Advanced Financial Planning Tutorial
If you want your business to succeed, you must understand financial planning. It forms the core of your business development, as it helps you to look into the future and make sense of the present.
In this guide, we’ll explain in detail what financial planning is about and the benefits it brings to your business. We’ll look at the core elements of a financial plan and the steps it takes to cover all the bases. We’ve even included example spreadsheets to help you plan your finances.
WHAT IS FINANCIAL PLANNING?
Financial plan for businesses is essentially a forecast of future performance. It most often involves estimating the capital requirements for achieving certain strategic goals.
The plan is conducted after a business determines its objectives and a vision for the future. It’s used for outlining and understanding the activities, resources, equipment and materials required for achieving these objectives. Furthermore, financial planning can also help determine the timeline for achieving these goals.
Therefore, a financial plan is typically used as part of a business plan, during the development and start of a business. The plan is a crucial part of a business plan, as it can help determine the viability of the business. It helps understand the finances behind the strategy and the timeline for getting the business on its feet.
But additionally, financial planning is required at later stages of business development. It can help define the actions the business can do in order to succeed. For instance, financial planning can be used when implementing a new strategy or acquiring new equipment.
WHY SHOULD A BUSINESS HAVE A FINANCIAL PLAN?
First, you should know that your plan is always wrong. But as the famous quote by Dr Gramme Edwards says, “It’s not the plan that’s important, it’s the planning.” Financial planning will ensure you are better prepared for the times when the plan doesn’t go according to plan.
There are a number of benefits of financial planning.
The first major benefit is the validation of the business plan. With proper planning, you are able to confirm the objectives can be achieved in terms of financial gain and spending. This can be especially crucial for assuring investors of the viability and therefore getting them on board with your business. In essence, your business can validate whether the business assumptions are met in real life and decide whether to continue or discontinue with the current strategy.
Furthermore, financial planning allows the establishment of a workable budget. It outlines the spending requirements needed for achieving specific objectives and measures the income requirements.
Finally, a major benefit of financial planning is how it provides better financial control. You are more in control as you are more aware of the costs associated with running the business and succeeding. For example, financial planning means you are more attentive to the business’ tax burden. Since you are able to work ahead and estimate expenses and income, you can prepare the business for taxes. Furthermore, you can manage the cash flow and prepare for future needs in advance. Overall, it also guarantees better debt management, as you are aware of the interest rates and other associated costs. This can allow accelerated debt repayment and boost the business finances further.
This is how you can go from your business model canvas to a financial plan.
THE BUILDING BLOCKS OF A FINANCIAL PLAN
Financial planning involves analyzing and estimating the following components:
- Start-up costs
- Cash flow projections
- Projected and previous balance sheets and income statements
- A break-even analysis
- A ratio analysis
The importance of each component depends on whether the business is just starting out or has been operating for a while. We’ll now outline each component in more detail.
If your financial planning is focused on getting a new business up on its feet, then start-up costs are an important part of the planning. These are essentially what the name suggests: the costs acquired when setting up a business.
Furthermore, they are one-time expenditures, not continuing expenses, and required in order for the business to start operating in the first place. Start-up costs include:
- Equipment costs
- Furniture and fixture costs
- Supplies and materials
- Inventory expenditure
- Licenses, permits and incorporation fees where applicable
For other costs, such as continuous expenditure for stocking up the inventory, the expenditure is noted under operating expenses. These are not included in start-up costs, but will be written down in income statements and cash flow projections.
Cash flow projections
Your financial plan will also need to examine cash flow projections. This is an estimation of when the business is expected to receive cash from sales. Cash flow projections are a crucial part of financial planning, as it helps the business to know when it’s able to pay the bills.
Businesses typically do cash flow projections on a monthly basis and at least a year into the future. For your business to succeed, you should regularly compare your projections with actual cash flow and use the information to revise your analysis.
Projected and previous balance sheets and income statements
Financial planning examines both projected and previous balance sheets and income statements.
Previous balance sheets and income statements
An income statement shows the actual revenues and expenses for your business. This includes all the money coming into your business and any money going out of your business. It can sometimes be referred to as a profit and loss statement.
Your financial plan should include at least the last year’s income statement, although you could have them available for a longer period.
A balance sheet should also be included from the previous years. Balance sheets are an insight into a specific period and they provide information regarding the business’ assets, liabilities and the owner’s equity.
Assets, which show what the business owns, include things such as cash, inventory and property. Liabilities, which are what the business owes, consists of things like taxes owed, mortgages, bank loans and so on. The owner’s equity, also referred to as the net worth of the business, highlights the assets minus liabilities.
Projected balance sheets and income statements
As well as including the current income statement and balance sheet, your financial plan should also examine projected, or pro forma, versions of both.
A pro forma income statement estimates the revenue and expenses over a specific period. Like with the cash flow, it’s important to have both worst and best-case scenarios covered with the prediction. You should also regularly compare the actual income statements with the projections to understand how well you’ve planned for your finances.
A pro forma balance sheet is an estimation of the business’ net worth at a specific time. Both of these projections are required by investors and lenders, as it helps them understand what your business’ finances might look in the future.
A break-even analysis
Financial planning will also examine the break-even analysis. The break-even analysis helps you determine the amount of sales the business needs in order to not lose money.
The break-even point is determined by the following formula: Total costs = Total Revenues
It essentially determines the viability, as well as the profitability, of your business.
A ratio analysis
Ratio analysis includes a variety of different business ratios. These analyze the relative health of the business and they help you to identify positive, as well as negative, trends in your business’ performance.
The data you use for ratio analysis comes directly from the balance sheet and the income statement. It’s a good idea to compare your specific ratios with other similar business. You can find this information on websites such as the US Securities and Exchange Commission and the RBA resource guide.
The business ratios you should incorporate in your financial planning include:
- Current ratio – highlights the business’ ability to pay bills. A ratio above 2:1 is generally favorable, as it shows your business as more current assets than current liabilities.
- Quick ratio– The ratio is the same except it doesn’t include inventory in its calculations.
- Debt to equity ratio – Compares the debts of the business to its equity, showcasing the proportion of business’ finances that are covered by investment. A ratio below 2:1 is advantageous.
- Return on investment ratio–The ratio compares your business’ net profits to investment. It’s considered one of the best ways of determining the profitability of your business and therefore, crucial for financial planning.
- Inventory turnover ratio – Examines the average turnover in a given year, meaning the time it took to clear your inventory. The calculations can differ depending the industry. For example, in retail the sales are compared to inventory and then looked in relation to industry standard.
You can find out more about business ratios from the below video:
STEPS FOR CREATING A FINANCIAL PLAN
Now that we’ve covered the basic components of a financial plan, let’s examine the steps for creating a sound plan for your business. Whether you are starting out or looking to implement a new business strategy, the below steps will help you on your financial planning adventure.
#1: Calculate start-up costs
If you are setting up a business, you first need to consider the cost of starting out. Calculating the start-up costs is straightforward and simple; you merely have to include all one-time costs you must pay for the business to come to life.
The costs associated for getting started will depend significantly on the type of business you are setting up. For example, launching an online-only business that deals with website development will most likely have less costs than setting up a restaurant.
Below is an example spreadsheet you can use for calculating start-up costs.
|Furniture, fixtures, equipment, signage|
|Legal, accounting, consulting|
|TOTAL STARTUP COSTS|
Remember not all points in the above spreadsheet necessarily apply to your business. For instance, you might not require the use of vehicles. You should initially estimate the costs, but ensure you adjust your spreadsheet as you get quotes for fees or find out the actual cost of certain elements.
#2: Work out cash flow projections
You’ll next need to estimate the cash flow projection. In order to do so, you should:
- Use previous sales figures. Naturally this is only applicable once your business is up and running.
- Calculate both the worst and the best-case scenarios and use an estimate or the most likely outcome.
- Establish a credit policy for the business and use it to estimate how much of your sales will be on credit.
It’s a good idea to prepare the cash flow projection for a total year, but to separate the projections for monthly estimates.
The example sheet below has space for two months, but you can create one file for all 12 months. Furthermore, the below example spreadsheet has a section for the estimated sums and for actual sums. This allows you to see how accurate your predictions have been at a glance.
|Account Receivable collected|
|Other cash received|
|Total cash in|
|Wages & Benefits|
|Loan payments (principal & interest)|
|Travel, auto, delivery|
|Licences and taxes|
|Total cash out|
|Surplus or Deficit|
The key to cash flow predictions is understanding the realistic ratio of receiving your invoices in cash and the timeline for doing so.
It’s rather unrealistic to assume you’d receive 100% of your invoices within the first 30 days of starting out, so you need to be realistic with your calculations.
#3: Prepare income statement and balance sheet
As mentioned in the previous section, it’s crucial to include the actual income statements and balance sheets, as well as the projected versions to your financial plan. Financial planning is more accurate if you use actual data for your estimations.
When it comes to financial planning, the expert advice is to create projected income statements and balance sheets for a three-year period at once.
Below is a sample income statement you can fill out with numbers. As with the cash flow projection above, certain aspects of the spreadsheet might not be relevant to your business.
|Year 1||Year 2||Year 3|
|Cost of Sales|
|Wages & Benefits|
|Net Income before Tax|
It’s important to have your pro-forma income sheet and the actual income sheet distinct to avoid confusion. So, have a separate file for both. You also want to compare the two, as big differences in numbers can highlight problems you might have in estimating certain expenses or revenues.
Here’s also an example spreadsheet you can use for calculating your balance sheet:
|Opening||Year 1||Year 2||Year 3|
|Equipment & Furniture|
|Current portion of long-term loan|
|Minus current portion|
|Retained earnings – current year|
|TOTAL LIABILITIES & EQUITY|
#4: Determine the break-even point
Finally, you need to determine the break-even point for your business. For calculating the break-even figure, you must focus on the following three factors:
- The selling price–The price at which you sell your product or service.
- The fixed costs – Costs, which don’t change depending on sales numbers. Includes expenditure such as rent, loan repayments, insurance, etc.
- The variable costs– Costs, which increase or decrease depending on sales figures. Covers expenditure such as materials, additional staff salaries and supplies, for example.
There are essentially two different ways of calculating the break-even point: the equation method and the contribution margin method.
The equation method allows you to determine the break-even point in units and your chosen currency, such as dollars. As mentioned above, the equation for calculating this is:
Sales price per unit x Number of units = Variable expenses x Number of units + Total fixes expenses
In the above formula, the right side stands for the total costs, while the left side represents the total sales in the currency. By knowing the sales price, the variable expenses and the total fixed expenses, you can solve the number of units you must sell in order to break even.
For example, business A might have determined the sales price per unit to be $15. It’s variable expenses stand at $7.50 per unit, with the annual fixed income running at $15,000. Using the formula above, the calculation would look like this:
15 x Q = 7.5 x Q + 15,000
15Q – 7.5Q = 15,000
7.5Q = 15,000
Q = 15,000 / 7.5
Q = 2,000
Q equals the unit quantity in the above calculation. Therefore, the break-even point in units is 2,000. You can then calculate the break-even point in dollars by multiplying the units (2,000) with the sales price per unit ($15). This would mean the break-even point for your business in dollars would stand at $30,000.
The other available method is the contribution margin method. This takes the total fixed expenses and divides them by the contribution margin per unit (the sales price per unit – the variable expenses per unit).
With the numbers from the above example, the calculation would look like this:
Break even-point = total fixed expenses / contribution margin per unit
Break even point = $15,000 / $7.5
Break even point = 2,000
The above information can then be presented in a break-even chart. Here’s a chart highlighting the above data:
A properly conducted financial plan will help your business to succeed. Financial planning essentially justifies your business ideas for it helps you answer the all-important question: Is my business viable and profitable?
It doesn’t just provide you with a peace of mind going forward; financial planning is the best way to convince investors and lenders to get on board as well.
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