THE FINANCIAL PLAN

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PR.OFILE

TONY HSIEH

282

PART

FROM THE OPPORruNIYTO THE BUSINESS PI-AN

warehouse to Kentucky to be nearer the UPS hub and to ensure the fast delivery of the
products offered, which has recently expanded to clothing, handbags. and accessories.
The company's focus on customer service is designed to make sure the customer has a

quality experience from beginning to end. In addition, all employees once hired must
complete a four-week customer loyalty training prograrn to make sure they understand the culture that has made the company so successful. To ensure that the hires are
serious, Tony makes a visit during the second week and offers anyone $2,000 if they
would like to drop out and quit the program. Only 1 percent of the hires have taken
him up on the offer. The unque culture of the company also includes such things as
happy hours, a nap room, fully paid health insuran(e, and life-related issue support
that Tony pays for out of his own pocket. His philosophy regarding these strategies is

that only a happy employee

ca.n

provide great service.

Once Zappos wins over a customer (75 percent of the customers are repeaters), the
cornpany tries to ensure their continued interest by keeping them engaged in various
online and social media outlets. Customers are invited to submit reviews and to share

their experience with others.

This not only enhances each customer's loyalty but also

attracts new customers.

Although these services, both at the employee and customer level, are costly to the
company, Tony believes that they are crucial in maintaining a competitive edge and
were important in achieving the $1 billion in sales. Good budgeting and financial planning are also significant factors in helping to reach these lofty goals'1

some unique hnancial characteristics, which are included in the discussion that follows.

OPERATING AND CAPITAL BUDGETS

Before developing the pro
ating and capital budgets.
sible for the tudgeting dec

entrepreneur should prepare operroprietor, then he or she is responship, or where employees exist, the

CHAPTER

10

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283

ndi
be

budgets will ultimately rest with the owners o.

"nt."p."ln?o.r.
As can be seen in the following, in the preparation
of the pro forma income statement, the
entrepreneur must first develop a sales budget that is an estimate of the expected volume of
sales by month. Methods of projecting sales are discussed next. From the sales forecasts
the
entrepreneur will then determine the cost of these sales. In a manufacturing venture the
ng them to
as a

buffer

Table 10.1 illustrates a simp

first three months of operation.

for the cost of goods produced,
tion from this budget is the actu
necessary to allow for sudden changes in demand. As can be seen, the production required
in the month of January is greater than the projected sales because of the need to retain
100 unis in inventory. In February the actual production will take into consideration the inventory from January
for that

continues
budg
inventory.

month. This
ales in_
crease. Thus, this
ncrease
demand and
cost of
goods sold as a direct expense. Thus, in those ventures in which high levels of inventory
ar
necessary or where demand fluctuates signifrcantly because ofseasonality, this budget can
be a very valuable tool to assess cash needs.
After completing the sales budget, re entrepreneur can then focus on operating costs. First
a list of fixed expenses (incurred regardless of sales volume) such as rent. utilities. salaries. advertising,
items can
contact w

the additional employee. This budget, along with the manufacturing budget illustrated in
Table 10.l, provides the basis for the pro forma statements discussed in this chapter.

_-.-

Tell the

Truth.

:,

'

A leader has an ethical obligation to be hoest

with stakeholders about issues tht directly concern them.

5. Prevent flarm.
2

Know YourProduct.
According to a recent three-part story in Ie
Wall Street Journal, the willingness of investors
to buy and sellfinancial products whose complexity they didn't fully understand was one of
the primary catalysts of the bust.
Because money was being made in these deals,
no one thought to question what was going on
or had the strength of character to speak up

about any suspicions. However; knowing your

product isn't a nicety of doing business. lt is an

2U

i .,

.. .:

When you can reasonably foresee that a decision is likely to hurt people and you make that
decision anyway, you're being both irrespon-

sible and stupid. For example, subprime

mortgage lenders and brokers who lend money
to people likely to default are enriching them_
selves at the expense of the rest of us. since the
federal government may be called upon for

financial

rescue.

6. Don't Exploit.
It is easy to take advantage of a situation for
financial gain, but doing so isn,t consistent with

good leadership. After Hurricane lke hit last

the wholesale price of gasolne shot up,
which was.nothing more than price gouging.
year,

ln the short run, companies that exploited a natural tragedy may have profited financially, but
,:

the long-term negative consequences are real

and significant: In New york State, for example,
more than a dozen companies were fined more
than $60,000 for unfair business practices following Hurricane Katrina.

10.

7. Don't Make Frornises You Can,t Keep . ..

. . . and keep the promises you make. There are
rare circumstances in which we not only have a
right but an ethical obligation to break a prom:
ise, but generally speaking. we have a strong
duty to be true to our word.
.

8. Take Responsibility for your Mistakes.

Transparency and accountability should be the
new buzzwords. This means, in part, that business leaders who make mistakes should apologize to those they have let down and do whatever is necessary to make amends. In the wake
of the toy industry's lead-paint scare in 2007.
Mattel CEO Robert Eckert took the high road
and told a Senate subcommittee that the company failed "by not closely overseeing subcon,
tractors in China whose toys didn't meet U.5.
safety standards," and that Mattel was
working with the Consumer product Safety

Source: Reprinted from February 2, 2009 issue of BusinessWeek by

special permission, copyight @ 2009 by The McGraw-Hill Companies, Inc., "Ae You a Good Leader?" bv Bruce Weinstein.
BusinessWeek Onlinz, p. 13.

Capital budgets are intended to provide a basis for evaluating expenditures that will
impact the business for more than one year. For example, a capital budget may project
expenditures for new equipment, vehicles, computers, or even a new facility. It may also
considerevaluating the costs of make or buy decisions in manufacturing or a comparison
of leasing, buying used, or buying new equipment. Because of the complexity of these
decisions, which can include the computation of the cost of capital and the anticipated
return on the investment using present value methods, it is recommended that the entrepreneur enlist the assistance of an accountant.

PRO FORMA INCOME STATEMENTS

The marketing plan discussed in Chapter 8 provides an estimate of sales for the next
12 months. Since sales are the major source ofrevenue and since other operational activities and expenses relate to sales volume, it is usually the first item that must be defined.
Table 10.3 summarizes all the profit data during the hrst year of operations for
MPP Plastics. This company makes plastic moldings for such customers as hard goods
285

286

PART

FROMTHEOPPORruNIYTOTHEBUSINESSPLAN

*Added shipper in month 3lTrade show

+Plant and equipment of $72,10 depreciated straight line for five yeus.

pro forma income

Projected net profit
calcul ated from proj ected
revenue minus projected
costs and expenses

manufacturers, toy manufacturers, and appliance manufacturers. As can be seen from the
pro forma income statement in Table 10.3, the company begins to earn a profit in the
eleventh month. Cost ofgoods sold remains consistent at 50 percent ofsales revenue.
In preparation of the pro forma income statement, sales by month must be calculated
hrst. Marketing research, industry sales, and some trial experience might provide the basis
for these hgures. Forecasting techniques such as survey of buyers' intentions, composite of
sales force opinions, expert opinions, or time series may be used to project sales.2 It may
also be possible to find hnancial data on similar start-ups to assist with these projections.
As would be expected, it wilt take a while for any new venture to build up sales. The costs
for achieving these increases can be disproportionately higher in some months, depending
on the given situation in any particular period.
Sales revenue for an Internet start-up is often more diffrcult to project since extensive
advertising will be necessary to attract customers to the Web site. For example, a giftware
Internet company can anticipate no sales in the first few months until awareness of the Web
site has been created. Heavy advertising expenditures (discussed subsequently) also will be
incurred to create this awareness. Given existing data on the number of "hits" by a similar
type of Web site, a giftware Internet start-up could project the number of average hits expected per day or month. From the number of hits, it is possible to project the number of
consumers who will actually buy products from the Web site and the average dollar amount
per transaction. Using a reasonable percentage of these "hits" times the average transaction
will provide an estimate of sales revenue for the Internet start-up.
The pro forma income statements also provide projections of all operating expenses for
each of the months during the frrst year. As discussed earlier and illustrated in Table 10.2,

CHAPTER

THE FINANCIAL

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287

ciation or Food Marketing Institute

These percentages are determined
industry- Other industries also pub
such as those listed in Table 7 -2- Trade associations and trade magazines will
also often
quote these ratios in industry newsletters or trade articles.
Salaries and wages for the company should reflect the number of personnel employed
as well as their role in the organization (see the organization plan in Chapter
9). As new
personnel are hired to support the increased business, the costs will
need to be included

In addition to the monthly pro forma income statement for the

should be made for years 2 and 3. Generall investors prefer to see
projections. Year I totals have already been calculated in Table 10.3.

In the pro forma statements for MPP Plascs (Tables 10.3 and 10.4), we can see that the
venture begins to eam a
. In the second year, the mmpany
does not need to spend
with the sales increase, shows a
modest profit of
e venture adds an additional em_
ployee and also incurs a 26 percent increase in sales, resulting in a net profit of
$121 ,gffi.
In projecting the operating expenses for years 2 and 3, it is helpful to first look at those
expenses that will likely remain stable over time. Items like depreciation, utilities, rent, insurance' and interest are likely to remain steady unless new equipment or additional space
is purchased. Some utility expenses such as heat and power can be computed uy using

p
a
$16,3)

288

PART

FROMTHEOPPORruNIYTOTHEBUSINESSPLAN

*No taxes are incuned in profitable yeus 2 and 3 because of tle carryover of losses in

yru l.

industry standard costs per square foot of space that is utilized by the new venture. Selling
expenses, advertising, salaries and wages, and taxes may be represented as a percentage of
the projected net sales. When calculating the projected operating expenses, it is most important to be conservative for initial planning purposes. A reasonable proht that is earned
with conservative estimates lends credibility to the potential success of the new venture.
For the lnternet start-up, capital budgeting and operating expenses will tend to be consumed
by equipment purchasing or leasing, inventory and advertising expenses. For example, the giftware Internet company introduced ealier would need to purchase or lease an extensive amount
of computer equipment to accommodate the potential buyers from the Web site. Inventory
costs would be based on the projected sales revenuejust as would be the case for any retail
store. Advertising costs, however, would need to be extensive to create awareness for the giftwae Web site. These expenses would typically involve a selection of seach engines such as
Yahoo!, Lycos, MSN, and Google; links from the Web sites of magazines such as Womnn's
Day, Family CircIe, and, Better Homes and Gardens; and extensive media advertising in magazines, television, radio, and print-all selected because of their link to ttre target market.

PRO FORMA CASH FLOW

Cash flow is not the same as profit. Proht is the result of subtracting expenses from sales,
whereas cash flow results from the difference between actual cash receipts and cash payments. Cash flows only when actual payments are received or made. Sales may not be regarded as cash because a sale may be incurred but payment may not be made for 30 days. In

CHAPTER

10

THE FINANCIAL

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289

addition, not all bills are paid immediately. On the other hand, cash payments
to reduce the
principal on a loan do not constitute a business expense but do constitut a
reduction ofcash.

revenue because of this fee.

g of this chapteq one
occasions, profitable
success

for

new ven

there
The
is illustrated in Table 10.5. In this met
For strict accounting purposes
the indirect and the direct method.

h flow,

which

the in_
come statement but to understand there are some adjustments that need to be made to
the

venture at a point in time and is sometimes easier to understand.

It is important for the entrepreneur to make monthly projections of cash like the monthly
projections made for profits. The numbers in the cash flow projections are constituted
from

AS' SEEN I N .B U'SI NESSWEEK

PROVIDE ADVICE TO AN.ENTREPRENEUR ABOUT SOLVING THEIR
CASH-FLOW PROBLEM TO STAY IN BUSINESS
Hot & Cotd Inc.. a plumbing and heating supply company in the heart of Virginia's Shenandoah Valley, is
hgqdgd forthe slaughterhouse. Asthe housing boom
g(ew,r so did sales. from $z millon a year to $14 million over four years. But as the company expanded,
its problems multpled, and no amount of sales could
cover the warts. As the economy faltered and poor
management continued. revenue started dropping
by more than $2 million a year.
Crunching the numbers over the past five years
shows lost opportunity and bad financial management have cost the company about 95 million in profits. Overtime alone is about 9250,000 a year. Today
Hot & Cold.is at $6 million in sales and is running at a
loss i'excess of $1 million. The bank is nervous, and
ready to pull the plug on its line of credit. The steady
supply of new business has dried up, and the three
owners'lives are on the line. The old cash cow is
chopped meat.
To keep the company alive, they've mortgaged their
homes, maxed out their credit cards at usurious interest

rates, and cashed in their 401(k)s. Worker morale is

low and employees are phoning it in because they are
convinced they'll be out of a job tomorrow. As a result,
the few remaining cf ients are unhappy, and threatening to take their business elsewhere.

SOLUTION: CONTROL, CONTROL,

CONTROL
The owners of Hot & Cold have three choices: Walk
away at great personal financial ruin; hope for a big
client to fly to their rescue and help them pay off
their huge debt; or take control of their own business. They're teetering on the verge of bankruptcy,
but it's not too late.
The three guys who took over from the family
who founded Hot & Cold have no training as managers. These are hard-working, talented contractors
and engineers with great knowledge of how to carry
plumbing and installation projects to completion.

...
But, for most of their careers, they worked for somebody else.
First they nged to:sit down with each department
head and develop an adopting plan for cash management. They need to be clear in their instructions, and
forceful in their insistence that there will be dire con.
sequences for failure to comply. Hold department
meetings at 8 a.m. on Monday, issue marching orders.
then meet again on Friday at 6 p.m. to see what did
and did not get done. Every job needs to be monitored by microscope from start to finish.
It'll hurt. Hot & Cold requires drastic niernal over-

haul, including deep cuts in operating costs.'They.

can't be "tepid" about this,:At least 20% of their
workforce of 50 will have to be fired. This business
needs to get serious about collecting the cash that
clients owe them, even if they have to take a hit by
offering cash discounts or accepting partial payment
just to bring the money in.
I also recommend that they meet face to face with
their banker. lf they've followed my advice so far,
they will be able to point to the cost measures already in place and forestall foreclosure on their loan.*

ADVICE TO AN ENTREPRENEUR
An entrepreneur friend saw the above article and has
asked you for some advce:
'|

My receivables are averaging about 75 days.

Should I be concerned that this wll affect mv
cash

flow?

2. What can I do to get faster payments on my

billing?

3. My business is profitable, but I seem to always

run short of cash at the end of each month?
Why is that?
+Source: Replinted from July 24,2UJ9 issu of BusinessWeek by
special permission, copyright @ 2009 by The McGraw-Hill Companies, Inc-, www.businessweek-com, "Solve Your Cash-Flou, Problem
to Stay in Business," by George Cloutier with Samantha Marshall.

the pro forma income statement with moditications made to account for the expected timing of the changes in cash. If disbursements are greater than receipts in any time period, the
entrepreneur must either borrow funds or have cash in a bank account to cover the higher
disbursements. Large positive cash flows in any time period may need to be invested in

short-term sources or deposited in a bank to cover future time periods when disbursernents

CHAPTER

10

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PI.AN

291

pro orma ceshflow

Projected cash available
calculated from projected
csh accumulations

minus projected cash

disbusements

example that 80 percent of the cost of goods is paid in the month

that it is incurred, with the

*Inventory is valud
at cost or average of $2 0O/unit.

rrhre f@nders put up 100'000

$
exDilslon

each for working capital through the first rhrre yars. After the third y@r
the venrure

wi nred

debt or equity finaocing for

292

PART

FROM THE OPPORruNIY TO THE BUSINESS PI-AN

remainder paid in the following month. Thus, referring back to Table 10.3, we can note that
in February the actual cost of goods was $ 16,000. However, we actually pay only 80 percent
of this in the month incurred-but we also pay 20 percent of the cost of goods sold that
is still due from January. Thus, the actual cost of goods cash outflow in February is
.8 x $16,000 + .2 x $10,m0, oratotal of $14,800.
Using conservative estimates, cash flows can be determined for each month. These cash
flow projections assist the entrepreneur in determining how much money he or she will
need to raise to meet the cash demands of the venture. In our example, the venture starts
with a total of $300,000, or $100,000 from each of the three founders. We can see that by
the twelfth month, the venture begins to turn a positive cash flow from operations, still
leaving enough cash available ($41,500) should the projections fall short of expectations.
If the entrepreneurs in our example had to use debt for the start-up, then they would need
to show the interest payments in the income statement as an operating expense and indicate
the principal payments to the bank as a cash disbursement, not as an operating expense.
This issue often creates cash flow problems for entrepreneurs when they do not realize that
debt is a cash disbursement only and that inerest is an operating expense.
It is most important for the entrepreneur to remember that the pro forma cash flow like
the income statement, is based on best estimates. A start-up venture in a weak economy
may hnd it necessary to revise cash flow projections frequently to ensure that their accuracy will protect the firm from any impending disaster. The estimates or projections should
include any assumptions so that potential investors will understand how and from where the
numbers were generated.a
In the case of both the pro forma income statement and the pro forma cash flow, it is
sometimes useful to provide several scenarios, each based on different levels ofsuccess of
the business. These scenarios and projections not only serve the purpose of generating pro
forma income and cash flow statements but, more importantly, familiarize the entrepreneur
with the factors affecting the operations.

PRO FORMA BALANCE SHEET

The entrepreneur should also prepare a projected balance sheet depicting the condition of
the business at the end of the first year. The balance sheet will require the use of the pro
pro fornla balance sheet
Summarizes the projected
assets. liabilities, and net

worth of the new venture

ssrs Items that

are

owned or available to
be used in the venture

operations

forma income and cash flow staements to help justify some of the hgures.5
The pro forma balance sheet reflects the position of the business at the end of the frrst
year. It summarizes the assets, liabilities, and net worth of the entrepreneurs.
Every business transaction affects the balance sheet, but because of the time and
expense, as well as need, it is common to prepae balance sheets at periodic intervals
(i.e., quarterly or annually). Thus, the balance sheet is a picture ofthe business at a certain
moment in time and does not cover a period of time.
Table 10.7 depicts the balance sheet for MPP Plastics. As can be seen, the total assets
equal the sum of the liabilities and owners'equity. Each of the categories is explainedhere:

Assets. These represent everything of value that is owned by the business. Value is not
necessarily meant to imply the cost of replacement or what its market value would
be but is the actual cost or amountexpended for the assel The assets are categorized
as current or fixed. Current assets include cash and anything else that is expected to be
converted into cash or consumed in the operation ofthe business during a period of
one yearor less. Fixed assets are those that are tangible and will be used over a long
period of time- These current assets are often dominated by receivables or money that

is owed to the new venture from customers. Management of these receivables is

CHAPTER

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293

lmportant to the cash flow of the business since the longer it takes for
customers to pay
their bills, the more stress is placed on the cash needs of the venture.
A

liabililies

Money that is

owed to creditors

'

more detailed
discussion of the management of receivables is presented in chapter
13.
Liabilities. These accounts represent everything owed to creditors. Some
ofthese
amounts may be due within a year (current liabilities), and others
may be long-term
debts. There are no long-term liabilities in our Mpp plastics example
because the
venture used funds from the founders to start the business. However.
should the
entrepreneurs need to borrow money fom a bank for the future purchase
of equipment or for additional growth capital, the balance sheet would sow
long-term liabilities in the form of a note payable equal to the principal amount borrowed.
As
stated earlie any interest on this note would appear as an expense
in the income
statement, and the payment of any principal would be shown
in the cash flow statement. Subsequent end-of-year balance sheets would show only
the remaining
amount of principal due on the note payable. Although pro-pi payment
of what is
owed (payables) establishes good credit ratings and a good retaiionship
with suppliers, it is often necessary to delay payments of bills to more
effectively manage cash
flow- Ideally, any business owner wants bills to be paid on time by
suppliers so that
he or she can pay any bills owed on time. unfortunately, during
*".riorrr,

-uoy

294

PART

FROM THE OPPORruNIYTO THE

BU5IN65 PLAN

firms hold back payment of their bills to better manage cash flow. The problem
with this strategy is that while the entrepreneur may think that slower payment of
bills will generate better cash flow, he or she may also f,rnd that customers are think-

ovrner

equitJ The

amount owners have

invested and/or retained

from the venture

operations

ing the same thing, with the result that no one gains any cash advantage. More discussion of this issue is also included in Chapter 13.
Owner equity. This amount represents the excess of all assets over all liabilities. It
represents the net worth of the business. The $300,000 that was invested into the
business by MPP Plastics' three entrepreneurs is included in the owners'equity or net
worth section of the balance sheet. Any profit from the business will also be included
in the net worth as retained earnings. In our MPP Plastics example, retained earnings
is negative, based on the net loss incuned in year 1. Thus, revenue increases assets
and owners' equity, and expenses decrease owners'equity and either increase liabilities or decrease assets.

BREAK-EVEN ANALYSIS
In the initial stages ofthe new venture, it is helpful for the entrepreneur to know when a
profit may be achieved. This will provide further insiglrt into the financial potential for the
start-up business. Break-even analysis is a useful technique for determining how many

breakeven Volume of
sales where the venture

neither makes a profit

nor incurs a loss

units must be sold or how much sales volume must be achieved to break even.
We already know from the projections in Table 10.3 that MPP Plastics will begin to ern
a profrt in the eleventh month. However, this is not the break-even point since the firm has
obligations for the remainder of the year that must be met, regardless of the number of units
sold. These obligations, or fixed costs, must be covered by sales volume for a company to
break even. Thls, breakevn is that volume of sales at which the business will neither make
a proht nor incur a loss.
The break-even sales point indicates to the entrepreneur the volume of sales needed to
cover totai variable and fixed expenses. Sales in excess of the break-even point will result
in a profrt as long as the selling price remains above the costs necessary to produce each

unit (variable cost).6

The break-even formula is derived in Table 10.8 and is given as:

B/E(Q\:

TFC
SP

VC/Unit (marginal contribution)

where B/E(Q) :

TFC :
.SP :
VC

lUnit:

break-even quantity

total hxed costs

selling price
vaiable costs per unit

As long as the selling price is greater than the variable costs per unit, some contribution can
be made to cover hxed costs. Eventually, these contributions will be sufficient to pay all
fixed costs, at which point the firm has reached breakeven.
The major weakness in calculating the breakeven lies in determining whether a cost is
frxed or variable. For new ventures these determinations will require some judgment. However, it is reasonable to regard costs such as depreciation, salaries and wages' rent, and insurance as hxed. Materials, selling expenses such as commissions, and direct labor are
most likely to be vaiable costs. The variable costs per unit usually can be determined by
allocating the direct labor, materials, and other expenses that ae incurred with the production of a sinsle unit.

CHAPTER

IO

THEFINANCIALPLAN 295

*Fixed costs are those

costs that. without change n present prductilc capacity,
re not afiffted by chmges in yolurc ofoutput
tVariable costs are those
that are aff@ted in total by changes in volume ofouFut.
The viliable costs per uoit
is all rose costs atributable to producing one uniL This cost
is constant within defined nngs of

production-

Recall that in our MPp plastics

for the toy industry and hard goods

plastic molded parts

Since the company is
es, it is necessary to

likely to be selling a large volume

make an assumption regarding the average selling price based
on production and sales
revenue' The entrepreneurs determine that the average selling price
of all these components is $4.00/unit. From the pro forma income statement (Table
10.4), we see that xed
costs in year I are $636,300. we also know from our example
that cost of goods sold is
50 percent of sales revenue, so we can assume a variable cost per
unit of $z.oo. uring
these calculations we can then determine the venture's break-even
point (B/E) in unit!

as

follows:

B/E:

TFC
SP

VCNnit

$636.300

$4.00

$2.00

$636,300
$2.00
3 I 8.

150 units

Any units beyond the 318,150 that are sold by the venrure will result
in a profit of $2.00 per
unit' Sales below this number will result in a loss for the company.
In cases where the firm
produces more than one product and it is feasible to
allocate hxed costs to each product,
then it is possible to calculate a break-even point for each product.
Fixed costs are determined by weighting the costs as a function of the sales projections
for each product. For example, if it is assumed that 40 percent of the sales are for product
X, ttren 40 percent of
hxed costs should be allocated to that product.
ln our MPP Plastics example, the large number of different products
and the size lots of
customerpurchases prohibit any individual product break-even
calculation. In this case we
estimate the average selling price of all components for use in
our calculations.

296

PART

FROMTHEOPPORruNIYTOTHEBUSINESSPLAN

One of the unique aspects of breakeven is that it can be gfaphically displayed, as in

Figure 10.1. In addition, the entrepfeneuf can try different states of nature (e.9., different
selling prices, different fixed costs and/or variable costs) to ascertain the impact on
breakeven and subsequent profits.

PRO FORMA SOURCES AND APPLICATIONS OF FUNDS

pro [orrna sources and

applicotiuns o.ffunds
Summarizes all the
projected sources

of

funds available to the

venture and how these
funds

will be disbursed

The pro forma sources and applications of funds statement illustrates the disposition of
earnings from operations and from other hnancing. Its purpose is to show how net income
and financing were used to increase assets orto pay offdebt.
It is often diffrcult for the entrepreneur to understand how the net income for the year
was disposed of and the effect of the movement of cash through the business. Questions often
asked are, Where did the cash come from? How was the cash used? and What happened

to asset items during the period?

Table 10.9 shows the pro forma sources and applications of funds for MPP Plastics
Inc. after the hrst year of operation. Many of the funds were obtained from personal
funds or loans. Since at the end of the frrrst year a proht was earned, it too would be
added to the sources of funds. Depreciation is added back because it does not reprsent

r."s ti.t""'"':,

i.-o:r"#;ffi;#;;

il

ilr:;-

pertise in industrial desiqn to market snack foods.

Unable to find a beer-flavored potato chip, Stern garita
Whipped up his own batch. Withi
whipped
hc rni
he
*
was shipping packages of aptly na
which retail from 91.39 to $3.60,

jt.1

ips,

ods

(WFMI). SuperValu (SVU), and publix grocery stores.

Stern used $ 11,200 of his own money to launch the
Portland (Ore.) company. He says he generated
$500,000 in revenue in 2OOj and g1.3 million in
2008. He claims a profit margin of l1%, which he
credits to his virtual business model: He outsources

Mary,

everything but the creativity. Controlling only the

design and direction of the product, he relies on
others to manufacture and distribute it. That keeps
his overhead low: His only employees_a book_
keeper and a marketer-both work part time from a
garage. Stern. who,s known to carry chip samples in

assl

298

PART

FROMTHEOPPORTUNIYTOTHEBUSINESSPI.AN

SOFTWARE PACKAGES
There are a number of financial software packages available for the entrepreneur that can
track financial data and generate any important financial statement. For purposes of completing the pro forma statements, at least in the business planning stage, it is probably easiest to use a spreadsheet program, since numbers may change often as the entrepreneur
begins to develop budgets for the pro forma statements. Microsoft Excel is the most widely
used spreadsheet software and is available in Macintosh and PC formats.
The value of using a spreadsheet in the start-up phase for financial projections is simply being able to present different scenarios and assess their impact on the pro forma slatements. It
helps to answer such questions as, Wtrat would be the effect of a price decrease of 10 percent
on my pro forma income statement? What would be the impact of an increase of l0 percent in
operating expenses? and How would the lease versus purchase ofequipment affect my cash
flow? This type of analysis, using the computer spreadsheet Software, will provide a quick
assessment ofthe likely hnancial projections given different scenarios.
It is recommended in the start-up stage, where the venture is very small and limited in
time and resources, that the softwae selected be very simple and easy to use. The entrepreneur will need software to maintain the books and to generate financial statements. Most of
these software packages allow for check writing, payroll, invoicing, inventory managment, bill paying, credit management, and [axes.
The softwae packages vary in price and complexity. The simplest to use and least expensive ($79 to $12t0) software products are QuickBooks (Intuit Inc-), Peachtree (Sage Software),
Microsoft Ofhce Accounting, and CheckMark Software Inc. These packages offer basic payroll and general ledger accounting software for the start-up venture. They typically offer
tutorials and support geaed toward the successful implementation of these packages, particularly for new users. All these firms offer more comprehensive accounting software, as do
many other companies. Prices for these packages can range from $199 to $999 (and up)
depending on the comprehensiveness of the softwae. A simple Intemet seach will identify
hundreds of accounting software companies. The most basic and most popular comprehensive packages are mentioned in the preceding, and these usually can bepurchased online or
at a local computer store. If a more comprehensive package is needed, the entrepreneur
should discuss the options with a business associate, frien{ or consultant who can
assess his or her needs, evaluate the benefits of the most appropriate options, and assist the
entrepreneur in selecting the package that will best t the venture's needs.

IN REVIEW

SUMMARY
This chapter introduces several financial projection techniques. A single fictitious example of a new venture (MPP Plastics Inc.) is used to illustrate how to prepare each pro
forrna statement. Each of the planning tools is designed to provide the entrepreneur
with a clear picture of where funds come from, how they are disbursed, the amount of
cash available, and the general financial well-being of the new venture.
The pro forma income statement provides a sales estimate in the first year (monthly
basis) and projects operating expenses each month. These estimates are determined
from the appropriate budgets, which are based on marketing plan projections and

objectives.

CHAPTER 1O THE FNANCIAL

PLAN

2gg

RESEARCH TASKS
1. Research the software packages avairabre to herp entrepreneurs.with
the
financials for a business pran. which do you berieve is te
best?l*iy?

2. companies pranning to make an initial pbric offering (rpo)

mustsubmita
financial plan as part of their prospectus. From the Internet,
collect a prospectus

from three different companies and analyze their financial plans.

wrt *i* ii"

major assmptions made in constructing these financiar prans?

compare and
contrast these financial plans with what we would
of a financial plan as

3'

part of a business plan.

""p"it
Find an initial public offering prospectus for three companies.
what items are
listed as assets? As riabirities? How much is the owners,
equity? for what purpose
do they say they are going to use the additional funds raised
frorn the intal

public offering?

DISCUSSION
1.

re
in
d

Does it depend
trepreneur face if
an entrepreneur

3. How useful is a financial plan when it

is based on assumptions of the future and

we are confident that these assumptions are not going to
be 100 percent correct?

3OO PART

FROMTHEOPPORUNITYTOTHEBUSINESSPLAN

SELECTED READINGS

#:"ffi1,ll,lii;';ffi1llly;*1lr;i3l1l;;:iil::;:i'::'Financ-:Finance

tor

A practical-oriented text that focuses specifically on the needs of individuals starting their own businesses. lts emphasis is on financial issues for proprietorships,
partnerships, lmited liability companies) and S corporations. A unique chapter on
personal finance as been added in ths edition.
(November 1 1, 2008). Howtl Fix Financial Reportins, Eusiness week
3#;ir"l;,. ,?:vid.
Twenty af the'wealthiest countries sent their finance ministers to a conference to
discuss how to overhaul the globat financial system. Basically, there needs to be a
chiange

in how companies think about capital markets, and they need to work more
customers, employees, and ttieir supply chains. ln addition, the author

with
argues that
closely

change:s are

needed n the

11.5.

Generally Accepted Accounting Princi-

ples (GAn4.
Carter, Richard B.; and Howard Van Auken.'(2005). Bootstrap Financing and Owners'
Perceptions of Their Business Constraints and Opportunities. Entrepreneurship and Re'
gional Development, vol. 17, no. 2, pp. 129-44.

The results of

a regional survey of

small-business entrepreneurs are presented.

their use of and their motivation to

use bootstrap financing. Extending the work of Wnborg and Landstrom, these
results indicate that perceived risk is highly associated with the owners'assessment of the importance of bootstrap financing techniques. The r.esults should
be helpful to consultants and agencies that assrst small firms with funding
These entrepreneurs were quered regarding

alternatives.
Gahagan, Jim. (2004). Reaching

for Financial

Success.

Strategic Finance, vol.2O, no- 7'

pp. 12-13.
This article drscusses the importance of reaching financial success for a business enterprise. As market conditions change dramatically withn a single planning period,
budgeting and planning forecasts and the financial plans they produce are critical

to the

business owner.

Jones, Craig. (February 2008). Reducing Operating Costs through Innovation. Convenience Store Decisionl pp. 6-8
A smal!-business owner of a servce center and car wash drscusses how he was able
to reduce costs through the integration of energy-cost-savng strateges. Not only
were costs reduced, but profits and convenience to the employees and customers
were increased.
Jordan, Chartes E.; and Marilyn A. Waldron. (2001). Predicting Cash Flow from Operations: Evidence on the Comparative Abilities for a Continuum of Measu res. Journal of
Applied Business Research, vol.17, no. 3, pp. 87-94.
Prior studies have'attempted to confirm or reject the asserton that accrual
accounting measures provide better information for predicting cash flows than do
cash basis measures. Howeven their results have proved largely inconclusive and
contradictory. This study identifies research constructs that may have driven these
inconsistent findings and makes adiustments to mitigate their effects.

Rappaport, Alfred. (2005). The Economics of Short-Term Performance Obsession. Financial Analysts lournal, vol. 61, no. 3, pp. 65-79.
This article focuses on a three-pronged program for reducng short-term corporate performance obsession. The author argues that short-term performance is

CHAPTER 1O THE FINANCIAL

PLAN

301

partc.ularly important to young companies. However,

it is important
thf because there is such fteibtity in estimating the timtiiiij

ii

to recognze
accruals, these

short-term performance predictiois may not accuratery picture

the cash frow
forecasts.

Rezaee, Zabihollah. (February 2003). High-euarity Financiar

Reporting: The six-Legged
Stool. Strategic Finance, pp. 26_30.
This articte argues that quality fin

we I I -ba I a nced, fu ncti o n i n

syste m
g ove rna nce, co mpan i es shou I d

sponsible and reliable reports.

parties, which are: the board of directors, the audit
committee, the top manage_
ment team' internar auditors, externar auditors, and governng
bodies.
Rhodes, David; and Daniel stelter. (February 2009). seize
Advantage in a Downturn.
Harvard Eusiness Review pp. 50_5g.
The authors offer recommendations to stabilize business
during a downturn. First,
companies should monitor and maximize cash flow by managng
customer credit
and reducing working capital. second, firms need to protect he
existing business
by reducing costs' managing the product tine, an divesting ninror"
business.
Third, firms need to maximize the business value relative
to rivais tJ *ing proactive
in investor relations.
sal.zman, Jessica Reagan. (November/December 200g). Time
ciaf Tune-Up. Home Business Magazine, pp.64_67.

for an

End of year Finan_

The article offers suggestions on how small businesses

can increase revenue
needs for 2009. Business owners shourd biil custotmers

financial

to

meet

lromptty to en-

hance receivabtes. Bitts should be paid on time to avoid /ate fees.

bo suggestions
are provided on where to find excess expenses.

Tarantino, David. (September/October 2001). Understanding Financial

Statements.
Physi ci a n Executive, pp- 7 2-7 6.

This article describes the critical "financials"

that can make or break a business. lt

explains each financial statement, how it differs from other financial
statements,
and what useful information about the business can be obtained
from each
statement.

Taylor; Mandie. (June 2008). How to rdentify short and Long-Term

Liquidity Needs
Accurately. Journal of Corporate Treasury Management, pp.
291_96.
The author describes.the. need to manage cash effectively
to ensure that funding
is secured at an earry date. These striteges invorve poducng
a reliable
projection with the appropriate cash budget. This forecast or projectioncash
of
cash needs is a work in progress and shout be monitored regut)rty
to ensure

reliability.

END NOTES
1

2.

PART