Tag Archives: cash flow

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.

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 investopedia.com):

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.

3 Things You Need to Remember About Profits

Are you a small business owner? Are you looking to start your own business? The politicians can misunderstand profits, and so can the general public, but you’d better not. Profits are good, not bad; but your business runs on cash, not just profits.

1. Profits are an accounting concept, not actual money.

Yes, they lead to money, in most cases. But profits are sales less direct costs less expenses, three concepts that are all subject to detailed accounting definitions and general principles. Timing can make a huge difference. I can book a sale today and not get paid for six months, so no money yet. And I might have paid the direct costs months ago. And I might pay the expenses months ago or in months to come.

2. Profits don’t guarantee cash.

Again, profits are likely to mean cash at some point, but not always. There are those timing issues built in. And businesses pay out money that doesn’t affect the profits at all, such as buying assets, repaying debts, and paying dividends. Lots of profitable companies go under for lack of cash flow.

3. Profits Aren’t Necessarily More is Better

There’s an inherent tradeoff between profits and growth. You as business owner decide whether to spend more on marketing to generate growth, or less on marketing to generate profits. I think real businesses need to find a point of balance. We need enough profits to sustain growth ( extra credit: “sustainable growth rate”) and keep ownership compensated for risk. But on the long term, growth is better than profits. And cash flow peace is better than growth.

Bonus Point: Most Newbies Overestimate Profits

The most common mistake in business plan financials from first-time entrepreneurs is overestimating profits. Occasionally there is a high-tech wonder business that yields extraordinary profitability, but that’s almost always just a short-term phenomenon. Real businesses make 5-10% profits on sales. When a business plan shows huge profitability, that’s a sign of not understanding the business, not of an exceptionally profitable business.

If you’re curious, try this link: NYU study on average profitability by industry.

And if you’re curious about why this fourth point is labeled bonus point, I wanted my title to list three, not four. Maybe I’m numbers obsessed. Go figure.

What Is so Great about Developing a Business Plan for a Business?

I couldn’t resist.

The question was, “What’s so great about developing a business plan for a business?”

Here’s my answer:

What’s great about a business plan starts with something similar to how we feel about having a collection of flight, hotel, and rental car reservations before we take a trip.

The business plan, done right, breaks the uncertainty into manageable pieces.

  • It sets the most important elements of strategy, including business offering, target market, and differentiators.
  • It sets the most important tactics for execution, and matches them to strategic focus.
  • It sets up and defines the important steps for the future.
  • It defines the key assumptions and resulting projections for sales, direct costs, operating expenses, and cash flow.

It’s a great tool for moving forward, figuring out what’s important, managing the important flow of tasks responsibilities, and money, and then—on a regular basis—checking results with review and revision.

It’s not the plan that really matters; it’s the planning. But you can’t have planning without a plan.

And here’s where that question and answer took place, on Quora: What is so great about developing a business plan for a business?

What ‘Accurate’ Means in a Business Plan

Questions_iStock_000011860969_modified (1)I just answered this questionon Quora. I think it’s an interesting question, one that comes up often enough, and one whose answer is worth considering.

How can I write a very accurate business plan. I’m hoping to win a grant in a business plan competition?

The rest of this post is my answer on Quora, reposted here with Quora’s (implied) permission:

This is an important question, but also a big one, hard to answer in a few hundred words. And I’m going to stick with the subset of business plans that apply to business plan competitions. These are more traditional and formal business plans, written to communicate with outsiders, and therefore significantly bigger than the lean plan (see below) you need to just run a business.

What Accuracy Means in a Business Plan

It starts with this: in your summary and descriptions of the business model, company formation, market, business offering, and management team, your readers take accuracy for granted and so should you. Tell the truth about your business and what you plan to do. Period. Accuracy isn’t a variable.

I have to guess that you bring up accuracy in the context of projections, specifically your market forecast, sales forecast, projected profit and loss, projected balance sheet, and projected cash flow.

Accuracy in market information

With market information, make sure you distinguish between the statistics, demographics, and descriptions you present as facts – external available information, with sources cites – and estimates and projections.

Approach this with the understanding that there are no facts about the future, just guesses; and there is no guarantee that the information you’d like to have will be publicly available. So therefore you have to develop reasonable estimates, based on assumptions, for which accuracy is mainly a matter of making your assumptions logical, and transparent.

Here’s a real example from a plan I was involved in recently for a social media consulting firm (Have Presence):

  1. The target market is small business owners who want social media presence, don’t want to do it themselves (or don’t have time), and have the budget to pay for a service.
  2. To develop an estimate for the U.S. portion of the market, I start with known statistics on small businesses in the U.S. and cite the source (in this case, the U.S. Small Business Administration), to arrive at some number, say 5.5 million (I’m not taking the time, while answering, to go check the actual number; but it’s a real number, publicly available, with a reliable source).
  3. From there I have to make an estimate of how many of those 5.5 million business owners meet the criteria of wanting presence, not doing it themselves, and having budget. There is no way to get the actual number with any accuracy. I have to estimate. And whether I end up saying it’s 2%, 5%, 10% or 20%, the quality of accuracy in this specific case is a combination of going from known statistics to estimates, and keeping the estimates clarified.
  4. If I really cared – perhaps because I was entering a business plan contest with my plan – I could probably figure out how to educate my guess in point #3 by looking at Facebook statistics, Twitter statistics, businesses by number of employees, and so forth – that would still leave me with estimates, but better estimates. In fact, I’m fine with what I did in point #3 because that tells me there is enough market to go for … whether it’s half a million to two million potential clients is irrelevant for business decisions, because it’s enough.

So this is just one example. Accurate in market description is a matter of combining what can be known with what can’t be an has to be estimated.

 Accuracy in Financial Projections

Financial projections are always wrong, by definition, but they’d better be laid out correctly, reasonable, transparent, in line with industry standards, and, above all, credible.

  1. The goal is to connect the dots in the financials so that spending is in proper proportion to sales and capital resources, and cash flow is sensitive to factors such as sales on account and inventory that make it different from profit and loss. Show that you understand how the financials are going to work in the real world. What drives what.
  2. The sales forecast has to be credible. Make sure you lay it out from the details up, not from top down. That means transparent assumptions about drivers, so for a product in retail channels it’s something like monthly sales per store, and stores carrying the product; and for a web business is traffic via organic, traffic via PPC, and conversion rates; and so on. Definitely not a top-down forecast, meaning show a huge market and a small percent of market.
  3. Profitability has to be credible. One of the most common flaws I see in business plans for competitions is absurd profitability, 30%, 40%, and more as profits to sales, in an industry in which the major players make 5% or 10% on sales.  That’s a huge negative. Accuracy in P&L means having realistic percent of sales for marketing expenses, general and admin expenses, and development expenses.
  4. Cash flow has to be credible. Another common flaw is failing to understand how sales on account and accounts receivable affect cash flow for business-to-business businesses; and yet another is failing to see the cash flow implications of having to buy product inventory and carry it before selling it.

Accuracy in the main body, descriptions, etc.

For the rest of the plan, industry information, competitive information, and so on, what’s really important is that you clearly distinguish between factual information from valid sources and guesses and estimates.

One of the worst things you can do in a business plan competition or pitching investors is to get caught presenting as fact something that one of the judges or investors knows is inaccurate. If you aren’t sure, clarify, disclose, call your guesses guesses. And it’s particularly bad to fudge the facts regarding your personal history, your business history, or those of your team members. Don’t cross the lines of accuracy related to degrees, job positions, and past jobs. You need to protect your integrity. And if you blur the truth on purpose, such as saying you studied business at Harvard or Stanford when you were just there for a few weeks in a special course, or when you failed to graduate, that can kill a deal.

7 Financial Facts Every Entrepreneur Should Know

You don’t have to be CPA or MBA to start or run a business. You don’t have to understand debits and credits, or be able to balance your books. But there are some financial facts you just plain need to know. Here’s a list.

  1. Every single dollar in Accounts Receivable (AR) is a dollar less in cash. AR is the standard for business-to-business transactions. You deliver the goods or service along with an invoice, and the client/customer pays you later. That money shows up as sales in the Profit & Loss (P&L), but it’s not in the bank; it’s in AR. This brings up AR aging, collection days, and a flock of related concepts that are all important because a business can die over failing to collect on AR – even profitable businesses choke on AR. Corollary: if you sell to consumers, in cash, check, or credit cards, this is not as important. And if you manage to get business customers to pay you a deposit in advance, that helps a lot too.You_iStock_000014706975XSmall
  2. Every dollar in inventory is a dollar less in cash. As with money you have in AR, money spent on inventory doesn’t show up in the P&L until you sell the stuff and it becomes cost of goods sold. So whatever is in inventory isn’t in your bank account. As with AR, companies that are profitable in the P&L can run out of cash in the bank because they got their inventory constipated. In some extreme cases, expenses get misdirected to inventory, and the system clogs up with inventory that pretends to be assets and creates a fiction that ends up with the reality of no cash in the bank. Corollary: most service businesses don’t have inventory to worry about, and those that do need inventory usually have less of a problem because they need less inventory per transaction.
  3. Every dollar in Accounts Payable (AP) is a dollar more in cash. Most businesses buy stuff on credit, meaning they get the stuff along with an invoice they have to pay in a few weeks. Almost nobody pays bills in cash immediately. Ideally, you finance inventory and AR with the money you owe to your vendors. You have to manage the pull between paying on time, paying late, and stretching AP without getting a reputation for late payments or a bad credit rating. It takes management. That satisfaction you get from paying everything immediately, and not owing anything to anybody – that’s not good financial management.
  4. Debt repayment doesn’t show up in P&L. It costs you money, but you won’t see it if you don’t track cash flow. The interest portion of payments is an expense, so that shows, but principal – debt repayment – doesn’t show up. You have to watch and plan for it.
  5. Buying assets doesn’t show up in P&L. It takes money to buy your assets (equipment, plant, land, furniture, etc.) but those don’t count as expenses, so you don’t see them in P&L.
  6. Fixed vs. variable costs matter. That’s because the trade-offs come up often and matter a lot, and this area is full of choices you can make. Do you hire the person as an employee or contract out for skills? Fixed costs are generally lower than variable costs, but they also increase the risk.
  7. Sunk costs don’t matter. It’s so not intuitive. We so often think we have to continue down some path because we’ve already spent so much money on it. It’s hard to let that go. But the money already spent is a sunk cost. You don’t get it back by spending more. So decide based on whatever decision criteria make sense, in a specific situation; money already spent is never a good reason, by itself, to spend more.

For the record, this post started as one of my answers on Quora: The original question was What are the most important financial concepts an entrepreneur should know?

What Percent of Small Business Owners Manage Cash Flow?

cash-ball-chain-bigstock-5041553 (1)I’m fascinated by the numbers Denise O’Berry turns up in her post Use Metrics To Manage Cash Flow – Small Business Expert Denise O’Berry. She quotes results of a survey sponsored by the American Institute of CPAs, which surveyed 500 owners of businesses averaging less than 10 employees and less than $2 million in revenues.

According to this, the biggest worry of small business owners, is (drumroll):

The number one issue facing small business is ensuring adequate cash flow from operations, according to 83% of survey respondents.

That’s Denise quoting Bill Reeb, CPA, surprising nobody. It is sort of like saying the number one issue in health is breathing.

(Of course, this is the AICPA asking … do you think (I’m just asking, that’s all) the results might have been different if the survey were taken by, say, the American Marketing Association? That increasing sales might have shown up as the top worry? That idea intrigues me. I’m just not a big fan of facts via surveys.) 

But this gets even more interesting, as Denise adds this:

Driving this issue is the fact that 51% of those surveyed say they don’t use a cash flow budget or forecasts to help manage their business and 32% say they don’t have specific metrics in place to monitor performance on a daily or weekly basis. And only 17% agreed that daily or weekly metrics are as important to them as their financial statements.

I commented on Denise’s post, wondering whether there might be a relationship between the roughly half of business owners who don’t plan and manage their cash flow and businesses whose normal operations don’t involve the cash-flow killers, sales on credit or product inventory. Sales on credit are not credit card sales, but rather business-to-business sales in which product or service is delivered to a business along with an invoice that will be paid later. That relates to collection days and accounts receivable. And product inventory means working capital is tied up in building and holding inventory, which separates the cash flow from the normal sales less cost of sales flow shown in a profit and loss statement.

I’ll tell you what taught me to watch cash flow, always, and very carefully: the lack of it. It wasn’t two years at business school; it was a growth spurt (sales doubled) that sucked up all the cash and left me looking for a second and third mortgage to keep the business going. That’s something you don’t forget.



Q&A: I Need a Loan to Fill Orders

This is another question I received via the ask-me form on my website:

I have master service agreements with [omitted for confidentiality] in the midwest.  I am also working on an agreement with a company in South America.  I have a great reputation with upper management and they want to use my services.  The only problem I find is carrying payroll until the invoices start coming in, in this case they are net 60.  I literally have facilities telling me here are multimillion dollar contracts, but I cannot afford the payroll.  Any suggestions?

Yes, I do have suggestions. And the problem that solutions depend a lot on who you are, what resources you have, and your past history. Still, here’s my offer of help: 

cash flow working capital Shutterstock pot of gold

  1. What you’re running up against is banking law that prevents banks from taking risks with depositors’ money. Banks can loan money for a business plan or a possibility. 
  2. The SBA (small business administration) can guarantee up to 70% of the risk so banks can loan you that money without violating the law. You need to submit paperwork, a business plan, and an application. More than 1,000 banks work with the SBA, so there is probably one near you. Ask the small business banks in your area. The deal is done by the bank, but guaranteed by the SBA.
  3. What most entrepreneurs do, if they have the resources, and they can deal with the risk, is borrow off of existing assets. For example, my wife and I had a lien on our house for years to support a credit line for Palo Alto Software. We didn’t like it. It was risky. But we did it, and it worked out, because the company survived and grew. But you can lose your house or whatever assets you pledge, so be very careful. Never bet something you can’t afford to lose. And business is betting. It’s not something I haven’t done myself, but it’s not something I recommend comfortably.
  4. Before Palo Alto Software, when I was still doing business plan consulting, I found a local non-bank financial company to loan me against invoices from a major local corporation. They charged high interest but they advanced me 80% of every invoice and they didn’t take the risk because they had a hold on my bank account and if an invoice hadn’t had been paid (that, thank goodness, never happened) they would have subtracted the amount from my bank account. Google credit line on receivables to see what comes up. And the difference between that situation and yours is I was getting advances on invoices for finished work. 
  5. Some people find investors to advance them money for a non-bankable situation in exchange for a high interest rate, a small share of ownership (called an equity kicker), and drastic guarantees that give them your company if you can’t pay the loan. All of the terms are negotiable. Search the web for “angel lending” and see what you come up with. Ask your local small business development center (SBDC), chamber of commerce, or business school if they have any leads. There is no paved road for this kind of transaction, so you have to beat the bushes. This is hard to feet, and a lot will depend on who you are, your resources, your business plan, and your past history. It’s asking people to bet on your future. 

(image: shutter stock photo)

5 Steps to Better Financial Projections

(Note: this is reposted from my post Monday on Amex OPEN forum. It had a different illustration there, and I’ve changed it to the hockey stick here in honor of so many sales forecast charts that looked like hockey sticks)

Every spring, I read and review dozens of business plans as a member of an angel investment group and a judge at several business plan contests. I love it. The plans I’ve seen are better than ever this year. But, for some reason, their financial projections are the worst I’ve seen.

How can the plans be better while their financials are worse? I think product/market fit, defensibility, scalability, market need and management experience are much harder to fix than bad financials. A good business with poor financial projections will survive and grow.

Still, it’s a damn shame. The worst, and by far the most common mistake, is absurdly high profitability. So, in honor of this epidemic of bad financials, here’s my five-step plan for better financial projections.

1. Start with a sales forecast

Make it bottoms-up, always; never tops-down. This means that you start with unit and price details and build up to sales from specific, concrete assumptions. For example, if it’s a website, base your forecast on metrics you and others can compare to other websites, such as unique visits, page views and conversions. If it’s a product going through distributors to retail stores, then look at the number of stores you can reach and the distributors required to reach them, and forecast units per store per month.

Never get caught forecasting a market by assuming the total market size and then projecting your market share. That doesn’t work. Nobody who matters believes it.

Do it monthly for 12 months, then annually for the second and third year. Think of it as a spreadsheet with months and years horizontally across the top and category names vertically along the left-hand side.

Your sales forecast should include your direct costs (also called unit costs) and costs of goods sold (or COGS). This is how much it costs you in direct costs, unit costs, per units sold. These are costs you don’t pay if you don’t sell. They go up and down as sales go up and down.

If you have no idea, don’t throw your arms up in frustration; don’t say “but it’s a new business, how could I know?” Break it into unit economics and unit assumptions. Get some comparisons from similar industries to show you what gross margin (sales less costs of sales) might be, and average profitability. Google “standard financial ratios” for leads, and don’t expect to pay more than $100 for one industry profile.

And if you still have no idea, then: 1. keep your day job; or 2. find some partners who know the industry.

2. Forecast running expenses

We call these operating expenses, such as rent, utilities, payroll, advertising, websites, travel and so forth. Here again, if you have no idea, you need to find financial profiles, take in a partner, talk to somebody who’s done it before, or maybe keep your day job. You don’t want to have no idea.

This is also a spreadsheet, with the same months and years as in the Sales Forecast horizontally across the top, and the categories vertically down the left side.

By the time you’re done with expenses, you’ve got everything you need to do an estimated profit or loss analysis. The standard format starts with sales, then subtracts direct costs to calculate gross margin. Then you subtract operating expenses to calculate profit before interest and taxes (called EBIT, with the E standing for “earnings.”)

If your projections have profits higher than 10 or so percent of sales, you’re not done. Either you have underestimated your costs or expenses, or you have an unusually strong business. It’s almost always the former.

Hint: No matter what industry you’re in, if your pretax profits are more than 15 percent, then I suggest you subtract 15 percent from your projected profits and add that amount back into operating expenses as marketing expense. Having profits too high usually means you aren’t projecting all your expenses. And marketing is where most people underestimate expenses. And besides, in a real business, well-spent marketing expenses are better than profits because they grow your business, which makes it more valuable over the long term.

3. Startup costs

Make a list of expenses you’ll have to pay before you start. Common startup expenses are legal expenses, website development, logos, signage, fixing up a location, computers and so on. Then make a list of assets you’ll need. Those are things like vehicles, equipment, furniture, startup inventory and starting cash in the bank.

The cash in the bank is the toughest. If you go back and look at your running profit and loss, that will give you an idea. You have to have money to support your early losses. Read the next step and then revisit it.

4. Understand cash flow

Unfortunately, making a profit doesn’t mean you have cash in the bank. The biggest problems here are the business-to-business sales, which typically mean you get paid a month later; and product businesses, because normally they have to buy things to sell before they sell them. If you’re a business that paid two months ago for what you sell today, and is going to get paid for that three months from now, then cash flow is both critical and unintuitive. You’re going to need money in the bank (you can call that working capital) to handle running expenses while you wait to sell stuff and get paid for it.

On the other hand, If you’re selling to people who pay immediately in cash, check, or credit card, especially if you’re not putting money into buying and keeping products, then cash flow is more predictable.

If you have no idea, and you do have business-to-business sales and inventory, then look at templates, or software, or books, or tutorials, or somebody who can help you. Don’t take cash flow for granted, even if you expect to be profitable. Ironically, some of the worst cash-flow problems come with high growth rates.

5. Review and revise regularly

Yes, you should forecast for 12 months and the two following years; but no, don’t expect your forecast to be accurate. They never are. You do the financial forecasts so you can set expectations and link spending to sales, but that’s just the start. Review your results every month. Compare actual results to what you had planned. And make corrections.

Final thought: all financial projections are wrong, by definition. We’re human and we don’t predict the future accurately. So don’t expect accuracy. Go for plausibility, and then follow up with regular plan versus actual analysis, review and revisions. We call that management.

(Image: Nicolas McComber/Shutterstock)

Big Mistake: On Business Plans, Cash, Investment, and Whose Peace of Mind Matters

This seems so strange to me. My business plan marathon has turned up several plans calling for way more money than the plan itself says it needs. How can that happen?

For example, a plan calls for $3 million investment for 2010 and its projected cash balance at the end of 2010, and again at the end of 2011, never goes below $2.5 million.

Why would investors ever say yes to that? They’re being asked to take money from their bank account and put it into some startup entrepreneur’s bank account instead; and there it sits. Unused.

That’s just strange. Sure there’s uncertainty, but don’t tell investors you want their money in your bank account. Do a “use of funds” table if you have to, and lay out where the money is going.

And if it’s in the cash balance at the end of the year, then you didn’t need it. Revise your plan. Sure, a reasonable cushion is fine, but I’ve seen a bunch of them this year, asking for money that ends up all, or mostly, in the end of year cash balance. That doesn’t work.

There’s supposed to be a match: the investment is as close as possible to what the company needs to grow on. The money is your best guess on what you need to spend to launch the company. It doesn’t sit in the bank.

If your business plan cash flow has disproportionate ending cash balances, then the fix is obvious. You should be asking for less money from investors. You’ll suffer less dilution.

Yes, I know, there are people out there advising entrepreneurs to seek more money than they think they need. That’s not horrible advice, if you have the kind of startup that can pull those amounts in. But hey, please, don’t insult your readers’ intelligence: show the money being spent on growth. Don’t show it in your projected cash balance.

True story: at one of the business plan contests I’ve judged (and I won’t say here which, or when) one of the contestants was challenged by one of the judges:

“But why do you need $600,000,” he asked? “Your plan doesn’t support that.”

“Oh, I know that,” the entrepreneur answered, “that’s peace of mind money. I need a cushion in case things go wrong, so I can sleep at night.”

The room went silent. After a pause, one of the other judges said the obvious:

“So you’re asking us to write you a check from our money so you can put it in the bank as your money?”

That’s a true story.