The Financial Forecasts for the Business Plan

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The Financial Forecasts for the Business Plan

• Shad Valley
• 2011

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Contact Info

• Ken Hartviksen
• Ken.hartviksen_at_lakeheadu.ca
• Office RB 1043
• 343-8497
• Web links
• http//foba.lakeheadu.ca/hartviksen
• http//www.scotiabank.com/businessplan

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Todays Agenda

• 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

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What we Hope to Accomplish

• 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

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The Purpose of Financial Forecasts

• To
• 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.

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The Purpose of Financial Forecasts What do
Investors Look For?

• 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

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Characteristics of Good Forecasts

• Reasonable/plausible
• Based upon good primary and secondary research
• Congruent with operating and marketing plans
• Can withstand stress testing
• Conservative/achievable

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Where do you Start?

• 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.

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Integrated Financial Forecasts
Analyze forecasts, adjust inputs and forecast
again.
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Before we Get StartedLets Review Some Things
about Business Plans

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

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Characteristics of a Good Plan

• readable
• organized
• targeted to the audience
• integrated
• complete
• short

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Uses of A Business Plan

• 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

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How a Business Plan is Read

• 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

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Abbreviated Contents

• 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

NOTE the location of the financial documents
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IV. Economics of the Business

• Gross and operating margins
• Profit potential and durability
• Fixed, variable and semi-variable costs
• Months to Break even
• Months to reach positive cash flow

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XI. The Financial Plan

• 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

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XII. Financing

• Proposed sources of financing
• use of funds
• investors forecast rate of return on invested
  capital

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The Basic Financial Forecasts

• Shad Valley Lakehead

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Types of Financial Forecasts

• 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

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Break-even Analysis

• Shad Valley 2007

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Break - Even Analysis(Cost/Volume/Profit
Analysis)

• 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!)

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Break - Even Analysis(Cost/Volume/Profit
Analysis)

• 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

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Cost Behaviour

• 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).

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Relevant Range

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

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Relevant Range

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

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Break - Even Analysis(Cost/Volume/Profit
Analysis)
Total Revenue Line
of Sales and Costs
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10
1 2
Number of units produced and sold
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Break - Even Analysis(Cost/Volume/Profit
Analysis)
Total Revenue Line
of Sales and Costs
20
10
1 2
Number of units produced and sold
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Break - Even Analysis(Cost/Volume/Profit
Analysis)
Total Revenue Line
Total Variable Cost
10
Contribution Margin per unit 2.50
7.50
Number of units produced and sold
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Contribution Margin

• 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..

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Contribution Margin 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

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Contribution Margin .

• 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 0.5
  0
• Direct labour costs (counter help
  cook) 2.75 2.75
• Total variable cost per unit 8.99 6.40

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Contribution Margin .

• 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 0.5
  0
• 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.

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Contribution Margin Analysis

• 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.

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Contribution Margin

• 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.

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Break Even Point

• 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

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Break Even Chart
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Annual Fixed Costs of the Bagel Business

• 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 _at_
  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 manager 34,000
• 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

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Break Even Point of the Bagel Business

• 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
• 1.51
• 54,073 meals
• This works out to 4,507 meals per month or 149
  meals per day.

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Break Even Point of the Bagel Business

• 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?

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Break Even Point of the Bagel Business

• 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

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Initial Investment Schedule
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Initial Investment Schedule

• The purpose of the initial investment schedule
• Identify proposed sources of capital
• Identify proposed initial uses of capital

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The Monthly Cash Budget
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The Monthly Cash Budget

• 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

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The Pro Forma Income Statement
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The Pro Forma Balance Sheet
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Subsidiary Forecasts

• 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

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Types of Small Business Loans

• 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

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Fixed Term Blended Payment Loans
This is a diagram of the cash flows involved
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Effective Annual Rate Calculations

• 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

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Calculating an Effective Monthly Rate

• Since most loans require monthly payments, it is
  necessary to determine the monthly rate that
  would equal the effective annual rate

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Calculating the Monthly Loan Payment

• Now we know all of the variables
• 10,000 loan
• 7 APR 1-year term loan
• We can calculate the loan payment

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Preparing a Loan Amortization Schedule
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Use of the Loan Amortization Schedule

• 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 the pro forma income statement.
• NOTE - repayment of principal is not a tax
  deductible expense.
• - the total payment is a cashflow burden
  borne by the firm

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Effective Annual Rates of Return

• 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.

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The Nature of Depreciation

• 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.

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CCA gives rise to a Tax Shield Benefit to the
Company

• CCA is a non-cash deduction 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.

4
K. Hartviksen
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ExampleConsider 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

• Company A Company B
• Earnings Before CCA Tax 10,000 10,000
• CCA 2,000 0
• Taxable Income 8,000 10,000
• Taxes _at_ 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

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.
5
K. Hartviksen
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CCA Rules

• 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.

7
K. Hartviksen
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CCA Over Time - A Simple ExampleAssume 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
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CCRA Form
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CCRA Form forecasting CCA out three years for one
asset class
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NOTE Regarding Depreciation in your Financial
Forecasts

• 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.

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Initial Startup Capital Required

• 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.

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Initial Investment

• 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

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Initial Investment Required Example
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The Cash Budget

• 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)

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Importance of Cash Flow

• 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, the timing
  and magnitude of any projected cash deficits or
  surpluses.

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Cash and Materials Flow
Cash Sales
Cash
Shareholders equity
Debt
Taxes
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The Cash Budget

• 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.

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Cash Budgets

• 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.

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General Form - Cash Budget
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Assumptions of Cash Budgets

• 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?

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General Form - Cash Budget
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General Form - Cash Budget
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Cash Balance
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Analyzing your financial forecasts

• Lakehead Shad Valley

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Ratio Analysis

• 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.

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Ratio

• 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

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Categories of Ratios

• Liquidity
• Asset Management
• Debt Management
• Profitability

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Liquidity Ratios

• 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!

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Liquidity Ratios

• Examples
• Current Ratio Current Assets
• Current Liabilities
• Quick Ratio Current Assets - Inventories
• Current Liabilities

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Asset Management Ratios

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

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Asset Management Ratios

• Examples
• Inventory Turnover Sales
• Inventory
• Average Collection
• Period Receivables
• Sales/365

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Asset Management Ratios

• Examples
• Fixed Asset
• Turnover Sales
• Fixed Assets
• Total Asset
• Turnover Sales
• Total Assets

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Debt Management Ratios

• 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.

87
Debt Management Ratios

• Examples
• Debt to
• Total Assets Total Debt
• Total Assets
• Times interest
• earned Operating Income
• Interest Charges

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Profitability Ratios

• Purpose
• to examine the historical (or prospective rate of
  return in the case of pro forma financial
  statements) rates of return earned on invested
  capital.

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Profitability Ratios

• Examples
• Profit margin
• on sales Net income
• Sales
• Return on
• Equity Net income
• Common Equity

90
Profitability Ratios

• Examples
• Return on
• Assets Net income
• Total Assets

91
Seasonality of Sales

• 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?

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Balance Sheet Accounts over time
93
Selecting the Fiscal Year End

• 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 sometime after 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

94
Ratio Analysis

• 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.

95
Income Statement Ratios

• 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?

96
Use of Ratios

• Evaluate your past financial performance
• Evaluate your financial forecasts

97
Role of Ratios in Your Business Plan

• 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.

98
Role of Ratios in Your Business Plan
Prepare Pro Forma Financial Statements based on
your business plans
Revise plan if necessary
Analyze your forecasts using ratio analysis
Once you are satisfied with your
forecastsproceed to raise the capital and
implement the plan
99
The Articulation of forecast Income Statements
and Balance Sheets

• 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.)

100
Questions?

• Good Luck