Toolkit on how to Start and Improve your Business

Business Implementation

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Sales and Marketing  I  Production  I  Organisation and Management

4. Instruction to Financial Plan
 

4.1   What is the total Capital Requirement?
Total capital requirement, also known as total project costs or total investment requirement is composed of three items: fixed assets, pre-operating expenses and working capital.

Fixed assets is the sum total of all costs of land and improvements, building, machinery, furniture and fixtures, vehicles, etc. (step 2.2)

Pre-operating expenses are those necessary expenses that are incurred before the business starts operating. These include registration fees and licenses, training costs, costs of preparing the business plan, trips to raw material and equipment suppliers, etc. (step 3.5)

Working capital is the amount of money permanently needed in cash or in kind to keep the business operating while it is awaiting full payment for goods sold to customers.

Working capital can be calculated by adding five factors:

1)   The costs of maximum raw material stocks that will have to be stored to ensure continuous production. In a few cases this may be three to six months worth, if the raw material is difficult to obtain or has to be imported, whereas in other cases (where raw materials are readily available) only one or two weeks worth may be needed;

2)   The costs of finished goods kept in stock and awaiting distribution to the customers;

3)   The costs of a work-in-process that is on factory floor, but have not yet been converted into a final product or finished goods;

4)   The costs of goods already distributed to customers, but have not yet been paid (accounts receivable);

5)   The amount of ready cash needed to pay workers and overheads.

• To determine the costs of raw material stocks, simply multiply the quantity needed by its purchase price;

• To determine the costs of finished goods stock, multiply the number of units to be kept by the unit production costs (step 2.18)

• To determine the costs of the work-in-process, first estimate the number of days it takes to convert the raw material into finished goods, then multiply this by the daily production level (step 2.6), thereafter multiply the figure obtained by the unit production costs determined in (step 2.18), and finally divide this figure by 2.

• To determine the costs of goods already distributed, but not yet paid for, estimate the quantity that will be given on credit and multiply this number by the unit production costs (step 2.18)

• To determine the amount of cash needed in the business, add the monthly labour costs in step 2.14 and overheads (step 2.17) to the monthly marketing expenses (step 1.12) and the administrative expenses (step 3.7)

Add these five cost elements together to arrive at the total working capital requirement. To calculate the total capital requirement, add the following:

+  Fixed Assets (step 2.2, step 3.6)

+  Pre-Operating Expenses (step 3.5)

+  Working capital (step 4.1)

=  Total Capital Requirement (Project Costs)

4.2   Is a Loan needed? What will the Equity Contribution of the
Entrepreneur be? And if so, how much?
Sourcing of total capital requirement can also be termed the financing plan. Bankers want to know these sources and what different project cost components are being funded by these various financial sources. After determining the total capital requirement, the next step is to see whether the amount required is too much for you to finance on your own, or beyond your capability to finance. If this is the case, then a loan will be needed.

The entrepreneur is almost always expected to make an equity (owner’s capital) contribution to the project. For example, if the project costs LC50,000, the bank may require the entrepreneur to put up at least LC10,000, or 20%. The LC10,000 constitutes the owner’s equity. 

To arrive at the amount of the loan needed, subtract the equity from the total capital requirement. List these as follows:

It is also possible to borrow from other sources like family members, friends, raw material and equipment suppliers, in addition to banks. Hence, your financing plan (although given here in a very simplified manner) may look like the above plan.

4.3   What Security (Collateral) can be given to the Bank?
In addition to equity the bank will demand to know what kind of security the entrepreneur can offer the bank to ensure that the loan is really repayable and repaid. Normally, land and building (the title of ownership has to be certified by the appropriate government authority) are used for security purposes. Be aware that if your building or house is valued by the bank at LC100,000, the bank may only accept 60% of its full value, or LC60,000, for security purposes.

In many countries titled land has a collateral value from 80 to 100%. Likewise, the machinery, vehicles or building which will finance the loan can also be used as collateral.  For example, machinery and equipment have a collateral value of 60% of its purchase costs in many countries. 

Some credit institutions, especially those catering to small loans, accept personal property (e.g., jewellery, private car, refrigerator, sewing machine, etc.) as collateral.

If the entrepreneur does not have enough security to cover the loan needed, he must then raise this security from friends and relatives or reduce the size of his project until the loan size matches the security requirements of the bank. 

4.4   What is the Loan Repayment Schedule?
Prepare the Loan Repayment Schedule. An example is given below. For a loan of LC120,000 at the cost of 10% for six years, the repayment schedule is shown in the table below: 

4.5   What does the Profit and Loss Statement indicate?
We now have all the data needed for preparing a profit and loss statement, also known as the income statement.

Start with sales which are derived from multiplying the unit selling price by the volume of expected sales during the year (step 1.9). From the annual sales revenue figure, step-by-step, subtract all the yearly expenses. They are as follows:

1)   Raw Material Costs: This is the sum of all raw materials used to produce the products that were sold.

2)   Labour Costs: This is the sum of all direct labour costs for the whole year.

3)   Factory Overhead Expenses: This is the sum of all miscellaneous costs such as minor raw materials, indirect labour, maintenance and repair costs, depreciation of production machinery, electricity, water, supplies, etc. that are associated in producing the product throughout the whole year.

The three items above are known as Costs of Goods Sold. Sales minus these three items results in Gross Profit.

4)   Marketing Costs: This is the sum of all selling and promotional costs, including distribution costs to retail shops, commissions, etc.

5)   Administrative Costs: This is the sum of all administrative costs, including office supplies, security guard salaries, accountant/ bookkeeper’s salaries, telephone bills, entertainment expenses, and the depreciation of office equipment and furniture, etc.

Gross profit less marketing/administrative costs results in Operating Profit.

6)   Financial Costs: This is the sum of interest paid to banks on the amount of borrowing.

Operating Profit less financial costs results in Net Profit Before Tax. Net Profit Before Tax less the relevant business income tax results in Net Profit After Tax.  If you are borrowing money from the bank, the latter would usually require you to project your profit and loss statement (and other figures) corresponding to the life of the loan. That is, if you intend to pay the loan within a span of five years, the bank will ask you to project your figures (e.g., sales forecast, profit and loss statement, cash flow statement, balance sheet, loan repayment schedule, etc.) for five years.
 

                  Determination of Selling Price and Profit Margin

4.6   What does the Cash Flow Statement indicate?
In this part of the business plan, the Cash Flow Statement is calculated and included. While the profit and loss statement gives the results of financial transactions of a business during a certain period (e.g. month or year), the cash flow statement shows the sources (inflows) and applications (outflows) of the cash in the business throughout the year.

Cash Flow Statement (example)

          NB:  The cash flow projection goes up to the end of the business life.

 4.7  What does the Balance Sheet indicate?
The balance sheet is the statement of assets and liabilities and provides the financial picture of the business on a certain date, for example, at the end of the year. 

4.8   What is the Break-even Point (BEP)?
Three kinds of break-even points (BEP) are commonly referred to, namely:

1)   BEP Sales (LC)

2)   BEP Production (volume)

3)   BEP Percentage (%)

a)     Break-even Point (BEP) Sales
Break-even point (BEP) Sales - is that amount of sales value at which no profit or loss is incurred by the business. 

b)     Break-even Point (BEP) Production
The Break-even point (BEP) Production - is that level (volume or quantity) of production at which no profit or no loss is incurred on the part of the business. Production above this level will result in a profit and production below this point will result in a loss. 

c)     Break-even Point (BEP) Percentage
Break-even point (BEP) Percentage - is that percentage level of sales or production at which the business neither makes a profit nor loss. Production above this level will result in a profit and production below this point will result in a loss.

To determine the BEP, three figures need to be calculated. These are:

Sales: annual sales as documented in the profit and loss statement (step 4.4).

Variable Costs - these are the costs that change significantly according to levels of production, and usually consist of raw material costs plus direct labour (step 4.4), provided it is hired and terminated according to the high level of production a factory is making.

Fixed Costs - these are costs such as indirect labour and overhead expenses (steps 2.17 and 3.7), interest and depreciation. These costs do not change significantly, if the factory produces more or less.

Break-even Point (BEP) Calculation

a. BEP Sales
To determine BEP Annual Sales, multiply annual sales found in the income statement by the annual fixed costs and divide by annual sales less annual variable costs:

b. BEP Production
To determine BEP Production Volume, divide BEP Sales by the Unit Selling Price (USP):

A further method is to: Divide Annual Fixed Costs by the Unit Selling Price less Unit Variable Costs, also known as Contribution Margin, that is, the remainder of what is left to cover fixed costs and profit. At BEP, the contribution margin can only cover fixed costs, not profit:

c. BEP Percentage
To determine the BEP Percentage on yearly sales, multiply the yearly fixed costs by 100, divided by annual sales minus the variable costs.

4.9 What is the Return on Investment (ROI)?
One important issue that should be looked into when deciding on whether or not to go ahead with your business is to answer this crucial question: "Will my money be better off in this business or safe at the bank, where it can earn a fixed interest in long-term bonds, savings or time-based deposits?" To answer this question, calculate the project’s return on investment (ROI), presenting one of the means of measuring profitability.

This is done by dividing Net Profit (step 4.4) by the total capital requirement times 100 (step 4.1): It is more advisable to use Net Profit after Tax, if this is applicable.

A variation in the profitability measure is the Return on Owner's Investments (ROI). This is derived by dividing Net Profit before Taxes by the Owner’s Equity (Capital or Investment) times 100, as shown below:

If the percentage is greater than the bank’s rate on long-term deposits, including allowances for the country’s inflation rate during the same period, then the project appears to be financially viable. If it is below the bank rate, then you may consider several alternatives which could include measures, such as increasing the level of production (provided the market is sufficient), looking for ways to reduce costs, or even abandoning the project altogether.

4.10 Is the Project feasible?
Now that all questions related to the four aspects of the business project - that is, marketing, technical, organisation and finance - have been answered, a conclusion should be made on the feasibility of starting the business. Is the profit on the first year sufficient enough to meet the loan and interest repayments? Can marketing or raw material supply problems be overcome? What will happen to project profitability, if raw material costs increase by 10%? What if, the sales forecast is only 80% realised? Any further outstanding questions should be dealt with in this last section.

You also have to decide for yourself whether the expected profit to make is worth all the risks you are taking by starting the business.

Likewise, in addition to ROI which is one of the measures of profitability, other kinds of financial analysis can be carried out to provide a better picture of the business.

These include:

1)   Measures of liquidity (e.g., current ratio)
 

A ratio of 2 to 1 has often been considered to be desirable. This rule of thumb, however, is not necessarily valid in all cases and is industry dependent.

2)   Measures of solvency (e.g., debt-equity ratio)
 

This ratio is very useful to creditors. A low debt-equity will be considered favourable by creditors, as it indicates the business is mostly funded by the owners themselves.

Another financial tool which is required by some banks is the Sensitivity Analysis, which entails subjecting the effects on production costs, profitability, margins, etc. by the changes of certain important inputs, such as raw material prices or labour costs increasing by a certain percentage, let us say 5 or 10%. 

back to Business plan 2  I  Executive Summary
Sales and Marketing  I  Production  I  Organisation and Management