Financial Planning: Importance, Process, and Analysis

1. FINANCIAL PLAN Assoc. Prof. Dr. Ismail Ab.Wahab Assoc. Prof. Hj. Wan Ismail Wan Mamat Assoc. Prof. Dr. Mohamed Dahlan Ibrahim

2. LEARNING OUTCOMES • At the end of the session, students should be able to: • Understand the importance of preparing a financial plan • Understand the process of developing a financial plan • Identify the components of a financial plan • Analyse the financial position of the proposed business • Prepare a financial plan for a small business

3. INTRODUCTION • A financial plan incorporates all financial data derived from the operating budgets i.e. the marketing, production (or operations) and administration budgets. Financial information from the operating budgets is then translated or transformed into a financial budget. • Based on the financial data, projections are prepared via the following pro forma statements: • Cash flow • Income (or profit and loss) statement • Balance sheet.

4. THE IMPORTANCE OF A FINANCIAL PLAN • A financial plan is crucial to the overall business plan that is developed for a particular business or project. Its importance can be summarised as follows: • To determine the size of investment • To identify and propose the relevant sources of finance • To ensure that the initial capital is sufficient • To analyse the viability of the project before actual investment is committed • To be used as a guideline for project implementation

5. THE PROCESS OF DEVELOPING A FINANCIAL PLAN • To develop a workable and meaningful financial plan, the entrepreneur has to follow these steps: • Step 1: Gather all financial inputs • Step 2: Determine the project implementation cost • Step 3: Determine the sources of finance • Step 4: Prepare the pro forma cash flow statement • Step 5: Prepare the pro forma income statement • Step 6: Prepare the pro forma balance sheets • Step 7: Perform basic financial analysis

6. Step 1: Gather the Financial Input (contd.) • The process of developing a financial plan for a specific project begins with the accumulation of financial information from the marketing, operations and organizational plans. • The financial requirements for each plan are presented in the form of budgets known as operating budgets (i.e. marketing, operations and organisation budgets)

7. Step 1: Gather the Financial Input (contd.) • In addition, the monthly or annual sales forecast derived earlier in the marketing plan is a very important input for the financial plan. • After gathering all information the financial plan is prepared in terms of financial budget.

8. Marketing Plan • Sales Forecast • Marketing Budget • Organizational Plan • Administrative Budget • Financial Plan • Project implementation cost • Sources of financing • Pro forma cash flow statement • Pro forma income statement • Pro forma balance sheet • Financial Analysis • Operations Plan • Operations Budget

9. Step 2: Determine the Project Implementation Cost • A project implementation cost incorporates both long-term and short-term expenditure needed to start a project. • Long-term expenditure refers to such expenditure as the procurement of plant, machinery, equipment, vehicles and other fixed assets needed by the new business.

10. Step 2: Determine the Project Implementation Cost (contd.) • Short-term expenditure, such as payments of utilities, salaries and wages, factory overheads, purchase of raw materials or inventories, represent the amount of initial working capital required to finance the daily operation until the business gets its first sale. • Components of project implementation cost: • Capital expenditure • Working capital • Other expenditure • Contingency cost

12. Step 3: Determine the Sources of Finance • Sources of finance refers to the sources where funds to finance a particular project’s implementation costs can be secured. • These can be categorised into internal and external sources. The internal sources mainly come in the form of equity contributions from the entrepreneurs. These contributions can either be in the form of cash or other assets.

13. Step 3: Determine the Sources of Finance (contd.) • External sources of finance are mainly derived from commercial banks, finance companies and government agencies. It may come in the form of term loans, hire purchase or grants. • The total amount of funds that has to be sourced should equal the total project implementation cost calculated earlier. This is to ensure that the project is fully funded and to avoid the risks of under-financing.

14. Step 3: Determine the Sources of Finance (contd.) • Components of sources of finance: • Internal sources • Equity contributions (cash and/or assets) • External sources • Term loan • Hire purchase • Others

16. Step 4: Prepare Pro Forma Cash Flow Statement • Pro forma cash flow statement refers to the projected statement of cash inflow and outflow throughout the planned period. • Under normal circumstances, the pro forma cash flow statement is prepared for three consecutive years, detailed by month for the first year and by year for the second and third years. However, longer periods are sometimes needed depending upon the projects undertaken.

17. Step 4: Prepare Pro Forma Cash Flow Statement (contd.) • The total amount of funds that has to be sourced should equal the total project implementation cost calculated earlier. This is to ensure that the project is fully funded as well as to avoid the risks of under-financing.

18. Step 4: Prepare Pro Forma Cash Flow Statement (contd.) • The pro forma cash flow statement must be able to show the following information: • Cash inflows – the projected amount of cash flowing into the business. • Cash outflows – the projected amount of cash flowing out of the business. • Cash deficit or surplus – the difference between cash inflows and outflows. • Cash position – the beginning and ending cash balances for a particular period.

19. Step 4: Prepare Pro Forma Cash Flow Statement (contd.) • Elements of cash inflows: • Equity contribution (cash) • Term loan • Cash sales • Collection of receivables • Others

20. Step 4: Prepare Pro Forma Cash Flow Statement (contd.) • Elements of cash outflows: • Marketing expenditure • Operations expenditure • Administrative expenditure • Term loan repayment • Hire purchase repayment • Purchase of fixed assets • Pre-operating expenditure • Payments for deposits • Miscellaneous expenditure

21. Example: Pro Forma Cash Flow Statement

22. Example: Pro Forma Cash Flow Statement (contd.)

23. Step 5: Prepare Pro Forma Income Statement • The next step in developing a financial plan is to prepare the pro forma income statement which shows the expected profit or loss for the planned period, usually for three consecutive years. • The pro forma income statement consists of the following elements: • Sales • Gross Income • Net Income Before Tax

24. Step 5: Prepare Pro Forma Income Statement (contd.) • Net income before tax is derived as follows: Sales - Cost of Sales = Gross Profit Gross Profit - Operating Expenses = Net Income before tax

25. Example: Pro Forma Income Statement Year 1 Year 2 Year 3 Sales 240,000 276,000 317,400 Cost of sales 94,600103,900108,940 Gross profit 145,400 172,100 208,460 Less: Operating Expenses Marketing expenses 18,000 18,900 19,845 Administrative expenses 96,000 100,800 105,840 Depreciation charges 7,200 7,200 7,200 Miscellaneous 2,700 600600 123,900127,500133,485 Operating income 21,50044,60074,975 Less: Financing expenses: Interest on term loan 4,500 3,600 2,700 Interest on hire-purchase 1,6001,6001,600 6,100 5,200 4,300 Net profit before tax 15,40039,40070,675

26. Step 6: Prepare Pro Forma Balance Sheet • While the pro forma income statement shows the financial performance of the business for the planned period, the pro forma balance sheet shows the financial position of the business at a specific point in time in terms of assets owned and how those assets are financed. • The pro forma balance sheet is normally prepared for a period of three years.

27. Step 6: Prepare Pro Forma Balance Sheet (contd.) • The pro forma balance sheet consists of the following elements: • The balance sheet shows the following equation: Assets = Owners’ equity + Liabilities • Assets • Owners’ equity • Liabilities

28. Step 6: Prepare Pro Forma Balance Sheet (contd.) • Assets are the economic resources of a business that are expected to be of benefit in the future. Assets reported in the balance sheet are generally categorised into two categories: non-current and current assets. • Non-current assets include fixed assets and other assets that are owned and usually held to produce products or services. These assets are not intended for sale in the short term. Examples: property, plant, machinery, equipment, vehicles, major renovations and long-term investments. For fixed assets, the values shown in the balance sheet are the book value i.e. the original cost less the accumulated depreciation.

29. Step 6: Prepare Pro Forma Balance Sheet (contd.) • Current assets are short-term assets that can be converted into cash within a year. Examples: cash, inventories (raw materials, work-in-process and/or finished goods), receivables and other short-term investments. • Owners’ equity refers to capital contributions from the owners or shareholders in terms of cash or assets plus the accumulated amount of net income. However, if the business suffers a loss, the amount of loss will be deducted from the capital contributions.

30. Step 6: Prepare Pro Forma Balance Sheet (contd.) • Liabilities are the amounts owed by the business to outsiders. They are categorised as non-current (long-term) and current liabilities. • Non-current or long-term liabilities refer to the long-term obligations of the business that mature in a period of more than one year. They usually include long-term loans as well as hire purchase. • Current liabilities refer to the short-term obligations of the business that mature within a period of less than a year. The most common forms of current liabilities are accounts payable and accrued payments

31. Step 6: Prepare Pro Forma Balance Sheet (contd.) • Liabilities are the amounts owed by the business to outsiders. They are categorised as non-current (long-term) and current liabilities. • Non-current or long-term liabilities refer to the long-term obligations of the business that mature in a period of more than one year. They usually include long-term loans as well as hire purchase.

32. Example: Pro Forma Balance Sheet Year 1 Year 2 Year3 Non-Current Assets (book value) Land & building 45,000 45,000 45,000 Machinery & equipment 18,400 13,800 9,200 Furniture & fixtures 5,600 4,200 2,800 Renovation 3,200 2,400 1,600 Vehicles 20,000 15,000 10,000 Deposit 800 - - 93,00081,20069,400 Current Assets Inventory of raw materials 3,000 3,500 4,000 Inventory of finished goods 3,000 4,000 5,000 Cash 40,900 77,600 145,575 46,90085,100154,575 Total Assets 139,900166,300223,975 Owners’ Equity Capital 72,500 72,500 72,500 Accumulated profit 15,400 54,800125,475 87,900127,300197,975 Long-term Liabilities Term loan 36,000 27,000 18,000 Hire-purchase 16,00012,000 8,000 52,000 39,000 26,000 Total Owners’ Equity & Liabilities 139.900166,300223,975

33. Step 7: Perform Basic Financial Analysis • Financial analysis is a technique of examining financial statements to help the entrepreneur analyse the financial position and performance of the business. • Financial analysis involves two basic steps: generating the information from the financial statements and interpreting the results. • The most common form of financial analysis is “ratio analysis”.

34. Step 7: Perform Basic Financial Analysis (contd.) • Financial ratios are normally used to compare figures from the financial statement with other figures, so that the true meaning of financial pictures can be obtained. • There are various financial ratios that the entrepreneur can look at. However, the most commonly considered ratios in small business decision-making fall into four categories: liquidity, efficiency, profitability and solvency. • For illustrative purposes, financial data presented in pro forma financial statements in the next slides will be used.

35. Pro Forma Income Statement Year 1 Year 2 Year 3 Sales 576,000 662,400 794,880 Cost of sales 227,000254,600278,460 Gross profit 349,000407,800516,420 Less: Operating Expenses Marketing expenses 56,500 62,150 68,365 Administrative expenses 226,000 248,600 273,460 Depreciation charges 21,000 21,000 21,000 Other operating expenses 5,000 4,000 4,000 308,500335,750366,825 Operating income 40,500 72,050149,595 Less: Financing expenses: Interest on term loan 16,50013,200 9,900 Net income before tax 24,00058,850139,695

36. Pro Forma Balance Sheet Year 1 Year 2 Year3 Non-Current Assets (book value) Land & building 100,000 100,000 100,000 Motor vehicles 64,000 48,000 32,000 Office equipment 5,600 3,000 2,000 Renovation 16,000 12,000 8,000 Machinery 32,000 24,000 16,000 Other assets (deposits) 1,000 1,000 1,000 217,000188,000159,000 Current Assets Inventory of raw materials 2,000 3,000 4,000 Inventory of finished goods 5,000 6,000 8,000 Cash 46,500105,350244,645 53,500114,350256,645 Total Assets 270,500302,350415,645 Owners’ Equity Capital 105,500 105,500 105,500 Accumulated profit 24,000 82,850222,545 129,500188,350328,045 Long-term Liabilities Term loan 132,000 99,000 66,000 Current Liabilities Accounts payable 9,000 15,000 21,600 Total Owners’ Equity & Liabilities 270.500302,350425,645

37. Step 7: Perform Basic Financial Analysis (contd.) • Liquidity Ratios • The term liquidity refers to the availability of liquid assets to meet short-term obligations. Thus, liquidity ratios measure the ability of the business to pay its monthly bills. • The most widely used liquidity ratios are current ratio and quick ratio.

38. Step 7: Perform Basic Financial Analysis (contd.) • Current ratio can be determined by dividing total current assets by total current liabilities. Generally, this ratio shows the business’ ability to generate cash to meet its short-term obligations. • Current ratio = Total current assets Total current liabilities

39. Step 7: Perform Basic Financial Analysis (contd.) • If the business’ current ratio falls below 1, it means that the business is in a serious liquidity situation. In most cases, the comfortable current ratio for most businesses is ‘2’. • Quick ratio, also known as the acid test ratio, measures the extent to which current liabilities are covered by liquid assets. • To determine quick ratio, the calculation of liquid assets does not take into account inventrories since it is sometimes difficult to convert them into cash quickly.

40. Step 7: Perform Basic Financial Analysis (contd.) Quick ratio = Total current assets-inventories Total current liabilities • In most cases, the comfortable quick ratio is ‘1’.

41. Step 7: Perform Basic Financial Analysis (contd.) • Efficiency Ratios • The efficiency ratios measure how efficient the business uses its assets to generate sales. • The most widely used efficiency ratio for planning purposes is inventory turnover ratio.

42. Step 7: Perform Basic Financial Analysis (contd.) • Inventory turnover (or stock turnover) measures the number of times inventories have been converted into sales and indicates how liquid the inventory is. All other things being equal, the higher the turnover figure, the more liquid the business is. • This ratio divides the cost of sales (or cost of goods sold) by the average value of inventory. The average value of inventory is derived by adding the opening and closing balance of and dividing the total by two. • Inventory turnover = Cost of sales Average inventory

43. Step 7: Perform Basic Financial Analysis (contd.)

44. Step 7: Perform Basic Financial Analysis (contd.) • Profitability Ratios • Profitability ratios are important indicators of the business’ financial performance. Investors will particularly be interested in these ratios since they measure the performance and growth potential of the business. • Some of the commonly used profitability ratios are gross profit margin, net profit margin, return on assets and return on equity.

45. Step 7: Perform Basic Financial Analysis (contd.) • Gross profit margin give a good indication of financial health of the business. Without an adequate gross margin, the business will be unable to pay its operating and other expenses. • Gross profit margin is calculated by dividing the business gross income by sales. • Gross profit margin = Gross profit Sales

46. Step 7: Perform Basic Financial Analysis (contd.) • Net profit marginis an indication of how effective the business is at cost control. The higher the net profit margin, the more effective the business is at converting sales into actual profit.

47. Step 7: Perform Basic Financial Analysis (contd.) • Net profit margin is calculated by dividing the business net income by sales. • Net profit margin = Net profit Sales

48. Step 7: Perform Basic Financial Analysis (contd.) • Return of assets measures the overall return that the business is able to make on its assets. • This ratio is derived by dividing the business net profit by total assets. • Return on assets = Net profit Total assets

49. Step 7: Perform Basic Financial Analysis (contd.) • Return of equity shows what the business has earned on its owners’ investment in the business. • This ratio is derived by dividing the business net profit by total equity. • Return on equity = Net profit Total equity

50. Step 7: Perform Basic Financial Analysis (contd.) • Solvency Ratios • This final category of ratios is designed to help the entrepreneur measure the degree of financial risk that his business faces. By referring to this ratio, the entrepreneur can assess his level of debt and decide whether it is appropriate for the business. • The most commonly used solvency ratios are total debt (liabilities) to equity (also known as leverage or gearing), total debt to total assets, and times interest earned (also known as interest coverage).