[SOUND] Hi, my name is Marlon Knoll and welcome to module three of the fundamentals of finance. In this module, we're going to be talking about forecasting and financing and how they work together. So again, welcome to module 3 of the fundamentals of finance, forecasting helps any new or existing business to determine what is going to happen in the next 2,3,5 years. And if you have the cash flow for the activity, it's important to know or estimate what your sales might be, what the cash needs might be, how you can grow effectively and efficiently. And forecasting helps you to do that, and then how do you get financing to make sure that you can accommodate your growth or your business needs? There is a difference between forecasting and budgeting, so budgeting, I prepare a budget on an annual basis and compare my actual to my budget. But forecasting, I do that in advance maybe 1 to 3 years, so that I can estimate different levels of activity and how that's going to affect my expenses. Then I need to know different types of financing and to do this, it starts with, first of all, how are you going to get cash to start the business and then where does the cash come from to maintain or grow the business. And then keeping good financials helps us to be able to be flexible when it comes to getting proper financing. When I'm forecasting, I need to come up with what my anticipated activity will be for the business. And I'm going to make sure I run forecasting with some different scenarios so that I have an idea of what I may want to do when I'm running my business. It's important to do this before even start my business because a lot of businesses fail because they run out of cash. So forecasting can give you an idea of what your expenses could be and can help you understand what you need as far as cash flow. Also can give you some ideas on ways to approach your revenues, you may not want to expand your revenues too quickly because you will not have the cash to pay the supplies or services. So, I have to make sure that I forecast, so I know what my operations and my business needs will look like, how do I forecast? Well I start with revenue, I start with revenue and then I proceed through my costs as it relates to revenue and then my general and administrative expenses. It helps me to understand cash flow, how much cash am I going to need to grow my business and again, I'm going to take the business through a few scenarios. If I get revenues that exceed my expectations, what will, how will that impact my costs, if I get revenues that are below my expectations, how will that affect my costs? So, and everything is estimated so there is no forecasting where somebody could say, I know exactly what's going to happen, you don't. But this helps businesses and business owners to anticipate at various levels of activity when I'm performing forecasting, where do I start? I always start with revenues and I will forecast revenues at various levels, if I'm selling just a few or a lot, I have to estimate what my sales might be with number of products or a number of hours of services. And then I allocate my what I expect my, I'm going to sell my product for or my hourly amount for my services or maybe my monthly amount for my services. Next I apply my cost of sales and I again, what are the cost of performing or selling the products where the cost of selling services and those have to come next? And I estimate again on the various levels of revenue after that, I apply my general and administrative expenses and it's good to use a specific format for this so that you don't miss any expenses that could be part of operating your business. So some of the simple basic things are your rent, utilities, equipment supplies, advertising, those are just general, most businesses have those expenses. But you can usually find some formats on the internet that will give you a good structure on estimating and and determining what your general and administrative expenses are. Forecasting is not an exact science, we have to estimate, we have to estimate how much we're going to sell, we have to estimate what we're going to sell our products for our services for, and we may be wrong. So we have to estimate, but we have to, this is why we provide a different, a few different scenarios in case we are wrong so that we understand how that's going to impact us. So I might be able though to get some my estimating from a similar business, or a business that I've been involved in in the past. And when I'm forecasting, I want to make sure I do this month by month so that I can break down what's going to happen each month, depending upon different scenarios. The scenarios are going to be how many of the products I'm going to sell or how many hours I'm going to be able to sell for my services. A lot of times again, business owners or prospective business owners are not correct in this. So we have to provide a couple of scenarios and we'll do this on an Excel spreadsheet or some other spreadsheet that you can use. That will enable you to change your formulas so that if you're not correct, you can adjust your forecasting, that that just helps you to anticipate your cash flow needs. When I'm forecasting revenue, I have to make some assumptions, this is not an exact science, so my assumptions, I need to make sure identify but how much am I going to sell? I make forecasts relating to my sales of products or services and when I do that, I need to know how much I'm going to sell my products or services for. And I need to do this month by month and using a format where I can adjust if I'm not accurate. So I go into my business and after one or two or three months, I realize that some of my assumptions were not correct. So with a forecast, I should be able to adjust the numbers so that I have a better idea eventually of what my number is, what my revenue will be. I begin with forecasting revenue and the ways to do this. I estimate how many products or how many hours of service I'm going to provide or sell during the month. And then I have to document every assumption that I'm making, how much I'm going to sell my product or service for, and then how many hours or how many products I'm going to sell. So I have to make sure that I document everything so that the person reviewing or looking at my revenue can see how I came to those numbers. Now, I have to make sure that my revenue is reasonable, I've seen people come up with projections that are 20 times the previous year's revenue. And don't have really any reason other than I'm really great and this is what I'm going to do, so that doesn't really fly with investors or your bank. So what you should have our strategies that you've developed in previous years or for this year. You're going to follow the strategies and if you do follow those strategies, you might have growth of 10%. Which ordinarily I would have growth based on CPI, I should always increase my prices every year because of CPI. But if I have good strategies that I've set up and align with the business, I might have growth that would happen because of the strategy implementation. So the 10% revenue increase would be reasonable if I can show that I'm going to implement a particular strategy. And because of that strategy I'm going to have a certain amount of growth. After I forecast the revenue, I need to identify my cost of sales as it relates to the revenue. What are the direct costs for my product? What does it take to make my product or buy my product that I'm selling? Or how much does it cost for me to pay the people who are providing the services? So those are the costs of sales I need to, after I anticipate my revenue, I need to identify my cost of sales and I need to do this month by month, as I have forecasted my revenue. You need to understand what the cost of sales are, so if I have a product that I am making, I'm going to have some direct labor, if I'm manufacturing the product and what are the materials, again, if I'm manufacturing. And then there's usually overhead the, if I have a facility where I'm making this product, there's overhead related to the facility, like rent, utilities, equipment, machinery. And then if I'm providing services, I have direct labor costs, but then I have also the load, what I call load on labor. So what are the payroll taxes, vacation expense, what are the additional expenses for the a direct labor costs? I need to document all of these assumptions on my spreadsheet. After I have completed forecasting my revenue and my cost of good sold, I get my gross profit. Then after I have my gross profit, I need to figure out what my general and administrative costs are. These are a little bit easier to estimate because they are typically not going to be changing much for a month to month. And how am I going to figure out what these costs are going to be? Well, if I have some history in my business, I would use that but if I am familiar with the business. A lot of businesses are started by people who have worked in a similar business. So they have experience and they can go on their history from the other experience that the other business that they worked in to get numbers. But what would these numbers consist of? They would be rent, utilities, salaries for administrative people, even the owner of the business. So it's the other monthly regular expenses that business is going to incur, just as a matter of being in business. When I'm projecting these general administrative and administrative costs, I need to make sure I have enough of estimated increase. So if I have rent on a monthly basis than if I'm forecasting for a number of years, of course my rent expense is going to go up. My utility's expense usually goes up, everything typically goes up at least by CPI, so I should be considering what those costs are. If I have an advertising strategy, I need to include those costs in my general and administrative costs. So, and again, if I'm going to have a strategy that's going to cause an increase in costs, does need to be documented at the bottom of my spreadsheet or somewhere in my spreadsheet. I have other things I need to forecast so I can estimate my cash flow. So I might have to purchase assets to be able to produce what I'm anticipating producing, like more equipment or possibly renting another space to be able to grow my business. Other examples or if I have a storm or earthquake or fire, [LAUGH] I don't want to forecast disasters, so I'm not saying to do that. But if there's something in the foreseeable future that you know or can estimate what happened, then you need to forecast for other things. Like I said, if you have to buy equipment or upgrade your software your IT, provide more training for your employees to be able to provide services, those are things you should forecast for. The key components of forecasting or making sure you do this on a monthly basis. After you've completed your forecast you can go back and see how accurate you were with your forecast. So this helps you with future forecasting and especially in a startup business, forecasting is going to be helping you make sure you have sufficient cash flow. Again, the worst thing a business can do is to run out of cash. I have to make assumptions for almost every single number, so I need to make sure I document what those assumptions are. Either in a formula for my revenue and my cost of sales or below the spreadsheet, below the numbers. I might have Asterix for revenue below the spreadsheet, identify that Asterix and put the assumptions that I made to generate the number for the revenue. And I do this for expenses as well, so this really helps anybody reading your forecast to get an ideal if the forecast is realistic or not. You have the forecast and you have a few months of experience, a variance will help you understand the effectiveness of the forecast and you may need to adjust your forecast. But maintain these documents because this helps anybody looking at your business in case you're thinking of selling your business, this will give a potential buyer an idea of what you've done for your business to help grow. So any time you can have a story that you're building. Then you can maybe provide more valued to a potential buyer. Let me give you an example of a forecast and we're going to use a painting business. I happen to have a friend who has a painting business and if I was going to start a painting business, I would want an estimate of the business and the cash flow for hiring. And I'm going to start with the number of houses that I think I'm going to gain as customers and then how much am I going to sell my painting services for? I should know what a reasonable estimate for this would be. So I need to do some research to get this information or I need to have experience in the painting business. And I always encourage people if you're going to go into a business, have some experience in that business before you jump into that business. I think in my business that I'm going to have ten houses that I'm going to paint. I need to have an idea of how many people I need to hire to actually paint those ten houses. What the timing will be, how long does it take for maybe two people to paint a house? I have to have that timing for that and then how do I build? I would want a down payment or some form of covering my initial costs before even start the job, if that's possible. And then I need to know because you're going to have to pay your employees for the painting before you actually collect in most instances. After a few months of having a forecast and actual numbers, I'm going to prepare a variance report. What is the variance report is comparing the forecast to actual and understanding what the differences are. So why was my forecast off? And I may want to re adjust the rest of my forecast, the forecast for the rest of the year. This is an example of a forecast of a painting company. So it's a start up, the painting company operator for the first month or two is operating out of the garage, so there's no rent. But as you can see, we have a slow start up with a couple of homes a month ramping up to more homes in the middle of the month. All of this is an estimate of what revenue I think I can make as a business operator. And all my assumptions are documented at the bottom of my spreadsheet. Now, if you notice the first few months, up until May, this been the business is losing money. So this tells me I need cash flow through May, I need to make sure that I can support the business. I need to be able to pay the painters and pay for the paint, all of the things that go into running a business. So this forecast helps me to know how much cash I need. I use the same template of a forecast. But instead of 58 homes, I'm estimating that I will only paint 30 homes. My marketing doesn't go as well as I thought it should. And at 30 homes, I lose money for the year. So it's important to do the various estimates for forecasting. So you know that if I have this type of a situation, I'm going to need that much over and above in cash to run this business. And again, same assumptions are at the bottom. I've got some identification of calculations in the middle of the spreadsheet. But this really tells me that instead of making a little bit of money starting in the month of May, I'm going to be losing money. So I'm going to need a lot more cash to start this business and it's better to guess low than high. When I'm running the business, I need cash, so how do I get cash? A lot of times it's from the sweat equity and I'm starting my business and an awful lot of business is an awful. A lot of small businesses have started their businesses from their garage or a home office, and as they grow, they might grow through sweat equity or friends and family. You might have an uncle that wants to participate in the business. Banks frequently do not finance brand spanking new businesses, same with angel investors or investment bankers. It's good to consider those options after you've been in the business for a few years. But when you're starting a business, unless you are a spin off of another business and you have some history. It's really difficult to get banking financing for new business if you're going to start a business, you should understand what that means as far as cash is concerned. So you may look at using your savings or using the equity in your home for the business. And or again you might start the business in your garage. So you don't really need that much cash, but you should prepare for negative cash flow in the first year or two. Very rare that a business is business starts generating a lot of cash flow initially. And so many businesses fail because they are not prepared for the cash that they will need to keep running the business. An awful lot of my entrepreneur friends say that they got their beginning cash from friends and family. And it may be a very good opportunity to offer your friends and family the chance to own part of a small business, and to estimate how much you need best to estimate high. So if you think you need $100,000 to start a business, you probably need $200,000. So, estimate high so that you have the cash and you don't run out of cash when you're starting your business. Here's a great question, I know you know the answer to this one. What is one of the most common ways to obtain capital to start a business? It is, is it A angel investors, B a bank loan, C rob a bank or D Sweat Equity from friends and family, or Sweat Equity or friends and family. You're brilliant, it is sweat equity or for money from friends and family. Having a good banking relationship is such a crucial part in growing your business. So banks typically don't fund startups although it just depends upon the ease of money and so sometimes this is not necessarily true. But after two or three years you may be able to get financing for your business and possibly after two, three or four years you can look to a bank to find your business. The SBA has a good program for providing small businesses with funding. So SBA is a Small Business Administration. SBA also is coincides with score. Score is free business advice to help business owners. Get ideas of ways to improve or expand their business, and I like anything that's free. So this is retired business owners that have experience that can help businesses to grow or improve their business. But if you're going to get a bank loan that a lot of times the bank will ask for support for the money that they're lending, so it might be with equity from your home or property. And there are typically requirements for having minimum revenue. Now one thing I encourage business owners to do is to make sure after a number of years, maybe 10, 15 years. That you try to get off being sharing or having support for the funding with equity, or being the support, or underwriting the loan. I'd like to take you out of that area of responsibility, so that if something happens with the bank, you are not totally financially devastated. Before I even get going, I should find a bank where I can get a good banking relationship, so what does that look like? Well, there are an awful lot of small business banks that support businesses. I was looking for a business loan to buy property in a business that I ran, and it was actually a great business, had very good cash flow. And I met with a banker who was really adversarial, asking me questions like I was lying about my financials. And to me, I didn't perceive that as being a potentially good banking relationship. So I would never work with that bank to be able to grow my business. Initially, if you are going to obtain financing, you need to make sure you have good credit rating. So that's something that you can start working on from the get go, make sure that you don't have any outstanding debts that make you look like you can't pay the bank loan back. And make sure that your business is fairly consistent in good business practices as far as your business operations. So the bank can look at your business, and look at the numbers, and look at the way you're running the business, and realize that you're doing a good job with your business. Whether you're using a bank or some other investor, make sure you understand how you're going to use the capital. And know your numbers, which includes good financial statements. And those financial statements should be prepared on a monthly basis, and you should have budgets for every single year. You should have budgets and you should be comparing your budgets, your actual to your budgets, and that will give you various reports. If there's any large variances, you should be able to explain those variances. And then monthly have comments about your financial statements. So that a banker or an investor knows how close you are watching your numbers because they care about your numbers even if you do not. When getting a bank loan, banks frequently have some standardized language. That they will ask you to make commitments as far as certain ratios, and you always have the right to say no. That does not make sense for me, like maybe that you should have a certain amount of cash in your reserves or you have certain ratios that you're going to uphold. So you need to understand what the banks are asking you to commit to. And again, you want to get away from personal guarantees, if that's at all possible. If you don't pay attention to the banking arrangements, you could end up having some significant problems. So a friend of mine had covenants with a bank, and this was during the downturn in 2008 and 2009. And he did not realize that the bank had the ability or powers to take his property. And so he lost everything for this one particular investment because of the agreements that he had with the bank. And so you do not want to end up losing property or losing your investment because you failed to pay attention to the agreements with the bank. There are many banks that are good with having relationships with businesses. So there are many banks that will be good partners for you in running a business, you want to make sure that you watch for that. And sometimes you're banking partner changes. So I had a relationship with a very large bank that I had a good relationship, and have a very good friend in the bank, and then the bank sold to another entity. And the relationship changed, and the agreements, and the numbers, and the percentages changed, so I had to leave that banking relationships. But you can have a good relationship with your bank. So look for those banks where they will support your business not be adversarial to you. You've heard me say this a few times, but good monthly financials are critical to running your business properly, but also having cash reserves are also critical. So a lot of business books will tell you you need 2-3 months in cash reserves. I say six months of cash reserves is, if you can get that much, that would be a good target to have as far as having enough cash for the just in case. And so when I say cash reserves, it's six months of your expenses. So whatever your expenses are on a monthly basis, take that multiplied by six, and try to have cash reserves for that amount. Now, if you have good cash reserves, that only helps to support your ability to grow when an opportunity raises its head. So good cash reserves is can really help you grow the business for the long term. But when you are getting a loan only use reputable lenders. So fly-by-night operator is not a good idea of broker might say I can work with you, I can get you any loan. I know a ton of business of a loan brokers who work with a variety of entities, but you really to have to borrow money. You want to make sure that you have a good relationship with your lender. So be careful about who you use as far as the lender is concerned. Do I keep the loan or if I have the cash to pay it off, do I pay off alone? Good question, I may want to keep the loan if I have another purpose for the cash. So you have to be planning ahead with what are my options and what can I do with cash that I have? However, if you can pay off the loan you will be reducing your expenses because you will no longer have interest expense. Now one thing that you may consider doing is getting a credit line, so that's different from having a regular loan. So regular bank alone or regular loan, you make monthly payments, and you have interest expense. It go along goes along with alone, but a credit line you don't necessarily have to draw on the credit line. It costs some money to set up a credit line, and it's there just in case you need the cash. Now, a credit line typically would have to be paid off once a year. So you have to be careful will you are using a credit line to not expected to act like alone, it is not the same as alone. But credit lines are very helpful when you have a cash me that you weren't expecting. So I have a friend that had a business, he had a great month of sales. And then realize that he had a cash flow issue because he needed to pay his people and for the supplies before he would actually receive money from his clients. So he needed to have to draw on his credit line that instance where he had a really good month. So good for having a great month in revenue, but you can expect to have costs that you have to pay before you're actually going to get paid by your customers. So credit line is a great tool for businesses, where it doesn't cost you an interest expense, but it's there for the just in case. So I hope this has given you some ideas of the importance of forecasting and some of the factors in borrowing money, what you need to know and and how you do these things. This is all part of running a good business, borrowing money is not a bad thing, it can be a good thing for businesses to help you grow. So just keep in mind, you should educate yourself a little bit on what it is that is important as you're borrowing money, and how that money is used as you're running the business.
