Last night we were talking about getting angel investment, and valuation, which is one of if not the most important points in the discussion. Valuation is essentially price.

Say you want to bring in $150,000 from an angel investor. The immediate question from the investor will be something like: “at what valuation?” Sometimes that’s called “pre-money valuation,” because the instant the deal happens the valuation will change into post-money valuation, which is always higher — because your company just got some new cash.

Your answer sets your deal equivalent of an asking price. If you say $500,000, then you’re offering the investor 30% of your company for $150,000. If you say $300,000, you’re offering 50%. If you say $1 million, then you’re only offering 15%.

Which leads to the question:

So how do I know? How do I set valuation appropriately? What is that based on? Is it some multiple of sales, or intellectual property, or what?

And that’s a good question, and very hard to answer. Sure, you want some compromise between what you want to give, as a percent of ownership in your company, and what investors would want to buy. Investors will simply say no if it’s not an attractive offer. But that’s still very vague.

• In the case of an existing business, with some history, you do have some formulas you can use. For a great site on that business interpretation of valuation, for existing busineses, I suggest bizequity.com, the zillo of small business.
• When we’re talking about startups, however, you don’t have history and you can’t really apply formulas based on sales, or revenue, or even intellectual property (although that could be more relevant).

So here’s my concrete suggestion:

1. Calculate starting costs. That’s two lists, the expenses you have to incur and the assets you have to have at the starting point — except cash. Leave that blank for a bit.  Add those all-except for cash assets to the starting costs, to get an amount, a number in dollars.  Click here for a lot more on that.  

   So, for example, in the illustration here, that would be about $40,000. Yes, I know it says $38,750, but this is just an estimated guess; always round up. You never guess just right.  

2. Calculate cash flow through the lean period at the beginning, before your sales cover your costs.  Make a good guess at how much money you need to cover the deficit spending to get you to an operational month-by-month break even level of cash. That’s where the cash requirement number in the illustration came from: it seemed like this company would need about $400,000 to survive from startup to break-even.  You can’t see much in the chart below, because it’s small, but it shows a projected 12 months of cash flow (in blue) with a minimum balance, a deficit (in red), of about $400,000.

   

3. That gives you a number. In this case, it’s $400,000. That’s what your cash flow shows you you’ll need to get to cash-flow break-even. In the last two months, the cash flow is positive, so the negative balance starts shrinking. With that estimate as a best guess, you go back into your startup costs calculation, and add in the cash required. It’s $400,000. You can see what that does to the startup costs worksheet in the next illustration here.
4. Having done that, you now know that you need about $500,000 from investors (again, technically it’s $458,750, but you’re using best-guess estimates, so round up.) Set that as the amount of investment you’re seeking. Then — and here it gets hard, to be sure — you need to decide how much of your company you’re going to offer to an investor in exchange for that $500,000.

5. Get some help here if you can. Ask somebody with experience in startups, or dealing with angel investors, or both. Ask an attorney you can trust, who should also be somebody with experience. The thing is, how much of your company you offer to investors is about a compromise between what you’d like — none, free money — and what will entice the investors to write checks.

   At this point a lot depends on your overall business offering, the cards your company brings to the table. Investors want as high return as possible, with as little risk, but in relation to return. How experienced is your team? How defensible is your product? How rich is the market? All these factors determine what kind of a deal will be acceptable to investors.

   • Let’s say, in this case, you’re new at startups, you have very little track record, and you want to attract an active angel investor as a partner. So maybe you set your initial valuation at $750K, meaning you’re offering to give away 2/3 of your ownership to get the money you need. You’re being realistic about what will attract an investor. You better really, really, like that investor, because he or she will essentially own your company. But this is a hypothetical case, and without a lot of experience and defensibility, that may be the best you can do.
   • Or maybe you’ve got better cards to play: you’ve got a team with startup experience, and a defensible new product, with some intellectual property, and it looks like an attractive market. That makes you able to set a stronger valuation, and maybe — we hope — still make it an attractive offer to investors. So maybe you say you’re valuing it at $1.5 million. You’re offering investors one third of your company for $500K.

So there’s a quick and (I hope) simple summary of how you set the initial (pre-money) valuation when you want to attract investment.

Note: The following is an excerpt from CPA’s Guide to Developing Effective Business Plans by Tim Berry, originally published by Harcourt Brace Professional Publishers, and reprinted and revised several times. It was subsequently published by Aspen Law and Business. Copyright © Timothy J. Berry. All rights reserved.

A rainy day in Rio

I looked out the window of a parked plane, at a dark, drizzly airport in Rio de Janeiro. Whatever spectacular views there might have been were obscured in low-hanging clouds. I was half a day from my starting point and still several hours from my eventual destination, Buenos Aires.

As I looked into the dampness outside the plane, I worried about exactly the same subject as discussed in this chapter — business planning for the international company. Apple Computer, which was then riding the height of its success in the late 1980s, had hired me to travel to Argentina to instruct its local dealers on business planning.

Why not? I had lived in Mexico, spoke fluent Spanish, and had written books on business planning. As a consultant, I had helped Apple develop its annual Latin American business plan for four years running. I had also developed the specialized software Apple dealers were using to do annual business plans.

What I worried about, however, that particular morning at the airport, was exactly that same question: why not? How about because I had never been in Argentina, hadn’t studied their local tax laws and accounting practices, wasn’t ready to predict their volatile currency exchange rates, and didn’t know their standard business practices? So I worried.

I know now that I needn’t have worried. Even though accounting practices and tax treatments may vary widely from country to country, the techniques of business planning are far more international than country-specific. That Buenos Aires occasion was the first of many. In the following three years I gave business-planning seminars in eight different Latin American countries, and five in Asia for four different computer manufacturer sponsors. At each one, I dealt with a few dozen computer dealers who ran their small businesses in their local markets. In 2003, I did another series of seminars in Europe and Latin America for software company owners. As I presented business planning and we discussed the specifics of their markets and their businesses, the techniques held up. A good plan is essentially a good plan, or not, depending on a lot of factors besides tax treatments and accounting practices.

Your business, your client’s business: what’s different?

So let’s assume you or your client are in the United States developing a business plan for an international business. How different is that business plan from a business plan developed for a strictly domestic business? The first answer, you’ve probably already guessed, is: not that much. However, we can be more specific than that. We can look at what kinds of differences there might be and how you might accommodate those differences.

Currency exchange rates?

Currency exchange rates are the first thing that concerns most people as they consider an international-oriented business plan. How do I handle currency exchange rates? How much does this influence my plan? Can I do a standard plan when I deal with currency exchange rates?

A big deal in international business

Currency fluctuations can be critical in international business. Changes in currency can mean changes in your costs and expenses, your sales, and even the value of your assets and liabilities.

For example, suppose you are importing handicrafts from Mexico. Your costs are mainly in Mexican pesos. When the peso trades at 3 pesos per dollar, then the hand-painted bowl from Oaxaca that costs you 15 pesos per unit costs you $5 per unit. When the peso exchange rate changes and the peso drops to 5 pesos per dollar, then the same bowl costs you only $3 per unit. If you think the peso is going to increase in value, you want to buy up bowls and convert them to inventory quickly. If you think the peso is going to decrease in value, then you want to postpone your purchases to reduce the ultimate cost.

The problem with currency fluctuations, however, is a classic problem of guessing the future. Like prices in the stock market, currency exchange rates are a guessing game. Guess right, and you make money. Guess wrong, and you lose.

In the larger international businesses, predicting and managing currency exchange can be critical. When I was consulting to Apple Japan in the early 1990s, chief financial officer Judy David produced substantial profits, occasionally comparable to the profits from the computer business, with astute currency management. This involved detailed programs to keep assets in whichever currency seemed likely to increase in value and liabilities in currencies likely to decrease in value. When I was with McKinsey Management Consulting in Mexico City in 1981, I saw major companies lose millions of dollars when the peso devalued, catching them with assets in pesos and liabilities in dollars.

Simple mechanics in the plan

As critical as currency exchange may be in your business, its specific treatment in your business plan is not much different than how a wheat farmer would treat fluctuations in the market price of wheat. To understand that, you should first recognize that regardless of how international your business might be, you are still going to do your books and report your numbers to the tax authorities in a single currency. If you are based in the United States, your business plan should be in dollars. It doesn’t matter how many countries you deal with, you still do your plan in dollars because you pay your taxes in dollars.

So where does the currency exchange come in? That depends on your business. Some businesses buy products in foreign markets and bring them into the United States to sell. Some export products made in the United States and sell them in foreign markets. You can sometimes be involved in multiple currencies, three or four in a single transaction. For example, you can buy computer circuit boards made in three countries and other hardware made in a fourth and a fifth, and then manufacture computers somewhere else and sell them in more than one country. In all these cases, however, if you are based in the United States then you are still going to have to translate all your currencies into dollars for your plan, your accounting, and your taxes.

Figures 1-2 show a simple example of how an import business handles its foreign currency costs in a start-up business plan, using Business Plan Pro Premier Sales Forecast and User-Added tables. In Figure 1 the sales forecast consists of projections for unit sales, dollar revenues per unit sold, total dollar sales, dollar costs per unit sold, and of course total dollar costs of sales.

Figure 1: The sales forecast consists of projections for unit sales, dollar revenues per unit sold, total dollar sales, dollar costs per unit sold, and total dollar costs of sales.

Figure 2 shows a simple two-row table for handling the currency exchange rates in the Business Plan Pro User-Added table. Use the Table menu to select the User-Added table.

• You can use copy and paste to copy the dates in the top row by selecting the date areas in any other table, copying them with the “Copy” command in the Edit menu, then returning to the User-Added table and using the “Paste” command in the Edit menu.
• Use your “Custom Number” command in the format menu to change currency format display from dollars to any other number format. When the dialog for formats appears, use your mouse to select the bottom option (”Custom”). Then click the indicated area on the upper right and type in your new currency format, using quotation marks for currency symbols. In Figure 2, for example, the format for the rows showing Mexican Pesos is “MN”$#,##0.00_);(”MN”$#,##0.00). The format for the rows showing Quetzals is “Q”$#,##0.00_);(”Q”$#,##0.00). Figure 60 shows that detailed custom format dialog.

Going back then to the sales forecast in Figure 1, focus on the second group from the bottom, the dollar costs per unit sold. These costs have to deal with the Mexican Peso (MN$) and the Guatemalan Quetzal (Q$). Notice how these costs change in March when both currencies (looking at Figure 2 again) change. You can work this into your business plan with some simple formula mechanics:

• The formula for the first row in costs refers directly to the Peso exchange rate in the User-Added table. To make that work, start with your mouse selecting in the first column, then type the equals (=) sign, then the number 25. You are saying that the average price in this row is 25 pesos. Then type the divided by sign (/) to indicate you want to divide that 25 by something else. Then use your Table menu to select the User Added table, find the peso rate for the first month, and click on it. Press Enter and Business Plan Pro entered your formula for you: “=25/’User added’!C2.” In practice that formula means that you are paying MN$25 per unit, which is worth (in this specific example) $8.33. The dollar cost is exactly 25 divided by 3. The peso rate below indicates that it takes 3 pesos to make up a dollar.
• With that formula entered in that cell, you can copy to the right (using the command in your Edit menu) to copy it to all the other monthly columns in that same row. From then on, when you go to the User-Added table to change your exchange rate forecasts, you will see your dollar cost forecast also changing automatically.
• You deal with the Quetzal prices with similar formulas, referring to the number of Quetzals required to equal a dollar.

Currency and expenses

Figure 1 shows an example of currency rates affecting costs of goods sold. Even without the specific details, you can imagine how to handle a business in which currency rates affect expenses instead of costs of goods. In this case, for Business Plan Pro purposes, your expenses are included in the Profit and Loss table instead of the Sales Forecast table. You can use a formula similar to the one in the example above to make expenses in the Profit and Loss change when the Peso or Quetzal rates change.

What’s the difference? It’s about standard accounting conventions. Accountants talk about costs as the cost of what you sell, and expenses are the operating expenses related to running the business. In the import example, an operating expense running in Pesos might be the rental of an office suite in Mexico City, with a voice mail box, for 250 pesos per month. Exactly as with the products in the detailed example, the dollar value would change when the peso rate changes.

Foreign currency in sales

Looking at these examples, you can imagine how to handle a situation in which you are exporting United States goods to other markets. For example, if you’re selling computers in Mexico your costs might be in dollars and your sales in Pesos. You would take your unit price estimate in the second block of the Sales Forecast table and create a formula calculating dollars from Pesos much like your formula that calculates dollars for pesos in costs.

Currency exchange: planning decisions

In all of the examples above, the business plan mechanics are relatively simple. The thinking can be quite complex, and the significance of planning and forecasting is huge. At this point in the example the mechanics end and the planning begins. The problem is not a problem of software or formulas; it is a problem of projecting rate fluctuations in the future. Guessing currency exchange rates is a major field of study and investment, every bit as much as guessing the future of interest rates. Factors affecting a change in currency exchange include political factors, economic factors, market factors, even psychological factors.

As an example, in the 1970s I was living in Mexico and writing for Business Week magazine. The Mexican Peso had traded at 12.5 to the dollar since the 1940s. In 1971 the United States dropped the gold standard and currencies began to fluctuate more than they had. By 1976 the peso was still stuck to 12.5 to the dollar despite growing capital flight (Mexicans investing their money outside the country in dollars) and balance of trade problems (Mexico was buying much more than it was selling). The economics suggested a devaluation by 1975, but politics kept the peso unchanged until the presidency changed hands in 1976. The peso dropped about half its value, meaning it took more than 20 pesos to equal a dollar. To guess the timing of the devaluation that eventually took place, one had to guess the flow of dollars and pesos and political will as well.

The business plan in the example needs to deal with the possibility of changes in exchange rates affecting costs. How do you price your goods in dollars when your costs are in other currencies? Do you commit to steady unchanging prices? This is not an unusual problem. The business plan mechanics are easy, but the related decisions are not.

Taxation and accounting environment

Aside from currency exchange, some international business plans must also deal with different tax and accounting practices. Still, the business plan for a U.S. company has to remain in dollars, and taxes paid outside the U.S. serve as a credit against U.S. taxes. For example, the value-added tax (VAT) is a major factor in most European markets, as well as Mexico and Japan. It is very significant for accounting and calculating tax burdens. However, in business planning, you are looking ahead and planning business decisions, not reporting to tax authorities. While you might use additional formulas to calculate your taxes, for planning purposes they are still going to be summarized in a single line towards the bottom of your profit and loss statement. Using Business Plan Pro, you could use the row in the Cash Flow worksheet to calculate the VAT or other taxes in more detail, and then run the results over to the tax line in your Profit and Loss. The form of the Profit and Loss doesn’t change for taxes: sales less cost of sales is gross margin, and gross margin less operating expenses is gross profit, also called Earnings before Interest and Taxes, or EBIT. Then you subtract interest and taxes to calculate net profits.

Added uncertainty

In general, as you plan the international business there is more uncertainty than with the strictly-domestic business. You have the immediate impact of currency exchange rates to start with. Then you add in some extra problems with estimating costs, sales, and expenses. Also, there are factors affected by when you translate your foreign currency elements into dollars.

Costs, sales, and expenses

The problems of estimating your business numbers are relatively easy to understand. When you buy your goods in Mexico and Guatemala, you are farther away from your suppliers. When you sell your goods in Japan or Europe, you have a different view of the same problem. The markets in Mexico might change because Japanese buyers are affecting supply and demand, which raises prices. Maybe the government needs to focus its weaving industry on producing low-cost basic goods instead of export items for international markets. Maybe a group of U.S. weavers gets the U.S. government to restrict imports from Mexico to prevent competition. Any of these changes in the local economy can change your business. Local politics, national politics, and international politics can affect import and export policies, availability, and pricing. Since you are farther from the market, you can expect more trouble estimating future trends.

Translation factors and timing of translation

As currencies fluctuate, the timing of your transactions can change your business. For example, if you are importing goods from Mexico and Guatemala, at what point do you translate their foreign-currency costs into dollars? Your accountant should be able to help you decide when – and at what exchange rate – to transfer your values to and from dollars. The timing can make a difference to profitability.

Market factors

Although the business planning mechanics don’t change as a result, the information gathering for international business is more complex. When doing business in multiple countries, you also have to deal with multiple markets and market trends. This makes your business plan preparation harder, even if it doesn’t change the mechanics of business planning. If you are selling in Europe, you need to know about your European customers. If you are buying in Central America, you need to know about market factors that could be affecting your costs.

International planning is still planning

When preparing this chapter, I was struck by an irony related to planning the international business. Despite having lived in three countries, and worked in more than a dozen others, I had to remind myself first how planning an international business might be different. I had the privilege of doing the annual business plans for Apple Computer’s Latin America group from 1984 to 1987, and for Apple’s Japan subsidiary from 1991 through 1994. I was also involved in smaller start-up companies, mostly high tech, some of them focused almost entirely on the U.S. domestic market. My own company now has a fully-owned subsidiary in the United Kingdom. There was always much more similarity than difference. Planning is still planning, not accounting.

The Break-even Analysis lets you determine what you need to sell, monthly or annually, to cover your costs of doing business—your break-even point. Illustration 1 shows the Break-even Analysis table:

Illustration 1: Break-even analysis

The Break-even Analysis table calculates a break-even point based on fixed costs, variable costs per unit of sales, and revenue per unit of sales.

Understanding break-even analysis

The break-even analysis is not our favorite analysis because:

• It is frequently mistaken for the payback period, the time it takes to recover an investment. There are variations on break even that make some people think we have it wrong. The one we do use is the most common, the most universally accepted, but not the only one possible.
• It depends on the concept of fixed costs, a hard idea to swallow. Technically, a break-even analysis defines fixed costs as those costs that would continue even if you went broke. Instead, you may want to use your regular running fixed costs, including payroll and normal expenses. This will give you a better insight on financial realities. We call that “burn rate” these post-Internet days.
• It depends on averaging your per-unit variable cost and per-unit revenue over the whole business.

However, whether we like it or not, this table is a mainstay of financial analysis. You may choose to leave it out, but really, a business plan would not be complete without it. And, although there are some other ways to do a Break-even Analysis, this is the most standard.

The Break-even Analysis depends on three key assumptions:

1. Average per-unit sales price (per-unit revenue):
   This is the price that you receive per unit of sales. Take into account sales discounts and special offers. Get this number from your Sales Forecast. For non-unit based businesses, make the per-unit revenue $1 and enter your costs as a percent of a dollar. The most common questions about this input relate to averaging many different products into a single estimate. The analysis requires a single number, and if you build your Sales Forecast first, then you will have this number. You are not alone in this, the vast majority of businesses sell more than one item, and have to average for their Break-even Analysis.
2. Average per-unit cost:
   This is the incremental cost, or variable cost, of each unit of sales. If you buy goods for resale, this is what you paid, on average, for the goods you sell. If you sell a service, this is what it costs you, per dollar of revenue or unit of service delivered, to deliver that service. If you are using a Units-Based Sales Forecast table (for manufacturing and mixed business types), you can project unit costs from the Sales Forecast table. If you are using the basic Sales Forecast table for retail, service and distribution businesses, use a percentage estimate, e.g., a retail store running a 50% margin would have a per-unit cost of .5, and a per-unit revenue of 1.
3. Monthly fixed costs:
   Technically, a break-even analysis defines fixed costs as costs that would continue even if you went broke. Instead, we recommend that you use your regular running fixed costs, including payroll and normal expenses (total monthly Operating Expenses). This will give you a better insight on financial realities. If averaging and estimating is difficult, use your Profit and Loss table to calculate a working fixed cost estimate—it will be a rough estimate, but it will provide a useful input for a conservative Break-even Analysis.

Illustration 2 shows a Break-even chart. As sales increase, the profit line passes through the zero or break-even line at the break-even point.

Illustration 2: Break-even chart

The illustration shows that the company needs to sell approximately 1,222 units in order to cross the break-even line. This is a classic business chart that helps you consider your bottom-line financial realities. Can you sell enough to make your break-even volume?

The break-even analysis depends on assumptions made for average per-unit revenue, average per-unit cost, and fixed costs. These are rarely exact. We recommend that you do the break-even table twice: first, with educated guesses for assumptions, as part of the initial assessment, and later on, using your detailed Sales Forecast and Profit and Loss numbers. Both are valid uses.

While we are trained to think of business as sales minus costs and expenses, which is profits, we have to manage cash as well.

Although cash is critical, people think in profits instead of cash. We all do. When you imagine a new business, you think of what it would cost to make the product, what you could sell it for, and what the profits per unit might be. We are trained to think of business as sales minus costs and expenses, which is profits. Unfortunately, we don’t spend the profits in a business. We spend cash. Profitable companies go broke because they had all their money tied up in assets and couldn’t pay their expenses. Working capital is critical to business health. Unfortunately, we don’t see the cash implications as clearly as we should, which is one of the best reasons for proper business planning. We have to manage cash, as well as profits.

A simple example
One of the best ways to understand the dilemma of cash vs. profits is to follow an otherwise-profitable company going broke because it can’t meet its obligations. This is a quick and simple example. It also leads us into the relationship between income statement, balance sheet, and cash.

Start with $100, which we’ll call capital. At the beginning of this exercise, your balance sheet has assets of $100—the money—and capital of $100. Assets are equal to capital plus liabilities. A summary of the simple financial statement at this point is shown in this first illustration, Starting Numbers.

Starting numbers

If you buy a widget for $100 and sell it for $150, you should end up with $50 profit, which is what your income statement covers. Sales minus costs are profit. You should have $150 in the bank. Now your balance sheet shows the same $100 in original capital plus $50 in earnings, which are equal to the $150 you have in cash as an asset. The next illustration shows you how the financials work after the sale.

Sell a widget

Buy another widget for $100 and sell it again for $150, and now you have $200 in the bank. Do it again, you have $250 in the bank. Your income statement shows sales of $450, cost of sales of $300, and profit of $150. The illustration shows your income statement and balance sheet at this point.

Sell three widgets

Adding some realism
Now go back a step and make the situation more realistic. For example, most sales of products to businesses go on terms, with the money due in 30 days. So if you sold that widget on credit you don’t have $150 in the bank. You still have $50 in your bottom line, but now you have nothing in the bank. Instead, a customer owes you $150, which is what we call “Accounts Receivable.” Compare the Sell a Widget illustration to this next illustration, Selling on Terms. This is what really happens to the huge number of businesses that sell to other businesses.

Selling on terms

Knowing you can buy a widget for $100 and sell it for $150, you get your Widget supplier to sell to you on the same terms you sell, net 30, instead of for cash. Now you have $100 that you owe to suppliers, which is called “Accounts Payable.” You also have $100 worth of widget in inventory. This gives you the case in the following illustration, Buying on Terms, in which you are now poised to sell another widget and make more profit.

Buying on terms

You have an extra $100 in assets (the widget in inventory) and an extra $100 as liabilities (Accounts Payable), so you are still in balance. Also, you still have no money. Our next illustration shows the financial picture with sales to businesses on credit and purchase of inventory on credit as a short-term debt.

Numbers mount up

Now the case is more like what you have with real business numbers, in which you have to manage your cash very carefully, and the amounts sitting in inventory and accounts receivable are significant.

More realism: working capital
Even in the case of the above illustration, the example is completely unrealistic. Where are the running expenses, such as rent, salaries, telephones, or even advertising those widgets? How would they affect the cash situation? How far would we get if we couldn’t pay the rent or the telephone bill while waiting for customers to pay us? Furthermore, what supplier would give us a widget on credit when we have no history and no assets? What bank would loan us money in this situation? Banks do loan against inventory and receivables, but only to a certain percentage of total value. What was missing here, all along, was working capital.

Important: In strict accounting terms, working capital is equal to short-term assets minus short-term liabilities. In real terms, however, working capital is the glue that holds your cash flow together. Get it into the bank before you need it, or you won’t survive the unexpected.

The following illustration goes back to the beginning of this whole example and does it right, with enough capital in the beginning to finance the company.

Working capital

Instead of starting with $100 as capital, this business looks a lot better with starting capital of $400. With this additional capital from the start, buying on credit and borrowing against assets is more realistic. In this scenario, working capital is up to $550. Now it has a proper input of working capital at the beginning. With even the barest of business plans, we could tell that $100 wasn’t enough to get this business going.

I hope the theoretical examples help make the concepts clear. If you followed these illustrations, you can see some enormous implications for running a business.

Important: Every dollar in accounts receivable means a dollar less in cash. Every dollar of inventory is a dollar less in cash. Every dollar of accounts payable is a dollar more in cash.

Continue reading Cash Flow: Part 2

Although cash is critical, people think in terms of profits instead of cash. We all do. When you and your friends imagine a new business, you think of what it would cost to make the product, what you could sell it for, and what the profits per unit might be. We are trained to think of business as sales minus costs and expenses, which is profits.

Unfortunately, we don’t spend the profits in a business. We spend cash. Profitable companies go broke because they had all their money tied up in assets and couldn’t pay their expenses. Working capital is critical to business health. Unfortunately, we don’t see the cash implications as clearly as we should, which is one of the best reasons for proper business planning. We have to manage cash, as well as profits.

In Part 1 of this article I talked about Cash Flow and how it is effected in business operations, and gave a simple example. Now let’s look at the implications in a real case. The real case is a computer reseller (that is, computer store) in a medium-sized local market, with sales of about $6 million per year.

The first chart, in this first illustration, shows a representative sample business plan cash flow for 12 months, given standard assumptions for sales, costs, expenses, profits, and cash management. The sample company is profitable and growing. It sells about $6 million annually, produces about 8 percent net profit on sales, and is self supporting.

As the cash case starts

The chart shows a 12-month projection of cash resources. Of the two sets of bars the green one represents the checkbook balance at the end of each month, and the red represents the cash flow, which is how much the balance changes in a month. The green bars should never drop below zero, because if your checkbook balance is less than zero, then you are bouncing checks. The mathematics don’t care, but the banks do. The red cash flow bars, on the other hand, can drop below zero without major problems, as long as the balance stays above zero. For example, if a company’s balance was $10,000 at the end of January, and its February cash flow is a negative $5,000, then the balance at the end of February is $5,000 and the cash flow is -$5,000. The green bar stays positive, but the red one is negative.

In the illustration below, only one assumption has changed: that same company now waits an extra 15 days, on average, to receive money from customers on invoices presented. The average wait, which is called “collection days” goes from 45 days to 60 days.

Nothing else changes — no new employees, no change in costs, no additional expenses.

Changing collection days only

A single change, from 45 to 60 days, makes a huge difference in the cash flow. No other changes except waiting on average an extra 15 days before receiving money owed, “Accounts Receivable”, from their customers.

Notice here the critical importance of cash, and the critical difference between cash and profits. With this single change in assumptions, the company is still as profitable as it was, down to the last dollar. Now, however, its projected bank balance in January is more than $50,000 below zero. Therefore, the company needs more than $50,000 in additional financing.

This is new money needed, new investment or new borrowing. The problem can’t be solved by reducing expenses or increasing sales.

Companies go out of business for problems like these. Even otherwise-healthy companies can go under for lack of cash. This kind of projection can kill a company if it sneaks up by surprise, but can be easily managed when there is a plan for it. This is an eloquent argument for good business planning.

In the third case, shown in the following illustration, we set the collection days back to the original assumption of 45 days, but change the assumption for inventory. Where previously it kept an average of two month’s worth of inventory on hand, in this changed assumption it now keeps three months of inventory on hand. Accountants call this Inventory Turnover. The changed assumption creates an inventory turnover rate of 4, instead of the previous rate of 5. The collection days are back to 45 in this next scene, but inventory turnover went from 5 to 4, which means keeping more inventory on hand.

Changing Inventory Only

The change in inventory turnover shows the cash balance is now well below zero. The implications of the above illustration are massive. This is still a profitable company, but it has a critical financial problem. You see how the cash balance bar falls to more than $600,000 below zero in November. That means that this company needs new money, new loans or new capital investment, to make up its cash deficit, even though it is still profitable. This is hard to swallow until you see it happen in real business, but it is the truth and it will happen.

Profits are not cash.

Read Cash flow–about business numbers: Part 1

Developing your sales forecast isn’t as hard as most people think. Think of your sales forecast as an educated guess. Forecasting takes good working knowledge of your business, which is much more important than advanced degrees or complex mathematics. It is much more art than science.

Whether you have business training or not, don’t think you aren’t qualified to forecast. If you can run a business, then you can forecast its sales. Most people can guess their own business’ sales better than any expert device, statistical analysis, or mathematical routine. Experience counts more than any other factor.

Break your sales down into manageable parts, and then forecast the parts. Guess your sales by line of sales, month by month, then add up the sales lines and add up the months.

The illustration below gives you an example of a simple sales forecast that includes simple price and cost forecasts which are used to calculate projected sales and direct cost of sales and estimate total dollar value for each category of sales.

A simple sales forecast

Use text to explain the forecast and related plans and background
Although the charts and tables are great, you still need to explain them. A complete business plan should normally include some detailed text discussion of your sales forecast, sales strategy, sales programs, and related information. Ideally, you use the text, tables, and charts in your plan to provide some visual variety and ease of use. Put the tables and charts near the text covering the related topics.

In my standard business plan text outline, the discussion of sales goes into the chapter on Strategy and Implementation. You can change that to fit whichever logic and structure you use. In practical terms, you’ll probably prepare these text topics as separate items, to be gathered into the plan as it is finished.

Sales strategy
Somewhere near the sales forecast you should describe your sales strategy. Sales strategies deal with how and when to close sales prospects, how to compensate sales people, how to optimize order processing and database management, and how to maneuver price, delivery, and conditions.

How do you sell? Do you sell through retail, wholesale, discount, mail order, phone order? Do you maintain a sales force? How are sales people trained, and how are they compensated? Don’t confuse sales strategy with your marketing strategy, which goes elsewhere. Sales should close the deals that marketing opens.

To help differentiate between marketing strategy and sales strategy, think of marketing as the broader effort of generating sales leads on a large scale, and sales as the efforts to bring those sales leads into the system as individual sales transactions. Marketing might affect image and awareness and propensity to buy, while sales involves getting the order.

Forecast details
Your business plan text should summarize and highlight the numbers you have entered in the Sales Forecast table. Make sure you discuss important assumptions in enough detail, and that you explain the background sufficiently. Try to anticipate the questions your readers will ask. Include whatever information you think will be relevant, that your readers will need.

Sales programs
Details are critical to implementation. Use this topic to list the specific information related to sales programs in your milestones table, with the specific persons responsible, deadlines, and budgets. How is this strategy to be implemented? Do you have concrete and specific plans? How will implementation be measured?

Business plans are about results, and generating results depends in part on how specific you are in the plan. For anything related to sales that is supposed to happen, include it here and list the person responsible, dates required, and budgets. All of that will make your business plan more real.

How many years?
I believe a business plan should normally project sales by month for the next 12 months, and annual sales for the following two years. This doesn’t mean businesses shouldn’t plan for a longer term than just three years, not by any means. It does mean, however, that the detail of monthly forecasts doesn’t pay off beyond a year, except in special cases. It also means that any detail in the yearly forecasts probably doesn’t make sense beyond three years. It does mean, of course, that you still plan your business for five, 10, and even 15-year time frames; just don’t do it within the detailed context of business plan financials.

How do you estimate specific costs for a new business? How do you predict expenses? Normally you need some experience. If you have no idea, then you might think again about starting this business. Maybe your team should add somebody who does have experience, and can make estimates. Here is why.

In the real world, there are no standard costs for anything. Your expenses will depend, not on the type of business, but rather on your specific strategy, your specific location, and other specifics of your business situation. You might be able to find recommended expense levels in some books, websites, or other sources, but don’t expect that kind of information to be available for all businesses. Don’t think that there is some source you’re missing that lists standard costs for different kinds of business start-ups.

One general exception to this rule is franchised businesses. If you look to start a business as a franchisee, you can expect the franchisor to have some starting lists of normal costs. This is part of what you pay for when you decide to build a franchise business instead of developing one completely by yourself. Since you are going to pay for this information, make sure you choose a successful franchisor, one that provides real business value. There are a lot of would-be franchisors who don’t really fulfill their promise.

Another exception, in some rare cases, is a sample business plan. If you happen to have a good match between a sample business plan and the business you want to build, then a sample plan can be helpful. However, do not depend on this likelihood, because really good matches with sample plans are rare. A good match would have to match your strategy, your location, and even your year of starting — expense levels for a couple of years ago won’t be the same today. Expense levels for a different location won’t be the same for your location. There are good reasons for this lack of generalized information. Business expenses depend on you, not on the type of business.

Take restaurants as an example. Imagine how much different the starting costs for a very expensive high-fashion restaurant in the best part of New York, serving the best possible French haute cuisine are from the starting costs of a small restaurant somewhere in the middle of the country, in a small town, serving sandwiches and French fries. The point is that starting costs aren’t set according to the type of business, they are determined according to what you, the author of the business plan, decides. As another example, consider the rent expense for a business office or manufacturing plant. This is an important element in the costs of any business, but no one outside your area can tell you what rent is going to be. You have to consider locations in your area, for your business. You must think about how big a space you want, what your target market is, how important the location is to that market. Then you have to make telephone calls and talk to people and find out rents for prospective locations that might work for you, by asking real estate people, or looking in the ads in the newspaper, or whatever. There is nobody in the world who can tell you what rent is for one type of business or another, because what matters is where you are, and the choices you make. That’s why people usually develop their own business plans. Sample plans help, and they may give you some good examples and ideas, but the best business plan is the one you develop yourself.

Forecasting is usually easier when you break your forecast down into components. As an example, consider a forecast that simply projects $1,000 in sales for the month, compared to one that projects 100 units at $10 each for the month. In the second case, when the forecast is price x units, as soon as you know the price is going up, you know that the resulting sales should also increase. Thinking of the forecast in components is easier.

The first illustration for this article shows a units-based sales forecast. It takes assumptions for sales in units, then the assumed average prices, and multiplies them to calculate sales dollar values. Then it takes assumptions for unit costs and uses them, along with unit sales assumptions above, to calculate direct cost of sales.

The units-based sales forecast illustration

Graphics as forecasting tools
Business charts are much more than just pretty pictures; they are an excellent tool for understanding and estimating numbers. You should always create charts to illustrate your sales forecast, then use them to evaluate the projected numbers. When you view your forecast on a business chart, does it look real? Does it make sense? It turns out that most humans sense the relative size of shapes better than they sense numbers, so we see a sales forecast differently when it shows up in a chart. Use the power of the computer to help you visualize your numbers.

For example, consider the monthly sales chart shown in the next illustration. You can look at this chart and immediately see the ebbs and flows of sales during the year. Sales go up from January into April, then down from spring into summer, then up again in the autumn. When you look at a chart like that, you should ask yourself whether that pattern is correct. Is that the way your sales go?

Monthly sales forecast chart

The next chart, Annual sales forecast, shows a comparison of three years of annual sales. Here again, you can sense the relative size of the numbers in the chart. If you knew the company involved, you’d be able to evaluate and discuss this sales forecast just by looking at the chart. Of course you’d probably want to know more detail about the assumptions behind the forecast, but you’d have a very good initial sense of the numbers already.

Annual sales forecast chart