Winging it is no way to run your business. You’ve got too much at stake. Even a 1% variance in your cash flow can cost you tens of thousands. Proper business planning is an essential tool for successful businesses. Here’s a primer on how to prepare your organization to respond effectively when things change, to align your team to reach new goals and to realize the potential for your organization.
Imagine that you are a pilot flying a plane through the mountains at night. Without your instrumentation you are toast. Now imagine trying to drive a car down the road by only looking out the rear view mirror. Driving a business without budgeting and planning is about as effective. But a surprising percentage of CEOs are running their business without any form of budgeting, forecasting or planning. Or, they have some kind of budget based on what happened last year or based on totally made up hopes and dreams. In other words, not very useful.
My day job is working with CEOs of mostly small to medium sized businesses. I’ve worked with thousands over the years. Part of my routine is to look at the financials over time. They me a story. Taken together with the story of the business from the CEO I get a really good understanding of how the business has responded to change.
All businesses are exposed to changes in the economic and competitive landscape. Over the years I’ve noticed something very powerful that separates businesses that have thrived from those who have struggled or failed. Thriving businesses are the ones that respond quickly and effectively to change. The ones that struggled were the ones who were slow to react. They may have ended up doing the right thing, but the delay is what did the damage, and the damage of continuing to slowly react to changes accumulated over time, likely resulting in hundreds of thousands of dollars in lost profits. It’s hard to quantify because no one ever takes the time to go back and look at what might have been.
Budgeting, forecasting and business planning is not about looking into a crystal ball and predicting the future. It’s about a process of understanding your business, proliferating that understanding into your organization, developing goals that are aggressive yet achievable, building the capacity to achieve those goals and the agility to adapt quickly when things change.
This sounds complicated, but it doesn’t have to be. We’ve found that most business owners have at least an intuitive understanding of these things in their head. They just need a way to translate them into something quantifiable and actionable.
The first principle is to begin with the end in mind. Start with an idea of where you want the business to be in say five years. Think goals.These goals should be something that are aspirational, yet achievable and quantifiable. A good example is “I’d like to grow my revenue by an average of X% per year for the next 5 years”. This is where a spreadsheet will be handy. Spend some time looking at your historical financials and look at how costs have changed when revenues have changed. Put together a spreadsheet model that links your costs to changes in revenue. Some will be variable directly with revenue, others will change over time based on other metrics (such as the number of people you have). Having a good understanding of your cost structure is a good example of how business planning in itself is beneficial. Look at things like human capital needs. What is your revenue per employee? When do you need to hire an employee? When are you at your optimal efficiency in terms of overall human resource utilization? Do the same thing with capital equipment. Having a good understanding of when you need to buy a new truck, computer or piece of equipment as revenue grows is critical. Building a a good spreadsheet model that links all of this as you change your revenue growth is key.
All of this work should lead you to some kind of forward looking profit and loss statement. The best are ones that map directly to your existing accounting system’s chart of accounts. This is the listing of how your revenues and expenses are laid out when you pull an income statement. This linkage will be handy as you move forward in time, allowing you to compare actual results to your budget.
The next piece will be to build out your balance sheet. This is where you keep track of your assets and liabilities and how they tend to change with changes in revenue. Businesses tend to require more assets as they grow. There are also other important assets to track that have critical impacts on cash flow such as accounts receivable and inventory. Growing businesses almost always need ways of financing this growth– these are the liabilities and equity. Building out a balance sheet can be more complex. Even many degreed financial analysts struggle with this task. Suffice it to say, you absolutely need to understand how your mix of assets and liabilities change with changes in your growth and how all of that impacts cash flow. We have seen businesses literally grow their way into insolvency because they didn’t understand that growth requires assets and assets require cash. In the model, all of these elements are linked to the goal (revenue growth) either directly or indirectly.
The final leg of the stool is the statement of cash flows. It begins where your income statement left off– net income. It then tracks changes in your assets and liabilities and ends up at the change in cash balance (your cash flow).
In addition to these three major components, you likely will want to build out other tabs in your model. Remember, spreadsheet real estate is cheap. You might want to have a tab that helps you track headcount. When do you need to hire an additional customer service rep or manager? We often times build out a revenue model that helps you rationalize how you will achieve your growth and to model things like pricing or market share changes. You might have others that track your accounts receivable, inventory and loan balances.
Once you have this model built out, play around with it. Change the assumptions and check the outputs. Make sure it makes sense. Take some extra time to focus on and build out metrics that are important for your business. Every industry has them. They are key ratios such as revenue per sales rep, gross margin percentage, various measures of capacity utilization, etc. If you don’t already have these metrics, spend some time researching your industry to get them. Often times industry associations are great sources for these, but also useful for what those metrics should be in terms of benchmarking and best-in-class performance. How does your business stack up? How are these metrics changing over time and why?
Then, the next phase begins: start the process of taking what’s in your head (and your team’s head) and get it reflected in the model. Meet with your senior team to talk about goals. Lay out your vision. Get their inputs. Start a process of translating these goals into the model. Do it with them. The idea is that by going through this process, your team can begin to see the business like you see it. They understand the impacts of hiring new people and buying new equipment. All of you will get to a new level of understanding of the business. They know how the business must perform to justify those investments, and they know what each part of the business–including themselves– must do to achieve those goals. This can be a very powerful process of unlocking the potential of your business and getting the shared commitment from your team to get there.
Once you have the multi-year plan built out, take a more detailed look at the first year. Take that year and break it down into 12 months. Month one should be close to where you are now, and month twelve should be close to were you need to be at the beginning of year two. Again, take some time to make sure it makes sense (i.e. is achievable) and that your team is bought in because this will become your budget for the next twelve months.
Another incredible benefit of the model is the ability to align bonus compensation to the plan and use the model to structure it. You have the ability to create a bonus plan that achieves the twin imperatives of affordability for the company and powerful alignment of the team’s focus to your goals.
Once you have that built out and validated, then you can upload this into your accounting system. Then you can create monthly reporting that will allow you to compare actual to budget. This is why it pays to begin with the end in mind by building out your model based on your chart of accounts. Having this constant framework of comparing actual to budget is the critical link that allows you to constantly monitor where you are on track and off track with a high level of precision. It does require that you have solid accounting that is timely, accurate and relevant. But keep in mind, even a one percent variance on a $5M a year business is $50,000 per year in cash flow to the bottom line. That’s a lot of beans and is why an investment in solid accounting and business planning is probably the best investment you can make in your business.
Now you have the capability to provide yourself and your team with a truly seamless view of the business from the past to the present and into the future. You have a tool that is useful, not only once a year for setting your budget, but also to put into action when things change to help you and your team understand clearly what needs to happen quickly. This applies to both positive and negative impacts. Money is won and lost in the interval of time between impact and action. This is the power of the plan!
Allen Engstrom is Managing Director of CFO Network (www.cfonet.biz), specializing in providing outsourced accounting, consulting and business planning services to small and medium businesses of all types, both locally and nationwide. He can be reached at 501-823-2363 or firstname.lastname@example.org.