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Financial Forecasts

Mon, 29 July 2002

Advice on how to prepare a financial forecast for your business.
Once you have an idea of your likely costs and an idea of how much you need to sell to make a profit you are in a position to prepare financial forecasts
There are three basic financial statements that describe the activities and financial state of any business:
• Profit and Loss Account (P&L)
• Cashflow Forecast
• Balance Sheet
These can be prepared on a historical basis - to show how a business performed during a defined period - or as forecasts - as estimates of how the business will perform in the future.
Three Steps to Forecasting
• Businesses often start by forecasting their cashflow and then aim to derive other forecasts from it. It makes more sense, however, to start by forecasting the income and expenditure of the business, which will indicate whether you will make a profit, then worry about when money will be received or paid out - to discover if you will have enough cash when it is needed. Income and expenditure is summarised in a profit and loss account.
• You will also need to look at your likely sales for, say, the year ahead. This needs to relate back to your market research and, if you are already in business, to previous performance. The direct costs can then be estimated (usually as a percentage of sales) to give gross profit.
• The next step is to estimate the likely overheads. Deducting these gives an operating profit forecast. If the net profit is too low you will either need to assess whether you can achieve higher sales or whether you can reduce the overheads.
When preparing your forecasts, remember to allow for increased costs, for instance, due to inflation or future pay awards. If you do need a loan, then you will also need to allow an amount for loan interest. If you use equipment, remember to allow for depreciation. Whilst depreciation is not included in the P&L, you may need to allow for the replacement or repairs of machinery, so you may wish to include a contingency.
The P&L forecast will show whether you are likely to achieve your first key financial requirement: making a profit.
Preparing Cashflow Forecasts
In preparing your forecasts, you will need to think carefully about all your costs, about your price and likely sales at that price, and about the timing of both receipts and payments.
As mentioned above, the first forecast that you set out should ideally be a P&L, summarising income and expenditure for, say, the year ahead. You might do this monthly or annually. The P&L is important for demonstrating profitability; over the very short-term, however, the key requirement is to generate cash and know the business' working capital requirements. This can best be done by preparing a cashflow forecast which should set out all the information, month by month, regarding cash inflows and outflows.

The cashflow forecast should include:
• receipts of cash from customers;
• payments for raw materials;
• payments for all other expenses;
• drawings and wages;
• capital expenditure;
• capital, loans or grants introduced;
• loan repayments;
• VAT receipts and payments (if VAT registered); and,
• tax payments.~
All of these items should normally be shown separately and in the month into which the money will be received, or paid by, your business.
For businesses with a modest turnover and that demonstrate profitability in the year, it is normal only to forecast one year ahead, with a monthly cashflow.
Larger businesses, especially those seeking equity investments and/or which do not show profitability in the year, may need to prepare forecasts for two or three years. The first year cashflow is usually shown monthly, the second year quarterly and the third year just a single annual figure.
It is often helpful when preparing cashflow forecasts initially to ignore any finance that is available from the bank or other lenders. The cashflow forecast then shows the true position of the business. It can then be used to decide if the budget is viable and can be adjusted to reflect the true position and to assess the total funding requirement.
If you do not have sufficient money of your own, then you will need to seek loan finance or an equity investor. Most small businesses simply look for loan finance. Aim to match the term of the loan to the life of the asset for which it is required. It would be normal to look for a short-term loan, for example, to purchase equipment, or a long-term loan to purchase premises. You will also need to buy stock and pay overheads whilst awaiting payment from your customers. The money required is called working capital and is typically funded by an overdraft.
When preparing your cashflow forecast, you may like initially only to include personal investment or loan finance for fixed assets and to ignore funds for working capital. The worst cumulative deficit will then give an indication of your total working capital requirement. Of course, the amount that you need to borrow can be reduced if you have more available to invest yourself.
If you have a term loan, the capital repayments will not figure in your profit and loss account - they are not a business expense - although the interest portion of the repayments will be charged as an expense. However, the repayments do need to be included in your cashflow forecast.
Balance Sheet
The money in a business can only come from three sources: capital introduced by the owner(s); loans (whether from the bank or, effectively, from creditors); and, retained earnings; that is, profit which has been generated by, and retained within, the business. That money is used to finance the fixed and current assets of the business.
Current liabilities include:
• creditors;
• overdrafts;
• loans due within one year;
• money owed under hire purchase agreements; and,
• any amounts owed in VAT or tax, etc.
In larger businesses, loans falling due in more than one year are usually shown separately. You will, however, have a better idea of your business’ performance if you show all loans as current liabilities.
Current assets less current liabilities shows your working capital requirement. Since the balance sheet is merely a snapshot, however, it may be better to deduce your working capital requirement from the cashflow forecast.
The net assets are always equal to the capital introduced plus reserves; that is, the net finance, sometimes known as net worth or the equity of the business.
The net finance, together with any long-term loans, is called the capital employed. All borrowing should be included when calculating capital employed.1

1 A number of key ratios can be derived from the balance sheet and can assist in exercising effective financial control.

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