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Creating a sound financial management strategy is a key to success
Do you balance your own checkbook every month? To the penny? Your answers these questions say a lot about how you will approach the financial management section of your business plan. If you do balance your checkbook, then you already understand the importance of maintaining your personal finances, and it is simply a matter of transferring these skills to your business plan. If you don't balance your checkbook, but your spouse or accountant does, then you will probably have to get some assistance for this section of your business plan. If your checkbook is never balanced, then you may want to reconsider going into business and try the lottery instead! Financial management tells you how much money you are making, how you are spending it, how much you have leftover, and whether you need to change your spending habits to stay out of trouble. By planning ahead, you'll know whether you have enough money to take on new projects, or if you will need additional financing from investors or banks. As you plan your business, keep in mind that you will need money for capital investment (machines, equipment, buildings), business expenses (salaries, supplies and inventory), and most importantly for you and your family to keep living. The key to successful financial management is your accounting system. It will help you to monitor your sales, control your expenses, and realize your profitability objectives. You'll need to have a bookkeeping system that gives you enough information to prepare the following key documents:
These three documents, along with a few financial ratios, act much like the dials and gauges on the dashboard of your car. They tell you if your business has enough gas, whether it is about to overheat, how far you have traveled (and how far you have to go), and when you need professional help to fix a problem. You must keep your eyes on the road and pay attention to early warning signals to stay out of trouble. If you are not comfortable with numbers and accounting systems, you can do some of the following to improve your to financial management plan.
Showing assets and liabilities on your balance sheet Much like your personal net worth statement, a balance sheet shows what your business owns (assets), what its debts are (liabilities), and the difference between the two (equity). Think of a balance sheet this way: if the only thing you owned was a car with a value of $8,000, and you had taken out a $6,000 bank loan to finance the car, then your personal balance sheet would show an asset of $8,000, a liability of $6,000, and equity of $2,000. In real life you probably own many things, like a house, a car and a variety personal items, and have numerous debts, like a mortgage, a car loan, and credit card balances. Similarly, in business you will have a few assets, like cash and equipment, and a few liabilities, like accounts payable and bank loans. These are shown on your balance sheet, which tells you what your business would be worth if you sold all of your assets, and paid off all of your liabilities. The balance sheet for your company will be divided into three parts, and conform with the following formula: Assets = Liabilities + Owners Equity All balance sheets, whether for General Motors or Paul's Pizza Shop, have the same general format. Assets go at the top of the page, liabilities in the middle, and owner's equity at the bottom. Alternatively, assets can be listed on the left hand side of the page, and liabilities and owner's equity on the right. Assets, like cash, inventories, and buildings, are always listed in decreasing order of liquidity. This means that cash, and equivalents, are always listed first, and the things that are hardest to convert to cash, like buildings and equipment, are listed last. Liabilities are shown according to their immediacy of payment. For instance, bills that are due right away, like payroll, come first, and debts that will not be paid off for years in the future, come last. The main distinction between balance sheets from different companies is the amount of detail they provide. Since General Motors is a large company, its balance sheet must provide significantly more detail than that of Paul's Pizza Shop. Greater detail is usually required to meet the information needs of a much wider audience, including investors, bankers, and management. Your balance sheet should be designed to provide enough detail to make it a useful for you to manage your business, and to meet the information requirements of your investors and bankers. No more, no less. Idetifying your profits with an income statement To understand how much money your business will make during the year, you will prepare an income statement, or a profit and loss (P&L) statement. While your balance sheet tells you how much money you have (owners equity), an income statement tells you how much money you made (net income). You start by showing your sales revenue at the top of the statement, followed by your costs and expenses in the middle, and the difference, or net income, at the bottom. Net income, or profit, is determined by subtracting all of your expenses from sales revenue, as shown in the following formula: Sales revenue - expenses = net income (or profit) The income statement is also directly tied to your balance sheet. If you were operating a profitable business, and prepared a set of financial statements at the end of the year, your owners equity and assets would increase by the amount of net income shown at the bottom of the income statement. Much like your bank account increases after you make a deposit. Conversely, if you had a loss, your owners equity and assets would decrease by this amount. Your income statement records the sales, expenses, and net profit for your business during a specific period of time. It could be for a week, a month, a quarter, a year, or whatever accounting cycle is important for your business. By looking at series of income statements, say for three consecutive years, you can get a good idea of where the business is headed from the trend in sales, expenses, and profits. For your business plan, you will be most interested in pro-forma or projected income statements. Projected financial statements are created to show how you think your business will perform financially in the future. They take into account your past financial performance (if you have any), along with assumptions about the future of your products and services , your target market, and your industry. Paying your bills with cash flow Keeping track of cash is one of the most important things that a new business can do. Without cash you can't buy inventory, pay salaries, or invest in equipment. It's entirely possible for a business to have assets on the balance sheet, to show a profit on the income statement, and still not have enough cash to keep going. This is analogous to the home owner that has paid off the mortgage, but doesn't have enough money to buy groceries. Plenty of assets, but no cash. One reason for this phenomenon is the difference between cash basis accounting and accrual basis accounting. Cash basis accounting is intuitive, since you record sales when your receive money, and expenses when you pay bills. However, accrual accounting it is less intuitive, since you record revenues when they are earned and expenses when they are incurred. For example, if you are using accrual accounting and provide credit to your customers, you may record sales revenue 90 days before you receive payment. Alternatively, think of an airline manufacturer that begins to recognize revenue on planes that won't be delivered for many years to come. With accrual accounting, comes depreciation expense. Depreciation is a method used in accrual accounting to show how big ticket items, like machinery and equipment, lose value over time. In cash accounting, there is no depreciation, since the expense for the entire item is recorded when you pay the bill. In accrual accounting, on the other hand, depreciation might spread the expense over a period of years. For instance, a $25,000 machine might have $5,000 of depreciation expense over the next 5 years. Like the income statement, the cash flow statement is a summary of activity over time. You will show where your cash is coming from and what it is being used for. For instance, you will receive cash from customers when they make purchases, and from banks when they give you a loan. You will use the cash to pay wages, buy inventory, and invest in property, plant and equipment. In your business plan, you will want to produce a series of pro-forma cash flow statements to cover at least the first 12 months after you start, and the next two years. At the top of your cash flow statement, start by listing where the cash is coming from, including: sales of products and services, dividend and interest income, financing from banks and investors. Keep in mind that you will only make entries for a given month or quarter, when you actually anticipate receiving the cash. Next, itemize how you are planning to use the cash, including: cost of goods sold, wages and salaries, rent, utilities, phone service, advertising, interest expense, equipment and machinery, and anything else that will require the transfer of cash out of your business. Although many of these entries may correspond to those that appear on your pro-forma income statement, there should be differences. Timing differences between credit sales and cash received, and depreciation are two that were discussed earlier. The difference between the cash coming into your business, and the cash going out, is called cash flow. A positive cash flow indicates that you have more cash coming in to your business than going out. A negative cash flow means you have more cash going out of your business than coming in. Obviously, a business cannot withstand a negative cash flow for very long without running into trouble with creditors. If you examine cash flow statements from some of the larger publicly traded companies in their annual reports, you will notice that the format is a combination of the income statement and the balance sheet. These companies prepare cash flow statements to show changes in balance sheet accounts, and eliminate non cash items from income statements.
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