Budgeting & Forecasting
I have included this page to remove some of the mystique from financial planning.
In my 33 years in business, having viewed thousands of business plans, the ‘Financials’ section of the Business Plan have often been poorly conceived and put together. I would say this is the principle reason why Banks reject proposals and the principle barrier to getting the finance you require i.e. this is where communication breaks down.
At the bottom of the page is a demonstration of my budgeting software.
7 Tips from the Frontline
You must build a forecast on a set of assumptions. You need to detail what the assumptions are, how you arrived at those assumptions and why they are reasonable.
For example, are you assuming payment in 30 days from customers whilst your suppliers will allow you 60 days? Is this reasonable to expect – if so, why? What happens if this does not work in practice i.e. customers take 60 or 90 days and your suppliers press for payment in 30?
You should investigate the sensitivity of your key assumptions. If these change, what impact does it have on your cashflow? You might want to run a number of scenarios to understand the dynamics of your business e.g. a low, medium and high sales scenario.
Build a margin of safety into your forecast i.e. be conservative with your assumptions – the bank will not want to lend you too much (to limit their risk) or too little, so be careful how you build that margin into your forecast.
Through understanding what the critical assumptions are, you need to build a management information system that monitors those critical assumptions so that you can take early action to correct your performance before you run out of cash. The Bank will also want a copy of your management information to satisfy themselves that you are in control and their lending is safe.
Try to keep your financial plans as simple as possible – if they are too complicated, you won’t use them as a tool for your business and your Bank might reject your proposals if they can’t understand them. Also, it will be impractical to design a management information system to monitor your progress.
By understanding the key income and cost drivers, you should have a set of key performance indicators to monitor those key performance areas. These will often be different for each business. See the list of key performance indicators on the Resources page.
Understand the Bankers point of view. If you are seeking Bank finance, understand what the Banks security position will be if you do not perform as expected. What is your financial contribution to the business? i.e. how much do you lose before the Bank loses a penny? – the Bank will want to see that you are committed so that you cannot simply walk away when the going gets tough and leave them holding the baby.
Only by putting yourself in the Bankers shoes can you begin to shape a bankable proposition. It is then important to remain a bankable business, otherwise your options will be limited and you could be subject to predatory pricing to reflect the risk the lender is taking.
What should I include in my Financial Plan?
We’ve already established that you need to provide a full set of the key assumptions you have used.
From the assumptions, you then need to prepare:
- a profit and loss forecast
- a cash flow forecast
- a balance sheet
It is not really feasible to do this manually because you want to be able to change the assumptions and run a number of ‘what if’ scenarios i.e. ‘what if’ this happens or ‘what if’ that happens?
You really need a good piece of software and someone who knows how to operate it – probably your accountant (or it could even be me if we work together on an online conference?)
Warning: you must never delegate this task completely as you must understand how your budget is created or you will quickly be undone when you get to speak to the bank manager. Also, if you do not understand it, the financial budget will not be used by you to control your business therefore negating much of the value in the exercise.
Why do you need all 3 of the above documents? Well, the profit and loss account, helps to create the cash flow forecast and the cash flow forecast helps to create the balance sheet – you cannot create one without the other (although many do!!!!) as they all are inter-related and flow together.
Let’s first look at the differences between a profit & loss account and a cash flow forecast:
Profit & Loss Forecast
- Sales are included when invoiced
- Purchases are included when incurred
- Includes depreciation of fixed assets
- includes only interest (not capital element of loan repayments)
- does not include capital invested by the owner
- ignores VAT completely
Cash Flow Forecast
- Sales plus VAT included only when cash actually received
- Purchases plus VAT included only when cash paid out
- Fixed assets included at full value when paid for
- Includes loans when received and loan repayments, as well as loan interest
- Includes capital invested by the owner
- Includes VAT received from customers, paid out to suppliers and handed over to HM Customs & Excise
- Includes bank balances (plus or minus)
What is a Balance Sheet? 
A balance sheet is a ‘snapshot’ of the assets and liabilities of a business at one day in time e.g. a month end or a year end, whereas the profit & loss and cash flow are over a period of time e.g. a year.
The two sides of a balance sheet show:
- where the money came from
- short term (or current liabilities or amounts due to creditors within 12 months) and long term liabilities
- the capital structure of the business i.e. shareholders funds
- what the money was used for
- the assets of the business i.e. how much is invested in fixed assets (e.g. property, plant 7 equipment, vehicles etc) and current assets (- current assets are debtors, stock and cash)
Balance sheet: Understanding Liquidity
Put simply, this is the ability of your business to pay its liabilities as they fall due. Usually it is determined by looking at the relationship between current assets and liabilities, the terms of trade and the ease with which current assets can be turned to cash to pay your bills.
See the ‘Current Ratio’ and the ‘Acid Test Ratio’ on the ‘Using Bookkeeping Data‘ page.
Balance Sheet: Understanding Gearing
Can be calculated in several ways but I favour this definition: the amount of borrowing (net or gross) as a percentage of shareholders funds.
This is an indication of the risk of lending or investing in the business but take care to look at industry and competitor comparisons as some businesses e.g. banks or builders, quite normally take on higher levels of gearing.
How do the Balance Sheet and Profit & Loss relate together?
- The Opening Balance Sheet = Wealth at the start of the year
- The profit and loss account records the Profit (plus) or Loss (minus) in the year
- The Closing Balance Sheet = Wealth at the end of the year
