Finance Plan And Project Financing
There are many sources for financing out there. It is your job to find a lender and convince him that your business idea is economically sound and profitable.
In order to do that, it is crucial to have a detailed and realistic financial planning.
The most important information in your finance plan needs to be shown in this chapter of your business plan, while the details can be given as an attachment.
The financial information you definitely need to include in your business plan are:
The amount of financing you are requesting and the total costs, including an overview about how you intend to cover the costs not requested to be financed through a lender. Also, include information about the condition for the loan you are requesting (especially loan term, repayment rhythm, etc.).
The expected profits or losses during your first years of business (at least three years should be shown).
When you expect to become profitable (break-even-point).
Explanation of your assumptions.
A statement about your personal finances.
Sources and Uses of Funds (Loan Request)
This section is brief, simply list where monies are coming from to fund the project or start-up of your business (“sources”) and how you will spend the “sources” to complete the Project or start up the business (“uses”).
The totals of both sides must be equal. “Working capital” is the money you have left over after totaling all of the specific “uses” and subtracting that total from the “sources” total. The “working capital” number will be used in month 1 of your “cash-flow projections”.
Most lenders expect you to invest some of your own money in the project, since it shows commitment and your willingness to bear some of the risks connected with your project. Usually, lenders expect you to invest between 10% and 30% of the project costs, some lenders even more. Attach proof that you actually hold assets that can be used to finance your part of the project costs (bank statements, deeds if you want to use property, etc.).
Also, it is a good idea to include information about what kind of loan you are requesting (short term, intermediate term, or long term) and how you plan to repay the loan, as well as collateral you are willing to offer in order to secure the loan.
In general, the loan term you are choosing should correspond with the life expectancy of the item you want to finance. For example, a car with an average life expectancy (standard appreciation time) of 5 years should not be financed with a loan longer than these 5 years.
Short Term (less than a year)
Short-term loans are called “Lines of Credit” (LOC) or “Revolvers” and work like a credit card, with a pre-determined amount. Lines of credit are primarily used for working capital and must be paid back in full within that year.
Intermediate Term (1 – 10 years)
An intermediate term loan can be used to buy a business, equipment or for long-term working capital. Repayment usually occurs in monthly payment, but quarterly, semi-annually or even annually payments are possible as well.
Long Term (10 years or more)
Loan with a long term work like a mortgage and can be used to finance commercial real estate, commercial vehicles (not cars) and heavy equipment.
Be aware, that lenders do not consider your offered collateral with the value you are stating. It is common for lenders to initiate appraisals of your collateral and to discount the value. The costs for appraisals have to be paid by you, in most cases. Include an estimate for these costs in your calculation. The total discounted collateral must at least equal the loan amount you are requesting, but some lenders require an additional coverage of up to 25%.
Example For A Collateral Calculation
|Example||Market Value||Discount||Discounted Value|
|Property (Real Estate)||50000||0.8||40000|
Pro-Forma Income Projections (Profit & Loss Statement)
The core of your profit and loss statement is the determination when your business will start to make profit (break-even-point) and how much profit you expect. It requires you to project (estimate) future sales/income and expenses based on the business plan going forward.
Existing businesses can use their historical financial information as a starting point to project future sales and expenses. If you are a start-up, you won’t have any prior numbers to work from.
You’ll have to give your best estimates on what they will be. You have to be realistic. Also, you should do some research to support your estimates and get quotes for expense items to make sure your estimates are reasonable.
This is a guideline for your business’s ability to be profitable. The business may not show profitability in its first year(s). However, it should be profitable within a reasonable amount of time or it may be showing you that the business can’t support you. The profit and loss statement should be prepared for at least the first three years, with the first year on a monthly basis, while the other years can be on a cumulated basis. If your business is seasonal, explain why and how that will affect the business’ income.
Pro-Forma Cash Flow Projections
Next to your income projections, your cash-flow projections are just as important. Here you calculate your in and outgoing payments on your business account. Also, the capital requirements for your business (especially for the start-up period) have to be included. Your income projections will tell you if you have to expect a capital (cash) shortage in the future, allowing you to react to it before it actually occurs.
That way, you can make sure that your business will always have enough cash to actually stay in business. Note that the government estimates that most small businesses that file for bankruptcy are actually profitable when they file. These businesses just run out of money needed to run day-to-day operations!
As with the profit and loss statement, your cash-flow projections should include at least the first three years of business, with the first year on a monthly basis, while the remaining years can be on a cumulated basis.
You will note that some numbers in the profit and loss statement and in the cash-flow projections are actually the same. But don’t assume that you are doing the same work twice. There are some decisive differences between the profit and loss statement and the cash-flow projections.
CREATING REVENUE AND EXPENSES (PROFIT & LOSS STATEMENT)
RECEIPT OF PAYMENTS AND MAKING PAYMENTS (CASH-FLOW PROJECTIONS)
- Whenever you sell a product and/or service and create a bill for it, you generate revenue that will be shown in your profit and loss statement immediately. But for your cash-flow plan it is important to know when that bill has been or will be paid. If your customer pays that bill two months after he bought your product and/or service, accordingly your cash-flow will be affected only two months after the sell.
- If you make investments (i.e. new computers, machines, cars, etc.) you have to pay these investments by delivery (or shortly after). Your cash-flow plan will show that investment as payment by the time you pay the bill. But your profit and loss statement will never show that payment since investments are not considered expenses. The expense related to that investment will be the related depreciation throughout the following years.
- If you take out a loan and that loan gets disbursed to you, your cash-flow plan will show the receipt of that payment. But receiving the loan does not create revenue for your business. Also, the repayment of the loan principal does not affect your profit and loss statement, only your cash-flow statement. The only loan related expense that will be shown in your profit and loss statement as well will be the interest!
Pro-Forma Balance Sheet (Fiscal Year-End Statement)
The balance sheet is a snapshot of your business financial situation on a given date (mostly 12/31 or 06/30, but every other combination is possible too. It is just important to remember to use the same date for every year), mirroring your assets and liabilities.
Here you will find the profit or loss, determined in the profit and loss statement, as one influencing factor. The balance sheet consists of two parts (sides), while the total of both parts must equal each other. The first part is called “assets” and includes all your companies “belongings” and claims you have towards other (“accounts receivable”).
It is important to know that asset’s “wear out”, which means they lose value over time. The only exception is land. The “lost” value is called “deduction” and is shown as a reserve for the “depreciation”, which will be found in your “profit and loss statement”. The remaining asset value in your balance sheet does not necessarily have to be equivalent to the real market value or the price you could sell that asset for.
The second part lists all your company’s debts (“liabilities”). The difference between these debts and the assets from the first part shows your company’s “capital or net worth”. The “liabilities” and the “capital or net worth” combined must equal the assets in your company.
If your company already exists, include the fiscal year-end statements for the last three years and an interim statement (not more than 90 days old) as attachment. For start-up companies, please provide an opening balance sheet that will show your company’s assumed financial situation the day after the loan closes.
|Cash||Current Portion of Long-Term Debt|
|Time deposits and short-term investments||Notes Payable|
|Accounts Receivable (A/R)||Accrued Taxes|
|Prepayments||Accounts Payable (A/P)|
|Inventory||Total Current Liabilites|
|Total Current Assets|
|Fixed Assets||Total Long-Term Liabilities|
|(Less Accumulated Depreciation)|
|Fixed Assets (net)||Total Liabilities|
|Advances to owners|
|Total Non-Current Assets||Owners Investment / Capital Stock|
|Total Assets||Total Liabilities & Capital|
This section will show you what level of sales will be needed to cover all of your fixed expenses. This will tell you at what point you start to produce profits. (One dollar more and your business is profitable. One dollar less and your business shows a loss). To determine the break-even point for your business requires you to determine two numbers. The first is your fixed cost. These are expenses you must pay every month regardless of your sales volume.
Fixed costs include rent, insurance, interest, office supplies, maintenance fees, administrative costs, salaries, etc. Total your Fixed Costs and divide the total by your Average Gross Profit Margin. Simply put, your Gross Profit is the amount of profit you make on a sale. The Gross Profit Margin is your Gross Profit shown as a percentage of your total sales.
For example, you sell an item for $25.00. The item has variable costs of $15.00, related strictly to the item and not including any overhead (fixed) costs. Your Gross Profit is $10.00 ($25.00 sale minus $15.00 cost). Your Gross Profit Margin is calculated by dividing Gross Profits by Sales Price.
In this example, the Gross Profit Margin is 40% ($10 divided by $25). Your Average Gross Profit Margin is the average estimated gross Profit Margin on all sales of all products. This is also expressed as a percentage.
Now that you know your Fixed Costs and your Average Gross Profit Margin, you can complete your break-even analysis. The formula is as follows:
|Fixed Costs||= Break-Even Point|
For example, if you have $1,000 per month in Fixed Cost and your Average Gross Profit Margin is 40%, then your Break-even point would be $1,000 divided by 0.40 or $2,500. This means that you have to sell good for $2,500.00 to break even for the month.
Determination of Loan Amount (1-2-3 Method)
No matter how high your startup costs are, there is a maximum amount of loans your business can handle. Many people (and especially first-time founders) have problems to determine how much money they should request from a lender. And although there is no definitive way to determine the best possible loan amount, some easy calculations can help you to come up with a number that can be used as starting point for your “negotiations” with potential lenders.
The “1-2-3 method” will provide you three different values: The lowest value from 1 to 3 is the maximum loan size you should request from your lender. If your capital need is higher than that, you need to think about increasing you own share of the project costs or revise the project completely in order to match it to the loan amount possible. If you manage it to obtain publicly subsidized financing with lower interest rates, the maximum loan amount goes up accordingly.
CALCULATION OF THE MAXIMUM LOAN AMOUNT
- “Collateral Coverage” (“Discounted Collateral”)
In general, it doesn’t matter how much money you want to borrow, it is important that every dollar borrowed is covered in collateral. As described in this section above, lenders discount the collateral that you offer to them. That means that the discounted value of your collateral (and not the assumed current value) must equal the loan amount. By following the example, your maximum loan amount would be $54,500.
- Your (business) ability to repay (“Debt Service Coverage”)
As a rule of thumb, every two dollars your business has in annual cash-flow, a lender will allow a maximum of one dollar in loan payments (50% rule). Of course, that will differ from lender to lender, but it should send you into the right direction.
Example: Your annual cash-flow is $12K, which results in $6K as the maximum amount lenders usually allow in annual payments. Now you need the average interest rate lenders charge on business loans. For our calculation, we assume 8% per anno for a 5 year loan. For every $1,000 loan, that would result in around $244 in payments per year. Finally, you divide the $6K (the maximum lenders allow as annual loan payments) by these $244 and you come up with 24.59 … which equals $24,590 (since the calculation was based on $1,000).
- Equity (“Debt-to-Worth” / “Leverage”)
Another rule says that a business can borrow up to three dollar for every dollar it has invested (“Capital Stock”).
Example: You business has a net worth or equity of $15K. The maximum loan based on the equity is $45,000 ($15K x 3).
You will gather the information necessary to complete the “1-2-3 method” during the course of writing your business plan anyway, so don’t be afraid of using them. It is much better for you if you find out by yourself that you can’t finance your project the way you wanted, than being told by a bank. That way you can revise your project and hopefully find another way to achieve your dream.
In our calculation, the lowest amount results from number 2 … $24,590. That means that even if your collateral could cover a much higher loan, your business can only support a loan in the amount of roughly $25,000.
Of course, you can always try to apply for an amount higher, but be aware that lenders do make their own calculation in order to find out how much loan your business can handle. Sometimes, if your collateral is really good, lenders are willing to give you a higher amount, but there is no guarantee for that.
This loan calculator will only provide you with estimates; you will receive the final and accurate loan breakdown from your lender at the time of closing.
If you ask yourself right now what a “business ratio” is, than just imagine it as a “score” that your business is reaching in a certain area. And there are many business areas lenders determine “scores” for. These “business ratios” help the lender to make a decision whether they want to be a part of your project or not.
Lenders (and potential investors as well) compare these ratios to:
Internal acceptable bank ranges,
Your company’s former years (history), and
Other companies in your industry.
You can find industry averages in reference books and on the internet. They include:
The RMA Annual Statement Studies,
The Almanac of Business and Industrial Financial Ratios,
Dun & Bradstreet,
Your industry’s associations,
Trade periodicals (magazines and newspapers for your industry), and
The Small Business Administration (SBA).
|ASSET MANGEMENT RATIOS|
|Accounts Receivable Turnover||=||Net Credit Sales Figure|
|Average Accounts Receivable (A/R)|
|... By dividing 365 (360) by the "Accounts Receivable Turnover" ratio, you will know how many days it takes for you to collect money that is owed to you. The lower, the better. Number sources are the balance sheet and the loss & income statement.|
|Inventory Turnover||=||Costs of Goods Sold|
|... By dividing 365 (360) by the “Inventory Turnover”, you will know how many days it takes you to turnover (or sell) your inventory. The lower, the better. Number sources are the balance sheet and the loss & income statement.|
|Working Capital||=||Current Assets - Current Liabilities|
|... Shows if your company has enough cash to pay bills. The answer must be positive. Otherwise your company needs more money (higher loan amount). Number source is the balance sheet.|
|Quick or Acid Test||=||Total Current Assets - Inventory|
|Total Current Liabilities|
|... This ratio eliminates the inventory from current assets and cash since it may become no longer useful. It is called “quick” because it includes only items that can be turned into cash. Number source is the balance sheet.|
|Current||=||Total Current Assets|
|Total Current Liabilities|
|... Tests a company’s short-term debt paying ability. The ratio must be at least one, but should be actually higher. Number source is the balance sheet.|
|Debt Management Ratios|
|Leverage (Debth-To-Worth)||=||Total Liabilities|
|... Determines whether a company has enough equity. Lower answers are better. Lenders prefer it to be lower than three. Number source is the balance sheet.|
|Accounts Payable Turnover||=||Accounts Payable (A/P) x 365|
|... Shows how quickly a company pays its suppliers. Lower number are better (a high number could implicate that your business has cash-flow problems). Number sources are the balance sheet and the loss & income statement.|
|Profitability Management Ratios|
|Profit Margin on Sales||=||Net Profit|
|... Shows the percentage of net profit for every dollar of sales. If the profit margin is too low: The prices are too low, the costs of goods are too high, or expenses are too high. You should compare the profit margin to previous years (for existing companies) and hopefully show a positive development. Number source is the loss & income statement.|
|Cash-Flow to Current Maturities (Debt Service)||=||Net Profit + Depreciation|
|Current Portion of Long-Term Debt *|
|... Shows your business' ability to pay term debts after owner's withdrawal. Lenders prefer a ratio of two or better. Number sources are the balance sheet and the loss & income statement. (* For new business, use one year's worth of loan payments.)|
For your business plan, it is not always necessary to calculate and include these ratios since lenders will make their own calculations anyway. But these ratios can give you information about the state of your business that can be useful for your day-to-day operations and for creating a business plan.
Therefore, you should familiarize yourself with these ratios. If you know where your business’ problems are, you are automatically identifying areas for improvements and areas where your business can potentially grow. Use these numbers for your business’ advantage and adjust your business plan in a way that your future is designed to improve these ratios.
Lenders don’t finance your business because they want it to stay the way it is. They always have in mind that every financing they give you should be used to improve your business. The ratios explained above can help you to show these improvements.