Written by Bill PettyA NOTE ON FORECASTING FINANCIAL REQUIREMENTSIf we were to ask owners of small businesses to identify their most pressing problem, the answers would be varied. Responses might include finding and retaining qualified employees, meeting the increasing cost of employee health care, and managing change. Also, any time this question is asked, the difficulty of acquiring the needed financing is invariably cited as a critical problem. As noted by one entrepreneur, "The biggest problem facing small business, as I see it, is money; where to get it, how to get it, and where to get enough when you need it."1 Regardless of whether we consider financing to be the most pressing problem, most would agree that it is an issue that we can ill afford to ignore or even slight. The problem is most pressing for new company startups and those firms that are experiencing growth. FINANCING THE VENTURE: THE BASIC QUESTIONSWhile the acquisition of financing may seem intimidating, it need not be. Itdoes require us to think carefully about the cash outflows needed to undertake a venture and where we might find the money to fund these cash expenditures. Effectiveness in such an analysis is largely dependent on developing a good understanding of the business, complemented with some common sense. In raising capital, there are some basic questions or issues that must be addressed prior to actually soliciting the funds. The three issues which we will look at here are as follows:1. Forecasting a new company's profits, and for a new firm, determining when it will achieve a break-even point in terms of profits.22. Understanding the nature of the asset and financing requirements fora new firm.3. Estimating the amount and basic type of the assets needed and financing required for the new venture.1"What is the Most Pressing Concern for Small Business Today?" Small Business Forum,Vol. 10, No. 1 (Spring 1992), p. 86. (The article provides the answers given by ten business owners to this question.)2Another question that we do not address at this time is the projection of the firm's cash flows. While projecting profits and financial requirements is important, understanding the firm's cash flows is vital to our success. In fact, failure to analysis the firm's cash flows would be a great oversight.. Draft: January 15, 1993Written by Bill PettyPROFITABILITY AND FINANCING A NEW VENTUREA key question for anyone starting a new business should be, "How profitable is the opportunity?" We have two concerns in this regard: 1. How do we project the firm's future profits?2. At what sales volume will we achieve a zero operating profit, where sales revenues exactly cover the firm's operating costs and expenses, which is the firm's operating profit break-even point?Both of these questions are of significance to the company's potential investors, whether they be our lenders or our partners.Forecasting ProfitsA company's profit is a primary source for financing future growth. The more profitable a company, all else being constant, the more funds it will have for growing the firm.3 Thus, we need a basic awareness of the factors that drive profits, so that we may make the needed profit projections. In this regard, a company's net income or net profits are dependent on five variables:1. Amount of sales Much that we project about a company's financial future is driven by the assumptions we make regarding future sales.2. Operating expenses Operating expenses include such expenses as the cost of acquiring our product or the expenses related to marketing and distributing the product. We will want, as best we can, to classify these expenses according to those that do not vary as sales increase or decrease (fixed operating expenses) versus those that change proportionally with sales (variable operating expenses).3. Interest expense When we borrow money, we agree to pay a fixed interest rate on the loan principal. For instance, if we borrow $25,000 for a full year and commit to pay 12-percent interest, our interest expense would be $3,000 for the year (12% X $25,000).4. Taxes The firm's taxes are, for the most part, a percentage of taxableincome, where the rate increases as the amount of income increases.Let's consider an example to demonstrate how we would estimate a new venture's profits in future years. 3This statement is not totally accurate. As we shall see more clearly in Chapter 20, a firmmay be highly profitable, but be cash poor. So we ought to be very careful about thinking that profits and cash are one and the same. They are not; however, we will reserve this issue for later.2 Draft: 1/14/2019Written by Bill PettyExample We are contemplating a new business, Oakcrest Products, Inc., to make stair parts for more expensive home. A newly developed lathe will permit the new firm to be more responsive to different design specifications, while doing so more cheaply than heretofore possible. In studying the market and the economics of the venture, we have made the following estimates for the next three years:1. Oakcrest Product's forecasted sales for the next three years are as follows:Projected Projected Unit Sales Dollar SalesYear 1 2,000 $250,000Year 2 3,200 $400,000Year 3 4,800 $600,000The dollar sales projections assume that the average unit sales price for each part will be $125.2. The fixed production costs are expected to be $100,000 per year, while the fixed operating expenses (marketing expenses, and administrative expenses) should be about $50,000. Thus, the total fixed operating costs will be $150,000.3. The variable costs of producing the stair parts will be around 20 percent of dollar revenues (sales); and the variable operating expenses will be approximately 30 percent of dollar sales. In other words, given an expected $125 sales price, the combined variable costs per unit, both for producing the stair parts and for marketing the products will be $62.50 [(20% + 30% ) x $125].4. The bank has agreed to loan the firm an increasing amount over the next three years at an interest rate of 12 percent. The bank would loan $100,000 in the first year, another $50,000 in the second year, and an additional $50,000 in the third year. Thus, the loan balance each year would be as follows:Draft: January 15, 1993Written by Bill PettyYear 1 $100,000Year 2 $150,000Year 3 $200,0005. Assume the income tax rate will be 25 percent; that is, taxes will be 25 percent of earnings before tax