Business school taught me the importance of how to read financial statements and analyze the fiscal health of a company. We spent hours poring over publicly-available financial reports (the infamous 10-K, 10-Q and annual reports). Our professors even quizzed us to determine whether we truly understood the revenue and expense drivers for each of the firms we were researching.
What I never learned, however, was how to build an integrated financial model that could actually be used to help entrepreneurs understand how to finance and grow their businesses. Over the past many years, a lot of my “on the job training” taught me the key aspects of a sound financial model.
Having raised capital for my own firm in a variety of rounds, helped clients do the same, advised companies on how to better manage their operations, survived workout with a major money-center bank, obtained asset-backed credit facilities, and more, I learned not just what is necessary from the entrepreneur’s perspective, but what all the other constituents in the company’s ecosystem need to know.
When building any financial forecast or budget, one must rely upon an integrated set of financial statements as the foundation for proper decision making. The three requisite statements: Profit & Loss (P&L), Balance Sheet, and Statement of Cash Flows, all work together to paint a comprehensive picture of a company’s health, both today and in the future.
The P&L provides a picture of the ongoing profitability of the business, based upon key assumptions for revenues (pricing), expenses (cost of goods sold, general & administrative, sales & marketing, personnel, research & development, customer service, etc.).
The Balance Sheet provides a snapshot of how the company is using its assets (cash, receivables and inventory) to enable the generation of the revenues shown on the P&L. The Balance Sheet also illustrates how the company is capitalized (i.e. where did (or will) the funds come from to fuel the engine that drives the business forward). If there is not enough fuel in the tank, the company will stall, so managing the capital structure for the firm is critical.
The Statement of Cash Flows is often ignored by entrepreneurs because it can be complicated to build and comprehend. However, it is the most important of the three financial statements because it shows how cash is generated and used.
Integrating the three statements happens in a variety of ways. For example, if a company is a manufacturer of goods, then purchasing raw materials is a necessary use of cash that will show up on the Statement of Cash Flows as well as the Balance Sheet (since inventory is an asset of the company).
The company may receive terms that enables it to pay for these purchases over time, which then delays the need to spend cash, but still affects the profitability of the firm in the form of increasing Cost of Goods Sold (an item on the P&L). Once the goods are produced and sold, the company will turn the raw materials into finished goods and sell them for cash (via e-commerce) or receivables (if sold via terms to wholesalers or retailers). This example is just one small picture of the importance of developing an integrated set of financials to enable proper cash flow management, profitability (margin) analysis, and optimal use of capital.
Key Performance Indicators
Key Performance Indicators (KPIs) are simply measures of the health of a business. Each business should develop its own set of KPIs that Management can use to actively monitor how well the business is performing. More importantly, by reviewing the change in a company’s KPIs over time (i.e. the trends), a CEO can use these measurements to proactively forecast where the company will be at some point in the future, be it 3 months, 6 months or even 3 years.
Let’s use for example a software business that sells using a monthly subscription model. Customers would need to purchase implementation, customization, or training services to enable them to get up and running. That business model could have as a KPI the total monthly recurring revenue that is generated across the entire customer base.
This KPI is often used by external sources (banks or other lenders, equity investors, shareholders, even acquirers) to determine not just the health of the business, but the inherent value as well. If you have a financial model that shows the historical trend in MRR for this business, then you can use that trend to forecast the future profitability and therefore, future value, of the company.
When building a sound financial model, KPIs are the necessary “knobs and dials” that enable you to visualize the business in a handful of variables so that you can make informed decisions when changing tactics or strategy.
A client asked me to define a model “assumption.”Since I use that term every day, I never realized that a business owner would need to have it defined. The easiest way to think about the assumptions for your business model is to conceptualize the parameters that affect how well the business is performing. For an ecommerce business, as an example, some of the critical assumptions include click-through rates, cost per thousand impressions, and conversion rates.
These variables are all used to drive the revenue forecast for the business based on social media advertising. Other assumptions include: month-over-month (or year-over-year) revenue growth rates, number of units sold per period or per region, gross margins by product line or SKU, number of employees needed to service the business, how much they will need in terms of benefits (and raises), etc.
There are hundreds of assumptions built into every model. One of the best practices I learned is to clearly delineate those assumptions that could materially change the forecasted results. Using the aforementioned “knobs and dials” analogy, these assumptions are like the “knobs” that you can turn so that you can easily see the impact of making one or more changes.
In financial parlance, this process is known as “sensitivity analysis.” By reviewing the changes in your assumptions with your Management Team, you can more effectively understand which changes are necessary and which ones can be delayed. By delineating your assumptions, you provide the team (and other constituents) with your reasoning behind the forecasted results, i.e. what is actually causing the company to generate profits in the coming years.
Detailed Operating Expenses
Operating expenses are the typical, recurring costs associated with running your business. Generally, these include items such as rent, payroll, utilities, and, depending on the nature of your operations, may also involve marketing, logistics, quality control, and information technology, among others.
These expenses tend to move in line with revenues over time, but they are not always directly related to actual sales. However, Operating Expenses are almost always necessary to support sales, so you may find yourself in a situation where you need to add costs to your business in advance of generating additional revenues.
It is critical for the entrepreneur to fully understand the cost structure of their organization, as each line item may have its own set of terms that impact cash flow. For example, rent, insurance, and leases are typically paid in advance, while salaries, benefits, payroll taxes, and utilities are usually paid in arrears; the timing of these items can impact cash available for inventory orders, debt reduction, or owner’s distributions. Building a model that can facilitate an in-depth analysis of ongoing expenses can often mean the difference between success and failure.
Comprehensive Revenue Model
When building a detailed Profit & Loss Statement, it is not sufficient to have one line that simply states “Revenues” on a monthly basis. By creating a detailed revenue and pricing model, you can clearly see the revenue drivers for the business over time. These revenue drivers could be a function of any number of variables and will be highly dependent on not just the industry you are in, but to whom you are selling your products and services, how you are selling them, and even when.
While many entrepreneurs understand their revenues to the product level, others make the mistake of neglecting to go further and analyze what specifically leads to sales, which sales are more profitable than others, and where to most efficiently grow revenues. A good revenue model should incorporate the cost of sales, typically known as Cost of Goods Sold, or COGS, down to the product level. Tying this together in a way that incorporates the Balance Sheet and Cash Flow Statement can be overhwelming, but is well worth the effort in the long run.
Even with textbook education emphasizing the value of reading and analyzing the fiscal vitality of a company, we have come to discover the real “tricks of the trade” to build a sound financial model that will help build and grow a business.
These tools emanate from on-the-job experience and knowing when and how to make adjustments. The process includes a thorough analysis of financial statements (Profit & Loss, Balance Sheet, and Statement of Cash Flows), designating Key Performance Indicators (KPIs), navigating critical assumptions and redefining parameters, routinely detailing operating expenses, and crafting a comprehensive revenue model. This fiscal discipline ultimately serves as the foundation upon which an enduring business is built.