Every business has its make or break financial assumptions. Also known as Key Performance Indicators (KPIs), these do-or-die figures are the drivers of your business. A web company’s KPIs might include the conversion rate (number of visitors who convert into customers) and average time spent on the site. A restaurant business might focus on the time it takes to turn a table, or the average ticket size. As your company grows, your financial drivers will determine your success. Neglecting them will result in lost potential, or worse.
Drivers vary by industry. If you’re not sure what your KPIs are, start by looking at industry reports. Read the 10-Ks of public companies in your industry and pay attention to what its managers focus on. Another great way to determine which indicators will most impact your business is with your financial model. Analyze the sensitivity of your inputs by testing each at different levels. The inputs that drastically affect your revenue or profit are likely your KPIs. Once you figure out you KPIs, make sure you know your numbers cold.
One financial number that you should always have in the back of your mind is how much runway you have left. At your current cash burn rate, how many months can you survive before you run out of money? Shoot for 18 to 24 months of runway at all times so you can focus on your business without worrying too much about money.
Calculate the runway left by dividing the money in the bank by your loss at the end of the money. For instance, suppose you are losing $10,000 per month, and you have $100,000 left in the bank. You have 10 months of runway left ($100,000/$10,000 per month = 10 months).
There are three things you can do to lengthen your runway: generate more revenue, lower your expenses, or raise more capital. If you increase your revenue and lower your costs, resulting in a $2,500 loss per month, then you’ve just increased your runway to 40 months ($100,000/$2,500 = 40 months).
Undercapitalization is the number one reason small businesses fail, so make sure that you always have enough runway to get your startup’s wheels off the ground.
Your financial projections are based on hundreds of assumptions and unknowns, so you have to sanity check your results. There are a couple great ways to do this. By far, the most important sanity check you can do is to compare your financial ratios with your industry’s standards. By combining the financial performances of companies in an industry, you can get an understanding of the industry norms. One great resource for this is the Risk Management Association, which provides industry ratio reports. Compare these results to year five of your projections. Are there any significant variations? If so, be sure that you understand which assumptions directly affect the variance and check their validity. If there are any discrepancies, the safest approach is to revert to the industry’s ratios.
Next, go through every assumption in your financial model with your advisors. There might be an important oversight or error in your calculations, or you might have misjudged a key assumption. Industry or startup veterans should be able to uncover weaknesses quickly. Either way, getting a second pair of eyes on your work will help fine-tune your model.
If you’re going after investors, your financial projections will get the most scrutiny. If your ratios are off, or assumptions are aggressive, you better have rock-solid explanations at the ready.
By the time your financial model is built, your business model should so well understood that you could go toe-to-toe with any banker or investor. Now it’s time for a gut check. Let’s use those projections to calculate the sales required to break even. While a straightforward calculation, this is often an eye-opening number.
Let’s consider a gift shop as an example. The average order size at this shop is $3, and the cost to deliver is $1. This makes the gross profit per unit $2. Next, suppose the overhead (rent, utilities, inventory, and employees) to keep the doors open is $30,000 per month.
By dividing the monthly overhead of $30,000 by the gross profit of $2, we see that the shop needs to sell 15,000 units per month to break even. Sounds reasonable enough, right? At this point you might hear an entrepreneur say something along the lines of, “There’s a ton of foot traffic, so we can make this work.”
Well, let’s break it down further: 15,000 units per month is 500 per day. Even if the founder is breaking her back working for 12 hours a day, she still needs to sell about 42 per hour. That’s one sale every 1.5 minutes, all day every day—that’s not the most realistic plan.
Do a breakeven analysis to see if you’re on the right track, or if your business model needs re-engineering.
Yes, your financial projections will be wrong. But that doesn’t get you off the hook. A financial model is valuable due not to its accuracy, but because building one forces you to think through every nook and cranny of your business. All of your assumptions will be quantified in your model, helping you determine whether your business, as you currently envision it, has potential or not. Often, businesses that make sense in the abstract are unrealistic when modeled out. Plus, now that you have a financial model, you can use it to manage your business. You can update your assumptions as you collect more data, and get instant feedback on how these changes affect your bottom line.
Because your model is so important, it would be a mistake to use a template. You need to go through the process of building it yourself. You need to know what’s going on under the hood, so you can explain how it works, and fix it if something breaks.
A financial model that incorporates all of your assumptions will help you take a holistic view of your business’s dynamics. The financials are where the rubber meets the road in business. So go ahead and build a bad financial model. It’s not the inaccurate projections that count; the important thing is the process.