Financial Planning and Analysis

1. chapter11 Financial Planning and Analysis

2. Chapter Objectives • Understand methods for estimating revenues and operating expenses. • Prepare pro forma financial statements and conduct a break-even analysis. • Examine techniques for determining return on investment. • Identify start-up costs and potential sources of funding. • Learn how recreation, event, and tourism businesses maintain financial control.

3. Financial Reality • All elements of business plan affect financial feasibility and profitability. • One thing is certain: An RET business must be profitable, and you must get a reasonable return on your investment in order to be successful and financially sustainable. • Profits that come from understanding and serving its customers extremely well are its only means of survival.

4. Broader Measure of Success • Company cannot be so focused on their own short-term financial gain that they ignore all else. • Governments regulate externalities. • Informed consumers do not support a company that: • Significantly contributes to environmental pollution • Adds to social degeneration through unethical practices (continued)

5. Broader Measure of Success (continued) • For relatively little additional cost, a company can build into its financial planning and manage additional expenses associated with environmental stewardship and social responsibility. • Many companies have shown that it is not only possible, but also required, to be financially, environmentally, and socially successful.

6. Four Components of Financial Planning Process 1. Projecting revenues 2. Estimating costs 3. Developing pro forma financial statements 4. Financing your RET business

7. Projecting Revenues • Your business concept will lead to sales, but how many? • Will sales be sufficient to develop the company and give you a reasonable return on your investment? • Projecting revenue in advance will help you answer these questions. • Sales forecasts allow you to plan sufficient staff levels and supply purchases. (continued)

8. Projecting Revenues (continued) • Projecting sales before your operation begins is a challenge. • Paint the financial picture of your company at • start-up, • end of the first year, and • several years into the future. • Projection of revenues is both science and art. • Use solid research and best guesstimates.

9. Critical Elements of Projecting Sales • In-depth research • Transparent estimation method • Clear identification and documentation of underlying assumptions • Comparison with similar enterprise

10. In-Depth Research and Integration • Objective research is the key to accurate projections. • Market size, growth rates, and external factors influence consumer demand. • Competitor analysis provides data on the level of competition and marketplace gaps or opportunities available, which give a sense of how rapidly your sales may grow. (continued)

11. In-Depth Research and Integration (continued) • Average price charged may vary by the season, month, or week. • Supplement past research with talking with suppliers, making further observations of competitors, and reading from industry journals. • Gather all this research and supporting data, and integrate the information into your revenue projections.

12. Transparent Estimation Method • Sales projection methods vary from sophisticated econometric models to simple projection tables. • For small RET businesses, a straightforward projection method is often sufficient. • The initial data are sales volume in the number of units for each service, such as rentals, river trips, or corporate events. • Later you will add in average revenues per sale for each service type to calculate monthly sales in dollars. • If business is highly seasonal, then you can develop high- and low-season tables rather than initially by month (see table 11.1 on page 212).

13. Components of Sales Projection Table • Identify profit centers: Major sources of revenue in your business • Average daily unit sales by profit center • Unit sales per week • Average unit sales per month (continued)

14. Components of Sales Projection Table (continued) Realistic estimates: • Prices you can charge: Average daily rate, average check size, average trip rate • Load or use factors, such as average occupancy rates and average number of passengers per trip (can acquire data from industry analysis and financial planning research).

15. Steps in Estimating Costs • Documentation of assumptions • Comparison with similar organizations • Estimating two broad types of costs: • Start-up costs: Expenditures needed to get the business from the decision to start, through the first day it is open • Operating expenses: • Fixed costs do not greatly vary with amount of sales over time • Variable costs vary with amount of sales • Costs of goods sold is cost of obtaining raw materials that are sold directly to customers without adding much value

16. What Pro Forma Financial Statements Provide • Financial statements are essential for success. • They provide you, your lending institutions, and Internal Revenue Service or Revenue Canada with basic information about how your company is performing financially. • They allow you to control finances of your company. • Projections for the next year are referred to as pro forma statements.

17. Basic Financial Statements • Income statements • Cash flow statements • Balance sheets

18. Income Statement • It describes monthly revenues and expenditures and the resultant monthly net profit or loss. • Net income illustrates whether you have a profit on paper. • “Paper profit” is not the same as cash flow. • It is common for a new business to show a net loss for many initial months and often for the first year. • But profits should build over time. • Multiyear pro forma income statements are needed.

19. Sensitivity Analysis • It is easy to overestimate profit initially. To minimize the chance of this happening, conduct a sensitivity analysis (SA). • SA shows effects on bottom line of overestimating revenues combined with underestimating key cost projections. Steps: 1. Develop a low scenario by reducing revenues by 5 to 10%. 2. Increase the projections for key expense accounts 5 to 10%. 3. If financial picture is still positive, then proceed with initial projections. 4. If sensitivity analysis shows a large loss, review projection assumptions, and revise “likely” scenario.

20. Cash Flow Statement • It’s considered the foundation for analyzing financial viability of a new company. • Cash flow is not the same as profit because most businesses sell services or products without generating cash through extending payments (credit) to consumers (e.g., a tour company may allow guests to make a down payment then pay off the balance through installments after the trip is complete). • It provides information on inflows and outflows of cash from operations. (continued)

21. Cash Flow Statement (continued) • It shows if there’s a need for additional funding to meet working cash obligations. • It identifies if you can place cash surpluses into new equipment or investments. • It identifies any capital costs (e.g., depreciation) and uses that are not shown on an income statement. An RET business may secure a loan at start-up (a cash source) and use that to purchase land and a building (a cash use). • Also shows uses of cash besides operations (e.g., paying off a loan from a line of credit and providing investor payoff or owner draw).

22. Cash Flow Can Vary by Season • Many RET businesses are highly seasonal. • In off-season this can result in negative cash flow. • Requires buildup of cash reserves during the preseason—when deposits come in but programs are not operating yet—or short-term loans. • Cash flow statement is your cash plan. • Will show you when you have negative cash flow periods and can plan ahead. That might require your company to take from financial reserves or secure financing. (continued)

23. Cash Flow Can Vary by Season (continued) • In cash-short times, delaying payments to suppliers can result in additional interest expenses and hurt your credit rating. • Emergency financing is much more costly than securing a line of credit well in advance. • To avoid the cash crunch, it is essential to forecast cash flow (see figure 11.1, next slide).

24. Forecasting Cash Flows

25. Balance Sheet • A monetary picture of effects of planned operations on company’s financial health (e.g., would describe if company is deeply in debt or free of liabilities) • Shows the assets, liabilities, and owners equity of a small business • Current assets • Fixed assets • Current liabilities • Long-term liabilities • Owners equity,or net worth, is owner’s claim on assets of the business

26. Ratio Analysis • Financial ratios allow for comparisons with other similar companies on degree of indebtedness, returns expected, and so on. • Information provided on balance sheet and income statement can be used to calculate ratios. • What is considered “normal” for a financial ratio varies considerably. • Financial ratios become valuable when they are compared to these factors: • Other ratios in the same set of financial statements • Ratios from previous time periods • Industry averages

27. Break-Even Analysis • If starting an RET business, you need to know when company will start making a profit. • A banker from whom you are seeking a loan would also want to know amount of sales needed to become profitable. • Using data from the income statement, you can estimate when the company will break even or make a profit. • A company has broken even at the time when its total sales or revenues equal its total expenses.

28. Hypothetical Break-Even Point

29. Financing Your RET Business • Even if pro forma financial statements are positive, you still have a potentially huge hurdle to leap: getting funding not only to start but also maintain your company until at least your break-even point. • Many a great business concept has failed to get off the ground because of the inability to raise start-up funds. • Or business is undercapitalized at start and unable to operate at projected levels. • RET businesses can have relatively low start-up costs. • But low entry funding needed means competition may be greater and profit margins smaller because more people are able to afford to start such a company.

30. Identifying Level of Funding Needed to Start Two broad funding needs: • Determine amount of working capital needed to operate for first year or two. • Find mix of funding sources to provide needed capital at a modest cost.

31. Start-Up Costs • It usually takes more money than planned to get to opening day of business. • If business is undercapitalized at beginning . . . • May not be able to open at all • May delay opening (costing you more money) • Draw from your working capital reserves, which hurts your operations • You must carefully identify costs that would likely be incurred to get to opening day. • May be one-time costs, such as purchase of office equipment. • Recurring costs involve things such as rent for the months before opening. • Develop a start-up costs table.

32. Average Amount of Money to Start Up a Small RET Business • Median amount of owner money solo entrepreneurs thought they would need to start their business was $6,000. • It was $20,000 for team ventures (Blade Consulting 2003). • But amount of capital costs is often much greater than expected. • Starting a small nonfranchise health club is estimated to cost between $75,000 and $150,000 (Adams Media Corporation 2006). • Other situations require significantly more funding: • Opening a new high-end restaurant in San Francisco that involves extensive refurbishing of a prime location costs an average of more than $1,000,000. • Franchise fees for well-known franchises alone can exceed $100,000. • Great variety in start-up costs, but in most cases required funds are more than what the entrepreneur has in personal funds.

33. Working Capital • It’s defined as current assets minus current liabilities. • In essence it is cash or financing needed to optimally operate a business. • Includes more than start-up funds because a new venture is cash poor and needs time to build sales and profitability. • How much working capital is needed after opening? Cash flow statement gives an indication (how much and when you will need additional cash to pay for operations). • But even with a cash flow projection, entrepreneurs tend to underestimate working capital needs.

34. Indirect Sources of Working Capital • One member of family works outside business and uses that outside job to support family financial needs during the initial years. Reduces the need for the other family member to draw as large a salary. • Entrepreneur may initially work another job at same time. This can place severe time and financial strain on family members.

35. RET Funding Sources • Small business entrepreneurs (especially RET companies) can have a more difficult time than expected attaining adequate funding to start their ventures. • Traditional sources of capital lack an understanding of the professionalism and profitability of industry. • They want to fund more customary businesses. • Owners may not have a proven record of performance. • Potential funders often see RET businesses as too high of a risk. • You may need to come up with creative financing that will propel the company forward and not completely drain personal and family assets. (continued)

36. RET Funding Sources (continued) • Majority of small RET businesses are self-financed (Ryan and Hiduke 2003). • But at some point in company life, it will need to seek external funding to be able to grow or meet unforeseen financial demands. • Growth in business is tied to having reasonably priced capital as much as it is to market demand and successful promotion. • It takes money to make money.

37. Self-Financing Needed, But How Much? • Refers to when entrepreneurs are able to provide funds to cover all start-up costs and working capital themselves • Acquiring funding for a new small business always starts with the founders. (continued)

38. Self-Financing Needed, But How Much? (continued) • Questions to ask yourself about self-financing: • How risk tolerant are you? • Are you willing to put up your own money to fund your idea? • Is it more your style to work for a company where you don’t jeopardize your own funds and you get a regular paycheck? • What are your personal and family resources? Do you have the support of your family if proposing to use their resources? • What is your credit rating? • How have you managed your own personal funds and debt in the past five years? • What kind of access to capital have you had in the past? • Can you wait two to five years for your business to become very profitable?

39. Two Types of Outside Funding • Nonequity • Equity investments • Each has very different sources of money and rights. • Equity investments are funds contributed to business in return for percentage of ownership, and there is no legal requirement to repay the investor.

40. Equity Investments • It may be tempting at start-up stage to seek many small investors, such as social friends, but they often expect preferential treatment, want discounts, and demand time-consuming information and justifications from management on the business operation. • Angel investors are wealthy individuals who want to actively oversee the operations. • A worst-case scenario is where an equity investor owns 51% or more of the company stock (i.e., has legal control of the company) and fires the founders who worked 14-hour days and built up company.

41. Nonequity Investments • It must be paid back over time, but this type of investor does not become owner of a percentage of the business (unless you default). • Debt, or funds secured with promissory agreement, is most common.

42. Examples of Nonequity Investments • Loans are promissory agreements that require payment of a portion of the original amount at specified time periods with interest. Loans are secured by collateral, such as your company equipment and real estate, which can be garnered if you fail to make payments. • Loans may be hard to get for start-up funds and can be quite costly. Most common types or sources of loans: • Friends and relatives • Banks, credit bureaus, and savings and loan companies • Home equity loan • Credit cards • Equipment leasing

43. Maintaining Financial Control During Operations • Critically important after startup • Small businesses are the most likely to fall into the trap of “shoebox accounting” where receipts and invoices are kept in a shoebox, and there is little understanding of where and when those funds come and go. • Basic actions should be taken: • Set up an accounting system. • Develop a budget. • Monitor the budget versus actual performance. • Establish controls for expenditures and receivables.

44. Establish Expenditure Controls • Purchase restrictions and purchase orders • Limited check signature authority • Expense reports • Recording expenditures in general ledger • Petty cash register • Inventory accounts • Accounts payable • Accounts receivable • Payroll monitoring