The Mechanics of Money: Building Business Plans

26 September 2008

Any business plan needs proforma financial statements regardless of whether it is boot strapped or VC funded. As the owner, founder CEO, your plan must show that you are going to make money and show it in a way that other people can easily understand it. Financial statements are the key method.

(Dear reader, if you are an accountant, please read no further, it will be a waste of your time. If not, I am assuming you have a basic understanding of accounting processes.)

Generating proforma statements is not a trivial undertaking. Fortunately, spreadsheet software was invented for just this purpose which makes the complexity much easier to handle. They key to designing a good set of proforma statements lies in understanding the mechanics of how value flows around the various accounts on the financial statements. Peter Kemball, CEO at Acorn Partners, likens this to a plumbing problem. Its is a good analogy with lots of fun clichés. Use your house as an example. Water (value or wealth) flows in and flows out. Within your house, you have reservoirs (accounts) where water can be stored and pipes (the rules) which govern the flow around the system. The goal of business is, simply put, to keep more water flowing in than flows out until the house floods (which, in the analogy, would be a good thing).

Note that in the analogy, water is equated to value not cash. Cash is just one “reservoir” of value but there are many reservoirs in the company where value is stored. So, as well as cash flow, think of value flow in the company. If you can keep increasing the value, you can likely find ways to manage the cash flow. Value can be monetized and converted to cash if need be. The clear default for startups is converting equity to cash by getting investors to join the company but it not the only choice. You can also convert the value in your accounts receivable to cash using Factors or speciality investors. Sell your future subscription income, trade on tax credits – it is all possible. This is one area of accounting where creativity pays.

In designing your financial plumbing, you need to select the accounts to use and the rules that govern how the money will flow around. These decisions will eventually drive the selection and setup of your accounting software. Are you, for example, running a product business which will require inventory with accounts for finished goods, work in progress and raw materials or is the business based on a service model with no inventory? It is important to define these at a rather low level but not so low that the account becomes trivial. The point of this exercise is not to create a Rube Goldberg contraption, but to manage the complexity of the whole by breaking it down into small and simple components that are controlled by your assumptions.

Some key assumptions include:

  • Growth rates and revenue
  • Cash conversion times
  • Fixed, variable and semi-variable costs
  • Fixed asset costs & depreciation
  • Interest rates
  • R&D, Marketing, Operations and Administration costs and time lines

Once you have the plumbing designed you need to translate the design to your financial spreadsheets. Here are my key time savers:

  • Don’t worry about format of the working sheets.
  • Keep all your assumptions on one sheet along with the key summary performance graphs and data generated by the other sheets.
  • Each account needs its own sheet. Columns are set up as weeks or months and rows are the elements of plan that affect that account.
  • Some costs are too complex to model within an account. Use separate sheets for these and then link the costs back to the relevant accounts.
  • The sheets used to display the summary financials should only have links and calculations on them – you should never have to enter values on them. The balance sheet should draw all its information from the subordinate accounts with the exception of cash and retained earnings which come from the cash flow and income statements respectively.
  • Get the model working before you try to make it presentable. By working, I mean the balance sheet should always balance as you change the assumptions.
  • Generate several sheets for the presentable financial summaries and tables that you can link to in your business plan documents. Spend the time to make these sheets look good.
  • Keep data in one place. Use DDE or ODB links to connect the spreadsheet model to your documents so that the documents are updated automatically. As much as possible, keep the text in your documents vague and refer to tables and graphs that you have linked to. This will save lots of time in revising the words as you modify your assumptions.

Once all of this is done, you will have a solid model on which to assess your assumptions and build what-if cases. While you may start out with good guess at what the critical assumptions are, the model will help you identify just how critical they really are. It will also help you determine how much cash you will require to succeed and the creative ways you can use to get it.

MJM Consulting – Helping Small Business Grow.

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