The financial statements

The company’s financial statements are the core of the business plan’s financial information
section. They present both the company’s past results and its forecasts for the future. For a
company seeking a subsequent round of financing, the prospective investors will want to see
the balance sheets, income statements, and cash-flow statements for the previous three years,along with five-year cash flow, income statements, and balance sheet forecasts. For new companies seeking seed capital, sales forecasting along with information on cost of
operations, selling and administrative costs, and cash flow may be sufficient. In other situations, more financial information may be desirable. For example, if significant amounts
will be invested in capital assets, you may want to provide a list of your anticipated purchases.

Preparing these statements requires expertise in finance and accounting. (Note: Preparing your financial statements using the accrual method of accounting is generally preferable to using the cash method since it is the preferred method of financial statement preparation.) The following are the main considerations in putting the forecasts together:

Time Frame The typical business-plan forecast covers five years. At a minimum, your forecast should be for three years. Anything less will be insufficient for evaluation by investors and lenders of your company’s potential. Forecasting beyond five years is considered too speculative to be of much use.Cash flow and income statements should be shown on a monthly basis for the first two years thereafter, they can be shown on a quarterly basis. The prospective balance sheets should be prepared on at least a quarterly basis for the first two years and annually thereafter.


Forecast Assumptions A forecast should represent your best estimate of future operations.To enable the investor or lender to evaluate the reliability of that estimate, you must provide the assumptions used in preparing the forecast. You should be conservative. All businesses have certain risks and projecting future results using the most favorable assumptions can lead to missed targets and undermined credibility with investors. Do not be creative; stick with industry accounting practices and assumptions widely accepted as standard.A key aspect of the forecast is internal consistency. The cash flow statements, income statements,and balance sheets must be based on the same assumptions. For example, your sales forecasts will appear on your income statement. Cash receipts, as shown on your cash-flow statement,must be a function of those sales forecasts and of your estimate of the collection period.Outstanding accounts receivable, as shown on the balance sheets, must be a function of those sales and cash receipts, as well as of your assumption as to the level of bad debt.Therefore, the first step in preparing a forecast is to establish the necessary assumptions.To the extent possible, your assumptions should be supported by facts, market surveys, or detailed analyses, and reflect past performance. This is based on the same information that was gathered to support other portions of the business plan. The forecast should include a brief description of the major assumptions used:

Sales Sales assumptions are generally the most critical in a forecast, as they establish the
volume of activity. You should explain the basis used for forecasting sales. The sales
forecast should conform to your description of the market, your marketing strategy, and
anticipated position in the market as described in the marketing section of the business
plan. For example, your market share should be consistent with your estimate of the total
market and your competitive advantage over others.
 
Sales may be forecast on either a unit or a percentage-of-volume basis. If you forecast sales
by unit, you should also describe your assumptions as to the unit sales growth, initial unit
sales price, and the timing of subsequent price changes. Since many products have distinct
seasonal patterns, it is important to make specific assumptions and assure that the pattern
is followed consistently throughout the forecast. This method is usually used to forecast
sales in the earlier years.
 
You may also forecast sales as a percentage increase in dollar volume each month. In this
case, describe the percentages used and state your reasons for using them. This method is
more common for the later years of the forecast.
 
If you will have more than one product line or service offering and the composition of sales
by product line will change over time, show separate forecasting and assumptions for each
line. Similarly, if you have a product designed for more than one market segment, show
sales to each segment separately. Depending on the nature of your product you may need to
make provisions for sales returns. If you use distributors you will need to consider the
likelihood of their return of unsold products. 


Cost of Sales Rather than merely assuming costs to be a percentage of sales, you should
analyze the material, labor, and overhead elements that go into making the product. Your
forecast should be based on the production plans that you have developed and should take
into account all cost components.

Develop detailed product bills of materials based on engineering estimates and on vendor
quotations. Labor costs should be prepared on the basis of an assumed production time and an estimated hourly wage. Overhead costs require an analysis of estimated annual costs; these costs are usually applied to product costs as a percentage of direct labor amounts.

If you have several product lines, indicate the unit of cost for each. Explain the factors that will affect unit costs. For example, materials costs may decline as increased production allows for volume purchases.

Marketing Expense For the first two years, marketing expenses should be based on a detailed marketing plan that builds on the marketing section of the business plan.This plan should include a personnel forecast and the related costs, sales commission arrangements, trade-show costs, promotional campaigns, and overall advertising costs.For subsequent years, you can estimate marketing expense as a percentage of sales if your distribution channels and marketing activity is expected to be similar.




Research and Development Costs Investors view research and development costs as an investment in the future. These costs, while highly discretionary, are critical to the long term healthy growth of your business. If your product carries a high margin and a short life, significant research and development costs should be expected in order to maintain continuous development of new products. In such a situation, your cost forecasts should be
based on a detailed plan that includes the types of products you expect to develop, personnel
requirements, and other expenditures.If research and development will not be a substantial activity once your initial product is developed, your cost assumptions at that point can be established as a percentage of sales.Remember that research and development expenditures are also important to many service businesses.


General and Administrative Expenses To forecast these costs, prepare a detailed schedule of the major general and administrative expenses, such as salaries for administrative and support personnel, communications, rent, and supplies. While it is not necessary to include this schedule in the assumptions, you should provide a brief description of the method used to forecast these expenses and indicate the total number of personnel for each time period.


Taxes on Income Estimate each year’s effective tax rate. Include federal, state, and local
taxes as well as available tax credits. Apply this tax rate to each month’s income before taxes.
If certain years generate losses, subsequent years’ effective tax rates should be adjusted for
available federal net-operating-loss carry forwards.Because of the complexity of the current tax laws, you may want to seek some assistance in calculating the appropriate taxes on income and in estimating quarterly tax payments.


Inventories Estimate the level of inventory needed to support your estimated sales volume.This will depend on the length of the manufacturing process and can be expressed either as a turnover rate (for example, inventory turns over four times a year) or a production cycle(three months). The timing of your inventory purchases will be a major factor in forecasting your cash needs.


Accounts Receivable Estimate the length of time between a sale and collection of the
related receivable. This can be expressed as an average collection period (such as 60 days)
or a turnover rate per year (a turnover rate of six times is an average collection period
of 60 days). Industry statistics may provide a good indication of the typical duration you
might expect.


Cash Estimate a minimum amount of cash to be maintained over the forecast period. This
will affect the amount of cash you need to raise through either borrowings or the sale of stock. Most business owners prefer to maintain enough cash (including cash investments)
to cover three month’s disbursements, to allow some cushion for unexpected problems and
costs. This cushion will also provide time to negotiate a good funding package when you are
ready for a subsequent round of financing.



Investments If you raise capital by selling stock, your investors will expect you to invest
any idle funds in low-risk money-market funds or certificates of deposit. The level of investment will depend on your monthly cash needs. Indicate the rate of interest you expect
to earn on excess funds. A good rule of thumb is to assume that interest will be earned at
the current money-market fund rate.


Property and Depreciation Describe the major assets you plan to buy and when you will buy them. Indicate the useful lives of the equipment and the method you are using to depreciate them. If you are planning to lease equipment, be sure to take into account...


Accounts Payable Estimate the period over which you expect to pay your bills. A business may initially have to pay promptly to establish a good credit history. Therefore, you should assure that your payment period will generally be shorter than the industry average during the early years. In forecasting accounts payable, payment terms are usually expressed in number of days (for example, payable are assumed paid within 30 days). If payroll is your
major expenditure, be sure to use the appropriate payroll period to forecast cash flow
requirements.


Debt and Interest Expense You should indicate the expected sources of borrowed funds and the assumed interest rate. Be realistic in setting the interest rate, and use one commensurate with the risk in your business.



Common and Preferred Stock Describe your anticipated sources of capital. If common stock has been issued, indicate the number of shares issued and the issue price. If you expect multiple rounds of venture-capital investment, indicate the total amount needed
and the timing of each round. The number of shares and the price per share will be determined as each round is funded, on the basis of the company’s progress.


Sensitivity Analysis The reliability of your forecast is dependent upon how accurate your assumptions turn out to be. Investors, in particular, may want to see a sensitivity analysis included in your forecast discussion. In preparing this analysis, you should identify the most critical assumptions that you used and then determine what the impact would be if those assumptions were changed.


The sales assumptions are critical to most forecasts. If you projected a 50% annual growth rate each year, what would the results be with a 30% growth rate? Or, what if costs are 5% higher than anticipated? For start-up companies, another critical assumption is milestone dates.What would happen if the initial shipment or launch were delayed three months?
You need not include prospective financial statements that use the changed assumptions.
Instead, provide a general discussion of the most critical assumptions used in preparing your
forecast and, in discussing the alternative results, focus on whether additional financing will
be required and on what income and return on equity will be at the end of the forecast period.Preparing your initial financial forecast is a time-consuming process. Properly done, however,it will give a reader sufficient financial information to evaluate your company’s potential.


The forecast is a tool for the financial management of your business. Use it as a budget. Assess the accuracy of your assumptions as you progress, and update or review your forecasts as necessary. Then, when you are ready for the next round of financing, updating your financial forecast will be a relatively simple matter.