Creating a financial plan for your small business can seem challenging and intimidating at first; however, once you educate yourself and understand the different components of a plan and how they fit together, it’s quite simple! Essentially, a financial plan is an overview of your small business’s current finances and future growth projections. With a financial plan, you can fully understand all of your finances and how they interact, set achievable goals, better adapt to potential roadblocks, and begin developing a strategy for growing your business that is grounded in your financial statements. Financial plans are key to running a successful business, receiving funding (through obtaining investors and securing loans), and planning for the future.
What makes up a financial plan?
Your financial plan should include seven key elements (which we will cover in more detail below): your profit and loss statement, operating income, cash flow statement, balance sheet, revenue projection, personnel plan, as well as your business ratios and break-even analysis.
#1: Profit and loss statement (P&L)
The profit and loss statement, otherwise known as an income statement, shows how your small business will make a profit or face a loss over a defined period of time (typically three months), by examining your revenue and expenses.
- Revenue, not to be confused with profit, is the total amount of income your business generates from normal business activities. An expense is the money spent in order to generate revenue, and covers everything from paying your employees, utility bills, and the cost of goods sold (also called COGS).
- Every business has operating expenses which are not directly tied with sales. Typically, these expenses are fixed.
- The cost of goods sold fluctuates based on your inventory and sales. These are considered variable costs.
Net profit or loss, also known as your gross margin, is calculated by subtracting the total expenses from total revenue. These three elements (revenue, expenses, and gross margin) show how your business makes or loses money and is essential to creating your business model.
#2: Operating income
Operating Income = Gross margin − Operating expenses
Using your Profit and Loss Statement, you can calculate your operating income. Subtract your operating expenses from the gross margin. Typically, the operating income is referred to as your EBITDA: earnings before interest, taxes, depreciation and amortization. This number reflects how much money you made in profit before you consider accounting and tax obligations and is your gross profit.
#3: Net income
Net income = Operating income – Interest + Taxes + Depreciation + Amortization
Your net income is your bottom line, and different from your operating income. To calculate your net income, you will need to know your operating income, as net income is equal to your operating income minus your interest, taxes, depreciation, and amortization expenses. Net is important because it is the simplest indicator of whether or not your business is profitable.
#4: Cash flow statement
Your cash flow statement reflects how much cash your business earned and paid out, and shows how you calculate your ending cash balance (usually, this is calculated on a per month basis). You can use your cash flow statement to better understand how much cash your business has on hand, where the cash is coming from, what you are spending it on, and how frequently you are spending it. The cash flow statement provides a critical insight into your business, as you can be profitable but not keep enough cash on hand to execute daily or monthly operations. On the other hand, you can be unprofitable and operating at a loss but still have cash in your business’s bank account. To further educate yourself on your cash flow statement, it is important to understand cash versus accrual accounting.
- When using the cash method, you account for your sales and expenses in the period in which they occur. The cash method provides a snapshot of your current finances. Many small businesses opt for this method because of its simplicity, and because taxes do not have to be paid until money is received.
- When using the accrual method, you account for your revenue when it is earned and expenses when they are billed, not paid. By matching expenses to sales, you get a better overall picture of how income and expenses relate to one another directly in the same time period. For example, if you wait to pay an expense until a month after the sale has been made, your second month can look less profitable than the first month, when in reality that is not necessarily the case. The accrual method is favored by accountants as it provides a more accurate view of your finances. Overall, accrual provides the most detailed and sophisticated look into how your business handles cash and allows you to make more informed decisions, as long as the complexity of the model (and the lack of a simple cash-flow oriented point of view), works for you.
#5: Balance sheet
Assets = Liability + Equity
Your balance sheet provides you with a look at how your business is doing at a particular moment, as it tells you the amount of cash you have on hand, how much money you are owed, and how much you owe. The balance sheet is based off of one simple equation: your assets equal your liabilities plus your equity. Let’s take a closer look into what these three parts of the equation entail:
- Assets: These are your accounts receivable (money owed to you, typically by customers), your money in the bank, inventory, etc.
- Liabilities: These are your accounts payable (money that you owe others), credit card balances that you need to pay off, loan repayments, etc.
- Retained Earnings: The amount of net income left over for your business after it has paid out dividends to your shareholders.
Equity: The value attributed to a business. Equity can also include shares owned by investors in your business, retained earnings (these do not apply to you if you are the only owner of your business; retained earnings equal zero if they are not rolled over or retained as they are in a large corporation), stock proceeds, etc.
Importantly, your assets need to always equal your liabilities plus your equity. If these two columns do not equal each other, you have accounted incorrectly and should review your balance sheet to make sure everything is in the correct column and accurately accounted for.
#6: Sales or revenue projections
This section shows what you think you will sell in a given period of time. To calculate your sales projections, you should create a forecast that is in line with the sales number in your P&L Statement. You do not want to under-predict how much you will sell, but you also do not want to make an over enthusiastic claim either. In short, you want your sales projections to be realistic for your business and informed by your past performance. Sales projections should be an ongoing part of your financial plan; pay attention to them and adjust them accordingly so you can ensure an appropriate and accurate growth plan moving forward. With your sales projections, you will also want to include the cost of goods sold (remember COGS). By including COGS, you will be able to calculate your projected gross margin and make adjustments to your business operations accordingly.
#7: Business ratios and break-even analysis
In order to create your business ratios, you need to utilize the figures on your P&L Statement, Cash Flow Statement, and Balance Sheet. The three ratios most used by business owners and requested by banks are typically:
- Gross margin: Gross margin = net sales revenue – cost of goods sold
- Return on investment (ROI): The ratio between net profit and cost of investment; a high ROI means that you gained significantly compared to how much you paid for your investment. ROI is used to evaluate the efficiency of an investment or compare multiple investments.
- Debt-to-equity: This is calculated by dividing your liabilities by total shareholder equity (for small businesses, there is usually one owner who holds all of the equity) and is used by banks to evaluate your business’s financial leverage. The higher your ratio, the riskier your business is viewed. To calculate your debt-to-equity ratio, use your Balance Sheet, and you can modify this ratio to focus on long term or short-term debt.
Finally, your break-even analysis will allow you to calculate how much you need to sell in order to cover all of your expenses and keep your doors open without making a profit. While it is not ideal for your business to only operate at its breaking-even point (since you want to be operating at a profit), breaking-even is preferable to operating at a loss and is a figure you should know as a small business owner. To calculate your break-even point, you need to divide your fixed costs by your contribution margin (your contribution margin is your sales price per unit minus variable cost per unit).
Now that you understand the importance and key parts of a financial statement, you can get a better handle on your small business and thoroughly understand every part of how your business is operating. Remember to keep your financial plan up to date and make sure it is accurate in order to run your business as profitably and strategically as possible.