Financial Plan
Most of us entrepreneurs hate finance just like what Albert Einstein said “do not worry, we are worse off than you in financial planning”. We are going to make finance as simple as possible. When you finish this chapter you would be having a good understanding on financial plan without getting a degree in finance.
Why a Financial Plan?
It will help one manage better. To show your lenders and investors that you have done your homework. A financial plan has three components, one “Basic Financial Report”, two “Breakeven Point Analysis” and three “Ratio Analysis”. Now let us take a look at each of these components.
Financial Report
Basic Financial Report has three major reports viz. balance sheet, income statement
and cash flow.
Balance Sheet
Provides details of a company’s worth on a given date which is Assets = Liability + Owner’s equity.
Assets are current, fixed and intangible. Current assets are short term ie.less than.1 year. These include cash in bank, items which can be converted into cash within one year that is accounts receivable and inventory less bad debts. Fixed assets are long term that is more than one year. These include land and building less depreciation. Intangible assets are copyright, patent, trademark and goodwill
Liabilities are current and long term. Current is short term that is less than 1 year. These include accounts payable, notes payable, wages, taxes etc. Long term that is more than one year include mortgage and long term note payable.
Owner’s equity is investment by the investors. 10 % increase or decrease on one side is reciprocated on the other side
Income Statement
Income statement is also known as Profit and Loss (P &L) statement. The purpose of this statement is to compare expense against revenue over a period of time. Profit or loss is the difference between revenue and expenses.
Cash flow statement
Cash flow statement shows the change in business working capital. To do this we first need the balance sheet and income statement and then the source of funds. Please note that depreciation is considered as a source of fund.
Total expense against total source is the increase or decrease in working capital.
Breakeven point Analysis
Breakeven point indicates the minimum level of sales required to reach break even. It provides a good indication but it is too simple to use as a final method because it ignores cash flow.
Ratio Analysis
Ratio Analysis compares significant numbers from the financial statement. Each ratio indicator depends on the business you are in. This is probably the most difficult part to understand in finance. We have attempted to keep it simple and we believe we have succeeded in doing so.
There are 4 main ratios and each in turn has other ratios
- Liquidity Ratios
– Indicates company’s ability to pay its bills
- Leverage Ratios
– Finances supplied by owner against creditors
- Operating Ratios
– Evaluating performances of the company
- Profitability Ratios
– Indicates how well a company is managed
These in turn have several ratios. It is beyond this article to explore them. You will need to attend a course or pick up a book on ratios to understand them further.
Managing Cash Flow
A healthy cash flow is an essential part of any successful business. Failure to have enough cash to pay your suppliers, creditors, or your employees implies that you’re out of business! Proper management of your cash flow is very important in making your business successful.
Understanding Cash Flow
In its simplest form, cash flow is the movement of money in and out of your business. It can be described as the process in which your business uses cash to generate goods or services for sale to your customers, collects the cash from the sales, and then completes this cycle all over again.
Why is it important to manage cash flow? Smart cash flow management is vital to the health of your business. Hopefully, each time through the cycle, a little more money is put back into the cash flow cycle than which flows out. Your profit is not the same as your cash flow. It’s possible to show a healthy profit at the end of the year, and yet face a significant money squeeze at various points during the year.
To properly manage your business’ cash flow, you must first analyze the components that affect the timing of your cash inflows and outflows. A good analysis of these components will point out the problem areas that lead to cash flow gaps in your business. Closing or even narrowing cash flow gaps is the key to cash flow management.
Important components to be examined are:
- Accounts receivable are the monies people owe you.
- Credit terms are the time allowed before you pay or others pay you.
- A credit policy is the one which details credit terms of your company.
- Inventory is the stock you have.
- Accounts payable are the monies you owe others.
In the next article we will explore “cash flow budget”.
All MBA students should read this
Excellent article. Very simple language and serves the purpose. We can give some reference to the ratios etc. so that interested reader can explore further on that.