Forecasts of Sales, Cash Flow and Break Even

The forecasts of sales and cash flow, and hence ultimate profitability, will be the bedrocks on which the potential financiers will assess the future viability of the business. It follows that these forecasts will come under severe scrutiny and critical judgement.

Sales Forecasts

The sales forecasts cannot be simply a series of numbers plucked out of the air as a result of wishful thinking. This is an area which is likely to come under vigorous cross questioning from the financiers during the application for funding. The forecasts must have sound backing from the information which has been described in the earlier chapters of this brochure, i.e. market size, customer needs, customer segmentation, state of development of the market, strengths and weaknesses of competitors, etc.

In addition, it will be necessary to add supporting evidence from the company’s current trading activities such as volume of orders on the books, trading levels with key clients, historical growth of business in the targeted market sector.

Cash Flow Forecast

Once a sales forecast has been prepared it is possible to calculate the cash flow forecast for the period of the business plan. This is an estimate of the net cash position of the company on a month by month basis. The cash flow forecast will itemise the difference between the income from forecast sales and the planned monthly expenditure for all known liabilities such as rent, rates, wages, material costs, interest payments etc. Some of these payments will occur on a regular monthly basis while others may be at more irregular intervals such as material purchases and capital investment in plant an equipment.

A further complication is that there will be a protracted time delay between the purchase of raw materials and the receipt of cash from customers. Large customers may well expect to be given the provision to make payment of invoices 60 days after delivery and in many cases may delay payment significantly beyond that. The cost of the materials must therefore be financed by the company from the time of their purchase until such time as the payment is received from the client.

It therefore frequently occurs that the company will experience a heavy cash outflow despite a buoyant level of sales. This is especially the case of the start of a new venture when capital investment and associated start-up costs may significantly outweigh the income from sales. It will therefore be essential to write into the business plan the provision of sufficient working capital either in the form of a bank overdraft or a loan to cover the heaviest cash outflow that can be foreseen.

Break-Even Forecast

The ultimate confirmation of the viability of the business venture is the demonstration of the break-even point when sales revenue first equals the sum of fixed and variable costs. Fixed costs arise from regular payments which are not affected by changes in the short term level of sales. These include items such as rent, rates, interest payments on loans and administration costs. Variable costs include payments which vary in proportion with changes in the level of sales revenue. Examples of this include material costs and energy costs. The question of whether labour costs are a fixed or variable cost is one which must be answered in terms of the nature of the business. In some situations labour may be available on a freelance or subcontract basis in order to carry out specific job-related tasks. In other cases the company may retain a labour force with a high level of specialist expertise and it would not be feasible to decrease and increase labour costs in line with fluctuations in sales revenue. The break-even point of the venture is not an immovable milestone. Its timing can be adjusted significantly according to whether the costs of the operation are predominantly fixed or variable. As was mentioned in chapter 6, the planners of the venture may have considerable flexibility in choosing the type of costing structure to incur. The installation of a manufacturing plant will require significant capital investment and it will be possible to calculate how long it will take to repay these costs from sales revenue.

If the alternative route is chosen of assembling subcontracted components, the variable cost of the bought-in components will be higher than the variable costs in the first case but the break-even point will be reached much earlier. In general terms, the sooner the break-even can be achieved, the more attractive a venture is to the potential financial backers.

It will be necessary to calculate a number of alternative break-even scenarios, i.e. best and worst case and showing sensitivity or robustness. This is done by repeating the calculations by inputting different assumptions on sales revenue and direct and variable costs. Typical variations might be to examine the effect of a 10% reduction in sales revenue accompanied by a 10% increase in costs. Other assumptions must be examined to establish the boundaries where the proposed venture become non-viable.

In order to produce a comprehensive financing plan for the new venture, it will be necessary to build up the break-even calculations in conjunction with a pro-forma balance sheet and a pro-forma profit and loss statement covering the projected five year period after start up. These will be produced by converting the estimates and policy decisions of the previous chapters into hard numbers.

Note that very complex investment projects e.g. chemical plant, steel plants and a number of high technology businesses may require more sophisticated techniques of project appraisal. These include:

Return on capital employed (ROCE)
Payback period
Discounted cash flow techniques i.e. net present value (NPV) and internal rate of return (IRR)

It is essential that specialist accounting expertise be acquired if such techniques of project appraisal are to be used.

The Pro-Forma Balance Sheet

The balance sheet will be a statement of the source of funds for the business in terms of loans, equity participation and retained profit and how these have been allocated. The allocation of the funds will be broken down according to investment in fixed assets of plant and equipment, and also current assets which are defined as working capital. The current assets refer to the stock of materials and completed manufactured goods and also cash funds which are held by the company. The balance sheet will also itemise the company’s current liabilities, which are money owed to creditors, bank overdraft and tax liability.

The balance sheet is a tabulation of pure numbers and there is no identification of the nature of the individual creditors, sources of loans and equity, or the type of fixed assets which have been purchased. These will, however, be identified elsewhere in the plan. The assets and liabilities are defined from the point of view of the business as an entity and not from the point of view of the creditors or the providers of finance.

The Pro-Forma Profit and Loss Statement

The function of the profit and loss statement is different to that of the balance sheet. While the latter will include a reference to the retained profit of the company, it will only do this in the context of a source of finance for the company and will not indicated how the profit arose. The profit and loss statement is a tabulation of the gross sales income to the company from which must be deducted all attributable costs. For the purposed of the business plan it will be necessary to prepared the first year’s projected profit and loss statement in some considerable detail. This is likely to require the year to be broken down into monthly figures or on a quarterly basis at the very least. For the remaining four years of the five year business plan it will be adequate to produce annual profit and loss statements. The assumptions on which the figures have been produced must be clearly stated. As with the break-even forecast, it will be necessary to test the sensitivity of the forecasts by producing additional statements based on lower sales income figures and higher figures for costs and expenses.

The initial deduction from sales income is the cost of the goods sold. This gives the gross profit. The cost of goods sold is calculated by totalling all the relevant variable costs, i.e. the material costs and labour costs. It will not include the cost of the machinery on which the goods were produced nor the cost of the factory which as constructed for their manufacture.

Next, it is necessary to deduct operating expenses from the gross profit in order to arrive at the profit before tax, PBT. The operating expenses include rent, rates, administration costs, depreciation, advertising costs, and other overhead costs.

Finally, having arrived at the profit before tax, it only remains to deduct the tax payments, the interest charges and the directors’ emoluments. This leaves the profit after tax from which dividends to the shareholders are distributed.

CHECK LIST
- Does the business have firm orders?
- Which customers are expected to place orders in the first year? How much and when?
- What market research data is to hand to support a sales forecast?
- Prepare a sales forecast for each major product group
- Prepare a system for updating the sales forecast at regular intervals.