Develop a Financial Plan

While we have already covered much of the “how-to” of financial planning, the drivers of your financial plan are your goals. Clarifying your business goals and financial goals takes consideration. Using the SMART formula helps not only clarify what you want to achieve but specifies how you will achieve it and the timing.

The SMART Formula

ACTIVITY

Are the following three financial goals SMART? Select 'Yes' or 'No' as your response.

How much cash do you need to run your business? Even a micro business requires some cash in the bank to ensure debts can be paid such as monthly rental and necessary supplies. A wholesaler or retailer requires even more capital to ensure they can pay for the inventory they require for their business and the warehousing of the stock.

Working capital is made up of three (3) components:

1. Stock management
2. Payment suppliers – creditor payments
3. Collection of cash from customers – debtor collection

As you can read on business.vic.gov.au, working capital is often referred to as ‘the working capital cycle’ and it is the length of time it takes from using your cash to purchase stock, convert stock into a product, sell the product and then secure a sales and receive the cash.⁴

A business can use its working capital cycle to improve its short-term liquidity and increase its cash.

Watch the following 5-minutes-video to learn more about the working capital cycle presented by the Corporate Finance Institute:

There are three (3) methods used for analysing working capital requirements:

1. Percentage of sales method
2. Regression analysis method
3. Cash conversion cycle method

The cash conversion cycle is the most commonly used method for analysing your working capital requirements and is the method that we will focus on. It calculates the number of days to convert the cash outflow to purchase stock into a cash inflow when the product is sold.

Since a business will rarely make enough revenue to cover its expenses in the first few months, it is important to know just how much capital you will need to cover you for that time.

To do that, you will need to work out your monthly expenses and calculate how much working capital you need either from your own savings or borrow, to cover you for the first few months and other lean times that you will inevitably face.

ACTIVITY:

Case study

Lara’s Lashes and Nails

If you remember in the last topic, Lara calculated her total operating expenses as $78,000 for the year.

Based on this, she would calculate her working capital requirements as $6,500 per month. But is that correct?

Some debts are not payable monthly. For example, she may need to pay her marketing costs for pamphlets in the first month, and she may need to stock her shelves with nail polish, gel, glue and so on at the same time.

What she should do is develop a cash flow projection to really understand how much working capital she needs in every quarter.

Will your business require costly machinery and equipment?

Consider your options:

• Leasing the equipment
• Taking out a business loan
• Using a line of credit that has a redraw facility
• Buying second-hand

Before deciding on any asset purchase, ask yourself these questions:

• How long will you need the asset?
• Is it cost-effective?
• Will the extra business you make cover the expense of leasing or purchasing?
• Will the asset become outdated in the near future? For example, a software may need to be constantly updated. If so, it may be better to take the subscription option that many software companies offer rather than purchasing it. The same applies to mobile phones.
• What are your current financial priorities? Are there other purchases that should be made first?
• How will the lease or purchase options affect your cash flow?
• What are the taxation implications of each alternative?

Managing your organisation’s assets, no matter what type, unlocks efficiency and greater accountability and is a must-have in any successful business, regardless of whether it’s a tiny local store or a multinational corporation serving millions.

Assets⁵ refer to anything owned by organisations that are used in business operations, such as computers, machines, desks, hardware and software, etc. Assets can be tangible (e.g. equipment) or intangible (e.g. goodwill, intellectual properties.⁶

Proper management of assets takes a systematic approach to maintain assets so they provide optimal value for as long as possible. This reduces asset expenditure and boosts work performance through high-quality equipment.

To effectively manage the assets, owners should consider any of the following asset management strategies:

• Preventative maintenance 
• Track the asset life
• Track depreciation of the assets
• Have a contingency plan
• Secure your assets to limit access to strengthen security and avoid theft and equipment damage.

Estimating asset requirements

Some businesses have huge asset requirements and others very few. A dental surgery can cost as much as $800,000 for highly specialised equipment such as drills, pumps, x-ray machines, dental chairs, etc. However, Lara’s Lashes requires only a salon bed, lighting and reception fit-out.

ACTIVITY

Consider a local small Garden and Landscaping business. What assets would be required to run the business?

How could you manage effectively these assets, whether you are leasing them or you purchased new (or second-hand) tools and machinery?

There is an age-old saying in business management that Cash is King. This is because the first thing that will cause a business to run into financial trouble, even if it is profitable, is cash flow. If a business doesn’t have the money to pay its commitments when they are due, it can easily run into financial problems from contractors, employees and the like.

Managing your cash flow is imperative, particularly if you are in a business that relies on invoicing customers, often for large sums. In this case, you may find that cash can take up to 30 days or more to flow into your accounts from the time that you make the sale and supply the products or service.

A cash flow projection projects how much cash will flow into the business each month and how much will flow out to pay expenses. This enables you to make more informed decisions around tax, new equipment purchases and gives you a warning if you need a business loan.

You can also see the likely effect of a potential business change or decision such as changing premises or hiring extra staff. You can add the related costs to your forecast to see the impact before deciding whether or not to go ahead.

You should include best, worst and most likely case scenarios because doing so will allow you to anticipate your cash position if you suddenly hit lean times or have a better-than-expected month. Developing a contingency plan is a good idea.

Adding a contingency means adding extra cash that can be drawn on such as taking out a provision for an over-draft if you need it.

When developing a cash flow projection:

• Look at the invoices to be raised and paid to you during the month
• Consider the supplier bills to be paid by you during the month
• Consider your other commitments like tax office obligations, salaries, rent and other fixed costs.

Your cash flow projection can help you make business decisions about major purchases because you will be able to tell how much cash is coming in and going out of the business each month.

Your cash flow forecast will inform you what your burn rate is and how much cash you need to keep on hand on a monthly basis. In the early stages of your business venture, you will need to fund the capital requirements either from your own funds or from venture capital that you source elsewhere. The estimate needs to be as realistic as possible. If your estimate is too low, and you do not have enough cash on hand, your business will be doomed to failure. Under-capitalisation is one of the primary causes of small business failure.

At this stage, you should work out a budget for your business to help you manage your capital and grow the business. You can then track the business’s performance against your budget targets to keep you motivated. 

While your forecast states the actual expectations for results, a budget lays out the plan for what you want to achieve. Your budget becomes your target.

Your budget is a separate document. It is a modified version of your financial plan that is created for a financial year. Once finalised it will not be modified. It will contain a budgeted monthly income statement, budgeted balance sheet and budgeted cash flow statement. This document will run alongside your finance plan and forecasting.

You will have a goal in mind for your business and usually, you want to stretch yourself and your staff to achieve better than average results. You use your budget to capture these goals/targets. You will monitor your budget either weekly or monthly, calculating the variance between what you have actually achieved and what you wanted to achieve. This is the time to consider what sales tactics have worked, what have not, and how you have managed expenses.

Whatever the results, you will not alter the budget until the end of the year when you reset targets.

On the other hand, you will usually review your forecast monthly to ensure you will have enough working capital for the business going forward. If you do not, you might have to:

• make adjustments to expenditure
• follow up on unpaid invoices (debtor management)
• postpone purchases
• draw down a loan you have organised from your lending institution.

Watch

Watch this video by Right Source to learn about how to prepare an annual budget for a company.

Use the following questions to check your knowledge:

1. What do you need to include in a financial plan?

   Answer

   1. Your financial goals
   2. Start-up costs
   3. Borrowing requirements
   4. Operating expenses forecast
   5. Cost of Goods (COGs)
   6. Sales Forecast
   7. Cash flow forecast
   8. Profit and Loss statement
   9. Break-even analysis
   10. Credit management

2. What's the difference between a financial forecast and a budget?

   Answer

   A financial forecast outlines the expected results of the business and indicates where the business is actually going. It is updated regularly. A budget is a plan for where the business wants to go and contains targets. Once created for a 12-month period the budget is not updated. It is created once for a given financial year.

3. Why you might choose to lease a vehicle for the business rather than purchasing it?

   Answer

   Leasing a vehicle frees up cash and buying a vehicle uses up cash and reduces your capital. So you might lease to free up this cash to enable you to purchase other assets or pay company bills.

4. How do you calculate net cash flow?

   Answer

   Receipts – Payments = Net cash flow

5. What is the SMART system and how is it used for establishing business goals?

   Answer

   SMART is a guide to setting effective goals. It is an acronym that defines the parameters that can help you to plan and achieve your business goals.

   • S – Specific
   • M – Measurable
   • A – Achievable
   • R – Relevant
   • T – Timely