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6)      Devising and revising a business plan

 

Devising a business plan boils down to modeling the future financial statements of your company; in order to be successful at such an exercise, you must remember a few overriding principles and keep in mind that there is no absolute method in writing a business plan. Thus, a lot of common sense will be necessary in order to avoid the many pitfalls that will pave your way.

 

Caveat: always be very wary of optimistic business plans. Entrepreneurs often tend to draw a wonderful picture of their projects in order to be able to find investors; it can thus be expected that they will come up with very enthusiastic projections which are completely disconnected from reality. Your objective will be to be able to dissociate facts from dreams and draw a clear line between reasonable investment and gambling.

 

Projecting the future level of sales

 

Projecting the level of sales properly is key to a successful business plan (by “successful” you must understand that we mean “realistic”; your goal is not to produce an over-optimistic business plan that will make you overinvest and lose money, nor is it to produce an over-optimistic business plan that will make you miss very lucrative opportunities).

 

There are roughly two methods that can help you determine the future level of sales for your business:

 

-          market studies: when you are starting a new business, you do not hold past data about your levels of sales and therefore you must rely upon exterior sources of information in order to anticipate the volume of your sales to come (as a function of the price of your products, since you obviously won’t realize the same level of sales if your products sell for very cheap or if they sell at a very expensive price). Practically, you can purchase the services of consulting (marketing) firms and ask them to do a market study for you, or if your business is small enough and doesn’t require high investments, you might want to do a market study yourself (the reason for this is that a complete market study by a renowned counseling firm will cost you a lot of money; it is therefore recommended only if the size of your projects warrants it).

 

-          trend extrapolation: when you already hold data about your past levels of sales (or those from similar businesses operating in the same conditions as yours), you can project your future levels of sales by pure mathematical extrapolation. However, this may be a dangerous practice in this that you must be extremely careful that the numbers you obtain are congruent with the economic reality of your operations. In particular, extrapolating the volume of sales over a very long period of time might be very inaccurate, because if the economy of the country slows down, people may refrain from buying your products (especially if these are luxury products). Similarly, extrapolating the price of the products sold can be hazardous because a new concurrent may enter the market and force you to lower your prices. In order to illustrate this fact, you can consider the following example:

 

 

            What is the level of sales that you can anticipate for 2010 ? Representing the levels from        the previous years on a graph will show you that they all stand on a line, and historically the level of sales from year n+1 is twice that from year n. Therefore, you might reasonably assume that the level of sales for 2010 will be around 40 x 2 = 80 (unless you hold major economic or financial reasons to believe that this might not happen). However, what can you say about the level of sales in 2020 ? Would it be reasonable to extrapolate our results until so far ahead in time ? According to our extrapolation, the levels of sales for 2020 would be 40 x 2^11 = 81,920. Imagine that you are operating a real estate agency in an average city in Utah, and imagine that the above numbers represent sales (in million USD). Do you really believe that you will be generating almost $82 billion in 2020 ? The answer is negative. Maybe the years 2007, 2008 and 2009 were just the beginning of your activity, and thus were characterized by a high growth in sales. But sooner or later, this growth will have to be curbed because your business can’t be growing up to the sky (unfortunately).

Always beware abuse extrapolation when building or revising your business plan, and always prefer very conservative assumptions to overoptimistic ones.

 

Building your income statement: your future levels of sales are going to be the major determinant of your future income statements (which in turn will determine your financing policy, etc … and thus will allow you to establish a clear picture of your future balance sheets). If you do not hold previous historical numbers about your business, then, as mentioned above, you will need to resort to market studies. In the following, we will indicate the relations that exist between the level of sales and various fields of the income statement or balance sheet, which might be useful to be aware of when building your business from scratch but also when establishing projections based on the extrapolation of past data.

 

Several quantities can be seen as roughly proportional to the level of sales (everything else being equal): for instance, the quantity of raw materials purchased (you obviously need more raw materials in order to produce and sell more products), the value of inventories and work in progress, etc …

 

This being said, the evolution of the EBITDA margin can also be monitored and extrapolated (remember that the EBITDA margin is the ratio EBITDA/Sales).  This will enable you to find a good approximation for the EBITDA of future periods.

 

Similarly, you can assume that the Working Capital as a percentage of sales must remain more or less constant (even though we did remark that most of the times Working Capital is growing more quickly than sales because of administrative and production inefficiencies).

 

Eventually, it is also reasonable to try and extrapolate future levels of Capex from past levels of sales, making the hypothesis that levels of production (and thus of sales) are proportionate to the manufacturing capacity of the firm, and that Capex are themselves proportionate to the value of the manufacturing capacities if investment outflows are perfectly spread in time – which is never really true, since there are periods when companies invest massively followed by periods where their investment cash outflows are very small -.

 

As a conclusion, one can remark that the level of sales is the most important number to evaluate, which should come as no surprise since this is the door through which money is entering the company.

 

Cash and marketable securities: you must beware when extrapolating the amount of cash and equivalents hold by the company on its accounts. Even if these amounts have been regularly decreasing, they will never fall close to zero for the mere reason that a company always need a minimum of cash available in order to operate (otherwise it will be illiquid).

 

Depreciation and Amortization: if the investment policy of the company isn’t going to change anytime soon, then the level of future D&A can be seen as roughly stable as a percentage of Capex, reflecting the fact that the “rate of renewal” of the company’s equipments is stable. However, be careful when extrapolating the rate of growth of D&A as a percentage of Capex, because such a growth is highly discretionary and may be completely different from one year to another. This is the reason why it is essential to have an idea of the future investment policy which will be adopted by the company.

 

Non-recurring items: these items are by definition non-recurring; therefore, you have no way whatsoever to anticipate them.

 

Corporate income tax: you can decide to use a normalized rate based on your historical rates, or you may want to determine your rate as a function of your future level of activity. There again, what you need most is consistency and common sense, as there is no golden rule which will give you the perfect prediction.