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MODULE 11

FINANCIAL PLAN

ENT300: Fundamentals of Entrepreneurship

LEARNING OUTCOMES
At the end of the session, students should be
able to:
Understand the importance of preparing a
financial plan
Understand the process of developing a financial
plan
Identify the components of a financial plan
Analyze the financial position of the proposed
business
Prepare a financial plan for a small business

INTRODUCTION
A financial plan incorporates all financial data derived

from the operating budgets i.e. the administration


budget, marketing budget and production (or
operations) budget.
Financial information from the operating budgets is
then translated or transformed into a financial budget.
Based on the financial data, projections are prepared
via the following pro forma statements:
1.
2.
3.

Cash flow
Income (or profit and loss) statement
Balance sheet.

THE IMPORTANCE OF A
FINANCIAL PLAN
A financial plan is crucial to the overall business
plan that is developed for a particular business
or project. Its importance can be summarised
as follows:
To determine the size of investment
To identify and propose the relevant sources of finance
To ensure that the initial capital is sufficient
To analyse the viability of the project before actual
investment is committed
5.
To be used as a guideline for project implementation
1.
2.
3.
4.

THE PROCESS OF DEVELOPING A


FINANCIAL PLAN
To develop a workable and meaningful financial
plan, the entrepreneur has to follow these steps:
Step
Step
Step
Step
Step
Step
Step

1:
2:
3:
4:
5:
6:
7:

Gather all financial inputs


Determine the project implementation cost
Determine the sources of finance
Prepare the pro forma cash flow statement
Prepare the pro forma income statement
Prepare the pro forma balance sheets
Perform basic financial analysis

Step 1:
Gather the Financial Input
The process of developing a financial plan

for a specific project begins with the


accumulation of financial information from
the marketing, operations and
administration plans.
The financial requirements for each plan are
presented in the form of budgets known as
operating budgets (i.e. marketing,
operations and administration budgets)

Step 1:
Gather the Financial Input
In addition, the monthly or annual sales

forecast derived earlier in the marketing


plan is a very important input for the
financial plan.
After gathering all information the financial
plan is prepared in terms of financial budget.

Step 2:
Determine the Project Implementation
Cost
A project implementation cost incorporates

both long-term and short-term expenditure


needed to start a project.
Long-term expenditure refers to such

expenditure as the procurement of plant,


machinery, equipment, vehicles and other
fixed assets needed by the new business.

Step 2:
Determine the Project Implementation
Cost
Short-term expenditure, such as payments of utilities,

salaries and wages, factory overheads, purchase of raw


materials or inventories, represent the amount of initial
working capital required to finance the daily operation
until the business gets its first sale.
Components of project implementation cost:
Capital expenditure
Working capital
Other expenditure
Contingency cost

Step 3:
Determine the Sources of Finance
Sources of finance refers to the sources

where funds to finance a particular projects


implementation costs can be secured.
These can be categorised into internal and

external sources.
The internal sources mainly come in the

form of equity contributions from the


entrepreneurs. These contributions can
either be in the form of cash or other assets.

Step 3:
Determine the Sources of Finance
External sources of finance are mainly

derived from commercial banks, finance


companies and government agencies. It may
come in the form of term loans, hire purchase
or grants.
The total amount of funds that has to be

sourced should equal the total project


implementation cost calculated earlier. This
is to ensure that the project is fully funded and
to avoid the risks of under-financing.

Step 3:
Determine the Sources of Finance
Components of sources of finance:

Internal sources
Equity contributions (cash and/or assets)
External sources
Term loan
Hire purchase
Others

Step 4:
Prepare Pro Forma Cash Flow
Statement
Pro forma cash flow statement refers to the projected

statement of cash inflow and outflow throughout the


planned period.
Under normal circumstances, the pro forma cash flow

statement is prepared for three consecutive years,


detailed by month for the first year and by year for the
second and third years. However, longer periods are
sometimes needed depending upon the projects
undertaken.
The total amount of funds that has to be sourced should

equal the total project implementation cost calculated


earlier. This is to ensure that the project is fully funded as
well as to avoid the risks of under-financing.

Step 4:
Prepare Pro Forma Cash Flow
Statement
The pro forma cash flow statement must be

able to show the following information:


CASH
INFLOWS

the projected amount of cash flowing into the


business.

CASH
OUTFLOWS

the projected amount of cash flowing out of the


business.

CASH DEFICIT
OR SURPLUS

the difference between cash inflows and


outflows.

CASH
POSITION

the beginning and ending cash balances for a


particular period.

Step 4:
Prepare Pro Forma Cash Flow
Statement
Elements of cash inflows Elements of cash outflows

Equity contribution
(cash)
Term loan
Cash sales
Collection of receivables
Others

Marketing expenditure
Operations expenditure
Administrative
expenditure
Term loan repayment
Hire purchase repayment
Purchase of fixed assets
Pre-operating expenditure
Payments for deposits
Miscellaneous expenditure

Pro Forma Cash Flow Statement

Pro Forma Cash Flow Statement

Step 5:
Prepare Pro Forma Income Statement
The next step in developing a financial plan is

to prepare the pro forma income


statement which shows the expected profit
or loss for the planned period, usually for
three consecutive years.
The pro forma income statement consists of

the following elements:


Sales
Gross

Profit/Loss
Net Profit/Loss Before Tax

Pro Forma Income Statement


Example: Pro Forma Income Statement
Sales
Cost of sales
Gross profit
Less: Operating Expenses
Marketing expenses
Administrative expenses
Depreciation charges
Miscellaneous
Operating income
Less: Financing expenses:
Interest on term loan
Interest on hire-purchase
Net profit before tax

Year 1
240,000
94,600
145,400

Year 2
276,000
103,900
172,100

Year 3
317,400
108,940
208,460

18,000
96,000
7,200
2,700
123,900
21,500

18,900
100,800
7,200
600
127,500
44,600

19,845
105,840
7,200
600
133,485
74,975

4,500
1,600
6,100
15,400

3,600
1,600
5,200
39,400

2,700
1,600
4,300
70,675

Step 6:
Prepare Pro Forma Balance Sheet
While the pro forma income statement shows

the financial performance of the business for


the planned period, the pro forma balance
sheet shows the financial position of the
business at a specific point in time in terms
of assets owned and how those assets are
financed.
The pro forma balance sheet is normally

prepared for a period of three years.

Step 6:
Prepare Pro Forma Balance Sheet
The pro forma balance sheet consists of the

following elements:
Assets
Owners

equity
Liabilities

The balance sheet shows the following

equation:
Assets = Owners equity + Liabilities

Step 6:
Prepare Pro Forma Balance Sheet
Assets are the economic resources of a business that

are expected to be of benefit in the future. Assets


reported in the balance sheet are generally categorized
into two categories: non-current and current assets.
Non-current assets include fixed assets and other

assets that are owned and usually held to produce


products or services. These assets are not intended for
sale in the short term. Examples: property, plant,
machinery, equipment, vehicles, major renovations and
long-term investments. For fixed assets, the values
shown in the balance sheet are the book value i.e. the
original cost less the accumulated depreciation.

Step 6:
Prepare Pro Forma Balance Sheet
Current assets are short-term assets that

can be converted into cash within a year.


Examples: cash, inventories (raw materials,
work-in-process and/or finished goods),
receivables and other short-term
investments.
Owners equity refers to capital

contributions from the owners or


shareholders in terms of cash or assets plus
the accumulated amount of net income.
However, if the business suffers a loss, the

Step 6:
Prepare Pro Forma Balance Sheet
Liabilities are the amounts owed by the business to

outsiders. They are categorised as non-current


(long-term) and current liabilities.
Non-current or long-term liabilities refer to the long-

term obligations of the business that mature in a


period of more than one year. They usually include
long-term loans as well as hire purchase.
Current liabilities refer to the short-term obligations

of the business that mature within a period of less


than a year. The most common forms of current
liabilities are accounts payable and accrued payments

Step 6:
Prepare Pro Forma Balance Sheet
Example: Pro Forma Balance Sheet
Non-Current Assets (book value)
Land & building
Machinery & equipment
Furniture & fixtures
Renovation
Vehicles
Deposit
Current Assets
Inventory of raw materials
Inventory of finished goods
Cash
Total Assets
Owners Equity
Capital
Accumulated profit
Long-term Liabilities
Term loan
Hire-purchase
Total Owners Equity & Liabilities

Year 1

Year 2

Year3

45,000
18,400
5,600
3,200
20,000
800
93,000

45,000
13,800
4,200
2,400
15,000
81,200

45,000
9,200
2,800
1,600
10,000
69,400

3,000
3,000
40,900
46,900
139,900

3,500
4,000
77,600
85,100
166,300

4,000
5,000
145,575
154,575
223,975

72,500
15,400
87,900

72,500
54,800
127,300

72,500
125,475
197,975

36,000
16,000
52,000
139.900

27,000
12,000
39,000
166,300

18,000
8,000
26,000
223,975

Step 7:
Perform Basic Financial Analysis
Financial analysis is a technique of examining

financial statements to help the entrepreneur


analyse the financial position and performance of
the business.
Financial analysis involves two basic steps:

generating the information from the


financial statements and interpreting the
results.
The most common form of financial analysis is

ratio analysis.

Step 7:
Perform Basic Financial Analysis
Financial ratios are normally used to compare figures

from the financial statement with other figures, so that


the true meaning of financial pictures can be obtained.
There are various financial ratios that the entrepreneur

can look at. However, the most commonly considered


ratios in small business decision-making fall into four
categories: liquidity, efficiency, profitability and
solvency.
For illustrative purposes, financial data presented in

pro forma financial statements in the next slides will


be used.

Step 7:
Perform Basic Financial Analysis
Pro Forma Income Statement
Sales
Cost of sales
Gross profit
Less: Operating Expenses
Marketing expenses
Administrative expenses
Depreciation charges
Other operating expenses
Operating income
Less: Financing expenses:
Interest on term loan
Net income before tax

Year 1
576,000
227,000
349,000

Year 2
662,400
254,600
407,800

Year 3
794,880
278,460
516,420

56,500
226,000
21,000
5,000
308,500
40,500

62,150
248,600
21,000
4,000
335,750
72,050

68,365
273,460
21,000
4,000
366,825
149,595

16,500
24,000

13,200
58,850

9,900
139,695

Step 7:
Perform Basic Financial Analysis
Pro Forma Balance Sheet
Non-Current Assets (book value)
Land & building
Motor vehicles
Office equipment
Renovation
Machinery
Other assets (deposits)
Current Assets
Inventory of raw materials
Inventory of finished goods
Cash
Total Assets
Owners Equity
Capital
Accumulated profit
Long-term Liabilities
Term loan
Current Liabilities
Accounts payable
Total Owners Equity & Liabilities

Year 1

Year 2

Year3

100,000
64,000
5,600
16,000
32,000
1,000
217,000

100,000
48,000
3,000
12,000
24,000
1,000
188,000

100,000
32,000
2,000
8,000
16,000
1,000
159,000

2,000
5,000
46,500
53,500
270,500

3,000
6,000
105,350
114,350
302,350

4,000
8,000
244,645
256,645
415,645

105,500
24,000
129,500

105,500
82,850
188,350

105,500
222,545
328,045

132,000

99,000

66,000

9,000

15,000

21,600

270.500

302,350

425,645

Liquidity Ratios

The term liquidity refers to the availability of


liquid assets to meet short-term obligations.

Thus, liquidity ratios measure the ability


of the business to pay its monthly bills.

The most widely used liquidity ratios are


current ratio and quick ratio.

Liquidity Ratios (Current Ratio)

Current ratio can be determined by dividing


total current assets by total current
liabilities.

Generally, this ratio shows the business


ability to generate cash to meet its shortterm obligations.
Current ratio =Year
Total
current
assets
1
Year 2
Year 3
Total current liabilities

Current assets

RM53,500

RM114,350

RM256,645

Curent liabilities

RM 9,000

RM15,000

RM 21,600

5.94

7.62

11.88

Current Ratio

Liquidity Ratios (Quick Ratio)

If the business current ratio falls below 1,


it means that the business is in a serious
liquidity situation. In most cases, the
comfortable current ratio for most
businesses is 2.

Quick ratio, also known as the acid test


ratio, measures the extent to which
current liabilities are covered by
liquid assets.

To determine quick ratio, the calculation of


liquid assets does not take into account
inventrories since it is sometimes difficult
to convert them into cash quickly.

Liquidity Ratios (Quick Ratio)


Quick ratio
inventories

= Total current assets Total current liabilities


Year 1

Year 2

Year 3

Current assets

RM53,500

RM114,350

RM256,645

Inventories

RM 7,000

RM 9,000

RM 12,000

Current liabilities

RM 9,000

RM15,000

RM 21,600

5.17

7.02

11.33

Quick Ratio

In most cases, the comfortable quick ratio is 1.

Efficiency Ratios

The efficiency ratios measure how efficient the


business uses its assets to generate sales.

The most widely used efficiency ratio for planning


purposes is inventory turnover ratio.

Inventory turnover (or stock turnover) measures


the number of times inventories have been
converted into sales and indicates how liquid the
inventory is. All other things being equal, the
higher the turnover figure, the more liquid the
business is.

Efficiency Ratios (Inventory Turnover)

This ratio divides the cost of sales (or cost of


goods sold) by the average value of inventory.
The average value of inventory is derived by
adding the opening and closing balance of and
dividing the total by two.
Inventory turnover = Cost of sales
Average inventory
Year 1

Year 2

Year 3

Cost of sales

RM227,000

RM254,600

RM278,460

Average inventory

RM 7,000

RM8,000

RM 10,500

Inventory turnover

32.42 times

31.83 times

26.5 times

Profi tabi li ty Ratios

Profitability ratios are important indicators of


the business financial performance. Investors
will particularly be interested in these ratios
since they measure the performance and
growth potential of the business.

Some of the commonly used profitability ratios


are gross profit margin, net profit margin, return
on assets and return on equity.

Profitability Ratios (Gross Profit


Margin)

Gross profit margin give a good indication of


financial health of the business. Without an
adequate gross margin, the business will be
unable to pay its operating and other
expenses.
Gross profit margin is calculated by dividing
the business gross income by sales.
Gross profit margin =
SalesYear 1

Gross profit
Year 2

Year 3

Gross profit

RM349,000

RM407,800

RM516,420

Sales

RM576,000

RM662,400

RM794,880

60.59%

61.56%

64.97%

Gross profit margin

Profitability Ratios (Net Profit


Margin)

Net profit margin is an indication of how


effective the business is at cost control. The
higher the net profit margin, the more effective
the business is at converting sales into actual
profit.
Net profit margin is calculated by dividing the
business net income by sales.
Net profit margin =
Sales
Year 1

Net profit
Year 2

Year 3

Net profit

RM 24,000

RM 58,850

RM139,695

Sales

RM576,000

RM662,400

RM794,880

4.16%

8.88%

17.57%

Net profit margin

Profitability Ratios (Return on


assets)

Return on assets measures the overall return


that the business is able to make on its assets.

This ratio is derived by dividing the business


net profit by total assets.
Return on assets = Net profit
Total assets
Year 1

Year 2

Year 3

Net profit

RM 24,000

RM 58,850

RM139,695

Total assets

RM270,000

RM302,350

RM415,645

8.89%

19.46%

33.61%

Return on assets

Profitability Ratios (Return on


equity)

Return on equity shows what the business has


earned on its owners investment in the
business.

This ratio is derived by dividing the business


net profit by total equity.
Return on equity = Net profit
Total equity
Year 1

Year 2

Year 3

Net profit

RM 24,000

RM 58,850

RM139,695

Total equity

RM129,500

RM188,350

RM328,045

18.53%

31.25%

42.58%

Return on equity

Solvency Ratios

This final category of ratios is designed to help


the entrepreneur measure the degree of
financial risk that his business faces. By
referring to this ratio, the entrepreneur can
assess his level of debt and decide whether it is
appropriate for the business.

The most commonly used solvency ratios are


total debt (liabilities) to equity (also known as
leverage or gearing), total debt to total assets,
and times interest earned (also known as
interest coverage).

Solvency Ratios (The total debt to equity ratio )

The total debt to equity ratio indicates what


proportion of equity and debt that the
company is using to finance its assets.

This ratio is calculated by dividing the the total


debt by total equity.
Debt to equity ratio = Total debt
Total equity
Year 1

Year 2

Year 3

Total debt

RM141,000

RM114,000

RM 87,600

Total equity

RM129,500

RM188,350

RM328,045

1.09 : 1

0.61 : 1

0.27 : 1

Debt to equity ratio

Solvency Ratios (The debt to


asset ratio )

The debt to asset ratio measures the


percentage of the business assets financed by
creditors relative to the percentage financed
by the entrepreneur.

This ratio is calculated by dividing the total


debts by total assets.
Debt to equity ratio = Total debts
Total assets
Year 1

Year 2

Year 3

Total debts

RM141,000

RM114,000

RM87,600

Total assets

RM270,500

RM302,350

RM415,645

52.13%

37.70%

21.08%

Debt to total assets ratio

Solvency Ratios (Times interest


earned ratio)

Times interest earned ratio measures the


number of times interest expense can be
covered by profit before interest and tax.

This ratio is calculated by dividing total


interest expense by profit before interest and
tax.
Time interest earned = Profit before
interest & tax
Interest
Year 1
Year 2
Year 3
expense
Profit before interest

RM40,500

RM72,050

RM149,595

Interest expense

RM16,500

RM13,200

RM9,900

Time interest earned

2.45 times

5.46 times

15.11 times

SUMMARY
The financial plan is an important part of the

business plan. It incorporates all financial data


derived from the operating budgets, i.e. marketing,
operations and administrative budgets.
Based on this financial data, several financial

projection tools are prepared to provide the


entrepreneur with a clear picture of the amount of
money needed to start a business, sources of
finance, the amount of cash available and the
financial performance and position of the business.

The output of a financial plan covers project

implementation cost schedule, sources of


financing schedule, pro forma cash flow
statement, pro forma income statement , and
pro forma balance sheet.
The business financial data gathered in the

financial statements are analysed in order to


obtain an overall financial picture of the
business. The financial ratios are used to
analyse the financial performance of the
business.