING:

make informed decisions about pricing your product or service and the cost to produce it.

CONTROL:

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 mealsyou are on track to break even!)

The break-even point can be found using the following equation:

B.E. Point = Fixed Costs

Contribution Margin

= Fixed Costs

Selling price/unit - Variable Cost/unit

You can classify fixed and variable costs according to how they change in response to changes in sales volume.

Fixed Costs

are costs that (within the relevant range) dont change in response to changes in sales volume.

Examples include depreciation expense, rent, salaries and other overhead costs.

Variable Costs

are costs that (within the relevant range) change in response to changes in sales volume.

Examples include direct materials and direct labour costs (wages paid by hour).

The relevant range is the range of output (units produced and sold) that the cost and pricing assumptions can reasonably be expected to hold.

If sales are expected to push the firm beyond its current physical capacity, (beyond the relevant range) cost behaviour assumptions must be revised.

For most small businesses, it is relatively easy to determine the variable cost per unit.

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.

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.

Look at the following example..

You plan to start a bagel shop.

The average customer will purchase a dozen bagels, some cream cheese and a coke.

You have determined that your variable costs to produce this average customer purchase as follows:

Variable Cost per unit

Coke and cup $0.85

12 Bagels cooked (materials and electricity) 2.99

Cream cheese and container 1.65

Straw/napkins/bag and other condiments 0.75

Direct labour costs (counter help & cook) 2.75

Total variable cost per unit $8.99

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

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!

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...

Variable Cost per unit Great Canadian Bagel

Coke and cup $0.85 $0.45

12 Bagels cooked (materials and electricity) 2.99 1.50

Cream cheese and container 1.65 1.20

Straw/napkins/bag and other condiments 0.75 0.50

Direct labour costs (counter help & cook) 2.75 2.75

Total variable cost per unit $8.99 $6.40

Conclusion:if you are to compete with the Great Canadian Bagel purely on price, you will fail.

Variable Cost per unit Great Canadian Bagel

Coke and cup $0.85 $0.45

12 Bagels cooked (materials and electricity) 2.99 1.50

Cream cheese and container 1.65 1.20

Straw/napkins/bag and other condiments 0.75 0.50

Direct labour costs (counter help & cook) 2.75 2.75

Total variable cost per unit $8.99 $6.40

Selling Price to the Public per unit $10.50 $8.25

Contribution margin per unit $1.51 $1.85

Your variable cost per unit is higher than the Great Canadian Bagels variable cost per unit.

Your proposed selling price is 27% higher than your competition yet your proposed contribution margin is 18% lower.

Faced with this pricing and costing analysis, you have some choices:

forget about going into this business

seek to negotiate arrangements where your direct operating costs can be lowered

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)

seek to locate your business somewhere there is no direct competition.(Nipigon, Marathon, Atikokan, Sioux Lookout)

Of course, further analysis will be required (before proceeding) to determine whether you could actually make a profit at the business.

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.

Once those fixed costs are covered, any further units that are sold will result in profit.

Is the point where total revenue equals to total costs

Variable and Fixed costs are summed to equal total costs.

Break even point in units =Annual Fixed Costs / contribution margin

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.

You estimate that once established, you will face the following fixed costs each year to run the business:

Annual building lease costs (12 months @ $2,000/month) $24,000

Office expenses (bank charges, accountant etc.) 8,000

Depreciation of equipment (ovens, microwave, etc.) 4,400

Gross Salary for the manager34,000

Employer contribution to CPP/EI and employer health tax 9,520

Other fixed costs (advertising and promotion) 2,000

TOTAL ANNUAL FIXED COSTS $81,650

The breakeven point, given your analysis to this point is:

Break-even point in #s of meals annually =Annual Fixed Costs

Contribution Margin

=$81,650

= 54,073 meals

This works out to 4,507 meals per month or 149 meals per day.

Break-even point = 54,073 meals

This works out to 4,507 meals per month or 149 meals per day.

This implies baking and selling 1,788 bagels per day with no wastage.

Do your ovens and facilities have the capacity to produce this volume each day?

If you are closed on Christmas, New Years or any other dayyou will have to sell more on the other days on average.

NOW - the big question.what is the market for your product in that locationwho would buy bagels?How frequently?What is their purchasing behaviour?Attitudes toward price?

Break-even point = 54,073 meals

At an average price per sale of $10.50, that volume of meals means annual sales revenue of:

Annual Sales Revenue = Price per meal times # of meals

= $10.50 * 54,073

= $567,766.50

The purpose of the initial investment schedule:

Identify proposed sources of capital

Identify proposed initial uses of capital

The purposes of the monthly cash budget:

Illustrate projected sources of cash timing and magnitude

Illustrated projected uses of cash timing and magnitude

Demonstrate the time to producing a positive cash flow

You will need to make a series of forecasts that will be incorporated into your overall financial forecasts.

Some of it will require outside data gathering for example:

Employer contributions to CPP and EI

WSIB premiums

The most common subsidiary forecasts are:

Loan amortization schedule

Capital Cost Allowance Schedule

Standard Bank Financing:

Fixed term

Fixed rate

Variable rate

Operating Line of Credit

Government Financing:

Northwestern Ontario

FedNor

Thunder Bay Ventures

Business Development Bank of Canada

You wish to borrow $10,000

Assume you are quoted a fixed term, fixed payment loan at 2.5 percent above the prime lending rate

The prime lending rate is currently 4.5%

The loan amortization period is 1 year

Since most loans require monthly payments, it is necessary to determine themonthlyrate that would equal the effectiveannualrate:

Now we know all of the variables:

$10,000 loan

7% APR 1-year term loan

We can calculate the loan payment:

The loan payment each month is a cash outflow that must be included in your cash monthly cash budget.

The total interest expense for the year is included in thepro formaincome statement.

NOTE: -repayment of principal is not a taxdeductible expense.

- the total payment is a cashflow burdenborne by the firm

Most loan rates are quoted in APR terms (annual percentage rate)

However, APR financing does not take into account the effects of compounding

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.

Capital assets such as buildings and equipment and land are very costly, but usually have a useful life of greater than one year.

Buildings and equipment tend to wear out over time(ie. They have a useful life of perhaps 10, 20 or 30 years)

Land doesnt wear out.

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.

CCRA predominantly uses one method of depreciationit is known as Capital Cost Allowance.

CCA is anon-cashdeduction from income that would otherwise be subject to income taxation.

As a result of the CCA deduction, taxable income is reduced.

This results in a savings in tax payable.

The tax shield benefits is equal to:T(CCA)

t = corporate tax rate

CCA = the dollar amount of CCA claimed

A firm with a 40% corporate tax rate and a $2,000 CCA deduction will save $800 in taxes.

Company A Company B

Earnings Before CCA & Tax $10,000 $10,000

CCA 2,000 0

Taxable Income $ 8,000 $ 10,000

Taxes @ 40% 3,200 4,000

Net Income $ 4,800 $ 6,000

Add back non-cash expense 2,000 0

Cash flow from Operations $ 6,800 $ 6,000

Assets are grouped into pools or classes and depreciated as a group

CCA rates are found in the regulations to the Income Tax Act and can be changed by Order-in-Council

There is no need for an estimate of salvage value or useful life

1/2 of the regular CCA rate for the class applies to the net additions to the pool for that year.

CCA cannot be used to create a tax loss.

You never include depreciation (CCA) on a cash flow (cash budget) forecast

You use depreciation only in your pro forma income statement, and on your pro forma balance sheet.

The initial estimate can and probably will be revised depending on your first iteration of the forecasts.

Separate the estimate into two categories:

Working capital

Fixed assets (plant and equipment)

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 owners equity.

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.

It is best is you divide the schedule up into two components:

Working capital requirements

Capital Equipment

Incorporates your startup capital estimates

Is strongly a function of your sales forecasts (that are predicated on your market research and some assumptions about your market penetration strategy)

Planning to have cash available to pay bills of the business as they become due is a critical aspect of business survivalit is a management skill.

Understanding the cash flow cycle of a firm can help you manage those elements that are critical to ensuring you can pay your bills.

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, thetimingandmagnitudeof any projected cash deficits or surpluses.

Cash budgets are most often prepared on a monthly basis.

Most funding partners expect to see three years of projects.Some may require as many as seven years.

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.

If there is seasonality effects, you will have to carefully manage your cash flows, inventories and accounts receivable to remain solvent.

allow us to forecast the cash flows of a firm over time (between balance sheet dates).

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.

may be used as the basis for pro forma financial statements.

that cash inflows and outflows occur evenly throughout the month.

this is rarely the case

disbursements often are predictable

wages/salaries due on 15th and 30th

payments to suppliers on 15th or 30th, etc.

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...

what is the impact of the foregoing?

how can we overcome this?

This is a technique used by investors and bankers (lenders) alike to assess the financial strength of your proposed business.

Once your business begins, ratios will be used to examine how well you are managing your business.

Is one number divided by another!

Purpose is the provide some insight into the complexity of financial information.

Example:

Current Ratio = Current Assets

Current Liabilities

Liquidity

Asset Management

Debt Management

Profitability

Purpose:

to examine the ability of the business to pay its bills on time.

A firm that cant survive in the short-term wont have to worry about the long-term!

Examples:

Current Ratio = Current Assets

Current Liabilities

Quick Ratio = Current Assets - Inventories

Current Liabilities

Purpose:

to give some insight into how well the business is being managed.

Examples:

Inventory Turnover = Sales

Inventory

Average Collection

Period = Receivables

Sales/365

Examples:

Fixed Asset

Turnover = Sales

Fixed Assets

Total Asset

Turnover = Sales

Total Assets

Purpose:

to examine the impact that the chosen methods of financing are having (likely to have) on the financial health of the business.

Lenders will also be concerned with your liquidity ratios because those ratios assess your firms ability to pay the bills when they come due.

Examples:

Debt to

Total Assets = Total Debt

Total Assets

Times interest

earned = Operating Income

Interest Charges

Purpose:

to examine the historical (or prospective rate of return in the case ofpro formafinancial statements) rates of return earned on invested capital.

Examples:

Profit margin

on sales = Net income

Return on

Equity = Net income

Common Equity

Examples:

Return on

Assets = Net income

Total Assets

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.

there are financial implications for firms that experience a marked seasonal sales cycle

what is the best time in the seasonal sales cycle to have the fiscal year end?

how do we finance the seasonal build-up in inventory levels?

what happens to the balance sheet accounts at different points in the seasonal sales cycle?

how comparable are two firms in an industry with a marked seasonal sales cycle if they have differ fiscal year ends?

tax considerations

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

the firms financial position

firms will look most healthy if the fiscal year end is set sometimeafter the seasonal sales peak....long enough afterward to see receivables collected.

auditors preferences

auditors are busy around the calendar year end...with firms and individuals that have selected Dec 31 as their year end.

auditors are busy from February through May with income tax

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.

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:

industry average ratios

historical ratios for the firm itself

other current ratios for the same firm

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?

ratio analysis is a starting point in analyzing the firm.It must be supplemented by analysis of the overall economy, the industry, etc.

Absolute Common Size Industry Avg.

Sales $250,000 100.0% 100%

Cost of Goods Sold 173,000 69.2% 70%

Gross Margin 77,000 30.8% 30%

Admin Expenses 50,000 20.0% 10%

EBIT 27,000 10.8% 20%

Interest Expense 5,000 2.0% 5%

Net Income $22,000 8.8% 15%

Profit Margin on Sales 8.8% 15%

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 firms fixed financing costs are low...is it just low cost or are they using less debt than others in the industry?

Evaluate your past financial performance

Evaluate your financial forecasts

Your business plan forecasts your firms future financial performance.

Conduct ratio analysis on your forecast position

determine whether you should pursue your plans

revise your plans.

Articulation refers to the fact that the forecast income statements and balance sheets are integrally linked.

For example:

Assets like building and equipment are stated on the balance sheet at their net value (net of depreciation)

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 years R/E balance and next years, is the amount of income after tax that is retained in the firm.)

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

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