Financial Planning

1. Financial Planning Innovation, Entrepreneurship & Design Toolbox

2. Financial modelling A financial model or plan is a projection of your venture’s financial position and development over time based on a set of assumptions resulting in a set of financial statements measuring different aspects of the company’s finances Income & expenditure Cash flow Balance sheet plus Sensitivity analyses to model changes in assumptions What?– Why? – How? – Example – Conclusion

3. Why make a financial plan? To evaluate how much cash the business is likely to require A basis for estimating the value of a project/venture Helps an entrepreneur/project leader to compare strategic alternatives for developing the business and select the one with the highest expected value Benchmarking: to later compare the plan with actual events, and provide an early warning if the project is not developing as expected, allowing you to react quickly (raise extra money/abandon the project) And finally, financial planning provides figures used for valuing a company when talking to investors What? –Why? – How? – Example – Conclusion

4. How to make a financial plan Basic principles Assumptions – revenue, costs, timings Workings – NWCN, capital investments, finance needs Outputs – financial statements Applying principles to the IED Financial Plan Template (downloadable from the IED Dashboard) Risks and Sensitivity/Scenario analysis What? – Why? – How? – Example – Conclusion

5. Components of a financial plan Assumptions re: Revenue Operating Costs Investments in assets Timing of events What? – Why? – How? – Example – Conclusion Income Statements (aka Profit & Loss statement) Cash Flow Statements Treasury & Balance Sheet Outputs Inputs Workings Net Working Capital Need External Financing needed Risks and Sensitivity/Scenario Analysis

6. To use the template: In each worksheet, enter information and figures into any fields that are filled in yellow In some yellow fields, pre-entered text in grey offers suggestions or examples of the type of information you need to enter; you should overwrite this text with your own information Your information needs to be entered into the Worksheets entitled ‘Rev-Cost Assumptions’, ‘NWC’, ‘Investments’ and ‘Finance’. Additional worksheets, such as the Profit&Loss (P&L), Treasury (Cash Flow) and Balance Sheet will be generated automatically, based on the information you entered in the earlier worksheets. Information must be presented in monthly units for the first year, then quarterly for the remaining four years IED Financial Plan Template What? – Why? – How? – Example – Conclusion

7. 1. Assumptions A. Revenues These depend on your market estimates (see your Entrepreneurial market research and Market testing) market size market development speed / growth Pricing What? – Why? – How? – Example – Conclusion

8. Quantitative Market size estimation What? – Why? – How? – Example – Conclusion TOTAL MARKET Top Down – desktop research MARKET SIZE FOR PRODUCT/COMPANY Bottom Up – market research, concept and market testing WITNESSES

9. Types and quantity of Revenue See ‘Revenue-Cost Assumptions’ Worksheet Depending on your business plan, you may have different types of revenue Sales of product Consulting Licensing Public subsidies These need to spelled out in the template (column B) along with the unit type (column F) e.g. hours or days for consulting service, units for physical products, contracts for software licences, etc. and unit price (column E) Then for each month or quarter (as applicable) enter the number of revenue units you expect to receive for each type of revenue (from column G onward) e.g. 20 days of consulting = 20 units; 6 software contracts = 6 units; 3,000 gadgets = 3,000 units What? – Why? – How? – Example – Conclusion IED Financial Template

10. Direct: directly attributable to unit of product sold/manufactured. E.g.: electricity uniquely used by a machine for manufacturing the product Indirect: related to overall operations, not a specific product, e.g. Administration, Marketing Variable: vary with the level of activity or number of products sold / manufactured. E.g.: raw materials used to make one unit of product Fixed – unchanging or flat rate, aka ‘overheads’, e.g. rent of premises, cleaners, fixed salaries Semi-variable: contain fixed and variable components E.g. Utility bills – partly based on a fixed flat rate and partly based on variable usage B. Costs - Types of cost What? – Why? – How? – Example – Conclusion Direct Indirect e.g. Raw materials for a specific product;hourly wages for product personnel e.g. Overall Machine running costs that vary with overall production levels Variable e.g. Overall General and Administrative costs, monthly salaries for admin staff; Rent of building e.g. Flat rate Machine rent for specific product; Flat wage for production staff Fixed

11. See ‘Revenue-Cost Assumptions’ Worksheet The template divides costs into the following categories: Direct Variable costs Fixed Costs Direct Variable costs – these arelisted by type of product, as already described in under ‘Revenue’ In column E: enter the overall direct variable cost for making and selling one unit of each type of product, e.g.: All the Raw materials, production costs, or the outsourcing cost of one unit Any cost per unit that varies as production and sales volumes vary In columns G onward, the spreadsheet automatically calculates £ amount of direct variable costs, based on the amount of product sold under ‘Revenue’ What? – Why? – How? – Example – Conclusion Costs IED Financial Template

12. Fixed Costs 2. Fixed Costs – Incolumn E, enter the expected cost per month for each type of fixed cost. The spreadsheet will transfer this to monthly or quarterly costs in the subsequent columns Human resources costs, e.g. Manufacturing staff, Sales staff (Front Office / Back Office sales), Administration staff, Technical/IT staff Note that in Rows 37 and 38, you may include an annual % salary increase and bonuses based on revenue. Training Expenses, e.g. Staff training Services rendered by third parties, e.g. patent attorney, lawyer, PR agency,… Operational/Infrastructure costs, e.g. travel, phone and utilities, consumable office supplies... Marketing, e.g. Website Design, Trade Fairs, Market research, Advertisements, etc. Note: you may modify the Fixed Cost categories to suit your own business; the same categories will carry over into other worksheets such as P&L and Cash Flow. You may also modify the way that costs are calculated (e.g. not the same cost per month), by overwriting the formulas in columns G onward What? – Why? – How? – Example – Conclusion IED Financial Plan Template

13. C. Timing of events – Net Working Capital From your bottom-up sales forecast, you should estimate when you expect to book sales, on a monthly and quarterly basis You will also estimate your operational costs You must then estimate when sales and costs will actually be paid (there is usually a time-lag between invoice dates and actual payment dates) You will need this information to determine your Net Working Capital Need and your Cash Flow analysis This is one of the factors determining how much external finance you will need to raise What? – Why? – How? – Example – Conclusion

14. Timing differences – Sales/profit vs. Cash flow Suppose you pay your suppliers 30 days after invoice And your customers pay you 60 days after invoice Your profit figures and cash in hand will be different at any given time, because your invoice date is considered the revenue date for profit analysis, but the payment date is your cash flow date Your profit breakeven and cash breakeven will also occur at different times What? – Why? – How? – Example – Conclusion November December January February Profit & Loss Sales (invoiced) 10000 8000 8000 9000 Costs (incurred) -5000 -5000 -4000 -4000 Profit for period 5000 3000 4000 5000 Cash flow Sales (receipts in) 0 0 10000 8000 Costs (paid out) 0 -5000 -5000 -4000 Opening cash 0 0 -5000 0 Net cash flow (S-C) 0 -5000 5000 4000 Closing cash (Treasury position) 0 -5000 0 4000

15. Net Working Capital Need Working Capital is your operating liquidity – the ‘current’ (liquid) assets with which you fund day-to-day operations to generate sales –including cash and also stock (since it can be sold in the short term) and receivables (money owed and soon to be paid to you by customers). Net Working Capital refers to your current assets minus any current liabilities; the latter include payables (money you owe to suppliers) and any loan interest due in the next 12 months, including interest on bank overdrafts. Because of Timing differences (credit periods) between invoicing and actual payment, money in and money out do not usually coincide, so NWC could be negative. Thus you will need to have a pool of cash to cover operations during those shortfall periods: this is your Net Working Capital Need (NWCN) What? – Why? – How? – Example – Conclusion

16. Timing differences in operations and NWCN What? – Why? – How? – Example – Conclusion Pay supplier Customer pays Credit to customer Credit from supplier Time Net Working Capital Need Production and stock period Purchase raw material Sale of furniture The company gets financed by suppliers during part of the production period, but needs to finance rest of production and stock period, and the customer’s credit period Credit and payment conditions typically depend on the industry and your power in the market.

17. How much NWC does a company need? A company is very healthy if NWC > NNWC (you hold orreceive more cash than you need to pay outin a given period) e.g.: supermarkets are paid instantly by customers at the till, but they usually pay their food suppliers 90 days after invoice. This means that they hold their revenue from sale of product for 90 days before they pay the supplier for that product! Suppliers finance the supermarket’s NWC. However, small companies are less likely to be granted such generous credit facilities by suppliers; they are more likely to have to pay their suppliers before they receive money from customers. Startups usually need to raise cash from other sources of finance (e.g. equity investors) to cover NWC Need until it can be covered by adequate ongoing sales revenue. This is commonly calculated as ‘Stock + Receivables – Payables’ What? – Why? – How? – Example – Conclusion

18. NWCN Go to the ‘NWC’ Worksheet Revenue/client and Cost/supplier information is exported automatically from the ‘Rev-Cost Assumption’ sheet Inputs for NWCN, column C: Stock and work-in-progress: If stock and materials are held on average for 3 months before sale, enter 100% in the yellow field (cell C20). For any other time scale, enter the appropriate multiple, e.g.: 33% for one month, 200% for six months. Customer credit: similarly, if you expect to grant customers an average 3 months credit on invoiced sales, enter 100% into yellow cell C23. Enter the appropriate multiple for other credit time periods. Supplier debt: if you estimate that suppliers will grant you one month’s credit, enter 33%, and so on. Ponder these estimates realistically, research industry norms!When in doubt, it is preferable to be conservative, e.g.: If you are a start-up, expect to grant customers long credit but to receive short grace periods from your suppliers, who will consider you a risky customer; Note that some costs must be paid immediately, such as salaries (enter 0% for HR) What? – Why? – How? – Example – Conclusion IED Financial Plan Template

19. D. Investments in Assets Investments = Tangible property and equipment acquired to run the business (machinery, computers, land and buildings) Intangible assets: IP costs such as Patent and Trademark filing Intangible assets: Costs incurred for Product Development You need to determine: the amount and timing of these investments; and the life expectancy of the assets acquired (Depreciation – see slide XX) What? – Why? – How? – Example – Conclusion

20. Investment Timing and Cash Flow Example: In 2004, purchase of machine for assembling furniture The machine has a useful life of 5 years purchase price: £100,000 Cash Flow event: one purchase date, one cash outflow What? – Why? – How? – Example – Conclusion 2004 2005 2006 2007 2008 - £100,000 → cash flow

21. P&L Matching principle: match costs and revenues over time periods: The Machine will be used to generate revenue over 5 years For profit analysis, spread the machine cost over 5 years, aka ‘depreciation’, and deduct £20,000 each year from the Revenue in your Profit/Loss (P&L), aka Income Statement P&L events: spread over time What? – Why? – How? – Example – Conclusion Investment Timing and Depreciation 2004 2005 2006 2007 2008 -£20,000 → P&L -£20,000 →P&L -£20,000 →P&L -£20,000 →P&L -£20,000 → P&L

22. Investments Go to ‘Investments’ worksheet: Enter the descriptions of asset investments in column B Enter the £ amount of the investment in column C For ‘Date’ in column D, enter the column numbershown above the month or quarter in which you make the investment For ‘Depreciation’ in column E, enter the expected life, in years, of the asset that you are buying e.g., you buy a machine that you expect to have a useful life of 5 years The worksheet will calculate your depreciation and the times at which you will make the investments. These figures will translate to your Cash Flow to determine how much external finance you need, and to your P&L to determine profit. What? – Why? – How? – Example – Conclusion IED Financial Plan Template

23. Start-ups usually spend a long time in the red before a cash break-even from sales They need financing to cover NWC Need, investments and other expenses until then What? – Why? – How? – Example – Conclusion 2. Workings – Financing Need + ‘Promised land’ [positive net cash flow] Bank Balance 0 Time Amount of finance needed - ‘Valley of death’ [negative net cash flow] From Birley & Norburn (1985)

24. Financing needs You will need to have enough financing to cover your net working capital needs (to produce, hold stock and pay expenses) until you receive cash from sales. You will also need financing to cover investment in non-current (aka ‘fixed’) assets such as equipment and fixtures, patent costs, property, etc. “Golden rule of financing”: each asset with a limited life expectancy is paid for by a funding source with approx. the same life expectancy All fixed assets (+ part of current assets) are financed with long-term funding (LT loans or share capital from equity investors) Some current assets are financed by short-term funding (credit from suppliers, ST loans, bank overdraft, credit cards) What? – Why? – How? – Example – Conclusion

25. Financing need and sources– Golden rule Your financing requirement should be divided into long-term and short-term finance: ‘each asset with a limited life expectancy is paid for by a funding source with approx. the same life expectancy’ See ‘Sources of Finance’ IED activity for further guidance What? – Why? – How? – Example – Conclusion Assets Equity and liabilities Equity Fixed Assets Long Term Loans Current Assets Short Term Debt

26. Finance need Your financing need is the amount of cash you need to raise from external sources to cover necessary cash expenses and investments that cannot be met by your revenue At any given time, this figure is the sum of yourNet Working Capital Need + Investments needed IED Template: You can determine your finance need in any period by looking in the ‘Cash Flow-Treasury’ Worksheet See amounts in row entitled ‘Amount to be financed’ (Row 19) Determine how you can cover these amounts with different sources of finance (see ‘Sources of Finance’ slides in IED Dashboard). What? – Why? – How? – Example – Conclusion Financing Need IED Financial Plan Template

27. Finance sources Go to ‘Finance’ Worksheet Equity capital – Determine how many rounds of equity finance you will need to raise, and when; Express each amount as a number of shares and a price per share (see ‘Valuation’ activity in IED Dashboard) Enter Date at which capital will be raised (expressed as column number for months and quarters) Subsidies Enter amount of subsidy, and Date (by column #) Debt – short-term, long-term, interest Enter short-term debt (loans of 1 year or less) and long-term debt in separate labeled sections; Enter the amount, duration of the loan, the annual interest rate, and If applicable, the period for which principal repayments are deferred (if NA then enter 0), e.g.: if you only have to begin repaying principle after one year, enter ’12’ in column H. For reference, see ‘Sources of Finance’ slides in IED Dashboard The template will automatically generate figures for principal repayments and interest rate payments and will calculate your debt outstanding for each period. These figures will transfer automatically to your financial statements. What? – Why? – How? – Example – Conclusion IED Financial Plan Template

28. 3. Outputs of the financial plan Income statement (aka P&L) Overview of revenues, costs and profits (operational, financial, and exceptional income vs. costs incurred during a specific period of time) Cash Flow projection Timed projection of future cashreceipts and outlays Basis for estimation of financing need and timing of financing Basis for valuation of company (Discounted Cash Flow - NPV) Balance sheet Snapshot of company assets at a given date, and how they are financed (debt and equity) What? – Why? – How? – Example – Conclusion

29. A. Income Statement (aka Profit & Loss or ‘P&L’) What? – Why? – How? – Example – Conclusion Income statement Revenues – Direct , variable costs = Gross margin – Admin, services and other goods – Salaries & other social costs – Depreciation of property/plant – Provisions for future losses –Other expenses = Operating Profit (=EBIT) - Interest expenses +/- Exceptional income/expenditure = Profit before tax - Tax charged on profit = Profit after tax

30. Break-Even (BE) Analysis – P&L BE point = volume of sales (in no. of units) at which costs = revenues What? – Why? – How? – Example – Conclusion Example £ Sales price per unit 5 Manufacturing cost per unit 1.5 Fixed costs 10,000 At Breakeven point, the number of units sold at a certain price creates enough revenue to exactly cover both manufacturing and fixed costs. See solution on next slide…

31. BE-point: point (x) at which: Total Cost = Total Revenues (price times units sold) therefore: 1.5 x + 10,000 = 5 x x= 2,857 units BE Example, cont. What? – Why? – How? – Example – Conclusion Break-even analysis 25000 Break-even point at 20000 2,857 units 15000 Number of units Euro/units TC TR 10000 5000 0 1 2 3 4 5 500 1000 2000 3000 4000 Number of units 10750 11500 13000 14500 16000 TC 2500 5000 10000 15000 20000 TR

32. Income statement Most figures in this statement are generated automatically from your Assumptions worksheets. To complete the Income (P&L) statement, you need to: Enter the relevant corporation tax rate in Cell B32 e.g. UK 2008 Corporation tax rate is 28% Check for UK rate updates at http://www.hmrc.gov.uk/rates/corp.htm or check with the relevant tax authority for your country of operation What? – Why? – How? – Example – Conclusion IED Financial Plan Template

33. B. Cash Flow Projection –Indirect’ method extrapolated from P&L and NWCN What? – Why? – How? – Example – Conclusion Cash Flow statement Depreciation in the P&L is not a cash event, so it is added back in the cash flow statement. Operating Profit (from P&L statement) + Depreciations - Change in NWCN Cash Flow from operations - Reimbursements (loan repayments) - Interest paid - Investments in assets - Taxes paid + Capital raised (cash for equity shares) + Long-term Financing (loans received) Cash Flow period Closing Cash Position (Treasury)

34. Cash Flow Projection (CF) = projection of future cash-ins and cash-outs Differences between CF and P&L: In the P&L, revenue and costs are matched with respect to the period in which they are incurred, in a particular business period (month, quarter, financial year); so, for every unit sold, the cost of that unit is reported in the same P&L statement period, along with the fixed costs incurred for that period of operation. P&L measures profit from activities. Cash flow shows the time that money actually changes hands – in practice cash does not always move the moment a sale is made or a cost incurred! For instance: you might normally pay your suppliers four weeks after the date of their invoice and your customers might take two months to pay your invoices (see Net Working Capital); tax may be incurred in one year but paid during the following financial year. e.g.: Invoice date in December 2008 >> revenue recorded in P&L 2008; but physical payment actually occurs in February >> recorded in Cash flow statement for Feb 2009 Cash flow measures your solvency at given times. It indicates how much finance you will need in order to remain solvent. If cash inflows are slower than cash outflows, it is possible to be profitable but not solvent! What? – Why? – How? – Example – Conclusion Receipts Operating expenses, investments

35. Cash-in <> revenue Some P&L items are non-cash events, such as adjustments to previous statements. Some Cash in-flow items are not related to sales revenue (e.g. loans received, capital from investors) What? – Why? – How? – Example – Conclusion Revenue Cash-in Adjustments to depreciations Sales Interest received Borrowing Capital raised

36. Cash-out <> cost What? – Why? – How? – Example – Conclusion • Some cash-outflow items are not operating costs or costs related to making products, which would go on a P&L. They are outlays related to how a business is financed. • Some Costs in the P&L, such as depreciation and write-offs, are not cash events. Cash-out Cost Depreciations Provisions Amounts written off on inventories and accounts receivable Investment Lending Loan Repayment Dividends Personnel costs Interest paid

37. Change in Net Working Capital Need What? – Why? – How? – Example – Conclusion If, for instance, 20% of sales invoiced are only paid during the following year: Year 2 Year 1 Sales 100 200 Cash receipts 80 160 Receivables(aka invoiced sales outstanding) (20) (40) Cash Flow 80 180 Change in NWCN +20 +20

38. Cash Flow The ‘Cash flow – Treasury’ worksheet is mostly generated automatically, based on your previous inputs In cell B25, You need to enter an estimated interest rate for any bank overdraft you might incur if you go overdrawn What? – Why? – How? – Example – Conclusion IED Financial Plan Template

39. C. Balance Sheet – how you will finance What? – Why? – How? – Example – Conclusion The balance sheet is a snapshot of a company’s holdings and its sources of finance at a specific date How the company has financed its holdings (s-term and l-term) Company holdings ASSETS EQUITY & LIABILITIES Formation Expenses Capital from shareholders Intangible Fixed Assets Reserves Speed of cash conversion (liquidity) Possibility to claim repayment Tangible Fixed Assets Accumulated P&L (aka ‘Retained profit’) Financial Fixed Assets Loans payable after 1 year Stocks and Work in Progress Accounts Receivable Accounts & debts payable within 1 year Cash

40. Terminology for Balance sheet Current Assets Stock (raw materials, work-in-progress, finished goods not yet sold) Cash in hand or on deposit Receivables/debtors (credit you granted to your customers) Current Liabilities (short-term debt) Payables/creditors Money you owe to suppliers Loan Interest due during the next 12 months Tax due during the next 12 months Bank overdraft Other short-term loans Non-current (Fixed) Assets Long-term investments Tangible – property, equipment, furniture, fleet of cars or vans, etc. Intangible – intellectual property costs (patents and trademarks), product development/design costs N.B.: Scientific ‘Research’ is an administrative expense in the P&L; however, ‘Development’ of commercial products arising from results of research may be considered an asset investment What? – Why? – How? – Example – Conclusion

41. What? – Why? – How? – Example – Conclusion Terminology for Balance sheet – cont.. • Non-current Liabilities (long-term debt) • Long-term debt (due in more than one year) • Equity • Cash paid in by equity investors in exchange for shares in the company • Accumulated P&L or ‘Retained profit’ (profits retained within the company since inception, not paid out to shareholders) • Other reserves (usually applicable to stock market listed companies (share premium) or certain industries (statutory reserves requirement)

42. Balance sheet The ‘Balance Sheet’ is designed to generate automatically from information in the other worksheets In case you have overwritten any pre-existing inputs or formulas, you should check that the Balance (row 23) always adds to zero in each month or quarter What? – Why? – How? – Example – Conclusion IED Financial Plan Template

43. What? – Why? – How? – Example – Conclusion Income statement Turnover - Direct , variable costs Gross margin - Services and other goods - Renumerations and other social costs - Depreciations Cash Flow statement - Provisions Operational result + Depreciations - Others - Change in NWC Operational result (=EBIT) Cash Flow from operations - Reimbursements Financial result - Interests Exceptional result - Investments Result before taxes - Taxes Taxes + Capital raised Result after taxes + Financing - Investments Cash Flow period Cash Position Linking the components of the financial plan Balance Sheet ASSETS EQUITY & LIABILITIES Formation Expenses Capital Intangible Fixed Assets Reserves Tangible Fixed Assets Accumulated P&L Financial Fixed Assets Debts payable after 1 year Stocks and Work in Progress Debts payable within 1 year Accounts Receivable Accounts payable Cash 3 2 1

44. Summary Sheet The ‘Summary’ worksheet is automatically generated from other worksheets and provides an overview of the company over 5 years What? – Why? – How? – Example – Conclusion IED Financial Plan Template

45. Sensitivity analysis / Scenario analysis Step 1: assess the most sensitive parameters and risks Step 2: determine the effect of these risks on Revenue and Profit Financing need (need for cash) e.g.: What if: the sales price is not feasible? the sales volume is not feasible? the planned timing of first sales cannot be met? prices of raw materials increase? Interest rates? etc... Run these simulations in a spreadsheet. What are effects on profit and cash flow? What is your margin of safety? How can you mitigate the odds of risks becoming realities? What? – Why? – How? – Example – Conclusion

46. Types of risk that may affect operational and financial outcomes Product risk, e.g. Problems/delays with product development Final product does not live up to expectation or concept is not feasible Cost of production increases (suppliers, processes) Technology risk, e.g. Technology still unproven In a fast-moving technological environment, product could be superseded by new tech developments Market risk, e.g. Pricing and business model may no longer suit the market Changes in customer sentiment, the competitive environment, market trends, the economy Operational risk, e.g. People, systems, processes, client management Financial risk, e.g. Changes to interest rates and availability of credit, currency exchange rates, investment environment (required return and discount rate), Legal risk, e.g. Problems with IP infringement (yours or others’) Problems enforcing contracts, fraud, confidentiality Reputational risk, e.g. Bad publicity due to product failure or other negative events; negative brand image What? – Why? – How? – Example – Conclusion

47. Building the financial plan: Example An example of a financial plan: facility management start-up What? – Why? – How? – Example– Conclusion

48. Example - Facility Management Software start-up What? – Why? – How? – Example– Conclusion Year 1 From Year 2 on Development Product sales Consulting Personnel costs Other costs Marketing and sales costs Personnel costs Other costs Investment Depreciation

49. CF Starting point: Income statement What? – Why? – How? – Example– Conclusion Double click on table to open the example spreadsheets in Excel

50. Cash Flow Statement Method 1: intuitively Method 2: use Net Working Capital What? – Why? – How? – Example– Conclusion