Developing A Sound Financial Plan

A business can be considered a financial success when it creates the highest value over time. This means it:

• turns a profit
• has a healthy balance sheet
• generates good cash flow
• generates a good ROI
• creates transferable value.

To attain these five objectives, say our experts, you need to start with a financial plan that includes both a historical record and future projections. By looking at the past to help plan and predict the future, you can gain much better control over your company's financial performance. Ideally, a financial plan should contain three specific segments:

• a historical analysis
• a three-year plan
• a one-year plan.

Each of these segments is based upon data from the company's balance sheet, income statement and cash flow documents, as well as selected financial ratios. In addition to the numbers, the financial plan should include analytical narrative – your analysis of what the numbers tell you – and the assumptions that underlie your projections.

Historical analysis

Once you have worked out where you want to go and how to get there, take an in-depth look at how you got to where you are today. Start by gathering financial data from the past three to five years in five areas:

• balance sheet
• income statement
• cash flow statement
• selected financial ratios
• key activity ratios.

One of the best formats for gathering and interpreting this kind of financial data is the 12-month moving annual total chart. This allows you to see trends from month to month and year to year, eliminating the distraction of seasonality.

Once you have the information, the next step is to identify problems and outline solutions in your plan.

The three-year plan

The three-year plan is a tool for looking into the future and determining how your company should perform. It gives you a yardstick to measure performance as it occurs, rather than after the fact. It enables you to spot trouble signs before things get out of hand, so that you can take appropriate action.

More important, the three-year plan allows you to grow the business without running out of cash. Growth in sales always requires extra cash to generate and support the additional revenues. You can finance the additional assets you need in one of three ways:

• Reinvest profits.
• Take on more debt.
• Inject more equity into the company.

When used properly, the three-year plan helps you to determine what additional assets will be needed to support your increased sales and what impact these will have on the balance sheet. In other words, the plan indicates how much additional debt or equity you will need to stay afloat.

How to develop your three-year plan

To develop a three-year plan, we recommend the following four steps.

1. Project the income statement. This includes developing a sales forecast and determining your expected gross margin percentage. Estimate your operating expenses as well, and use all three figures to determine your projected profit (or loss).
2. Project the balance sheet. As sales go up, so do other areas of the business:

• If the net income plus the increase in variable liabilities equals or exceeds the increase in variable assets, the company will have the resources to finance itself. If not, you must bring in additional debt or equity.

3. Project cash flows. Using the information in steps one and two, project how these numbers will affect your cash flow. Pay special attention to how much new debt or equity you will need to inject into the business, and when.
4. Project key balance sheet and income statement ratios. You should never grow at the expense of the balance sheet. If your projected ratios show a weakening balance sheet, go back to the drawing board and rethink your projections. Or, start looking at ways to cut costs, improve margins and run a leaner, tighter operation.

The one-year plan

The final piece of the financial plan relates to the short term: the one-year plan. It involves the same steps as the three-year plan, but projected on a monthly rather than an annual basis.

Why financial plans are crucial

A good financial plan performs three critical functions.

1. The process of gathering the data, analysing the numbers and projecting them into the future gives you a detailed picture of what is really going on in the business.
2. The plan gives you a benchmark by which to measure your financial performance.
3. Having a plan to measure against tells you when you are getting off track.

With all this information to hand, you can take action before serious financial deterioration occurs.

Return on investment

We suggest adding one more step to your financial plan – an ROI payback analysis. After all, there's no sense in implementing a plan if it won't yield the desired return.

Planning for payback

As a business owner, you're either investing in or drawing out of your business. Therefore, the ultimate question is: "How much will it cost to grow my business and how long will I need to stay in investment mode?" If you're investing for growth, you ought to have a clearly defined payback period and action plan to get you through it as fast as possible. Yet, entrepreneurs often plan for growth without considering how long it will take to get a payback or developing the action plans to get there.

We all have great ideas. The issue is how you get those ideas to bear fruit. In order to see your financial plan through, you have to translate ideas into behaviours, which require action plans.

That's where the ROI payback analysis comes in. It forces you to answer the question: "If I invest this money, how quickly will I get paid back and what are the action plans that will get me to that point?" If you're comfortable with the answer, go ahead with your plan. If not, don't invest until you can develop one that you can live with.

And finally . . .

As always, flexibility is key. Most companies find that change occurs more frequently than once a year. So although a one-year plan serves a useful purpose, as Eisenhower said: "The plan is nothing; the planning is everything."

You may therefore find it useful to tear up the plan every 90 days, particularly during a downturn. Never let yourself be tyrannised by a budget.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.