Companies that only use financial projections (a “financial model”) as a valuation tool ahead of specific events (capital raise, loan, etc.) are missing out on the tremendous benefit offered by maintaining a current view into one’s medium-term future. We recommend companies keep a rolling 36-month projection and use it for two primary functions: (1) plan for how the company will manage cash, and (2) measure performance-versus-plan. The former will keep the company in a proactive stance when it comes to spending, and the latter will help the company use leading indicator metrics to drive performance. I would like to share a few tips on how to get there, so that you can make decisions like:
- Can I afford to hire person X right now?
- How many people will I need on staff when my revenue hits $Y?
- If I hired person Z, would the cash I have today be enough to cover them until they produce revenue?
- How much can I afford to pay myself?
- If I tried to do A, then would I need to raise cash? If so, when would I be cash flow positive?
Rolling financial projections should be operational in nature, not a one-off exercise.
It is not enough to build projections; they have to be built such that they can be evaluated and updated. First, that means that the model itself is part of a broader business planning and evaluation cycle. Each month, there should be a review of results against the plan. This should drive forward-looking discussion topics like, “Since we are consistently three months ahead of revenue targets, can we afford to accelerate our hiring plans?”
Second, that means that the builder needs to use Next-Level Excel skills to get the job done. The more that can be automated, the lower the level-of-effort will be to run quarterly updates or perform scenario testing. If updates take too much effort, then the company will not stick with the routine.
This is a medium-term projection, so do not lose your mind over one month’s results.
In many industries, financials can be volatile on a monthly basis. A financial projection, however, is going to be relatively smooth. In some cases, we even project things like fractions of new clients. Why? We’re showing growth through estimates and formulas (see above about automation). The model may show 400, 410, 420, while the reality may be 250, 530, 450. None of those monthly projections are right, but the three-month total is spot-on.
The response to monthly volatility is two-fold. First, instead of looking at one month at a time, a company may review its results each month based on the prior three months (“rolling three months”). The more volatile the monthly revenue is, the more that this approach makes sense. Secondly, the company should take care only to update the model on a quarterly cycle, even if it is looking at results monthly. This will help avoid a whipsaw effect in projections.
Ultimately, leading performance indicators are the way to go when evaluating performance. If the company can produce leading indicators that it trusts (example: total sales pipeline, backlog of project hours, etc.), then it can avoid overreacting to one crazy month.
Like business, everything in projections flows from revenue, so spend more time on it.
When I am asked how we put together all of the numbers that go into a financial model, I share a simple truth: most of it is not complicated. General and administrative expenses (everything but cost of sales and labor) are almost always a function of revenue, headcount, or general growth rate. So back-test those items, figure out which one it is, and apply it forward. Once you have your income statement and balance sheet figured out, cash flow statements are just math.
So, it is important to spend the most time figuring out revenue, gross margin, and labor because those can be complicated and they’re critical. Do not directly project dollars; instead, project drivers like new clients, quoted business, close rates, etc. Whatever it is that the company talks about and wants to measure each day, week, month, and beyond. After that, have the model formulaically translate the assumptions into dollars. That way, when financial results do not turn out as planned, the discussion turns to drivers and not esoteric accounting ratios.
Practice makes perfect. Go out and start. Build something somewhat simple and improve it over time. Call in help if you need, because decisions about growth and investment need to be educated. Use drivers, tweak them when they are not quite right, and get better with each iteration. Guess at first! And of course, if you need help setting up a process like this, give us a call. We are here to help.