Financial Risk and Business Planning

The Financial Plan

• Chapter 8 focuses on financial risks: how to measure and express them
• Risk is related to the rewards of a business
• A business can be evaluated to determine if it is "worth the risk" or "worth the trouble"

Story From Real Life

• Ms. Yong Suk Daley opened a clothing-alteration shop in Springboro, Ohio, in 2000
• The business slowed down in 2005
• Ms. Daley renovated her business and renamed it "Young's Special Occasion Apparel" in 2006
• She altered clothes for special occasions with bigger budgets
• The purchase of her inventory and display was financed with her personal credit cards
• Daley got a business coach in August 2006 to help her develop a proper business plan
• Daley prepared a cash budget as part of a loan application to reduce credit card debt
• She strengthened recordkeeping, improved financial management, and marketing
• In October 2006, Daley was granted a loan, and she no longer had to use her credit card to finance inventory

Financial Plan Essentials

• Financial plan: The business plan expressed in numbers of money terms
  • Includes cash budgets, the amount of external financing required, and an assessment of the risks and rewards
• It summarizes the components of your business plan
• It expresses how high startup costs will be, how much the new factory will cost, and what sort of working capital will be required
• It quantifies all of your plans into measurable units of money
• It explains the total investment required, the fixed assets, the working capital, and the amount of salary expenses in comparison to raw material costs
• Financial plans show the monetary rewards and how much an investor's money can grow
• Three goals:
  • Demonstrate the need for funds
  • Demonstrate the reward/return of a business
  • Measure financial risks
• Three components:
  • Cash budgets
  • Conclusions reached from the cash budget
  • Ways to measure risk
• The time frame of a cash budget will cover several years
• A cash budget should be enough to cover five years if it will to build a stable business by the fifth year
• Taking the investor's point of view is another method to determine the time frame
• The time frame of the cash budget should be equivalent to the time frame of the investor
• Five years is a reasonable time frame for most investors

Cash Outflows

• Cash outflows/costs: Sorted into variable and fixed costs
• Variable costs change/vary with the number of units sold: The more sold, the higher the variable costs will be
• Raw materials and labor used in production are examples of variable costs
• Variable costs are expressed as a percent of sales
• Fixed costs do not change with the number of units sold
• The amount remains constant for a wide range of sales volume or for a time period
• New businesses cash budget’s show the first years as having negative net cash flows

Cash Flow

• Small beginning cash balances, and negative net cash flow lead to a smaller/negative ending cash balance
• External funds are required to bring the amount back to minimum operating cash level in the sub-period
• External funding is required

Glossary of Terms

• Cash budget: Tracks the expected flow of cash as it comes into and goes out of a business over a future time frame
• Terminal Value: The forecast value of your business by the end of a specified period, and is used to limit the time frame in a cash budget
• Variable costs: Change or vary with the number of units sold and often expressed as a percent of sales
• Fixed costs: Do not change or remain fixed over a wide range of sales volume
• Minimum operating cash: The least amount of cash a business needs for day-to-day operations
• Payback period: The time it takes for a business to fully recover or pay back the initial investment (Shorter = more attractive)
• Internal rate of return: The percentage rate that equates the cash outflows and inflows (higher than the required rate = more attractive)
• Net present value: Today's value of future cash flows minus the initial investment (positive NPV is attractive)
• Breakeven point: The number of units your business must sell to just be able to cover costs=zero profit
• Sensitivities: Forecasts that differ from the original forecast because one or several variables are changed = used to find out the result effects on the financials

Measuring Risks

• Net present value: Today's value of all future cash flows minus the initial investment
• You need to input a required rate of return in the calculation
• It determines if the business gets to earn sufficient money each year, to pass the test of the investor, and to see if it still produces a net positive amount, by the end of the project
• A business with positive NPV is attractive
• Required rate of return: The minimum reward a business must provide for an investor to invest in it; it is expressed as a percentage
• The breakeven point is the number of units the business must sell to cover all costs or achieve at least zero profit
• The business is not profitable below break-even
• Introducing sensitivities: Present alternative cash budgets which result in an optimistic and pessimistic scenario
• Introduce a best-case and a worst-case scenario - to know what would happen if sales are higher or lower than expected

Chapter 8 discusses the measurement of financial risks and how they relate to business rewards. A real-life story illustrates how Yong Suk Daley renovated her shop and improved financial management with a business plan and loan application, reducing credit card debt and improving marketing.