How to Use the 3 Financial Statements in Your Business Plan

Financing is one of the key purposes of a business plan. Including a neat projection in the financial statements format connecting every aspects in your business plan is to communicate with investors in their language and thus helps win the funding.

Indeed, other parts of the business plan, such as product and services, sales and marketing, management team etc., are the center of notice, But after reading those exciting contents, the audience will want to see how you transform your exciting plans into numbers.

This post will walk you through the process to project the finance for your business plan in the format of 3 financial statements with an example.

In this post you will read:

• What is a business plan?
• Why use financial statements in the business plan?
• Transforming business plan into financial numbers with an example

1. What is a business plan?

In a simple sentence, a business plan is a document that outlines a company’s goals, how to achieve them, and what resources it requires.

A business plan could serve internal or external purposes.

Internally focused business plan will emphasize the strategies, intermediate objectives, and activities the teams will conduct to achieve the the business goals. The main audience is your internal teams and it could guide the performance evaluation system like balanced scorecard.

Externally focused business plan, on the other hand, aims at communicating with external stakeholders, such as investors and creditors as the major categories. 99% of time, the business plan holds the key to the financing process.

An effective preparation is to begin with externally focused one, then the internally focused one will extend the sections involving internal business activities such as marketing and operations.

While there could be hundreds of pages in a business plan for an established company, some argue that the business plan for startups could be leaner. Indeed, startups’ may include less details, but there still should be those aspects to communicate key information.

Rather than stuffing contents into the business plan, it is important to clarify the goals you want to achieve and identify your target audience, so that you can strategically detail the most relevant aspect(s).

So what aspects should I emphasize? It depends on the specific business (this is an annoy answer). Harvard Business Review’s <How to Write a Winning Business Plan> provides a great framework even though the article was published many years ago. The very brief conclusion is whichever aspects that focus on market, address investors’ needs, and detail the action plan.

How should I emphasize those aspects? Quantifying all aspects with support from extended studies and research and presenting them in the financial projection will make your business plan like a poetry to investors’ ears, because financial numbers are investors’ language.

2. Why use financial statements in the business plan?

The 3 financial statements are income statements, balance sheet, and cash flow statement.

In another post <How to Generate Financial Reports for Your Business>, I mention there is also a fourth statement called Statement of Changes in Equity. But this statement is not involved in the financial projection because financial projection does not focus on ownership but on operating results.

But the good news is, in the financial projection of business plan, you normally do not need to prepare the financial statements by precisely recording transaction by transaction. A lum sum will be fine.

It is better to be approximately right, than precisely wrong, in the financial projection.

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2.1 Income statement

If you can choose only one from the 3, income statement should be the one included your business plan, because it contains the information or the information to derive what investors care when making investment decisions.

As a quick note, income statement contains revenues and expenses, then the calculated net income. Businesses normally categorize expenses into cost of goods sold (or cost of services, if the business only provides services), operating expenses, and non-operating expenses.

• Distinguish the cash flow sources, operating, investing, and financing activities: How to Generate Financial Reports for Your Business

You may ask what if I have revenues and expenses that are just one-time and will NOT recur in the future? This issue will be taken care of by a process named normalization. Essentially, it it a process removing the abnormal revenues and expenses to assess what the normal business looks like.

2.2 Balance sheet

The balance sheet items are presented in main categories: cash balances, working capital, capital expenditure, long-term loans, and equity.

And when companies grow, you may need to input more capital for its daily operation – this is what we call working capital. It is not a focus on a daily basis, but it affects many daily operation of your business, such as paying your bills. The formula is:

Working capital = current assets – current liabilities

But in financial projection, we estimate working capital with a percentage of revenues – after all, the required working capital tends to grow with the revenue size. Take inventory as an example: the more sales you make, the more inventory you need to stock so that you do not lose sales because of out of stock.

To maintain the core business profitable, companies need to re-invest. Hence, capital expenditure items such as purchasing fixed assets and mergers & acquisitions are also critical in financial projection.

Last but not, you have the long-term liabilities and equity projection.

2.3 Cash slow statement

You may have heard of this phrase: cash is the the king.

To generate the cash flow projection, you follow the same process of generating cash flow statement, to start from net income, minus the calculated income taxes, add back the depreciation, minus the capital expenditure, and minus the projected interest expenses.

Minor non-cash transactions are not necessarily considered in the financial projection.

3. Transforming business plan into financial numbers

Let’s dive into the real work through entrepreneur David and his Software.co.

Here are some more details about Software.co:

The company was founded and registered in 2022. David and his co-founder, leaving their big tech employers, each input $50,000 into their business. David is leading the programming while his co-founder is leading the product management.

They spent the entire 2022 and worked days and nights to develop a beta version and launched it in 2023. They charged $20 subscription fee per year (I know the price is too good). 5,000 customers subscribed in 2023.

In 2022 and 2023, they paid themselves $20,000 each, purchased a $2,500 laptop for each, and did other IT and admin work themselves.

During 2023, the feedback was great, and their initial capital is almost fully spent, they decided to apply for funding. Before presenting their business to any investors, they need to prepare a business plan. After finishing other qualitative parts, David is working on the financial projection to ask for $500,000 of funding.

For this practice, I only projected 3 years from 2024 to 2026. But in practice, you may need to project 5 years even 7 years, depending on the requirements of the investors or bankers.

Firstly, David pulls out their financial statements for 2022 and 2023 that reflect the story above:

Cash Flow Statement

Now David is ready to project the future of their business in numbers!

3.1 Prepare income projection

The first step is to project revenues. How to project revenues depends on your business model. Software.co’s revenues mainly come from subscription fee. Therefore, the revenues = price * number of subscribers. This is the revenue model for the subscription based software/application companies.

David lists the revenue projection in a table as below:

How does David get those number of subscribers? It is a combination of science and art, as any forecasting and projection. You will, or if you can afford, hire consultants to conduct market research. Then you use your best estimate to determine how many subscribers you will be able to get, according to your analysis of the business and your team’s capabilities. Those numbers should align with your “Sales and Marketing Plan”.

Once you have the revenues set, you can project the expenses per line item. For example, David plans to pay the co-founders a more decent salaries in the future, hire sales and marketing professionals, upgrade their technical infrastructure. You also need to think about the expenses coming with hiring new employees, like buying a new laptop for them.

Then you have the income statement projection:

The numbers are amazing. Although I simplified the business case a lot, software industry, on average, earns undeniable high margin. The company structure tends to be simpler than companies in the retail sector, for instance. The main difficulties lie in product development and sales.

3.2 Prepare cash flow projection

Next step is to project the cash flows.

I should have mentioned but it will not be obvious in the income projection section, because it was blended in the IT expenses. So I keep it in the cash flow section. That is the fixed asset accounting.

Fixed assets are assets which are purchased for long-term use and are not likely to be converted quickly into cash, such as land, buildings, and equipment.

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Why we need to have the fixed asset schedule for the cash flow projection? Because depreciation included in the income statement is non-cash, therefore we need to add this expense back to derive the cash flows.

Accounting for fixed asset is a big topic for beginners. I will be discussed in details in another post.

But for this post, I will explain the simplest case here. As fixed assets have more than one year of use, you should not expense the entire price according to the matching principle (matching expenses with the revenue or period they occur). Every year, you can record a portion of its total value as expenses – this is the process of depreciation.

Accounting standards allow certain depreciation methods. Tax authorities also define their own ways to depreciate the fixed assets – this is how much you are allowed to deduct for tax purposes.

The simplest depreciation method is the straight-line depreciation, which means that the annual depreciation = original price / economic life. The economic life can be defined by asset class, for example, furniture usually has economic life of 5 years.

Another way to check the economic life is to go to the tax authority’s website. For example, according to Canada Revenue Agency, furniture is allowed to deduct 20% of original price per year, equivalent to 5 years of economic life.

Another note is that you can record 50% of the annual depreciation in the first year. For instance, for a fixed asset cost $1,000 with 5 years of economic life, the first year depreciation = 1,000 / 5 * 1/2 = 100.

Here I simply explain how to account for laptop, a kind of fixed assets with 2 years of economic life. It is a good practice to build a separate spreadsheet for fixed assets – fixed asset schedule. Below is the one for Software.co:

In the fixed asset schedule, you list all the fixed assets you purchased or will purchase with information such as purchase time and price before tax on each row. In 2022 an 2023, only David and a co-founder was working for Software.co, so there were only 2 laptop in total of $5,000.

Then we calculate the depreciation for 2022: 5,000 / 2 *1/2 = 1,250. And for 2023: 5,000 / 2 = 2,500. Fill in the annual depreciation amount under the according years, until the balance of THIS fixed asset reaches 0. This balance is calculated on the most right column.

From 2024, David plans to hire more people, therefore he will buy more laptops and record the purchase on the following rows. You repeat the calculation of depreciation for each new purchase and add the depreciation amounts for each year on the bottom of the columns for the year. Now you have the total depreciation for the year on the bottom.

To go one step further, we calculate the net balance of fixed assets (total original price – total accumulated depreciation) by formula: beginning net balance + new purchase of the year – total annual depreciation. This is the balance we will show in balance sheet.

We have the depreciation amount. Now we can project the cash flows:

As you can see, the purchases of new laptops are shown in the cash flows from investing activities.

While in the cash flows from financing activities, there is $500,000 share issuance for the funding and David’s dividend payment plan: $100,000 for 2024, $150,000 for 2025, and $150,00 for 2026.

On the bottom, you have the cash balances of the year.

3.3 Prepare balance sheet projection

Lastly, let’s project the balance sheet.

Software.co’s business model is subscription based, which means that the customers pay for the year then use the application, There is no accounts receivable. Meanwhile, costs such as server rental are also subscription based – David pays the rent upfront. Thus, there is no accounts payable.

David borrows no loan either. Hence, the balance sheet projection is about the cash balance, fixed assets, the equity. You get the cash balance from the cash flow projection. You get the fixed asset balance from the fixed asset schedule.

For the equity in 2024, David plans to issue 5,000 shares (face value at $1.00) for $500,000 of investments. Therefore, the total shares become $6,000 ($1,000 + $5,000) and the surplus of $495,000 ($500,000 – $5,000) is added. You also show the accumulated dividend paid over years.

Summary

Voilà! This is how to do financial projection for your business plan with the 3 financial statements. If the business do not have complex revenue and expense structure, like Software.co, it is completely possible to create them by the business owners themselves.

Finishing your business plan is just the first step. One said that more than 90% of the success of a business lies in the execution. I wish you best luck in obtaining the resources to make your business successful!

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