Projecting Financial Risk and Reward
Your financial plan shows your readers the current status and future forecasts of the company’s financial performance. As noted in previous chapters, financial projections need not be exhaustive, but they must be addressed. The financial picture you paint here represents your best estimate of the risks involved and the return on investment, usually over a period of three to five years. Even if you have expert advice, crunching the numbers yourself is a worthwhile exercise. The gritty work of building an income statement and balance sheet will help you determine whether you will achieve your financial objectives.
Preparing your financial plan
Below are some key components of the financial plan:
• Capital requirements: How much money do you need to raise? How much do you expect from investors? And how do you intend to use the money? Whether your project is a business expansion or a new venture, be transparent.
• Assumptions: What are your expectations about growth rates in the industry and market? What are your assumptions about the internal components of the business, such as variable and fixed costs, growth rate of sales, cost of capital, and seasonal cash flow fluctuations? Your assumptions are the underpinnings of your financial plan, so they should be backed up with strong evidence and expert opinions. Include a more detailed set of assumptions as an attachment.
• Income statement: Also known as your pro forma profit and loss statement, this document details your forecasts for your business for the coming three to five years. Here use numbers from your sales forecast, expense projections, and cash flow statement. Revenue, minus cost of goods sold, is your gross margin. TechEx’s gross margin, for instance, is the money the company earns from subscriptions, less the cost of the fitfast monitors and the underlying technology. Revenue, less expenses, interest, and taxes, is net profit (also known as the “bottom line”). In TechEx’s case, net profit is the money it earns minus the cost of the fitfast monitors and other technology, the salaries it pays to the management team, nutritionists, trainers, and others, taxes it owes, and the cost of the print and web ad campaigns.
• Balance sheet: This is an expression of the business’s assets, equities, and liabilities at a specific point in time, and is generally prepared by your accountants.
• Cash flow statement: This shows the times of peak need and peak availability of money and indicates whether your company is successfully turning its profits into cash. If your new business is a start-up venture, pay close attention to cash flow in your financial plan. Although most people think of profits first, cash flow can be more important for a start-up. The cash flow statement shows in broad categories how a company acquired and spent its cash during a given period of time. Expenditures appear on the statement as negative figures, and sources of income appear as positive figures. The bottom line in each category is simply the net total of incoming and outgoing cash flow, and it can be either positive or negative. The broad categories are, generally, operating activities (cash generated by or used for ordinary business operations), investing activities (outgoing cash spent on capital equipment and other investments and incoming cash from the sale of such investments), and financing activities (outgoing cash used to reduce debt, buy back stock, or pay dividends and incoming cash from loans or from stock sales). The cash flow statement shows the relationship between net profit (from the income statement) and the actual change in cash that appears in the company’s bank accounts. Many business planning software programs contain these formulas to help you make your projections.
Anticipating readers’ concerns
Your financial plan provides a more complete picture of your proposal’s future. As you craft this part of the business plan, consider your readers’ perspectives. The investment committee member, for instance, will want to know whether your venture can achieve the company’s hurdle rate (the minimum rate of return expected of all projects). On the other hand, the venture capitalist (or even a smart family member) considering buying into your venture will want to know what kind of return on investment she will achieve. The bank or lender will want to know about the company’s borrowing capacity and its ability to repay its debt when deciding whether to approve a loan.
Let’s look at some of the other sections that typically comprise the financial plan.
Breakeven analysis
As noted earlier, the breakeven point is the pivotal moment when the business begins to be profitable. At what point do you expect the business to make money? Will it take six months or two years? The breakeven point for sales is calculated as follows:
Fixed costs are those expenditures that don’t change as sales go up or down (for example, rent), and variable costs change in proportion to sales (for example, raw materials such as plastic or chemicals). Often, this calculation is included in the attachments to your business plan.
Assessing risk and reward
A risk/return graph can quickly show your readers the likelihood of failure, of achieving the predicted levels of return, and of phenomenal success (see figure 1). After all, measuring hypothetical investment returns without also measuring the amount of risk required to produce those returns is pointless.
The most likely outcome is indicated by the area under the bell curve, ranging from an acceptable (perhaps) return of 15% to the most likely return of 30% and a possible 45% rate of return. Depending on the fundamental riskiness of the venture, the investor will require different rates of return to balance the possibility of loss.
FIGURE 1
Risk/return graph
Source: Harvard ManageMentor® on Business Plan Development, adapted with permission.
Anticipating financial returns
Investors also want to know the expected financial returns—typically either the return on investment (ROI) or the internal rate of return (IRR). For an internal project, the financial return should exceed the company’s hurdle rate. For a risky start-up business, investors generally require a higher return to compensate for the higher level of risk of loss. To calculate the ROI, divide net operating income by total investments.
Net operating income/total investments = ROI
For example:
$45,000/$300,000 = 0.15 or 15% ROI
The higher the ROI, the more efficient the company is in using its capital to produce a profit.
Perhaps the simplest way to calculate IRR is to build a spreadsheet. That way, you can enter your own values and make adjustments as you go. For instance, to calculate an IRR of 50%—the return an investor might expect for a risky investment—use the following formula:
FV = investment × (1 + 0.5)n
(where FV is future value, investment is the dollar amount of the investment, and n is the number of years to receive the return).
Exit strategy
Your business plan should offer a candid proposal for the end of the process, according to William Sahlman. How will the investor ultimately get money out of the business, assuming that it is successful, even if only marginally so? Investors typically like to see companies that work hard to maintain and even increase a broad variety of exit options along the way. Your exit plan, for instance, may include taking your company public, merging your business with another one, or putting your company up for sale.
SAMPLE EXCERPT OF A FINANCIAL PLAN
Capital requirements
TechEx seeks to raise $250,000. According to current projections, the company believes this sum, together with $84,000 the company raised in its initial friends and family round of financing, will be sufficient to achieve its business plan. If the company is indeed able to raise this amount of money, the company will be able to fund all operations, marketing, and product development costs internally after the first six months of operation.
The company intends to use the $334,000 during the first six months of operation, as shown below:
• $100,000 for marketing
• $100,000 for system development and technology programming
• $60,000 for advances for contracts with dieticians, behavior coaches, and trainers
• $45,000 for working capital to fund future product development and promotion
• $29,000 for product design and creation (for the fitfast wearable monitor)
Summary financial projections
The financial plan portrays a projection of first-year sales of $11.74 million, gross margins in excess of 60%, and net margins of approximately 42% before tax. The company expects to be profitable after the first six months of operation and remain profitable thereafter. Other expenses are budgeted as a percentage of revenues according to similar industry ratios. Given these projected numbers, TechEx anticipates being profitable and cash flow positive within six months of launch. The results of the financial forecast are summarized:
Assumptions
The financial projections are based on current industry estimates of diet and weight loss customers, primary and secondary market research data, and estimates of the TechEx’s market penetration and sales growth. More detailed information on the assumptions can be found in the statements prepared for years 2015 through 2019, which incorporate projected income statements, balance sheets, and cash flows. Revenues include those resulting from registration of new accounts and sales of additional services. Marketing and sales expenses include costs associated with advertising, PR, and promotions. The company will not carry any inventory and will operate with minimal overhead. No salary will be drawn by the management team in the first year.