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Help to the Financial Plan
4.1 What is the total capital requirement? Total capital requirement, also known as total project cost or total investment requirement, is composed of three items: fixed assets, pre-operating expenses and working capital. Fixed assets is the sum total of all costs of land and improvements, building, machinery, furniture and fixtures, vehicle, etc. (step 2.2) Pre-operating expenses are those necessary expenses which are incurred before the business starts operating. These include registration fees and licenses, training costs, cost of preparing business plan, trips to raw material and equipment suppliers, etc. (step 3.5) Working capital is the amount of money permanently needed in cash or in kind to keep the business operating while it is awaiting full payment for goods sold to customers. Working capital can be calculated by adding five factors: 1) the cost of maximum raw material stocks that will have to be stored to ensure continuous production. In some cases this may be three to six months worth, if the raw material is difficult to obtain or has to be imported, whereas in other cases (where raw materials are readily available) only one or two weeks worth may be needed; 2) the cost of finished goods which will be kept in stock awaiting distribution to the customers; 3) the cost of work-in-process which are on the factory floor but have not yet been converted into a final product or finished goods; 4) the cost of goods already distributed to customers but which have not yet been paid for (accounts receivable); 5) the amount of ready cash needed to pay workers and overheads.
Add these five cost elements together to arrive at the total working capital requirement. To calculate the total capital requirement, add the following: + Fixed Assets (step 2.2, step 3.6) + Pre-Operating Expenses (step 3.5) + working capital (step 4.1) = Total Capital Requirement (Project Cost)
4.2 Is a loan needed? What will be the equity contribution of the entrepreneur? And how much? How the total capital requirement is going to be sourced is called the financing plan. Bankers want to know these sources and what different project cost components are being funded by these various financial sources. After determining the total capital requirement, the next step is to see whether the amount required is too much for you to finance on your own, or beyond your capability to finance. If this is the case, then a loan will be needed. The entrepreneur is almost always expected to make an equity (owner’s capital) contribution to the project. For example, if the project costs LC50,000, the bank may require the entrepreneur to put up at least LC10,000, or 20%. The LC10,000 constitutes the owner’s equity. To arrive at the amount of loan needed, subtract the equity from the total capital requirement. List these as follows (using our CEFE Soap Manufacturing example):
4.3 What security (collateral) can be given to the bank? In addition to equity, the bank will want to know what kind of security the entrepreneur can offer the bank to ensure that the loan is really repaid. Normally land and building (the title of ownership has to be certified by the appropriate government authority) are used for security purposes. Be aware that if your building or house is valued by the bank at LC100,000, the bank may only accept 60% of its full value, or LC60,000, for security purposes. In many countries, a titled land has a collateral value from 80 to 100%. Likewise, the machinery, vehicles or building which the loan will finance can also be used as collateral. For example, machinery and equipment have a collateral value of 60% of its purchase cost in many countries. Some credit institutions, especially those catering to small loans, accept personal property (e.g., jewellery, private car, refrigerator, sewing machine, etc.) as collateral. If the entrepreneur does not have enough security to cover the loan needed, he must then raise this security from friends and relatives or reduce the size of his project until the loan size matches the security requirement of the bank. 4.4. What does the Profit and Loss Statement indicate? We now have all the data for preparing a profit and loss statement, also known as income statement. Start with sales which are derived from multiplying the unit selling price by the volume of expected sales during the year (step 1.9). From the annual sales revenue figure, step by step, subtract all the yearly expenses. They are as follows: 1) Raw Material Cost - This is the sum of all raw materials used to produce the products that were sold. 2) Labour Cost - This is the sum of all direct labour costs for the whole year. 3) Factory Overhead - This is the sum of all miscellaneous costs such as minor raw materials, indirect labour, maintenance and repair cost, depreciation of production machinery, electricity, water, supplies, etc. associated in producing the product for the whole year. The three items above are known as Cost of Goods Sold. Sales minus these three items results in Gross Profit. 4) Marketing Cost - This is the sum of all selling and promotional costs, including distribution cost to retail shops, commissions, etc. (See step 1.12) 5) Administrative Cost - This is the sum of all administrative costs, including office supplies, security guard's salary, accountant/bookkeeper’s salary, telephone bills, entertainment expenses, and depreciation of office equipment and furniture, etc. (see step 3.7) Gross Profit less marketing and administrative costs results in Operating Profit. 6) Financial Cost - This is the sum of interest paid to banks on the amount of borrowing. Operating Profit less financial cost results in Net Profit Before Tax. Net Profit Before Tax less the relevant business income tax results in Net Profit After Tax.
Determination of Selling Price and Profit Margin Monthly Cost Raw Material 26,070 Direct Labour 1,600 Overhead Expenses 2,333 Total Monthly Production Cost 30,003 Marketing
and Administrative Cost 550
LC 31;136.50 Total
Cost per kg = LC12.97 4.5 What does the Cash Flow Statement indicate? In this part of the business plan, the Cash Flow Statement is calculated and included. While the profit and loss statement gives the results of financial transactions of a business during a certain period (e.g. month or year), the cash flow statement shows the sources (inflows) and applications (outflows) of the cash in the business during the year. The example below is drawn from the business plan of the CEFE soap manufacturing project.
Cash Flow Statement (first year)
4.6
What does the Balance Sheet indicate? The balance sheet is the statement of assets and liabilities and gives the financial picture of the business as of a certain date, for example, at the end of the year.
Balance
Sheet as at the end of first year
4.7 What is the loan repayment schedule? After determining the annual net profit, prepare the Loan Repayment Schedule. An example is given below. For a loan of LC120,000 at the cost of 10% for six years, the repayment schedule is shown in the table below:
4.8 What is the break-even point (BEP)? Three kinds of break-even point (BEP) are commonly referred to, namely: 1) BEP Sales (LC) 2) BEP Production (volume) 3) BEP Percentage (%) a) Break-even Point (BEP) Sales Break-even point (BEP) Sales - is that amount of sales value at which no profit or loss is incurred by the business. b) Break-even Point (BEP) Production Break-even point (BEP) Production - is that level (volume or quantity) of production at which no profit or no loss is incurred by the business. Production above this level will result in a profit and production below this point will result in a loss. c) Break-even Point (BEP) Percentage Break-even point (BEP) Percentage - is that level of percentage of sales or production at which the business makes neither profit nor loss. Production above this level will result in a profit and production below this point will result in a loss. To determine the BEP, three figures need to be found. These are: Sales: annual sales as given in the profit and loss statement (step 4.4). Variable Costs - these are costs which change significantly according to levels of production and usually consist of raw material cost plus direct labour (step 4.4), provided it is hired and terminated according to how much production a factory is making. Fixed Costs - these are costs such as indirect labour and overhead expenses (steps 2.17 and 3.7), interest and depreciation. These costs do not change significantly, if the factory produces more or less.
To determine BEP Annual Sales, multiply annual sales found in income statement by the annual fixed costs. Annual Sales x Annual Fixed Cost BEP (Sales) = Annual Sales - Annual Variable Costs 2. BEP Production To determine BEP Production Volume, divide BEP Sales by the Unit Selling Price (USP) Break-even Point Sales BEP Production = Unit Selling Price Another
method is: Annual Fixed Costs BEP Production = Unit Selling Price - Unit Variable Costs
3. BEP Percentage To determine BEP Percentage on yearly sales, multiply the yearly fixed costs by 100, divided by annual sales minus the variable costs. Annual Fixed Costs x 100% BEP Percentage = Annual Sales - Annual Variable Costs
4.9 What is the return on investment (ROI)? One important issue that should be looked into when deciding whether or not to go ahead with your business is to answer this crucial question "Will my money be better off in this business or in the bank where it can earn a fixed interest in long term bonds or savings or time deposits?" To answer this question, calculate the project’s return on investment (ROI) which is one of the measures of profitability. This is done by dividing Net Profit (step 4.4) by the total capital requirement (step 4.1): It is better to use Net Profit After Tax, if this is applicable. Net Profit Return on Investment = x 100 Total Equity A variation in the profitability measure is the Return on Owner's Investments (ROI). This is derived by dividing Net Profit Before Taxes by the Owner’s Equity (Capital or Investment), as shown below: Net Profit Return on Owner’s Investment = x 100 Owner’s capital If the percentage is greater than the bank’s rate on long term deposits, including allowances for the country’s inflation rate during the same period, then the project appears financially viable. If it is below the bank rate, then you may consider several alternatives which could include measures like increasing production level (provided the market is sufficient), looking for ways to reduce costs, or even abandoning the project altogether. 4.10 Is the project feasible? Now that all questions related to the four aspects of the business project - that is, marketing, technical, organisation and finance - have been answered, a conclusion should be made on the feasibility of starting the business. Is the profit on the first year sufficient to meet the loan and interest repayments? Can marketing or raw material supply problems be overcome? What happens to project profitability, if raw material cost increases by 10%? What if sales forecast is only 80% realised? Any further outstanding questions should be dealt with in this last section. You also have to decide for yourself whether the profit you expect to make is worth all the risks you are taking in the business. Likewise, in addition to ROI which is one of the measures of profitability, other kinds of financial analysis can be done to give a better picture of the business. These include: 1) measures of liquidity (e.g., current ratio) Current Assets Current Ratio = Current Liabilities A ratio of 2 to 1 has often been considered a desirable one. This rule of thumb, however, is not necessarily valid in all cases and is industry dependent. 2) measures of solvency (e.g., debt-equity ratio) Total Debts Debt-Equity Ratio = Total Equity This ratio is very useful to creditors. A low debt-equity will be considered favourable by creditors as it indicates the business is mostly funded by the owners. Another financial tool which is required by some banks is Sensitivity Analysis, that is, subjecting the effects on production cost, profitability, margins, etc. by the changes of certain important inputs such as raw materials' price or labour cost increase by a certain percentage, say 5 or 10%.
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