Wednesday, August 26, 2009

Bridging the Gap Between the Financial Model and Budget

bridging the gapA financial model and an operating budget are two different things, but the two should correlate with and complement each other. I’m going to briefly discuss the differences, what each is used for, and how to use them both more effectively to run and improve your business.
Financial modeling/forecasting usually takes a big-picture approach and avoids too many details. The model is used to assess opportunities and the cause and effect of major business decisions. The model is often expressed in terms of yearly performance.
An operating budget, in contrast, is mired in the details. It needs to tie directly to the accounting system’s general ledger, or chart of accounts for QuickBooks users, and is usually a month-by-month forecast of the activities of each account for the next 12 to 24 months. Use of the operating budget includes analysis of the budget vs. actual performance each month.
A business needs to have both a financial model and an operating budget. An operating budget without a long-term model/forecast leaves a company pretty directionless and lacking the ability to understand the impact of business decisions on financial performance. A financial model without an operating budget is a “pie-in-the-sky” dream that is not founded in reality. There is no way to track progress towards accomplishing the goals and objectives, if they are even outlined, and it is almost impossible to hold anyone accountable. Every business should have both.
The place where many companies go wrong is that they do not actively use both of them and ensure they “feed” into one another. For example, let’s assume we have modeled $5,000,000 in sales for 2009 but our operating budget calls for $3,500,000. This discrepancy is large and invalidates one, the other, or both!
The operating budget needs to validate and complement the assumptions made in the financial model, and vice-versa. In fact, the monthly review of the budget vs. actual performance can often generate valuable information about our assumptions and can justify changes and updates regularly to the financial model.
For example, let’s assume we project a 50% gross profit in our 5-year financial model. Due to changes in the economy, increasing material prices, and a slight change in mix of products, our gross profit is coming in every month at 45%. We find and track this in our operating budget analysis each month. Since the trend seems to be consistent, we may make a decision to update the gross profit assumption in our financial model.
With an understanding of the differences between a financial model and operating budget, we can see the need to bridge the gap between the long-term planning and short-term budgeting so that they complement each other. While this requires some effort and often the expertise of a CFO, the result is always a competitive advantage in terms of a more effective execution of our business model. That means more cash flow and better profitability that your competitors, which results in a sustainable competitive advantage.

Wednesday, August 19, 2009

Three Most Common Mistakes when Modeling the Balance Sheet

Every sensible financial model projects the results of all three major financial statements - the profit & loss, balance sheet, and statement of cash flow.  The balance sheet, not the profit and loss, is what drives the cash flow of the business.  If the balance sheet is not correctly modelled, then the cash flow forecast is most likely inaccurate and worthless.  Yet the balance sheet is the part of the model that is usually the most neglected and least understood.

In order to help get the balance sheet forecasting correct, we have identified three common mistakes that entrepreneurs, CEOs, business owners, and even business financial consultants make: NO balance sheet projections, failure to correlate operating activities on the P&L to changes in the operating assets and liabilities on the balance sheet, and disregard for the debt and equity transactions of the firm.

The most common mistake made is the exclusion of a balance sheet forecast from the financial model.  The balance sheet represents the most complex transactions of the company and may be left out of the model because the company lacks the expertise of a CFO  or financial executive to assemble this critical part of the model.

The major operating assets include accounts receivable, inventory, pre-paid items, and more.  The major operating liabilities include accounts payable, taxes payable, and other accrued expenses.  When sales go up, accounts receivables go up, and cas goes down.  But does the model capture that?  If sales go up, can we expect our inventory level to stay the same?  Most likely it will need to increase.  The increments of these changes are dependent upon the relationship between our days sales outstanding and our inventory turnover.

As sales increase, our accounts payable usually increase as well.  The timing of our payments against our accounts payable is a major outflow in the cash flow puzzle that is called working capital.  We need to define the relationship that payables have with our operating activities and implement this relationship in our balance sheet model.

There are several other operating assets and liabilities that dramatically impact cash flow.  We will avoid all of the details of each, but it is fair to say that without properly forecasting them, our cash flow forecast will never be accurate.

Are we bringing in any more equity investments during the period we are modelling?  What is our dividend policy for shareholders?  Is some or all of the active shareholders compensation coming through equity?  All of these items can have a significant impact on cash flow, although none of them show up on the P&L.

In addition to equity transactions, the structure of all of the company's debts and obligations need to be correctly reflected on the balance sheet.  An interest only line of credit will keep the same balance until more is withdrawn or some is paid back based on the cash flow of the firm.  Term loans need to show the correct amount of principal being reduced every month.

Obviously these items can seriously change our cash flow, and they need to be included in the financial model so we can correctly forecast our cash flow.

This list of common mistakes is certainly not comprehensive (you'll notice we did not address capital expenditures at all), but should create a positive foundation to build the balance sheet model.  Accurately modeled balance sheets help businesses get a handle on their companies, make the best strategic decisions possible, raise necessary capital, and perhaps most importantly, track their progress so they can correct problem areas and make more valid assumptions in the future.

Friday, August 14, 2009

Three Worksheets Your Financial Model Must Have

A good financial model should feed into three main pages, which happen to match the three main financial statements of a business - profit & loss, balance sheet, and statement of cash flow.  These three components of the model should never be circumvented nor should we ever try to short-cut the need for all three.

With these three pro forma statements as the final deliverable, there are at least three additional worksheets that need to be part of the model. They include assumptions, marketing/sales/COGS, and payroll.

Every working financial model should have one page that contains a majority of the assumptions for the model. Assuming we are using Excel or another spreadsheet template to create the model, these assumptions should be linked throughout the model. This gives us the ability to make a change to any one of our assumptions and then see how that changes our profitability and cash flow outcomes.

We need detail! It is not sufficient to say we are going to grow sales by 50%. What are the marketing activities that will drive that growth? How many leads will we need to generate a sale? What is the cost of these leads and other marketing activities? Which product or service lines will grow more than others? How does our gross margin differ on these lines as compared to slower-growth or even obsolete lines? Is there a difference in both the collections and the payment for costs of goods sold between these lines? How will this impact cash flow? These are the questions we look to this worksheet to answer.

How many people is it really going to take to accomplish what out financial model projects? What are the salary and wage costs to hire all of these people? Are our hiring practices in line with the sales per employee financial ratio according to our industry benchmark? Have we correctly factored in all payroll burden and benefit costs, including FICA, FUTA, SUTA, worker's comp, other state payroll taxes, health insurance, 401(k) match, etc.? Have we correctly forecast all of the costs associated with adding these new employees, including recruiting, HR, and new office and computer equipment? These need to be factored into our plan so that we can demonstrate a realistic cost for growing our firm.

While there are many other supplemental worksheets that may be used to help build a formidable working financial model, these three are a requirement.

Tuesday, August 11, 2009

Two Biggest Flaws with Break-Even

Most of the folks who read my blog know I write from the CFO and entrepreneur perspective on start-up, emerging, and medium-sized businesses.  This post will be no different, and its intent will be to clarify the two most significant flaws entrepreneurs, business owners, and CEOs experience when trying to understand their break-even point, both in terms of sales volume and units.

The traditional method for calculating break-even requires us to separate the fixed and variable costs.  These come from the profit & loss statement, or statement of operations.  Often a significant portion of the active owners' compensation, meaning the "wage" for their time and effort working in the business day-to-day and excluding profits and dividends, is pushed through the balance sheet for tax purposes.  Specifically, an S-corp often pays a reasonable salary to the owners to meet IRS requirements and also has a regularly scheduled distribution to make up the difference.

Here is an example.  Let's assume a business that is structured as an S-corp has one owner who requires $150,000/year to pay her bills and do the things she wants and needs to do.  She is advised by her tax advisor to only pay herself $90,000 as a salary.  This flows through the profit & loss and will be included in the break even analysis.  She is additionally advised to take the other $60,000 as a dividend to avoid unnecessary payroll taxes.  So she schedules a $5,000/month dividend to herself and counts on that not as a distribution of profit but as her regular and expected wage.  The challenge is that this $5,000/month flows through the balance sheet and is not part of the break-even calculation, even though it is, for all intents and purposes, just like a fixed cost.

The way to solve this is to add another $5,000 per month to the fixed cost total for running the firm each month.  This will being the break-even calculation to a more correct place.

Another fixed outflow of money that is often missed in the break-even calculation is reduction of the principal balance of outstanding notes and loans.  The interest portion of all debt payments shows up on the profit & loss and should be part of the fixed costs of the break-even calculation.  But the principal only flows through the balance sheet.

In some cases the amount of depreciation being recognized as a fixed cost is about equal to the principal reduction, but often it is not.  For example, a business that is paying an extra $3,000 per month towards one of their equipment loans.  The owner has set this as a requirement that the business must meet every month.  When this owner thinks about break-even, she is hoping that this extra $36,000 of principal reduction is considered.  In addition, she is also hoping the fixed dividend of $6,500 she takes every month from the company is included as well.

Hopefully you picked up on the place where break-even flaws occur - transactions that only hit the balance sheet.  In some ways, start-up, emerging, and medium-sized companies need to look very closely at both their operational break-even and their cash flow break-even to truly understand the minimum level of sales they can experience and still stay at a break-even from a profitability and a cash flow perspective.  Business finance textbooks teach only operational break-even and they fail to mention the inherent flaws to its calculation.

What good is knowing your break-even?  Besides the clarity and peace of mind it will bring, it can become essential in helping you price your products and services and help you refine your business model to its most efficient and effective state.  There is a power in being able to say: "We need to sell 100 units to break-even this month."

Wednesday, August 5, 2009

Responsibility, Accountability, and Teamwork

Most employees are responsible. Employees will do their job well, (at least they think they are doing a good job.) Employees generally feel responsible. These feelings of responsibility are feelings of obligation, and are pretty much instilled in all of us since childhood.  So why aren’t these employees measuring up? Well, we need to look first to accountability and then past the individual to the team and processes.

Remember you and your employees are in business not busyness. Busy work is not the work of business. Doing the wrong things well helps no one. So responsibly doing busy work is worthless.

So what is the answer? We all need to be held to account to do the work that needs to be done. And that is what accountability is all about. Accountability occurs when managers specify what they want subordinates to produce (quantity, quality, time and resources), judge how well the subordinate worked and thereby manage the employees. A manager may be reluctant to have the hard conversation, but part of the manager’s job is to ensure that  employees are being productive. Human beings are of course social animals. So management must never tolerate or allow bad behavior to be rewarded; think of it as a moral issue for management. No retailer would ever think of using an open cash draw instead of a cash register. An open cash draw rewards bad behavior.

Beyond the individual, most work is done in teams. Again, almost all employees strive to be a part of a winning team. The main inhibitors of teams are unclear work processes, bad incentives, unclear decision making, bad communications and/or lack of knowledge of how the rest of the firm works.  Almost all of the problems and issues happen at the margin or transitions--the handoffs, decision points, approval points etc. If you really want to improve employee performance, look at what happens between the teams. Now as the financial crisis on Wall Street shows, the bad incentives can really mess up ever the most profitable business. Well done financials can, of course point the way.

Fix the process, particularly the incentives and many employee problems take care of themselves.  FedEx is a good example. Here is what Charles Munger, Warren Buffett’s partner said…”the Federal Express system requires that all packages be shifted rapidly among airplanes in one central airport each night. And the system has no integrity for the customers if the night work shift can’t accomplish its assignment fast…”  Federal Express could not get the night shift to get the packages out on time.  “They tried moral persuasion. They tried everything in the world without luck. And, finally, somebody got the happy thought that it was foolish to pay the night shift by the hour when what the employer wanted was not maximized billable hours of employee service but fault-free, rapid performance of a particular task. Maybe, this person thought, if they paid the employees per shift and let all night shift employees go home when all the planes were loaded, the system would work better. And, lo and behold, that solution worked.”  (from an article “The Psychology of Human Misjudgment”).

Monday, August 3, 2009

How Many Forecasts Do You Have?

How many forecasts do you keep concurrently in your company?  If the answer is zero, then we have some serious work to do.  But if your answer is one, you may be falling well short of what is necessary in these difficult economic times.

Here is a real story of a conversation I had with a banker in the last 6 months.  My client needed to finance some heavy growth and we stretching to try and use only bank financing to accomplish this growth.  The banker was concerned about the effects that our plans for growth could have on the business.

He said: "Ken, I have your projections in front of me, and I understand they are conservative, but I'm not going to feel comfortable about this deal until you can show me convincingly that a 25% downturn in this company's top-line will not kill this company."  I agreed to re-work our forecasts based on his request, and I went ahead and ran an additional model with 25% additional growth on top of the already projected growth trends.  In about two hours we went from one forecast to three, and the exercise was overwhelmingly valuable.

In the July/August 2009 issue of CFO Magazine, Tenet Healthcare CFO Briggs Porter said: "Developing a plan on three different levels (baseline, high, and low) is a good idea in any environment, but it is a necessity in this one."  I could not agree more with this statement.  Forecasting is tough enough, but these uncertain times make it even more difficult.  And the stakes are high - if you fail to plan for each scenario, you can quickly put the company in a world of hurt.

Financial modeling and forecasting is an exercise that ultimately only proves beneficial if we use the models and forecast to validate or invalidate our assumptions, make necessary and timely changes in our businesses, and continue to try and stay ahead of the where we are going.  In large organizations, the CFO usually runs and updates the model.

I have and will continue to make this promise to anyone willing to take this challenge: If you will put a forecast/budget in place and track your actual performance next to your budgeted performance every month for 12 consecutive months, you will know more about your business and industry than at least 80% of your competitors and the competitive advantage you gain from the insights and knowledge you will gain during this process will add an overwhelming amount of value to your business.