1. FINANCIAL PLAN Assoc. Prof. Dr. Ismail Ab.Wahab
Assoc. Prof. Hj. Wan Ismail Wan Mamat
Assoc. Prof. Dr. Mohamed Dahlan Ibrahim

2. LEARNING OUTCOMES
At the end of the session, students should be able to:
Understand the importance of preparing a financial plan
Understand the process of developing a financial plan
Identify the components of a financial plan
Analyse the financial position of the proposed business
Prepare a financial plan for a small business

3. INTRODUCTION
A financial plan incorporates all financial data derived from the operating budgets i.e. the marketing, production (or operations) and administration budgets. Financial information from the operating budgets is then translated or transformed into a financial budget.
Based on the financial data, projections are prepared via the following pro forma statements:
Cash flow
Income (or profit and loss) statement
Balance sheet.

4. THE IMPORTANCE OF A FINANCIAL PLAN
A financial plan is crucial to the overall business plan that is developed for a particular business or project. Its importance can be summarised as follows:
To determine the size of investment
To identify and propose the relevant sources of finance
To ensure that the initial capital is sufficient
To analyse the viability of the project before actual investment is
committed
To be used as a guideline for project implementation

5. THE PROCESS OF DEVELOPING A FINANCIAL PLAN
To develop a workable and meaningful financial plan, the entrepreneur has to follow these steps:
Step 1: Gather all financial inputs
Step 2: Determine the project implementation cost
Step 3: Determine the sources of finance
Step 4: Prepare the pro forma cash flow statement
Step 5: Prepare the pro forma income statement
Step 6: Prepare the pro forma balance sheets
Step 7: Perform basic financial analysis

6. Step 1: Gather the Financial Input (contd.)
The process of developing a financial plan for a specific project begins with the accumulation of financial information from the marketing, operations and organizational plans.
The financial requirements for each plan are presented in the form of budgets known as operating budgets (i.e. marketing, operations and organisation budgets)

7. Step 1: Gather the Financial Input (contd.)
In addition, the monthly or annual sales forecast derived earlier in the marketing plan is a very important input for the financial plan.
After gathering all information the financial plan is prepared in terms of financial budget.

8. Marketing Plan Organizational Plan Financial Plan Operations Plan
Sales Forecast
Marketing Budget
Organizational Plan
Administrative Budget
Financial Plan
Project implementation cost
Sources of financing
Pro forma cash flow statement
Pro forma income statement
Pro forma balance sheet
Financial Analysis
Operations Plan
Operations Budget

9. Step 2: Determine the Project Implementation Cost
A project implementation cost incorporates both long-term and short-term expenditure needed to start a project.
Long-term expenditure refers to such expenditure as the procurement of plant, machinery, equipment, vehicles and other fixed assets needed by the new business.

10. Step 2: Determine the Project Implementation Cost (contd.)
Short-term expenditure, such as payments of utilities, salaries and wages, factory overheads, purchase of raw materials or inventories, represent the amount of initial working capital required to finance the daily operation until the business gets its first sale.
Components of project implementation cost:
Capital expenditure
Working capital
Other expenditure
Contingency cost

12. Step 3: Determine the Sources of Finance
Sources of finance refers to the sources where funds to finance a particular project’s implementation costs can be secured.
These can be categorised into internal and external sources. The internal sources mainly come in the form of equity contributions from the entrepreneurs. These contributions can either be in the form of cash or other assets.

13. Step 3: Determine the Sources of Finance (contd.)
External sources of finance are mainly derived from commercial banks, finance companies and government agencies. It may come in the form of term loans, hire purchase or grants.
The total amount of funds that has to be sourced should equal the total project implementation cost calculated earlier. This is to ensure that the project is fully funded and to avoid the risks of under-financing.

14. Step 3: Determine the Sources of Finance (contd.)
Components of sources of finance:
Internal sources
Equity contributions (cash and/or assets)
External sources
Term loan
Hire purchase
Others

16. Step 4: Prepare Pro Forma Cash Flow Statement
Pro forma cash flow statement refers to the projected statement of cash inflow and outflow throughout the planned period.
Under normal circumstances, the pro forma cash flow statement is prepared for three consecutive years, detailed by month for the first year and by year for the second and third years. However, longer periods are sometimes needed depending upon the projects undertaken.

17. Step 4: Prepare Pro Forma Cash Flow Statement (contd.)
The total amount of funds that has to be sourced should equal the total project implementation cost calculated earlier. This is to ensure that the project is fully funded as well as to avoid the risks of under-financing.

18. Step 4: Prepare Pro Forma Cash Flow Statement (contd.)
The pro forma cash flow statement must be able to show the following information:
Cash inflows – the projected amount of cash flowing into the business.
Cash outflows – the projected amount of cash flowing out of the business.
Cash deficit or surplus – the difference between cash inflows and outflows.
Cash position – the beginning and ending cash balances for a particular period.

19. Step 4: Prepare Pro Forma Cash Flow Statement (contd.)
Elements of cash inflows:
Equity contribution (cash)
Term loan
Cash sales
Collection of receivables
Others

20. Step 4: Prepare Pro Forma Cash Flow Statement (contd.)
Elements of cash outflows:
Marketing expenditure
Operations expenditure
Administrative expenditure
Term loan repayment
Hire purchase repayment
Purchase of fixed assets
Pre-operating expenditure
Payments for deposits
Miscellaneous expenditure

21. Example: Pro Forma Cash Flow Statement

22. Example: Pro Forma Cash Flow Statement (contd.)

23. Step 5: Prepare Pro Forma Income Statement
The next step in developing a financial plan is to prepare the pro forma income statement which shows the expected profit or loss for the planned period, usually for three consecutive years.
The pro forma income statement consists of the following elements:
Sales
Gross Income
Net Income Before Tax

24. Step 5: Prepare Pro Forma Income Statement (contd.)
Net income before tax is derived as follows:
Sales - Cost of Sales = Gross Profit
Gross Profit - Operating Expenses = Net Income before tax

25. Example: Pro Forma Income Statement
Year 1 Year 2 Year 3
Sales 240, , ,400
Cost of sales 94, , ,940
Gross profit 145, , ,460
Less: Operating Expenses
Marketing expenses 18,000 18,900 19,845
Administrative expenses 96, , ,840
Depreciation charges 7,200 7,200 7,200
Miscellaneous 2,
123, , ,485
Operating income 21,500 44,600 74,975
Less: Financing expenses:
Interest on term loan 4,500 3,600 2,700
Interest on hire-purchase 1,600 1,600 1,600
6, , ,300
Net profit before tax 15,400 39,400 70,675

26. Step 6: Prepare Pro Forma Balance Sheet
While the pro forma income statement shows the financial performance of the business for the planned period, the pro forma balance sheet shows the financial position of the business at a specific point in time in terms of assets owned and how those assets are financed.
The pro forma balance sheet is normally prepared for a period of three years.

27. Step 6: Prepare Pro Forma Balance Sheet (contd.)
The pro forma balance sheet consists of the following elements:
The balance sheet shows the following equation:
Assets = Owners’ equity + Liabilities
Assets
Owners’ equity
Liabilities

28. Step 6: Prepare Pro Forma Balance Sheet (contd.)
Assets are the economic resources of a business that are expected to be of benefit in the future. Assets reported in the balance sheet are generally categorised into two categories: non-current and current assets.
Non-current assets include fixed assets and other assets that are owned and usually held to produce products or services. These assets are not intended for sale in the short term. Examples: property, plant, machinery, equipment, vehicles, major renovations and long-term investments. For fixed assets, the values shown in the balance sheet are the book value i.e. the original cost less the accumulated depreciation.

29. Step 6: Prepare Pro Forma Balance Sheet (contd.)
Current assets are short-term assets that can be converted into cash within a year. Examples: cash, inventories (raw materials, work-in-process and/or finished goods), receivables and other short-term investments.
Owners’ equity refers to capital contributions from the owners or shareholders in terms of cash or assets plus the accumulated amount of net income. However, if the business suffers a loss, the amount of loss will be deducted from the capital contributions.

30. Step 6: Prepare Pro Forma Balance Sheet (contd.)
Liabilities are the amounts owed by the business to outsiders. They are categorised as non-current (long-term) and current liabilities.
Non-current or long-term liabilities refer to the long-term obligations of the business that mature in a period of more than one year. They usually include long-term loans as well as hire purchase.
Current liabilities refer to the short-term obligations of the business that mature within a period of less than a year. The most common forms of current liabilities are accounts payable and accrued payments

31. Step 6: Prepare Pro Forma Balance Sheet (contd.)
Liabilities are the amounts owed by the business to outsiders. They are categorised as non-current (long-term) and current liabilities.
Non-current or long-term liabilities refer to the long-term obligations of the business that mature in a period of more than one year. They usually include long-term loans as well as hire purchase.

32. Example: Pro Forma Balance Sheet
Year 1 Year 2 Year3
Non-Current Assets (book value)
Land & building 45,000 45,000 45,000
Machinery & equipment 18,400 13,800 9,200
Furniture & fixtures 5,600 4,200 2,800
Renovation 3,200 2,400 1,600
Vehicles 20,000 15,000 10,000
Deposit
93,000 81,200 69,400
Current Assets
Inventory of raw materials 3,000 3,500 4,000
Inventory of finished goods 3,000 4,000 5,000
Cash 40,900 77, ,575
46,900 85, ,575
Total Assets 139, , ,975
Owners’ Equity
Capital 72,500 72,500 72,500
Accumulated profit 15, , ,475
87, , ,975
Long-term Liabilities
Term loan 36,000 27,000 18,000
Hire-purchase 16,000 12, ,000
52, , ,000
Total Owners’ Equity & Liabilities , ,975

33. Step 7: Perform Basic Financial Analysis
Financial analysis is a technique of examining financial statements to help the entrepreneur analyse the financial position and performance of the business.
Financial analysis involves two basic steps: generating the information from the financial statements and interpreting the results.
The most common form of financial analysis is “ratio analysis”.

34. Step 7: Perform Basic Financial Analysis (contd.)
Financial ratios are normally used to compare figures from the financial statement with other figures, so that the true meaning of financial pictures can be obtained.
There are various financial ratios that the entrepreneur can look at. However, the most commonly considered ratios in small business decision-making fall into four categories: liquidity, efficiency, profitability and solvency.
For illustrative purposes, financial data presented in pro forma financial statements in the next slides will be used.

35. Pro Forma Income Statement
Year 1 Year 2 Year 3
Sales 576, , ,880
Cost of sales 227, , ,460
Gross profit 349, , ,420
Less: Operating Expenses
Marketing expenses 56,500 62,150 68,365
Administrative expenses 226, , ,460
Depreciation charges 21,000 21,000 21,000
Other operating expenses , , ,000
308, , ,825
Operating income 40, , ,595
Less: Financing expenses:
Interest on term loan 16,500 13, ,900
Net income before tax 24,000 58, ,695

36. Pro Forma Balance Sheet
Year 1 Year 2 Year3
Non-Current Assets (book value)
Land & building 100, , ,000
Motor vehicles 64,000 48,000 32,000
Office equipment 5,600 3,000 2,000
Renovation 16,000 12,000 8,000
Machinery 32,000 24,000 16,000
Other assets (deposits) 1, , ,000
217, , ,000
Current Assets
Inventory of raw materials 2,000 3,000 4,000
Inventory of finished goods 5,000 6,000 8,000
Cash , , ,645
53, , ,645
Total Assets 270, , ,645
Owners’ Equity
Capital 105, , ,500
Accumulated profit 24, , ,545
129, , ,045
Long-term Liabilities
Term loan 132,000 99,000 66,000
Current Liabilities
Accounts payable 9, , ,600
Total Owners’ Equity & Liabilities , ,645

37. Step 7: Perform Basic Financial Analysis (contd.)
Liquidity Ratios
The term liquidity refers to the availability of liquid assets to meet short-term obligations. Thus, liquidity ratios measure the ability of the business to pay its monthly bills.
The most widely used liquidity ratios are current ratio and quick ratio.

38. Step 7: Perform Basic Financial Analysis (contd.)
Current ratio can be determined by dividing total current assets by total current liabilities. Generally, this ratio shows the business’ ability to generate cash to meet its short-term obligations.
Current ratio = Total current assets Total current liabilities
Year 1
Year 2
Year 3
Current assets
RM53,500
RM114,350
RM256,645
Curent liabilities
RM 9,000
RM15,000
RM 21,600
Current Ratio
5.94
7.62
11.88

39. Step 7: Perform Basic Financial Analysis (contd.)
If the business’ current ratio falls below 1, it means that the business is in a serious liquidity situation. In most cases, the comfortable current ratio for most businesses is ‘2’.
Quick ratio, also known as the acid test ratio, measures the extent to which current liabilities are covered by liquid assets.
To determine quick ratio, the calculation of liquid assets does not take into account inventrories since it is sometimes difficult to convert them into cash quickly.

40. Step 7: Perform Basic Financial Analysis (contd.)
Quick ratio = Total current assets-inventories Total current liabilities
Year 1
Year 2
Year 3
Current assets
RM53,500
RM114,350
RM256,645
Inventories
RM 7,000
RM 9,000
RM 12,000
Current liabilities
RM 9,000
RM15,000
RM 21,600
Quick Ratio
5.17
7.02
11.33
In most cases, the comfortable quick ratio is ‘1’.

41. Step 7: Perform Basic Financial Analysis (contd.)
Efficiency Ratios
The efficiency ratios measure how efficient the business uses its assets to generate sales.
The most widely used efficiency ratio for planning purposes is inventory turnover ratio.

42. Step 7: Perform Basic Financial Analysis (contd.)
Inventory turnover (or stock turnover) measures the number of times inventories have been converted into sales and indicates how liquid the inventory is. All other things being equal, the higher the turnover figure, the more liquid the business is.
This ratio divides the cost of sales (or cost of goods sold) by the average value of inventory. The average value of inventory is derived by adding the opening and closing balance of and dividing the total by two.
Inventory turnover = Cost of sales Average inventory

43. Step 7: Perform Basic Financial Analysis (contd.)
Year 1
Year 2
Year 3
Cost of sales
RM227,000
RM254,600
RM278,460
Average inventory
RM 7,000
RM8,000
RM 10,500
Inventory turnover
32.42 times
31.83 times
26.5 times

44. Step 7: Perform Basic Financial Analysis (contd.)
Profitability Ratios
Profitability ratios are important indicators of the business’ financial performance. Investors will particularly be interested in these ratios since they measure the performance and growth potential of the business.
Some of the commonly used profitability ratios are gross profit margin, net profit margin, return on assets and return on equity.

45. Step 7: Perform Basic Financial Analysis (contd.)
Gross profit margin give a good indication of financial health of the business. Without an adequate gross margin, the business will be unable to pay its operating and other expenses.
Gross profit margin is calculated by dividing the business gross income by sales.
Gross profit margin = Gross profit Sales

46. Step 7: Perform Basic Financial Analysis (contd.)
Year 1
Year 2
Year 3
Gross profit
RM349,000
RM407,800
RM516,420
Sales
RM576,000
RM662,400
RM794,880
Gross profit margin
60.59%
61.56%
64.97%
Net profit margin is an indication of how effective the business is at cost control. The higher the net profit margin, the more effective the business is at converting sales into actual profit.

47. Step 7: Perform Basic Financial Analysis (contd.)
Net profit margin is calculated by dividing the business net income by sales.
Net profit margin = Net profit Sales
Year 1
Year 2
Year 3
Net profit
RM 24,000
RM 58,850
RM139,695
Sales
RM576,000
RM662,400
RM794,880
Net profit margin
4.16%
8.88%
17.57%

48. Step 7: Perform Basic Financial Analysis (contd.)
Return of assets measures the overall return that the business is able to make on its assets.
This ratio is derived by dividing the business net profit by total assets.
Return on assets = Net profit Total assets
Year 1
Year 2
Year 3
Net profit
RM 24,000
RM 58,850
RM139,695
Total assets
RM270,000
RM302,350
RM415,645
Return on assets
8.89%
19.46%
33.61%

49. Step 7: Perform Basic Financial Analysis (contd.)
Return of equity shows what the business has earned on its owners’ investment in the business.
This ratio is derived by dividing the business net profit by total equity.
Return on equity = Net profit Total equity
Year 1
Year 2
Year 3
Net profit
RM 24,000
RM 58,850
RM139,695
Total equity
RM129,500
RM188,350
RM328,045
Return on equity
18.53%
31.25%
42.58%

50. Step 7: Perform Basic Financial Analysis (contd.)
Solvency Ratios
This final category of ratios is designed to help the entrepreneur measure the degree of financial risk that his business faces. By referring to this ratio, the entrepreneur can assess his level of debt and decide whether it is appropriate for the business.
The most commonly used solvency ratios are total debt (liabilities) to equity (also known as leverage or gearing), total debt to total assets, and times interest earned (also known as interest coverage).

51. Step 7: Perform Basic Financial Analysis (contd.)
The total debt to equity ratio indicates what proportion of equity and debt that the company is using to finance its assets.
This ratio is calculated by dividing the the total debt by total equity.
Debt to equity ratio = Total debt Total equity
Year 1
Year 2
Year 3
Total debt
RM141,000
RM114,000
RM 87,600
Total equity
RM129,500
RM188,350
RM328,045
Debt to equity ratio
1.09 : 1
0.61 : 1
0.27 : 1

52. Step 7: Perform Basic Financial Analysis (contd.)
The debt to asset ratio measures the percentage of the business’ assets financed by creditors relative to the percentage financed by the entrepreneur.
This ratio is calculated by dividing the total debts by total assets.
Debt to equity ratio = Total debts Total assets
Year 1
Year 2
Year 3
Total debts
RM141,000
RM114,000
RM87,600
Total assets
RM270,500
RM302,350
RM415,645
Debt to total assets ratio
52.13%
37.70%
21.08%

53. Step 7: Perform Basic Financial Analysis (contd.)
Times interest earned ratio measures the number of times interest expense can be covered by profit before interest and tax.
This ratio is calculated by dividing total interest expense by profit before interest and tax.
Time interest earned = Profit before interest & tax Interest expense
Year 1
Year 2
Year 3
Profit before interest
RM40,500
RM72,050
RM149,595
Interest expense
RM16,500
RM13,200
RM9,900
Time interest earned
2.45 times
5.46 times
15.11 times

54. SUMMARY
The financial plan is an important part of the business plan. It incorporates all financial data derived from the operating budgets, i.e. marketing, operations and administrative budgets.
Based on this financial data, several financial projection tools are prepared to provide the entrepreneur with a clear picture of the amount of money needed to start a business, sources of finance, the amount of cash available and the financial performance and position of the business.

55. SUMMARY (contd.)
The output of a financial plan covers project implementation cost schedule, sources of financing schedule, pro forma cash flow statement, pro forma income statement , and pro forma balance sheet.
The business financial data gathered in the financial statements are analysed in order to obtain an overall financial picture of the business. The financial ratios are used to analyse the financial performance of the business.

56. END OF MODULE 11