Where a business plan is used to seek equity funding from private equity investors or venture capitalists, care must be taken to develop a sound financial plan. Sometimes, companies seek the help of business consultants to assist in this process, especially for complex businesses.
Cash flow projections are vital to entrepreneurs. Cash flow projections allow entrepreneurs to keep an eye on the cash flow of the business to anticipate and cater to the needs of the startup today, tomorrow and five years down the road.
A company's profit figures may be on the uptrend, but until the entrepreneur looks at free cash flow, one may not know if the company has really generated cash in a given year or not. Free cash flows represent real cash whilst net profits are masked by accounting data.
Also, cash flow projections form the core of the financial section of a business plan and help entrepreneurs in computing the valuation of a business. Knowing the value of a company allows entrepreneurs to make their companies more marketable to venture capitalists, private equity investors and other seed investors.
When developing business plans, entrepreneurs learn how to write business plans, turn to the financial analysis, first developing pro-forma income statements and balance sheets and then cash flow projections as well as cash flow projection sample sheets. Writing business plans is a science by itself. Financial statements projections for business plans derive information from two parts of the financial statements, namely the income statement and the balance sheet. Balance sheet projections, together with income statement projections, can be used to formulate cash flow projections.
In an introduction to financial projections for a business plan, a previous article on Financial Projections for Business Plans had introduced Company XYZ which clearly had to conceptualize and formulate business strategies to strengthen the current business, weed out low or no margin customers, identify new business opportunities and reduce costs. XYZ also had to manage the key business risks it faced. A separate article on Income Statement Projections for Business Plans covered how to formulate income statement projections for business plans. Yet another article on Balance Sheet Projections for Business Plans covered how to formulate balance sheet projections for a business plan. The free sample template for cash flow projection sample sheets below shows entrepreneurs how to formulate cash flow projections for business plans, be it for a restaurant business, property valuation, daycare or e-commerce startup.
Free Cash Flow for Cash Flow Projections
Free Cash Flow (FCF) is the output of all cash flow projections for each period forecasted. This is calculated as the Company’s operating cash flow minus its capital expenditures. This essentially refers to the cash the Company is able to use after taking into account its capital expenditure needs for its expansion plans. This cash can then be utilized to generate growth for the business by the entrepreneur.
The formula for free cash flow is as follows:
FCF = Net profit after tax + Depreciation + Amortization – Capital Expenditure – Changes in Net Working Capital
Formulating free cash flow projections entails forecasting free cash flows available to equity holders (or to debt and equity holders) over a finite forecast horizon (usually five to ten years).
Using Income Statement Projections for Cash Flow Projections
An entrepreneur should firstly forecast income statements for five years. Cash flow projections begin with net profit figures obtained from these pro-forma income statements. Subsequently, the entrepreneur should extract the forecasted depreciation and amortization figures from the detailed income statement projections. Depreciation is a non-cash expense that reduces the value of a fixed asset over the fixed asset’s useful life. Similarly, amortization is a non-cash expense that reduces the value of an intangible asset. Both depreciation and amortization are accounting concepts and should be added back into a company’s profits because they require no immediate cash outlays.
Using Balance Sheet Projections for Cash Flow Projections
After extracting the net profits, depreciation and amortization figures from the pro-forma income statements, the entrepreneur should then forecast the balance sheets for five years. From these, the entrepreneur can obtain the amounts for the changes in net working capital. Working capital refers to the cash a business requires for day-to-day operations.
When there is an increase in working capital, it signifies that more cash is tied up in working capital as compared to the prior year and this is treated as a cost against free cash flow. When forecasting the changes in net working capital, the entrepreneur must take care to note that as a business grows in sales revenue and volume, more investment in assets such as inventory and accounts receivable will be needed to match the growth of the business and these must be factored into the projections as well.
The formula for net working capital is as follows:
Net Working Capital = Current Assets - Current Liabilities
As a business grows, the entrepreneur also needs to project capital expenditure to meet the expansion needs. Capital expenditure refers to money spent to acquire fixed assets such as buildings and machinery.
Jo Bilson - Jo Bilson is a management consultant with interests including venture capital and entrepreneurial finance.
