TECHNOPRENEURSHIP Week 12

Know the role of budgets in preparing pro forma financial statements.Understand why positive profits can still result in a negative cash flow.Learn how to prepare monthly pro forma cash flow, income, balance sheet, and sources and uses of funds statements for the first year of operation. Explain the application and calculation of the break-even point for the new venture.

Before developing the pro forma income statement, the entrepreneur should prepare operating and capital budgets.If the entrepreneur is a sole proprietor, then he or she is responsible for the budgeting decisions.In the case of a partnership, or where employees exist, the initial budgeting process may begin with one of these individuals, depending on his or her role in the venture.

Figure 10.1 illustrates a simple format for a production or manufacturing budget for the first three months of operation. This provides an important basis for projecting cash flows for the cost of goods produced, which includes units in inventory. The important information from this budget is the actual production required each month and the inventory that is necessary to allow for sudden changes in demand. As can be seen, the production required in the month of January is greater than the projected sales because of the need to retain three units in inventory. In the second month, the actual production required is less than projected sales because the inventory needs are less than in the first month.

Thus, this budget reflects seasonal demand or marketing programs that can increase demand and inventory. The pro forma income statement will only reflect the actual costs of goods sold as a direct expense. Thus, in those ventures in which high levels of inventory are necessary or where demand fluctuates significantly because of seasonality, this budget can be a very valuable tool to assess cash needs.

After completing the sales budget, the entrepreneur can then focus on operating costs. First a list of fixed expenses (incurred regardless of sales volume) such as rent, utilities, salaries, interest, depreciation, and insurance should be completed. Estimated costs for many of these items can be ascertained from personal experience or industry benchmarks or through direct contact with real estate brokers, insurance agents, and consultants. Anticipation of the addition of space, new employees, and increased advertising can also be inserted in these projections as deemed appropriate.

These variable expenses must be linked to strategy in the business plan. Figure 10.2 provides an example of an operating budget. In this example we can see that rent increases in month 3 because the company adds warehousing space. Salaries are also expected to increase in this month because of the addition of a shipper, and advertising increases because the primary season for this product is approaching. This budget, along with the manufacturing budget illustrated in Figure 10.1, provides the basis for the pro forma statements being discussed.

Capital budgets are intended to provide a basis for evaluating expenditures that will impact the business for more than one year. For example, a capital budget may project expenditures for new equipment, vehicles, computers, or even a new facility. It may also consider evaluating the costs of make or buy decisions in manufacturing or a comparison of leasing, buying used or buying new equipment. Because of the complexity of these decisions, which can include the computation of the cost of capital and the anticipated return on the investment using present value methods, it is recommended that the entrepreneur enlist the assistance of an accountant.

The marketing plan discussed in the previous session provides an estimate of sales for the next 12 months. Since sales are the major source of revenue and since other operational activities and expenses relate to sales volume, it is usually the first item that must be defined.

Figure 10.3 summarizes all the profit data during the first year of operations for MPP Plastics. This company makes plastic moldings for such customers as hard goods manufacturers, toy manufacturers, and appliance manufacturers. As can be seen from the pro forma income statement in Figure 10.3, the company begins to earn a profit in the fourth month. Cost of goods sold fluctuates because of the higher costs incurred for materials and labor in order to meet the sales demands in a particular month.

In preparing the pro forma income statement, sales by month must be calculated first. Marketing research, industry sales, and some trial experience might provide the basis for these figures. Forecasting techniques such as survey of buyers' intentions, composite of sales force opinions, expert opinions, or time series may be used to project sales. It may also be possible to find financial data on similar start-ups to assist with these projections. As would be expected, it will take a while for any new venture to build up sales. The costs for achieving these increases can be disproportionately higher in some months, depending on the given situation in any particular period.

The pro forma income statements also provide projections of all operating expenses for each of the months during the first year. As discussed and illustrated in Figure 10.2, each of the expenses should be listed and carefully assessed to make sure that any increases in expenses are added in the appropriate month.For example, selling expenses such as travel, commissions, and entertainment should be expected to increase somewhat as territories are expanded and as new salespeople or representatives are hired by the firm. Selling expenses as a percentage of sales may also be expected to be higher initially since more sales calls will have to be made to generate each sale, particularly when the firm is an unknown.

The cost of goods sold expense can be determined either by directly computing the variable cost of producing a unit times the number of units sold or by using an industry standard percentage of sales. For example, for a restaurant, the National Restaurant Association or Food Marketing Institution publishes standard cost of goods percentages of sales. These percentages are determined from members and studies completed on the restaurant industry.

Salaries and wages for the company should reflect the number of personnel employed as well as their role in the organization (see the organization plan).As new personnel are hired to support the increased business, the costs will need to be included in the pro forma statement. In January, for example, a new secretary is added to the staff. Other increases in salaries and wages may also reflect raises in salary.

The entrepreneur should also consider the need to increase insurance, attend special trade shows, or add space for warehousing. All these are reflected in the pro forma statement in Figure 10.3. Insurance for liability, medical, and so on, is increased in November and again in May. These charges can be determined easily from an insurance company, and then reflect the status of the operations at that time. In February, an important trade show increases the advertising budget significantly. Any unusual expenses such as the trade show should be flagged and explained at the bottom of the pro forma statement.

In addition to the monthly pro forma income statement for the first year, projections should be made for years 2 and 3. Generally, investors prefer to see three years of income projections. Year 1 totals have already been calculated in Figure 10.3. Figure 10.4) illustrates the yearly totals of income statement items for each of the three years. For the first year, the percent of sales is calculated. This percentage can then be used as a guide in determining the projected expenses for years 2 and 3.

In year 3, the firm expects to significantly increase its profits as compared with the first year. In some instances, the entrepreneur may find that the new venture does not begin to earn a profit until sometime in year 2 or 3. This often depends on the nature of the business and start-up costs. For example, a service-oriented business may take less time to reach a profitable stage than a high-technology company or one that requires a large investment in capital goods and equipment, which will take longer to recover.

In projecting the operating expenses for years 2 and 3, it is helpful to first look at those expenses that will likely remain stable over time.Items like depreciation, utilities, rent, insurance, and interest can be more easily determined if you know the forecasted sales for years 2 and 3. Some utility expenses such as heat and power can be computed by using industry standard costs per square foot of space that is utilized by the new venture.

Selling expenses, advertising, salaries and wages, and taxes may be represented as a percentage of the projected net sales. When calculating the projected operating expenses, it is most important to be conservative for initial planning purposes. A reasonable profit that is earned with conservative estimates lends credibility to the potential success of the new venture.

Cash flow is not the same as profit. Profit is the result of subtracting expenses from sales, whereas cash flow results from the difference between actual cash receipts and cash payments. Cash flows only when actual payments are received or made. Sales may not be regarded as cash because a sale may be incurred but payment may not be made for 30 days. In addition, not all bills are paid immediately. On the other hand, cash payments to reduce the principal on a loan do not constitute a business expense but do constitute a reduction of cash. Also, depreciation on capital assets is an expense, which reduces profits, not a cash outlay.

As stated earlier, one of the major problems that new ventures face is cash flow. On many occasions, profitable firms fail because of lack of cash. Thus, using profit as a measure of success for a new venture may be deceiving if there is a significant negative cash flow.For strict accounting purposes there are two standard methods used to project cash flow:1. The indirect method.2. The direct method.

In this method the objective is to not repeat what is in the income statement but to understand there are some adjustments that need to be made to the net income based on the fact that actual cash may or may not have actually been received or disbursed. For example, a sale transaction of P1,000 may be included in net income, but the amount has not yet been paid so no cash was received. Thus, for cash flow purposes there is no cash available from the sales transaction. For simplification and internal monitoring of cash flow purposes, many entrepreneurs prefer a simple determination of cash in less cash out. This method provides a fast indication of the cash position of the new venture at a point in time and is sometimes easier to understand.

It is important for the entrepreneur to make monthly projections of cash like the monthly projections made for profits. The numbers in the cash flow projections are constituted from the pro forma income statement with modifications made to account for the expected timing of the changes in cash. If disbursements are greater than receipts in any time period, the entrepreneur must either borrow funds or have cash in a bank account to cover the higher disbursements.

Large positive cash flows in any time period may need to be invested in short-term sources or deposited in a bank in order to cover future time periods when disbursements are greater than receipts. Usually the first few months of the start up will require external cash (debt) in order to cover the cash outlays. As the business succeeds and cash receipts accumulate, the entrepreneur can support negative cash periods.

Figure 10.6 illustrates the pro forma cash flow over the first 12 months for MPP Plastics. As can be seen, there is a negative cash flow based on receipts less disbursements for the first four months of operation. The likelihood of incurring negative cash flows is very high for any new venture, but the amounts and length of time before cash flows become positive will vary, depending on the nature of the business.

The most difficult problem with projecting cash flows is determining the exact monthly receipts and disbursements. Some assumptions are necessary and should be conservative so that enough funds can be maintained to cover the negative cash months. In this firm, it is anticipated that 60 percent of each month's sales will be received in cash with the remaining 40 percent paid in the subsequent month.

Thus, in August, 60 percent of the August sales are received in cash, as are 40 percent of the July sales, giving a total of P46,000. Similar assumptions can be made for other disbursements. For example, from experience it is expected that 80 percent of the cost of goods will be a cash outlay in the month incurred. The remaining 20 percent is paid in the next month. Additional outlays will be made for materials to maintain an inventory.

Using conservative estimates, cash flows can be determined for each month. These cash flows will also assist the entrepreneur in determining how much money he or she will need to borrow. For this firm, P225,000 was borrowed from a bank and P50,000 from the personal savings of the two entrepreneurs. By the end of the year, the cash balance will reach P50,400 as sales build up and cash receipts exceed cash disbursements. This cash surplus can be used to repay any debt, can be invested in highly liquid assets as a buffer in case of negative cash months, or can be used to purchase any new capital equipment.

It is most important for the entrepreneur to remember that the pro forma cash flow, like the income statement, is based on best estimates. As the venture begins, it may be necessary to revise cash flow projections to ensure that their accuracy will protect the firm from any impending disaster. The estimates or projections should include any assumptions so that potential investors will understand how and from where the numbers were generated.

In the case of both the pro forma income statement and the pro forma cash flow, it is sometimes useful to provide several scenarios, each based on different levels of success of the business. These scenarios and projections not only serve the purpose of generating pro forma income and cash flow statements but, more importantly, familiarize the entrepreneur with the factors affecting the operations.

The entrepreneur should also prepare a projected balance sheet depicting the condition of the business at the end of the first year.The balance sheet will require the use of the pro forma income and cash flow statements to help justify some of the figures.

It reflects the position of the business at the end of the first year. It summarizes the assets, liabilities, and net worth of the entrepreneurs.Every business transaction affects the balance sheet, but because of the time and expense, as well as need, it is common to prepare balance sheets at periodic intervals (i.e., quarterly or annually).Thus, the balance sheet is a picture of the business at a certain moment in time and does not cover a period of time.

Figure 10.7 depicts the balance sheet for MPP Plastics. As can be seen, the total assets equal the sum of the liabilities and owners' equity.

These represent everything of value that is owned by the business. Value is not necessarily meant to imply the cost of replacement or what its market value would be but is the actual cost or amount expended for the asset. The assets are categorized as current or fixed. Current assets include cash and anything else that is expected to be converted into cash or consumed in the operation of the business during a period of one year or less.

Fixed assets are those that are tangible and will be used over a long period of lime. These current assets are often dominated by receivables or money that is owed to the new venture from customers. Management of these receivables is important to the cash flow of the business since the longer it takes for customers to pay their bills, the more stress is placed on the cash needs of the venture.

These accounts represent everything owed to creditors. Some of these amounts may be due within a year (current liabilities), and others may be long-term debts, such as the loan taken by MPP Plastics to purchase equipment and support cash flow. Although prompt payment of what is owed (payables) establishes good credit ratings and a good relationship with suppliers, it is often necessary to delay payments of bills in order to more effectively manage cash flow. Ideally, any business owner wants bills to be paid on time by suppliers so that he or she can pay any bills owed on time.

This amount represents the excess of all assets over all liabilities. It represents the net worth of the business. The P50,000 that was invested into the business by the two entrepreneurs is included in the owner equity or net worth section of the balance sheet. Any profit from the business will also be included in the net worth as retained earnings. Thus, all revenue increases assets and owner equity, and all expenses decrease owner equity and either increase liabilities or decrease assets.

In the initial stages of the new venture, it is helpful for the entrepreneur to know when a profit may be achieved. This will provide further insight into the financial potential for the start-up business. Break-even analysis is a useful technique for determining how many units must be sold or how much sales volume must be achieved in order to break even.

We already know from the projections in Figure 10.3 that MPP Plastics will begin to earn a profit in the fourth month. However, this is not the break-even point since the firm has obligations for the remainder of the year that must be met, regardless of the number of units sold. These obligations, or fixed costs, must be covered by sales volume in order for a company to break even. Thus, breakeven is that volume of sales at which the business will neither make a profit nor incur a loss.

The break-even sales point indicates to the entrepreneur the volume of sales needed to cover total variable and fixed expenses. Sales in excess of the break-even point will result in a profit as long as the selling price remains above the costs necessary to produce each unit (variable cost).

The break-even formula is derived in Figure 10.8 and is given as:B/E (Q) = TFC / (SP - VC/unit [marginal contribution])As long as the selling price is greater than the variable costs per unit, some contribution can be made to cover fixed costs. Eventually, these contributions will be sufficient to pay all fixed costs, at which point the firm has reached breakeven.

The major weakness in calculating the breakeven lies in determining whether a cost is fixed or variable. For new ventures these determinations will require some judgment. However, it is reasonable to expect such costs as depreciation, salaries and wages, rent, and insurance to be fixed.Materials, selling expenses such as commissions, and direct labor are most likely to be variable costs.The variable costs per unit can usually be determined by allocating the direct labor, materials, and other expenses that are incurred with the production of a single unit.

Thus, if we determine that the firm has fixed costs of P250,000, variable costs per unit of P4.50, and a selling price of P10.00, the breakeven will be as follows:B/E = TFC / (SP - VC/unit)= P250,000 / PI0.00 - P4.50= P250,000 / P5.55= 45,454 units

Any units beyond 45,454 that are sold by the above firm will result in a profit of P5.50 per unit. Sales below 45,454 units will result in a loss to the firm. In those instances where the firm produces more than one product, breakeven may be calculated for each product.Fixed costs would have to be allocated to each product or determined by weighting the costs as a function of the sales projections.

Thus, it might be assumed that 40 percent of the sales are for product X; hence 40 percent of total fixed costs would be allocated to that product. If the entrepreneur feels that a product requires more advertising, overhead, or other fixed costs, this should be included in the calculations. In addition, the entrepreneur can try different states of nature (e.g., different selling prices, different fixed costs and/or variable costs) to ascertain the impact on breakeven and subsequent profits.

The pro forma sources and applications of funds statement illustrate the disposition of earnings from operations and from other financing.Its purpose is to show how net income and financing were used to increase assets or to pay off debt.

It is often difficult for the entrepreneur to understand how the net income for the year was disposed of and the effect of the movement of cash through the business. Questions often asked are, Where did the cash come from? How was the cash used? What happened to asset items during the period?

Figure 10.10 shows the pro forma sources and applications of funds for MPP Plastics, Inc., after the first year of operation. Many of the funds were obtained from personal funds or loans. Since at the end of the first year a profit was earned, it too would be added to the sources of funds. Depreciation is added back because it does not represent an out-of-pocket expense.

Typical sources of funds are from:1. Operations2. New investments3. Long-term borrowing4. Sale of assetsThe major uses or applications of funds are:1. To increase assets2. Retire long-term liabilities3. Reduce owner or stockholders' equity4. Pay dividends

The sources and applications of funds statement emphasize the interrelationship of these items to working capital. The statement helps the entrepreneur as well as investors to better understand the financial well-being of the company as well as the effectiveness of the financial management policies of the company.

1. Is it more important for an entrepreneur to track cash or profits? Does it depend on the type of business and/or industry? What troubles will an entrepreneur face if she or he tracks only profits and ignores cash? What troubles will an entrepreneur face if she or he tracks only cash and ignores profits?2. How useful is a financial plan when it is based on assumptions of the future and we are confident that these assumptions are not going to be 100 percent correct?3. Software packages that are available to help entrepreneurs with the financials for a business plan.