Business plan financials: from revenue to profit to free cash flow

Startup company business plans. Once the strategic, technical and organizational
elements of your business plan are in place, it’s a good idea to include estimated financials
in your business plan. Which key numbers should you forecast? How do the key metrics in a business plan
relate to each other? Get started with this short video on business
plan financials, going from revenue to profit to free cash flow. Let’s take a look at Nick’s business plan. He has a startup company idea that will take
a few years to fully mature once he puts his idea into action. Year 1 will be the year of heavy investment
and the start of operations. Year 2 scaling up. Year 3 rapid growth and expansion. Year 4 stabilization and fine-tuning. Year 5 fully maturing with operational excellence. Nick has done some pro-forma financial projections,
based on market data, technical data and financial data that he has gathered so far. In year 3 after starting his business, Nick
is aiming for half a million dollars in revenue. Revenue is the sum of the value of the goods
and services delivered and invoiced to customers during the year. From this revenue number, he deducts variable
costs of $300,000. Variable costs are the type of costs that
increase when you sell more units. Examples of variable costs are raw material,
production labor, and the electricity that is needed to run the production equipment. If Nick takes revenue and deducts variable
costs, he gets to Contribution Margin of $200,000. This is a profitability “subtotal”: what
he sells his products and services for minus the amount he makes them for. Next, he deducts fixed costs of $150,000. Fixed costs are the costs that do not increase
when you sell more units. Examples are depreciation on the production
equipment, marketing expenses, and the salary of the managing director (Nick himself). Nick takes Contribution Margin and deducts fixed costs, to get to Operating Margin of $50,000. This is another profitability “subtotal”
that represents the margin generated from operations. Next, he deducts interest, the cost of debt
financing, and corporate income taxes. These total $20,000. That gets him to the “bottom line” of
the projected income statement for his startup company: net income, also known as net profit
or net earnings. What’s left if you deduct all expenses from
revenue. In his case $30,000 in year 3. Time to catch our breath. Projecting your startup company income statement
can be a lot of work, as there is a lot of data to be gathered, and there are a lot of
assumptions to be made. What else do you need to do to get a bigger
picture of the financial attractiveness of your startup business idea? The answer to that is: gather cash flow related
information! First of all, some good news. Not all of the costs that Nick incurs are
paid in cash in the same year. An example of this is depreciation, which
is the accounting process of allocating the upfront investment in production equipment
over the years that he uses the equipment. The cash outflow occurred when Nick bought
the equipment, depreciation is just spreading that investment amount over the years, accounting for the use of the production equipment as an expense. In Nick’s example, the fixed costs that
we deducted in order to calculate the estimated profit included $70,000 of depreciation. For Nick to get to the cash flow picture,
he needs to add back the deprecation that was deducted earlier. Next step to get from profit to cash flow is to look at the working capital needs in year 3. As the company is expected to grow rapidly,
Nick projects an increase in working capital, which means from the cash flow perspective
that there is a cash outflow. Here’s how that works. Working Capital is the sum of Accounts Receivable
(invoices that you sent to customers that have not been paid yet), plus Inventory (goods
that you hold to sell), minus Accounts Payable (invoices received from your supplier that
you have not paid yet). If Working Capital goes up, then cash goes
down. The opposite would also be true: if Working
Capital goes down, then cash goes up, but this is unlikely to happen in a fast-growing
startup company. Once Nick adds up the last three lines, Net Income plus Depreciation minus the cash outflow from the increase in working capital, he gets a cash flow subtotal called Cash From Operating Activities. This is the amount of cash generated from
the business operations. As you see, this is projected to be zero for
year 3. This brings us to an important learning point
for any startup company. Profit does not equal Cash Flow. Let’s look at the final element in this
example. Nick expects to expand the production capacity
of his startup company in year 3 to capture a bigger piece of the value chain, in other
words make a more valuable product. To do that, he needs an additional investment in equipment, also called capital expenditures, of $200,000. This brings his Free Cash Flow to minus $200,000,
in other words he needs to bring more capital into the business (through an equity injection
from shareholders or a loan from the bank) to take his year 3 plans forward. Free Cash Flow is that part of the total cash flow that is not required for operations or reinvestment. If Free Cash Flow is positive, then you can
take cash out of the business. If Free Cash Flow is negative, then additional
cash needs to be invested into the business. Hopefully, Nick can achieve a positive Free
Cash Flow in years 4, 5 and onward, in order for his startup idea to generate value. How? More revenue, lower costs, managing working capital, and planning the capital expenditures carefully! Want to learn more about business and finance? Then subscribe to the Finance Storyteller
YouTube channel! Thank you.

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