CHAPTER 10

THE FINANCIAL PLAN

SERJOE ORVEN GUTIERREZ - MMEd
REPORTER
LEARNING OBJECTIVES

1. To understand the role of budgets in preparing pro forma

statements.
2. To understand why positive profits can still result in a negative cash
flow.
3. To learn how to prepare monthly pro forma cash flow, income,
balance sheet, and sources and application of funds statements for
the first year of operation.
4. To explain the application and calculation of the break-even point
for the new venture.
5. To illustrate the alternative software packages that can be used for
preparing financial statement.
The financial plan provides the
entrepreneur with a complete picture
of how much and when funds are
coming into the organization, where
funds are going, how much cash is
available, and the projected financial
position of the firm.
It provides the short-term basis for budgeting
control and helps prevent one of the most
common problems for new ventures-lack of cash.

The financial plan must explain to any potential

investor how the entrepreneur plans to meet all
financial obligations and maintain the ventures
liquidity in order to pay off debt or provide a good
return of investment.
In general, the financial plan will need
three years of projected financial data
to satisfy any outside investors. The
first year should reflect monthly data.
 OPERATING
AND
CAPITAL BUDGETS
Before developing the pro forma
income statement, the entrepreneur
should prepare operating and capital
budgets. If the 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 venture.

For example, a sales budget may be prepared by a

sales manager, a manufacturing budget by the
production manager, and so on. Final determination
of these budgets will ultimately rest with the
owners or entrepreneurs.
In the preparation of the pro forma income
statement, the entrepreneur must first develop a
sales budget that is am estimate of the expected
volume of sales by month.

From the sales forecasts the entrepreneur will then

determine the cost of these sales. In a manufacturer
venture the entrepreneur could compare the cost of
producing these internally or subcontracting them
to another manufacturer.
Also included will be the estimated
ending inventory needed as a buffer
against possible fluctuations in
demand and the costs of direct labor
and materials.
Table 10.1 illustrates a simple format for a production or manufacturing
budget for the first three months of operations.
Table 10.2 provides an example of an operating budget. In this example, we can see that salaries
increase in month 3 because of the addition of of a shipper, advertising increases because the
primary season for this product is approaching, and payroll taxes increase because of the additional
employee. This budget along with the manufacturing budget illustrated in Table 10.1, provides the
basis for the pro forma statements.
Capital budgets are intended to provide a basis for
evaluating 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 cost 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.
 PRO FORMA
INCOME STATEMENTS
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.
Table 10.3 summarizes all the profit data during the first year of operations for MPPI Plastics. This
company makes plastics moldings for such customers as hard goods manufacturers, toy manufacturers
and appliance manufacturers.
PRO FORMA
CASH FLOW
Cash flow is not the same as profit. Profit is the
result of subtracting expenses from sales, whereas
cashflow results from the the difference between
actual cash receipts and cash payments.

Cash flows only when actual payments are received

or mades. Sales may not be regarded as cash
because a sales 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 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.
 PRO FORMA
BALANCE SHEET
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 pro forma income
and cash flow statements to help
justify some of the figures.
The pro forma balance sheet
reflects the position of the
business at the end of the first
year. It summarizes the assets,
liabilities, and net worth of the
entrepreneurs.
Table 10.7 depicts the balance sheet for MPPI Plastics. As can be seen, the total assets equal the sum
of the liabilities and owners’ equity.
Assets
• These represents 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 time.
Liabilities
• 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.
Owner equity
• This amount represents the excess
of all the assets over all liabilities. It
represents the net worth of the
business. Any profit from the
business will also be included in the
net worth as retained earnings.
BREAK EVEN
ANALYSIS
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 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 to break even.

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 cost necessary to produce each unit (variable
cost).
PRO FORMA SOURCES
and
APPLICATION OF FUNDS
The pro forma sources and
applications of funds statement
illustrate the disposition of earnings
form operation and form 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? and What
happened to asset items during the period?