Historically, financial planning and analysis (FP&A) referred to the group inside enterprise companies that produced the quarterly forecasts needed to satisfy outside investors.
But oh, how times have changed. FP&A now refers to a practice that firms of all sizes can and should engage with. And, mid-pandemic, FP&A is becoming more of a strategic function as change occurs at an unprecedented rate. Especially now, your company’s management team — no matter the size — needs help to understand how certain exogenous changes impact the business on a quarterly, monthly and even weekly basis.
As the pandemic escalated in March, FP&A groups at those enterprise companies were tasked with urgent scenario planning to account for the multitude of possible outcomes.
And it remains CFOs’ biggest areas of focus, per our recent survey of those in the role.
As an entrepreneur running your own business, you’ve likely been practicing FP&A, even if just running scenarios in your head as the pandemic plays out. Institutionalizing this financial planning, and borrowing some best practices from the big guys, will allow your business to adjust more quickly to whatever comes next.
Most companies singularly focus on their prospects based on sales commitments and indications without regard for competition and the macro environment. The macro environment tends to generate attention with finance people only when ominous signs emerge — cue the coronavirus.
While understandable, a lack of attention to broader market conditions is a missed opportunity because, put simply, the economy and the state of your specific industry affect your company’s future finances, and all the more in the COVID-19 era. For example, modeling the likely changes to your EBITDA if your sector were to rebound in six vs. 12 vs. 24 months allows you to change your approach to prevent major losses — or capitalize on forecasted gains.
I’m not suggesting you run out and hire a macroeconomist (though making use of the ones that the U.S. Department of Commerce hires is a wise alternative). Rather, you should add the macro as a driver in your model. Identify the key trends that impact your sector. A weak macroenvironment is not equally impactful for all businesses. For example, in the current pandemic many sectors are seeing a boom in business:
A few potential reverberations of the pandemic worth consideration:
The purpose of financial planning is not to accurately predict the future but rather to lay out some likely scenarios against which you’ll adjust your financial plan. Once you have general macro-scenarios in place as drivers, you can focus on the elements of the business you can control to respond appropriately. Understand your variable versus fixed costs, and key in on the variable side. Shifts in demand and new competitors are especially apt at affecting variable costs.
The variable inputs are those that can be adjusted depending upon the macro, sector, and company backdrops.
When analyzing your sector, account for any competitors who may enter the market or cause shifts in customer desires (say with new improved products). Model out scenarios for various outcomes in terms of their market share, pricing, access to new customers, etc.
Company backdrop, i.e. understanding what your customers do, is also especially important: Let’s say we're a food commodities distributor. If we are shipping veggies to restaurants and hotels, then we're in a bad place. If we're supplying wheat and barley for beer, not so bad.
The biggest variable is likely future headcount additions for services companies, and probably raw materials for products businesses. Some headcount additions may be variable and necessary in order to operate the business successfully. Classify those as such. Other headcount additions might be “nice to have” and planned assuming the growth trajectory is maintained. Label headcount additions in one of three categories: necessary, steady-state base case and bullish scenario. Also account for any skills gaps, which could pull a position from “nice to have” to “must have,” particularly if you respond to changing conditions with a directional change for the business. For example, your retail business might need someone who understands ecommerce much more now, in late 2020, than it did last year.
Most growing businesses require additional headcount in order to manage increasing sales. However, most company projections also include hires they would “like to have” in order to pursue ancillary opportunities or cushion existing staff. These hires should be labeled as contingent on a strong company/economic backdrop. In less certain times, contractors might fill the void until needs become more clear.
Identify other variable inputs you can adjust depending on current conditions, whether that’s a manufacturing plant or a technology investment. Prioritize these investments so that as soon as those macro trends materialize, you know immediately the initiatives to push out. Alternatively, if your sector and therefore revenue prospects improve, you’ll know the ones that will be a good use of cash and can be implemented in short order. Also, work now to understand what you'll need in-hand in order to secure, say, a loan for such expansion.
Without good, current data, the greatest financial modelers are at a loss. When collecting inputs, especially sales projections, business leaders must understand and account for inherent biases. Salespeople by their very nature are optimistic and may discount their projections by a commensurate amount based on the likelihood of various company growth scenarios.
“It is a capital mistake to theorize before one has data.”
—Sherlock Holmes in “A Study in Scarlett” by Arthur Conan Doyle
In my experience as CFO, the most accurate modeling is a direct outcome of constant, consistent conversations with the main players internally. Conversely, when I met with key influencers only once per quarter, the data was at a massive risk of becoming stale. As a leader at a growing firm, you’re likely in close contact with your team. Keep it up.
Be broad when it comes to gathering information for the financial modeling process. I have found that some senior people tend to be bigger-picture and less in tune with the specifics, as they may delegate certain day-to-day activities to subordinates. In those cases — or if that “senior person” is you — speak to the people who may be junior but have a keen sense of the day-to-day changes in customer and/or supplier behavior.
There are generally two to three main business drivers or key performance indicators (KPIs) for the top line that you should model. You can always add drivers but risk overcomplicating and a false sense of precision.
For software-as-a-service companies (and really any subscription-based company), the drivers are traditionally churn and its inverse, retention, which determine lifetime value (LTV) plus gross and net dollar retention rates. For manufacturing companies, common drivers include production rate and volume of products sold. In distribution, it’s usually changes to the product mix and supply chain. Main drivers for professional services tend to be the prices and mix of your offerings and number of effective salespeople.
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On the cost side, it’s imperative that you split out variable and fixed costs. Then you can break out the key variable costs and adjust them based on your revenue drivers. Group variable costs in general buckets: headcount, marketing, travel & entertainment, and capital expenditures. Product companies should add cost of goods sold and distribution to the list.
While the data collection part of the process is time-intensive, you can dynamically reforecast to account for changing assumptions such as a higher churn because of a price increase or fewer new customers because of a travel reduction. Do not view forecasts as static data points. Forecasts should evolve as you review and reflect on their accuracy.
In which lines were you accurate in the forecasts? Where were the forecasts way off your estimates? As my grammar school teacher would say, “It’s not about getting it right or wrong, it’s the logic you showed to get to your answer.” You will learn much more about your business from the inaccurate forecasts than from any that you got right.
A good process to follow:
When I served as interim CFO of an ecommerce company, we realized that our shipping and fulfillment costs were wildly off relative to our projections, dramatically underestimating the costs. When a wide discrepancy is found, ask questions to multiple people with different vantage points. Was it a one month or quarter anomaly that will adjust in the subsequent period or one that needs further digging into.
What we found after asking folks within the different groups was manifold: 1) Our fulfillment rates on direct shipments were too high, and when compared against similar companies could be negotiated downward and 2) a large customer was overcharging us on shipping. We identified the heart of the issues and quickly were able to take action.
Humans are not naturally gifted prognosticators, whether on sports outcomes (note the beautiful, glamorous casinos) or the overall economy. (Economists have predicted nine of the past five recessions, joked Paul Samuelson.) However, it does not mean forecasting is a fool’s errand.
“An economist is an expert who will know tomorrow why the things he predicted yesterday didn't happen today.”
The key is to constantly reflect on what you got right and, more importantly, what you got wrong and why. Predictive models are iterative, and you should constantly tweak them to more accurately reflect how internal and external factors impact your business.
Once you have constructed a solid predictive model, the key focus should be on cash flow. Identify cash flow by month and what that means for your company’s runway given the available cash and debt facilities. If under certain scenarios the cash flow isn’t as strong as you’d like it to be, closely examine the variable expenditures by priority level.
Mark a definitive future point in time (ideally by month) as the point at which, if things manifest to the downside, you will delay lower-priority expenditures. Also mark a point for revenue and/or profitability targets that, if reached in a defined period of time, mean you’ll implement certain priority decisions. The biggest future decisions tend to involve headcount additions, many that will determine next year’s growth. Tie these hiring decisions to reaching those important milestones, otherwise you are adding costs to a non-optimally functioning base. This way, decisions will be based on solid financial data.
“Mistakes are the portals of discovery.”
FP&A is critical to your company’s decision-making process. If you haven’t already practiced it, then go forth and make mistakes. Then, spend the most time evaluating the divergence between your estimates and actuals, as therein lies some nuggets about your business. As James Joyce famously stated, mistakes are the portals of discovery.