Getting those numbers and ratios right

Writing a business plan is full of speed breakers. Now and again, you will find yourself stumbling over a roadblock, a question you can’t seem to answer. While research can help you find a good deal of information about the industry and the competition, you will need to indulge in some serious mental exercise to be able to make sense of numbers. If you feel bogged down by all the data available out there, or the lack of it, start afresh and get those numbers right in your business plan!

Follow these simple steps to prepare your financial plan:

1. Draw up a start-up budget:

How much investment do you need to start the business? Simply, add up all the expenses you will need to incur before the business can reach the phase of revenue generation. For an e-commerce portal, website development is a major chunk of the costs. Obtain quotes from your web designer for it. Other fees such as registration charges or fixed expenditure such as office set-up costs, etc must also be added up at this stage. It is best to classify total expense into fixed and variable. Monthly variable expenses will include salaries, electricity, rent of premises and so on.

2. Projected income and expense accounts:

In this step, a statement of projected income and expenses is prepared. The income side will contain revenue from sale of goods, revenue from services, add-ons, interest income, etc. To estimate income, it is important to first identify sources of revenue, for example, in a health center, revenue may come from membership fees, sale of health products, advertising, etc.

Expenses will include all expenditures expected to be incurred for running the business. Make sure you add up the office and administrative costs, selling and distribution costs as well as the basic cost of goods sold. Prepare your annual income and expense account for the next 3-5 years, making sure that your assumptions are clearly stated, for example, one can assume revenue from sales to grow by 10% per annum from year one two, etc. You should be able to justify your assumptions, based on industry trends and anticipated demand-supply conditions for your product or service. Conclude the statements with various profit figures. From your operating profit, subtract the interest payments to obtain PBT (profit before tax) and then subtract tax to obtain PAT (profit after tax) or net profit.

3. Draw up a balance sheet:

The balance sheet is a statement of the business’s assets (what it owns), liabilities (what it owes), and owner’s equity (what it is worth). It can be prepared in vertical or horizontal format. Usually it is a T-form account with Assets on the right side and liabilities and owner’s equity on the left. The two columns should tally.

4. Calculate Financial Ratios:

Using the above statements and accounts, on can calculate many important financial ratios that reflect the firm’s health and overall financial well-being. Four types of ratios are most commonly used to study financial statements. Their meaning, calculation and implication are summed up as under:

  • Liquidity Ratios: Liquidity ratios attempt to measure a company’s ability to pay off its short-term debt obligations. A higher liquidity ratio is always better than a lower one as it shows confidence in the firm’s ability to service short term debts. The two most common liquidity ratios are current ratio and quick ratio. The Current Ratio is calculated as the ratio of current assets and current liabilities. It is used to ascertain whether the current assets such as cash, cash equivalents, marketable securities, receivables and inventory are readily available to pay off the current liabilities such as bills payable, short term debt, accrued expenses and taxes. The Quick Ratio or Liquid Ratio, on the other hand, is a liquidity indicator that refines the current ratio and measures the amount of the most liquid current assets called the quick assets to cover current liabilities. It excludes inventory and other current assets, which are more difficult to convert into cash.
  • Profitability Ratios: These ratios are concerned with the different measures of profitability and financial performance. These ratios throw light on the efficiency with which resources are employed and whether shareholder value is being created. The long-term profitability of a company is a concern for investors, stockholders and the managers of the company. Four major profitability ratios can help one analyze the profitability position of a company: The Profit Margin rations, The Return on Assets (ROA), the Return on Equity (ROE) and Return on Capital Employed.

As calculated earlier, there are four profit figures relevant for a business:

  1. Gross Profit (GP) = Sales: Cost of goods Sold
  2. Operating profit or EBIT (Earnings before interest and tax)
  3. Profit Before Tax (PBT) = EBIT: Interest
  4. Net Profit = Profit After Tax (PAT) = PBT: Tax

The four profit margin ratios can be calculated by diving each of these by the Net Sales (Revenues). These ratios highlight the profitability of a company and can be used for inter-temporal and inter-firm comparisons for a given industry. They also have a high influence on the stock price of a firm. The Gross Profit Margin shows how efficiently a company employs its resources used in production. These may be raw materials, labour, manufacturing costs, factory power and other direct expenses. The Operating profit or EBIT can be obtained by deducting the selling, general and administrative (SG&A) or operating expenses from the gross profit number. These expenses can be controlled by the management and hence, indicate the quality of management decisions in the firm. It is the best indicator in inter-company comparisons and financial projections.

The Net Profit Margin, often called the bottom line, is the most commonly cited indicator of a firm’s profitability and accounts for all the above factors in a single figure obtained after deducting both interest and tax.

IBM, a blue chip company, has an operating margin of 18.11% while a much smaller company Eagle Materials has a margin of only 7.15%.

  • Debt Ratios: These ratios highlight the debt burden and debt servicing capacity of a company and mostly deal with long term debt. They also give an idea about the leverage of a firm. The concept of financial leverage explains how much of capital is debt and what is its impact on the net profit available to shareholders. The debt ratio is a ratio of the total debt to total assets. These figures can be obtained from the balance sheet. A low percentage means that the company is less dependent on leverage, has a strong equity position and less risk.

Debt to Equity ratio is another critical indicator. Larger companies are in a better position to raise debt at lower costs of capital. Hence, they usually have a higher Debt Ratio. IBM, a blue chip company, has a debt to equity ratio of 86.86% while a much smaller company Eagle Materials has a debt to equity ratio of 61.12%.

If you have taken debt or other forms of external financing with fixed interest commitments, it is advisable to calculate the interest coverage ratio also. It shows how easily a company can pay interest expenses on outstanding debt. Calculate the ratio by dividing your earnings before interest and taxes (EBIT) by the interest expenses for the same period. A higher ratio is preferred.

  • The Fixed Assets Turnover Ratio: The Fixed Assets Turnover Ratio shows sales revenue as a proportion of fixed assets like land, property, building, etc. It reflects a company’s efficiency in managing the assets. Higher the ratio, the better it is. Tata Motors has an asset turnover ratio of 1.93 while Mahindra and Mahindra has a much higher ratio of 3.85.

A related concept in operating performance is the operating cycle. It is similar to cash conversion cycle when it comes to the components. The parts are the same – receivables, inventory and payables. In the operating cycle, they are analyzed from the perspective of how well the company is managing these critical operational capital assets. Calculating the operating cycle is part of working capital management and no start-up with inventory issues can afford to neglect this part of the financial analysis.

5. Cashflow Statement:

The Financial statement analysis and preparation can be summed up in a statement of projected cashflows. As against accounting profits, which are based on the accrual principle, the cachflow statement is based on actually inflow and outflow of cash from three major set of activities: Operating, financing and investing. These three parts are the crux of any enterprise and a careful classification must be made by the entrepreneur.

The above statements and ratios put together make up the financial part of your business plan. It’s best to leave no stone unturned! To get those numbers right, understand each of the concepts and terms explained above before you sit down to put research and an entrepreneurial spirit to action.

Unnati NarangAbout me:Unnati is a freelance writer, author and entrepreneur. From her blog to media initiatives like Times Ascent, HT Edge and The Better India, she is always keen on any writing opportunity that may come her way. Her writing bug extends to her venture, a publishing portal she co-founded early 2009, for emerging authors. She is also the author of Drenched Soul (poetry) and If At All (Fiction).

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