Startups need plans. Without plans, they are mere ideas and distant wishes. Financial planning is the quantification of those plans. You would simulate those plans to see what expenses you will make, how much revenue you will earn, and what strategic objectives you will achieve over a specified period.
Financial planning is challenging for all startups. Funding is usually quite hard for entrepreneurs who are starting from scratch. Furthermore, big banks want a long, proven track record of growth before approving loans. Startups typically don't have that kind of documentation.
However, as a business owner, you must understand that your business can't grow without the financing it needs to fund growth opportunities.
Creating a sound financial plan is no small task by any means. That is where financial planning comes in. Financial planning helps startups manage their current financial needs and reach their long-term financial goals. Many founders and entrepreneurs struggle with these types of financial numbers and reports. Over 82% of startups fail due to poor cash flow visibility and management.
Many startups make the mistake of writing poor financial reports that fail to back up their claims of success. Unsurprisingly, investors don't believe in businesses that don't understand their numbers.
It is clear today to investors and entrepreneurs that making these financial statements is an irreplaceable task. Even though it's a painful and time-consuming process, you cannot secure a sustainable financial future without a solid financial plan.
So, how can you know your numbers quickly, and how can financial planning enhance your startup? Read the full article for a better understanding of the topic.
What is startup financial planning?
Startup financial planning is the process of outlining your business. When you prepare a financial plan, you project expenses and revenues and outline your annual growth strategies. A financial plan is not just a pictorial representation of your business workflow with graphs and charts. Financial planning entails all financial activities with real numbers.
With a financial plan at your table, you can study your business's payback period. You know what efforts you need to achieve your goals. Financial planning outlines your current financial status and predicts your future financial position over a timeline based on assumptions(values). These assumptions do not come from anywhere but are based on historical performance and industry research.
We assume that you know the financial statements we require to determine the financial status of a company. For a quick reminder, these are the Balance Sheet, the Cash Flow Sheet, and the Profit and Loss (P&L) Statement.
Profit and Loss (P&L) statement figures out your revenue (top-line) and net income (baseline). The balance sheet studies the assets and liabilities of a company. The cash flow sheet determines how much cash flows in and out.
Whether you are a startup or an already-in-market business, there are seven components for you to study and make projections about for financial planning. These are pretty much the same as components in the basic financial statements.
For a good plan, we need accurate financial projections based on assumptions for different scenarios. Before that, let us study why a financial plan is essential.
Why is a financial plan vital?
A good financial plan will make you optimize your revenues and expenses. A financial plan lets you deal with the different scenarios that emerge during the process. You are well prepared to cope with the challenges and negative scenarios when you have foreseen them.
During the financial planning process, you must brainstorm and think critically.
For example, with company growth, the expenses could grow. You may hire many customer support reps if your customer base has grown exponentially.
A good financial plan covers all aspects of your business and ensures you are always up and running. All of the assumptions are tied to actions and events. Say you plan for churn based on the fact that you will increase pricing.
On top of that, startups need funds to carry out their business plan. Have you ever thought about what statements would entice investors to invest in your startup? These are, of course, financial models. The investors understand the language of numbers. A good financial plan will attract the funds and loans for your startup.
Seven components of a financial plan
Preparing a financial plan is a laborious task. Most entrepreneurs and founders try to cut corners and bypass financial planning. They often find themselves in trouble as they lack a roadmap to follow. They are also unable to show numbers to venture capitalists and thus fail to attract any investment in their business.
Profit and loss statement
The profit and loss statement figures out your top line and bottom line. The top line is the total revenue, and the bottom line is the net income. The money your business makes is reported in the top-line/revenue metric. We then subtract expenses, taxes, and interest payments from revenue to estimate the bottom line (net income).
Businesses prepare their profit and loss statements yearly when they file tax returns. Similarly, you need to project your top line and bottom line for a financial plan. Suppose you make a financial plan for five years. You will project your revenue, cost of sold goods, sales and marketing expenses, operating expenses, taxes, interest payments, and net income on a timeline of 5 years.
You may ask why it is crucial to project operating income in a financial when we have already projected net income in the P&L statement. There's a difference. Operating income shows the profitability of the core business operations of a company.
Suppose you have a textile company. Your company has recently made some big bucks on its real estate investment. That revenue will not relate to the core business operations of your company. Thus, it will be non-operating revenue. There are also some non-operating expenses for a business. They are typically tax and interest payments.
Sometimes, we need to distinguish between net income and operating income to know the profitability of the core operations of a business.
Operating Income = Net income - Non-Operating Revenue - Taxes - Interest
Please do not confuse operating income with EBIT(earnings before interest and taxes). Operating income can, however, be the same as EBIT if your company collects no non-operating revenue.
Net income, also referred to as the bottom line, is a company's net earnings. The calculation of net income is simple. You subtract the cost of sold goods, sales and marketing expenses, general expenses, and taxes/interest from sales to calculate net income.
Cash Flow Statement
This financial model shows how much cash flows in and out. It also details where the cash goes (where it is spent) and where it comes from ( the source of cash). A cash flow statement also indicates whether your cash flow is positive or negative. You need to estimate and project cash flow for your startup financial planning.
The balance sheet is one of the basic financial statements. Assets, liabilities, and equity are recorded in a balance sheet. Assets are the economic resources your company owns. Equity is shareholders' money. It is the sum of shareholder investments plus the reserves accumulated over time.
Assets = Liabilities + Equity
This equation must hold true all time. If this doesn't, you need to revise your accounts. And for a financial plan, project your assets, liabilities, and equity.
Sales and revenue projections
You need to project your sales for a financial plan. This is the most crucial part of a financial plan as all rest on it. Do not rush when you have to assume values for your financial modeling. Do market research, observe trends, and make realistic assumptions. We will soon discuss how to make assumptions and a sound financial plan.
It is the section where we study the payback period for a business. All founders and entrepreneurs want to know when they are going to break even and enter into a profitability area. For a financial plan, we estimate and project the payback period.
How to make a financial plan?
To understand your numbers, they should be split into three parts. Hindsight. Insight. Foresight. Hindsight is the bookkeeping part. These are the audited financials, and it's all the company's financial histories. Insight knows what the drivers of your business are. Foresight encompasses the models that you have to create when you're looking to fundraise or get a loan or any kind of financing. Foresight, simply put, is about predicting the future of your business.
These three parts must fit seamlessly to show an attractive financial plan to investors. However, many startups try to put these parts together manually. Still, it never works since it doesn't link up very well. Overall, it just doesn't tell a coherent story that an investor would buy.
So why is hindsight so critical? Businesses should always learn from the past, improve, and adjust their strategies. We can't learn from the past if we don't know the past. And if we don't keep a record of these numbers– no one learns. These days, most people outsource their bookkeeping to third parties. Most people want to put in the slightest effort to pass the audit or do their taxes. Often, this leaves decision-makers in the dark when it comes to knowing critical financial insights.
While these granular accounts related to taxes and bookkeeping may not seem important, founders can use these accounts to see the margin by different products and overheads broken down into different categories. So by having founders dictate their own bookkeeping, founders know and understand how much they are putting into other aspects of their companies.
Insight is the numbers on startups' reporting dashboards, objectives, and key results. It's essential to know what the critical financial levers (Investor Reporting, Dashboards, KPI/OKR/Target) are when you pitch to an investor. It is essential to focus on what a startup is strong on rather than bring up everything as if it's all great. It's unrealistic. If a startup doesn't have much revenue but great margins and growth, that should be the focus when presenting to investors.
Many of the negatives can be explained away, but there has to be a plan to improve some of these numbers in the future. This is especially important for software companies that lose much money in the beginning but need to explain to investors how to turn it around. These insights vary between company and industry but are crucial to any startup.
Many founders make 5-year financial models and never look at them again. The problem is when investors ask them to build quarterly or annual financial reports. It doesn't tie in with the 5-year model. There are also issues with cash flow management, where 5-year models are not updated and are very difficult to use or prove to the investors as changes are constant.
Furthermore, the runway calculations that most people use are generally the amount of money a company has divided by its burn rate. This can go very, very wrong. Usually, when the burn rate increases, the runway shortens much quicker than expected, catching many founders out.
So when founders meet with venture capitalists who like the company's vision and mission but suddenly pull out after seeing the finances, there is usually something in there that makes them anxious. However, this issue can be easily solved through good financial planning. If a startup does have excellent financial planning, it could be the push they need to acquire funding and raise capital. Some founders even stated that almost all the firms that agreed to meet with them about financial planning made an investment or an offer. This proves the importance of a sound financial plan.
Valuable tips for effective financial planning
Startup financial planning is by no means a straightforward task. It is complex and intricate. Here are some tips that you will find helpful while planning for your startup.
Visualize multiple scenarios
You cannot enter the arena with a sole Plan A. You need to have backup plans with you. For efficient financial planning, you need to create multiple plans. You can only cope with the challenges you have foreseen and prepared for. Plan and prepare for, as victory loves preparation.
Ideally, it would help if you had a baseline, upside, and downside plan. The baseline plan assumes that your business will remain steady. The upside plan is for the best-case scenario. You assume that you will acquire new customers, your revenues will grow, and expenses will remain flat. And the downside plan is for the worst-case scenario. You assume that your revenues will contract and expenses will expand.
SaaS companies may assume growth in revenue for a new marketing campaign. But the numbers must be tied to events. For example, for a SaaS company, you can assume churn for the increase in pricing.
The sooner you realize your expenses won't remain flat, the better. For example, you own a SaaS company and have acquired hosting services from a third party. You would account for the increase in hosting prices in your financial plan.
An increase in expenses is not necessarily a bad thing. You may observe an increase in expenses with company growth. There has been an increase in demand, and you plan to capitalize on that. For example, you may plan to hire personnel for the night shift in your shoe manufacturing company. The expenses would undoubtedly grow to put a whole new shift in place.
Know the key drivers of your business
A startup's financial plan entails all the key elements and revenue drivers. You must know what the key drivers of your business are. It would be best to determine what (google ads, Facebook ads, salespeople, sponsored newsletters, events) brings you business and quantify that. For example, you can easily account for what you spent on google ads, how many customers they brought to you, and what number you will collect as a result.
For financial planning, you need to single out your key drivers. You can then project expenses and revenue associated with them. Revenue doesn't grow on its own. There are always certain key drivers to your business.
Get feedback from stakeholders.
Share your plan with stakeholders. We recommend that you share your financial plan with co-founders, team leaders, and other stakeholders and have feedback from them. For example, your marketing team manager could know the optimization of marketing costs better than you.
Review your financial plan regularly.
Financial planning is continuous. Financial planning and financial analysis go hand in hand. You can't simply switch your planning off and on. To give your business the best chance of success, you need to make continuous adjustments to your plan based on your financial performance and other factors affecting your operations.