If one component of a business plan attracts more attention that any other, this is certainly the financial plan. The financial plan is a forecast of the business financial statements and includes a minimum of a profit and loss account and a cashflow statement, over multiple years. Before we can generate a financial forecast we need to develop a good understanding of one year’s financial statements.
Financial statements comprise three financial accounts called the Cashflow statement (CF), the profit & loss account (P&L) and the Balance Sheet (BS). From these statements, key ratios can be derived and provide useful measures to managers and providers of finance on the profitability of the business, its operational performance, its short-term liquidity and its longer-term stability.
Financial statements are traditionally prepared in the context of financial reporting and can be found in every company annual report. Reading annual reports is the best way to learn about a business before investing into it, however annual reports focus on the immediate past and only cover the last year or two or a few quarters. In a business plan, we will need to generate financial statements that are looking into the future and span a number of years. The time horizon must be at least as long as the product, service or project full lifecycle in order to be meaningful. For instance, for a fast-moving consumer good product like a mobile phone the forecast horizon might be as short as 2-3 years, including a period of 12 months when the product is marketed and an additional period of 2 years to cover after-sales service. For an infrastructure product like a UMTS base station, a horizon of 5 to 10 years will be common.
Financial statements can get extremely complex in the context of financial reporting. As an accountant or auditor you have to be very precise, above all because of issues of revenue recognition, the amortization of intangible assets as well as taxation issues. Annual reports must be prepared in conformity with certain accounting standards and the local accounting practice, which both vary from country to country and also change over time. Even within the Generally Agreed Accounting Principles (GAAP), issued by the American Financial Accounting Standards Board (FASB), there are considerable differences between countries. For instance US GAAP is not the same as UK GAAP: the latter allows the amortization of purchased goodwill, the former not any more. In addition, in some countries like Germany, the same set of financial statements is used to report to shareholders and tax authorities, whereas in other countries like the UK and the USA, two sets of books are required. In the latter countries, accelerated asset depreciation can be used when reporting to the tax authorities; the direct impact is to lower short-term tax payment and postpone tax to a future period. Taxation rules are often complex in their application and change all the time, so that we will not enter into much detail here.
On the other hand, the guiding principles behind financial statements are simple to understand and resistant to the passing of time. At a high level, the calculation of the main items is straightforward and remains the same in all accounting standards. This will be sufficient in almost all business plans. If you need very accurate and audit-proof figures, for instance in an M&A context, then you will have to draw on the expertise of accountants and other financial advisers. As the saying goes, the devil lies in the detail (are accountants devils?).
But to start with, why are there three statements? Each financial statement looks at the business from a different perspective and with different objectives, so that the three statements complement each other nicely.