Chapter 6   Financial
Chapter 6   planning
Chapter 6   

Financial planning is a fairly general term which covers a range of different activities, from the initial estimating of resource requirements and associated costs, forecasting sales revenue, identifying ongoing operating costs and preparing the budgetary plans which combine the former information. It also involves cash flow forecasting to ensure that there are no gaps between income and expenditure, analysing breakeven levels and forecasting profits.

It is because the process draws together all of the other aspects of planning the business, and then expressing those plans in monetary form, that it is so important to prepare correctly, as it is the primary point of interest for bankers and any other potential financiers or investors.

The objective of this chapter is to describe the various processes involved, and the reasoning behind them, so that the reader is in a position to prepare the necessary information for his or her own business plan. The sort of information which is required by bankers is also virtually identical to the evidence requirements of Unit A4 of the NVQ in Business Planning. In particular we shall be examining the financial forecasts specified in the evidence requirements for Element A4.3, cash flow, breakeven etc., individually and in more detail later in the chapter. As part of the process we shall also be defining and explaining some of the financial terminology which it is essential for the owner-manager to understand.

There are five key documents with which we are concerned, all of which are interlinked as they are developed from the same or overlapping information and the first two feed into the others:

•   the owner-manager's own survival budget;

•   the breakeven analysis;

•   the budgetary plan;

•   the cash flow forecast;

•   the profit or loss forecast.

The personal survival budget

It may seem strange to start with this item, particularly as it is not really part of the information central to the business plan, but it does form an essential part of the budgetary plan and the cash flow forecast. The key question here is: ‘If I am going into business for myself, how much money do I realistically need to draw from the business to maintain a reasonable and comfortable lifestyle?’ Note carefully the wording here, in that we are not talking about a luxurious lifestyle (that hopefully comes later) and neither are we looking to find the minimum figure that we can survive on. If you are working hard, with long hours, substantial stress and risking your own personal resources, it is not unrealistic to expect to be able to draw sufficient income to enable you to live in basic comfort, especially if you have a family to support. You my find it quite acceptable to live on a very minimal budget during the early stages of the business, but there has got to be a cut-off point beyond which you must expect some comfort. If you fail to realize that fact yourself, then there will certainly come a point when your family will soon start to remind you of it, and probably in quite a firm manner, as financial pressures can strain any relationship, no matter how sound the latter may be. It really boils down to the fact that if you cannot achieve a basic reasonable lifestyle from your business, then you must ask yourself if the business is right for you in the first place.

The personal survival budget is effectively a summary of all your domestic outgoings over a period, typically a year, although for the purposes of your business budget you will no doubt break it down on a monthly basis. For example, for a family of two adults and two teenagers:

	£
Annual mortgage payments	3 600
Rates, water, sewage	900
Gas, electricity, telephone	900
Repairs and maintenance to home	300
Food and clothing for family	4 800
Loans, hire purchase, credit cards	600
Insurance policies, pension, savings	1 200
Car loan and running costs	3 600
Leisure, birthdays, Christmas, holidays	1 560
School travel, children's expenses.	780
Total:	18 240

Remember here, that the sum of £18 240 per annum (£1520 per month) does not constitute gross earnings, as it is the minimum sum which needs to be drawn from the business to pay for what is a far from exorbitant range of family expenses. As such it does not include any income tax or national insurance which must be paid on the gross figure. If the business is a limited company then, depending on tax allowances, the owner-manager would probably need to be paid a salary of at least £24,000 per annum to achieve the required net figure. In the case of a sole trader or partnership, the expected profit generated by the business would have to be sufficient to provide an after tax profit of around £19,000 to allow for drawings and Class 2 NIC. Otherwise owners would be eating into their own capital and almost certainly creating future cash flow problems and a shortage of working capital.

The break-even analysis

First we must define what we mean by ‘breakeven’, and in order to do this, we must distinguish between fixed costs and variable costs. Fixed costs are generally regarded as overhead costs, but the definition is that they remain ‘fixed’ in relation to changes in the level of sales or output. Typically they would include things like rent, rates, management and administration costs (including the owner-manager's own drawings), insurance etc. In contrast, variable costs are defined as those costs which vary directly in relation to changes in sales or output. This would include the costs of raw materials, components, labour production costs (particularly bonus pay or overtime), invoicing, packaging and distribution, etc. The breakeven point then is the point at which the revenue from sales equates to the variable costs incurred in achieving that level of sales, plus the full overhead cost. Put another way:

Sales revenue = fixed costs + variable costs + profit

When we are breaking even, by definition we are making no profit, so our sales revenue must be matching our fixed or overhead costs, plus what it cost us to make the goods we have already sold.

Another useful concept here is that of contribution, which can be found by turning around the above equation:

Here we mean that the difference between the selling price and the variable cost of that item makes a contribution towards the profit and overheads of the business. For example, if a secondhand car dealer buys a car for £1000 (variable cost) and sells it for £1500 (selling price) then the difference of £500 makes a contribution to the dealer's overhead costs and profits.

There are several ways of calculating the breakeven point, including a graphical breakeven chart, but the two most accurate methods involve fairly simple calculations based on the above two equations. To illustrate this we will use the following example where selling price = £10 per unit, variable cost = £4 per unit, fixed costs = £150 000 per annum, and the breakeven sales level = Y units.

The equation method uses the simple formula mentioned above:

Sales = variable costs + fixed costs + profit

10Y = 4Y + 150 000 + 0

10Y - 4Y = 150 000

6Y = 150 000

Y = 150 000 ÷ 6

Y = 25 000 units

So we see that when sales levels reach 25 000 units, the income is sufficient to cover the variable costs incurred, plus the total overhead costs. However, it is only when sales start to exceed this level that the revenue will make a contribution towards the profit of the business.

The contribution margin method uses a different equation:

When calculating profit margins and setting prices it is important to remember the effect that small changes can have on breakeven level. Using the above example, lets say that our marketing specialists had advised that a small change in the selling price, (£9 instead of £10) would generate an increase of 10 per cent in sales. It sounds good, but is it worthwhile? Using the equation method, 9Y = 4Y + 150 000, we find that the breakeven point Y is 30 000 units. Unfortunately for us, the increase of 10 per cent in sales volume has only shifted a total of 27 500 units, so we are worse off than before, as we actually needed a 20 per cent increase in sales to break even at £9 per unit.

The budgetary plan

A budget is a financial plan for an organization, detailing income and expenditure over a fixed period of time, typically an accounting period. So, the primary purpose of setting a budget is to enable us to forecast levels of income and expenditure over the coming year to tell us where our money is coming from and where it is going.

There are basically two ways of preparing a budget, the most popular of which is historically based, where we take the budget for the previous period and adjust it for known or anticipated changes. This is quite a simple and reliable process, assuming of course that the figures from the previous year have been prepared carefully and have turned out to be realistic. The problem with this process is, that any contingencies or slack previously built into the system are usually compounded by the effects of inflation, leading to ever increasing inaccuracies.

The second way is zero-based budgeting where the budget is formulated from scratch, ignoring the figures from previous years, and thereby forcing every single budget heading to be carefully analysed and individually justified. This process has tended to be unpopular, partly because it is time-consuming if done properly and partly because it is prone to error if shortcuts and guesswork are permitted in order to save time, and very often the justification of parts of the budget are historically based anyway.

Historical budgets can be too ‘loose’ leading to inefficiency, whilst zero-based budgets can be too ‘tight’ leading to inflexibility, but apart from the first year when all budgets are by definition zero based, the historical approach is by far the most popular and practical.

So, why do we bother with budgets? The answer is that they are a very useful and practical management tool, and act as a yardstick against which we can monitor:

•   levels and fluctuations in sales revenue;

•   sales trends and changes in demand;

•   profitability and cash flow;

•   changing costs of overheads, raw materials, labour, sales and marketing, transport and distribution, administration, etc.;

•   the impact of advertising programmes on sales;

•   working capital requirements;

•   the effects of changes in interest rates and exchange rates on operating costs.

So, if it can do all of this for us, how do we go about it? The budget calculations are produced on a spreadsheet which is basically a grid containing row and column calculations. If the rows and columns have been prepared correctly, then all the totals across, and all of the totals down, should correspond when carried to the bottom right-hand corner. However, Murphy's First Universal Law of Cock-Ups is always there to ensure that it never works first time. There will always be one frustrating little error or typing mistake that invariably takes ages to find, and I defy any honest person to say that it has never happened to them. An example of a budget spreadsheet is shown in Figure 6.1. Note that all budget figures always exclude VAT charged and payable.

The first stage is to identify the key areas of income, distinguishing between income generated by sales of goods or services, and non-trading income, e.g. rent from subletting space. You may wish to subdivide the sales income to show revenue from different product groups, from different types of customer or carrying different profit margins. For example, a beer and wine wholesaler would want to distinguish between those two major product areas, but the budget headings may also differentiate between sales to retail outlets where a 20 per cent profit margin is expected, and sales to other wholesalers at a 10 per cent profit margin. The revenue figures throughout the year will also need to reflect seasonal trends. In the case of the wholesaler, this would involve peaks over the summer months and at Christmas, and much quieter periods during February to March and October to November. Any other sources of income are identified and included under a separate heading, e.g. capital receipts of loans, and then all items of income are totalled.

The next stage is to carry out a similar exercise for all known areas of expenditure, including overheads, operating costs, stock purchases (which should reflect sales levels) distributions costs, capital expenditure and loan repayments, etc. As with income, these are totalled for each month and for the year as a whole.

Figure 6.1 Winston Wight: 12-month budgetary plan

Case Study

The third stage is to calculate the net income or expenditure for each month and for the year as a whole. If done correctly, this can be quite a complicated and time-consuming exercise the first time around. It is particularly important then, that the time invested is not wasted once the bank manager has seen it, by simply filing the budget in the cabinet and forgetting it until next year. The budget is a working document, but it will only work for you if you use it properly. The monthly figures against each item of income and expenditure are your forecasts, and the benefit of budgeting is only gained by the regular monthly monitoring of actual income and expenditure against those forecasts. By comparing the two, you will be able to identify discrepancies, and in searching for explanations to these you will further identify potential problem areas. Ignore the process, and you may find that the problems continue to grow unnoticed, until it may be too late to rectify them.

The cash flow forecast

In many respects the preparation of a cash flow forecast resembles the process of preparing a budget spreadsheet, as the format and calculations are basically the same. However, the purpose of cash flow forecasts is different in that where the budget is concerned with identifying levels of income and expenditure for each part (e.g. month) of the budgetary period, the cash flow forecast is concerned with when that income is received and when payments are made for expenditure incurred. In order to do this the cash flow forecast will need to reflect:

•   cash-balances brought forward from the previous period;

•   payments due to suppliers (creditors) incurred in the previous period;

•   payments due from customers (debtors) owing from the previous period, and adjustments for bad debts;

•   ongoing credit being given and received during the year;

•   receipts of loan income or capital;

•   capital purchases, lease payments, loan repayments etc.

•   in the case of sole traders and partnerships, the income tax liability for the business in the previous year, and with limited companies, the corporation tax liability for the previous period.

Again, as with budgets, cash flow forecasts always exclude VAT charged on sales or paid on purchases. This is because VAT is seen as a positive influence on cash flow, in that all payments are offset against receipts and the balance paid to HM Customs and Excise quarterly in arrears, so that the balance due is collected before it has to be paid out. In theory then, VAT's short-term residence in the trader's bank account should improve cash flow temporarily.

So, why do we bother with cash flow forecasting? The answer quite simply, is solvency, i.e. ensuring that the business can pay its bills and settle its liabilities as and when they fall due. Unless that is the case, the business may be insolvent and, if so, it cannot legally continue to trade, unless steps are taken promptly to redress the insolvency situation. As is explained in Chapter 8, one of the biggest reasons for failure amongst small firms is lack of working capital and, irrespective of how profitable they might be, if they cannot pay their bills, they often go bankrupt or into liquidation.

What then, are the main influences on cash flow? I find that the best way to understand cash flow is to picture working capital as a bucket with holes in it. Cash receipts pour in through the top, and leak out as expenditure through the holes in the bottom. There are ways in which the rate of flow can be increased to top up the level in the bucket, and there are factors that cause a faster outflow, thus reducing the level of working capital in the bucket:

•   Increased profits or net receipts from trading improve working capital.

•   Receipts of loans or capital investment increase working capital.

•   Sale of fixed assets (e.g. land and buildings) or investments releases cash.

•   Reduction of stock levels can free cash previously tied up.

•   By decreasing debtors (collecting money more quickly or giving less credit) or by increasing creditors (obtaining extra credit or paying late) it is possible to improve cash flow and levels of working capital.

•   Conversely, increasing debtors (giving longer credit to customers or taking on more credit customers) and decreasing creditors (paying suppliers quicker) will adversely affect cash flow, reducing the level of available working capital.

•   Similarly, repayment of loans, redemption of capital, reduces available cash and working capital. Payment of dividends, profit shares and taxation, have a similar effect in reducing available cash.

•   Increasing stock levels ties up cash, and often the increased stock-holding is a response to expansion, which if coupled with an increase in credit customers can reduce available working capital, quite severely.

•   Purchase of fixed assets and investments also takes money out of the system. Fixed (long-term) assets need to be financed by long-term liabilities such as loans or mortgages, not by using working capital which is a current (short-term) asset and which is there to fund day-to-day expenditure.

The structure of the cash flow forecast spreadsheet is broadly the same as that of the budget, with the exception of the bottom line. This is an additional line below the net income/expenditure line, which shows the cumulative effect of income and expenditure on cash flow. The basic rule of thumb is that the biggest cumulative deficit figure is the absolute minimum overdraft requirement for the period. If you bear in mind that the cumulative figures represent the roll-up for the month as a whole, there may be times within the month when, due to late payment by customers and creditor bills falling due, the actual deficit is higher than that shown by the cash flow forecast. Beware, as Murphy's Second Universal Law of Cock-Ups states that your customers will always pay you late when you need it most. So it pays you to build some contingencies into the overdraft requirement, as not only do bank managers tend to worry about requests for repeated increases in overdraft facilities, they charge you extra fees for arranging them.

Figure 6.2 Winston Wight cash flow forecast

Figure 6.3 Winston Wight profit forecast

Case Study

The profit (or loss) forecast

The two primary accounting statements that are produced at the end of the financial year are the balance sheet and the profit and loss account. The balance sheet is like a snapshot taken at the final moment of the financial year. It shows the resources which have been put into the company by the owners or investors, any long-term borrowing (capital and liabilities), and the way in which those resources have been deployed (assets) e.g. in the form of land, buildings, machinery, cash, stock, etc. In contrast, the profit and loss account for the financial year acts as a summary of the trading and profitability of the business over the year as a whole. The reason these two statements are read together is quite simple. Whilst the balance sheet tells us all about the assets, capital and liabilities of the business, it tells us nothing about the profitability. Conversely, the profit and loss account tells us all about the profitability and efficiency of trading over the year, but it shows us nothing of the assets and liabilities.

Case Study

As stated above, the profit and loss account is a historical record prepared at the end of the year, but the profit forecast, which ideally follows the same format for ease of comparison, is prepared at the same time as the budgetary plan and cash flow forecast. In fact, much of the information for the profit forecast will be drawn from the ‘Totals’ column of the budgetary plan.

In summary, we have examined the five main forecasts which would be expected to be included in a business plan: the personal survival budget, the breakeven analysis, the annual budgetary plan, the cash flow forecast and the profit forecast. It may be however, that depending on your circumstances you would not actually need all of these in your own business plan. For example, a non-profit-making organization by definition would not need a profit forecast, but it still needs to know if it is breaking even. Someone working part-time on a self-employed basis may only need a simple budget, and if working for cash, this could also form the cash flow forecast. The important factor is that you need to know how these documents work and what they are used for in order to decide whether or not they are relevant to your own particular business plan. If you are an NVQ candidate, you need to be able to show that you understand the documents in order to satisfy the underpinning knowledge requirements of the NVQ Unit A4. Most important of all, you need to understand them in order to use them to monitor and control the growth and development of your business.

Further reading

Izhar, R. (1994). Accounting, Costing and Management. Oxford University Press.

Mason, R. (1993). Finance for Non-Financial Managers in a Week. IoM and Headway.

Secrett, M. (1993). Mastering Spreadsheet Budgets and Forecasts. Pitman and IoM.

Sizer, D. (1997). An Insight into Management Accounting. Penguin.