Business plan components: Financial Projections: Crunching Numbers in Your Business Plan

1. Why financial projections are important for your business plan?

One of the most crucial aspects of your business plan is the financial projections. These are the numbers that show how your business will perform in the future, based on your assumptions, goals, and strategies. Financial projections are not only important for securing funding from investors or lenders, but also for guiding your decision-making and planning as a business owner. In this section, we will discuss why financial projections are essential for your business plan and how to create them effectively. Some of the reasons why financial projections are important are:

- They help you test the feasibility of your business idea. By projecting your income, expenses, cash flow, and balance sheet, you can see if your business idea is viable and profitable in the long run. You can also identify the potential risks and challenges that you may face and how to overcome them. For example, if your projections show that you will run out of cash in six months, you may need to adjust your pricing, sales, or expenses to avoid a cash crunch.

- They help you set realistic and measurable goals. Financial projections can help you define your business objectives and milestones, such as reaching a certain level of revenue, profitability, or market share. You can also use them to track your progress and performance over time and compare them with your actual results. This way, you can evaluate your strengths and weaknesses and make necessary changes to improve your business. For example, if your projections show that you will achieve a 10% profit margin in the first year, but your actual results show a 5% margin, you may need to analyze the reasons for the discrepancy and take corrective actions.

- They help you communicate your business potential to others. Financial projections can help you showcase your business potential to potential investors, lenders, partners, or customers. They can demonstrate how your business will generate value and returns for them and how you will use their funds or resources efficiently and effectively. They can also help you persuade them that you have a clear and realistic plan for your business and that you are capable of executing it successfully. For example, if your projections show that you will have a positive cash flow and a high growth rate in the next three years, you may be able to attract more investors or lenders who are interested in your business opportunity.

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2. How to estimate your revenue, expenses, and profit?

One of the most important parts of your business plan is the financial projections. These are the numbers that show how your business will perform in the future, based on your assumptions and goals. The financial projections consist of three main statements: the income statement, the balance sheet, and the cash flow statement. In this section, we will focus on the income statement, which summarizes your revenue, expenses, and profit for a given period of time.

The income statement is also known as the profit and loss statement or the statement of operations. It shows how much money you make and how much money you spend in your business. The difference between your revenue and your expenses is your profit, which indicates how profitable your business is. The income statement can help you track your performance, identify trends, and plan for the future.

To create an income statement, you need to estimate your revenue, expenses, and profit for a specific period of time, such as a month, a quarter, or a year. Here are the steps to follow:

1. Estimate your revenue. Revenue is the amount of money you receive from selling your products or services to your customers. To estimate your revenue, you need to consider factors such as your pricing strategy, your target market, your sales channels, and your marketing efforts. You can use historical data, market research, or industry benchmarks to project your revenue. For example, if you run a bakery and you sell 100 loaves of bread per day at $5 each, your daily revenue is $500. If you expect to increase your sales by 10% every month, you can multiply your daily revenue by 1.1 to get your monthly revenue. For the first month, your revenue would be $500 x 30 x 1.1 = $16,500. For the second month, your revenue would be $500 x 30 x 1.1 x 1.1 = $18,150, and so on.

2. Estimate your expenses. Expenses are the costs you incur to run your business, such as rent, utilities, salaries, supplies, marketing, taxes, and depreciation. To estimate your expenses, you need to list all the categories of costs that apply to your business and assign a value to each one. You can use historical data, quotes, invoices, or industry averages to estimate your expenses. For example, if you run a bakery, your expenses might include:

- Rent: $2,000 per month

- Utilities: $500 per month

- Salaries: $10,000 per month

- Supplies: $3,000 per month

- Marketing: $1,000 per month

- Taxes: $2,500 per month

- Depreciation: $500 per month

Your total expenses for the first month would be $19,500. For the second month, your expenses might increase or decrease depending on factors such as inflation, seasonality, or growth. For simplicity, let's assume your expenses remain the same for the second month.

3. Estimate your profit. Profit is the difference between your revenue and your expenses. It shows how much money you have left after paying for your costs. To estimate your profit, you need to subtract your expenses from your revenue. You can also calculate your profit margin, which is the percentage of your revenue that is profit. For example, if you run a bakery, your profit for the first month would be $16,500 - $19,500 = -$3,000. This means you have a negative profit, or a loss, of $3,000. Your profit margin for the first month would be -$3,000 / $16,500 x 100% = -18.18%. This means you lose 18.18 cents for every dollar you make. Your profit for the second month would be $18,150 - $19,500 = -$1,350. This means you have a smaller loss of $1,350. Your profit margin for the second month would be -$1,350 / $18,150 x 100% = -7.44%. This means you lose 7.44 cents for every dollar you make.

The income statement can help you evaluate your business performance and identify areas for improvement. For example, if you run a bakery and you have a negative profit, you might want to consider increasing your revenue by raising your prices, expanding your market, or adding new products. You might also want to reduce your expenses by negotiating lower rent, finding cheaper suppliers, or cutting unnecessary costs. By doing so, you can increase your profit and make your business more sustainable.

3. How to track your cash inflows and outflows?

One of the most important aspects of your financial projections is your cash flow statement. This statement shows how much money is coming in and going out of your business over a given period of time, usually a month or a year. It helps you to monitor your liquidity, solvency, and profitability, as well as to plan for future investments, expenses, and financing needs. A cash flow statement consists of three main sections: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. Here are some tips on how to track your cash inflows and outflows in each section:

- Cash flow from operating activities. This section shows the cash generated or used by your core business operations, such as selling goods or services, paying salaries, or buying inventory. To calculate your cash flow from operating activities, you need to adjust your net income for non-cash items, such as depreciation, amortization, accounts receivable, accounts payable, and inventory. For example, if your net income is $10,000, but you have $2,000 in depreciation, $3,000 in accounts receivable, and $1,000 in accounts payable, your cash flow from operating activities is $10,000 - $2,000 + $3,000 - $1,000 = $10,000.

- Cash flow from investing activities. This section shows the cash spent or received from buying or selling long-term assets, such as equipment, property, or securities. To calculate your cash flow from investing activities, you need to subtract the cash outflows from the cash inflows. For example, if you buy a new machine for $5,000 and sell some shares for $2,000, your cash flow from investing activities is $2,000 - $5,000 = -$3,000.

- Cash flow from financing activities. This section shows the cash raised or paid from borrowing or repaying loans, issuing or repurchasing shares, or paying dividends. To calculate your cash flow from financing activities, you need to subtract the cash outflows from the cash inflows. For example, if you borrow $4,000 from a bank and pay $1,000 in dividends, your cash flow from financing activities is $4,000 - $1,000 = $3,000.

To get your total cash flow for the period, you need to add up the cash flows from each section. For example, if your cash flow from operating activities is $10,000, your cash flow from investing activities is -$3,000, and your cash flow from financing activities is $3,000, your total cash flow is $10,000 + -$3,000 + $3,000 = $10,000. This means that your cash balance increased by $10,000 during the period. You can use a cash flow statement template to track your cash inflows and outflows and compare them with your budget and forecast. This will help you to identify any gaps or discrepancies and take corrective actions if needed.

4. How to show your assets, liabilities, and equity?

One of the most important parts of your financial projections is the balance sheet. This is a snapshot of your business's financial position at a given point in time, showing what you own (assets), what you owe (liabilities), and what you have invested in your business (equity). A balance sheet can help you evaluate your business's performance, liquidity, solvency, and efficiency. It can also help you attract investors, lenders, and partners by demonstrating your financial health and credibility. To create a balance sheet, you need to follow these steps:

1. List your assets. Assets are the resources that your business owns or controls, such as cash, inventory, equipment, accounts receivable, prepaid expenses, and intangible assets (such as patents, trademarks, or goodwill). You should classify your assets into two categories: current and non-current. Current assets are those that can be converted into cash within a year, such as cash, inventory, and accounts receivable. Non-current assets are those that have a longer lifespan, such as equipment, buildings, and intangible assets. You should report your assets in order of liquidity, from the most liquid to the least liquid.

2. List your liabilities. Liabilities are the obligations that your business owes to others, such as loans, accounts payable, taxes, wages, and accrued expenses. You should also classify your liabilities into two categories: current and non-current. Current liabilities are those that are due within a year, such as accounts payable, taxes, and wages. Non-current liabilities are those that have a longer term, such as long-term loans, bonds, and leases. You should report your liabilities in order of maturity, from the shortest to the longest.

3. Calculate your equity. Equity is the difference between your assets and your liabilities, or the amount that you and other owners have invested in your business. Equity can be divided into two components: contributed capital and retained earnings. Contributed capital is the amount that you and other owners have contributed to your business, such as shares, capital contributions, or donations. Retained earnings are the amount of profits that your business has generated and reinvested, rather than distributed to the owners. You should report your equity in the order of seniority, from the most senior to the least senior.

To illustrate how a balance sheet works, let's look at an example of a fictional company called ABC Inc. That sells widgets. Here is their balance sheet as of December 31, 2023:

| Assets | | |

| Current assets | | |

| Cash | $10,000 | |

| Accounts receivable | $15,000 | |

| Inventory | $20,000 | |

| Prepaid expenses | $5,000 | |

| Total current assets | | $50,000 |

| Non-current assets | | |

| Equipment | $30,000 | |

| Less: accumulated depreciation | ($10,000) | |

| Net equipment | | $20,000 |

| Intangible assets | $10,000 | |

| Total non-current assets | | $30,000 |

| Total assets | | $80,000 |

| Liabilities and equity | | |

| Current liabilities | | |

| Accounts payable | $8,000 | |

| Taxes payable | $2,000 | |

| Wages payable | $5,000 | |

| Total current liabilities | | $15,000 |

| Non-current liabilities | | |

| long-term loan | $20,000 | |

| Total non-current liabilities | | $20,000 |

| Total liabilities | | $35,000 |

| Equity | | |

| Contributed capital | $30,000 | |

| Retained earnings | $15,000 | |

| Total equity | | $45,000 |

| Total liabilities and equity | | $80,000 |

As you can see, the balance sheet shows that ABC Inc. Has $80,000 of assets, $35,000 of liabilities, and $45,000 of equity. This means that the company has more assets than liabilities, and more equity than debt, which indicates a strong financial position. The balance sheet also shows that the company has $50,000 of current assets and $15,000 of current liabilities, which means that the company has a current ratio of 3.33. This means that the company has enough liquidity to meet its short-term obligations. The balance sheet also shows that the company has $30,000 of non-current assets and $20,000 of non-current liabilities, which means that the company has a debt-to-asset ratio of 0.25. This means that the company has a low level of leverage and a high level of solvency. The balance sheet also shows that the company has $30,000 of contributed capital and $15,000 of retained earnings, which means that the company has a return on equity of 0.33. This means that the company has a high level of profitability and efficiency.

5. How to determine when your business will start making money?

One of the most important questions that any entrepreneur or business owner needs to answer is: when will my business start making money? This is not only crucial for planning and budgeting, but also for attracting investors and lenders who want to see a realistic and viable projection of your profitability. To answer this question, you need to perform a break-even analysis, which is a calculation of the point at which your total revenue equals your total expenses. In other words, the break-even point is the level of sales or output that you need to achieve in order to cover all your costs and start earning a profit.

There are several steps involved in conducting a break-even analysis for your business plan. Here are some of them:

1. Identify your fixed and variable costs. Fixed costs are those that do not change with the level of production or sales, such as rent, salaries, insurance, etc. Variable costs are those that vary with the level of production or sales, such as raw materials, packaging, shipping, etc.

2. calculate your contribution margin. This is the difference between your selling price and your variable cost per unit. For example, if you sell a product for $10 and your variable cost per unit is $6, your contribution margin is $4. This means that each unit sold contributes $4 to cover your fixed costs and generate a profit.

3. Divide your fixed costs by your contribution margin. This will give you the break-even point in units. For example, if your fixed costs are $20,000 and your contribution margin is $4, your break-even point in units is 5,000. This means that you need to sell 5,000 units to break even.

4. Multiply your break-even point in units by your selling price. This will give you the break-even point in dollars. For example, if your break-even point in units is 5,000 and your selling price is $10, your break-even point in dollars is $50,000. This means that you need to generate $50,000 in sales to break even.

5. Compare your break-even point with your projected sales. This will help you determine how realistic and attainable your break-even point is, and how much margin of safety you have. For example, if your projected sales are $100,000, your break-even point is $50,000, and your profit is $50,000, your margin of safety is 50%. This means that your sales can drop by 50% before you start losing money.

A break-even analysis can help you set your pricing strategy, evaluate your cost structure, and measure your profitability. However, it is important to note that a break-even analysis is based on assumptions and estimates, and it does not account for factors such as market demand, competition, seasonality, and changes in costs or prices. Therefore, you should update your break-even analysis regularly and use it as a guide, not a rule.

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6. How to test different scenarios and assumptions for your financial projections?

One of the most important aspects of creating a business plan is to project the financial performance of your business idea. However, these projections are based on certain assumptions and scenarios that may or may not materialize in the future. Therefore, it is essential to test the robustness and validity of your financial projections by conducting a sensitivity analysis. A sensitivity analysis is a technique that allows you to examine how different variables affect the outcome of your financial model. By changing one or more variables and observing the impact on the results, you can identify the key drivers of your business success and the potential risks and opportunities. A sensitivity analysis can also help you to refine your assumptions and scenarios, improve your decision making, and communicate your financial projections more effectively to potential investors and stakeholders.

There are different methods and tools for conducting a sensitivity analysis, depending on the complexity and purpose of your financial model. Here are some of the common steps and best practices for performing a sensitivity analysis for your business plan:

1. Identify the variables and parameters that you want to test. These can be internal factors (such as sales volume, price, cost, etc.) or external factors (such as market size, growth rate, competition, etc.) that affect your financial projections. You should focus on the variables that have the most significant and uncertain impact on your key financial indicators, such as revenue, profit, cash flow, break-even point, etc.

2. Define the range and scenarios for each variable. You should assign a minimum, maximum, and base value for each variable, based on your best estimates and research. You can also create different scenarios that reflect the possible outcomes of your business environment, such as optimistic, pessimistic, and realistic scenarios. You should justify and document the sources and assumptions behind each value and scenario.

3. Create a sensitivity table or chart that shows the results of your financial projections under different combinations of values and scenarios. You can use spreadsheet software, such as Excel, to create a data table that calculates the outcome of your financial model for each variation of the variables. You can also use charts, such as tornado charts, spider charts, or waterfall charts, to visualize the sensitivity of your financial projections to each variable and scenario. You should clearly label and format your table or chart to make it easy to read and understand.

4. analyze and interpret the results of your sensitivity analysis. You should look for patterns and trends in your table or chart that reveal the sensitivity of your financial projections to each variable and scenario. You should also identify the variables that have the highest and lowest impact on your financial outcome, as well as the variables that have a positive or negative correlation with your financial outcome. You should explain the logic and implications of your findings, and highlight the key insights and takeaways for your business plan.

5. Adjust and optimize your financial model based on the results of your sensitivity analysis. You should use the feedback and information from your sensitivity analysis to improve and refine your financial projections. You should also consider the possible actions and strategies that you can take to mitigate the risks and leverage the opportunities that arise from different variables and scenarios. You should update and revise your financial model accordingly, and document the changes and assumptions that you make.

To illustrate the concept of sensitivity analysis, let us consider a simple example of a hypothetical business that sells coffee. The business has the following financial projections for the next year:

- Sales volume: 10,000 cups per month

- Price: $3 per cup

- Variable cost: $1 per cup

- Fixed cost: $5,000 per month

- Revenue: $30,000 per month

- Profit: $15,000 per month

We can conduct a sensitivity analysis to test how different variables affect the profit of the business. For simplicity, we will focus on two variables: sales volume and price. We will assign a range of values for each variable, as follows:

- Sales volume: 8,000 to 12,000 cups per month

- Price: $2.5 to $3.5 per cup

We can create a sensitivity table that shows the profit of the business for each combination of sales volume and price, as follows:

| Sales Volume | Price | Profit |

| 8,000 | $2.5 | $9,000 | | 8,000 | $3 | $13,000| | 8,000 | $3.5 | $17,000| | 10,000 | $2.5 | $10,000| | 10,000 | $3 | $15,000| | 10,000 | $3.5 | $20,000| | 12,000 | $2.5 | $11,000| | 12,000 | $3 | $17,000| | 12,000 | $3.5 | $23,000|

We can also create a tornado chart that shows the sensitivity of the profit to each variable, as follows:

![Tornado chart](https://i.imgur.com/4Yw0tQa.

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7. How to calculate how much money you need and how you will use it?

One of the most crucial aspects of your business plan is estimating how much money you will need to start and run your business, and how you will allocate it to different expenses and investments. This will help you determine the feasibility of your venture, the amount of funding you will need to raise, and the financial performance you will expect to achieve. To calculate your funding requirements, you will need to follow these steps:

1. Identify your startup costs. These are the one-time expenses that you will incur before you launch your business, such as legal fees, equipment, inventory, licenses, etc. You can use online calculators, industry benchmarks, or quotes from suppliers to estimate these costs. For example, if you are opening a coffee shop, you might need to spend $10,000 on equipment, $5,000 on inventory, $3,000 on rent deposit, and $2,000 on legal and accounting fees.

2. Project your operating costs. These are the ongoing expenses that you will have to pay to keep your business running, such as rent, utilities, salaries, marketing, maintenance, etc. You can use historical data, industry averages, or market research to estimate these costs. For example, if you are running a coffee shop, you might have to pay $2,000 per month for rent, $500 for utilities, $8,000 for salaries, $1,000 for marketing, and $500 for maintenance.

3. Forecast your revenue. This is the amount of money that you will generate from selling your products or services to your customers. You can use market analysis, customer surveys, or competitor data to estimate your revenue. For example, if you are operating a coffee shop, you might expect to sell 200 cups of coffee per day at $3 each, resulting in a daily revenue of $600 or a monthly revenue of $18,000.

4. calculate your break-even point. This is the point where your revenue equals your total costs, meaning that you are not making a profit or a loss. You can use the formula: break-even point = Fixed costs / (Revenue per unit - Variable cost per unit), where fixed costs are the costs that do not change with the level of output, such as rent and salaries, and variable costs are the costs that change with the level of output, such as inventory and utilities. For example, if you are running a coffee shop, your fixed costs might be $11,000 per month and your variable costs might be $0.5 per cup of coffee. Therefore, your break-even point would be: Break-even point = $11,000 / ($3 - $0.5) = 4,400 cups of coffee per month.

5. Determine your funding gap. This is the difference between your funding requirements and your available funds, such as your personal savings, loans, grants, or investments. You can use the formula: funding gap = startup costs + (Operating costs - Revenue) x Number of months until break-even. For example, if you are starting a coffee shop, your funding gap might be: Funding gap = $20,000 + ($12,000 - $18,000) x 6 = $44,000. This means that you will need to raise $44,000 to cover your expenses until you reach your break-even point.

By following these steps, you will be able to calculate how much money you need and how you will use it for your business. This will help you create a realistic and convincing financial projection for your business plan. Remember to review and update your funding requirements regularly, as they may change over time due to market conditions, customer feedback, or operational adjustments.

8. How to present your financial projections to potential investors and lenders?

After you have prepared your financial projections, you need to present them to potential investors and lenders in a clear and convincing way. Your financial projections are not just numbers, they are the reflection of your business plan, your vision, and your strategy. Therefore, you need to communicate them effectively and persuasively to your audience. Here are some tips on how to do that:

- 1. Tailor your presentation to your audience. Different investors and lenders may have different expectations and preferences when it comes to financial projections. Some may want to see more details, some may want to see more scenarios, some may want to see more graphs and charts. You need to research your audience and understand what they are looking for, and then customize your presentation accordingly. For example, if you are pitching to a venture capitalist, you may want to emphasize your growth potential and your competitive advantage. If you are applying for a bank loan, you may want to focus on your cash flow and your repayment ability.

- 2. Highlight your key assumptions and drivers. Your financial projections are based on certain assumptions and drivers that affect your revenue and expenses. You need to explain what these are and how you derived them. For example, you may have assumed a certain market size, growth rate, customer acquisition cost, pricing strategy, etc. You need to justify these assumptions and drivers with data, research, and logic. You also need to show how sensitive your projections are to changes in these factors, and what are the risks and opportunities associated with them.

- 3. Provide a range of scenarios and outcomes. Your financial projections are not set in stone, they are subject to uncertainty and variability. You need to acknowledge this and provide a range of scenarios and outcomes that reflect different possibilities. For example, you may have a base case, a best case, and a worst case scenario, and show how your revenue, expenses, profit, cash flow, and valuation change under each scenario. You also need to explain what are the drivers and assumptions behind each scenario, and what are the actions and contingencies you have in place to deal with them.

- 4. Use visual aids and storytelling. Your financial projections may be complex and technical, but you need to make them easy to understand and engaging for your audience. You need to use visual aids such as graphs, charts, tables, and diagrams to illustrate your numbers and trends. You also need to use storytelling to connect your numbers to your business plan, your vision, and your strategy. You need to show how your financial projections support your value proposition, your competitive advantage, your market opportunity, and your growth potential. You need to tell a compelling story that shows why your business is worth investing in or lending to.

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