The Importance of a Financial Plan for a Business - Assignment Example

[Manager] 30 August a) Outline why you consider a business plan is a necessary requirement in the assessment of the financial requirements of a business and also explain why you would never use it as the only tool to assess a proposed enterprises chances of success? Ans. Planning is a very essential part of business operations. It is a never ending process and is extremely important in the early stages of any new venture especially when an entrepreneur needs to prepare a preliminary business plan. A business plan is a document which is prepared by the entrepreneur, describing the relevant external and internal elements which are involved in new business startups it answers the questions such as where the organization stands right now, which direction is it going in and how to get there. It acts as a resume for any proposed business and is usually created to explain the vision and entrepreneur has for his business. A business plan is read by investors, employees, bankers, venture capitalists, customers, suppliers and advisors. Every stakeholder has a different perspective and interest in the business and so the content and focus of a business plan depends upon who is going to read it. For a profit organization, a business plan typically focuses on the financial goals such as profits. It comprises of the industry dynamics, company’s vision and mission, the resources required to run the business, the amount of capital needed, the sources of capital, the production and marketing plan and the pro forma financial statements to determine the expected profitability of the company over time. In short, it is a complete document consisting of all the information related to a business. A business plan is valuable not only to an entrepreneur, but to potential investors or even the new personnel who want to familiarize themselves with the venture, its goals and objectives. Following are three major roles of a business plan: It helps in determining how viable a business is in the designated market. It serves as a guideline for the entrepreneur in organizing planning activities. It serves as an important tool in helping to raise finance. A business plan is used for the following purposes: For starting a new business, a business plan is used to assess every aspect of a business and shows how it will succeed While purchasing an already established business, a business plan is required to identify the strengths and weaknesses of that business in order to decide if it’s worth purchasing or not. For an already running business, a business plan is used to acquire extra finance by convincing investors for putting capital in the business For application of many grants available. The financial assessment of a business is an important activity which must be carried out on a continuous basis. It is done to identify if the business is solvent, that is, if its assets exceeds its debt and thus making the business capable of paying to all its creditors on time. Secondly, it helps entrepreneurs of investors to estimate the equity value of the company at any given point in time. A business is considered a financial success if it meets the following criteria: It remains profitable. It has a healthy balance sheet.] It generates good cash flows. It produces a good return on investment for all shareholders. The financial plan of a business is the section in the business plan which determines if the new business venture is viable or not, or if it would be able to attract investors in an entrepreneur’s business idea. It comprises of a budgeted income statement, balance sheet and a cash flow statement and an analysis of the three financial statements. The financial plan made in the business plan serves as a benchmark to monitor the financial progress of the company over time and to determine if it is in sync with the plans which would ultimately take the organization towards achieving its long term and short term goals. The assessment of financial requirements starts from identification and evaluation of the expenses. The expenses of a new business venture can be first divided into two main parts; the business startup costs and the operating expenses. The two categories are further divided into other parts. For the business startup, the following expenses can be incurred: business registration fees business licensing and permits starting inventory rent deposits down payments on property down payments on equipment utility set up fees Operating expenses comprise of the costs incurred to keep the business running and include the following expenses: salaries raw materials loan payments distribution promotion rent or mortage payments telecommunications utlities storage office supplies maintenance All these expenses need to be financed through the resources which the owner of the business has. Usually, every business expects to finance the operations cost from the profits generated by the company’s operations. To finance startup costs, the entrepreneur looks for either equity financing or debt financing. Both of these finances are explained later. The pro-forma income statement determines the total expected revenue the business would generate based on the expected sales of the company and the fixed and variable operating expenses it would incur during the period and the profit during a particular period. With the help of the income statement, the entrepreneur can assess the profitability of his new business venture which is one of the primary goals of a for-profit business organization, that is, to earn profits. The cash flow projection determines how much cash is expected to flow in and out of the business. It helps in determining the company’s liquidity over time, that is, how much cash it would hold to meet day to day operations. A projected cash flow statement would assist the entrepreneur and other stake holders, such as lenders, to determine the credit riskiness of the proposed business and whether the company would be able to meet its short term obligations without liquidating the assets of the company. The budgeted balance sheet determines a business’s net worth over a particular period of time. It is a summary of all the financial data of the business divided into three sections: assets, liabilities and equity. With the help of a budgeted balance sheet, the entrepreneur can assess how many assets its company would require in future and the sources of financing those assets; either by loan ( liabilities) or equity. A pro-forma balance sheet is a summary of all the information in the income statement and the cash flow projections. For a potential investor, it is very important to know the financial forecasting of the business plan. Even if it is made on assumptions, an investor looks for the thinking process of the entrepreneur in order to judge his assessment on issues such as profitability, cash flows and cash requirements. A business is financed through two sources; Equity and debt. Equity financing is either done by the entrepreneur himself or through investors such as venture capitalists who provide large sums of capital for ownership in the business and expect to cash out the invested money out within five to seven years. For investors, it is very important to know the rates of return the company would generate over time and thus will focus on the market and financial projections of the company for the time they have invested in the company. As far as lenders are concerned, they are primary interested in the ability of the new venture to back the debt along with interest within a set frame of time. They focus mainly on four Cs of credit: character, collateral, equity contribution and cash flows. For an entrepreneur to convince the investors or lenders to provide the needed financial resources, he must present a business plan with an attractive, profitable financial plan. Complete reliance on a business plan to evaluate the success of a proposed business plan is never recommended and usually other tools are used by investors and lenders before financing any new business venture. The reason for this is that a business plan is based entirely on an entrepreneur’s own assumptions. He builds his business plan on the basis on his judgment of the potential market and his belief that his product (goods or service) would be liked by the consumers. The financial plan in the business plan is based solely on forecasts. Anything based on assumptions and forecasts can never be accurate in the real world, which is why two thirds of new business ventures do not survive more than two years. For an entrepreneur, his business idea is always a very successful one and that is why his business plan usually overstates the actual profits. Furthermore, he assumes that his product would be accepted in the market and everyone would want to buy it, it is this belief that any entrepreneur is willing to take the risk of investing his time and money on his business plan. b) Two companies are considering expanding their businesses. One is a small manufacturing concern which at present has total revenue of £5 million with £400,000 profits. They are financed, at present, by £400,000 equity and a similar amount of loan finance, their overdraft facility is £ 250000. They need £1 million to expand, split evenly between fixed investment and working capital. The other company is an import /export business selling dried fruit in the UK and agricultural produce overseas They turnover £11Million and make a similar profit to the other company. They can expand the business which will allow them purchasing efficiencies which will increase their margins by 20%. They also need £1 million to expand mostly for working capital. Their financing at present is £500000 equity and £1.5 million in loans with an overdraft facility of £500000 Give a brief outline to each company of how it should proceed- what financial structure do you suggest for each company after it expands, what are the advantages and what are the risks involved in your suggestions? What options can you see? Ans. Both the companies have two options to raise finance, either through equity or through debt. If the companies decide to expand by taking debt, it will avail the following advantages: A loan will not have to dilute the ownership of the company and hence every shareholder (if it is not a sole proprietor business) will receive the equal share of profits. As the lender will only be entitled to receive a fixed interest and principal amount, the owners will have the right over any extra income the company makes after expansion. As the interest rates and the borrowed amount are known, the management of the company can easily forecast and plan for the repayment of loan before borrowing the amount. On the other hand, the company can also have the following disadvantages by taking loan rather than equity: Unlike equity, loan will need to be repaid even if the company is making a loss. Interest is a fixed cost and during difficult financial periods can increase the risk of insolvency. The company will need to pledge assets to the lender as collateral so that if the loan is not repaid, the lenders have the right of ownership over the assets. On the other hand, if the company plans to raise finance through equity, it will have the following advantages: The shareholders will not have the obligation to repay the amount taken. The raised finance will not have any fixed costs attached to it. The risk of insolvency is removed if the company raises equity finance. But at the same time, the company can also suffer because of the following reasons: As the profits would be shared among more shareholders, everyone might receive lesser share of profit. Ownership will dilute and hence decision making will be split among partners. Company 1: The information about the company reveals the following ratios: Return on Equity (ROE)= Net Income / Average Stockholders´ Equity 400,000/400,000= 1 Debt to equity ratio= Total debt/ Equity 400,000/400,000=1:1 If the company borrows $1000,000 following will be the impact on the company’s ratios: Return on Equity (ROE) = 400,000- Interest/400,000= < 1 Debt to equity ratio= 1400,000/400,000=3.5:1 If the company raises the finance through equity, following would be the impact on the company’s ratios: Return on Equity (ROE)= 400,000/1400,000= 0.2857 Debt to equity ratio= 400,000/1400,000=2:7 From the forecasted ratios for both equity financing and debt financing, we can see that if the company borrows the loan its return on equity would decrease as it would have the added expense of paying the interest as well as the principal debt. Moreover, its debt to equity ratio would also go up which would increase the risk of insolvency for the company. However, if it applies for equity finance, although its return on equity would decrease if the owner decides to raise finance through investor, but its debt to equity ratio would decrease marginally. For the first company, I would suggest that it uses short term financing be taking a short term loan for financing the working capital and repay it from the profits earned. For the fixed investment, I would prefer the owners to either finance the amount by equally contributing (if it is a partnership) as this would not change the profit sharing ratios of the partners and would not dilute ownership. If the company finances by using debt, the debt to equity ratio would increase to 3.5 which would increase the chances of insolvency. The company must only go for long term loan if it believes that the expansion would result in a greater profit which would be enough to repay the debt. Company 2: From the given information, we can conclude the following ratios: Return on Equity (ROE)= Net Income / Average Stockholders´ Equity 11,000,000/500,000= 22 Debt to equity ratio= Total debt/ Equity 1500,000/500,000=3:1 If the company borrows $1000,000 following will be the impact on the company’s ratios: Return on Equity (ROE)= 11,000,000- Interest/500,000= < 22 Debt to equity ratio= 2500,000/500,000=5:1 If the company raises the finance through equity, following would be the impact on the company’s ratios: Return on Equity (ROE)= 11,000,000/1500,000= 7.333 Debt to equity ratio= 1500,000/1500,000=1:1 From the ratios calculated above, the debt financing of the company can increase the debt to equity ratio of the company to 5:1 which increases its risk of insolvency. However, if the company goes for equity financing, the debt to equity ratio would show a reasonably fair value of 1:1 but the return on equity would show a marginal decrease. For company 2, I would suggest that it’s better that the company goes for debt financing if it is sure that it would be able to increase its margins by more than or equal to 20%. If the company gets a loan on even 15% interest, it would still be able to easily pay back the loan and interest from the extra profit earned, and at the same time it will not even need to dilute the ownership of the company. Although the risk of insolvency is high, but once the company is sure that it would be able to generate enough income from expansion to finance the debt, the best option is to go for debt financing in this case. Works cited "Internal and External Analysis." My strategic plan (2008): n. pag. Web. 19 Apr 2010. . Schaefer, Patricia . "The Seven Pitfalls of Business Failure ." Business knowhow (2006): n. pag. Web. 19 Apr 2010. . Cox, Helen. "The Importance of a Business Plan ." Ezine articles (2010): n. pag. Web. 19 Apr 2010. . "The importance of a business plan." VCGate (2010): n. pag. 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" Top Ten Mistakes made in Business Plans." Woopidoo articles n. pag. Web. 19 Apr 2010. . Read More