Your Financial Plan Has Superpowers You Didn’t Know About
5 ways to leverage your financial plan for success
Product is sexy; customer acquisition is exciting; financial planning is dull and dreaded. I believe this is a big part of why young businesses fail.
Ignoring the guidance you can get from your financial plan is like descending into the proverbial ‘valley of death’ barehanded and led by your gut. While it is tempting to act like a superhero who doesn’t need any help, chances are you will soon find your cape tangled up in the brambles.
If you pay close attention to your financial plan, however, you are bound to unlock some real insights that could drastically improve your company’s chances of success.
There are countless ways a solid financial plan can help your business survive and thrive. Five of them are worth calling out explicitly because they help you deal with some of the most critical challenges you will face on your entrepreneurial journey.
1) Manage Your Cash
While the long-term health of your business should be top of mind whenever possible, it’s important to never lose sight of a key short-term factor — your cash runway. No matter how inspiring your long-term plan looks, you’ll never get there if the business runs out of cash!
The first job of a financial plan is to estimate your cash runway, which will show you how many months, weeks, or days (yes, it happens) of cash you have left at the bank.
The cash runway is a function of two variables: current cash balance and projected ‘cash burn’ (the net of your cash inflows and outflows). When the cash burn reduces your projected cash balance to zero, this marks the end of your runway.
Cash Runway (months) = Cash Balance / Monthly Cash Burn
An up-to-date financial plan can act as an early-warning system that helps your business avoid running out of cash. Knowing your projected cash balance, and specifically the projected shortfall at a certain point in time, will allow you to work out when and how much new funding is needed to keep your business going and to hit your next milestones.
It will also help you determine what cash savings may be required to bridge you to the point when new funding comes in. If supplier or creditor payments need to be delayed, or if you face the extremely difficult scenario of having to postpone payroll, sufficient advance notice and time to discuss the situation with stakeholders may prove vital.
It seems that for most entrepreneurs the advantages of financial planning start and end here, and we haven’t even gotten to the fun part yet!
2) Set a Path to Profitability
Neither you nor your investors want to support a business that will never manage to cover its costs. So once your immediate cash needs are sorted, you really need to turn your attention to profitability.
Turning profitable technically happens in an instant but is usually the result of years of careful planning and execution (about 3 years for a new product business according to the Entrepreneur magazine). It all starts by putting your business on a path to profitability.
This path rests upon three pillars of your financial plan — Unit Economics, Sales Volume, and the Fixed Cost Base.
Unit Economics
Unit Economics is about each individual sale’s contribution to profitability. This takes into account the unit price or revenue and all variable costs that result from a sale, such as the cost of goods sold, direct sales and marketing, distribution, installation, customer service, and others.
Unit Contribution = Unit Price — Unit Variable Costs
A path to corporate profitability is only possible when unit profitability is present; in other words, when Unit Contribution > 0. But how much contribution per unit exactly is required? To determine this, you need to look at the other two pillars first.
Sales Volume
The Sales Volume will depend on the size of the addressable market and the share of that market your business could capture and sustain over time. Key determinants of your market share are how competitive your pricing is and your overall value proposition relative to other market players.
As you may recall from Economics 101, a higher price typically leads to lower market demand and a lower market share. Therefore, while a higher price will increase your Unit Contribution, it will also result in a lower Sales Volume, and vice versa.
The goal is to find a point of balance — a Unit Price that both ensures positive Unit Contribution and a competitive market positioning, leading to a healthy Sales Volume and scale of operations over time. (If such a price doesn’t exist for your product, you may have to overhaul your variable cost structure or consider pivoting towards a different product altogether.)
Assuming you can find such a price point, you can then work out your total Annual Variable Contribution as follows.
Annual Variable Contribution = Unit Contribution * Annual Sales Volume
The last step is to compare your Annual Variable Contribution and Fixed Cost Base over time.
Fixed Cost Base
The Fixed Cost Base is effectively the aggregate of all costs not captured within the Unit Economics. These are costs that would exist whether or not a new sale is made. While not completely fixed, they are certainly more sticky than variable costs, and comprise things such as staff compensation, professional services, R&D, rent, utilities, and others.
Fixed costs provide the underlying infrastructure necessary to run your business. Consequently, your first concern here should be to check whether you are making adequate investments in fixed costs, particularly staffing, to enable your team to realize the sales volumes and capture the market share you are targeting.
In the end, you want to ensure that your projected Annual Variable Contribution grows sufficiently over time to surpass your Fixed Cost Base and achieve ‘break-even’ or profitability. Only at the point of break-even would you have proven the business model and its ability to generate shareholder returns. Therefore, demonstrating the business can get there is a key part of the narrative for propsective investors.
Profitability = Annual Variable Contribution > Fixed Cost Base
It may require multiple rounds of iteration on your Unit Prices, Sales Volumes, and Fixed Costs until you find a combination that results in a steady and believable path to profitability. But once you have, your way forward (and out of the valley) should be clear as day.
3) Select the Right Capital Partners
Having identified a path to profitability, it may be a good time to ask yourself whether you and your investors are happy to walk down this same path together.
Suppose your financial plan projects that the business will break even 3 years after the start of operations. Is this too slow, too fast, or about right? The answer is: it depends on your investors and their required rate of return.
It is difficult to overstate how critical it is to partner with the right investors while funding your business, but especially when you come to your larger rounds (typically Series C and beyond) and/or when you may need to give up majority control.
Your investors are not just a source of capital; they are also advisors, co-decision makers, and ultimately the people you will be stuck with in the trenches, fighting shoulder to shoulder to help your business succeed.
There are multiple criteria to apply in your selection of capital partners, but arguably the most important is alignment between the return required by the investors and the return your business can reasonably deliver. Without this, the investor-investee relationship is destined to fail.
The return required by investors is mainly driven by the riskiness of your business and, more specifically, the level of certainty that your projected cash flows will materialize. That in turn depends on a slew of factors such as industry, product or team track record, growth rate, market share, competitive pressures, regulatory environment, and others. At the end of the day, it all translates into an internal rate of return required to compensate investors for their perceived level of risk.
So, how do you gauge the internal rate of return that your business can deliver? The good news is that the path to profitability charted by your financial plan already carries an implicit internal rate of return. It is a function of your cash flow projections and an estimated company value at the time of exit or liquidation. It can be easily calculated with Excel’s ‘IRR’ function (which computes the rate of return weighted according to cash flow timing) as follows.
Internal Rate of Return = IRR (Free Cash Flow + Liquidation Value)
Your ‘Base Case’ rate of return should ideally have a reasonable amount of overlap with the lowest figure your prospective investors are willing to accept. Think of this overlap as your room for error and room for negotiation. Without it, you would start your new investor relationship with your back already against the wall.
But surely, you must be thinking, investors are smart enough to self-select into the right investment risk profile, so why should you be doing all this heavy lifting for them?
Well, the reality is that even sophisticated investors, just like everyone else, often get their financial projections wrong, and that as an insider you certainly know the business better than any investor ever could. Sadly, if you let investors fully dictate the financial projections and valuation underlying their investment case, you have nothing to gain and everything to lose.
If they overestimate the business potential, you will end up with unrealistic performance expectations leading to multiple rounds of disappointing results and a souring relationship. If they underestimate the business potential, they will either skip over the opportunity for more attractive investment options, or strcuture their investment to capture the majority of any future gains.
For this reason, you will do everyone a favor by taking the lead on crafting a financial plan that both sides are fully aligned on. Plus, this will provide a lot more than just alignment of expectations. Actively driving the financial planning and investor selection process will give you a more prominent seat at the negotiation table and three important keys to long-term success:
- more autonomy in execution and decision-making,
- capacity to make long-term decisions with clarity on how to prioritize between growth, profitability, and cash flow, and
- ability to negotiate a set of targets that you and your team can successfully deliver on.
4) Get Your Team Marching to the Same Drum
You’ve got money in the bank, a clear path to profitability, and the right capital partners to join you on that path. You can finally focus on the fun part of your job — executing your business plan!
When it comes to execution, as a leader, you will naturally be thinking about empowering, incentivizing, and deploying your team in the most effective way possible. This requires rallying your team around a concrete set of goals, which can and should tie to your financial plan.
By this point, you already know the trajectory you want to follow in terms of sales growth, profitability, and cash flow. You just need to distill and formalize the trajectory’s building blocks into specific goals and targets for the various layers of your organization.
Perhaps nowhere else is the value of a detailed financial plan more obvious than in the creation of a specific set of goals and targets that can drive team performance and results across an entire business. Consider the following aspects of goal setting that are significantly enhanced by the presence of a detailed and comprehensive financial plan:
- Goal selection — a dynamic financial plan can demonstrate the relative weight of value drivers (i.e. assumptions) on the business’ top KPIs, and help select annual goals and priorities accordingly, ensuring the team’s effort is focused on what matters most;
- Annual targets — a long-term financial plan can provide context and validation for annual targets by presenting them as steppingstones leading to a larger objective, such as achieving a target market share, reaching profitability, or becoming self-sustainable in terms of cash flow and funding;
- Monthly & quarterly targets — a detailed financial plan is typically constructed at a monthly cadence, which provides an essential monthly and quarterly breakdown of annual targets, used not only to drive sales performance, but also to plan for working capital needs and for investments that may require a longer lead time (e.g. hiring, significant capital expenditures, or expansion of production or distribution capacity);
- Department expense budgets — a comprehensive financial plan covers the activity of each department, whether it is revenue-generating or in a support function, thus enabling strict control of expenditures and accountability for department heads and senior managers; and
- Performance incentives — a financial plan, typically including a range of upside and downside scenarios, offers a great framework for establishing your team performance incentives as it can directly link them to the financial and operational KPIs already pre-approved by investors.
Simply put, a financial plan helps you formulate a clear set of broader business goals, specific targets, department budgets, and associated team performance incentives, all validated by a long-term objective shared by management and investors. Add a pinch of leadership charisma, and you’ve got all the ingredients needed to rally your team and get them marching to the same drum — inspired, determined, and focused on delivering results.
5) Understand Why Things Did or Didn’t Work
You’ve sent the marching orders to the team and everyone is in full-on execution mode. Тhe business performance data starts rolling in and it is time to respond.
How you respond probably matters more than anything else you have done until now — more than all the planning, investor negotiations, team organization, and incentive setting. Indeed, all they’ve done is bring you this precious window of undisturbed opportunity to sit at the board table flanked by your best women and men, examine the business performance data, and make that executive call.
Whether you decide to revise pricing plans, boost your sales force, change marketing strategy, speed up or delay product development, get more aggressive with suppliers, or otherwise redeploy your resources, this is your truest moment of entrepreneurial trial (and thrill!). How well you execute will determine whether you get a shot at the next one. Needless to say, you want to make the right call and make it consistently.
What will you base your decision upon? How would you address underpreforming profitability targets by 50% this past quarter? Which lever among the hundred available to you is the right one to pull in response? Just take a deep breath and remember that you’ve got a detailed financial plan to guide and validate your decisions along this journey.
A detailed financial plan can be extremely useful when evaluating actual performance and can inform management decisions and interventions accordingly.
As you update your financial plan and model with actual performance data, you will begin to see all the areas where your original projections over- or under-estimated reality. These so called ‘budget variances’ can be drilled into layer by layer until any inaccuracies in the model’s core assumptions are identified and corrected, ultimately revealing the root causes of why things did or did not work out as planned.
Budget Variance = Budgeted Amount — Actual Performance Result
Once you understand which assumptions or hypothesis were off, and by how much, you can confidently explain a new set of results and respond with targeted action. If you are ahead of plan, you can identify the source of the surplus and figure out whether it is a temporary boost or can be sustained going forward. If you are falling behind plan, you can quickly determine whether a course-correcting change of strategy is feasible, or a reset of targets is ultimately required.
If you are behind plan and opt to course-correct, you will possibly need to chart a new path that gets you to the same destination as your original plan. There is a likelihood that your re-forecast will imply a higher investment amount in order to be operationalized, which may mean making a cash call on investors. If, alternatively, you determine that the original targets are no longer within reach and need to be revised downwards, you may face one of the most difficult situations as an entrepreneur — presenting investors with the double whammy of higher capital need and lower profitability.
Either way, your best bet is to remain confident and demonstrate control of the situation, thus preserving the trust of your investors and team. And nothing can help you do this like being fully on top of your numbers, including being able to clearly understand and explain your budget variances and underlying drivers of over- or under-performance.
This will allow you to turn every missed target into a more accurate set of assumptions and projections, which also equates to a lower risk of execution and higher probability of future success.
Conclusion
Successfully navigating through these challenges requires a great deal of information, insight, and intuition. Doing so without the help of any tools would indeed require superhuman abilities and a whole lot of luck. Instead of a cape, all you truly need is a thorough financial plan that can help guide your decision-making along the way.
Whether it is managing your cash, charting a path to profitability, attracting the right investors, motivating your team, or understanding and improving performance, a financial plan is packed with real superpowers that will come in handy at some of the most critical junctures in your entrepreneurial journey. So, learn how to use one and become the real superhero that your business needs you to be!
I am the founder of BudgetSage — a business that offers financial planning tools and services designed to empower entrepreneurs and help their businesses succeed.
