The language of financial planning

The language of financial planning

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  The language of financialplanning A short introduction to some of the keywords in startup budgets By Jan Bendtsen One of the inspiring challenges of teaching young entrepreneurs about budgets is that we are often starting on different pages. Some know all the concepts and words from commercial school. To others it seems like I am speaking a completely new language. This little eBook is a short and practical introduction to some of the key concepts and the intention is to bring us a bit more on the same page before we go further into the details.
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  2 | Thelanguage of financial planning Intro Where I grew up on the west coast of Jutland there are a lot of holiday cottages along the coast. Some of them are built for pleasure and relaxation, but nowadays many of them are probably also built for business. So let’s say that we want to buy a holiday house to make it a business and earn money by renting it out on a weekly basis for tourists. What do we want to know before making the decision? In general terms it is exactly the same things we want to know before we start a business – even though our uncertainty will probably me much higher. Establishing budget The first thing we want to know is how much it will cost us to get started:  The price we have to pay for the summerhouse.  The costs of fx repairing, painting and shining up the house before it is ready for our first guests.  Alarm system.  Furnture.  Salaries for the lawyer and real estate broker involved.  Initial spending on marketing to attract the first customers. Let’s just say we buy a holiday house in Søndervig for 2.000.000 DKK and have additional costs of 200.000 before we open the doors for the first customers. This is our establishing budget, and it tells us what our initial one-time-investment will be. In a startup budget it is basically the investment we have to make before we are ready to sell to customers and create our first income. BENDTSEN start og udvikling | www.janbendtsen.dk
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  3 | Thelanguage of financial planning Operating budget After we have found out what it will cost to get started with our little holiday cottage business, we want to find out if it will be worth the effort:  How fast will we be able to pay back our initial investment as stated in the establishing budget?  Will the profit be worth the effort? We typically do this with an operating budget on a yearly basis. The operating budget is a statement of  The total income/revenue per year.  The total costs per year. In the holiday cottage case the income will be  Weekly rent from guests. So let’s look a bit closer at the different numbers and concepts of the operating budget. Turnover The turnover is the major income in your operating budget. It is your total sales – typically within a year. Let’s imagine that the price for renting our holiday cottage is DKK 6.000. If we let out the house for 40 weeks a year, it will give us an annual turnover of 40 * 6000 = DKK 240.000. BENDTSEN start og udvikling | www.janbendtsen.dk
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  4 | Thelanguage of financial planning Costs To find out if this is a good business, we will have to find out all our recurrent costs on a yearly basis. For the holiday house the costs will be fx  Heating, water and electricity  Cleaning  Marketing  Insurance  Real estate tax  Interest on loans However, costs are not just costs. Some costs we will have, no matter if we let out the house or not. Other costs we will only have if we let out the house. We call them fixed and variable costs (sometimes also called regular and direct costs). Variable costs If we don’t let out the holiday house, we will use no hot water for showers or Jacuzzi and we don’t have to spend money on heating and electricity. In principle at least, but of course we will have to heat a bit in winter and let the fridge on. Furthermore we don’t have to clean the house if nobody is using it. This means that our variable costs will be:  Heating, water and electricity  Cleaning Let’s imagine that the variable costs are DKK 500 every time we let out the house for a week. But why do we want to know our variable costs? Because we want to estimate our contribution margin! BENDTSEN start og udvikling | www.janbendtsen.dk
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  5 | Thelanguage of financial planning Contribution margin Every time we let out the holiday house, we earn DKK 5.500 DKK Sales price for a week 6.000 Variable costs 500 Contribution margin 5.500 Contribution margin – which is often roughly the same as gross profit – is telling us how much we earn every time we sell a product – in this case a week’s rent. This is the core of generating profit, and it gives us a clear idea about how much extra profit we would make if fx we could let out the house all 52 weeks of the year instead of the 40 weeks I mentioned earlier. 12 more weeks would generate an additional contribution margin of 12 * 5.500 = DKK 66.000. In the annual income statement and in the operating budget the contribution margin will be calculated for a year in total: Total turnover – Total variable costs = Total contribution margin. Contribution margin ratio However, if we let out the holiday cottage during Christmas, the variable costs for heating will probably be higher than when we let it out during summer. This means that the contribution margin can vary over time. If we want to monitor our money making machine from month to month or year to year, or if we want to compare it to competitors – or our neighbor who also has a holiday cottage, we will need a more general number: The contribution margin ratio that is the constribution margin as a percentage of the sales price: Contribution margin ratio = Contribution margin * 100 Sales price BENDTSEN start og udvikling | www.janbendtsen.dk
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  6 | Thelanguage of financial planning Or on a yearly basis: Total contribution margin * 100 / Total contribution margin. In our holiday cottage case the contribution margin ratio should be 5.500 * 100 / 6.000 = 91,7%. This means that we earn DKK 91,70 DKK every time we sell for 100 DKK. If we see that because of very cold weather the contribution margin in December was only 85% we will be warned that the heating might have been more expensive than expected. Or maybe we see in November that we only had a contribution margin of 75% because we gave a special discount just to get customers. Fixed costs If we let out the cottage for 40 weeks we expect a contribution margin of 40 * 5.500 = DKK 220.000. This means that we have earned 220.000 to cover the rest of our costs. The fixed costs. The fixed costs are regular costs that are not directly dependent on our sales, and could be:  Marketing  Insurance  Maintenance  Real estate tax  Depreciation  Interest on loans (if we borrowed money to buy the house) One of those may require a bit further explanation: Depreciation. BENDTSEN start og udvikling | www.janbendtsen.dk
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  7 | Thelanguage of financial planning Depreciation Depreciation is actually not something you pay, buy if you have a car, you will know that a new 200.000 DKK car is not a 200.000 DKK car after three years. Let’s imagine that you could sell the car for 120.000 DKK after a year. Then the depreciation would have been 80.000 DKK (new price – price after a year). So apart from gasoline and insurance etc. the car actually cost you an additional 80.000 DKK in depreciation – or loss you may call it. The same is relevant if you buy furniture for your holiday cottage. Let’s say we buy for DKK 100.000 worth of furniture and after 5 years we will have to change it and maybe sell the old furniture for 10.000. This means that we will have a loss after year five of 90.000. But since we could argue that the furniture has lost value all the way and not just in year five, we would like to depreciate the furniture year by year, so we can see the current value. If we know that the furniture will lose 90.000 over five years, we will have to depreciate it every year by 90.000 / 5 = DKK 18.000 Net profit After considering these different costs, we can finally make a full operating budget and calculate the net profit. I have added the assumptions that we have fixed costs of 100.000 DKK and that we took loans of 2.000.000 DKK at 4% interest to buy the cottage. DKK Turnover 240.000 Variable costs 20.000 Contribution margin 220.000 Fixed costs 100.000 Earnings before depreciation and interest 120.000 Depreciation 18.000 Earnings before interest 102.000 Interest 80.000 Net profit 22.000 This means that if things go as expected, we will earn 22.000 DKK a year on our holiday cottage. Would that be worth the risk and effort to you? BENDTSEN start og udvikling | www.janbendtsen.dk