Financial planning

In the previous module, we introduced how to interpret three key financial statements to understand the financial health of your business. These statements are:

1. Balance sheet (also called a statement of financial position): Shows what a business’ financial position is at a moment in time.
2. Profit and loss statement (also called an income statement, or statement of financial performance): Shows financial performance in a particular period of time.
3. Cash flow statement: Records money coming and going for a particular period of time – like your bank statement, but with insights into patterns and/or problems.

While each statement focuses on different aspects of the business, they work together to provide a comprehensive picture of the business’ financial performance and position. These statements are interconnected and changes in one can affect the others.

In the previous module, we provided a link to an example of each statement. It would be helpful to have these statements available to view as you go through this topic. You can view or download these statements using the following links:

1. Balance sheet
2. Profit and loss statement (P&L)
3. Cash flow statement

Balance sheet

A balance sheet is a financial statement that provides a snapshot of a company's financial position at a specific point in time, usually at the end of a reporting period, such as the end of a month, quarter, or financial year. It presents what the company owns (assets), owes (liabilities), and what is left over after deducting liabilities from assets (owner’s equity).

Watch

How to Read a Balance Sheet

Watch the following video which provides an overview of how to read a balance sheet.

Expected Duration: 1:54 minutes

The balance sheet equation illustrates the fundamental relationship between assets, liabilities, and owner’s equity:

The equation ensures that the total assets of a company are always equal to the sum of its liabilities and owner’s equity. This serves as a check to verify the accuracy of financial records and transactions.

Your accountant may produce a balance sheet for you or can do so yourself using accounting software. Trying to produce a balance sheet yourself without accounting software can be difficult. If you are a sole trader with few assets then producing a balance sheet isn’t necessary, but as your business grows it will become more important.

Financial forecasting

Forecasting a balance sheet for small business start-ups can be impractical due to several reasons:

• Small start-ups often lack historical financial data, making it challenging to forecast balance sheet items accurately.
• Balance sheet items, such as assets and liabilities, can be more complex and subject to volatility compared to revenue and expenses.
• Small start-ups often have limited financial resources, time, and expertise to develop complex balance sheet forecasts. They may prioritise other aspects of financial planning, such as cash flow projections and profit and loss forecasts, which are more immediately relevant to their operations and decision-making.

Profit and loss forecasts and cash flow forecasts, however, are very useful tools and essential components of a business plan for several reasons:

• Financial planning: By estimating revenue, expenses, and cash flows, business owners can anticipate potential financial challenges and opportunities and develop strategies to address them proactively.
• Feasibility analysis: By projecting future revenues and expenses, business owners can determine whether the business is likely to generate enough profit to sustain operations and achieve financial goals.
• Investor and lender confidence: Investors, lenders, and other stakeholders often require detailed financial projections as part of the business plan. Profit and loss forecasts and cash flow forecasts demonstrate the business owner’s understanding of the financial aspects of the business and provide insight into the expected return on investment and repayment ability, increasing confidence in the business' potential success.
• Resource allocation: Profit and loss forecasts and cash flow forecasts help allocate resources effectively by identifying potential funding needs and prioritising spending. Business owners can use these forecasts to determine the amount and timing of investment required for start-up costs, working capital, and growth initiatives.
• Risk management: Profit and loss forecasts and cash flow forecasts facilitate risk management by identifying potential financial risks and uncertainties.
• Performance monitoring: Once the business is operational, profit and loss forecasts and cash flow forecasts serve as benchmarks for monitoring actual financial performance against projected targets. By comparing actual results to forecasts regularly, business owners can identify variances, analyse the underlying causes, and adjust strategies accordingly to achieve financial goals.

We will delve into profit and loss and cash flow later in this topic.

Assumptions

Including assumptions and reasoning behind forecasting is essential for providing context, transparency, and credibility to the financial projections in a business plan. When forecasting for a business without historical data, business owners must rely on educated assumptions and logical reasoning based on market research, industry knowledge, and business insights. Here's how to effectively include assumptions and reasoning in financial projections for a business plan:

• Conduct market research and analysis: Begin by conducting thorough market research and analysis to understand the target market, industry trends, customer needs, and competitive landscape. Use this information to inform your assumptions about market demand, pricing strategies, and potential sales volume.
• Document your assumptions: Clearly document the assumptions underlying your financial projections in the business plan. Provide rationale and supporting evidence for each assumption based on market research, expert opinions, or industry benchmarks.
• Validate your assumptions: Validate assumptions through feedback from industry experts, potential customers, advisors, or mentors. Seek input from professionals with relevant experience in the industry to ensure the reasonableness and validity of your assumptions.
• Monitor and adjust continuously: Monitor actual performance against projected results regularly and adjust assumptions and forecasts as needed based on new information, market feedback, or changing business conditions. Continuously refine and update the business plan to reflect the evolving realities of the business environment.

The table below outlines some common financial assumptions to include in a business plan. Some of these assumptions will be demonstrated in the forecasts themselves, but the rationale behind the assumptions should still be provided. We will cover many of the concepts in the table below in more detail later in this topic.

Revenue assumptions	Sales forecasts: Projected sales volume for each product or service offering, including assumptions about market demand, pricing strategy, and sales channels. Growth rate: Anticipated growth rate for the business, considering factors such as market trends, industry growth, and competitive landscape.
Cost assumptions	Cost of sales (COS): Estimates of direct costs associated with producing or delivering the products or services. Operating expenses: Assumptions about fixed and variable operating expenses, such as rent, utilities, salaries, marketing, and administrative costs. Initial investment: Assumptions about the amount of capital required to start or expand the business, including costs for equipment, facilities, and technology. Cost inflation: Expectations regarding the rate of inflation for various cost components, impacting future expenses.
Financing assumptions:	Funding sources: Expectations regarding sources of financing, such as equity investment, loans, grants, or other forms of capital. Interest rates: Assumptions about prevailing interest rates for debt financing, impacting borrowing costs and repayment terms.
Operating assumptions	Sales cycle: Assumptions about the length of the sales cycle, from lead generation to closing, influencing cash flow and working capital needs. Payment terms: Expectations regarding customer payment terms and collection cycles, affecting cash flow projections. Seasonality: Considerations about seasonal fluctuations in demand or revenue, impacting sales forecasts and resource allocation.
Market assumptions	Market size and share: Assumptions about the total addressable market and the business's potential market share, guiding revenue projections. Competitive landscape: Expectations regarding competitor behaviour, market positioning, and potential competitive threats.

An example of an assumption would be that the business owner expects their revenue to grow by 5% for the year. They could then explain why 5% is a reasonable growth rate given the industry growth. This would be an important note for someone looking at the forecast to understand how the revenue figures had been calculated.

The following video provides an introduction to the profit and loss statement and refers to the example statement linked earlier.

Watch

The profit and loss statement

This video provides an introduction to the profit and loss statement and refers to the example statement referred to earlier in this topic.

Expected Duration: 1:45 minutes

As mentioned in the video, a profit and loss statement consists of three key components:

1. Revenues
2. Expenses
3. Profits.

This is also the case for profit and loss forecasts. We’ll explore each of these components in the following sections.

Revenue

Revenue represents the total income generated from the sale of goods or services during a specific period. In a profit and loss forecast, revenue projections are based on anticipated sales volume and pricing for the products or services offered by the business. Revenue is typically the top line of the profit and loss statement, and it serves as the starting point for calculating other financial metrics.

Forecasting revenue for a new venture can be challenging if you do not have historical to work from. When estimating your anticipated sales volume, consider the following:

• Market research: Understand your target market, competitors and industry trends. Estimating the size of your target market will help you determine the portion of the market you can realistically capture. You will have conducted market research as part of the previous module and assessment.
• Seasonality and trends: Consider any seasonal fluctuations or cyclical trends that may affect demand for your products or services. Adjust your revenue forecast accordingly to anticipate variations in sales volume throughout the year.
• Seek advice: Your business coach or mentor and other experts, such as your accountant, may be able to offer valuable insights. You can also try tapping into your network or any industry associations you are a member of.
• Monitor and update regularly: Continuously monitor your actual sales performance against your revenue forecast and adjust your projections as needed. Stay informed about changes in the market, customer preferences, and competitive landscape, and update your revenue forecast accordingly.

Note that you should also consider the above even if you do have historical data to work from.

Pricing your product or service

Break-even pricing is a pricing strategy that involves determining the minimum price at which a product or service must be sold to cover all costs and reach the break-even point, where total revenue equals total costs.

To calculate the break-even price, the business needs to consider both fixed costs (operating expenses (OPEX)) and variable costs (cost of sales (COS)). You must also use the same period of time for the costs and sales volume, i.e., one month of fixed costs, one month of variable costs, one month of expected sales volume. The formula for break-even pricing is:

To decide on the price of your product or service, you’ll first need an understanding of your expenses. Expenses are covered in the following section.

Break-even pricing is often used as a baseline for pricing decisions, providing insight into the minimum price necessary to sustain operations and make a profit. Other factors should be considered such as competition and what customers are willing to pay. These factors and other pricing strategies are covered later in this module.

Expenses

Cost of sales (COS)

Cost of sales (COS), also known as cost of goods sold (COGS), represents the direct costs associated with producing or acquiring the goods or services sold by the business. These costs are variable, meaning that they fluctuate according to your sales. For example:

• If you manufacture products, your COS includes the costs of raw materials required to manufacture products.
• If you sell products, your COS includes the cost of the goods you buy to then sell onto customers.
• If you provide a service, your COS could include any consumables you use or travel expenses you incur in order to provide a service.

Operating expenses (OPEX)

Operating expenses (OPEX) are the indirect costs associated with running the day-to-day operations of the business. These costs are fixed, meaning that they do not fluctuate according to your sales. Examples of OPEX include salaries, rent, utilities, marketing and insurance.

Note that start-up costs are typically not included in the profit and loss forecast because they represent one-time expenses incurred at the beginning of a business venture to establish operations and get the business up and running. Start-up costs will be represented in the cash flow forecast.

Whether some expenses are considered COS or OPEX can vary from one business to the next (for example freight, warehousing and lease expenses). Decide what makes the most sense for your business and ensure you remain consistent with the approach you have chosen.

Other expenses

Non-operating expenses are shown in the statement example and include interest expenses and unusual expenses. Interest expenses are simply the amount of interest you pay on your debt, while unusual expenses can be legal costs (if not associated with income), or other one-off expenses not related to revenue generation.

Depreciation is also shown in this example statement. Depreciation is the gradual decrease in the value of an asset over time due to factors such as wear and tear. Depreciation is a non-cash expense and therefore is often excluded from profit and loss forecasts. Including depreciation may mean the forecast does not accurately reflect the business's ability to generate cash and cover expenses. Depreciation is typically accounted for separately in financial statements for tax and accounting purposes.

The tax on the example statement is shown as being 28%, which is the flat tax rate for a company. If your business is not a company then your tax will look different. For example, if you are a sole trader, your tax rate is the same as that for individuals. Refer to the IRD website or ask your accountant for advice. Remember that it is better to overestimate than to underestimate tax requirements to ensure you put enough aside.

Operating profit will be explained later in this topic.

Profits

Gross profit is the difference between revenue and the cost of sales, reflecting the profit generated from core business activities. It indicates the profitability of a business’ core business activities before considering other expenses, providing insight into operational efficiency.

Operating profit, also known as earnings before interest and tax (EBIT), is the profit earned from a company's primary operations after deducting operating expenses but before deducting interest and taxes. It is used to assess a business’ ability to generate profits from its primary operations.

Net profit, also known as net income, is the overall profit earned by a company after deducting all expenses, including cost of sales, operating expenses and other expenses, from total revenue. It represents the ultimate measure of a business’ profitability.

Profit margins

While gross profit, net profit, and operating profit are represented as dollar amounts, profit margins are expressed as percentages.

The dollar amounts allow for direct comparison of profitability across different periods or businesses, while profit margins enable comparison of profitability relative to revenue size. Profit margins provide insight into the profitability of each dollar of revenue generated. Profit margins are often used as KPIs. The formulas below show how to calculate profit margins.

Profit and loss forecasting

Profit and loss forecasting, also known as income statement forecasting, is a financial planning tool used by businesses to predict and estimate their future revenues, expenses, and profitability over a specific period. Profit and loss forecasting is a key part of a business plan, demonstrating the viability and financial sustainability of the business to stakeholders such as investors, lenders, and partners.

The content of profit and loss statements and forecasts have been covered simultaneously in this topic as they have the same key components.

There are plenty of free templates available online, and in different formats, for you to produce your profit and loss forecast. Note that the layout, terminology and level of detail may vary between templates. For example, in the template provided below, the operating expenses have been split into two categories: selling and administrative. Depreciation has been included under selling expenses. As mentioned earlier, how expenses are categorised can vary from one business or template to the next. Decide what makes the most sense for your business and ensure you remain consistent with the approach you have chosen.

An expense listed in the template that you may not have heard of before is bad debts. Bad debts arise when customers fail to pay their outstanding invoices, typically due to bankruptcy, or disputes. Depending on the industry, some businesses may have an expected proportion of bad debts. So some businesses want to assume that a portion of sales will be uncollected.

If you have historical data in your accounting software, you can use this to automatically generate a profit and loss report which can be useful in helping to guide your profit and loss and cash flow forecasts. Your accounting software should provide guides for how to do this and you should easily be able to locate these in the software or online. Guides for two popular accounting software packages are provided below.

Cash flow statement components

When looking at a cash flow statement, there are four key components:

• cash flow from operations
• cash flow from investing
• cash flow from financing activities
• balances.

Cash flow from operations

This component in the cash flow statement:

• Represents the cash generated or used by a company's core business operations, including revenue-generating activities and day-to-day expenses.
• Includes cash receipts from sales of goods or services, interest received, and dividends received from investments.
• Includes cash payments for operating expenses such as salaries, rent, utilities, inventory purchases, and other costs associated with running the business.
• Provides insights into a business’ ability to generate cash from its core business activities, its operational performance and financial health.
• As mentioned in the earlier article regarding financial KPIs, operating cash flow can be used as a KPI.

Cash flow from investing

This component in the cash flow statement:

• Reflects the cash flows related to the buying, selling, or acquiring of long-term assets and investments.
• Includes cash receipts from the sale of property, plant, and equipment, as well as proceeds from the sale of investments such as stocks, bonds, or other securities.
• Includes cash payments for the purchase of property, plant, and equipment, investments in securities, and other capital expenditures necessary for the growth and expansion of the business.
• Cash flow from investing activities provides insights into a business’ investment decisions and long-term growth prospects.

Cash flow from financing activities

This component in the cash flow statement:

• Represents the cash flows related to the financing of the business, including transactions with shareholders and creditors.
• Includes cash receipts from issuing new debt (e.g., loans, bonds) or equity (e.g., issuing new shares), as well as proceeds from borrowing or raising capital through financing activities.
• Includes cash payments for the repayment of debt (e.g., principal payments on loans), dividends paid to shareholders, and repurchases of company shares.
• Provides insights into how a company funds its operations, manages its debt obligations, and returns value to shareholders through dividends or share buybacks.

Balances

Opening and closing balances refer to the amount of cash held by a company at the beginning and end of a specific period, respectively. The net change in cash is calculated by subtracting the opening balance from the closing balance.

The net change in cash reflects how much cash the business has either gained or lost during that time frame. A positive net change in cash indicates that the business has generated more cash than it has spent, resulting in an increase in cash reserves, while a negative net change in cash indicates that the business has spent more cash than it has generated, leading to a decrease in cash reserves.

Cash flow forecasting

Cash flow forecasting is a financial planning tool used by businesses to predict the inflow and outflow of cash over a specific period. Cash flow forecasting is useful to provide to lenders in a business plan because it demonstrates a business's ability to manage its finances effectively. By outlining projected cash inflows and outflows, lenders can assess whether the business will generate sufficient cash to cover its expenses and repay any loans.

Watch

Understanding your cash flow

Watch the following video which provides a recap of cash flow statements and an introduction to cash flow forecasting and how to do this.

Expected Duration: 4:47 minutes

As with the profit and loss forecast there are free cash flow forecast templates available online, and these will also vary from one template to the next. While the template linked below contains a graph, it is not necessary to include one.

We have talked about the four key components of a cash flow statement:

• cash flow from operations
• cash flow from investing
• cash flow from financing activities
• balances.

In a cash flow forecast, the layout is quite different, in fact it is more similar to that of the profit and loss forecast. The focus is also more on the cash flow from operations, than on the cash flow from investing or financing.

Take a look at the cash flow forecast template from ASB. Cash flow from operations is represented in the income, COS, and OPEX sections, while cash flow from investing or financing is summarised under the ‘Other additional cash transactions’ section below/near the bottom.

As mentioned in the video earlier, business.govt.nz provides a cash flow forecaster tool. The tool produces a graph and gives you the option of exporting the data to a spreadsheet. You will then need to edit the spreadsheet as the cash in and cash out sections of the tool only allow you to input figures for one month. As mentioned in the earlier article, cash flow forecasting is something that should be done regularly, you can use the exported spreadsheet as a starting point. It also mentioned including as much detail as possible when it comes to your expenses.

Start-up costs

Cash flow forecasts predict the inflow and outflow of cash over a specific period. Start-up costs represent the expenses incurred when launching your business, including equipment purchases, marketing expenses, lease payments, and initial inventory. Start-up costs usually come under operating expenses in a cash flow forecast.

Start-up costs for small businesses can vary widely depending on the nature of the business, industry, location, and scale of operations.

The article above listed salaries as a start-up cost but this is actually more of an ongoing cost or operating expense. It is worth noting however that there can be initial one-off costs associated with hiring staff, whether they are an employee or another staff type. These costs can include things like recruitment and training. Take a look at the discretionary costs section of the business.govt.nz employee cost calculator mentioned earlier in this topic.

Funding

You may require funding to help cover the initial start-up costs as well as operating expenses until you break-even and start making a profit. Sources of finance options were covered in the previous module.

A cash flow forecast includes the funding you hope to receive and the interest you need to pay. The profit and loss forecast does not include funding source amounts but does include interest on loans under the non-operating expenses.

As a business owner – and your own boss – don’t forget about how you’re going to pay for your living expenses. Perhaps you have another job that can cover this or perhaps you are reliant on paying yourself a salary from your new business venture. If the latter, then this will need to show in your cash flow forecast as owner’s drawings or owner’s salary.

Summary

Financial planning is crucial for businesses as it helps in managing resources effectively and forecasting future financial needs. Producing a profit and loss forecast and a cash flow forecast are two key requirements of a business plan.