Category Archives: Business Plan Financials

Standard Business Plan Financials: Indirect Cash Flow Forecasting

I’ve been doing a series on standard business plan financials, summarizing the basics so anybody who runs a business can know and understand the numbers. This one is a special follow up to How to Project Cash Flow and LivePlan Cash Flow last week. Indirect cash flow forecasting is a valid and often convenient method to look ahead at cash flow.

This one is about a very common alternative cash flow method, called indirect, which projects cash flow by starting with net income and adding back depreciation and other non-cash expenses, then accounting for the changes in assets and liabilities that aren’t recorded in the income statement. This one comes from the Sources and Uses of Cash Statement that frequently serves as a surrogate for a Cash Flow in formal financial statements.

Sources and Uses works great for analyzing cash flow after the fact, with past financial statements. It’s a simple way to understand where the money came from and where it went. For example, the following illustration would show the bicycle store Projected Sources and Uses for a hypothetical February of a hypothetical new year, with the same numbers shown in the that previous post on cash flow and in another previous one on Projecting the Balance Sheet:

Indirect Cash Flow


Notice that this seemingly simpler method produces exactly the same cash flow projection as the direct method. When you turn back to the previous and compare it, the direct method involved more than 25 rows of calculations (many with zeros in them) compared to the six rows here.

While this works great after the fact, when you know what happened, there is a catch in using this method for projecting the future: We don’t know whether any given item is a source or a use of cash in any future month. For example, in the bicycle store projections for June of Year 1, both Accounts Receivable and Inventory amounts decreased, so they became a source, not a use, of cash; so the layout has to change for a Sources and Uses cash flow:

Sources and Uses Projection


During my years with financial projections, I’ve developed an alternative to Sources and Uses, also based on the indirect cash flow method, which works better for the ebbs and tides of projected balance amounts over months and years. The following illustration shows how it works:

Indirect Cash Flow Projection


Either direct or indirect cash flow methods, when applied correctly, give the same results. I find the direct method, despite having more rows, is generally easier to understand because as you make inputs you are projecting payments or receipts, money going out or coming in, while with the indirect method you project changes in balance amounts.

In fact, for years now, I usually include both methods in my projections, so that the one provides an automatic error check of the other.

And – important note for our LivePlan users – LivePlan also does both, behind the scenes, and checks them, one against the other. The spreadsheet-intensive views here are not needed with LivePlan, but your cash flow is based on these same calculations.

A Cash Flow Lesson

My Friday video this week is me (well, my voice; I don’t appear) offering a visual demonstration of a critical cash flow lesson. This first very nicely with my theme of business plan financials in the last week or two. It shows how much business-to-business sales, sales on account, and waiting for customers to pay invoices can affect projected cash flow.

I use the LivePlan web app to demonstrate the concept here; and I’m founder of Palo Alto Software, which publishes LivePlan. I try not to post “salesy” content on my blog here, but this demonstrated the concept so well, and the concept is so important to financials, that I can’t resist.

And I apologize for the lack of video production. This is just me, talking to you, with a screen grab while I do it.


An Important Cash Flow Lesson in LivePlan from Tim Berry on Vimeo.

Business Plan Financials: Tips and Traps

This is the latest post in my series on standard business plan financials. I’ve already written about the three essential projections, and how to do each, plus posts on standard vocabulary, timeframes, and so on. This one covers some common misunderstandings and errors that occur.

The area of financial analysis is one in which definitions matter a great deal. This area is full of terms, such as “assets” and “expenses,” that have specific meaning in accounting and finance that is much more carefully defined that what we have in general business discussion. A great logo or excellent brand history might be called an asset in a general way, and in a general sense, they both are – but neither are assets in a strict accounting and finance context.

So this post is to help with these common misconceptions. I don’t particularly like the way the area of finance and accounting demands specific meanings, but for standard business plan financials, this is important.

Profit and Loss is Also Called Income

The two phrases have the same meaning. An Income Statement, or Projected Income, is exactly the same as a Profit and Loss Statement, or Projected Profit and Loss. Too bad both exist because every time I write about them I always have to clarify. Now you know.

Cash vs. Profits

This is critical. I covered this basic concept in this list of top business plan mistakes in and in several other posts on this blog, because it’s important. However, I can’t do this list without starting with this very big one. It’s one of the most dangerous misunderstandings in business. Profitable companies can run out of money, and fail. It happens, for example, when an important customer stops paying in time and there isn’t enough working capital. Or when too much money is invested in inventory.

If you have a business that sells only for cash, credit card, or checks, then the cash flow implications of sales on credit and accounts receivable don’t affect you. If you don’t make, distribute, or resell products, then the cash flow implications of inventory don’t affect you. If you have a very simple cash flow, then profits are pretty close to cash. If you don’t, watch that difference very carefully. Profits are an accounting fiction. You spend cash, not profits.

Understand sales on credit and accounts receivable. When your business sells anything to another business, you usually have to deliver an invoice and wait to get paid. That’s called sales on credit, which has nothing to do with credit cards, but plenty to do with B2B sales. When you make the sale and deliver the invoice, the invoice amount increases sales and accounts receivable. When that money gets paid, it decreases accounts receivable and increases cash.

Assets vs. Expenses

Although many accounting and financial definitions are rigid, use and application aren’t. Much depends on interpretation and application.

For example, take development expenses. As you pay a construction company to build a new building for your business, you are buying an asset. What you pay is not deductible as an expense. But when a software business pays programmers to build a new software product, that company is spending on an expense, not an asset. Lines of programming code aren’t normally assets. Nor is a product design, packaging design, or a prototype. Those are expenses.

Who decides these things? The government does, in tax code. A smart business owner would prefer to book every dollar spent as either direct cost or business expense, because that would reduce taxable income and mean more money in the bank. Tax law decides what you can call an expense and what has to be booked as an asset.

So U.S. federal tax code makes buying office equipment an expense, at least up to an annual limit that changes, but has been more than $100,000 for several years now. That’s good for businesses because they can buy computers, phones, and other office equipment and deduct the cost from taxable income. But it’s odd because logically that’s buying assets, so it should increase the sum of the assets and not affect the profits or taxes. And you could choose to book those computers as assets, if you’d rather show higher profits on your books, and more assets, but have less money.

Costs vs. Expenses vs. Inventory

In the earlier post Six Key Terms I made the distinction between direct costs and expenses. Direct costs are also called COGS for Cost of Goods Sold and unit costs. These are costs that happen only if the business makes a sale, such as the cost of the bicycles our bike storeowner sells, or the cost of gasoline used by the taxi. Although the distinction between costs and expenses makes no difference to the profits in the bottom line, we use this distinction to calculate Gross Margin. Gross Margin is sales less direct costs. It is a useful basis of comparison between different industries and between companies within the same industry. Furthermore, the direct costs number helps in understanding variable costs and fixed costs, which is another useful analysis in itself, and it’s the core of a break-even analysis as well.

The distinction isn’t always obvious. For example, manufacturing and assembly labor are supposed to be included in direct costs, but factory workers are sometimes paid even when there is no work. And some professional firms put lawyers,’ accountants,’ or consultants’ salaries into direct costs. These are judgment calls. When I was a young associate in a brand-name management consulting firm, I had to assign all of my 40-hour work week to specific consulting jobs for cost accounting.

When in doubt, remember that consistency is the rule. Whichever way you do it, stick to it over time.

Depreciation and Amortization

Depreciation is something you learn once and it usually sticks. Most business owners understand it. Tax codes and accounting standards prevent business owners from deducting the cost of business assets such as a vehicle, a building, office furniture, or land when you buy them. We’d all prefer to call those things expenses because they reduce our taxable income and therefore our taxes; but we can’t. So our consolation prize is that we get to depreciate them, and depreciation is an expense that reduces taxable income.

The practical result is that any business owning assets has depreciation as an expense. Tax code specifies formulas for depreciation based on the type of asset, but as a simple example, assume you can deduct one-fifth of the purchase price of a business vehicle every year for five years. That deduction is depreciation. The book value of the asset starts at the purchase price, and declines by one fifth every year for five years. At the end of the five years, the book value is zero, so if you sell the vehicle, the entire sales price is profit. Profit is based on book value, for tax purposes.

Depreciation shows up as an expense even though it doesn’t actually cost money. The asset did cost money, but that went somewhere else in your books, not into profit and loss.

Most people count depreciation as an operating expense, but some don’t.

Amortization is depreciation’s sidekick, which works like depreciation but applies to assets like legal expenses, which weren’t really assets anyhow (it’s tax law — don’t try to understand; just be aware of it.) You can also think of it essentially as depreciation of intangible assets, like intellectual property, or so-called goodwill.


Profit and Loss with EBITDA

The classic Profit and Loss includes EBIT, which stands for Earnings Before Interest and Taxes. Lately EBITDA has become more fashionable. The DA in EBITDA stands for “depreciation and amortization” and the EBIT is the same EBIT, so EBITDA is probably a more useful term because of the nature of depreciation and amortization.

Timing is Very Important

As I explained in What’s Accrual Accounting and why does it matter, accrual accounting gives you a more accurate financial picture, unless you’re very small and do all your business, both buying and selling, with cash only. I know that seems simple, but it’s surprising how many people decide to do something different. And the penalty of doing things differently is that then you don’t match the standard, and the bankers, analysts, and investors can’t tell what you meant.

Your Profit and Loss depends on timing. It’s supposed to show financial performance over some specified period of time, like a month or a year. What you call sales on that statement is supposed to be sales made during that period. The goods changed hands or the services were delivered. When you were paid for it, and when you originally bought what you sold, is supposed to be irrelevant.

Therefore, the direct costs are supposed to be the costs of the items or services reported as sales during that period.

So when a bike storeowner buys a bicycle he wants to sell, the money he spent on it remains in inventory until he sells it. It goes from inventory (an asset) to direct costs for the income statement in the month when it was sold. If it is never sold, it never affects profit or loss, and remains an asset until some day when the accountants write off old never-sold obsolete inventory, at which time its lowered value becomes an expense. In that case, it was never a direct cost.

Expenses have timing issues too. If you contract a television advertisement in October, and it appears in December, then it should go into the December Profit and Loss. And that’s true even if you end up paying for it in February. The idea is that sales, direct costs, and expenses go into the month they happen.

Additional Details

  1. Tax law allows businesses to establish so-called fiscal years instead of calendar years for tax purposes. For example, your fiscal year might go from February through January, or October through September. Use “FY” (as in “FY07”) to specify the year in your plan. The year is always the calendar year in which a plan ends, not the year it starts.
  2.  Don’t call your investment venture capital unless it comes from one of the few hundred actual VC firms. If you’re getting venture capital, you’ll know it. If not, just call it investment.
  3. Pro forma is just a dressed up way to say projected or forecast. It’s one of those potentially daunting buzzwords that really isn’t complicated. The pro forma income statement, for example, is the same as the projected profit and loss or the profit and loss forecast.

Business Plan Financials: How Many Months and Years

Do complete business plan financials include three years of monthly financial projections? Five years? One year? Obviously the answer to this frequently asked business plan financials question depends on the specific context. Sometimes specific organizations, business plan readers, require some specific timeframe. The Small Business Administration (SBA), for example, requires at least 12 months of monthly projections for most of its mainstream loan guarantee programs.

For normal planning purposes, for any normal company, you should have at least 12 months detailed month by month for business plan financial forecasts. That would be for sales forecast, cost of sales, your burn rate, and eventually the complete financial forecast, if you’re going to do it. Then have another two years beyond that, for three years total, as annual projections.

If you’re using LivePlan this solves itself with the settings in your plan. If you’re doing it yourself with a standard spreadsheet, the normal structure looks like the illustration here:


That doesn’t mean you don’t think in longer terms. Think about what you want for your business for 5, 10, 20 years. I’m all in favor of that. But I don’t think you should plan for very long time periods in the detail of financial forecasts. The larger numbers — sales, for example, involve so much uncertainty that the time you spend trying to project more detail isn’t worth it. At least not in normal cases. If you’re farming lumber from tree farms, maybe. Another special case I’ve seen is the long development and planning cycle for mainstream pharmaceutical research, requiring years of spending before getting to revenue.

You can put too much detail into a business plan. You run into a problem of diminishing returns. For the detail it takes to run the monthly cash flow into the second year and beyond, with so much compounded uncertainty, the information value, and decision-making benefits, are rarely worth it.

Be forewarned. You’ll run into experts who will say you need more than 24 months, or more than five years in detail. They will be very sure of themselves. Sometimes what they mean is that they know more than you do, so they want you to suffer more. Or they want you to pay them to do the financials instead. Or they don’t like you or your business plan and they’re embarrassed to tell you. So instead, they say you need to forecast in more detail. If they are investors, what they mean is they don’t want to invest and they don’t want to tell you why. If they are loan managers, they don’t want to make the loan. And they don’t want to tell you the real reason.

My advice to you, when that comes up, is that unless you are a special case (if you are, you know who you are), look for another expert.


Business Plan Financials: Cash vs. Accrual Bookkeeping

I hate the buzzwords and general environment related to accounting and financial terms. No wonder business owners shy away from it. “Accrual accounting” sounds like something you do with thumb screws, rack, and chains. But – damn – it matters. If you run a business, you have huge incentive to understand this stuff.Money Details

And there is some good news in this area. At least it’s easy to understand, once you get over the sound of it. Give me just five minutes to read this blog post, and you’ll get it. I hope.

It turns out that all business bookkeeping is going to be either cash basis or accrual. Those are the rules. Too bad “cash basis” sounds so simple and attractive, because accrual is way better, and easier to manage too. Cash basis accounting only works right if you absolutely always pay immediately for every business purchase, and you never buy something before you sell it, and all of your customers pay you in full whenever they buy something from you. That case is extremely rare.

Cash Basis Hides Info

In cash basis accounting, if you sell goods and don’t get paid immediately, the sale doesn’t show up on the books. Sure, there was a sale, and now somebody owes you money. But cash basis bookkeeping ignores it. That sale gets into your books only later, when you get paid. The money your customer owes you doesn’t show up. You keep track of it in a shoebox, or maybe in your head.

In cash basis accounting, when you order some goods, nothing happens. Sure, you now have an obligation to pay; you’ve agreed to spend some money. But it’s not in your books. When the goods come, if you don’t pay for them in cash when they arrive, nothing happens.  Yes, you have a debt at that point, but it doesn’t go into your books until you pay it. You keep track of it in a shoebox, or maybe in your head.

Accrual Accounting is Way Better

In accrual accounting, when you make a business-to-business sale on account, you record the accrued amount as Accounts Receivable (definition), so you keep track of the amount, the date, and the customer who owes it to you. It’s obvious that unless you never sell without immediate payment, accrual basis is better.

In accrual accounting, when you receive the goods you ordered, but you don’t pay for them immediately, you still owe that money. You have an invoice to pay. You record the accrued amount as Accounts Payable (definition), along with the date, a record of what you bought, and who and when you are supposed to pay.

I’m so sorry that the accounting standards that were set a few generations ago chose to call it “cash basis” when you don’t record money owed into your books until it’s paid; or money you owe until you pay it. It’s a terrible idea to keep that information in your head instead of in your bookkeeping. That causes many mistakes as we business owners fail to keep track and remind ourselves of these outstanding obligations. And yet, ironically, they call that “cash basis” accounting. I do wish that the right way to do it, which is accrual accounting, didn’t have such an off-putting name.

Standard Business Plan Cash Flow: LivePlan

Most of my series on standard business plan financials is generic, meaning that it is about concepts, not business planning software. Of course I’m biased about business plan software, because I believe in LivePlan as the best available solution. I try to keep that out of most of my posts. However, when we look seriously at business plan cash flow, I honestly have to recommend LivePlan. It does mathematically and financially correct calculations in the background, so that your essential business projections are as accurate as your assumptions. That takes some additional assumptions for cash flow, which you do with LivePlan guided input, as shown below in this post.

LivePlan Cash Flow Assumptions

Setting Starting Balances

For existing companies, LivePlan uses simple settings of starting balances to make calculations and estimate payments and expenses and financial flows. The simple input is shown in the illustration here:

The Vital Cash Flow Metrics

Sales on Credit, Collection Days, Payables, and Payment Days

With LivePlan’s business plan cash flow assumptions function you can change critical cash flow assumptions and watch the impact on your projections as you do. Increase your estimated sales on credit, and you decrease your estimated cash balance. Increase the days you wait to get paid, and you decrease your cash balance. And with payments, increase your purchases on credit, and you increase your cash balance. Increase the days you wait to pay, and, there too, you increase your cash balance (and make your vendors unhappy, and possibly hurt your credit rating, but that’s for a different discussion).

Remember please that these are simple assumptions. Don’t sweat the details. You may be tempted to try to divide your receivables flow into categories of customers, or make allowances for special customers, but on the long term that doesn’t work well. This is planning, not accounting. Don’t expect your estimates to be exactly right for every month, and remember the goal is to set assumptions you can track during your monthly review and revision session.

If you have no idea, go back to fundamentals. Sales on credit are the rule with business-to-business sales, so if you sell to businesses, play it safe and put 100% sales on credit. If you sell to a mix of business and consumers, or you sell to some consumers on credit, then think it through. One easy way to estimate, if you have some past history, is to divide your average balance of Accounts Receivable for the last year by your average total monthly sales for the year, and use that percentage as a guide.

For collection days, you can calculate your average collection days from past results by using a simple formula (thanks to

Definition of Collection Period

If you’re not sure, or you have no past results to go on, estimate 60 days unless you are in a particularly slow paying area of industry (you should know), in which case you should estimate 90 days.

Dealing with Inventory

You might notice in the illustration above the switch at the bottom of the LivePlan cash assumptions, for inventory. Service companies don’t typically have to manage inventory, so this is a switch that is either on (for product businesses) or off (for service businesses). When switched on, it gives you two additional assumptions needed to add the impact of buying and managing inventory into the projected cash flow.

LivePlan Cash Flow

LivePlan automatically takes your assumptions for sales, spending, and the three critical cash flow assumptions for sales on credit, payments, and inventory; and gives you month-by-month estimated cash flow. The result is in the illustration here:

Obviously cash is vital to business, and cash flow is vital, so this is a critical component of every lean business plan.

LivePlan Reality Check

Just as it did with the Gross Margin for the sales forecast direct expenses, the LivePlan Benchmarks view also helps you compare your cash assumptions to industry standards:

Sporting Goods Sample Benchmarks

Cash Flow Takes Constant Attention

Don’t think the cash flow comes out fine the first time you do your LivePlan projections. More often than not, and especially with startups, after the first round of assumptions, the estimated cash balance is negative.

That’s really important information. It tells you that you need to plan for working capital. If your projected cash balance is negative, then you’re not done with your projections. Welcome to the real world. You can’t have a negative cash balance. The spreadsheets don’t care, but the bank will, and your payees will, because your checks will be bouncing. So you have some classic options to deal with:

  1. Go back to your projections and figure out how to sell more or spend less; or
  2. invest more money as capital: yours, or some other investor’s; or
  3. borrow money to make up the difference.

With LivePlan, as you decide how to handle your working capital problems, you go back into your assumptions and revise them. Use the Loans and Investment feature to add money from either source. Use the sales forecast and spending budget to estimate how you will increase sales or cut spending.

Remember, though, that there is no use for unrealistic assumptions. Make it happen in the real world, not just in the plan. Lean business planning is about running your business better, not just managing projections to look good.

Standard Business Plan Financials: How to Project Cash Flow

No matter what your business planning objectives, cash flow is still the most vital resource in the business, and managing cash is the single most important business function. Without cash, you go under. So I always assume cash flow is included in every kind of real business plan. And it is the most important component of standard business plan financials. This is another of my series on standard business plan financials.

After all, all the strategy, tactics, and ongoing business activities mean nothing if there isn’t enough money to pay the bills. And that’s what a cash flow projection is about – predicting your money needs in advance. You need to know how to project cash flow. profits-vs-cash-small

(Important: If you’re using LivePlan, life gets a lot easier for you. Please read LivePlan Cash Flow instead of this post. )

The Projected Cash Flow is what links the other two of the three essential projections, the Projected Profit and Loss and Projected Balance Sheet, together. The cash flow completes the system. It reconciles the Profit and Loss with the Balance.

Experts can be annoying. There are several ways to do a cash flow plan. Sometimes it seems like as soon as you use one method, somebody who is supposed to know tells you you’ve done it wrong. Often that means that expert doesn’t know enough to realize there is more than one way to do it.  I’m doing direct cash flow for this post. I may do indirect in a later post.

Direct Cash Flow

So here is a direct cash flow plan. You can see the potential complications and the need for linking up the numbers from the other statements. Your estimated receipts from accounts receivable must have a logical relationship to sales and the balance of accounts receivable. Likewise, your payments of accounts payable have to relate to the balances of payables and the costs and expenses that created the payables. Vital as this is to business survival, it is not nearly as intuitive as the sales forecast, personnel plan, or income statement. The mathematics and the financial projections are more complex.

Here’s a sample Projected Cash Flow for a bicycle shop, so you can see how that works:

Cash Flow Example


Estimating Receipts from Receivables

The first two rows of Garrett’s cash flow projection depend on detailed estimates of money coming in as his customers on account pay their invoices. To estimate that, he lays out his guess based on the assumption that only 10% of his sales are on credit (on account), and that his customers pay their invoices in about one month on average. That estimate looks like this:


In this case, the sales on credit are 10% of the estimated total sales in the Sales Forecast, $26,630. That’s the result of Garrett’s assumption, based on the nature of his business. And the money involved comes in one month later. This worksheet projects the Accounts Receivable value in Garrett’s Projected Balance Sheet, as well as the Received from AR value in the Projected Cash Flow. The receivables analysis depends on information in the Profit and Loss Projection, plus an assumption about Sales on Credit, and another on waiting time before payment. And it affects the Projected Balance and the Projected Cash Flow, as shown in this next illustration:

Cash and Receivables


Estimating the Impact of Inventory

Inventory presents another set of important cash-related assumptions. I explained earlier that in the case of inventory, proper accounting practices require special details. The cost of inventory that shows up in the Projected Profit and Loss is related to timing of sales. The actual cash flow implications of inventory depend on when new inventory is purchased, as shown here:


As with Accounts Receivable in the previous illustration, the inventory analysis depends on information from the Sales Forecast, and it sends information to both the Projected Balance Sheet (Ending Inventory) and the Projected Cash Flow (Inventory Purchase).

Estimating the Impact of Payables

Most businesses wait a month or so before they pay invoices for goods and services received from other businesses. That means we can save on our cash flow by holding back some money and paying it later. With proper accrual accounting, that money is recorded on the Balance Sheet as Accounts Payable. Estimating Accounts Payable takes a careful combination of calculations and assumptions. First we have to collect the full amount of payments. Then we account for payments made immediately, not held in Accounts Payable. After that, we estimate how long, on average, we hold payments. That analysis is shown below:

Cash and Payables


In this case, it is assumed that the store will pay its bills about a month after it receives them.

Cash Flow is About Management

Reminder: you should know how to project cash flow using competent educated guesses based on an understanding of the flow in your business of sales, sales on credit, receivables, inventory, and payables. These are useful projections. But real management is minding the projections every month with plan vs. actual analysis so you can catch changes in time to manage them. The illustration here shows projected profits for the bicycle store compared to the projected cash flow, using the projections presented in this chapter:

Profits vs. Cash

Standard Business Plan Financials: Important Cash Flow Vocabulary

As I continue with my series on standard business plan financials, I want to look at the basic cash flow These words put some people off because they sound like accounting and financial analysis. But they’re good terms to know, especially if you’re running a business. This is important cash flow vocabulary.

  • Cash in business planning and financial projections is not coins and bills. It’s liquidity, money in checking and other instantly available accounts; money you have and you can spend.
  • Cash sales include sales by real cash, bills and coins; plus sales paid by check or credit cards. In financial projections, sales are either cash or on credit (below).
  • Sales on credit isn’t about credit cards, but rather the common practice of businesses selling to other businesses, and sometimes businesses selling to consumers. It’s also called sales on account. It refers to when a business delivers the goods and services to a business customer along with an invoice that will be paid later, not immediately. The amount involved is considered Accounts Receivable for the seller, and Accounts Payable for the buyer.
  • simple collection days formulaCollection days is how many days, on average, a business waits for customers to pay their invoices. The unit is days, so 30 is about a month and 90 about three months. Accountants and analysts calculate average collection days for a business by multiplying 365 times times the average receivables balance and dividing that by annual sales on credit. And this is often called Collection Period.
  • Receivables is short for Accounts Receivable, which is money owed to a business. It may include some outstanding loans to employees, for example, and some other items; but the bulk of Accounts Receivable, and analysis of Accounts Receivable, is amount owed to a business by customers who haven’t paid yet.
  • Accounts Payable is money a business owes. When your business customers haven’t paid you, what is accounts receivable to you is accounts payable to them.
  • Payment days is how many days, on average, a business waits before paying its invoices. The unit is days, so 30 is about a month and 90 is about three months. In many ways it’s just the other side of the coin of collection days. If I’m your customer, then my payment days figure into your collection days. However, the formulas for payment days are harder to deal with than for collection days, because standard accounting keeps much closer track of sales on credit than new entries to accounts payable, and new accounts payable is not an obvious concept. So I’m defining it with this illustration:new-payablespayment days formulaTotal New Payables for a year would be the sum of all the monthly entries in the bottom row of the illustration above. So once you get that number for total new payables, you can then calculate payment days with a formula similar to the one for collection days: multiply the average payables balance by 365, and divide that product by the total new payables for the year.
  • Inventory is goods and materials that you’ve purchased and you keep until you sell it to customers. That could be materials you’re going to assemble into something, or products you’re going to sell. Inventory is an asset. It doesn’t become a cost until you sell it. Therefore it doesn’t show up on the profit and loss statement until you sell it. But you may have already paid for it by the time you sell it.
  • inventory turnover formulaInventory Turnover is a measurement of how much inventory you have on hand. Inventory on hand tends to be a drain on working capital because you pay for it before you sell it. The higher the turnover, the less inventory is sitting in your business waiting to get sold, and the better for cash flow. Analysts talk about “turns,” so that if your average inventory is equivalent to a year’s worth of sales, that’s one turn. Businesses aim for 10, 20, or more turns. Calculate inventory turnover by dividing your cost of goods sold by your average inventory balance.

Word of warning:

Unfortunately, even with financial analysts and accountants as literal as they are, with their insistence on things being exactly correct, there are different ways to calculate some of these numbers. And, to make matters worse, many of them calculate a number one way and don’t realize that there is more than one way. For example:

  • Many of them use the number 360 in these calculations instead of 365
  • Many of them use ending balance for these calculations instead of average balance.
  • Many of them calculate payment days using cost of goods sold instead of new payables.

And other discrepancies will turn up. Don’t take them too seriously when they say that one of these calculations are wrong. It’s just different.

Standard Business Plan Financials: Keep the Balance Simple

In standard business plan financials, the balance sheet is a projection, not a recounting of actual money. It links to projected Profit and Loss to help project cash flow. It’s the most important example of the difference between planning and accounting.  In accounting, the Balance Sheet statement has exact details broken into categories and sub categories. In business plan financials, the Balance Sheet projection is necessarily summarized and aggregated. In the illustration here, I point out an example in numbers.

Accounting vs. Planning Balance Sheet

This means that your balance sheet categories should be summary categories from your accounting. For example, assets categories are probably only Cash, Accounts Receivable, Inventory, Other Current (or Short-term) Assets, and Long-term Assets (or Plant and Equipment). Liabilities are probably only Accounts Payable, Income Taxes Payable, Sales Taxes Payable, Short-Term Debt, and Long-term Liabilities. Capital is only Paid-in Capital, Retained Earnings, and Earnings.

There are two good reasons for this:

  1. You can only produce properly linked and correct fully balanced projections of Profit and Loss, Balance Sheet, and Cash Flow if there are exact links between the items on the Projected Balance Sheet and those in the Projected Cash Flow. That’s a fact of math and financial principles.
  2.  It’s useless to try to predict future assets and liabilities in detail; nobody can do it. So you might be able to estimate the total amounts of future purchases of assets, using some reasonable assumptions; but trying to estimate the month of purchase and value of each future asset is a waste of time.

In contrast to the Projected Balance Sheet, the Balance Sheet as a financial statement is a compiled report drawn from a database of details. Accounting knows each transaction: exactly when each asset was purchased, for how much, and its depreciation history and schedule. Accounting knows each loan (called notes) history. Every detail in the statement is based on actual transactions. It goes into tax reports and legal reporting. The projection, on the other hand, is a collection of educated guesses that help you plan your financial needs in advance.

Handling of depreciation is the best example. The accumulated depreciation in a Balance Sheet Statement is a summary of detailed depreciation for each asset the business owns. It comes from the depreciation in the Profit and Loss Statement, which is compiled from the detailed depreciation of each asset. Tax code defines allowable depreciation schedule for each asset according to type, so for example, buildings are normally depreciated over 30 years, while vehicles might be over three or five years. Depreciation in a Projected Profit and Loss, in contrast, is an estimated guess of an aggregated future amount. A good forecaster will look at depreciation over the recent past, plus projected purchases of new assets, to estimate future depreciation. That estimate ends up in the Balance Sheet as Accumulated Depreciation, which subtracts from the value of Long-term Assets.

Standard Business Plan Financials: Projected Balance

This is another in a series of posts on standard business plan financials, continuing from last week.

“Think of it as your business dashboard, providing a snapshot of the financial health of your company at a specific moment in time. The purpose is simple: balance sheets list assets, liabilities and owner equity, typically in order from shortest- to longest-term assets and liabilities divided on either side of the balance sheet.”

Financial Post

The Balance Sheet includes spending and income that isn’t in the Profit and Loss. For example, the money you spend to repay a loan or buy new assets doesn’t show up in the Profit and Loss. And the money you take in as a new loan or a new investment doesn’t show up in the Profit and Loss either. The money you are waiting to receive from customers’ outstanding invoices shows up in the Balance Sheet, not the Profit and Loss. The Balance Sheet shows many reasons why profits are not cash, and why cash flow isn’t intuitive. It’s all related to the essential principles of cash flow.

The Balance Sheet shows your financial picture – assets, liabilities, and capital – at some specific moment. It helps to understand that the Profit and Loss shows financial performance over a length of time, like a month, quarter, or year. The Balance, in contrast, is a moment. Usually it’s the end of the month, quarter, or year. Sometimes it’s the end of the business day.

Balancing is a common term associated with bookkeeping, accounting, and finance. We “balance the books.” It’s a lot like reconciling a checkbook: if it isn’t right down to the last penny, then it’s wrong. Assets have to equal liabilities plus capital. Always.

A traditional Balance Sheet statement shows assets on the left side and liabilities and capital on the right side or the bottom, as in this illustration:



The balance sheet involves the other three of the six key financial terms (the ones that aren’t on the Profit and Loss: Assets, Liabilities, and Capital).

  • Assets. Cash, accounts receivable, inventory, land, buildings, vehicles, furniture, and other things the company owns. Assets can usually be sold to somebody else. One definition is “anything with monetary value that a business owns.”
  • Liabilities. Debts, notes payable, accounts payable, amounts of money owed to be paid back.
  • Capital (also called equity). Ownership, stock, investment, retained earnings. Actually there’s an iron-clad and never-broken rule of accounting: Assets = Liabilities + Capital. That means you can subtract liabilities from assets to calculate capital.

Although traditional printed balance sheet statements are usually arranged horizontally, as in the illustration above, balance sheets in financial projections are usually arranged vertically, showing the assets first, then the liabilities, and then the capital. Here, for example, is the balance sheet for the first few months of the bike store I mentioned earlier. It’s the balance sheet associated with the Profit and Loss for the same company, Garrett’s bicycle store:

Projected Balance

This is planning, not accounting. It’s one of the primary principles of the lean business planning. To make a powerful and useful cash flow projection, you need to summarize and aggregate the rows of the balance sheet. Resist the temptation to break it down into detail the way you would with a tax report after the fact. This is a tool to help you forecast your cash.

The Link Between Balance and Profit

The balance sheet is so different from the Profit and Loss that there is only one direct link between the two, a vital one that connects them so that when the books are right, the balance balances: That is the direct line from profits (Net Profits) on the Profit and Loss to Earnings and Retained Earnings on the Balance Sheet. The illustration here shows the link with the bicycle store sample: