7 Essential Components of a Financial Plan
Creating a financial plan is imperative to the success and growth of small businesses and understanding the essential components of a plan is the first step. As an overall summary of a business’s current finances, a well strategized financial plan helps business owners to interpret their business’s needs, anticipate potential hurdles, and develop data-driven business strategies for the future.
What are the major elements of a financial plan?
Operating income, revenue projection, cash flow statement, personnel plan, balance sheet, profit and loss statement, business ratios and break-even analysis are all elements one should include in their financial plan.
#1: Profit and loss statement (P&L)
By analyzing revenue and expenses, one can determine how their small business will come to a profit or loss over a defined length of time (usually three months). This is called a profit and loss statement, or income statement.
Revenue is the total amount of income generated by the sale of goods or services related to a company's primary functions. An expense is the cost required to generate revenue. This spending can be allocated to things like utility bills, employee payment, and cost of goods sold (COGS).
Unlike other expenses, operating expenses are typically fixed and not directly connected to a business’s sales.
Variable costs are the cost of goods sold by a business determined by its sales and inventory.
By subtracting total expenses from total revenue, a business can determine its gross margin, also called net profit or loss. Gross margin, expenses, and revenue are three integral factors of a business model as they convey how a business makes or loses money.
#2: Operating income
Operating Income = Gross margin - Operating Expenses
A business can determine its operating income with its profit and loss statement by subtracting operating expenses from the gross margin. Operating income is also known as EBITDA: earnings before interest, taxes, depreciation and amortization. This number is a business’s gross profit, indicating how much it made in profit before making allowances for accounting and taxes.
#3: Net income
Net Income = Operating Income - Interest + Taxes + Depreciation + Amortization
Net income differs from operating income in that it shows the final profit based on all income and expenses, rather than just operating expenses. Understanding net income is crucial as it’s the most basic measure of whether or not a business makes a profit.
#4: Sales or revenue projections
Calculating a business’s sales projections starts with creating a forecast that reflects the sales number in its P&L statement. Doing so allows a business to estimate how much it might sell in a given time period. The goal of sales projections is to give a realistic estimate for a business’s potential revenue considering its past performance. It allows for growth as a business moves forward and is an important element of its financial plan. Sales projections should include cost of goods sold (COGS) in order to calculate projected gross margin and modify business functions appropriately.
#5: Cash flow statement
The final cash balance from the total amount of cash a business earns and pays out, typically on a monthly basis, is a cash flow statement. Cash flow statements reflect how much cash a business has available, how often it’s being spent, what it’s being spent on, and where it comes from. It is important to track cash flow statements to ensure a business has enough accessible cash to perform its standard operations, even if they make a profit. Alternatively, an unprofitable business operating at a loss might still have available cash in its bank account. Remember: cash and accrual accounting are not the same.
The cash method exhibits a business’s current finances, accounting for sales and expenses during the term in which they occur. This method is ideal for small businesses because taxes do not have to be paid until money is earned.
The accrual method allows businesses to account for revenue as it is earned and as expenses are billed, rather than paid. A business can determine how income and expenses coincide in the same time period by matching expenses to sales. By taking care of expenses and sales as they relate in the same time period, businesses can avoid confusion when identifying their profit per said period. Many accountants prefer this method as it gives a very accurate view of a business’s finances and provides the most detailed view of how it manages cash.
#6: Balance Sheet
Assets = Liability + Equity
A balance sheet shows how much money a business is owed, how much it owes, and how much it has on hand, giving insight into how a business is doing at a specific time. A balance sheet can be looked at as assets equal liabilities plus equity.
Assets: This includes a business’s inventory, money in the bank, and accounts receivable, meaning money owed to the business by customers.
Liabilities: This includes a business’s credit card balance that needs to be paid off, loan repayments, and accounts payable, meaning money that it owes others.
Equity: This is a business’s attributed value. Equity can also include stock proceeds, investor shares, retained earnings that only apply if there are multiple owners of a business and which equal zero if not retained or rolled over. The sum of a business’s liabilities and equity must always be its assets. If it is not, a business likely accounted incorrectly, and the balance sheet must be reassessed.
#7: Business ratios and break-even analysis
Utilizing cash flow statement, balance sheet, and figures on your P&L statement are all important steps in creating business ratios. Below are the three most common ratios for business owners:
Return on Investment (ROI) is the ratio between net profit and cost of investment. Calculating ROI allows businesses to examine the effectiveness of an investment or compare separate investments. If a business gains significantly in comparison to how much they paid for an investment, its ROI is considered high.
Gross margin is equal to net sales revenue minus the cost of goods sold.
Debt-to-equity is used by banks to evaluate a business’s financial leverage and can be determined by dividing liabilities by total shareholder equity. A balance sheet is also helpful to calculate this number and can be modified to long-term or short-term debt. Typically, there is one owner with all equity in small businesses. If a business has a high ratio, it might be seen as risky.
The break-even analysis tells businesses how much they need to sell in order to cover all expenses before reaching a profit. In other words, it displays the point in which total cost and total revenue are equal. To determine a business’s break-even point, divide fixed costs by its contribution margin, or sales price per unit minus variable cost per unit. For small business owners, a break-even point is important to know as to avoid functioning at a loss but might not be a beneficial point to operate from as it’s best to strive to make a profit rather than break even.
It is important to keep financial plans current and accurate to run a most profitable and strategic business. By understanding these key elements and how they function together in a financial statement, small businesses can begin to operate at their greatest potential.