The financial plan and its key components

THE FINANCIAL PLAN, KEY COMPONENTS AND HOW TO BUILD A FINANCIAL PLAN SUCCESSFULLY

In the following post, I will explain the key parts of a financial plan for a start-up project or company. It is very important to understand that the 4 key metrics (“KPIs”) from a management point of view that any CEO should define, monitor and control are:

1. Enterprise value (“EV”), that is directly related to the sustainable long-term cash-flow generation of the business and the strategic position of the company, sustained in its unique value proposition, clear target customer definition, how the company delivers value to the customer through its value chain and business model (competitive advantage). EV could be defined as the net present value of the future cash-flows generated by a company or project.
2. Customers’ satisfaction.
3. Employee’s satisfaction.
4. Corporate Social Responsibility impact.

Second level metrics or KPIs could be defined from this top KPI level, and 2+3 could be summarized in maximazing stakeholders’ satisfaction. All the decisions aimed to increase the enterprise value of a company should be under the umbrella of the CEO and CFO, and should be in some way reflected in the financial plan of a company. Any action undertaken by the company that is not increasing cash-flow generation in a “healthy way” and with a strategic long-term perspective should be avoided (short-term profit versus long-term profit). Please keep also in mind that profit and cash-flow are not the same concepts, as a company can make a sale that the company may never get paid.

The financial plan of a company would be a document that could define the “financial roadmap” of the organization in the next 3-5 fiscal years, and should comprise and integrate the outputs from all the other key parts of a business plan: Human Resources, Marketing and Sales, Operations and Supply Chain Management, Information and Technology Systems, etc.

Any financial plan should take into account the following core components:

1. ASSUMPTIONS AND LIMITATIONS

When designing a financial plan, the management can make certain assumptions that will limit the scope of the financial plan, or some limitations could apply. This assumptions and limitations part would define the framework under the financial plan is estimated. Examples of assumptions and limitations could be: (1) Full costing system for cost accounting, (2) Cost items will be updated using the inflation forecast from the International Monetary Funds, (3) The stock accounting system used will be the FIFO methodology, (4) The payments of VAT and corporate taxes are undertaken at the end of the fiscal year (Dec-31), etc; (5) For the investment appraisal of the project discounted cash-flow techniques will be used, etc.

Once we understand the framework that limits the financial plan modeling, we need to estimate the total funding needs required by the project or start-up to run operations.

2. TOTAL FUNDING NEEDS OF THE PROJECT.

Any project or company, in general terms should get funding to undertake operations, but before deciding which funding sources are used, we need to estimate the total amount of money that the project requires. In the following link is explained the methodology to be used, but it should take into account:

1. Cash needed for the investment plan (“CAPEX”)-> Cash required for purchasing non-current assets.
2. Cash needed to pay the start-up expenses of the business in t=0. All the expenses that the project/company could have at the start-up (notary fees, local taxes, etc) should be considered.
3. Cash needed to run the business for “X” months (SG&A), even in the case there is not sales in this “X” period of time. The total funding needs should consider that on a monthly basis there are operational fixed costs that must be paid, and a liquidity buffer to offset these costs for a period of time should be considered. The period of time depends on the entrepreneurs, but it could range x3-x18 months.
4. Cash needed to build a certain stock level, defined by the days of supply metric (D/S). Imagine a company that sells online premium coffee, a minimum stock level of product must be held, and the cash to buy this stock must be allocated too.
5. Cash needed for VAT paid in t=0. In order to undertake CAPEX, start-up expenses and build a stock level, these items will pay VAT (Value Added Taxes), and a liquidity buffer must be allocated too, otherwise it will not be possible to undertake 1, 2 or 4.
6. Cash allocated for unexpected events or expenses. This is called “Cotingency Buffer”. This is liquidity buffer for expenses that are not foreseen now, but that could impact in the future, but we are not able to foresee now. This buffer is decided by the management team and could range from zero to “x” months of SG&A.

The sum of 1+2+3+4+5+6 will determine the total funding needs of the project.

3. FUNDING MIX (%E, %D, Ke, Kd, WACC)

Once we have determined the total amount of money required by our project/company, we need to borrow this amount from the funding sources available. Funding sources can range:

1. Equity funding from shareholders (%E).
2. Debt funding through financial banking debt (%D).
3. Grants provided by public or private institutions (%G).
4. Crowdfunding initiatives (%C).

All these funding sources usually have a cost, as the funding is never for free (grants and crowdfunding could be for free, but equity and banking debt has a yearly cost). The yearly cost of equity in percentage will be defined as Ke (“Cost of equity”), the yearly cost of the financial banking debt in percentage will be defined as Kd (“Cost of debt”=cost of the banking loan interests), the yearly cost of the grants in percentage will be defined as Kg (“Cost of grants”) and the yearly cost of the crowdfunding in percentage Kc (“Cost of crowdfunding”).

There could be other funding sources, but most of the projects/companies get funding from 2 out of this 4: Equity and banking debt, being these two funding sources the most important one.

The %E at its cost Ke, and the %D at it cost Kd defines the “financing scheme” or “funding mix” of the project, and it is explained in more detail in this link. The average cost of the funding mix, calculated as a weighted average of the funding sources is defined as the “WACC” (Weighted Average Cost of Capital). The funds borrowed from funding sources should generate a profit equal or greater than the WACC, otherwise the project or company’s cash-flow generations can not pay the funding sources cost and the project would not be profitable. In order to calculate the economic profitability of a project, investment appraisal techniques must be used taking into account discounted cash-flow techniques and time-value of money, in order to calculate Net Present Value (“NPV”), Internal Rate of Return (“IRR”) and payback period (“PB”).

4. ESTIMATION OF THE FINANCIAL STATEMENTS.

The 4 key financial statements of a company, that should be estimated in a 3-5 years time frame would be, by this order:

1. Profit and Loss Account (P&L). It provides information of the income generated by the company, the expenses incurred to generate that income, and the net profit that shareholders obtain.
2. Cash-flow statement, in order to understand the cash generated in a fiscal year by the company, and that is comprised of: (1) CFO or operational cash-flow generated from the main business activity of the company, (2) CFI or investment cash-flow generated from investing activities such as financial assets, undertaking non-current assets purchases , (3) CFF or Financing cash-flow generated from financing activities. Once we have calculated the cash-flow generated by the project or company in a year=CFO+CFI+CFF, we can forecast the balance account.
3. Balance Account or Balance Sheet. It provides information of how the company gets funding (left side of the balance account: Equity and liabilities) and where this funding is employed (in buying assets, A, right side of the balance account). In the balance account the following equation must be met: A=E+L. Liabilities are also called debt (“D”).
4. Changes in the equity. It provides information about how the equity owners or shareholders change over a period of time (i.e. new investors in the company).

5. FINANCIAL RATIOS ANALYSIS

By definition, a ratio is a division of two metrics X/Y, and from a financial point of view there could be a great number of ratios to be analyzed, however, the idea behind the ratio analysis is to get an overall picture of the “financial health of the company” from 5 categories:

1. Liquidity: Ability of the company/project to pay in the short-term (less than a year). This ratios are directly related to the ability of the company to convert sales into cash, and involves mainly the following accounts: cash and cash equivalents, accounts payable, accounts receivable, inventories and corporate tax/VAT tax liabilities.
2. Solvency: Ability of the company/project to pay in the long-term (more than a year). The solvency of the company is directly related to the long-term cash-flow generation and the funding mix equity-debt (“leverage of the company”). This ratio %D/%E somehow determines if the company can bear a financial risk in the long term. The higher the ratio %D/%E, the higher the risk, and the higher the probability to being unable to pay the financial costs of the company.
3. Activity/rotation: Ratios that provide and idea of how fast is the cash-conversion cycle (cash->raw materials->finished goods as stock->sale->accounts payable and receivable->cash. Rotation refers to how many times specific accounts move over time.
4. Profitability: Metrics that analyze the profit from different perspectives: Gross margin, EBITDA, EBIT, Net Income, ROE, ROA, IRR, ROIC, etc.
5. Valuation: Ratios that analyze stock market and valuation of the company. Some examples of KPIs such as IRR, NPV, Ke, Kd, WACC, PER, dividend yield, pay-out.

A company could be analyzed using only 15-20 financial ratios. Some of the most important ones:

1. Liquidity: Acid test-> Cash/ current liabilities.
2. Solvency: Net Financial Debt/EBITDA, %D/%E, Interest coverage (EBIT/interests).
3. Activity/rotation: Accounts payable (AP), accounts receivable (AR), days of stock (D/S), net operating cycle (D/S+AR-AP).
4. Profitability: EBITDA, Net Income, ROIC, ROE, IRR, ROIC.
5. Valuation: WACC, IRR, NPV, PER, dividend yield, pay-out ratio.

6. BREAKEVEN POINT (in units=BE)

Defined as the total number os units that need to be sold in order to offset the fixed cost and obtain and Earnings before taxes=0 (EBT). The BE point gives an idea of how feasible or not is to achieve an EBT=0. Imagine that we run a business where the yearly BE is 365,000 units, that would mean a daily sale of 3,650 units. If our business opens 8h, it would mean an hourly sale of 3,650/8=456 units per hour, that could be unrealistic.

The break even point is defined as: Income=Expenses=COGs+fixed expenses=COGs+SG&A+D&A+interests.

1. Income=Selling price excluding VAT*BE=P*BE
2. COGS at breakeven point=COGs*BE
3. P*BE=COGs*BE+SG&A+D&A+interests
4. BE=Breakeven in units=Fixed costs/(P-COGs)=[SG&A+D&A+interests]/[P-COGs]

7. INVESTMENT APPRAISAL OR ECONOMIC FEASIBILITY OF THE PROJECT

The idea of this chapter is to analyze if the project undertaken is profitable or not from a financial point of view and taking into account the time value of money. In finance, in order to determine if a project is profitable 3 KPIs must be calculated:

1. Net Present Value (“NPV”): Projects with an NPV equal or greater than zero are profitable. The NPV means the excess of return in monetary units, that the shareholders obtain over their minimum profit expectations defined by the cost of equity Ke.
2. Internal Rate of Return (“IRR”): It is a compound annual growing rate, providing the yearly return of a project in percentage. If the NPV is greater than zero, then the IRR should be greater than Ke.
3. Payback period (“PB”): It is the total number of years it takes that the cumulative positive cash-flows equal the cumulative negativa cash-flows. It is usually referred as the total number of years it takes to recover the investment made in the project.

8. SCENARIO ANALYSIS.

When the financial plan is being defined, we could have 3 approaches:

1. Deterministic scenario with 1 potential outcome: We assume that under the assumptions, limitations and inputs of our model, there will be inly one possible outcome (1 financial plan for the most likely scenario that will be called “Base Scenario”).
2. Deterministic scenario with 3 potential outcomes: We estimate an optimistic financial plan, a pessimistic financial plan, in addition to the base scenario. Therefore we build 3 financial plans (+, base, -) and assign probabilities of occurrence to each scenario in order to get an “expected financial plan”. This can be easily done by being conservative or optimistic in the input variables of the model (higher sales plan, lower costs, higher estimation forecast, lower financial costs, etc).
3. Deterministic scenario with a high number of estimated financial plans. Instead of building 3 financial plans, we change all the potential variables that impact the model and generate “infinite” or a high number of financial plans (“almost all the probable scenarios are estimated”). If we get as a result of this automated process and simulation 100,000 financial plans, we could analyze and determine the probability distribution of many of the variable included in the financial plan, and we could apply all the statistics tools in order to analyze and answer questions such as: with a 99.9% probability, what is the expected value of the net present value? What is the probability that the EBITDA is less than 20%? What is the probability that the net income is negative?

When analyzing variance analysis, we can be at stage “1” of the process or at stage “3”. For sure stage “3” requires a high level of automatization, and usually, at investment firms, the scenarios and financial plans projected are at the stage 2. In general terms, being at stage “2” could be a good proxy for financial plan estimations and its variance analysis from pessimistic and optimistic assumptions. For those that consider a great workload, it is recommend being in stage “2” and at least for the P&L, estimate an optimistic, base and pessimistic scenario for the variables of the P&L in order to understand the level of variance in magnitudes such as net sales, COGs, SG&A, EBITDA ranges, EBIT ranges and Net Income ranges.

9) CONCLUSION

A financial plan must always have a conclusion, summarizing the key facts of the project and the financial feasibility of it.