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Chapter 10Chapter 10

The Financial PlanThe Financial Plan

Vishnu Parmar, IBAVishnu Parmar, IBA

University of Sindh, JamshoroUniversity of Sindh, Jamshoro


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IntroductionIntroduction

Financial Plan provides a complete picture ofFinancial Plan provides a complete picture ofhow much and when funds are coming into thehow much and when funds are coming into theorganization?organization?

Where funds are going?Where funds are going?

How much cash is available?How much cash is available?

What is the projected financial position of theWhat is the projected financial position of the

firmfirm It provides short term basis for budgeting andIt provides short term basis for budgeting and

helps to prevent lack of cashhelps to prevent lack of cash


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IntroductionIntroduction

The financial plan must explains to meet allThe financial plan must explains to meet all

financial obligations and maintains thefinancial obligations and maintains the

ventures liquidity in order to either pay offventures liquidity in order to either pay offdebt of provide a good return on investment.debt of provide a good return on investment.

FP needs three years of projected finance dataFP needs three years of projected finance data

to satisfy any outside investorsto satisfy any outside investors

First year must reflect monthly dataFirst year must reflect monthly data


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Pro Forma StatementsPro Forma Statements

Pro Forma StatementsPro Forma Statements

Are projections of a firms financial position overAre projections of a firms financial position over

a future period (pro forma income statement) or ona future period (pro forma income statement) or on

a future date (pro forma balance sheet).a future date (pro forma balance sheet).

Using beginning balance sheet balances, theyUsing beginning balance sheet balances, they

depict projected changes on the operating anddepict projected changes on the operating and

cashcash--flow budgets which are added to createflow budgets which are added to createprojected balance sheet totals.projected balance sheet totals.


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Preparing Financial BudgetsPreparing Financial Budgets

BudgetBudget One of the most powerful tools the entrepreneur can use inOne of the most powerful tools the entrepreneur can use in

planning financial operations.planning financial operations.

Operating BudgetOperating Budget A statement of estimated income and expenses over aA statement of estimated income and expenses over a

specified period of time.specified period of time.

Cash BudgetCash Budget A statement of estimated cash receipts and expendituresA statement of estimated cash receipts and expenditures

over a specified period of timeover a specified period of time..

Capital BudgetCapital Budget The plan for expenditures on assets with returns expectedThe plan for expenditures on assets with returns expected

to last beyond one year.to last beyond one year.


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The Operating BudgetThe Operating Budget

Sales ForecastingSales Forecasting

Creating an operating budget through preparation of theCreating an operating budget through preparation of thesales forecast.sales forecast.

F

orecastingF

orecasting Linear regression: a statistical forecasting technique.Linear regression: a statistical forecasting technique.

Y = a + bxY = a + bx

YYis a dependent variableis a dependent variableits value isits value is dependent on thedependent on thevalues ofvalues ofaa,, bb, and, and xx..

xxis an independent variable that is not dependent onis an independent variable that is not dependent onany of the other variablesany of the other variables

aa is a constant.is a constant.

bb is the slope of the line of correlation (the change inis the slope of the line of correlation (the change in YY

divided by the change individed by the change in xx).).


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Operating & Capital BudgetsOperating & Capital Budgets

Before pro forma income statement, the entrepreneurBefore pro forma income statement, the entrepreneur

should prepare operating & capital budget.should prepare operating & capital budget.

Sole proprietor prepares total budget by himself as heSole proprietor prepares total budget by himself as he

is the alone decision makeris the alone decision maker

In partnership and Corporation other people alsoIn partnership and Corporation other people also

involves, it depends upon the responsibilities likeinvolves, it depends upon the responsibilities like

sales budget may prepare by Sales Manager,sales budget may prepare by Sales Manager,Production manager prepares manufacturing budgetProduction manager prepares manufacturing budget

etcetc


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Table 10.1 (Sales Budget)Table 10.1 (Sales Budget)

DescriptionDescription JanJan FebFeb MarchMarch

Projected Sales UnitProjected Sales Unit 5,0005,000 8,0008,000 12,00012,000

Desired Ending InventoryDesired Ending Inventory 100100 200200 300300

Available for SaleAvailable for Sale 5,1005,100 8,2008,200 12,30012,300

Less Beginning InventoryLess Beginning Inventory 00 100100 200200

Total Production RequiredTotal Production Required 5,1005,100 8,1008,100 12,10012,100


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Table 10.2Table 10.2

Operating Budget for 3 monthsOperating Budget for 3 monthsExpensesExpenses JanJan FebFeb MarchMarch

SalariesSalaries 23.223.2 23.223.2 26.226.2

RentRent 22 22 22

UtilitiesUtilities 0.90.9 0.90.9 0.90.9

AdvertisingAdvertising 13.513.5 13.513.5 1717

Selling ExpensesSelling Expenses 11 11 11

InsuranceInsurance 22 22 22

Payroll taxesPayroll taxes 2.12.1 2.12.1 2.52.5

DepreciationDepreciation 1.21.2 1.21.2 1.21.2

Office expensesOffice expenses 1.51.5 1.51.5 1.51.5

Total ExpensesTotal Expenses 47.547.5 47.447.4 54.354.3


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Pro forma Income StatementPro forma Income Statement

Income StatementIncome Statement

Commonly referred to as the P&L (profit and loss)Commonly referred to as the P&L (profit and loss)

statement from activities of the firm.statement from activities of the firm.

Provides the results of the firms operations.Provides the results of the firms operations.

Income Statement CategoriesIncome Statement Categories

Revenues:Revenues: gross sales for the periodgross sales for the period

Expenses:Expenses: Costs of producing goods or servicesCosts of producing goods or services

Net Income:Net Income: The excess (deficit) of revenues overThe excess (deficit) of revenues over

expenses (profit or loss)expenses (profit or loss)


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Pro forma Income StatementPro forma Income Statement

Proposed net profit calculated from projectedProposed net profit calculated from projected

revenue minus projected cost and expensesrevenue minus projected cost and expenses

It should be made for 3 years because investorsIt should be made for 3 years because investorsprefer to use three years of income projectionsprefer to use three years of income projections

TABLE 10.3TABLE 10.3


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Statement of Cash FlowStatement of Cash Flow

An analysis of the cash availability and cash needs ofAn analysis of the cash availability and cash needs of

the business that shows the effects of a companysthe business that shows the effects of a companys

operating, investing, and financing activities on itsoperating, investing, and financing activities on its

cash balance.cash balance. How much cash did the firm generate fromHow much cash did the firm generate from

operations?operations?

How did the firm finance fixed capitalHow did the firm finance fixed capital

expenditures?expenditures?

How much new debt did the firm add?How much new debt did the firm add?


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Statement of Cash FlowStatement of Cash Flow

Was cash from operations sufficient to financeWas cash from operations sufficient to finance

fixed asset purchases?fixed asset purchases?

The use of a cash budget may be the best approachThe use of a cash budget may be the best approach

for an entrepreneur starting up a venturefor an entrepreneur starting up a venture..

Cash flow can be determined for each month.Cash flow can be determined for each month.

It assist the entrepreneur in determining howIt assist the entrepreneur in determining how

much money he or she will need to raise tomuch money he or she will need to raise tomeet the cash demands of the venturemeet the cash demands of the venture


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ProPro--forma Cash Flowforma Cash Flow

Projected cash available calculated fromProjected cash available calculated from

projected cash accumulation minus projectedprojected cash accumulation minus projected

cash disbursementcash disbursement

Cash flows only when actual payments areCash flows only when actual payments are

received or madereceived or made

The most difficult problem with projectingThe most difficult problem with projecting

cash flows is determining the exact monthlycash flows is determining the exact monthly

receipts and disbursementsreceipts and disbursements


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ProPro--forma Balance Sheetforma Balance Sheet

Represents the financial condition of a company at aRepresents the financial condition of a company at a

certain date.certain date.

It details the items the company owns (assets)It details the items the company owns (assets)

and the amount the company owes (liabilities).and the amount the company owes (liabilities).

It also shows the net worth of the company andIt also shows the net worth of the company and

its liquidity.its liquidity.

Assets =Assets = LiabilitiesLiabilities ++ Owners EquityOwners Equity An asset is something of value the businessAn asset is something of value the business

owns.owns.

Current and fixed assetsCurrent and fixed assets


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ProPro--forma Balance Sheetforma Balance Sheet

LiabilitiesLiabilities are the claims creditors haveare the claims creditors have

against the company.against the company.

ShortShort-- and longand long--term debtterm debtOwners equityOwners equity is the residual interest ofis the residual interest of

the firms owners in the company.the firms owners in the company.

Table 10.7Table 10.7


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Breakeven AnalysisBreakeven Analysis

Used to determine the level of activity a firmUsed to determine the level of activity a firm

must achieve to stay in business in the long runmust achieve to stay in business in the long run

Shows the mix of fixed and variable cost andShows the mix of fixed and variable cost andthe volume required for zero profit/lossthe volume required for zero profit/loss

Profit/loss generally measured by EBITProfit/loss generally measured by EBIT


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BreakBreak--Even AnalysisEven Analysis

BreakBreak--even occurs when the volume of sales iseven occurs when the volume of sales issufficient to cover all fixed and variable costs.sufficient to cover all fixed and variable costs.

BreakBreak--even point (BEP) is the point at whicheven point (BEP) is the point at which

revenue equals costs.revenue equals costs.

At breakAt break--even point sales revenues equals theeven point sales revenues equals thecosts necessary to generate them.costs necessary to generate them.

As long as forecasted sales are greater than theAs long as forecasted sales are greater than the

breakbreak--even point, you must stay in business, ifeven point, you must stay in business, if

they drop below it, you may decide againstthey drop below it, you may decide against

starting or continuing it.starting or continuing it.


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Determining the BreakDetermining the Break--EvenEven

PointPoint BEP shows the relationship between cost andBEP shows the relationship between cost and

volume.volume.

The components of breakThe components of break--even analysis are:even analysis are: RevenueRevenue

Determined by multiplying unit sales by unitDetermined by multiplying unit sales by unitpriceprice

Fixed costsF

ixed costs Expenses that do not vary with the level ofExpenses that do not vary with the level of

production or salesproduction or sales

Variable costsVariable costs


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BreakBreak-- Even AnalysisEven Analysis

BreakBreak--even analysis identifies that point where revenueseven analysis identifies that point where revenuesexactly cover costs.exactly cover costs.

Steps to Calculate BreakSteps to Calculate Break--EvenEven

Step 1Step 1Fixed CostsFixed Costs-- Those that remain constant over aThose that remain constant over a

reasonable range of sales, or do not vary appreciablyreasonable range of sales, or do not vary appreciablywith sales volume.with sales volume.

Rent Rent Office Supplies Office Supplies Advertising Advertising Salaries Salaries Payroll Taxes Payroll Taxes Utilities Utilities

Depreciation Interest Expense Depreciation Interest Expense Insurance Insurance


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BreakBreak-- Even AnalysisEven Analysis

Variable CostsVariable Costs-- Are those that varyAre those that vary

directlydirectly or proportionallyor proportionally to sales.to sales.

If you cant decide what to call an expense,If you cant decide what to call an expense,be conservative, and call itbe conservative, and call it fixedfixedthusthus

making your breakmaking your break--even point higher.even point higher.


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Determining the Breakeven FormulaDetermining the Breakeven Formula

TR = SP x QTR = SP x Q

TC = TFC + TVCTC = TFC + TVC

SP x Q = TFC+TVCSP x Q = TFC+TVC

TVC = VC/units x QTVC = VC/units x Q

Thus SP x Q = TFC + (VC/Units x Q)Thus SP x Q = TFC + (VC/Units x Q)

(SP x Q)(SP x Q) (VC/Units x Q) = TFC(VC/Units x Q) = TFC

Q(SPQ(SP VC/Unit) =TF

CVC/Unit) =TF

CBreakBreak--even (Q) =even (Q) = Total Fixed CostsTotal Fixed Costs

SPSP--VC/Unit (Marginal contribution)VC/Unit (Marginal contribution)


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Costs/Revenue

Output/Sales

Initially a firm

will incur fixed

costs, these do

not depend on

output or sales.

FC

As output isgenerated, the

firm will incur

variable costs

these vary

directly with the

amount produced

VC

The total costs

therefore

(assuming

accurate

forecasts!) is the

sum ofFC+VC

TCTotal revenue is

determined by the

price charged and

the quantity sold

again this will be

determined by

expected forecast

sales initially.

TRThe lower the

price, the less

steep the total

revenue curve.

TR

Q1

The Break-evenpoint occurs where

total revenue

equals total costs

the firm, in this

example would

have to sell Q1 to

generate sufficient

revenue to cover its

costs.


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BreakBreak--Even AnalysisEven AnalysisCosts/Revenue

Output/Sales

FC

VCTCTR (p = 2)

Q1

If the firm chose

to set price

higher than 2(say 3) the TR

curve would be

steeper they

would not have

to sell as manyunits to break

even

TR (p = 3)

Q2


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Output/Sales

FC

VCTCTR (p = 2)

Q1

If the firm

chose to set

prices lower

(say 1) it

would need tosell more units

before

covering its

costs

TR (p = 1)

Q3


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Output/Sales

FC

VC

TCTR (p = 2)

Q1

Loss

Profit


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Output/Sales

FC

VC

TCTR (p = 2)

Q1 Q2

Margin of Safety

TR (p = 3)

Q3

A higher

price would

lower the

break even

point and

the margin

of safetywould widen


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Remember:Remember:

A higher price or lower priceA higher price or lower price does notdoes not meanmeanthat break even willthat break even will nevernever be reached!be reached!

The BE point depends on theThe BE point depends on the number of salesnumber of salesneededneeded to generate revenue to cover coststo generate revenue to cover costs thetheBE chart is NOT time related!BE chart is NOT time related!


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Importance ofImportance ofPrice Elasticity of DemandPrice Elasticity of Demand::

Higher pricesHigher prices might mean fewer sales tomight mean fewer sales tobreakbreak--even but those sales may take a longereven but those sales may take a longer

time to achieve.time to achieve.

Lower pricesLower prices might encourage moremight encourage morecustomers but higher volume needed beforecustomers but higher volume needed before

sufficient revenue generated to breaksufficient revenue generated to break--eveneven


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Links of BE to pricing strategies and elasticityLinks of BE to pricing strategies and elasticity

Penetration pricingPenetration pricing high volume, low pricehigh volume, low price more sales to break evenmore sales to break even

Market SkimmingMarket Skimming high price low volumeshigh price low volumes fewer sales to break evenfewer sales to break even

ElasticityElasticity what is likely to happen to sales whenwhat is likely to happen to sales whenprices are increased or decreased?prices are increased or decreased?