What are the basic steps to improve your company’s financial planning and analysis function? This blog post will explore four key areas to focus on to get more accurate projections and perform more meaningful analyses.
Understand Your Financial Statements
Understand your income statement, cash flow statement, and balance sheet. What are the most important and most impactful drivers of revenues and expenses? What factors will increase revenues, and what does the cost structure (variable v. fixed costs) look like?
Analyze the relationships between those drivers and other metrics on your financial statements to understand how changes in one variable affect others. For instance, what is the relationship between sales growth and an increase in monthly burn?
Build a model to represent how those relationships work and understand the triggers that could cause changes in certain key drivers. For instance, what would be the impact on costs and related gross margin or operating if sales growth was 20% in the next quarter?
Make Assumptions (and how to make better assumptions) For Your Model
Make better assumptions by addressing external factors, which haven’t historically gotten enough consideration but often have a lot more impact than we give them credit for. Covid and its aftermath is the perfect example, but obviously couldn’t be predicted. Smaller-scale external events can still move the needle; such as actions of competitors, changes within the industry, or even macro events like presidential elections should be considered in your financial planning and analysis.
Refine your assumptions by deepening your understanding of your business’s competitive position. This can add significant value to your models because you have a framework to understand how your business fits in the industry (and also what strategies might be most effective for your business). One framework is to assess how the Five Competitive Forces by Michael Porter impact your business:
- Barriers to Entry: What keeps other companies from entering the industry and competing? For smartphone makers, it costs a lot of billions of R&D dollars annually to stay competitive, restricting new smaller entrants. Facebook has massive network effects, limiting ability of new entrants to gain momentum. What does your industry look like as a whole? If there are high barriers you have less to worry about new entrants, and conversely if there are limited barriers there’s always a threat of new competition to worry about.
- Leverage of Customers: Low volume-high dollar customers can make you susceptible to changes in customer behavior. If you only have a few customers, each one matters more. What drives customer behavior? Get to know your customers better because they have a disproportionate effect on your business. Any forecasting should at least consider whether there are any meaningful data points to suggest change with major customers.
- Leverage of Suppliers: Just as a concentration of customers can be a risk, a concentration of suppliers can be a risk. If you make a product and need a part that only one supplier produces, that vendor has significant leverage over you. It can also be a source of labor with a certain technical expertise that is in very limited supply. Even if it is just passing on inflationary costs, you don’t have much choice. Accordingly it is prudent to focus some energy to have a strong idea of what’s going on with those vendors when making assumptions about the future for your forecasts.
- Competition in the Industry: What does the composition of your industry look like? Industries with a large number of similar competitors (such as CPA firms) have a high levels of competition because customers can easily switch providers. Other industries (like internet search) are less competitive because it is more difficult to find alternatives. Where do you fit in, for most small businesses you won’t have any meaningful market share unless you are in a VERY niche market. So it is likely you are in a highly competitive situation and need to plan accordingly.
- Substitutes: Substitutes are not directly competing like Coke and Pepsi but provide more indirect competition such as tea and coffee. While not the same product customers can substitute one for the other, and could be considered part of the same addressable market for your business. Starbucks might be able to market to tea drinkers to switch to coffee for growth. If you’re a smaller tea company developing your budgets and forecasts you need to consider whether Starbuck’s new campaign will hurt sales. If you own a gym, Dick’s sporting goods might be a competitor for those people who decided to make a home gym after Covid.
Having a comprehensive understanding of how your business fits in the industry and what its competitive factors are is really important to make assumptions in a budget or forecasting model for your financial planning and analysis. You will better be able to focus your attention on what factors really are impactful and spend most of your energy honing assumptions on those factors.
Create a Projection for the Next 12 Months for Your Financial Planning and Analysis
Use the model and assumptions you created to build a forward-looking projection for your financial planning and analysis. Make sure to include other members of the executive team to get a balanced perspective for your assumptions. Don’t just copy the previous year as you won’t be able to account for unexpected developments in the future. Consider what risks could have a meaningful impact on your assumptions.
Identify factors that have the most importance, approach them with the Pareto principle in mind (90% of the impact/effect is predicated on 10% of the effort/cause). This gets the most bang for the buck with your energy. This is called sensitivity analysis where you determine what will have the largest impact based on changes in which assumptions. Here’s a quick hint: while there will be more drivers, assumptions for revenues and costs of goods sold are always two of the most important. For service-based businesses, labor and fringe are your biggest costs and should be your primary focus on the cost side. For product businesses, it is the cost of your product but labor costs will still be necessary to focus on. Assess the range of possibilities for key assumptions to determine what variables are most important.
Develop an estimate for each assumption along with a confidence level and make sure to be realistic rather than aspirational. Generating multiple scenarios with different confidence levels will allow you to integrate multiple scenarios into a final holistic projection.
Use this projection as a benchmark when reviewing interim and annual going forward. This will help identify and highlight opportunities to improve on your plan as you go.
Track Revenues, Expenses, and Key Performance Indicators
Based on the projections you generated, develop the key performance indicators that drive the main assumptions you had. These should be both financial and operational, both quantitative and qualitative.
Be aggressive with your planning timeline: don’t wait until month end to pull data together for an analysis of what happened during the period! Do this as early as possible to have enough time to make updates and take action.
Track the actual results against your projections. Your planning process should be dynamic and iterative: every time there is a milestone achieved or an event occurs, adjust the assumptions accordingly so that your projections are always up to date. Save separate copies of the original and each iteration to review in a post mortem, so you can learn from it and improve on future projections.
Analysis should include comparison within your business between periods as well as benchmarking against competitors and companies in your industry sector.
Manage Your Key Performance Indicators and Metrics for Your Financial Planning and Analysis
Determine how your key performance indicators will be best measured (qualitatively or quantitatively), what the target is, when it should be reported on, and who has ownership of each metric.
Measure the performance of each key performance indicator along with its drivers. This will allow you to drill down into specific aspects that are impacting overall results and determine what if any corrective actions to take. Being able to explain the drivers will enable you to build consensus. When necessary update the assumptions in your models, but first and foremost provide decision support for management when action needs to be taken.
In conclusion, financial planning and analysis isn’t a one-off activity. It should be an ongoing process that is iterative in nature: it starts with building assumptions, measuring and tracking performance, then updates them as new information becomes available. Doing it well will add significant value, provide a deeper understanding of the business, and allow for better visibility into the future.
