What Are the Financial Assumptions on a Business Plan?
by William Pirraglia, Demand Media
Business plans are required for all small businesses seeking loans or investors. Financial assumptions and
projections are critical components of all business plans. Three universal financial presentations are
expected in all business plans. You must include a projected income statement, balance sheet and cash
flow statement for the coming three to five years. Along with the numbers, include a narrative that
explains your assumptions and how the line items were computed
Financial assumptions are often the most critical components of good business plans.
WARNING:
Making financial projections based on solid assumptions is wonderful. But you must
explain the derivation and calculations to give business plan readers’ confidence in your data. Don't
commit newer entrepreneur mistakes. Many spend hours pouring over data and create reasonable
financial projections. However, newbies often forget or feel inadequate to explain their assumptions in
text format. Assuming that loan officers are experts in reading business plans is smart. However,
assuming they are experts in your industry is a mistake. Write as detailed a narrative as possible for your
financial assumptions, with references that your loan officer can verify.
EXPERT INSIGHT: Making valid financial assumptions, and explaining them clearly, can make the
difference in receiving the funds you need or suffering rejection by lenders or investors. Often, the
primary reason for approval or rejection relates to your display of expertise in your industry. Perform
your industry and competition research diligently and with a total focus on becoming an expert. You
must then make financial assumptions based on this expertise -- and communicate this clearly in your
business plan. Your financial assumptions will be challenged. Have knowledgeable answers ready for
these challenges.
Entrepreneurs often make two basic assumptions about a new business: that they have a product
consumers will want and that the business owner can make and sell the product profitably. An investor
or partner will want to see that you’ve done your homework and can support more key assumptions
than those two, with research and data.
Product or Service Need
One of the first and most important assumptions to address in a business plan is that there is a
demonstrated need for your product or service in the marketplace. You can do this with a competition
analysis, showing that others are making this product or offering this service and selling it profitably. If
you believe you have a new idea no one has tried yet, demonstrate that there’s a need or desire for the
benefit you offer, which can include showing how other companies currently address this consumer
need, but not as well as your new idea will.
Sufficient Customer Base
Another key assumption is that enough consumers want your product or service that you can generate
adequate sales to make a profit for the long run. You will need to demonstrate that there are many
more people in your target market than you need, because all of them won’t buy, and many will buy
from competitors. There is no specific formula businesses use to calculate this number, but your excess
potential customer base should be more than just a percentage of your sales need. For example, if you
need 100 people to buy from you each day, don’t plan on surviving in an area with 120 or 130 potential
customers. Plan on needing an exponential number, which might be five to 10 times the number of
customers you need.
Profitability
Every entrepreneur assumes he will be profitable, but that assumption must be borne out by market
research, budgeting and sales projections. Profitability does not depend only on sales -- it centers
around your cost to make and sell your product. Once you have calculated your manufacturing and
overhead costs, review the various price levels at which you might sell your product to determine if you
can pay off your start-up costs, then start making a profit. You can choose a pricing strategy that
generates high sales volumes by selling at a low price or by trying to maximize profit margins with a
higher price.
Management Expertise
A product doesn’t make itself, and a company doesn’t run itself. One of the key assumptions of a
business plan is that the principals can run a business profitably. The creator of a widget might make the
best widget the marketplace has ever seen, but that doesn’t mean she knows how to organize a
company, handle accounting, create marketing strategies, develop budgets, handle legal issues, prepare
taxes and perform the many tasks required to operate a business. A business plan should demonstrate
that the principals not only know how to make a product or deliver a service, but also will be able to
manage all aspects of the business.
Adequate Capitalization
Even when a business starts making a profit from operations, it might still take months or years to pay
off the initial start-up costs. Many small businesses fail because the owner believes he can fund the
operations on sales. Sales volumes that will be more than adequate for making a profit in year two or
three might not even be close to helping you meet your debt service obligations your first year.
Demonstrate in a business plan that you have sufficient capitalization to run the business until breakeven and afterward, or provide the amount of investment or loan you’ll need to start the business.
Income Statement
Construct your income statement on a month-to-month basis for the first one to two years. You can
then switch to quarterly projections for years three through five. One key item dominates this
presentation. Base your income and expense assumptions on factual, verifiable information. For
example, if your product competitively sells for $25 to $40, refrain from using a $60 selling price to craft
your sales projections. Also, base your sales volume assumptions on realistic statistics, easily verified by
a quick market analysis.
Balance Sheet
Assumptions for balance sheet presentations should be conservative and based on reasonable
expectations of asset acquisitions in the coming five years. Of particular concern to lenders and
investors are inventory and accounts receivable. Both are functions of sales. Therefore, carefully match
your inventory assumptions with your gross income projections. Unless accounts receivable are typically
large in your industry, do not project high balances. Because cash is usually in short supply for small
businesses, tying up this precious resource in excessive inventory or accounts receivable can be
damaging.
Cash Flow Statement
If you have a new small business or a modest company needing financing or investment, the projected
cash flow Statement may be the most important financial assumption you make. While both lenders and
investors want your small business to generate solid net income and have a strong balance sheet, cash
flow is more important. It is from cash flow that you can repay loans or distribute cash to investors from
profits.
When it comes to writing a top-notch business plan, the devil is in the details. While broad overviews
and assumptions should start your plan, investors, lenders and partners want as much research and
support as possible to determine whether your idea will fly. Even if you’re not looking for funding or
help, the more questions you can answer in your business plan, the more valuable it is.
Organization
An excellent business plan is organized in a logical, thoughtful way that makes it easy to move from your
assumptions to your justifications. The more organized your document, the easier it is to follow and to
review later when you need specific information. Include a detailed contents page, an executive
summary that tells what’s coming, sections on your product or service, the marketplace and financial
numbers, a summary and supporting documents.
Executive Summary
Many professional business plans start with an executive summary at the front of the document, rather
than at the end. This summary tells the reader the business idea, the reasoning behind it, what factors
make you think it will work and the estimated startup costs, break-even period and eventual profits. An
executive summary is often only a half-page or less, containing no detailed market research or financial
numbers. The goal of the executive summary is to get the reader interested in reviewing the business
plan.
Company Overview
This section includes a description of your product or service, its benefits, how it differs from the
competition and what brand, or image, you will create for it in the marketplace. Don’t get into your
manufacturing costs or profits at this point -- your goal here is simply to prove that there is a need for
your product and its benefit in the marketplace. A weak business plan tries to convince readers that an
idea is “great.” An excellent business plan proves that there’s a consumer demand for a product or
service.
Marketing Section
The marketing section of a thorough business plan goes beyond discussing advertising, public relations
and promotions. It begins by presenting market research that supports the fact that your idea will sell.
This includes information about the marketplace, target customer, competition and current sales figures
of competing products. Include a discussion of the distribution channels you’ll use and why. Once you’ve
completed this information, present your advertising, PR and promotions strategies and tactics,
referring to your market research to show why you are recommending these.
Financials
The most useful business plans provide detailed financial information, including startup expenses,
manufacturing and overhead costs, sales expenses, break-even point and profit projections. Include
more than one budget in your business plan to show readers you’ve done your homework: a budget
outlining your startup costs, an annual master budget, budgets that break out overhead and
manufacturing costs and a cash flow statement. Provide enough detail so that if someone hands you a
check for your requested amount, you won’t need to spend money on anything that isn’t already in your
business plan.
Support
Add an appendix to your business plan that includes research, data, charts and graphs that help prove
the information you’ve supplied in your plan is sound. Once you’ve proved you have a viable concept,
explained what it will take to fund the launch of and initial operating costs and forecast the profits,
demonstrate that you are qualified to do this. Include your biography, highlighting any experience you
have relevant to the business. Explain whom you will hire or use as contractors.