In essence:
As your business expands, you have probably been doing financial planning and analysis (FP&A) all along. The moment has come to formally define that role.
What comes first on the agenda? Think about the macro.
Use and improve your predictive model frequently once you’ve built one. Don’t be afraid to make mistakes since, if handled correctly, they can act as catalysts for your company’s overall improvement.
Financial planning and analysis (FP&A) used to be the term for the department within enterprise businesses that created the quarterly predictions required to satisfy outside investors.
Nevertheless, how have times changed? Today, the term “FP&A” refers to a practise that businesses of all sizes may and ought to use. In addition, when change happens at an unprecedented rate in the middle of the epidemic, FP&A is evolving into a more strategic role. No matter the size of your organisation, the management team needs assistance right now to comprehend how specific exogenous changes affect the firm on a quarterly, monthly, and even weekly basis.
FP&A groups at those large organisations were charged with immediate scenario planning to take into consideration the wide range of potential outcomes as the epidemic worsened in March.
According to our most recent study of CFOs, it continues to be one of their key areas of concentration.
You’ve probably been practising FP&A as an entrepreneur running your own business, even if it’s only playing out possibilities in your brain as the pandemic unfolds. Your company will be able to adapt to whatever happens next more rapidly if you institutionalise this financial planning and take some best practises from the big players.
Beginning with the macro
Most businesses prioritise their prospects above everything else, ignoring the competition and the macro environment in favour of sales promises and signals. Only when concerning indicators appear, such as the coronavirus, do finance professionals often pay attention to the macro environment.
Although reasonable, ignoring larger market conditions is a missed opportunity because, to put it simply, the economy and the state of your particular industry have an impact on your company’s future financial health, and this is especially true in the COVID-19 era. For instance, you can alter your strategy to avoid significant losses or to take advantage of anticipated profits by modelling the expected changes to your EBITDA(opens in new tab) if your sector were to rebound in six, twelve, or twenty-four months.
I’m not advocating that you immediately hire a macroeconomist (though making use of the ones that the U.S. Department of Commerce hires is a wise alternative). The macro should instead be included in your model as a driver. Determine the major trends that affect your industry. Not all firms are affected equally by a poor macroenvironment. For instance, numerous industries are seeing a boom in business due to the current pandemic:
Particular markets for residential real estate as loan rates decline and some buyers leave major cities sector for home improvement
Technologies for working from home, such as Zoom and DocuSign Alcohol producers as consumption rises (opens in new tab)
Here are a few possible pandemic repercussions to think about:
a surge in births brought on by months of nesting
a weak office space real estate market as businesses commit to permanent work from home
As a regular component of care, telemedicine
Determine the variable inputs
Financial planning’s goal is to present some potential future scenarios against which your financial plan will be adjusted, not to perfectly forecast the future. You may concentrate on the aspects of the business you can manage to react correctly once you have general macro-scenarios in place as drivers. Know the difference between your variable and fixed costs, and focus on the former. Variable costs are particularly susceptible to being impacted by changes in demand and new rivals.
The inputs that are subject to change based on industry, corporate, and macroeconomic conditions are known as variable inputs.
Consider any potential competitors who might enter the market or trigger changes in customer preferences when you analyse your industry (say with new improved products). Predict possible implications for their market share, pricing, accessibility to new clients, etc.
Understanding the business environment, or what your customers do, is also crucial: Consider that we are a distributor of food products. We are in a horrible position if we are sending vegetables to restaurants and hotels. Not too awful if we’re providing wheat and barley for beer.
The main determinant is certainly future increases in manpower for service organisations and perhaps raw materials for manufacturing businesses. Variable and essential workforce increases might be made from time to time in order to successfully run the firm. Put those in this category. If the growth trajectory is maintained, additional headcount expansions can be considered “good to have” and planned. Additions to the workforce should be categorised into one of three groups: essential, steady-state base case, or bullish scenario.
Consider any skills gaps as well, as they could turn a job from “good to have” to “must have,” especially if you adapt your strategy for the company to changing circumstances. For instance, your retail firm may require someone who comprehends ecommerce lot more now than it did last year, in late 2020.
Most expanding businesses need more staff in order to handle rising revenue. The majority of business estimates do, however, also take into account hires that would “be nice to have” in order to pursue supplementary prospects or support current workers. These hires ought to be marked as subject to a favourable business and economic environment. Contractors may step in to fill the gap in less certain times until demands are more obvious.
Find other variable inputs, such as a production facility or a technological investment, that you may change based on the situation. Set these investments in a higher priority so that you will be aware of the efforts to launch as soon as the macrotrends start to take shape. Alternately, you’ll be able to identify the ones that will be a wise use of money and can be implemented quickly if your industry and consequently revenue prospects increase. Moreover, start working now to determine what you’ll need to have on hand in order to, example, obtain a loan for such expansion.
Data Gathering
Even the strongest financial modellers struggle without reliable, up-to-date data. Business leaders need to be aware of and take into account inherent biases when gathering information, particularly sales estimates. Because to their inherent optimism, salespeople may lower their forecasts in proportion to the possibility of different firm growth scenarios.
In my experience as CFO, regular, consistent talks with the key internal players directly lead to the most accurate modelling. On the other hand, the data was seriously in danger of being outdated when I only met with important influencers once every three months. At a developing company, you are probably in close contact with your staff as a leader. Keep going.
When acquiring data for the financial modelling process, be thorough. I’ve seen that certain senior individuals have a tendency to see the large picture and pay less attention to the details because they may assign some day-to-day tasks to subordinates. Speak to those who may be junior but are keenly aware of the daily changes in customer and/or supplier behaviour in those situations, or if that “senior person” is you.
Determine the Important Business Drivers
For the top line, you should model two to three core business drivers or key performance indicators (KPIs). Drivers can always be added, but doing so increases complexity and creates a false impression of precision.
The typical drivers for software-as-a-service businesses (and really any subscription-based business) are churn and retention, which define lifetime value (LTV) as well as gross and net dollar retention rates. Production volume and sales volume are frequent factors for manufacturing businesses. Changes to the supply chain and product mix are typically made through distribution. The costs, the variety of your offers, and the number of skilled salesmen are frequently the primary determinants of professional services.
You must distinguish between variable and fixed costs on the cost side. The important variable costs can then be separated out and modified in accordance with your key revenue drivers. Headcount, marketing, travel and entertainment, and capital expenses can all be grouped together as generic categories for variable costs. Product manufacturers should include distribution and cost of items sold on the list.
Never Stop Predicting
Even though the data gathering phase of the process takes a lot of time, you can dynamically reproject to take shifting presumptions into account, such as a greater churn rate due to a price rise or fewer new customers due to a decline in travel. Forecasts should not be regarded as static data. Predictions should change as you evaluate and consider how accurate they were.
Which lines did your forecasts come true? Where did the forecasts diverge most from your predictions? It’s not about obtaining the answer right or wrong, my grammar school teacher used to say, it’s about the logic you used to get at your conclusion. The erroneous estimates will reveal much more about your company than any accurate ones.
An effective method to use is:
We discovered that our shipping and fulfilment expenses were drastically understated compared to our predictions when I was acting as an ecommerce company’s interim CFO. When a significant disparity is discovered, consult several sources with various perspectives. Was it a one-month or quarter abnormality that will be corrected in the next period, or was it something that needs more investigation.
We discovered a variety of things after polling members of the various groups: 1) Our fulfilment rates for direct shipments were too high and could be negotiated down when measured against those of similar businesses; and 2) a significant customer was overcharging us for shipping. We located the root of the problems and swiftly took appropriate measures.
People aren’t particularly good at making predictions, whether they’re about the state of the economy or the results of sporting events (notice the stunning, glitzy casinos). Paul Samuelson made the joke that nine out of the past five recessions were foreseen by economists. But that does not imply that forecasting is a foolish endeavour.
The secret is to regularly evaluate your accomplishments and, more crucially, your mistakes and the reasons behind them. Iterative predictive models should be continuously improved to better precisely reflect how internal and external events affect your company.
The Goal of FP&A for a Growing Company
The major area of concentration after building a strong predictive model should be cash flow. Determine your company’s runway based on monthly cash flow and the available cash and debt facilities. Consider carefully examining the variable expenses by priority level if, in certain circumstances, the cash flow isn’t as strong as you’d like it to be.
If things go wrong, choose a specific future date (preferably within a month) as the period when you will postpone lower-priority expenses. Make a note of any income or profitability goals that, if attained in a predetermined timeframe, entail the implementation of specific priority decisions. The largest decisions for the future usually entail hiring new employees, many of whom will decide the growth for the following year. Connect these recruiting choices to achieving those crucial objectives; otherwise, you’ll be adding costs to a base that isn’t operating at its best. Decisions will then be supported by reliable financial information.
The decision-making process at your firm must consider The Bottom Line FP&A. Go out and make blunders if you haven’t already practised it. Spend the most time analysing the discrepancy between your estimates and actuals because it contains some business-related insights. The quote “Mistakes are the doors of discovery” by James Joyce is well known.