Starting a new business is a challenging process and involves a number of hurdles. The challenges range across finance, reporting, legal, commercial and number of other issues. Any serious start-up need a business plan and a financial cashflow model where all strategic and operational assumptions are reflected.
Many entrepreneurs shy away from the construction of a solid financial cashflow model and rather focus on big picture topics such as pretty powerpoints and investor pitching documents. This is often due to the combination of lack of capability and a view that ‘what is the point of trying to forecast something that you know will be different in reality’. The first point is important enough and has some very tangible solutions – outsourcing, training courses or self-study. The second point however brings us to the core of this article – why a financial model is called a ‘model’ and plan is called a ‘plan’.
I recommend that the process of developing a financial cashflow model for a start-up business to have a two-step process: The first step is to establish a ‘plan’ and the second step is to convert the plan into a tool for what-if analysis of the plan – i.e a ‘financial model’.
The business plan
In its most simple form a business plan in the shape of a spreadsheet can be a ‘one-pager’ indicating growth of different products and high-level calculations of the key cost and revenue drivers. When working towards the development of this first cut spreadsheet I would strongly recommend not to get bogged down in detail but to focus on the big picture to identify bottlenecks and potential problems in the growth phase.
It is important to highlight that the development of a business plan spreadsheet is not, and shouldn’t be, about financial modelling skills. If you prefer to hard code all numbers then that’s fine too – as long as the job gets done.
Building a financial model for the business plan
Once the business plan spreadsheet has been reviewed and agreed internally (or in some cases by external investors/board) it is now time to convert the simple analysis spreadsheet into a sophisticated tool for what-if analysis.
The aim of any financial model is to answer analytical questions about the business. The questions asked will be different for every business and could cover a great range of topics:
- What is the impact on my business if prices drop 20% in the market?
- How long could I sustain a positive cash balance if my biggest client cancelled the contract or defaulted?
- Is it worth investing $1m in new machinery if it reduced the labour requirement by 10%?
- Should we proceed with a new offshore opportunity which can increase the sales volume by 30% but the margin drops 7% due to higher cost of sales?
- What sales volumes do I need to achieve to be able to comfortably retire in two years time?
Of course a financial model can only give you assistance in answering questions about your business. Sometimes you already ‘know’ the answer and just want to confirm the answer by quantifying the outcomes in the model. In more advanced cases you may not be able to answer the question without the financial model.
Engineering financial model results
A financial model can be engineered to produce any output as it merely reflects the views of the person who built it. Critically reviewing the assumptions before relying on someone else’s model is of the highest importance.
The importance of instinct
No financial model will ever be able to correctly reflect strategically important but intangible issues such as:
- The value of a long-term client relationship
- The risk of your reputation being harmed after a series of flawed product launches
- Unexpected changes in the industry (such as the invention of a superior product by a competitor)
- Community support
Often the intangible questions have a far greater impact on a start-up business than the quantifiable ‘hard’ topics.
In my view the ‘plan’ in step one has to be developed on the basis that ‘all intangible topics are well managed and have a good outcome‘. If you can’t get comfortable with this statement the there is a great risk that you will fall into the trap of thinking – what is the point of building a financial model when we all know that it is not going to happen anyway…