We know that building a financial plan can be a daunting task for entrepreneurs who don’t have financial backgrounds though. The good news is that there are specific areas you need to look at, and most of your financial plan is simply ensuring that your costs don’t outweigh your profits.
Here’s how you do it.
Build your financial plan
While your financial plan covers multiple different areas in your business, your core goal is to create a budget, forecast what your sales will be, and then compare them to each other to determine if your business will make money – or lose money.
1.Create your budget
An expense budget is a tool (usually in an excel spreadsheet) that helps you to determine your cost of sales, in other words how much you need to spend to deliver your final product or service to your customer.
- When you create your budget, you are planning what you will spend based on known figures, from what your monthly rental is and how much you spend on salaries, to how much you think you will spend on your utilities bill.
- Because you have this plan in place, you can then compare it to your actual costs each month to see if you are on track.
- If your expenses are higher than expected, you will not only very quickly recognise that there is a problem, but be able to address the problem before your costs spiral out of control.
Budgets are split into fixed costs and variable costs.
Fixed costs are any costs that do not change on a month-by-month basis. Examples include salaries, rental agreements, insurance and so on.
Variable costs do change, and should be tracked carefully. Your toner bill, mobile phone contracts, raw material costs, utilities including water and lights and even the tea and coffee bill are based on usage. These are costs that can creep up if they aren’t monitored, and should be carefully tracked.
To get started, list all of the expenses associated with running your office and producing and delivering your product or service. Every line item should be taken into account.
You can’t compare your revenue to your costs to determine if you’re making a profit (or when you will make a profit) if you aren’t tracking your expenses.
Key questions to consider:
- What are your fixed monthly expenses?
- What are your variable monthly expenses?
- How will you determine how much you can spend on fixed and variable expenses each month?
- Have you listed everything, calculated it, and can you compare it to your revenue projections?
2. Create projections
Projections are concerned with how much revenue you will bring in based on a number of factors, including how many customers you are targeting, how many sales people are in the field, your marketing efforts and the size of your market.
You’re making high-level assumptions or estimates based on past trends, your industry knowledge and your sales and marketing efforts.
While these are just assumptions, they’re extremely important when compared to your budget.
For example, if your budget comes to $20 000 per month on fixed and variable expenses, but your projections show that you will most likely only make $15 000 in sales, your start-up will be running at a loss.
While it’s expected that you will run at a loss from anywhere between six months and 18 months, at some point your business will need to breakeven and then start making a profit.
Projections help you to determine when this will be, and importantly, if you need to cut costs to make the entire model work.
Your sales forecast is an integral part of your projections.
Key questions to consider:
- How many customers do you think you’ll have?
- How much will you charge them?
- How often will they pay you?
- What will you sell each product or service for?
- How many units do you need to sell to breakeven?
3. Build your 12-month cash flow statement
Cash flow is the money running through your business. It isn’t invoices sent or deals won – its money that has been paid into your bank account, and money that has left your bank account to pay suppliers.
Cash flow is often referred to as the lifeblood of a business, and this is why – without it, you can have all the signed deals in the world, but you still won’t be able to pay your bills.
So, what is a cash flow statement? It tracks when you will be paid versus when you need to pay suppliers. These columns need to balance – you need to have the money in hand before you’re able to pay suppliers.
- If your suppliers expect payment on 30 days but most of your clients only pay you on 45 or 60 days, you will pick up this problem in your cash flow statement.
- You will also be able to pick up if you’re overspending based on poor cash flow, or if you have money to invest in growth based on strong, positive cash flows.
It should also be monthly, quarterly and for 12-months, to track seasonal shifts as well as when you might run into some problems – something you want to know long before it happens so that you can prepare yourself, approach a bank or cut costs or increase sales.
Key questions to consider:
- Have you kept your payment terms as short as possible with customers, while asking suppliers for extended credit terms?
- Do you know exactly who owes you money, how much they owe you and when they’re due to pay you?
- Do you know what your cash balance is at the end of each month?
Your profit margin is how you can measure whether your business is making money after all of your costs and expenses have been subtracted from your revenues, or income.
There are four different types of profit margins, gross profit, operating profit, pre-tax profit and net profit, but the most commonly referred to is net profit, which is calculated when you divide your net income by your revenue.
In general terms, net profit refers to a company’s bottom line after all other expenses, including taxes, have been removed from revenue.
Net income is calculated as sales less the cost of goods sold. You then divide your net income by your revenue (all the money your company brought in) over a set period of time.
This percentage is your net profit margin. Always expressed as a percentage, profit margin specifies how many cents of profit the business has generated for each dollar of sale.
Why is it important?
Profit margins are used by creditors, investors, and businesses themselves as indicators of a company’s financial health, management’s skill, and growth potential.
Stress test your figures
A stress test is how something works in the real world when it’s under pressure. Using your financials as an example, stress testing will involve considering all the ways that your carefully built budget and projections will come under pressure once your business is operational.
Your goal is threefold:
- To figure out where there might be potential problems that will increase costs, lower revenue or both
- To increase your revenue
- To lower your costs
The point of a stress-test is to help you see where your business is weakest before it’s really in trouble. This provides you with an excellent opportunity to fix those problems before they do real damage.
Make a copy of your financials and do this exercise:
- Increase your costs by 10% and then 20%. How does this impact your revenue model and your profit margin? Is your business still sustainable if your costs were increased by either of these percentages?
- Where could your costs potentially increase?
- Are there any areas where you might have missed hidden costs?
- Complete this exercise looking for areas where hidden costs will emerge – you want to create the worst-case scenario in a stress test.
Next, look at your revenue:
- What would happen if your projections were 10% higher than your actual revenue?
- Lower your projections by 10% and then 20%. How does this impact your profit margins if your costs remain the same?
- Run an exercise where customers on 30-day payment terms only pay on 45 days and on 60 days. What happens to your revenue model if everyone pays late? What happens if only 50% pay late?
Based on these exercises, you will be able to determine how tight your margins are. If a 10% increase in costs or a 10% decrease in revenue erodes your profit margins, it’s a good idea to relook your costs and revenues.
Where can you trim costs? Where could you potentially increase revenues? Treat this exercise as a must have, rather than a nice to have.
If you absolutely had to trim a bit away from the costs column and add to the revenue column, how would you do it?
Get your pricing right
After you’ve completed your stress-test exercise, you should have a good indication of whether or not your financials are healthy. Are you making enough money based on how much it’s costing you to deliver your product or service?
A key consideration here is your pricing:
- If your prices are too low, you might not be viewed as a quality option by your customers – this can negatively impact your sales
- Prices that are too low could also impact your cost base and prevent you from making a profit
- If your prices are too high, you could also negatively impact sales – your customers will know what they believe is a reasonable price for what you’re offering.
To get your pricing right, there are two key areas you need to focus on:
- What is the market’s appetite for what you’re offering? What do your customers consider to be a good price?
- You don’t want to under-price yourself or over-price yourself, so market research is important.
- If you know your price is right but customers are viewing it as too high, consider your messaging – are you adequately explaining the value you offer?
- Are your pricing and cost-base aligned?
- If you need to push your prices up too high to cover your costs, either you don’t have a viable business model, or you need to find areas where you can trim costs to make the model work.
Mistakes to avoid
There are many areas where businesses go wrong when it comes to their financials. This is a complicated area in your business, and having a good book-keeper, accountant and eventually a great financial manager is a good idea – and the sooner the better.
Here are a few other key mistakes that business owners make – but which you can avoid if you’re looking out for them.
Don’t keep hoping cash flow will get better without your intervention. If you’ve had a bad month and the numbers aren’t balancing, interrogate why. Are your sales too low, or are your costs too high?
Don’t invest in good financial management too late. Successful business owners will usually offer the same advice – the moment they invested in a good financial manager or even financial director is when the business trajectory improved. Great financial managers cost more, but what they save the business in terms of sound financial decision-making is so much more. It’s an investment worth making.
When it comes to your financials, don’t make assumptions. As a start-up, there’s some guesswork in your projections, but the moment you start operating you have real figures to work with. Learn to watch your numbers, review your books weekly and interrogate every line item. The more familiar you are with your numbers, the more you’ll understand your business – and the healthier (and more successful) your company will be.