GURUKUL > Creating your startup – Part 9

We took a detour in the last Gurukul to talk about the process of incorporating a company. With this Gurukul, we’ll get back on track. We’ll look at the Financials of a business plan.

Finance is the lifeblood of the business and should be understood by the entrepreneur. This should get reflected in the business plan discussions – it also generates confidence amongst the investors that their money is in the hands of someone who knows what to do with it.

So, what are the key issues to keep in mind while on this section of the business plan?

For starters, while estimating various costs it’s a good idea to use standard and expected ratios. For example, if marketing and sales expenses in your industry run at around 45%, you will have much explaining to do if you show sales and marketing expenses in your company to be at 30% or at 70%. You don’t want to look like an amateur in front of investors by being too far off on common ratios. This holds for other common ratios like gross margins and net profit margins. Look at the industry and financial information e.g. annual reports, business magazines and journals etc, of other companies in your industry to get a sense of the typical ranges various ratios like:

• Sales/Marketing and general administrative costs as a percentage of total sales
• Gross and Net Margins as a percentage of total sales
• R&D as a percentage of total sales
• Maintenance revenues as a percentage of product costs
• Advertising and sales promotion
• Sales and Net Income per employee

You must also factor in the stage and type of your company while arriving at range of acceptable values. For example in an early stage technology company, sales and marketing costs will be significantly lower than R&D while in a later stage B2C business, almost all the costs will be on account of sales, marketing and general administrative.

Preparing the financial statements requires getting good data. You must, for example, find out what price are customers willing to pay for the product or service based on the benefits it delivers them; what the current pricing situation in the market is; Beware of working backwards from the answers, however tempting it may be. For example, you may be shooting for Rs 500m sales in 5 years with a 10% post tax profits in order to meet certain valuation goals. So you iterate through a spreadsheet and voila! You have the required price of your product to meet these goals! Well, the bad news is that you have a number that works in the spreadsheet model, not necessarily in the market. There is no substitute for knowing the market and competitive situation.

The three basic financial statements that must be clearly understood by the start-up entrepreneur are balance sheet, profit & loss (P&L), and cash-flow (sources & uses of cash). Of these, the cash-flow statement is the most critical in the early stage start-up. Remember at this stage, cash is king! It is worthwhile for you to become familiar with the jargon and procedures in these statements. Let us have a quick review of these financial statements.

A balance sheet represents the state of the business at a point in time (“as on March 31st 2000”). It is a snapshot of your business. The balance sheet shows the status of your company’s assets, liabilities and equity on a given date usually at the close of a month or a year. One way of looking at your business is as a mass of capital (assets) arrayed against the sources of capital (liabilities and equity). Assets must equal liabilities. Balance sheets are compared to prior balance sheets for efficient analysis viz. to see improvement and degradation of various positions and ratios etc.

The profit & loss statement summarizes sales, costs and expenses activity over a period of time. Revenue and income are sometimes confused. Revenues are gross sales figures while income denotes profits. Of the financial statements, this is the easiest to understand

The cash flow statement is the most difficult of the financial statements to understand. And is also the most important for a startup. The cash flow statement allows you to analyze the changes in the financial position (represented by the balance sheet and P&L statements) of the business from one period to another. Understanding of working capital is the key to understanding the cash flow statement. Working capital is equal to current assets minus current liabilities and it finances the cash conversion cycle of your business. The cash conversion cycle includes time to achieve actual sales and accounts receivables into cash. This statement has two parts: a set of transactions that increase working capital such as net income, depreciation, sale of equity, increase in deferred taxes etc; the other part refers to the way funds are used such as for purchase of equipment, repayments of debt, redemption of shares etc.

Since becoming profitable at the earliest is the most important goal of your business, it’s also a good idea to know when your business will break even. Break even occurs when sales equals costs.

It may be worthwhile to attend a course on finance and pick up books on corporate finance to understand the basic terms and concepts. This will enhance your understanding of your business and help you deal with investors better.