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How to Write the Financial Section of a Business Plan

2010-06-30 15:37:30

An outline of your company's growth strategy is essential to a business plan,

but it just isn't complete without the numbers to back it up. Here's some

advice on how to include things like a sales forecast, expenses budget, and

cash flow statement.

A business plan is all conceptual until you start filling in the numbers and

terms. The sections about your marketing plan and strategy are interesting to

read, but they don't mean a thing if you can't justify your business with good

figures on the bottom line. You do this in a distinct section of your business

plan for financial forecasts and statements. The financial section of a

business plan is one of the most essential components of the plan, as you will

need it if you have any hope of winning over investors or obtaining a bank

loan. Even if you don't need financing, you should compile a financial forecast

in order to simply be successful in steering your business.

"This is what will tell you whether the business will be viable or whether you

are wasting your time and/or money," says Linda Pinson, author of Automate Your

Business Plan for Windows (Out of Your Mind 2008) and Anatomy of a Business

Plan (Out of Your Mind 2008), who runs a publishing and software business Out

of Your Mind and Into the Marketplace. "In many instances, it will tell you

that you should not be going into this business."

The following pages will cover what the financial section of a business plan

is, what it should include, and how you should use it to not only win financing

but to better manage your business.

Dig Deeper: Generating an Accurate Sales Forecast

How to Write the Financial Section of a Business Plan: The Purpose of the

Financial Section

Let's start by explaining what the financial section of a business plan is not.

Realize that the financial section is not the same as accounting. Many people

get confused about this because the financial projections that you include --

profit and loss, balance sheet, and cash flow -- look similar to accounting

statements your business generates. But accounting looks back in time, starting

today and taking an historical view. Business planning or forecasting is a

forward-looking view, starting today and going forward into the future.

"You don't do financials in a business plan the same way you calculate the

details in your accounting reports," says Tim Berry, president and founder of

Palo Alto Software, who blogs at bplans.com and is writing a book, The

Plan-As-You-Go Business Plan. "It's not tax reporting, it's an elaborate

educated guess."

What this means, says Berry, is that you summarize and aggregate more than you

might with accounting, which deals more in detail. "You don't have to imagine

all future asset purchases with hypothetical dates and hypothetical

depreciation schedules to estimate future depreciation," he says. "You can just

guess based on past results. And you don't spend a lot of time on minute

details in a financial forecast that depends on an educated guess for sales."

The purpose of the financial section of a business plan is two-fold. You're

going to need it if you are seeking investment from venture capitalists, angel

investors, or even smart family members. They are going to want to see numbers

that say your business will grow -- and quickly -- and that there is an exit

strategy for them on the horizon, during which they can make a profit. Any bank

or lender will also ask to see these numbers as well to make sure you can repay

your loan.

But the most important reason to compile this financial forecast is for your

own benefit, so that you understand how you project that your business will do.

"This is an ongoing, living document. It should be a guide to running your

business," Pinson says. "And at any particular time you feel you need funding

or financing then you are prepared to go with your documents."

If there is a rule of thumb when filling in the numbers in the financial

section of your business plan, it's this: be realistic. "There is a tremendous

problem with the hockey-stick forecast" that projects growth as steady until it

shoots up like the end of a hockey stick, Berry says. "They really aren't

credible." Berry, who acts as an angel investor with the Willamette Angel

Conference, says that while a startling growth trajectory is something that

would-be investors would love to see, it's most often not a believable growth

forecast. "Everyone wants to get involved in the next Google or Twitter, but

every plan seems to have this hockey stick forecast. Sales are going along flat

but six months from now there is a huge turn and everything gets amazing,

assuming they get the investors' money," Berry says.

The way you come up a credible financial section for your business plan is to

demonstrate that it's realistic. One way, Berry says, is to break the figures

into components, by sales channel or target market segment, and provide

realistic estimates for sales and revenues. "It's not exactly data because

you're still guessing the future. But if you break the guess into component

guesses and look at each one individuals, it somehow feels better," Berry says.

"Nobody wins by overly optimistic or overly pessimistic forecasts."

Dig Deeper: What Angel Investors Look For

How to Write the Financial Section of a Business Plan: The Components of a

Financial Section

A financial forecast isn't necessarily compiled in sequence. And you most

likely won't present it in the final document in the same sequence you compile

the figures and documents. Berry says that it's typical to start in one place

and jump back and forth. For example, what you see in the cash-flow plan might

mean going back to change estimates for sales and expenses. Still, he says that

it's easier to explain in sequence, as long as you understand that you don't

start at step one and go to step six without looking back -- a lot -- in

between.

Start with a sales forecast. Set up a spreadsheet projecting your sales over

the course of three years. Set up different sections for different lines of

sales and columns for every month for the first year and either on a monthly or

quarterly basis for the second and third years. "Ideally you want to project in

spreadsheet blocks that include one block for unit sales, one block for

pricing, a third block that multiplies units times price to calculate sales, a

fourth block that has unit costs, and a fifth multiplies units times unit cost

to calculate cost of sales (also called COGS or direct costs)," Berry says.

"Why do you want cost of sales in a sales forecast? Because you want to

calculate gross margin. Gross margin is sales less cost of sales, and it's a

useful number for comparing with different standard industry ratios." If it's a

new product or a new line of business, you have to make an educated guess. The

best way to do that, Berry says, is to look at past results.

Create an expenses budget. You're going to need to understand how much it's

going to cost you to actually make the sales you have forecast. Berry likes to

differentiate between fixed costs (i.e., rent and payroll) and variable costs

(i.e., most advertising and promotional expenses), because it's a good thing

for a business to know. "Lower fixed costs mean less risk, which might be

theoretical in business schools but are very concrete when you have rent and

payroll checks to sign," Berry says. "Most of your variable costs are in those

direct costs that belong in your sales forecast, but there are also some

variable expenses, like ads and rebates and such." Once again, this is a

forecast, not accounting and you're going to have to estimate things like

interest and taxes. Berry recommends you go with simple math. He says multiply

estimated profits times your best guess tax percentage rate to estimate taxes.

And then multiply your estimated debts balance times an estimated interest rate

to estimate interest.

Develop a cash flow statement. This is the statement that shows physical

dollars moving in and out of the business. "Cash flow is king," Pinson says.

You base this partly on your sales forecasts, balance sheet items, and other

assumptions. If you are operating an existing business, you should have

historical documents, such as profit and loss statements and balance sheets

from years past to base these forecasts on. If you are starting a new business

and do not have these historical financial statements, you start by projecting

a cash flow statement broken down into 12 months. Pinson says that it's

important to understand when compiling this cash flow projection that you need

to choose a realistic ratio for how many of your invoices will be paid in cash,

30 days, 60 days, 90 days and so on. You don't want to be surprised that you

only collect 80 percent of your invoices in the first 30 days when you are

counting on 100 percent to pay your expenses, she says. Some business planning

software programs will have these formulas built in to help you make these

projections.

Income projections. This is your pro forma profit and loss statement,

detailing forecasts for your business for the coming three years. Use the

numbers that you put you re your sales forecast, expense projections, and cash

flow statement. "Sales, lest cost of sales, if gross margin," Berry says.

"Gross margin, less expenses, interest and taxes, is net profit."

Deal with assets and liabilities. You also need a projected balance sheet.

You have to deal with assets and liabilities that aren't in the profits and

loss and project the net worth of your business at the end of the fiscal year.

Some of those are obvious and affect you at only the beginning, like start-up

assets. A lot are not obvious. "Interest is in the profit and loss, but

repayment of principle isn't," Berry says. "Taking out a loan, giving out a

loan, and inventory show up only in assets -- until you pay for them." So the

way to compile this is to start with assets, and estimate what you ll have on

hand, month by month for cash, accounts receivable (money owed to you),

inventory if you have it, and substantial assets like land, buildings, and

equipment. Then figure what you have as liabilities -- meaning debts. That s

money you owe because you haven t paid bills (which is called accounts payable)

and the debts you have because of outstanding loans.

Break-even analysis. The break-even point, Pinson says, is when your

business' expenses match your sales or service volume. The three-year income

projection will enable you to undertake this analysis. "If your business is

viable, at a certain period of time your overall revenues will exceed your

overall expenses, including interest." This is an important analysis for

potential investors, who want to know that they are investing in a fast-growing

business with an exit strategy.

Dig Deeper: How to Price Business Services

How to Write the Financial Section of a Business Plan: How to Use the Financial

Section

One of the biggest mistakes business people make is to look at their business

plan, and particularly the financial section, only once a year. "I like to

quote former President Dwight D. Eisenhower," says Berry. "'The plan is useless

but planning is essential.' What people do wrong is focus on the plan and

figure once the plan is done it's forgotten. It's really a shame because they

could have used it as a tool for managing the company." In fact, Berry

recommends that business executives sit down with the business plan once a

month and fill in the actual numbers in the profit and loss statement and

compare those numbers with projections. And then use those comparisons to

revise projections in the future.

Pinson also recommends that you undertake a financial statement analysis to

develop a study of relationships and comparisons of items in your financial

statements, comparative financial statements over time, and even comparing your

statements to those of other businesses. Part of this is a ratio analysis. She

recommends that you do some homework and find out some of the prevailing ratios

used in your industry for liquidity analysis, profitability analysis, and debt

and compare those standard ratios with your own.

"This is all for your own benefit. That's what financial statements are for.

You should be utilizing your financial statements to measure your business

against what you did in prior years or to measure your business against another

business like yours," she says.

If you are using your business plan to attract investment or get a loan, you

may also include a business financial history as part of the financial section.

This is a summary of your business from start to the present. Sometimes a bank

might have a section like this on a loan application. If you are seeking a

loan, you may need to add supplementary documents to the financial section,

such as the owner's financial statements, listing assets and liabilities.

All of the various calculations you need to assemble the financial section of a

business plan are a good reason to look for business planning software, so you

can have this on your computer and make sure you get this right. Software

programs also let you use some of your projections in the financial section to

create pie charts or bar graphs that you can use elsewhere in your business

plan to highlight your financials, your sales history, or your projected income

over three years.

"It's a pretty well-known fact that if you are going to seek equity investment

from venture capitalists or angel investors," Pinson says, "they do like

visuals."

Dig Deeper: How to Protect Your Margins in a Downturn