Some of the entrepreneurs I have spoken to have said “I don’t really think about planning”, or “I’ll just leave that to my accountant”. I think part of this reticence about getting engaged with financial planning is due to it being seen as overly complex. Something for a trained professional.
We have tried to remove these barriers of complexity, to demystify finance. But if you’ve not started a business before, what can you draw on to try and understand how to forecast and plan a business?
Last week we discussed how knowledge gained through personal financial planning can be extended to business planning. I argued that there are similarities between personal planning and financial planning for businesses. Now I want to give you a practical example.
Here, I’m going to look at an imaginary household (belonging to Jane and Bob) as if it were a business. As you’ll see, financially a household has many of the ingredients of a business. It has cash coming in, cash going out, owns assets and may need external funding. What I hope you’ll see is that there’s not much difference between understanding household planning, and getting a grip on the basics of business planning.
Forecasting the household vs forecasting the business
- Salaries – Jane and Bob’s combined salaries come to £3,200 a month, plus a £1,000 bonus.
- Savings interest – Currently this is about £150, received in May each year.
- Cashback – The household earns £150 cashback every year, paid in July.
- Selling old junk – Every year the household sells some of its old junk, raising £100.
Annual household income: £39,800
Forecasting future income:
The main source of the household’s income is Jane and Bob’s salaries. If this household were a business, where would we start? One of the sensitivities we could model is changes in salaries. A pay rise is simple to model, but there will be more considerations around changing job (different travel costs, maybe different food and insurance costs) or spending time out of work. The latter is a good test to run on this household’s plan – if Jane or Bob become unemployed, how much of a safety net does the household have, and can it reduce its spending on luxuries to compensate? The timing of these changes is very important, as while the other sources of income above seem small compared to Jane and Bob’s salaries, they could have a more meaningful impact if either becomes unemployed.
How would this be different in a real business plan? The basic ingredients are the same – cash coming in at different points in the year from different sources. One potential difference is timing. Salaries are regular, but a business’ invoices may not be paid immediately. In addition, when a business makes a sale there are often directly related costs. This means that when more sales are made, these costs increase in proportion to the sales.
How these income sources are broken down into individual streams of revenue is going to be important when analysing the plan. For the household, this is quite simple, but businesses may have to think carefully about which lines to break their revenue into. For example, would book sales be best split into hardback and paperback, or by publisher, or by genre? Each of these splits will provide different information about the business. Breaking estimated revenue down into its different sources will enable planners to tweak their forecast based on the real data that starts to come in. To give another example, if computer hardware businesses’ big ticket items are generating less revenue than expected, but small servicing jobs are doing better than expected it will be useful to have these split out and adjust the forecast accordingly.
- Rent and bills – £1,400 per month.
- Food – £250 per month.
- Car costs – £240 per month, plus repairs, servicing and MOT, usually costing £500/year in August.
Annual household overheads: £23,180
Forecasting future overheads:
In all likelihood, little will change with these overheads over the coming years. There may be small increases in the cost of living, but unless more dramatic strategic changes in Jane and Bob’s lives happen (dramatically increased travel costs, or the reverse, or having an extra mouth to feed) these costs will remain fairly consistent. These costs cover the necessities of running the household. Whatever else happens to Jane and Bob’s cash flow, they must be able to pay these costs to maintain their present standard of living.
Similarly to household overheads, a business’ costs should not change dramatically unless there are strategic changes in the way the business is run. Future considerations might include moving to larger premises, paying higher salaries, or making new hires.
- Fun & hobbies – £400 per month, including eating out, cinema, sports etc.
- Holidays – £2,000 per year is set aside for holidays, which are taken in the summer months.
Annual household expenses: £6,800
Forecasting future expenses:
Jane and Bob are going to have to make some difficult choices here if they want to increase their savings. Flexing how much to spend on leisure activities is a great way for them to see how their choices affect their bottom line. The timing of these expenses is also very important, with a large holiday expenditure expected in the summer, the household’s cash flow must be able to accommodate this. In worst case scenarios, such as if Jane or Bob are out of work, there should be a reduced expenditure plan to work with these new circumstances.
Unless the business throws a lot of very expensive parties, there probably aren’t many direct equivalents for these expenses in a business. But there are similar ones – costs not directly related to the day-to-day running of the business. These could range from big marketing activities and special events (that will hopefully drive a lot of income but aren’t strictly necessary for the business to stay afloat) to smaller expenses like company parties. How much money the business has to spend on these activities, investing either in itself, its employees, or big promotions, is going to be very important for future planning.
- Computers – the household plans to buy a new home PC for £1,000.
- Bikes – the household owns 2 bikes, worth about £200 each.
- Cars – the household owns 2 cars, each worth about £4,000.
Annual household asset purchases: £1,000 (this year…)
Estimated current asset value: £8,400
Forecasting future assets:
There are three elements to assets as far as Jane and Bob are concerned: 1. When do they need replacing? 2. How much do they cost to replace? 3. What is their saleable value, if any? If 2 cars are no longer necessary, how much cash could selling one generate? The timing of the sale is important here too – if the plan relies on selling one car to prevent financial disaster it is worth thinking about how long it will likely take to successfully sell that car. In addition, the plan should be able to handle the replacement of these assets at unexpected times. What happens, for example, if a car needs to be written off and replaced immediately? Careful planning should ensure that there are always emergency funds available for the replacement of crucial assets like this.
Most businesses also own assets, be they the tools of their trade, computers, buildings or vehicles. For a business the concerns of asset lifetime, how long an asset will last until it needs replacing, are going to be similar to the concerns of household asset planning. In addition, both individuals and businesses purchase investments, which are also a kind of asset.
Savings accounts – £7,500
Forecasting future funding:
At the moment, Jane and Bob’s household funding is very simple – they have savings accounts for their hard earned cash. But, if they take out a loan to start a business, or a mortgage to buy a house, they will need to think more carefully about how much they can afford to repay each month, and how these payments affect the other income and cost considerations outlined above.
Funding a business can be more complex. The business may have taken out a loan, but it will likely also have cash invested in it by the business owner or shareholders. Depending on the arrangements made with different shareholders the business may need to pay out cash dividends to shareholders once certain conditions are met, often meaning the more successful the business is, the more it has to pay in dividends. Testing different types of funding for the business, and how they affect its long and short-term financial forecasts is a good thing to do well in advance of actually needing funding. Making the wrong decision could have a big impact further on, especially if it involves control of the business’ future.
End of year forecast
So how did Jane and Bob’s financial forecast pan out for the year?
Savings at the start of year 1: £7,500
Total income in year 1: £39,800
Total costs in year 1: £30,980
Money saved in year 1: £8,820
Savings at the start of year 2: £16,320
These totals are very top level. But they do give us a good idea about Jane and Bob’s position at the start of the next year. When planning a business we would want to see monthly figures to really understand the financial picture of what’s going on. It may be that there are months when the business is in danger of going cash negative, even if it ends the year on a high. Our business plan should also forecast at least 3 years in the future, and ideally more, to see the full impact of decisions laid down in the short term.
As you can see, a lot of the groundwork of business planning is laid in day-to-day financial planning. So, it may not be that big a leap from understanding your household finances to understanding your business. There’s always more to learn – but don’t be put off the financial side from the start. It can be simpler than you might think.