HOW TO DEVELOP BELIEVABLE FINANCIAL DATA
In my work over the past 11 years with SCORE, Hagerstown, I have constantly been asked for help developing financial information for inclusion in a Business Plan. This seems to be a major stumbling block for many entrepreneurs who otherwise may have a workable plan, but without financial data funding sources are simply not interested.
And with good reason. How can you lend money to a startup business and have no idea how and when it can be paid back? Even when financial data, such as often happens when sales and expenses are included in the Business Plan, they are mostly guesswork, and usually follow the pattern of a few losing years, followed by steady growth and profits from then on.
In this short paper I want to cover the basics of developing a financial plan as an integral and believable part of the overall Business Plan. I will do so in terms of several concepts: 1) Financial data must be constructed both on a top down and bottom up basis, 2) Revenue and associated costs must be based upon research, not guesswork, 3) The basic tool of financial analysis is the cash flow statement, and 4) Assumptions about market acceptance, cost figures and company performance must be documented and reviewed on a regular basis.
ITEM 1 – FINANCIAL DATA ON BOTH A TOP DOWN AND BOTTOM UP BASIS
Top down financial data is represented by total revenue and associated costs. But totals are made up of individual transactions over time, and can only be evaluated from the bottom up. Bottom up revenues are individual sales to customers. Bottom up costs are payments for labor, materials, and overhead as individual products (and or services) are produced and sold. The planner, business executive, and funding source can only rely upon the bottom up data in terms of its validity. Knowing how many individual sales are projected, and what level of associated costs are being planned for is the best way to develop a workable financial plan, and even then it is the product of projection and estimation, not reality. Until after the fact, that is.
ITEM 2 – REVENUE AND COST ESTIMATES BASED UPON RESEARCH
In this context I am reminded of an episode on ‘Shark Tank’ (the television program in which entrepreneurs present their business idea to a panel of potential investors seeking their commitment to provide financing) in which an idea was presented and an investor asked how many of the prototype products had been sold in the past year. The answer was something like 12. And the entrepreneur was seeking several hundred thousand dollars for a small percentage of equity in the firm. The panel rejected the request unanimously. How could real world experience of a tiny fraction of projected sales indicate how well customers might receive the product? Research is needed to develop information on interest in the product from likely buyers, and also the capacity of the organization to produce, sell, and service customer orders. Or, in other words, costs.
ITEM 3 – THE BASIC TOOL OF FINANCE IS THE CASH FLOW PROJECTION
When results are tabulated, the net inflow of cash determines business survival. No firm can operate continuously burning through more cash than it takes in. And the best way to both predict and manage the firm’s solvency (ability to function financially) is by developing and monitoring a cash flow projection. In advance of the action, a projection should be the guide to financial operations. During the action, a cash flow statement should be used to monitor both the present and likely future cash position. After the action, cash flow analysis compares the projection with the actual results to determine both our current performance and future needs versus availabilities (of cash). The statement is made up of beginning cash balance, projected revenue or other inflow (such as loans) and projected outflow. At the end of each reporting period (typically a month) the final figure is the net cash balance, which is carried over as the starting figure for the next period. Analysis looks at every aspect of both revenue and cost to determine how the cash situation can be improved and how appropriate action can be taken to maximize liquidity (the availability of cash to pay operating expenses).
ITEM 4 – ASSUMPTION DOCUMENTATION, ALL REVENUE AND EXPENSE
Every organization operates with a set of assumptions about customer acceptance, future orders, present and future costs, and the expected level of profits and/or losses. These assumptions must be reviewed from both a top down and bottom up approach. On the revenue (inflow) side, availability of loans, level of customer orders, and customer satisfaction is assumed in advance and worked out in practice. Serious deviations from the firm’s assumptions must be carefully investigated and corrected if negative, while being maintained if positive. Similarly assumed levels of expense (outflow), for materials, labor and overhead must be verified and appropriate adjustments made in operations if cost levels are higher then assumed (a negative result). And if those cost elements are lower than assumed, they could be used to lower sales prices to attract more business while maintaining profit margins. All of the above must be documented and reviewed regularly.
Financial data is an all important element of a sound Business Plan. Yet financial estimates made purely on the basis of guesswork can only lead to disgruntled investors and/or banks so it so important to create believable (before the fact) and verifiable (after the fact) financial reports. Using the 4 item checklist presented above can help an entrepreneur do just that.
Working with a SCORE mentor can help you create the financial future you are seeking. Contact SCORE today!