Tuesday, July 3, 2018

The Key Elements of the Financial Plan

the key elements of a financial statement

Digging into your business’s financials can feel a bit like eating your fruits and vegetables, but what’s good for your business’s health is good for you.

This article is part of both our Business Startup Guide and our Business Planning Guidecurated lists of our articles that will get you up and running in no time!

When you’re putting a business plan together, the financial plan can feel like the most intimidating part. If you’re like most business owners, you probably didn’t go to business school or have a degree in accounting. 

That’s O.K. This article will explain everything that you need to include in your financial plan so you get off to a good start.
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All business plans, whether you’re just starting a business or building a plan for an existing business, should include the following:

Even if you’re in the very beginning stages of your business, these financial statements can still work for you.

The good news is that they don’t have to be difficult to create or hard to understand. With just a few educated guesses about how much you might sell and what your expenses will be, you’ll be well on your way to creating a complete financial plan.

Profit and loss statement

A profit and loss statement is essentially an explanation of how your business made a profit (or incurred a loss) over a certain period of time. It’s a table that lists all of your revenue streams and all of your expenses—typically for a three-month period—and lists at the very bottom the total amount of net profit or loss.

This is a financial statement that goes by a few different names—profit and loss statement, income statement, pro forma income statement, P&L (short for “profit and loss”)—but no matter what you call it, it’s an essential report and very important to understand.

There are different formats for profit and loss statements, depending on the type of business you’re in and the structure of your business (nonprofit, LLC, C-Corp, etc.).

A typical profit and loss statement should include:

  • Your revenue (also called sales) 
  • Your “cost of sale” or “cost of goods sold” (COGS)—keep in mind, some types of companies, such as a services firm, may not have COGS
  • Your gross margin, which is your revenue less your COGS

These three components (revenue, COGS, and gross margin) are the backbone of your business model—i.e., how you make money.

You’ll also list your operating expenses, which are the expenses associated with running your business that aren’t incurred directly by making a sale. They’re the fixed expenses that don’t fluctuate depending on the strength or weakness of your revenue in a given month—think rent, utilities, and insurance.

Your gross margin less your operating expenses will give you your operating income:

Gross Margin – Operating Expenses = Operating Income

Depending on how you classify some of your expenses, your operating income will typically be equivalent to your “earnings before interest, taxes, depreciation, and amortization” (EBITDA)—basically, how much money you made in profit before you take your accounting and tax obligations into consideration. This is also called your “profit before interest and taxes,” gross profit, and “contribution to overhead”—many names, but they all refer to the same number.

Your so-called “bottom line”—officially, your net income, which is found at the very end (or, bottom line) of your profit and loss statement—is your EBITDA less the “ITDA.” Just subtract your expenses for interest, taxes, depreciation, and amortization from your EBITDA, and you have your net income:

Operating Income – Interest, Taxes, Depreciation, and Amortization Expenses = Net Income

For further reading on profit and loss statements (a.k.a., income statements), including an example of what a profit and loss statement actually looks like, check out “How to Read and Analyze an Income Statement.”

Cash flow statement

A cash flow statement (also called a “statement of cash flows”) is an explanation of how much cash your business brought in, how much cash it paid out, and what its ending cash balance was, typically per-month.

That might sound like sales, expenses, and profits, but it’s not.

Consider this: What happens when you send out an invoice to a client, but they don’t pay it by the due date? What happens when you pay your own bills late, or early? These kinds of things aren’t reflected in your profit and loss statement, but they are explained in your cash flow statement.

Your cash flow statement is just as important as your profit and loss statement. Businesses run on cash—there are no two ways around it.

Without a thorough understanding of how much cash you have, where your cash is coming from, where it’s going, and on what schedule, you’re going to have a hard time running a healthy business. And without the cash flow statement, which lays that information out neatly for lenders and investors, you’re not going to be able to raise funds. No business plan is complete without a cash flow plan.

The cash flow statement helps you understand the difference between what your profit and loss statement reports as income—your profit—and what your actual cash position is.

It is possible to be extremely profitable and still not have enough cash to pay your expenses and keep your business afloat, and it is also possible to be unprofitable but still have enough cash on hand to keep the doors open for several months and buy yourself time to turn things around—that’s why this financial statement is so important to understand.

How cash versus accrual accounting affects the cash flow statement

There are two methods of accounting—the cash method and the accrual method.

The cash method means that you just account for your sales and expenses as they happen, without worrying about matching up the expenses that are related to a particular sale or vice versa.

The accrual method means that you account for your sales and expenses at the same time—if you got a big preorder for a new product, for example, you’d wait to account for all of your preorder sales revenue until you’d actually started manufacturing and delivering the product. Matching revenue with the related expenses is what’s referred to as “the matching principle,” and is the basis of accrual accounting.

If you use the cash method of accounting in your business, your cash flow statement isn’t going to be very different from what you see in your profit and loss statement. That might seem like it makes things simpler, but I actually advise against it. I think that the accrual method of accounting gives you the best sense of how your business operates, and that you should consider switching to it if you aren’t using it already.

For the best sense of how your business operates, you should consider switching to accrual accounting if you aren’t using it already.

Here’s why: Let’s say you operate a summer camp business. You might receive payment from a camper in March, several months before camp actually starts in July—using the accrual method, you wouldn’t recognize the revenue until you’ve performed the service, so both the revenue and the expenses for the camp would be accounted for in the month of July.

With the cash method, you would have recognized the revenue back in March, but all of the expenses in July, which would have made it look like you were profitable in all of the months leading up to the camp, but unprofitable during the month that camp actually took place.

Cash accounting can get a little unwieldy when it comes time to evaluate how profitable an event or product was, and can make it harder to really understand the ins and outs of your business operations. For the best look at how your business works, accrual accounting is the way to go.

Balance sheet

Your balance sheet is a snapshot of your business’s financial position—at a particular moment in time, how are you doing? How much cash do you have in the bank, how much do your customers owe you, and how much do you owe your vendors?

The balance sheet is standardized, and consists of three types of accounts:

  • Assets (accounts receivable, money in the bank, inventory, etc.)
  • Liabilities (accounts payable, credit card balances, loan repayments, etc.)
  • Equity (for most small businesses, this is just the owner’s equity, but it could include investors’ shares, retained earnings, stock proceeds, etc.)

It’s called a balance sheet because it’s an equation that needs to balance out:

Assets = Liabilities + Equity

The total of your liabilities plus your total equity always equals the total of your assets.

At the end of the accounting year, your total profit or loss adds to or subtracts from your retained earnings (a component of your equity). That makes your retained earnings your business’s cumulative profit and loss since the business’s inception.

However, if you are a sole proprietor or other pass-through tax entity, “retained earnings” doesn’t really apply to you—your retained earnings will always equal zero, as all profits and losses are passed through to the owners and not rolled over or retained like they are in a corporation.

Sales forecast

The sales forecast is exactly what it sounds like: your projections, or forecast, of what you think you will sell in a given period (typically, a year to three years). Your sales forecast is an incredibly important part of your business plan, especially when lenders or investors are involved, and should be an ongoing part of your business planning process.

Your sales forecast should be an ongoing part of your business planning process.

You should create a forecast that is consistent with the sales number you use in your profit and loss statement. In fact, in our business planning software, LivePlan, the sales forecast auto-fills the profit and loss statement.

There isn’t a one-size-fits-all kind of sales forecast—every business will have different needs. How you segment and organize your forecast depends on what kind of business you have and how thoroughly you want to track your sales.

Some helpful questions to ask yourself are:

  • How many customers do you anticipate?
  • How much will you charge them?
  • How often will you charge them?

Your sales forecast can be as detailed as you want it to be, or you can simplify your forecast by summarizing. However you choose to do a sales forecast, you should definitely have one.

Generally, you’ll want to break down your sales forecast into segments that are helpful to you for planning and marketing purposes. If you own a restaurant, for example, you’d probably want to separate your forecasts for dinner and lunch sales; if you own a gym, it might be helpful to differentiate between single memberships, family memberships, club shop sales, and extra services like personal training sessions. If you want to get really specific, you might even break your forecast down by product, with a separate line for every product you sell.

Along with each segment of forecasted sales, you’ll want to include that segment’s “cost of goods sold” (COGS). The difference between your forecasted revenue and your forecasted COGS is your forecasted gross margin.

Personnel plan

The importance of the personnel plan depends largely on the type of business you have. If you are a sole proprietor with no employees, this might not be that important and could be summarized in a sentence of two. But if you are a larger business with high labor costs, you should spend the time necessary to figure out how your personnel affects your business.

Think of the personnel plan as a justification of each team member’s necessity to the business.

If you create a personnel plan, it should include a description of each member of your management team, explaining what they bring to the table in terms of training, expertise, and product or market knowledge. If you’re writing a business plan to present to lenders or investors, you could think of this as a justification of each team member’s necessity to the business, and a justification of their salary (and/or equity share, if applicable). This would fall in the company overview section of your business plan.

You can also choose to use this section to list entire departments if that is a better fit for your business and the intentions you have for your business plan. There’s no rule that says you have to list only individual members of the management team.

This is also where you would list team members or departments that you’ve budgeted for but haven’t hired yet. Describe who your ideal candidate(s) is/are, and justify your budgeted salary range(s).

Additional calculations you might find useful:

Business ratios

If you have your profit and loss statement, your cash flow statement, and your balance sheet, you have all the numbers you need to calculate the standard business ratios. These ratios aren’t necessary to include in a business plan—especially for an internal plan—but knowing some key ratios is almost always a good idea.

You’d probably want some profitability ratios, like:

  • Gross margin
  • Return on sales
  • Return on assets
  • Return on investment

And you’d probably want some liquidity ratios, such as:

  • Debt-to-equity
  • Current ratio
  • Working capital

Of these, the most common ratios used by business owners and requested by bankers are probably gross margin, return on investment (ROI), and debt-to-equity.

Break-even analysis

Your break-even analysis is a calculation of how much you will need to sell in order to “break even” (i.e., how much you will need to sell in order to pay for all of your expenses).

Consider a restaurant: It has to be open, with the tables set and the menus printed and with the bartender and all of the cooks and servers working, in order to make even one sale. But if it only sold one dinner, the restaurant would be operating at a loss—even a $50 meal isn’t going to cover the night’s utility bills. So the restaurant owner might use a break-even analysis to get an idea of how many meals the restaurant needs to sell on a given night in order to cover its expenses.

In determining your break-even point, you’ll need to figure out the contribution margin of what you’re selling. In the case of a restaurant, the contribution margin will be the price of the meal less any associated costs. For example, the customer pays $50 for the meal. The food costs are $10 and the wages paid to prepare and serve the meal are $15. Your contribution margin is $25 ($50 – $10 – $15 = $25).

Using this model you can determine how high your sales revenue needs to be in order for you to break even. If your monthly fixed costs are $5,000 and you average a 50 percent contribution margin (like in our example with the restaurant), you’ll need to have sales of $10,000 in order to break even.

Conclusion

Your financial plan might feel overwhelming when you get started, but the truth is that this section of your business plan is absolutely essential to understand.

Even if you end up outsourcing your bookkeeping and regular financial analysis to an accounting firm, you—the business owner—should be able to read and understand these documents and make decisions based on what you learn from them. Using a business dashboard tool can help, so you’re not wading through spreadsheets to put your figures on the important details.

If you create and present financial statements that all work together to tell the story of your business, and if you can answer questions about where your numbers are coming from, your chances of securing funding from investors or lenders are much higher.

Do you have any questions about creating a financial plan for your business? Let us know on Twitter @Bplans



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