Chapter 10 Financial Projections

Introduction

The final section of a business plan presents a firm’s pro forma (or projected) financial projections. Having completed the previous sections of the plan, it’s easy to see why the financial projections come last. They take the plans you’ve developed and express them in financial terms. As a result, you’ll find yourself referring to earlier sections in your business plan frequently while you prepare your financial projections. For example, you prepared your sales forecasts in  Chapter 6 , a marketing budget in  Chapter 7 , and a schedule of the salaries of your initial management team in  Chapter 8 . These numbers, along with others, flow directly to the financial projections you develop in this chapter.

There are three things to be particularly mindful of as you approach this chapter. First, although you may be very passionate about a particular business idea, like starting a fitness center for people 50 years old and older, the people who read your plan will be primarily interested in your business’s potential financial results. Investors are normally interested in the size of the returns and how quickly a company can grow, whereas bankers are more interested in the predictability and stability of a company’s financial results and how it will minimize risk. As a result, it’s important to provide these folks the financial information they need to make their judgments. If your plan is beautifully written, but the financial section is lacking, investors and bankers simply won’t have the information they need to offer you financing or funding.

The second thing to be mindful of as you approach this chapter is that your financial statements show whether your business can get up and running successfully. There are many businesses that once started represent viable ongoing businesses. The trick is to get them started. Unless your business is cash flow positive from the beginning, which is rare, there will be a period of time when you’ll lose money while you’re ramping up the business. For example, as you’ll see later in the chapter, Prime Adult Fitness’s financial projections look very promising for 2015 and beyond. But its startup year, 2014, is projected to be challenging. Its 2014 income statement projects a $94,570 loss, and its 2014 cash flow statement shows that the company will need to rely on a prearranged line of credit from a bank to avoid running seriously low on cash. The main reason that Prime Adult Fitness’s first year will be so tough is that it will open its doors on January 1, 2014, with a fully equipped building and staff (and all the related expenses), but only a handful of members. It will take the entire year for the company to reach its goal of 2,100 membership units. In the meantime, all of its fixed expenses (and most of its variable expenses) march on. In 2015 and beyond, its cash flow improves dramatically because its membership goals are projected to be met. The challenge for Prime Adult Fitness will be to survive 2014 (the year it is building its membership) to get to 2015 and beyond.

Most startups are similar to Prime Adult Fitness—there will be a startup period during which they lose money until they are fully up to speed and reach profitability. A firm’s pro forma financial statements, in particular its initial balance sheets and cash flows, show how this period will unfold. Discerning readers will be looking for this information. Very few, if any, investors or bankers will finance a firm that doesn’t demonstrate that it has thought through this critical issue. If the statements are missing, or if they are done poorly or incorrectly, the entire plan will be compromised.

The third thing to be mindful of as you approach this chapter is that most students and entrepreneurs are not familiar with how to complete pro forma financial projections. If you fall into this category (as most people do), don’t wing it. Get help. The financial statements are too important to not be completed carefully and accurately. A good source for one-on-one help is SCORE ( http://www.score.org ), an organization of retired businesspeople who will normally provide assistance for free. Small business development centers frequently hold classes and workshops on how to complete financial statements. Approaching an accounting professor in your own college or university to ask for assistance may be another viable option.

This chapter consists of six parts that cover the information normally included in the financial section of a business plan: sources and uses of funds statement, assumptions sheet, income statements, balance sheets, cash flows, and ratio analysis.

Now let’s look at the first section in this chapter, the sources and uses of funds statement. The Prime Adult Fitness sources and uses of funds statement is shown in  Figure 10-1 .

Sources of Funds
Source	Amount
Management Team Investment	$ 325,000
Angel Investor—Timothy Kemp	$ 175,000
Grant from Healthy After 50	$ 60,000
Line of Credit with Oviedo Security Bank
($100,000 LOC; $50,000 to be disbursed when business opens)	$ 50,000
Total Funds Committed	$ 610,000
Total Funds Required	$ 1,125,000
Total Funds Needed from an Equity Investor	$ 515,000
Uses of Funds
Cost	Item
Retrofit Building (including architect)	$ 750,000
Exercise Equipment—Purchase Outright	$ 50,000
Office and Computer Equipment	$ 60,000
Furniture	$ 30,000
Sales and Marketing	$ 40,000
Attorney Fees	$ 10,000
Initial Inventory	$ 20,000
Other	$ 15,000
Cash (working capital and reserve to cover 2014 losses)	$ 150,000
Total Required Funds	$ 1,125,000

*Approximately $25,000 in additional startup costs have been bootstrapped by founders.

Figure 10-1 Source and Use of Funds Statement (Prime Adult Fitness Business Plan)

Source and Use of Funds Statement

The source and use of funds statement is a document that lays out specifically how much money a firm needs (if the intention of the business plan is to raise money), where the money will come from, and what the money will be used for. Normally, a portion of the startup funds is provided by the founders or the initial management team; a portion is contributed by an early investor, such as an angel investor, a friend, or a family member of one of the founders; and the remainder is what’s still needed. The level of detail, regarding both sources and uses of funds, shown in the Prime Adult Fitness sources and uses of funds statement in  Figure 10-1  is appropriate for most new ventures. The items from the sources and uses of funds statement normally become the initial assets and liabilities of the firm. As explained later in this chapter, only certain items qualify to be reflected on a firm’s balance sheet. Still, the sources and uses of funds statement is an important starting point in preparing the initial balance sheet for the firm.

If any of the funds you will be receiving come from an unusual source, you should substantiate the source of funding. For example, one of Prime Adult Fitness’s sources of funds, as shown in  Figure 10-1 , is a grant from a nonprofit agency called Healthy After 50. This organization believes in Prime Adult Fitness’s overall mission and has committed $60,000 to help the company get started. Placing a letter from the director or president of Healthy After 50 in the appendix to the business plan to verify that the grant is forthcoming would be appropriate.

The next section of this portion of the business plan presents the assumptions sheet. This section of the Prime Adult Fitness business plan is shown in  Figure 10-2 .

The financial statements depend on important assumptions. The key underlying assumptions are as follows:

General (Assumptions)

1. Interest in fitness and exercise will remain strong.

Sources: Mintel, IBISWorld, International Health, Racquet & Sportsclub Association

2. We assume access to equity capital in the amount of $515,000, consistent with the sources and uses of funds statement in this business plan.

Financial Statements (Assumptions)

Income Statements

1. Sales forecasts are based on the analysis presented in the “market analysis” section of this business plan. Sales are projected to increase 6 percent per year.

2. We assume that our receivables, which will primarily consist of overdue monthly membership fees, will take 30 days (on average) to collect.

3. Officer’s compensation based on “Ownership and Compensation” table shown in the “management team” section of this business plan.

4. COGS for each month includes direct labor costs associated with delivering fitness classes and maintaining fitness machines.

5. Employees’ benefits figured at 17.5 percent of salary.

Source: Percentage obtained from Katherine Chen, CPA

6. Marketing expenses based on annual marketing budget in “marketing plan” section of this business plan.

Balance Sheets

1. Accumulation of accounts receivable is consistent with industry norms.

2. The retrofitting of the building and the leasing of fitness equipment are “off the balance sheet” transactions consistent with normal accounting practices.

Figure 10-2 Assumptions Sheet (Prime Adult Fitness Business Plan)

Assumptions Sheet

An assumptions sheet is an explanation of the most critical assumptions that your financial statements are based on. Some assumptions will be based on general information, and no specific sources will be cited to substantiate the assumption. For example, if you believe that the U.S. economy will remain strong, and that’s an underlying assumption driving your sales projections, then you should state that assumption. In this instance, you wouldn’t cite a specific source—you’re reflecting a consensus view. (It’s then up to your reader to agree or disagree.) Other assumptions will be based on very specific information, and you should cite the source for your assumption. For example, on its pro forma income statements, Prime Adult Fitness computes employee benefits at 17.5 percent of salary. Primed Adult Fitness obtained that percentage from Katherine Chen, the certified public accountant (CPA) it is working with (and is identified in  Chapter 8 ). Ms. Chen works with businesses that draw from the same labor pool that Prime Adult Fitness will draw from.

In many instances, the assumption sheet references earlier portions of the business plan. For example, Prime Adult Fitness computed its sales projections in the market analysis section of the plan, where a full explanation of where the numbers came from was provided. The explanation doesn’t need to be repeated here. Although the assumption sheet is only meant to comment on the most critical numbers used to prepare the financial statements, it’s impossible to overemphasize the importance of conveying to your reader that your statements are built on good data. The online resources shown in  Appendix 2.2  at the end of  Chapter 2  provide an excellent starting point to look for industry norms and other data. There are two reference books that are also helpful in computing financial statements: Dun & Bradstreet Industry Norms and Key Business Ratios  1  and the Almanac of Business and Industrial Financial Ratios. 2  Both of these books are usually available in the reference section of a university or major city library. The Almanac of Business and Industrial Financial Ratios, for example, reports the average operating costs (for line items such as cost of operations and employee benefits) as a percent of net sales for many lines of business at different sales levels.

In many instances, simple gumshoe labor and inquisitiveness is all that’s needed to obtain and report an important financial number. For example, if your business will be occupying a building, a simple call to the electric company or a rental company that manages buildings may be all that’s needed to get a good handle on anticipated utility costs. It’s fully appropriate to cite these types of sources, as long as you’re convinced that they’re credible, in the assumptions sheet.

Pro forma Financial Statements

The pro forma (or projected) financial statements are the heart of the financial section of a business plan. Although at first glance preparing financial statements appears to be a tedious exercise, it’s a fairly straightforward process if the preceding sections of your business plan are thorough. If your plan has been built in the manner described in this book , most of the hard work, such as projecting sales and creating a marketing budget, has already been done. The financial statements also represent the culmination or finale of the entire plan. As a result, it’s interesting to see how they turn out.

A firm’s pro forma financial statements are similar to the historical statements an established firm would normally prepare, except they look forward rather than track the past. Pro forma financial statements include the income statement, balance sheet, and cash flow statement. The statements are usually prepared in this order because information flows logically from one to the next. Most experts recommend three to five years of statements, with the first two years for the income statement and the cash flow statement completed on a monthly basis. If the company you’re writing your plan for already exists, you should also include three years of historic financial statements.

The first statements that are normally prepared are the pro forma income statements. The Prime Adult Fitness pro forma income statements for 2014, 2015, 2016, and 2017 are shown in  Figure 10-3 .

Pro Forma Income Statement

The pro forma income statement reflects the projected results of the operations for a firm for a given period of time. It records all the projected sales and expenses for the given period and shows whether the firms will be making a profit or experiencing a loss (which is why the income statement is often referred to as the “profit and loss” statement). Income statements are typically prepared on a monthly, quarterly, or annual basis. For a startup, it’s important to complete the statements on a monthly basis, at least for the first two years. Most pro forma income statements are prepared in a multiyear format, making it easy to spot trends.

The pro forma income statements for Prime Adult Fitness are shown in  Figure 10-3 . The value of the multiyear format is clear. After a loss in 2014 (its startup year), the company is projected to experience healthy increases in sales and net income for 2015, 2016, and 2017. An income statement also exposes a company’s risks. For example, even though Prime Adult Fitness shows a $317,740 net income in 2015, a 15 percent drop in projected sales would turn the $317,740 gain into a $44,736 loss. This scenario illustrates in part why projecting sales as accurately as possible is such a critical issue.

The three numbers that receive the most attention when evaluating an income statement are the following:

· Net sales. Net sales consist of total sales minus allowances for returned goods and discounts.

· Cost of goods sold (COGS). COGS includes all the direct costs associated with producing or delivering a product or service, including the material costs and direct labor. For Prime Adult Fitness, this includes the direct labor needed to teach the center’s classes, run its programs, and maintain the fitness equipment, as well as the materials disbursed to members in classes.

· Operating expenses. Operating expenses include marketing, utilities, and administrative costs not directly related to producing a product or service.

 

 

 

Figure 10-3 Pro Forma Income Statements 2014, 2015, 2016, 2017 (Prime Adult Fitness Business Plan)

In regard to increases in net sales from one year to the next in the pro forma statements, these numbers are normally determined in the “market analysis” portion of a firm’s business plan and are simply transferred to the pro forma statements. There are two ways to handle year-to-year increases in projected expenses. Some increase in expenses will be known. For example, in 2016, Prime Adult Fitness projects adding a senior vice president of strategic planning to its management team. The salary range for this position is known, so a direct number can be added to the category “officers’ compensation,” and appropriate adjustments can be made to payroll taxes and employee benefits to reflect the change. For general expense items, many firms use the constant ratio method of forecasting—which increases expense items at the same rate as sales. Prime Adult Fitness used this method in preparing the expenses portion of its pro forma income statements.

One ratio of particular importance in evaluating a firm’s pro forma income statements is a firm’s projected profit margins, or return on sales (ROS). This number is computed by dividing net income by net sales. Beyond 2014, its startup year, Prime Adult Fitness’s ROS is projected to be 13.1 percent, 10.5 percent, and 11.3 percent for the years 2015, 2016, and 2017, respectively. These are healthy numbers. IBISWorld reported in the “industry analysis” section of this business plan that the average ROS for a sample of 196 fitness centers was 9 percent. Prime Adult Fitness’s higher percentages likely reflect the greater scale of its operations than many of the fitness centers in the survey. Any time an apparent discrepancy appears in financial ratios, you should be prepared to explain the discrepancy at a minute’s notice. For example, Prime Adult Fitness’s projected drop from a 13.1 percent ROS in 2015 to a 10.5 percent ROS in 2016 may require an explanation in an investor presentation. The projected drop is due to the company’s plans to add a VP of strategic planning position to its top management team in January 2015, as mentioned previously, at a cost of $70,000 a year plus benefits. The salary and benefits are reflected as a 70,000+ increase in expenses, without a corresponding increase in sales. This is what’s causing the drop in 2015 ROS.

Pro forma income statements are useful in envisioning a firm’s overall earnings potential and prospective changes from year to year. They don’t, however, provide an indication of a firm’s cash position. A firm can show excellent sales numbers, but if the sales accumulate as accounts receivable (or are used to build inventory), a firm can run out of cash despite glowing income statements. As a result, enthusiasm for impressive sales and net income figures on pro forma income statements are usually tempered. The sales still have to be realized and the money has to be collected for the results to be meaningful.

Still, Prime Adult Fitness’s growth in net sales and net income during the period projected demonstrates the upside potential of the opportunity. If everything goes right, and the company launches as planned, the numbers appear to be realistic and feasible. The key phrase, however, is that everything must go as planned. Ultimately, your reader must have confidence that you and your team have the ability to execute the opportunity.

The second set of pro forma financial statements that are normally prepared are the pro forma balance sheets. Prime Adult Fitness’s pro balances sheets for 2014, 2015, 2016, and 2017 are shown in  Figure 10-4 .

 

Figure 10-4 Pro Forma Balance Sheets 2014, 2015, 2016, 2017 (Prime Adult Fitness Business Plan)

Pro Forma Balance Sheet

Unlike the pro forma income statement, which covers a specific period of time, a pro forma balance sheet is a projection of a firm’s assets, liabilities, and owner’s equity at a specific point in time. The top of a balance sheet (or the left-hand side, depending on how it is displayed) shows a firm’s assets, whereas the bottom (or right-hand side) shows its liabilities and owner’s equity. The assets are listed in order of their “liquidity,” or the length of time it takes to convert them to cash. The liabilities are listed in the order in which they must be paid. A balance sheet must always “balance,” meaning a firm’s assets must always equal its liabilities plus owner’s equity.

Most startups create a projected opening, or base, balance sheet that shows what the business will look like at a beginning point in time. The Prime Adult Fitness base balance sheet is January 1, 2014, which coincides with the start date for its pro forma income statements and cash flows. The major categories of assets listed on a pro forma balance sheet are the following:

· Current assets. Current assets include cash plus items that are readily convertible to cash. It also includes items such as accounts receivable and inventory.

· Fixed assets. Fixed assets are assets used over a longer time frame, such as real estate, buildings, equipment, and furniture.

The major categories of liabilities listed on a balance sheet are the following:

· Current liabilities. Current liabilities include obligations that are payable within a year, including accounts payable, accrued expenses, and the current portion of long-term debt.

· Long-term liabilities. Long-term liabilities include notes or loans that are repayable beyond one year, including liabilities associated with purchasing real estate, buildings, and equipment.

· Owners’ equity: Owners’ equity is the equity invested in the business by its owners plus the accumulated earnings reported by the business after paying dividends.

Balance sheets, regardless of whether they are actual or projected, are somewhat deceiving. Firms spend money on many things that never show up on their balance sheets. For example, many operating leases, like Prime Adult Fitness’s lease of fitness equipment, are “off balance sheet” transactions. Similarly, intellectual property, such as patents, trademarks, and copyrights, receive value on the balance sheet in some cases, and in other cases, they don’t. In addition, intangible assets, such as the amount of training a firm has provided to its employees or the value of its brand, are not recognized on its balance sheet. Real estate is valued on a balance sheet at its cost rather than fair market value. Although this stipulation doesn’t normally affect pro forma balance sheets, it’s another facet of balance sheets that needs to be understood. A firm could buy a piece of land for $250,000 and watch its value increase to $1 million over time but would still value the land at $250,000 on its balance sheet.

As a result of these issues, it’s important to understand what a set of pro forma balance sheets potentially accomplish. When evaluating a pro forma balance sheet, the two primary questions are whether a firm will have sufficient short-term assets to cover its short-term debts and whether it is financially sound overall. Two calculations provide the answer to the first question. At the end of 2014, Prime Adult Fitness’s projected working capital, defined as its current assets minus its current liabilities, is projected to be $53,430. This number represents the amount of liquid assets the firm has available. Its projected current ratio, which equals its projected current assets divided by its projected current liabilities, is 1.28, meaning that it is projecting that it will have $1.28 in current assets for every $1.00 in current debt. This is a tight number and may cause you to pause and wonder if the company will have sufficient current assets to meet its current liabilities. The numbers are stronger in future years, as the company’s projected earnings help it build cash reserves. Prime Adult Fitness’s current ratio is projected to be 3.42, 4.08, and 5.0 at the end of 2015, 2016, and 2017, respectively. This is a healthy trend.

The second question, will a firm be financially sound overall, is assessed by computing a firm’s overall debt ratio. A company’s debt ratio is computed by dividing its total debt by its total assets. Prime Adult Fitness is projecting a debt to asset ratio of 50.50 percent at the end of 2014, which is high. Similar to its current ratio, its debt to asset ratio improves over time as its projected earnings build cash and improve its overall financial situation. Its projected debt to asset ratio is 23.30 percent, 16.45 percent, and 14.81 percent for 2015, 2016, and 2017, respectively. This is obviously a healthy trend. Again, although these numbers are impressive, they hinge on Prime Adult Fitness’s management team’s ability to execute all phases of its business plan.

The numbers across all of a firm’s pro forma financial statements are consistent with one another. Note that the profit of $317,740 Prime Adult Fitness reports on its pro forma 2016 income statement shows up as the difference between its 2016 and 2015 pro forma balance sheets.

The final set of pro forma financial statements that are prepared are the projected cash flows. These statements must be prepared last because they rely on data from their corresponding pro forma income statements and balance sheets to be completed. Prime Adult Fitness’s pro forma cash flow statements for 2014, 2015, 2016, and 2017 are shown in  Figure 10-5 .

Pro Forma Cash Flow

Many of the readers of your business plan will consider your pro forma cash flows to be the most valuable of your financial statements for the reasons mentioned earlier in the chapter. The cash flow statements provide an indication of whether a firm will be able to maintain a sufficient cash balance to get up and running successfully. This issue is critical enough that you should prepare your cash flow on a monthly basis, at least for the first two years of your firm’s existence.

Interpreting and analyzing pro forma cash flow statements takes practice. The entries are intuitively obvious but still cause you to pause and think because there are a lot of unusual additions and subtractions involved. The basic idea behind a cash flow statement is to start with a beginning balance, like the amount of cash you have on hand at the beginning of a month; add your projected monthly income (or loss); and then list all the other transactions that either add or subtract from your cash. To capture items in an organized manner, the cash flow statement is divided into three activities: operating activities, investing activities, and finance activities.

· Operating activities. Operating activities include net income (or loss), depreciation, and changes in current assets and current liabilities other than cash.

· Investing activities. Investing activities include the purchase, sales, or investment in fixed assets, such as real estate, equipment, and buildings.

· Financing activities. Financing activities include cash raised during the period by borrowing money, making payments on loans, or paying dividends.

 

 

 

 

 

 

Figure 10-5 Pro Forma Cash Flow Statements 2014, 2015, 2016, 2017 (Prime Adult Fitness Business Plan)

The best way to visualize how a cash flow works is to spend some time looking at the Prime Adult Fitness pro forma cash flow statements, shown in  Figure 10-5 . On the statements, the uses of cash are recorded as negative figures (which are shown by placing them in parentheses), and the sources of cash are recorded as positive figures. In regard to operating activities, an item like depreciation is shown as a positive figure because it was deducted from net income on the income statement but was not a cash expenditure. Similarly, an increase in accounts receivable is shown as a negative item because it was added to your net income but wasn’t collected as cash. The treatment of investing and financing activities is more straightforward. If you buy a piece of equipment, that subtracts from your cash. If you take out a loan, that adds to your cash. If you make a principal payment on a loan, that subtracts from your cash, and so forth. The closest attention is typically paid to operating activities because it shows how changes in a company’s accounts receivable, accounts payable, and inventory levels affect the cash it has available to maintain routine activities.

As stated earlier in the chapter, Prime Adult Fitness’s pro forma cash flow shows that it will run low on cash midway during its first year of existence. Anticipating this challenge, the founders arranged for a line of credit from a bank, which the company will use to shore up its cash position during this period. If the founders hadn’t completed pro forma financial statements and realized that they will run low on cash in May of 2014, they could have found themselves in a very tight cash position. The time to arrange a line of credit isn’t when you’re running out of cash. Instead, their 2014 pro forma cash flow alerted them to this challenge, which they prepared for by arranging the line of credit.

In summary, it’s extremely important that all of a firm’s pro forma financial statement be prepared as accurately and realistically as possible. If your business plan does capture the attention of an investor or banker, your financial statements will be gone over very carefully, as part of the “due diligence” process. Incorrect entries, math errors, exaggerated items, and estimates that are simply off the mark (i.e., the average price to rent warehouse space in your community is $12.00 per square foot, and you’re projecting you can rent it for $4.00 per square foot) will be picked up and may compromise your ability to get funding or financing if they are serious enough. Conversely, sharp financials that realistically translate a firm’s plans into numbers and are error free can make a very positive impression.

Finally, like the business plan itself, going through the process of preparing your pro forma financial projections may be as valuable as the projections themselves. The numbers will invariably change, but the lessons you’re bound to learn through preparing the statements are invaluable. Sometimes, entrepreneurs discount the value of financial analysis, thinking that the numbers are just a guess so they’re really not important. Still, demonstrating the ability to prepare financial statements and think through the issues behind them is vital. This point is illustrated through a vignette reported by Rich and Gumpert in their book Business Plans That Work. The vignette portrays the reaction an investor had when an entrepreneur claimed that financial projections aren’t really that important:

One entrepreneur who was undergoing some intense questioning by panelists about his company’s projections finally said, in exasperation, “I really don’t take our projections or any projections more than a year out all that seriously. After all, I don’t really know how much business is reasonable to expect three, four, and five years into the future.” A panelist’s response was swift and certain. “We know you can’t say for sure what’s going to happen,” the panelist observed. “But you must go through the thought process. You must consider best-case and worst-case scenarios. You must demonstrate that you can quantify the marketing, production, and other research and testing you’ve done. We may not agree with your projections, but we want to see that you’ve thought about where your company might be in five years and quantified your thinking.” 3

Business Plan Insight Break-Even Analysis: A Simple Yet Very Valuable Calculation

Break-even analysis is a calculation that allows a firm to determine the volume of business it must do to “break even” in terms of profit and loss. It’s a form of analysis that’s often used by startups and by existing firms to discern whether adding a new product to their existing product line makes sense. Technically, the break-even point for a new company or a new product is where the total revenue received equals the total costs associated with the company or product.

The best way to show how a break-even analysis works is to provide an illustration. Say you’re interested in opening a smoothie restaurant. You could use a break-even analysis to determine whether opening the restaurant is feasible. The formula for break-even analysis is as follows:

Total fixed costs/( price – average variable costs )Total fixed costs/( price – average variable costs )

As a result, if the total fixed costs associated with opening the restaurant is $85,000, the average prices of the smoothies you’ll sell is $4.50, and the variable cost for each smoothie is $2.10, then the break point for your restaurant is as follows:

$85,000 (total fixed costs)/($4.50–$2.10) or $2.40=35,417 units$85,000 (total fixed costs)/($4.50–$2.10) or $2.40=35,417 units

This number means that you’ll have to sell 35,417 “units” or smoothie drinks per year to break even. That number breaks down to 98.5 smoothies per day, on average, based on a 360-day year. To determine whether opening the restaurant is feasible and makes good financial sense, that number should be compared to the sales that similar smoothie restaurants experience.

Break-even analysis is also useful in helping entrepreneurs determine whether different business strategies make sense. Assume you’re considering moving to a location with more foot traffic to boost your sales. Your rent will be higher, and your total fixed costs will jump from $85,000 per year to $112,000. If your prices and variable costs remain the same, the move will increase your break-even point to the following:

$112,000 (total fixed costs)/($4.50–$2.10) or $2.40=46,666 units.$112,000 (total fixed costs)/($4.50–$2.10) or $2.40=46,666 units.

On a daily basis, the move will increase your break-even point from 98.5 smoothies a day to 130. You’ll have to then decide whether moving to the new location will provide you with sufficient increased sales to justify the move.

Another financial instrument that is often used but was not computed for Prime Adult Fitness is the break-even analysis. An explanation of the break-even analysis and how it’s used is provided in the Business Plan Insight box.

The next section of this chapter focuses on ratio analysis, which is a standard technique for analyzing pro forma financial statements. This portion of the Prime Adult Fitness business plan is shown in  Figure 10-6 .

 

Figure 10-6 Ratio Analysis (Prime Adult Fitness Business Plan)

Ratio Analysis

The most practical way to interpret or make sense of a firm’s historical or pro forma financial statements is through ratio analysis.

In general, ratios are computed by taking numbers out of financial statements and forming ratios with them. Each ratio has a particular meaning in regard to the potential of a business. Your readers will instantly recognize the general picture that a particular ratio conveys. For example, as mentioned earlier in the chapter, Prime Adult Fitness’s current ratio is projected to be 1.28 at the end of 2014. That ratio will alert a discerning reader to pay attention to whether the firm has a backup plan (such as a prearranged line of credit) to use if its cash position deteriorates further. It will also alert the reader to look forward to see if the projected cash position improves over time. Another valuable use of ratios is to compare a firm’s ratios to industry norms. If a firm’s ratios, such as projected return on assets (ROA) and ROS, are consistently better than industry norms, that’s probably an indication that the firm’s financial projections are too optimistic.

The three most common categories of financial ratios are profitability ratios, liquidity ratios, and overall financial stability ratios. Profitability ratios compare the amount of income earned against the resources used to generate it. Liquidity ratios measure the relationship between a company’s short-term assets and its short-term liabilities. Overall financial stability ratios measure the overall financial stability of a firm.

The Prime Adult Fitness projected financial ratios are shown in  Figure 10-6 . The ROA ratios are high, reflecting in part the company’s ability to generate high income in a facility it is leasing. Thus, the value of the facility doesn’t show up on the firm’s projected balance sheet. If Prime Adult Fitness was purchasing the building it will occupy for $5 million, its ROA in 2015 would be 7 percent.

Chapter Summary

1. The final section of a business plan presents a firm’s pro forma financial projections. Having completed the previous sections of the plan, it’s easy to see why the financial projections come last. They take the plans you’ve developed and express them in financial terms.

2. The source and use of funds statement is a document that lays out specifically how much money a firm needs (if the intention of the business plan is to raise money) and what the money will be used for.

3. An assumptions sheet is an explanation of the most critical assumptions that your financial statements are based on.

4. The pro forma income statement reflects the projected results of the operations for a firm for a given period of time. It records all the projected sales and expenses for the given period and shows whether the firms will be making a profit or experiencing a loss.

5. Pro forma income statements are useful in envisioning a firm’s overall earnings potential and prospective changes from year to year. They don’t, however, provide an indication of a firm’s cash position.

6. Unlike the pro forma income statement, which covers a specific period of time, a pro forma balance sheet is a projection of a firm’s assets, liabilities, and owner’s equity at a specific point in time.

7. Many of the readers of your business plan will consider your pro forma cash flows to be the most valuable of your financial statements. The statements provide an indication of whether a firm will be able to maintain a sufficient cash balance to get up and running successfully.

8. To capture items in an organized manner, the cash flow statement is divided into three activities: operating activities, investing activities, and finance activities.

9. The most practical way to interpret or make sense of a firm’s historical or pro forma financial statements is through ratio analysis.

In general, ratios are computed by taking numbers out of financial statements and forming ratios with them. Each ratio has a particular meaning in regard to the potential of a business.

Review Questions

1. Why is the financial plan typically one of the last chapters in a business plan?

2. What is the purpose of a sources and uses of funds statement?

3. What is the purpose of an assumptions sheet?

4. Briefly describe the three pro forma financial statements that should be included in a business plan.

5. How is it possible for a firm to show a sizable net income on its income statements and still be running out of cash?

6. Describe the term “cost of goods sold (COGS).”

7. Why would a current ratio of 1.1 raise concerns?

8. Describe why many people feel that the cash flow statement is the most valuable statement of the three financial statements normally included in a business plan.

9. Describe the purpose of ratio analysis.

10. Briefly describe at least one profitability ratio, one liquidity ratio, and one overall financial stability ratio.

Application Questions

1. Suppose a friend of yours showed you the pro forma income statements for his startup and exclaimed excitedly that during its first three years of operation, his firm will make a net income of $150,000 per year, which is just the amount of money, $450,000, that the firm will need to pay off a three-year loan. Explain to your friend why he might not actually have $450,000 in cash, even though his pro forma income statements say that he will earn that amount of money.

2. Suppose a colleague of yours is gearing up to write a business plan for a business she plans to start. She told you she plans to prepare the financial statements first, to get that job out of the way before she tackles the rest of the plan. Explain to your colleague the flaw in her approach.

3. An acquaintance of yours is looking to invest in a local restaurant. He has narrowed the possibilities to three restaurants. He has requested and received both historical and pro forma income statements, balance sheets, and statements of cash flow from each of the restaurants. He’s turned to you for advice in terms of how to use the financial statements to assist him in his investment decision. Provide your acquaintance advice on a systematic approach for using the financial statements to aid in his decision.

4. You have been invited to speak at a small business growth conference. The title of the speech that you’ve been asked to deliver is “Be Careful What You Wish For: How Growing Too Fast Can Financially Overwhelm A Company.” Write a summary of the points that you’ll make in the speech.

5. Imagine that you are an investor and that you’re leafing through the business plan of a startup that has attracted your interest. You’ve reached the financial projections section of the plan, glance at your watch, and realize you only have five minutes to make an assessment. List the items you would look at and the order in which you would look at them. Justify why each of these items would be a priority in the five minutes you have available.

Endnotes

1. Dun & Bradstreet, Industry Norms & Key Business Ratios: Statistics on Over 800 Lines of Business, Desk Top Edition (New York: Dunn & Bradstreet, 2003).

2. L. Troy, Almanac of Business and Industrial Financial Ratios (New York: CCH, Inc., 2007).

3. S. Rich and D. Gumpert, Business Plans That Work (New York: Harper & Row, 1985).