Be an Entrepreneur

Chap 08

The Entrepreneur

The Business Plan

The Enterprise•Epilogue

Be an Entrepreneur

CHAPTER 08

The Financial Plan

Chapter 8 overview

In Chapters 5 , 6, and 7, we discussed the parts of a business plan.

We now integrate all of these parts and express them in money terms in the financial plan.

Chapter 8 overview

In chapter 8, we take a close look at financial risks, how to measure them, and express them.

Chapter 8 overview

We relate risk to the rewards of a business.

We find ways to evaluate if the business is “worth the risk” or “worth the trouble.”

Coverage of the Chapter

• Cash Budgets• Time Frame or Period of a Cash Budget• Cash Inflows • Cash Outflows • Financing Section

Coverage of the Chapter

What you can learn from the Cash Budget:• I Need this much External Funding• Now, I can see the Reward or Return of the

Business• Payback period. • Internal Rate of Return. • Net present value.

Coverage of the Chapter

• Measuring Risks• Required rate of return.• Break-even Point• Internal Rate of Return.• Sensitivities: what if…

Activities

Icebreaker

Glossary. Video. Story:

Yong Suk Daley

Cash Budget

Return on investmen

t

Story: Welti.

fixed costs and

variable costs

Math example

Story: Hasina Jahan.

Exercises in

workbookSummary. Case

analysis: Enzo.

Learning Objectives

• Define a financial plan and discuss its importance to an investor

• State the goals of a financial plan• Discuss ways to set up the time frame for a

cash budget• Distinguish variable costs from fixed costs

Learning Objectives

• Explain how a cash budget helps determine the funding need

• Discuss measures of return of an investment• Discuss the required rate of return, break-

even analysis, and sensitivities as measures of risk

Central Idea

Financial

Plan

Story from Real Life

Ms. Yong Suk Daley, a Korean-American, opened a clothing-alteration shop in Springboro, Ohio, in 2000 and operated it successfully.

Business slowed down in 2005. She renovated her business in 2006 and called

it, “Young’s Special Occasion Apparel.”

Story from Real Life

She refocused on altering and fixing clothes for special occasions like weddings, where the consumer budgets are bigger.

The purchase of her inventory and display was financed with her personal credit cards.

Story from Real Life

In August 2006, Ms. Yong finally got a business coach who helped her develop a proper business plan.

She prepared a cash budget as part of an application for a loan, to supplant the credit card debt.

Story from Real Life

She strengthened recordkeeping and financial management. She improved the marketing plan.

A loan was finally granted to her in October 2006.

Because of the loan, she no longer had to use her credit card to finance inventory.

Glossary

Financial plan: The business plan expressed in

numbers of money terms. It includes the cash budgets, the

amount of external financing required and an assessment of the risks and rewards of the business.

Glossary

Cash Budget: A cash budget tracks the expected flow

of cash as it comes into and goes out of a business over a future time frame.

Glossary

Terminal Value: The forecast value of your business at

the end of a specified period. It is used to limit the time frame in a cash budget.

Glossary

Variable costs: Costs that change or vary with the

number of units sold. Because of their relation to sales,

variable costs are often expressed as a percent of sales.

Glossary

Fixed costs: Costs where the amount does not

change or remains fixed over a wide range of sales volumes.

Minimum operating cash: The least amount of cash a business

needs for day-to-day operations.

Glossary

Payback period: The time it takes for a business to fully

recover or pay back the initial investment.

Shorter payback periods represent more attractive businesses.

Glossary

Internal rate of return: The percentage rate that equates the

cash outflows and cash inflows. An internal rate of return higher than

the required rate, means the venture is attractive.

Glossary

Net present value: Today’s value of future cash flows

minus the initial investment. The rate used to convert future cash flows to

today’s value is the required rate of return.

A business with positive NPV is attractive.

Glossary

Breakeven point: The number of units your business

must sell to just cover all costs resulting in zero profit.

Glossary

Sensitivity Analysis: A way of producing forecasts that differ

from the original forecast because one or several variables are changed.

Sensitivities are used to find out the effects of a change in one variable on the financials.

Ask Yourself

• Am I going to be as diligent as necessary to make the detailed forecasts and calculations?

Ask Yourself

• If I have no idea how to forecast the sales of a certain business, will I make the effort to interview a knowledgeable person, or a practical businessman, to get the information?

Points to Remember

• The financial plan is the future story of your business, told in the language of numbers or money. It tells the story of your business using numbers.

Points to Remember

• The financial plan is a convenient summary of all the components of your business plan. It expresses how high the start-up costs will be, how much the new factory will cost, and what sort of working capital will be required.

Points to Remember

• The financial plan quantifies all of your plans into measurable units of money. It explains the total investment required this year, how much will be in fixed assets, how much in working capital, and how big are salary expenses versus raw material costs.

Points to Remember

• The financial plan shows the rewards. It shows how much the investor's money can grow.

• Your financial plan has three goals:• To demonstrate the need for funds. • To demonstrate the reward or return of a

business. • To measure financial risks.

Ask Yourself

• Can I develop expertise in running electronic spreadsheets to make the calculations?

Points to Remember

To address these goals, your financial plan will have three components:

• the cash budgets• the conclusions reached from the cash

budgets• ways to measure risk.

Points to Remember

• The time frame or period of a cash budget will usually cover several years.

• If you estimate that it will take five years to build up the business, and that the business will be stable by the fifth year, it would mean that your cash budget should be enough to cover five years.

Points to Remember

• Another way to determine the time frame is to take the point of view of the investor (the provider of funds).

• The time frame of the cash budget has to be equivalent to the time frame of the investor.

• Five years would be a reasonable time frame, for most investors.

Points to Remember

• Cash outflows or costs may be sorted into variable and fixed costs. Variable costs change or vary with the number of units sold. The more you sell, the higher your variable costs will be.

Points to Remember

• Raw materials and labor used in production are examples of variable costs. Because of their relation to sales, variable costs are usually expressed as a percent of sales.

Points to Remember

• By contrast, fixed costs do not change with the number of units sold. The amount remains constant for a wide range of sales volume, or constant for a time period.

Points to Remember

• For most new businesses, the first years are years of investment and hard work. We see this in the cash budget as negative net cash flows in the first years.

Points to Remember

• If the beginning cash balance is small, a negative net cash flow will lead to a smaller, even negative, ending cash balance.

• External funds will then be required to bring the amount back to minimum operating cash level, in the sub-period.

• That is how, you find out, how much external funding is required.

Points to Remember

• The payback period is the time it will take for the business to fully recover or pay back the initial investment.

• The IRR is the percentage rate that equates the cash outflows and cash inflows. The higher the rate of return, the better.

Points to Remember

• Net present value is today’s value of all future cash flows minus the initial investment.

• You need to input a required rate of return in the calculation, to see if the business gets to earn sufficient money each year, to pass the test of the investor, and to see if it still produces a net positive amount, by the end of the project.

Points to Remember

• A business with positive NPV is attractive. • Required rate of return: the minimum reward

a business must provide for an investor to invest in it. It is expressed as a percentage.

Points to Remember

• The breakeven point is the number of units your business must sell to just cover all its costs or “break even” or to achieve at least zero profit.

• Below break-even, your business is not profitable.

Points to Remember

• If you present alternative cash budgets, you would be giving sensitivities. You can present an optimistic and a pessimistic scenario.

• You can present a best-case and a worst-case scenario. This is how you know what would happen if: (a) sales is higher than expected or (b) lower than expected.

Ask Yourself

• Can I test my level of prudence by acting responsibly after careful thought and planning?

• Do I make the effort to exercise great care in calculating the budget using realistic numbers?

Ask Yourself

• Am I focused in planning out the business, or am I dismayed by the effort involved to research the requirements of this particular business?

Ask Yourself

• Will I make the effort to open a financial management textbook to learn the proper formulas for these return calculations?

• Do I resolve to be creative in developing alternative scenarios for the best-case and worst-case outcomes for my business?

Case Study questions

Do you think a cash budget would help Mr. Enzo even though his business is already running?

Why or why not?

Case Study questions

In your view, which costs (variable costs, working capital, one-time fixed costs, recurring fixed costs) is the greater source of Mr.Enzo’s cash flow problems?

• What would you suggest to Mr. Enzo to improve cash flow?

Exercises in Workbook

Costs/ Payments for Fixed (F) or Variable (V)

One-time (O) or Recurring (R)

Materials

Labor

Factory Managers

Major Equipment

Office Rent

Maintenance

Zakat

In the table below, classify the costs or payments as to whether largely fixed or variable, largely one-time or recurring.

Exercises in WorkbookAnswer the questions based on the summary cash budget below. The cash budget is over the first six months of operations and the entrepreneur put in Sr50,000 of his own funds.

Oct Nov Dec Jan Feb MarTOTAL CASH IN 250000 240000 260000 255000 235000 255000TOTAL CASH OUT 264500 253300 260800 267900 238600 242200

NET CASH FLOW -14500 -13300 -800 -12900 -3600 12800BEGINNING CASH 50000 35500 25000 25000 25000 25000ENDING CASH 1 35500 22200 24200 12100 21400 37800FINANCING/ (PAYMENT) 0 2800 800 12900 3600 -12800ENDING CASH 2 35500 25000 25000 25000 25000 25000

CUMULATIVE FINANCING 0 2800 3600 16500 20100 7300MINIMUM CASH BALANCE 25000

Learning from Internet

To know more about the cash budget or cash flow:

http://www.obdc.com/how-to-manage-and-plan-for-cash-flow/http://indonesia.smetoolkit.org/indonesia/en/content/en/604/Projecting-Cash-Flow

Learning from Internet

To know more about risk and reward:http://www.smallbusinessentrepreneurs.co.uk/balancing-risk-reward.htmlpeople.exeter.ac.uk/trkaplan/finance/

finance4.ppt

Review Questions

We learn that the financial plan is a convenient summary of all the components of your business plan. It is like an executive summary that is expressed in money terms. What does this mean?

Review Questions

We learn that the financial plan quantifies all of your plans into measurable units of money. What is the benefit of expressing the plan into units of money?

Review Questions

We learn that the financial plan shows the rewards. Why is it important for the plan to show rewards? Who are we trying to impress?

Review Questions

We learn from the book that the cash budget should eventually "break even" to graduate from negative cash flows to positive cash flows. Why is this very necessary for any business?

Review Questions

Is it not enough that a business creates jobs? What would you say about a business that creates 10,000 new jobs, but the cash flow is always negative?

Review Questions

State a couple of ways to limit the time frame of a cash budget.

What is the difference between variable costs and fixed costs?

Review Questions

How does the cash budget help determine funding need?

What are the ways by which we can measure the return of an investment?

Review Questions

What are the measures of risk of a business? Briefly describe each.

Discussion Questions

Suppose your cash budget shows a positive net cash flow from the first year of operations. Would you still need external funding? If so, what type of external funding would you seek?

Discussion Questions

There are other ways to assess the rewards of a business. One can measure reward in terms of profits or the stock price. Why the focus on cash in this chapter? Is cash a better measure than profits?

Discussion Questions

Where there is little or no inflation, money today is not very much different from money tomorrow. In such cases, wouldn’t the quicker, simpler payback period be a better way to assess the attractiveness of a business?

Discussion Questions

How many sensitivities should you make and what changes should we consider? Discuss this question with your peers and come up with a general answer.

NEXT CHAPTER: 09

Secure Funding

Chapter 9 overview

• In chapter 9, we look at the ways to find money for your business.

• We talk about raising money and securing the necessary funding. • You need long-term investment capital for buying

machines and factories (the fixed assets). • You also need short-term working capital for

buying raw materials.

Chapter 9 overview

• The young entrepreneur may have winning plans and impressive projects, but he still needs to find the money to start the enterprise. • The first and logical source of funding is personal

savings and personal assets. • Afterwards comes investment money from

relatives or friends.

Chapter 9 overview

• When funding comes from other people, you can distinguish between many kinds of external investors. • Some investors are kind and patient; • many are brutal and impatient.

Chapter 9 overview

• Venture capital (such as funds from angel investors) usually comes in at an early stage in the company’s development.

• Later on, larger-sized private-equity investors come in to bring the company to a higher level.

Chapter 9 overview

• After some years of successful operation, the company will be able to approach a bank for further financing.

Chapter 9 overview

• An aggressive bank can provide long-term capital on easy terms, based on an impressive business plan alone.

Chapter 9 overview

• A conservative bank would provide small amounts of short-term loans if there is collateral.

• Collateral is property that could be confiscated in case of non-payment of loans.

Chapter 9 overview

• At a later stage, the business owner may be able to sell some shares of stock to raise big money for a corporate expansion.