How is this module organized? Suggestions on how to use this module The six-pointed star A. How to Test if Your Business Will Make Money Introduction Financial Feasibility Study of the Business’ Offerings Introduction The analyzing process Uses of the analysis Summary Break-even Point (BEP) Analysis Introduction to break-even point analysis How to perform a break-even analysis Assignment of costs Variations of the break-even analysis Points to consider when using break-even analysis and related formulae Uses of the break-even analysis Summary Preparing Pro-Forma Cash Flow Statements Introduction How do you prepare a Pro-Forma Cash Flow Statement? Other products and modules for sale Glossary of Terms How to Test if Your Business Will Make Money Business Description Goals and Results Business Offerings Marketing Finances Personnel Management A CorNu Enterprise Educational Product BIZBITE CONSULTING GROUP How to test If Your Business Will Make Money Every effort was made to ensure that these materials comply with the requirements of copyright clearances and appropriate credits. CorNu Enterprises Inc. will attempt to incorporate in future printings any corrections communicated to it. Copyright 2004 CorNu Enterprises 1412-621 Discovery Street Victoria, BC V8W 2X2 All Rights Reserved Printed in Canada BIZBITE CONSULTING GROUP How to test if your business will make money © i CorNu Enterprises Inc. Disclaimer The personal experience of the content specialist, Graeme Robertson, forms the bases for this material. 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Any modification or merged por tion of this or any other CorNu Enterprises course, in whole or in part, is prohibi ted except as authorized in advance by CorNu Enterprises. If you transfer possession of any copy, modification, or merged portions of any CorNu Enterprises materials without authorization, you may be liable for prosecution and CorNu Enterprises may take legal action against you and/or your company. BIZBITE CONSULTING GROUP How to test if your business will make money © ii Credit Page The founders of BizBite Consulting Group and developers of CorNu Enterprises dynamic approach to education are Graeme Robertson and Dr. Shirley Chapman The following people contributed to this document: Content Specialist J J J . . . G G G r r r a a a e e e m m m e e e R R R o o o b b b e e e r r r t t t s s s o o o n n n Graeme Robertson is a seasoned business management professional with over 30 years of experience. He has held senior positions in retail, wholesale, and distribution operations. Additionally, Mr. Robertson was Regional Manager for a national personnel-consulting firm and he has been actively engaged in business management consulting for over 20 years. Designer and Developer D D D r r r . . . S S S h h h i i i r r r l l l e e e y y y C C C h h h a a a p p p m m m a a a n n n B. Ed. M.Ed. Ph.D. Dr. Shirley Chapman is a veteran educator with over 30 years of experience. She is an expert in course/program desi gn and development. Her experience covers public schools, colleges, and universities . Shirley is experienced in designing and developing training specif ically for delivery via face-to-face, on-line (Internet), and manuals for organizations, colleges, and businesses. She is responsible for the page layout and format as well as the graphi cs in any materials that she designs. BizBite Consulting Group How to test if your business will make money © iii How is this m odule organized? We divided the How to Test Your Busi ness will make Mone y module into three major headings: 1. Financial feasibility study of the business offering 2. Break-even point analysis 3. Preparing pro-forma cash flow statements Within the module, the material is divided into these headings: Introduction How to use this section New businesses Existing businesses (Content of the section) Uses Summary Celebrate Celebrate! It is important that you r ecognize your achievements and celebrate each small step. Phone some friends and celebrate it. We w ill offer you opportunities to celebrate at the end of each part of the module. Have fun with them. We had fun creating them for you. BizBite Consulting Group How to test if your business will make money © iv Suggestions on how to use this module This module is organized so that you decide: • In what order you want to access the various titles • What you want to ignore • How many times you want to revisit the material Just return to the Table of Contents and click on what you want to read or review again. The six-pointed star We have depicted business a nd a business plan as a six-po inted star. Each part of the star represents a major aspect of your business a nd an important element of a business plan. Togeth er, they form a complete view of your business and your business plan. We have carried this star thr oughout all the BizBite Consulting Group products and all the modules. As each new section is begun or completed, the ap propriate part of the star is colored and the rest of the star is colorless. This may help you to see how a specific topic relates to the whole business and to remind you that it is part of the whole. BIZBITE CONSULTING GROUP How to test if your business will make money © 1 How to Test if Your Business Will Make Money Will this idea work in my business so that I can make money? How can I test it? G G G l l l o o o s s s s s s a a a r r r y y y Each term that is used in this se ction is defined in the Glossary of Terms. You will notice that the fi rst time it is used it is coloured green in Bold Italics. Click on the Glossary in the Bookm arks or Thumbnails and scroll down to find the defi nition. Alternativel y , p rint the Glossar y . BIZBITE CONSULTING GROUP How to test if your business will make money © 2 Introduction Once the market has been thorough ly researched an d analyzed and a marketing plan developed, you must test whether the plan can be handled financially by your business. Can adjustments be made to the marketing plan if the business cannot handle the marketing plan? What will those adjustments be? Will it be possible to start with a less ambitious plan and phase in th e original plan? All of these considerations , and more, are the purposes behind doing financial test s of the marketing plan. In the first two sect ions of this module we will discuss: 1. Financial feasibility st udy of the business’ offerings 2. Break-even point analysis BIZBITE CONSULTING GROUP How to test if your business will make money © 3 Financial Feasibility Study of the Business’ Offerings Introduction Whether it is a new business or an exis ting business, the de cision-making process regarding what offerings your business is go ing to market, or is marketing, are the same. This section assumes that you have already completed :  Competition and your competitive edge  Market analysis  A customer/client profile analysis  Products and sources of supply  The marketing plan  The target market and target marketing plan A financial feasibility study will determine if your o ffering mix or offering line is financially doable. It answers this question: Will you make a profit with this offering line or offering mix to these desi gnated market segments? BIZBITE CONSULTING GROUP How to test if your business will make money © 4 How to use this material New businesses This module assumes that you have alrea dy made tentative decisions about what offerings the business will sell. Take this la st step. You need to complete a financial feasibility study of them before coming to a final decision. This feasibility analysis will determine if you can make a profit using this market segment with these offerings. For a new business, the offe rings will be proj ected and the calculation estimates based on industry norms derive d from your market research. Existing businesses An existing business has the a dvantage of having historical data. It also has a great deal of local knowledg e about the market it serves. However, every time a business plan is prepared, it is important to go through the same process by • Testing the current offerings mix • Examining and considering new offerings that may be avai lable or offered by competitors Through the financial feasibility process outlined belo w, your business will decide at regular intervals (yearly busin ess plan proces s) whether to: • Add new offerings • Expand, curtail or elimin ate current offerings For both new and existing busin esses, this analysis is an important forerunner to the development of goals and re sults and especially to th e marketing strategy of the business plan. This is because a major commitment of the resources of a company will be directed towards the marketing of whatever offering mix is selected. BIZBITE CONSULTING GROUP How to test if your business will make money © 5 The analyzing process Use this analyzing process to determine if it is financially doable to sell the offerings • To the various specifie d market segments • At the specified prices The six steps of this analyzing process are: 1. List and describe the vari ous offerings of your busi ness (either th e ones that you already have on hand or those that you tent atively have chosen.) There is an example belo w that demonstrates the next three steps. (2, 3, and 4) 2. Describe the relationshi p, if any, between each market segment of your business • Describe the part each market segment plays in the business • Identify the relative importance of each market segment of your business 3. State the volume contributio n of each market segmen t versus the time spent and expenses incurred 4. State the profit contribution of each market segment versus the time spent and expenses incurred 5. Show a Break-even analysis (B EP) of each market segment (See Break-even Point Analysis below ) 6. Draw conclusions about your offering mix and your market segments No two businesses are the sa me. In addition, the relationship between business segments is often c onstantly ch anging. BIZBITE CONSULTING GROUP How to test if your business will make money © 6 Here is an example of thre e of the steps (2–4) mentioned above and how decisions can be made because of the analysis. For Example The chart below indica tes the answers to the next five questions: This example is a continuation of the building materials business mentioned in Goals and Results ( Writing goals and results ) and Business Descriptions ( Why write business descriptions ? In the module, Overview of Business Plan—Why you need one . ) 1. The five market segments in this example are retail, commercial, industrial, go vernment, and institutional. 2. The volume’s contribution of each market segment is 25%, 45%, 15%, 5%, 10% respectively 3. What proportion of revenu e does each market segm ent contribute to the business? See number 1 in the chart below. 4. What is the profit contribution of ea ch market segment? See number 2 in the chart below. 5. What is the proportion of the expenses used by each market segment? See number 3 in the chart below. Institutional Commercial Industrial Retail Gov’t 1. Proportions of revenue 25% 45% 15% 5% 10% 2. Profits contributed 55% 30% 3% 5% 7% 3. Expenses used 30% 45% 10% 10% 5% You, or your business manager, may well decide that the sales volume and profit contribution of the industrial , government, or in stitutional business is not worth the drain on the resources of the organization. BIZBITE CONSULTING GROUP How to test if your business will make money © 7 Because of the analysis, it could be decide d to cut back or eliminate these market segments. In this example, the commercial busine ss segment uses 45% of the expenses and only contributes 30% of the profit. However, in th is type of business often volume buying required to serv ice the commercial busin ess segment lowers the overall cost of the offerings. The commercial business segment enhanc es the profit margin of the retail market segment . If the company re duces the commercial business, it could have an adverse effect on th e total profit of the company. Therefore, the decision will likely be to retain the commercial market segment. As you can see from this simple exam ple, the relationshi p between market segments can be complex and have many variable factors to consider. It is, therefore, very important that these re lationships be anal yzed frequently. You have completed the market research—n ow you can make some final decisions about the specific offerings with whic h you will provide your customers. Make those decisions. Place a summary and conclusion of this analysis in your business plan. The analysis should be placed either in the business plan Appe ndix or kept in files (filing cabinet or computer). As already indicated, complete this analysis more frequently than once a year. Possibly, add thes e other analyses to y our business plan as addenda. Write a detailed descripti on of the offerings (or cate gories of offerings) you are going to market and place it in your business plan. This detailed description should include all the decisi ons made in the previous sections about your busine ss, your offerings, and your customers/clients that relate to yo ur offerings. It should include all the details that a re pertinent to the offerings like the: Exact quality of offe rings Name brands Volume Names of wholesalers Sizes Size of inventory BIZBITE CONSULTING GROUP How to test if your business will make money © 8 If you are an existing busine ss, indicate which ones are added, modi fied or changed from the last busines s plan. (Use colour for this step.) Review your description of your market segments in your business plan ( The Customer/client base, found in the module, Market Analysis and Supplier— Keys to success ) and add the following information to each market segment listed. • Proportions of revenue • Profits contributed • Expenses used Uses of the analysis There are several uses for the offering analysis . Use it to: 1. Assist you in developing goals an d results for your business plan 2. Make decisions about retaining or dism issing either mark et segments or specific offerings 3. Make decisions about addi ng or modifying offering s or market segments 4. Make decisions of which market segments and offe rings your new business will have 5. Write your marketing plan. Summary This section is the final step for a ne w business in determ ining what market segments should be targeted and which offerings should be marketed. This section provided the framework for making your final decisions about the offerings your business would market for both the new a nd the existing businesses. BIZBITE CONSULTING GROUP How to test if your business will make money © 9 Celebrate!! Now I know how to test my business ideas before implementing them. BIZBITE CONSULTING GROUP How to test if your business will make money © 10 Break-even Point (BEP) Analysis Introduction to break-even point analysis The break-even point analysis is one of the most importa nt tools in assessing the viability of pursuing new market segments as well as the relative return on investment of various existing market segments. A break-even point (BEP) is the point where the business’ total costs will just equal its total revenue. If you know the break-even po int, you have a definite target to shoot for and can put a step-by-step strategic plan together to achieve the goal. Legend Red bracket indicates the loss area Blue bracket indicates profit area Pink bracket indicates total variable costs Green bracket and line indicates total fixed costs Y Y e e l l l l o o w w oval indicates the break-even point A break-even point analysis can evaluate possible prices. BIZBITE CONSULTING GROUP How to test if your business will make money © 11 Express these objectiv es in dollars or units of pr oduct. A business should do a break-even point analysis frequently. Then, it can be constantly aware of what has to be achieved before the busin ess begins to make a profit. Certainly, before embarking on new pr ograms or focusing on new markets, consider all the expected costs, and complete a break-ev en point analysis. Sometimes, what looks like an attractive business opportu nity is not so great upon closer examination. Increased sales do not necessarily mean increased profits. This is because a dramatic increase in sales, or the launch of a new pr ogram, may necessitate the purchase of additional equipm ent or the funding of additional internal or external resources. The result could be that the ‘bottom line’ or net profit to the company will stay much the same. In other words, the ‘return on investment’ (RO I) is not worth the additional expense. Sometimes, this is only a sh ort-term effect an d, in the long run, making the investment ma y be a good decision. Every business case is diff erent and only the business owners or managers can make that decision. What often happens is the additional invest ment creates unused capacity in the business; th us, the amount of business required to br eak-even or reach profit goals is in creased significantly. The break-even analysis helps the business owner or manager to make intelligent decisions when considering new programs or any additi onal investment in the company. How to use this material New businesses Some of the figures you need to calculate the break-even point will have to be estimates. It is often a good idea to use very conservative sales figures and overstate the expenses somewhat. Existing businesses Some of the figures you need to calculate the break-even point will have to be estimates. It is often a good idea to use very conservative sales figures and overstate the expenses somewhat. BIZBITE CONSULTING GROUP How to test if your business will make money © 12 How to perform a break-even analysis Calculating the break-even point can be simple for a singl e offering business, but more complex for multi-line or multi-servi ce businesses. Whatev er the complexity, the basic technique is the same. Formula Meaning of the formulae Example S = FC + VC S = Break-even level of sales in dollars $221 = $55 + $166 FC = Fixed costs in dollars FC = $55 VC = Variable costs in dollars VC = $166 Examples of fixed costs are : Rent Management salaries Office and administrative expenses Property tax and insurance Interest on loans Depreciation Examples of variable costs are: Raw material Labour (wages) and payroll taxes Packaging materials Outgoing freight Sales Commission Advertising and promotion Expenses for parts Utilities Equipment maintenance Miscellaneous expenses (office supplies, garbage removal) BIZBITE CONSULTING GROUP How to test if your business will make money © 13 Note that both fixed and va riable costs are part of op erating expenses and they appear on the monthly opera ting statement (sometimes refe rred to as the profit and loss statement). A business selling o fferings buys and sells inventory. Inventory is not part of operating expense. It is accounted for as part of the cost of goods sold (CGS ). The examples that follow show the application of a gross margin (GM ) to the sales price in order to determine break- even points and profit goals. The methodology is valid in either a fee-for-service business with no inventory or a business selling offerings. However, in businesses wi th inventory, other accounting issues (for example, invent ory, inventory management, and offering turnover) are not discussed here. Assignment of costs Complete the assignment of costs in as mu ch detailed or generally as necessary. However, complete it based on pe rcent of sales (revenue). If property tax and insurance were $40,000 And the total sales revenue was $600,000 Then, property tax and insurance represents $40,000/$600,000 = .066 or 6.6% of sales In a business that has seve ral divisions or aspects to the business, such as offering sales, a service depa rtment, and product installations, it is necessary to assign properly a fair share of the common overhead expenses. This assignment or pro-rating of common expenses is accomplished based on the sales contribution of the different divisions. For example If the offering sales account is 45% of the total revenue The service department is 30% of total revenue And the product installa tions is 25% of total revenue Then divide the office and administrative expense of the company in th e same proportions between those divisions. BIZBITE CONSULTING GROUP How to test if your business will make money © 14 Take this same approach with in a department in order to assign costs to a particular major offering group or a special project. 1. In a business where goods are manuf actured, raw materials must be acquired and these commodities probabl y fluctuate in price. Labour costs may vary, and sales commissions or shipping cost s may change. 2. In retail or wholesale busi nesses, the cost of goods sold could increase or a new labour agreement with warehouse staff would incr ease labour costs. If the public carrie r you use has to increase thei r rates suddenly, it will obviously increase shipping co sts and affect the profitability of the business. 3. In a service business, star ting a new project or service may require a greater amount of the business’ res ources than expected. Without careful analysis of the internal and external costs that would be involved, th e business could be in for a nasty surprise. Some t ypical factors to examine are: • The extra people necessary • The additional resources de voted to servicing the client in the office • The additional resources devoted to servicing th e client in the field • The additional marketing costs to launch a new program • The possible increased liability exposure to the company • The possible current and future costs imposed by regulatory agencies • To what extent will th e new program impact the financial resources and people resources of the co mpany and, for what period? Without developing careful estimates of the expected cost s and applying a break-even analysis test, the business could em bark on a new program that could prove to be disast rous for the business. When doing these tests, devel op at least three projections: 1. An optimistic result projection 2. An average result projection 3. A pessimistic result projection BIZBITE CONSULTING GROUP How to test if your business will make money © 15 Variations of the break-even analysis Considering all the variable costs can requi re detailed analysis and very thoughtful consideration. This is necessary if you really want to know the true profit picture of the business. If you are calculating a projected break-even point, you may not know all of the variable costs , that being so, you may want to estimate various scenarios. Prepare an optimistic, an average, and a pessimisti c scenario. To perfor m these, a variation of the break-even formula may be used. There are at least three variations of the break-even poi nt (BEP) analysis. Variation 1—When the gross margin (GM) is known Formula Definitions of the elements of the formula Example S = FC+VC/GM S = Break-even level of sales in dollars S = $2,579.55 FC+VC = Fixed and variable costs in dollars FC+VC = $227.00 GM = Gross margin as a % of sales GM = 8.8% (.088) In the above example $2,579.55 (S) = $227 (FC+VC) divided by .088 (GM) Or, it could also be stated another way, namely: .088 (GM) times $2,579.55 (S) = $227 (FC + VC) Therefore, if you know what gross margin you normally expe ct to generate, you can test to see whether yo u can cover basic costs. You may get this information from pr evious years’ financial statements. You may also obtain it by consulting industry standards for your type of business. BIZBITE CONSULTING GROUP How to test if your business will make money © 16 Example 1 Then, based on this historical informat ion and actual percentage to sales relationships of expense items, you can estimate how much gross margin those expenses will likely consume. Equipped with this information, you can now make any necessary adjustments to gross margins or expenses to ensure the profitability of the business. In the example above, what we are illustrating is that .088 (the GM) x $2,579.55 (Sales) = $227.00 (the sum of the FC+VC) If you are selling products, you may translate the dollar break-even point into units of product by simply dividing by the unit cost of the product. (See the two examples below) To arrive at sales objectives for your sa les people, you now are able to calculate how many units they must sell before the company starts to make a profit For some businesses, you may want to extend the exercise to show how many customers are needed to be profitab le. See the example that follows. Here are two examples of using the break-even point analysis formula : Money needed per year/mont h for a break-even point FC + VC = Fixed Costs + Variable Costs $14,700 per year GM = Gross Margin 20.7% BEP = FC + VC/GM (per year) (BEP means break-even point) $14,700/.207 = $71,014.50 (per year) *BEP per mo. = BEP per year/12 (BEP means sales break-even point) $71,014.50/12 = $5,917.87 (per month) BIZBITE CONSULTING GROUP How to test if your business will make money © 17 Example 2 Number of customers per day that are needed for a break-even point There may be hundreds of items, all at different pric es. This example simply assumes, for illustration purposes, that the average per unit is $3.00 in order that you can determine an approximate number of sales necessary for BEP. If the average unit selling price is $3.00 The average customer purchases two times per week $6.00 There are 4.3 weeks/month therefore, the average customer $25.80 sales/month = 4.3 x $6.00 = BEP = FC/GM (per month) (BEP means break-even point) $5,917.87 Consequently, the customers need ed for a break-even point are: 7.6 customers $5,917.87/$25.80 = $230 × 12 month = $2,760 per year/365 days= per day We rounded off the above figures for simplic ity. In addition, the example is typical of a business that sells products rather than a fee-for-service business. In a fee-for-service business, the GM percentage would be much higher, perhaps 60% or mo re and the necessary sales would then drop significantly. For example $14,700 (expenses)/ . 60 (GM) = $24,500 (sales) BIZBITE CONSULTING GROUP How to test if your business will make money © 18 Variation 2—Profit Planning Formula The break-even analysis can be adapte d to profit planning by simply altering the formula slightly. The ba sic formula is P = S - (FC+VC) This formula shows that if you subtract the sum of the fixed costs and the variable costs from sales , what is left over is the profit to the company. Of course, if S - (FC + VC) = 0, then P in this formula is actually the break-even point (BEP) because the sales are exactly offset by the fixed costs and the variable costs. In practice, the profit-pla nning version of the formula is used when the GM is known or assumed to be at a certain level. There are several uses of th e profit plan ning formulae: 1. To illustrate the process, refer to our previous Exampl e #1 where we show how a GM of 20.7% of sales is necessa ry for the busine ss to break-even. Most people would not be satis fied with only breaking even. (GM = gross margin) After all, they may have their life savi ngs invested in th e business and could probably get a better return on their money by ma king other investments or simply leaving the money in the bank and drawing interest on it. 2. Let us assume that the owners of th e business in Example #1 feel that they should earn a 10% return because that is comparable to what they could earn on their money elsewhere. .31 of the selling price (S) = profit (P) + costs (FC + VC) Formula Example .31 x $71,014 = P + $14,700 . 31S = P + (FC + VC) $22,014.49 = P + $14,700 P = $22,014.49 – $14,700 P = $7,314.49 BIZBITE CONSULTING GROUP How to test if your business will make money © 19 Variation 3—Pricing product to achieve profit margin goals Now that you have established the gro ss margin necessary to cover costs and achieved the desired profit, how can you easily use this information to properly price products? The following formula will i llustrate this as it applie s to the example above: S - . 31S = C We are saying here that the selling price (S) - .31S = cost of inventory © Hence: S - .31S = C .69S = C .69 x $71,014.50 = C C = $49,000 What we have shown here is that: If the GM is 31%, the cost of inventory is $49,000/$71,014.50 = .69 or 69% of the selling price. Accordingly, if .69 divides a cost price of any inventory item, we will know the appropriate selling price to yield the desired GM of 31%. The formula is S = C/.69 The formula presented here is useful in maintaining selling prices at levels consistent with the levels of GM percenta ge yield desired. This approach is also consistent with the way in which to show the financial data on the business operating statements. The profit-planning formula is a useful tool in determini ng what sales are required to achieve a desired profit goal. BIZBITE CONSULTING GROUP How to test if your business will make money © 20 You can see how useful and important the break-even point analysis and the related formula are to daily operations a nd to business pl anning. There are many ways to use this technique and we have only discussed a few here. For example, If you were thinking of making a significant capital investment in the business, you might apply the above formulas to: Î Project a worst-case business scenario Î Project a best-case business scenario Î Project a most probable case scen ario for your future business After consultation with yo ur accountant, and perfor ming a break-even point analysis, you may decide to lease that expensive piece of equipment rather than buy it. Be creative and us e the break-even point analysis in areas of the business other than sales. You often have more contro l over expenditures th an you do over sales. A break-even point anal ysis is helpful but do not follo w it blindly. It is useful for analyzing costs and for ev aluating alternatives. The prudent business owner or manager should also relate any analysis to a ‘gut fee ling’ for the needs of the marketplace. Points to consider when usin g break-even analysis and related formulae 1. The break-even point analys is does not consider the effect of price on the quantity that customers/c lients will want (the dema nd curve). It evaluates whether the company will be able to break-even with a particular price, on a specific offering, at a pa rticular point in time. 2. Base the factors used in the formulae on historical data. The marketplace is unpredictable and conditions can, a nd do, change very rapidly. Thus, although break-even analysis and the related formulae are very useful tools, the business owner or mana ger must use them in re lation to her/his best estimate of the changes in market conditions. 3. Sudden increases in ope rational costs can infl uence profitability. 4. Sudden increases in offering cost pric es can necessitate big increases in pricing that may result in plummeting sales. 5. Unexpected consumer demand may resu lt in shortages of supply or the need to commit greater resources to cust omer service. In either event, the impact on profitability could be significant. BIZBITE CONSULTING GROUP How to test if your business will make money © 21 6. The business may suddenly be confro nted with extremely strong price competition, which could drive pr ices down and affect profits. 7. It is a good idea to get in the ha bit of testing a nd monitoring the performance of the business on, at least, a quarterly basis. Risk assessment and break-even analysis s hould be part of any business plan along with the development of cont ingency plans in case of ‘the worst-case scenario’ occurring. Uses of the break-even analysis The break-even analysis can to be used to: 1. Evaluate possible prices of the various product lines 2. Monitor the viability of existing business segments 3. Assess the viability of purs uing new market segments 4. Assess the relative return on invest ment of various existing market segments 5. Test the effect of changing mark et conditions on business segments 6. Test the viability of an y expansion plans such as adding new equipment or entering a new market 7. Assess after addi ng additional production equipment 8. Assess after increasi ng staff for any reason 9. Assess if there are sudde n increases in fees, li cences, or taxes from government or regu latory agencies 10. Assess after—increasing marketing costs to promote an offering. 11. Assess after—increasing marketing costs to service a new market. BIZBITE CONSULTING GROUP How to test if your business will make money © 22 Summary In this section, you have learned how im portant break-even analysis is as a business-monitoring tool. We have discussed variations of the break-even analysis and examples of how to use them within the business. We have shown how to use the break-even analysis and its variations: • Test the feasibility of new business ventures and offering introductions • Test the effect of changes in market conditions • Price offerings at a profitable level If you are preparing an inte rnal business plan, the next step is to prepare: • Pro-Forma Cash Flow Statements (found below) • Operating Statements These will forecast the actual results in detail for the next ye ar’s operations and include summary projections for at least the following two years. We will outline what is necessary in the next section. BIZBITE CONSULTING GROUP How to test if your business will make money © 23 Celebrate!! BIZBITE CONSULTING GROUP How to test if your business will make money © 24 Preparing Pro-Forma Cash Flow Statements Introduction Sometimes, Pro-Forma Cash Flow Statement is labelled a Cash Flow Projection or simply a Cash Flow Statement. We will use a Pro-Forma Cash Flow Statement in this section. Effective cash flow management is essentia l to the continued hea lth and survival of any business. Good cash flow management assists in: Financial planning Inventory purchases Formulating credit and collection policies Renewing business lines of credit Making an effective presentation to your lender Keeping on top of operating capital needs Providing early indications of when expenses are getting out of line BIZBITE CONSULTING GROUP How to test if your business will make money © 25 What exactly does the pro-forma cash flow statement do? A pro-forma cash flow statement compares projected income and expenses with actual income and expenses on a monthl y basis throughout th e fiscal year. It is one of the most effective tools that an owner or manager has to control their business. When asked how they manage their cash flow, many small business people will admit that they really don’t have a formalized plan. They will often say that they ‘sort of kn ow’ or ‘they have a fe el’ for the seasonal changes in their business and cut back or make ad justments accordingly. Comparing the actual cash flow of the busines s to a 12-month cash flow projection can reveal any sudden change s that have occurred in your expenses and the effect that may have on your curren t and future ca sh position. Good cash flow management can take a lot of pressure o ff the business. The cash flow projection is si mply a budgeting tool that , if used properly, can smooth out the highs and lows in your business because of cyclical or seasonal changes. It is not a cure-all, but it do es help to give a sense of direction and, along with a written business plan, cl ears the mind for more pr oductive and creative thinking. BIZBITE CONSULTING GROUP How to test if your business will make money © 26 How to use this material New Businesses For a new business, th e Pro-Forma Cash Flow Statemen t is a particularly important part of the business planning process. After testing the feasibility of the business offerings using break-even analysis, the Pro-Forma Cash Flow Statement projects the result of that analysis over a 12-month period. Spotting fluctuations in cash flow is easy on the spreadsheet. T T h h e e b b u u s s i i n n e e s s s s o o w w n n e e r r o o r r m m a a n n a a g g e e r r m m a a y y t t h h e e n n Anticipate the need for adjusting expenses Arrange for a term loan Arrange for a line of credit Having sufficient capital and financing at the be ginning of the busin ess is essential to the success of the new business. Each month, compare the actual cash fl ow performance of the business to the projected results. By critically examining any ma jor differences, a business manager can identify areas where to ma ke adjustments befo re the business is seriously damage. Existing Businesses The Pro-Forma Flow Statement is just as important for the existing business. However, the existing busine ss has the benefit of busine ss history and, therefore, the projected figures should be a more accurate estimate of the expected business performance. The existing business will use the Pro- Forma Flow Statement to forecast the effect on th e business of: Adding products or services to the business Addition of personnel Consult the Pro-Forma Cash Flow Statement every month to monitor and compare actual and projec ted results. This is an essential pa rt of good business management and planning. A change of location Increases in taxes BIZBITE CONSULTING GROUP How to test if your business will make money © 27 How do you prepare a Pro-Fo rma Cash Flow Statement? In this section, you will move step-by-step through the process of preparing a pro- forma cash flow statement. You will be us ing the following three spreadsheet forms in this process: 1. Projected Cash and Accounts Receivable 2. Projected Accounts Payable 3. Pro-Forma Cash Flow Statement To simplify the illustration, the example used will be the format used for a fee-for- service business. That is a business where revenue is not derived from the sale of products but rather is generated from fees for work performed. Examples of people in this type of business are: Lawyers Accountants Health professionals In these businesses, total sales revenue is derived from the servic es provided to the customers/clients. Security services Consultant In a business selling products, deduct the cost of the product and all the directly related expenses from the selling price in order to determine the net revenue or income derived from sales. Personnel services Real Estate Delivery service In other words, in a business selling products Net Sales Revenue is the selling price less the Cost of Goods Sold. The details of doing this calculation are demonstrated on the Income Statement of the business. We will not be dealing with the Income Statement in this section. A Pro-Forma Cash Flow Statement (Cash Flow Statement) is only concerned with the net cash receipts and expenditures of the business. BIZBITE CONSULTING GROUP How to test if your business will make money © 28 Steps in preparing a Pro-forma Cash Flow Statement (Cash Flow Statement) There are nine steps in the pro-forma cash flow statement process. They are: 1. Estimate sales and fees-for-service. 2. Estimate your revenue received from Accounts Receivable. 3. Decide how much of your business will be for cash or thirty day terms. 4. Repeat the same process as 1–3 only for expense items. 5. Accounts Payable planning is related closely to expected revenues. 6. Enter the estimated total cash received and estimated total expenses on the Cash Flow Worksheet. 7. Fill in all other estimated income and expense items on the Cash Flow Worksheet. 8. Calculate the total Cash In and Cash Out for each month and enter the surplus or deficit on the Worksheet. 9. Enter the opening Cash balance in the first month and carry this forward in each months calculation to arrive at the ‘actual surplus or deficit’ BIZBITE CONSULTING GROUP How to test if your business will make money © 29 The nine steps are explained in detail below. You may find it necessary to print either the set of directions and/or the three spreadsheet forms ( See below ) hence, you can relate the instructions to the worksheet. P P l l e e a a s s e e n n o o t t e e The reference on the Projected Cash and Accounts Receivable worksheet to ‘Enter on line 1’ ‘Enter on line 2’ refers to specific lines on the following Pro-Forma Cash Flow Statement where the summary information is to be entered. In addition, the reference on the Projected Accounts Payable worksheet to ‘Enter on line 22’ refers to the specific line on the following Pro-Forma Cash Flow Statement where the summary information is entered. 1. First, estimate the Sales or Fees-for-S ervice for each mont h of the fiscal year. Factor into these seasonal variations or changes what you expect in the business cycle. For example Use the conservative forecasts if you are in, or expect to be entering, a recession period. On the other hand, use an optimistic forecast if you are in a growth period or, expect to be entering a growth period. The previous year’s results can be a forecasting guide but you may want to apply other standards. However, most of the time, the middle-of-the-road approach is the best. These figures are entered on a spreadsheet 2. Next, estimate your revenue received from the Accounts Receivable for e ach month of the fiscal year. (See example below–Projected Cash and Accounts Receivable) To do this, include: What you would usually expect to re ceive from the previous month’s Sales/Fees What you would expect to receive from 60-day accounts What you expect to receive from all Sales/Fees before 60 days Total these figures and enter them on the Projected Cash and Accounts Receivable spreadsheet . BIZBITE CONSULTING GROUP How to test if your business will make money © 30 3. Decide how much of your business will be for cash or thirty-day terms, and how much will be carried for longer terms. For example If, your business has been 10% cash/30 days and 90% longer credit terms it likely will remain the same if you don’t plan to make changes to your credit policies. If, however, this is obviously putting a strain on the business and you don’t wish to increase your operating loan, you may well want to review your credit policies. You have to decide whether the cost of carrying the additional business on account is worth it. 4. Now, you do the same exercise for your expenses and prepare a spreadsheet if your business involves the purchase and resale of products. (See example below– Projected Accounts Payable) For example First, estimate the purchases you plan to make each month and enter the figures. Then estimate the payments normally made on purchases made on the current month’s purchases, the payments normally made on the previous month’s purchases, the payments normally made on 60-day pu rchases and, finally, the payments usually made on purchases over 60 days. Total the Accounts Payable and enter this on the spreadsheet . BIZBITE CONSULTING GROUP How to test if your business will make money © 31 5. Complete Accounts Payable planning in close relationship to the revenues expected from Sales/Fees. For example Very favourable payment terms at very low or no interest can ease the burden on the business and the expense of each month’s payment is reflected in the month that it will be paid. 6. Now that you have, your total cash received and cash payments estimated, go to your Pro-Forma Cash Flow Statement, (See example below) and enter your totals. If, however, a large purchase is made at a special price but must be paid for now, it may not be a good deal if the goods will not be used up for several months. A very rough ‘rule-of-thumb’ would be, don’t buy more than you need for the next 60 days unless you are getting an additional 5% discount for each additional month you will carry the product. For example, if you were not going to use the product up for 6 months, you would need at least a 20% discount to make the same Net Profit . BIZBITE CONSULTING GROUP How to test if your business will make money © 32 7. Your next step is to fill in all the other items rela ted to income and expense. Under Income is Under Expenses is Other Operating Expenses Loan proceeds–this is the monthly amount received from the operating loan and will be filled in last Sale of Fixed Assets Other Cash Received Rent Management Salaries Other Salaries and Wages Legal and Audit Fees Utilities (heat, light, water) Telephone Repairs and Maintenance Licences and Municipal Taxes Various kinds of insurance Payments on Purchases of Fixed Assets Interest paid on loans (short-term loans, lines of credit, overdrafts) Payments on Mortgages/Term Loans Income Tax Payments Cash Dividends Paid Payments on Accounts Payable Other Cash Expenses 8. When all of this data is ente red, you should now calculate your Total Cash In and the Total Cash Out for each month throughout the fiscal year and determine in which m onths there may be a cash surplus or deficit. 9. Enter the amount of your business opening cash balance in the first month of your fiscal year and carry this forw ard through your calcul ations to arrive at the ‘actual’ projected surplus or deficit each month. This figure is, theref ore, an estimate of the least amount you will re quire as an Operating loan to run you r business. For now, ente r this amount under Loan Proceeds in the Cash In section in order to balance the statement. Once this is completed, you are prepared, along with your financial statements and your business pl an, to meet with your Lender. BIZBITE CONSULTING GROUP How to test if your business will make money © 33 Each month, you will enter the actual figures for the items listed on your worksheet. The items will vary somewhat w ith the business and this is only an example. Communicate closely with your Lender and make them aware of any significant changes, particularly if it may affect your need for operating capital. A well-informed Lender can be a powerf ul resource. However, frequently you hear small businesses complaining about the support of their Lender. Usually, if the truth were known, the real story is that business owners do not do their homework and provide their Lender with the detailed information that is needed. Pro-forma Cash Flow Statement Now you have a projected Pro-Forma Cash Flow Statement. The pro-forma cash flow statement has columns to show the projected income and expense for each month of the fiscal year and blank columns beside each month’s projection to record the actual figures, as they become known. The projected figures are your one-yea r operating budget. Careful analysis of any deviations from this budget can help to minimize expenses and maximize profits—referred to as do ing a Budget Deviation Analysis. It only takes a few hours each month to review and it should be a regular part of your business management activity. It is easy to forget to do some of these business planning and directio n activities when times are good and the business is flying high. Neverthele ss, Budget Deviation Analysis is an essential part of effective business management. Perform a budget Deviation Analysis on a monthly basi s to be meaningful and useful. If a business has se veral projects ‘on the go’ at one time, it may be a good idea to devise separate bu dgets for each project. This is one of the best so urces of current operating information for your business and, if the budgets have been prepared carefully and thoughtfully , the Budget Deviation Analysis will te ll you at a glance, which pa rts of your business, are getting out of control. Experience will te ach you what deviations are significant and what magnitudes of vari ances are important. W W h h a a t t d d i i d d I I d d o o r r i i g g h h t t ? ? BIZBITE CONSULTING GROUP How to test if your business will make money © 34 Carefully and critically examine any change s, whether positive or negative, and the reasons for it determined. If the change is negative, then implement a corrective plan of action. If the change is positive, then you should ask yourself: With a little digging, you may discover something that, if controlled and directed, could have a major impact on the fu ture profitability of the company. Suggestions and tips While doing your Pro-Forma Cash Flow Stat ement for the month, it is important to cast your eye back upon pr evious months to id entify any trends or offsets. A review and analysis of any monthly fluc tuations will often reveal: • The negative deviation in one month is offset by a positive deviation in the following month • Seasonal fluctuations or business cycle factors that are, perhaps, because of the variable timing of projects With experience, budgeting a nd analysis will become mo re exact and you will have greater control over the pr ofitability of your busine ss. All financial control documents should be adapted to the needs of your business in terms of the items included and the degree of detail, but the format sh ould adhere to generally accepted accounting principles. Your accountant will help you in this area but, you must be the one to decide what informatio n is most useful to you in running the business, and what info rmation reflected by the Budget Deviation Analysis is most significant. Below are samples of: 1. Projected Cash Sales a nd Accounts Receivable 2. Projected Accounts Payable 3. Pro-Forma Cash Flow Statement (Worksheet) . Projected Cash and Accounts Payable Month Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec. Projected Sales $10,000 Cash Sales (line 1) $9,500 Coll. Of Sales 1 mo. Prior $5,000 Coll. Of Sales 2 mo. Prior $2,000 Coll. Of Sales Over 2 mo. $500 Total Accts. Rec. (line 2) $27,000 0 0 0 0 0 0 0 0 0 0 0 Projected Accounts Receivable Month Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec. Planned Purchases $2,000 Pay On Current Mo. Purch. $1,000 Pay On Purch. 1 Mo. Prior $200 Pay On Purch. 2 Mo. Prior $200 Pay On Purch. Over 2 Mo. $100 Total Accts. Payable(line 22) $3,500 0 0 0 0 0 0 0 0 0 0 0 How to test if your business will make money © 35 How to test if your business will make money © 36 Income (Cash Month May d Actual 1.Cash 2.Collection from 3.Loan Proceeds 4.Sale of Fixed A 5.Other Cash Rec 6. Total Cash In 0 7.Rent (for prem 8.Management 9.Other Salaries 10.Legal and A 11.Utilities ( hea 12.Telephone 13.Repairs and M 14.Licences and M 15.Insurance 16.Other Operat 17.Payments on P 18.Interest Paid (short-term loans 19.Payments on M 20.Income Tax 21.Cash Dividends 22.Payments on A 23.Other Cash E 24.Total Cash 0 25.Surplus or Def 0 (subtract cash i 26.Opening Cash 27.Closing Ca 0 Pro-Forma Cash Flow Statement Only) January January February February March March April April May Planned Actual Planned Actual Planned Actual Planned Actual Planne Accounts Receivable ssets eived 000000000 ises, equipment, etc.) Salaries and Wages udit Fees t, light, water) aintenance unicipal Taxes ing Expenses urchases of Fixed Assets on Loans , lines of credit, overdrafts) ortgages/Term Loans Payments Paid ccounts Payable xpenses Out 000000000 icit 000000000 n minus cash out) Balance sh Balance 000000000 BIZBITE CONSULTING GROUP Celebrate!! Now I know how to save money. How to test if your business will make money © 37 BIZBITE CONSULTING GROUP Other products and modules for sale Other modules available on th is site deal specifically with aspects of business planning research and analysis. For a co mplete, in depth tr eatment of business planning go to the BizBit e Consulting Group products— The Business Plan . All of the business testing formulae presented in this module are available in Interactive form in our pro duct ‘Interactive Excel Wor kbooks’. In the workbooks, you can insert your own figures in the va rious formulae and the calculations are automatically completed for you. You simply follow the directions on the title page of the Workbooks. For detailed information on the content of these products, plea se go to ‘Product’ on the menu bar on the web site. How to test if your business will make money © 38 BIZBITE CONSULTING GROUP Glossary of Terms Break-even point (BEP)— the sales quantity where the firm’s total cost will just equal its total revenue. Break-even point formulae —(S = FC + VC)(FC + VC = Fixed Costs + Variable Costs) Break-even analysis —an approach to determine whether the firm will be able to break-even that is, covers all its costs with a pa rticular price. It is a method to determine the point at which business will neither make a profit nor incur a lo ss. That point is expressed ei ther in the total dollars of revenue exactly offset by the total of the fixed and variable expenses or, in total units of production, the cost of which exactly equals the income derived by their sale. Cost of goods sold (CGS)— appears on the operating statement, which is sometimes called either the Net Inco me Statement or the Profit and Loss Statement. Adding inventory purchase s during the accounting period to the beginning inventory and th en subtracting the ending inventory for the period arrive at the CGS. Fixed costs— fixed costs are those cost s not associated with, or the result of, the acquisition and sale of business offerings. Examples: mortgage payments, rent, light, heat, and taxes Gross margin (GM)— the money left to c over the expenses of selling the offerings and operating the business. Same as Gross Prof it Margin defined below. Gross profit margin —the difference between revenue and the cost of goods or services sold. Liability —is money owed by individuals or companies. Offerings — the products and services that a business provides its clients/customers Profit —a business’ earnings af ter paying all expenses. The excess of the selling price over all costs and expenses incurred making the sale. In addition, the reward to the entrepreneur for the risks assumed in the establishment, operati on, and management of the business enterprise How to test if your business will make money © 39 BIZBITE CONSULTING GROUP Pro-forma —a projection or es timate of what may result in the future from actions in the present. A Pro-Forma financial statement is one th at shows how the actual operations of the business will turn out if certain assumptions are realized. Revenue or sales —are the dollars you receive for the offering you sell. Total costs —is the sum of th e total fixed and total variable costs. The total fixed costs cannot remain the same because the total variable costs change. Total fixed costs —is the sum of those costs that are fixed, no matter how much is produced. These expenses that remain constant no matter what the sales or fees from services are. Variable costs— variable costs are business costs related to the acquisition and resale of offerings or the production of goods and services How to test if your business will make money © 40
