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Financial Planning
Module objectives
Delegates are able to
q Define Financial planning and management
Buy custom financial planning term paper
q Highlight tools of Financial Planning
q Calculate their Income statement
q Define what cash flow is.
q Calculate Cash flow of their businesses
q Calculate financial ratios
q Identify financial ratio formulas
q Define break even point
q Calculate the break even point of their businesses
q Practically analyse the position of their businesses
1. FINANCIAL PLANNING
1.1. The concept of Financial Planning as a whole
Ø Definition of Financial Planning
Ø The components of Financial Planning
Ø Tools of Financial Planning
Ø List the benefits of a Financial Plan
1.. The Income Statement
Ø Definition of the Income Statement
Ø List components of Income Statement
Ø List importance of the Income Statement
Ø Draw up own Income Statement for Business
1.. The Cash flow statement
Ø Definition of the Cash Flow Statement
Ø List the features of the Cash flow Statement
Ø List the importance of the Cash flow Statement
Ø Practise how to draw up Cash flow statement
Ø Draw up own Cash flow Statement for Business
1.4. Financial Ratios
Ø Definition of Financial Ratios
Ø Discussions of terms in Financial Ratios
Ø List importance of Financial Ratios
Ø Practice the Calculation of Financial Ratios
Ø Calculate Financial Ratios for own business
1.5. Breakeven Analysis
Ø Definition of Break even point
Ø Calculation of Break even point
Ø Calculation of Break even point for business
1.6. Additional Analysis Material � Take home
Ø Analyse present business situation
Ø Discuss problems and Proffer solutions to financial problems in business
. INTRODUCTION TO FINANCIAL PLANNING
There is one simple reason to understand and observe financial planning in your business - to avoid failure. Eight of ten new businesses fail primarily because of the lack of good financial planning.
Financial planning affects how and on what terms you will be able to attract the funding required to establish, maintain, and expand your business. It affects the human and physical resources you will be able to acquire to operate your business. It will be a major determinant of whether or not you will be able to make your hard work profitable.
This section provides an overview of the essential components of financial planning and management. Used wisely, it will make the reader - the Business owner/manager - familiar enough with the fundamentals to have a fighting chance of success in todays highly competitive business environment.
A clearly conceived, well documented financial plan, establishing goals and including the use of Pro Forma Statements and Budgets to ensure financial control, will demonstrate not only that you know what you want to do, but that you know how to accomplish it. This demonstration is essential to attract the capital required by your business from creditors and investors.
Financial management in the small firm is characterized, in many different cases, by the need to confront a somewhat different set of problems and opportunities than those confronted by a large corporation. One immediate and obvious difference is that a majority of smaller firms do not normally have the opportunity to publicly sell issues of stocks or bonds in order to raise funds. The owner-manager of a smaller firm must rely primarily on trade credit, bank financing, lease financing, and personal equity to finance the business. One therefore faces a much more severely restricted set of financing alternatives than those faced by the financial vice president or treasurer of a large corporation.
On the other hand, many financial problems facing the small firm are very similar to those of larger corporations. For example, the analysis required for a long-term investment decision such as the purchase of heavy machinery or the evaluation of lease-buy alternatives, is essentially the same regardless of the size of the firm. Once the decision is made, the financing alternatives available to the firm may be radically different, but the decision process will be generally similar.
One area of particular concern for the smaller business owner lies in the effective management of working capital. Net working capital is defined as the difference between current assets and current liabilities and is often thought of as the circulating capital of the business. Lack of control in this crucial area is a primary cause of business failure in both small and large firms.
The business manager must continually be alert to changes in working capital accounts, the cause of these changes and the implications of these changes for the financial health of the company.
. TOOLS OF FINANCIAL PLANNING
This section introduces the tools required to prepare a financial plan for your businesss development, including the following
Ø Basic Financial Statements - the Balance Sheet and Statement of Income
Ø Ratio Analysis - a means by which individual business performance is compared to similar businesses in the same category
Ø The Pro Forma Statement of Income - a method used to forecast future profitability
Ø Break-Even Analysis - a method allowing the small business person to calculate the sales level at which a business recovers all its costs or expenses
The Cash Flow Statement - also known as the Budget identifies the flow of cash into and out of the business
Pricing formulas and policies - used to calculate profitable selling prices for products and services
Types and sources of capital available to finance business operations
Short- and long-term planning considerations necessary to maximize profits
The business owner/manager who understands these concepts and uses them effectively to control the evolution of the business is practicing sound financial management thereby increasing the likelihood of success.
Why do you think a financial Plan is important for your business?
4. FINANCIAL STATEMENTS
4.1. The Statement of Income
The second primary report included in a businesss Financial Statement is the Statement of Income. The Statement of Income is a measurement of a companys sales and expenses over a specific period of time. It is also prepared at regular intervals (again, each month and fiscal year end) to show the results of operating during those accounting periods. It too follows Generally Accepted Accounting Principles (GAAP) and contains specific revenue and expense categories regardless of the nature of the business.
4.. Statement of Income Categories
The Statement of Income categories are calculated as described below
Net Sales (gross sales less returns and allowances)
Less Cost of Goods Sold (cost of inventories)
Equals Gross Margin (gross profit on sales before operating expenses)
Less Selling and Administrative Expenses (salaries, wages, payroll taxes and benefits, rent, utilities, maintenance expenses, office supplies, postage, automobile/vehicle expenses, insurance, legal and accounting expenses, depreciation)
Equals Operating Profit (profit before other non-operating income or expense)
Plus Other Income (income from discounts, investments, customer charge accounts)
Less Other Expenses (interest expense)
Equals Net Profit (or Loss) before Tax (the figure on which your tax is calculated)
Less Income Taxes (if any are due)
Equals Net Profit (or Loss) After Tax
Calculating the Cost of Goods Sold
Calculation of the Cost of Goods Sold category in the Statement of Income (or Profit-and-Loss Statement as it is sometimes called) varies depending on whether the business is retail, wholesale, or manufacturing. In retailing and wholesaling, computing the cost of goods sold during the accounting period involves beginning and ending inventories. This, of course, includes purchases made during the accounting period. In manufacturing it involves not only finished-goods inventories, but also raw materials inventories, goods-in-process inventories, direct labor, and direct factory overhead costs.
Regardless of the calculation for Cost of Goods Sold, deduct the Cost of Goods Sold from Net Sales to get Gross Margin or Gross Profit. From Gross Profit, deduct general or indirect overhead, such as selling expenses, office expenses, and interest expenses to calculate your Net Profit.
Is your revenue more than your Expense? if not why ?
5. THE CASHFLOW STATEMENT
5.1. Cashflow method
Cash in business can be compared to water that flows in a river. Cash flows in from sales, loans, and equity. This puts the business highly dependent on its customers, financiers and stakeholders
Cash inflows are from Sales, Equity, Loans, Collection from credit sales
Cash flows out to pay for materials, Salaries ( including the entrepreneur’s), rent, electricity, water, interest, supply, transport ,etc.
If there is more water coming out than coming into the river, then it will soon dry out. Similarly businesses having more cash outflows than inflow will soon get into trouble. They will not be able to pay for expenses as they fall due. This is a difficult situation that every entrepreneur should avoid. Hence the importance of cash flow planning.
When cash outflow is more than cash inflow = Danger alert
When cash inflow is more than cash outflow = Good
5.. What is Cash Flow Management?
If you were able to do business in a perfect world, you would probably like to have a cash inflow (a cash sale ) occur every time you experience a cash outflow ( pay an expense ) but it is a well known fact that business takes place in the real world, and things just don,t happen that way.
Instead, cash outflow and inflow occur at different times and more often cash inflows lag behind your cash outflows, leaving your business short of money.
5.. What is a cash flow gap ?
This represents an excessive outflow of cash that may not be covered by a cash inflow for weeks, months, or even years.
Managing your cash flow allows you to narrowly or completely close your cash flow gap. It does this by examining the different items that affect the cash flow of your business .
Examining your cash inflows and outflows and looking at the components that have a direct effect on your cash flow, allows you to answer the following questions
Ø How much cash does my business have?
Ø How much cash does my business need to operate, and when is it needed?
Ø Where does my business get its cash, and spend its cash?
How do my income and expenses affect the amount of Cash I need to expand my business?
If you can answer these questions, you’re managing your cash flow! effectively
Some businesses can actually have very high profits and be cashless. Why ? consider a situation that all sales are given on credit in a month, even if there is profit there would be no cash to run the business
What do you understand as a cash flow and how do you think you can manage it in your business
6. INTRODUCTION TO FINANCIAL RATIO ANALYSIS
Ratio Analysis is applied to Financial Statements to analyze the success, failure, and progress of your business .Ratio Analysis enables the business owner/manager to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry. To do this compare your ratios with the average of businesses similar to yours and compare your own ratios for several successive years, watching especially for any unfavorable trends that may be starting. Ratio analysis may provide the all-important early warning indications that allow you to solve your business problems before your business is destroyed by them .
6.1. Income Statement Ratio Analysis
The following important State of Income Ratios measure profitability
6.. Gross Margin Ratio
This ratio is the percentage of sales Naira left after subtracting the cost of goods sold from net sales. It measures the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold) available to pay the overhead expenses of the company.
Comparison of your business ratios to those of similar businesses will reveal the relative strengths or weaknesses in your business. The Gross Margin Ratio is calculated as follows
Gross Margin Ratio = Gross Profit divided by Net Sales
(Gross Profit = Net Sales - Cost of Goods Sold)
6.. Net Profit Margin Ratio
This ratio is the percentage of sales dollars left after subtracting the Cost of Goods sold and all expenses, except income taxes. It provides a good opportunity to compare your companys return on sales with the performance of other companies in your industry. It is calculated before income tax because tax rates and tax liabilities vary from company to company for a wide variety of reasons, making comparisons after taxes much more difficult. The Net Profit Margin Ratio is calculated as follows
Net Profit Margin Ratio is Net profit before Tax divided by Net Sales
6.4. Management Ratios
Other important ratios, often referred to as Management Ratios, are also derived from Balance Sheet and Statement of Income information.
6.5. Inventory Turnover Ratio
This ratio reveals how well inventory is being managed. It is important because the more times inventory can be turned in a given operating cycle, the greater the profit. The Inventory Turnover Ratio is calculated as follows
Inventory Turnover Ratio is Net sales divided by average inventory at cost
6.6. Return on Investment (ROI) Ratio.
The ROI is perhaps the most important ratio of all. It is the percentage of return on funds invested in the business by its owners. In short, this ratio tells the owner whether or not all the effort put into the business has been worthwhile. If the ROI is less than the rate of return on an alternative, risk-free investment such as a bank savings account, the owner may be wiser to sell the company, put the money in such a savings instrument, and avoid the daily struggles of small business management. The ROI is calculated as follows
Return on Investment is Net Profit before Tax divided by Net worth
These Liquidity, Leverage, Profitability, and Management Ratios allow the business owner to identify trends in a business and to compare its progress with the performance of others through data published by various sources. The owner may thus determine the businesss relative strengths and weaknesses.
7. BREAK-EVEN ANALYSIS
Break-Even means a level of operations at which a business neither makes a profit nor sustains a loss. At this point, revenue is just enough to cover expenses. Break-Even Analysis enables you to study the relationship of volume, costs, and revenue.
This may be done by employing one of various formula calculations to the business estimated sales volume, estimated fixed costs, and estimated variable costs.
Generally, the volume and cost estimates assume the following conditions
Fixed expenses (rent, salaries, administrative and office expenses, interest, and depreciation) will remain the same at all volume levels; and
Variable expenses (cost of goods sold, variable labor costs, including overtime wages and sales commissions) will increase or decrease in direct proportion to any increase or decrease in sales volume.
Two methods are generally employed in Break-Even Analysis, depending on whether the break-even point is calculated in terms of sales dollar volume or in number of units that must be sold.
7.1. Calculation of Break-Even Point .
The steps for calculating the first method are shown below
Obtain a list of expenses incurred by the company during its past fiscal year.
Separate the expenses listed in Step 1 into either a variable or a fixed expense classification
Express the variable expenses as a percentage of sales. In the condensed income statement of the Small Business Specialities Co. ( below), net sales were $1,00,000. In Step , variable expenses were found to amount to $70,000. Therefore, variable expenses are 60 percent of net sales ($70,000 divided by $1,00,000). This means that 60 cents of every sales dollar is required to cover variable expenses. Only the remainder, 40 cents of every dollar, is available for fixed expenses and profit.
Substitute the information gathered in the preceding steps in the following basic break-even formula to calculate the break-even point.
Increased sales do not necessarily mean increased profits. If you know your companys break-even point, you will know how to price your product to make a profit. If you cannot make an acceptable profit, alter or sell your business before you lose your retained earnings
Define break even point
8. PROFIT CHECKLIST ADDITIONAL ANALYSIS MATERIAL � TAKE HOME
Making a profit is the most important - some might say the only - objective of a business. Profit measures success.
It can be defined simply Revenues - Expenses = Profit. So, to increase profits you must raise revenues, lower expenses, or both. To make improvements you must know whats really going on financially at all times. You have to watch every financial event without any kind of optimistic filter.
This Guide is a series of questions with comments to help you analyze your profits, their sufficiency and trend, the contribution of each of your product lines or services to them, and to help you determine if you have the kind of record system you need. The questions and comments are not meant to be definitive presentations on the subjects. They are meant to point to areas where further study might be - well - profitable.
8.1. Are You making A Profit?
Analysis of Revenues and Expenses
Since profit is revenues less expenses, to determine what your profit is you must first identify all revenues and expenses for the period under study.
1. Have you chosen an appropriate period for profit determination?
For accounting purposes firms generally use a twelve month period, such as January 1 to December 1 or July 1 to June 0. The accounting year you select doesnt have to be a calendar year (January to December); a seasonal business, for example, might close its year after the end of the season. The selection depends upon the nature of your business, your personal preference, or possible tax considerations.
. Have you determined your total revenues for the accounting period?
In order to answer this question, consider the following questions
What is the amount of gross revenue from sales of your goods or service? (Gross Sales)
. Do you know what your total expenses are?
Expenses are the cost of goods sold and services used in the process of selling goods or services. Some common expenses for all businesses are
Cost of goods sold (Cost of Goods Sold = Beginning Inventory + Purchases - Ending Inventory)
Wages and salaries (Dont forget to include your own- at the actual rate - youd have to pay someone else to do your job.)
Rent
Utilities (electricity, gas telephone, water, etc.)
Delivery expenses
Insurance
Advertising and promotional costs
Maintenance and upkeep
Depreciation (Here you need to make sure your depreciation policies are realistic and that all depreciable items are included)
Taxes and licenses
Interest
Bad debts
Professional assistance (accountant, attorney, etc.)
There are of course, many other types of expenses, but the point is that every expense must be recorded and deducted from your revenues before you know what your profit is. Understanding your expenses is the first step toward controlling them and increasing your profit..
8.. Sufficiency Of Profit
The following questions are designed to help you measure the adequacy of the profit your firm is making. Making a profit is only the first step; making enough profit to survive and grow is really what business is all about.
1. Have you compared your profit with your profit goals?
. Is it possible your goals are too high or too low?
. Have you compared your present profits (absolute and ratios) with the profits made in the last one year?
4. Have you compared your profits (absolute and ratios) with profits made by similar firms in your line?
8.. Trend Of Profit
1. Have you analyzed the direction your profits have been taking?
The preceding analysis, with all their merits, report on a firm only at a single time in the past. It is not possible to use these isolated moments to indicate the trend of your firms performance. To do a trend analysis performance indicators (absolute amounts or ratios) should be computed for several time periods (yearly for several years, for example) and the results laid out in columns side by side for easy comparison. You can then evaluate your performance, see the direction its taking, and make initial forecasts of where it will go.
. Does your firm sell more than one major product line or provide several distinct services?
If it does, a separate profit and ratio analysis of each should be made
To show the relative contribution by each product line or service;
To show the relative burden of expenses by each product or service;
To show which items are most profitable, which are less so, and which are losing money; and
To show which are slow and fast moving.
8.4. Mix Of Profit
The profit analysis of each major item help you find out the strong and weak areas of your operations. They can help you to make profit-increasing decisions to drop a product line or service or to place particular emphasis behind one or another.
8.5. Records
Good records are essential. Without them a firm doesnt know where its been, where it is, or where its heading. Keeping records that are accurate, up-to-date, and easy to use is one of the most important functions of the owner-manager, his or her staff, and his or her outside counselors (lawyer, accountant, banker).
8.6. Basic Records
1. Do you have a general journal and/or special journals, such as one for cash receipts and disbursements?
A general journal is the basic record of the firm. Every monetary event in the life of the firm is entered in the general journal or in one of the special journals.
. Do you prepare a sales report or analysis?
a. Do you have sales goals by product, department, and accounting period (month, quarter, year)?
b. Are your goals reasonable?
c. Are you meeting your goals?
If you arent meeting your goals, try to list the likely reasons on a sheet of paper. Such a study might include areas such as general business climate, competition, pricing, advertising, sales promotion, credit policies, and the like. Once youve identified the apparent causes you can take steps to increase sales (and profits).
8.7. Buying and Inventory System
1. Do you have a buying and inventory system?
The buying and inventory systems are two critical areas of a firms operation that can affect profitability.
. Do you keep records on the quality, service, price, and promptness of delivery of your sources of supply?
. Do you know
d. How long it usually takes to receive each order?
e. How much inventory cushion (usually called safety stock) to have so you can maintain normal sales while you wait for the order to arrive?
4. Have you ever suffered because you were out of stock?
5. Do you know the optimum order quantity for each item you need?
6. Do you (or can you) take advantage of quantity discounts for large size single purchases?
7. Do you know your costs of ordering inventory and carrying inventory?
The more frequently you buy (smaller quantities per order), the higher your average ordering costs (clerical costs, postage, telephone costs etc.) will be, and the lower the average carrying costs (storage, loss through pilferage, obsolescence, etc.) will be. On the other hand, the larger the quantity per order, the lower the average ordering cost and the higher the carrying costs. A balance should be struck so that the minimum cost overall for ordering and carrying inventory can be achieved.
8. Do you keep records of inventory for each item?
These records should be kept current by making entries whenever items are added to or removed from inventory. Simple records on x 5 or 5 x 7 cards can be used with each item being listed on a separate card. Proper records will show for each item quantity in stock, quantity on order, date of order, slow or fast seller, and valuations (which are important for taxes and your own analyses.)
8.8. Other Financial Records
1. Do you have an accounts payable ledger?
This ledger will show what, whom, and why you owe. Such records should help you make your payments on schedule. Any expense not paid on time could adversely affect your credit, but even more importantly such records should help you take advantage of discounts which can help boost your profits.
. Do you have an accounts receivable ledger?
This ledger will show who owes money to your firm. It shows how much is owed, how long it has been outstanding and why the money is owed. Overdue accounts could indicate that your credit granting policy needs to be reviewed and that you may not be getting the cash into the firm quickly enough to pay your own bills at the optimum time.
. Do you have a cash receipts journal?
This journal records the cash received by source, day, and amount.
4. Do you have a cash payments journal?
This journal will be similar to the cash receipts journal but will show cash paid out instead of cash received. The two cash journals can be combined, if convenient.
5. Do you prepare an income (profit and loss or P&L) statement These are statements about the condition of your firm at a specific time and show the income, expenses, assets, and liabilities of the firm. They are absolutely essential.
8.. Do you prepare a budget?
You could think of a budget as a record in advance, projecting future inflows and outflows for your business. A budget is usually prepared for a single year, generally to correspond with the accounting year. It is then, however broken down into quarterly and monthly projections. There are different kinds of budget cash, production, sales, etc. A cash budget, for example, will show the estimate of sales and expenses for a particular period of time. The cash budget forces the firm to think ahead by estimating its income and expenses. Once reasonable projections are made for every important product line or department, the owner-manager has set targets for employees to meet for sales and expenses. You must plan to assure a profit. And you must prepare a budget to plan.
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