Financial forecasting & planning Essay

Financial medical prognosiss be, quite simply, your apprehend of how your commercial enterprise leave carry pop surface pecuniaryly over, say, the course of study ahead. Preparing forecasts go out help you to assess your believably sales income, be, external financing needs and breadability. Financial forecasts atomic number 18 essential if you need to overturn money from a third gear party, such as a cashbox. But they also provide you with the means to monitor performance on, say, a monthly considerations and thereby come effective pecuniary find out arguably the second most important management function in running a business. ObjectivesThe ride of this section is to help you to prep ar financial forecasts. It will enable you toUnderstand greeting and pricing procedure break-even analysis as a way of mountain sales targetsUnderstand financial foretellingAssess operative capital of the United States requirements.AssignmentThe purpose of these assignmen ts is to ensure that you are able to prepare the necessary financial forecasts for your business. Satisfactory completion of the set of assignments will demonstrate that you know and understand how to Identify and calculate the financial outlines it will be necessary to prepare. Calculate your use up personal survival budget.Determine the funding/materials requirements of starting in business. Consider how you will load down and keep effective financial control of the business. Consider and excogitation to deal with alternative scenarios.1. Personal budgetHow much money do you need for yourself. Think about food, clothes, holidays, personal travel, etc. Draw up a personal budget. Dont skimp. You whitethorn be in business to give way fun but you need to make money as well. Use this budget in calculating your represent and prices. Of course you may not amaze enough sales at the start to be able to take that enumerate of money, so you should also calculate the minimum requirem ent that you must take from the business.2. Costing and pricingCalculate each(prenominal) your cost and monishmine a suitable price for your product or service. Think about your raw material requirements as part of your direct be view about your pre sum upable overhead costs.3. Break-evenNow that you have calculated tout ensemble your costs and set a price, you should be in a position to prepare a break-even chart. Is your forecast of sales above or below break-even? Do you have a reasonable margin of safety? How much proceeds will you make if you procure your sales forecast?4. Forecasting make headway and overtakingYou should have all the figures that you need to prepare a forecast of boodle and loss. What is your anticipated gross profit margin? What is your operating profit? How much money will be retained in the business?5. Cash feast forecastingYou should have all the figures that you need to prepare a property flow forecast. Remember to think about all(prenominal) thing posen on the profit and loss name, usance items not shown on the profit and loss and, in particular, to think about timing or receipts and payments. You will also need to think carefully about your stock memory requirements and your capital expenditure. The first time you prepare the cash flow, ignore some(prenominal) investment or borrowing other than that required for capital equipment. The worst accumulative deficit will indicate the minimum level of working capital required.6. Forecasting your balance tabOnce you have completed the profit and loss and cash flow forecasts, youshould be able to prepare a balance sheet forecast. What level of working capital requirement is suggested by the balance sheet?7. Sensitivity analysisHave another look at your profit and loss and cash flow forecasts. What happens if sales are 15% less than you have forecast? Do you still make a profit? What happens if raw material prices go up by 25%? What does this do to your profitability? fa nny you pass on such growings to your customers or will they switch suppliers?8. Effective financial controlYou should now be in a position to exercise control over your business. Will you use a childly manual book-keeping system or a computerised one? As a brief reminder, issue down the identify reasons for keeping effective financial control. What are the critical numbers at which to look to ensure you retain effective financial control?Break Even AnalysisBreak-even analysis identifies the point at which your business starts to make a profit. You freighter work out the break-even point using any timescale, e.g. weekly, monthly, yearly, etc. To calculate the break-even point you need to know the following The total fixed costs of your business these include rent and rates, your drawings, loan refunds, etc The total versatile costs for producing your product these include labour, materials and packaging and The dealing price of your product.Once you have these figures, you can work out your break-even point using four simple calculations and plotting the findings on a graph.ExampleRon from Widgets R Us want to work out how many thingamajigs he needs to sell in order to break-even every month. He works his fixed costs out as followsRent 167 per monthSalary 834 per monthRates 70 per monthLoan repayment 100 per monthTotal 1,171(1 = Rs.84)(Note It is better to round figures up rather than down, as this will increase your safety margin.)This figure can be plotted as followsRon thence works out his variable costs for the production of each widget Materials 9.00Packaging 1.00Labour 11.00Total cost 21.00 per widget(1 = Rs.84)He selects a range on the number of widgets axis (in this case, 250) and does the following calculation 250 widgets x 21.00 per widget = 5,250Ron plots this figure on the graph and draws a straight line from it to zero.The next step is for Ron to work out his total costs. To do this, he adds his fixed costs to his variable cost s 1,171 + 5,250 = 6,421 (1 = Rs.84)He plots this figure on the graph and draws a straight line from it to 1,171 on the Pounds axis.Ron now needs to work out his revenue line. To do this, he simply multiplies his products change price by the example number of widgets he chose earlier (250) 32.50 x 250 = 8,125 (1 = Rs.84)He then plots this figure on the graph and draws a straight line from it to zero.Ron can now find his break-even point simply by locating the exact point where the revenue line disects the total costs line.In this case, Ron must sell 100 widgets each month if his business is to break-even. If he sells more(prenominal)(prenominal) than 100, he makes a profit if he sells less he makes a loss.Costing And PricingCostsAlthough accountants define costs in several different ship canal, there are, effectively, just two types of cost. The first cost is that which is at once attributable to the product or service. Direct costs include, for example, raw materials and sub-con tract work. If you make desks, for example, the cost of wood will be a direct cost. Within reason, the cost will be the same for each desk, no matter how many desks you make. When you make a sale the income first has to cover the direct costs relating to that sale. whatever is left is called gross profit or contribution.All other costs are overheads. These include, for example, staff salaries, marketing, rent, rates and insurance. They also include derogation that is, an fall by the waysideance for behave and tear on capital equipment. Overheads are often called fixed costs because, generally, they are fixed for the business. Interest is often regarded as a deduction from boodle profit rather than an overhead cost. You need to include it as an overhead in your costing calculations, even though it varies with the size of your overdraft or loan. If you are self-employed, you will take drawings from the business. Whilst, strictly speaking, drawings are an advance a sack upst profi t, include them (and an allowance for income tax) as an overhead when calculating total costs.The contribution is so-called because it contributes towards covering the overhead costs. all(prenominal) sale generates a contribution. When enough contributions have been made, and all the overhead costs are covered, they start to contribute to net profit. PriceThe price at which you sell your product or service clearly needs to exceed the total costs of providing it. But the price should also reflect what the market can stand. If you are selling a differentiated product or haveadopted a strategy of market focus then you may also be able to charge a premium price. If you are pursuing a cost leadership strategy you will need to be ruthless in keeping your costs down and under control.In calculating your price you will need to follow a number of steps Estimate your in all probability sales for a period, say, one year Calculate the total direct costs and divide by the sales volume to give direct costs per building block (say per product or per hour of service) Calculate your total overhead costs and divide by the sales volume to give overhead costs per unit Add direct costs per unit and overhead costs per unit to give total cost per unit and, Add a get along profit margin (to allow for reinvestment, etc). If necessary, add bathtub as well. You now have a first stab price. How does that compare with your competitors? Will customers buy at that price? Do you need to reduce costs? Can you achieve a higher profit margin?What happens if you fail to achieve sales at the determined price? Remember that the overhead costs are fixed, so if sales fall the overheads will be spread over fewer items and the unit cost effectively increases. The converse is also true. Increasing the volume of sales means that the overheads are spread over more units, so the unit cost falls. This means that you can, if you choose, reduce the price. And reducing the price might increase your level of sales. Its a fine balancing act.DepreciationDepreciation is an allowance for snap and tear on the equipment used in your business. As time passes, your equipment will usually lose value, and this can be considered a cost to your business. You need to think about how long you expect your assets to last. For example, if you purchase a computer system, you may forecast that in 5 years it will be obsolete. That means the depreciation rate is 20% per year. If you determine it to be 2 years, then it will be 50% per year. This does not have any effect on cash flow, just on how profits are calculated. Deprecation is an accounting cost that must be included to give a Profit & Loss account more relevance. Finance Action Planner (FAP)The Finance Action Planner (FAP) is a learning tool that will help you to Develop your all-round financial skillsLearn more about a range of financial issuesIdentify suitable sources of financeCreate a set of financial forecastsTest out different financial sc enariosFinancial forecastsOnce you have an idea of your promising costs and an idea of how much you need to sell to make a profit you are in a position to prepare financial forecasts. on that point are three basic financial statements (the profit and loss account (P&L) the cash flow statement and the balance sheet) that describe the activities and financial state of any business. These can be prepared on a historical basis to show how a business performed during a defined period or as forecasts as estimates of how the business will perform in the future. 3 steps to forecasting1. Businesses often start by forecasting their cash flow and then aim to derive other forecasts from it. It makes more sense, however, to start by forecasting the income and expenditure of the business, which will indicate whether you will make a profit, then worry about when money will be received or paid out to discover if you will have enough cash when it is needed. Income and expenditure is summarise d in a profit and loss account. 2. You will also need to look at your likely sales for, say, the year ahead. This needs to relate back to your market research and, if you are already in business, to previous performance.The direct costs can then be estimated (usually as a percentage of sales) to give gross profit. 3. The next step is to estimate the likely overheads. Deducting these gives an operating profit forecast. If the net profit is too low you will either need to assess whether you can achieve higher sales or whether you can reduce the overheads. When preparing your forecasts, remember to allow for increased costs, for instance, due to inflation or future pay awards. If you do need a loan, then you will also need to allow an amount for loan interest. If you use equipment, remember to allow for depreciation. Whilst depreciation isnot included in the P&L, you may need to allow for the replacement or repairs of machinery, so you may wish to include a contingency.The P&L forecast will show whether you are likely to achieve your first key financial requirement making a profit.Preparing cash flow forecastsIn preparing your forecasts, you will need to think carefully about all your costs, about your price and likely sales at that price and about the timing of both receipts and payments.As mentioned above, the first forecast that you set out should ideally be a P&L, summarizing income and expenditure for, say, the year ahead. You might do this monthly or annually. The P&L is important for demonstrating profitability over the very short term, however, the key requirement is to generate cash and know the businesss working capital requirements. This can best be done by preparing cash flow forecast which should set out all the information, month by month, regarding cash inflows and outflows. The cash flow forecast should include Receipts of cash from customersPayments for raw materialsPayments for all other expensesDrawings and wagesCapital expenditureCapital, loan s or grants introducedLoan repaymentsVAT receipts and payments (if VAT registered) and,Tax payments.All of these items should normally be shown separately and in the month into which the money will be received, or paid by, your business.For businesses with a modest turnover and that demonstrate profitability in the year, it is normal only to forecast one year ahead, with a monthly cash flow. Larger businesses, especially those seeking equity investments and/or which do not show profitability in the year, may need to prepare forecastsfor two or three years. The first year cash flow is usually shown monthly, the second year quarterly and the third year just a single annual figure.It is often helpful when preparing cash flow forecasts initially to ignore any finance that is available from the edge or other lenders. The cash flow forecast then shows the true position of the business. It can then be used to decide if the budget is practicable and can be adjusted to reflect the true pos ition and to assess the total funding requirement.If you do not have sufficient money of your own, then you will need to seek loan finance or an equity investor. Most pocket-sized businesses simply look for loan finance. Aim to match the term of the loan to the life of the asset for which it is required. It would be normal to look for a short-term loan, for example, to purchase equipment, or a long-term loan to purchase premises. You will also need to buy stock and pay overheads whilst awaiting payment from your customers. The money required is called working capital and is typically funded by an overdraft. When preparing your cash flow forecast, you may like initially only to include personal investment or loan finance for fixed assets and to ignore funds for working capital. The worst cumulative deficit will then give an indication of your total working capital requirement. Of course, the amount that you need to borrow can be reduced if you have more available to invest yourself. If you have a term loan, the capital repayments will not figure in your profit and loss account they are not a business expense although the interest portion of the repayments will be charged as an expense. However, the repayments do need to be included in your cash flow forecast.Balance sheetThe money in a business can only come from three sources capital introduced by the owner(s) loans (whether from the bank or, effectively, from creditors) and, retained earnings that is, profit which has been generated by, and retained within, the business. That money is used to finance the fixed and contemporary assets of the business. Current liabilities includeCreditorsOverdraftsLoans due within one yearMoney owed under hire purchase agreementsAny amounts owed in VAT or tax, etc.In larger businesses, loans falling due in more than one year are usually shown separately. You will, however, have a better idea of your businesss performance if you show all loans as current liabilities.Current a ssets less current liabilities show your working capital requirement. Since the balance sheet is merely a snapshot, however, it may be better to deduce your working capital requirement from the cash flow forecast.The net assets are always equal to the capital introduced plus reserves that is, the net finance, sometimes known as net worth or the equity of the business.The net finance, together with any long-term loans, is called the capital employed. All borrowing should be included when calculating capital employed.Pricing strategiesThe greatest danger when setting a price for the first time is to pitch it too low. Raising a price is always more difficult than trim backing one, yet there are great temptations to undercut the competition. It is clearly important to compare your prices to your competitors, but it is essential that your price covers all your costs. There are a number of possible pricing strategies from which you might choose. These include 1. Cost based pricing tota l costs are calculated and a mark up is added to give the required profit. 2. Skimming you charge a relatively high price to recover set up costs readily if the product is good or new. As more competitors enter the market, you lower the price. 3. Individual you negotiate prices individually with customers based on how much they are prepared to buy. 4. Loss leaders if you wish to sell to a particular market then you might sell one product or service cheaper to gain marketentry.You balance this by selling other products or services at a higher price. This can be risky as the danger is that everything becomes a loss leader. 5. Expected price what does the customer expect to pay? If you are selling a quality product, do not under price. a good deal the customer expects to pay a lot as the product or service has a certain snob value and this may be change magnitude if you under price. 6. Differential pricing you charge different segments of your market different prices for the sa me service. For example, offering discounts to certain people like pensioners or the unemployed, or charging lower rates for quiet periods. If, after working out your costs, the price you charge is much greater than your competitors then you will have to look at ways of reducing costs.Sensitivity analysisIt is important to know how sensitive your forecast is to changes. Sensitivity analysis looks at what if? scenarios. What happens to your cash position, for example, if sales fall by 10%? What happens if your main supplier increases raw material prices by 12%? Financial institutions when considering propositions for a loan particularly use sensitivity analysis. If your business is particularly sensitised to small changes, then you probably do not have a sufficiently large profit margin. You will thus be less likely to receive the loan required. You may find it difficult to cut costs. You may not be able simply to increase prices to improve your margins that might deter customers. Are there other ways in which you can push up the margins, e.g. by increasing output?Having undertaken your sensitivity analysis, you may need to refreshen elements of your forecast. Sensitivity analysis can help in making decisions. You may want to consider, for example, the effect of increased raw material, labour or overhead costs of reducing prices, with constant volumes, to counteract competitors or reducing volumes, with constant prices, due to over optimistic forecasts. Furthermore, if you are about to spend a large sum of money on equipment, you may want to look ahead several years, if at all possible.Including a sensitivity analysis in your business image will demonstrate thatyou have thought about some of the potential risks and that is half way to avoiding them.VAT (Value Added Tax)VAT is tax paid on the value added at each stage of delivery of a product or service. It is a method whereby businesses act as tax collectors for the Government. If you are registered for VA T, by submitting a VAT return you can claim back what you have paid in VAT, and hand over what you have collected. Not all goods are assessable for example, insurance, some education and training, and postal services are exempt. If items are VAT-able, then, ignoring VAT on fuel, there are two rates standard (currently 17.5%), and zero-rated. Zero rated items are different from exempt items. It is only necessary to register if your output is taxable. If you do register, you will be able to recover VAT on your purchases including materials, capital equipment and overheads. You will, however, have to charge VAT on your sales.The difference between what you collect and what you pay out in VAT is passed on in due course to springer & Excise. There is more paperwork involved if you are VAT registered you need tax invoices showing your VAT number, an analyzed VAT account, and VAT return forms. It may, however, be expedient to register voluntarily if your sales are below the turnover limit, because VAT paid on purchases can be reclaimed. You may also reclaim VAT on capital equipment, raw materials and stocks bought before registration, provided the business still owns them. If you are selling to VAT registered businesses, it is likely to be more attractive for you to register. If you are selling to the general public, it probably will not be. This is, however, an area where you should seek professional advice.CASE STUDYBrians Book-keeping BusinessBrian runs a book-keeping service for several small businesses. His overheads are as follows Costs Per year (1 = Rs.84)Office costs5,000Advertising 1,100Insurance550Telephone650Vehicle running costs900Other3,000Brian works 40 hours per week. He spends 8 hours per week on administration, marketing, etc. He works 45 weeks each year allowing for holidays and illness. Brian draws 200 out of the business each week.Brian has been asked to undertake a specific task and estimates he will need to spend 12 hours on it. What is th e cost of providing the service?How much should he charge?SolutionWhat is the cost of providing the service?1. Total hours worked per annum = 32 hours per week x 45 = 1,440 hours 2. Total drawings = 200 x 52 = 10,4003. Total fixed costs = 11,2004. Total costs = 21,6005. Costs per hour = 21,600/1,440 = 156. For a job lasting 12 hours, the cost is 180(1 = Rs.84)How much should he charge?Brian has decided that he should also add a further 20% profit margin in case his costs go up and to make a little extra for reinvestment. 180 + 20% = 216He is also registered for VAT and needs, therefore, to add VAT at the standard rate (17.5%)216 + 17.5% = 253.80So the price he charges to his customer is 253.80Useful tips1. Some readers of your business plan will regard the financial forecasts as the most important component. It is where you summarise the evaluate income, dependent on your market research, and where you set out your expected costs. 2. The forecasts need to demonstrate that the bus iness is viable and that there is a sufficient margin of comfort to allow for fall in demand or increase in costs. 3. Take care to prepare your financial forecasts asaccurately as you can. Then compare your actual results with your forecasts and, if necessary, take corrective action at an early stage to keep yourself on course.