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. I
n 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. Operations
2. New investments
3. Long-term borrowing
4. Sale of assets
The major uses or applications of funds are:
1. To increase assets
2. Retire long-term liabilities
3. Reduce owner or stockholders' equity
4. 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.