This post has been first shared on YSB Balkans.
For most people, financial planning is certainly not a fun activity. You have probably never met a single person that said “oh we just got together with a bunch of friends for beers and a relaxed financial planning exercise”.
So why even bother about financial planning?
“Life is what happens while we are busy making plans” – John Lennon
For startups and small businesses, financial planning is crucial to survival – even if you are not looking for money from investors or donors. It helps you understand the nuts and bolts of your business. And in many cases, it even tells you whether it is worth pursuing your idea or not.
In the past years, we have worked with over 400 entrepreneurs across the world at Yunus Social Business. And I personally had my own share of startup mania as a CFO and Product Manager for startups and as a mentor at Google Launchpad.
I found that many startups only have a vague idea about how much money they have to make to become financially sustainable (i.e. break even). So I tend to do a quick financial planning exercise with them (not more than 20 minutes) which more often than not is a real eye-opener. They suddenly realise the challenges, identify the things they have to validate and how they can scale their business.
Financial Planning as a Blueprint
Financial Planning helps you to understand which levers you need to push in order to go to full steam with your startup!
So think of planning as a blueprint to a steam locomotive that has numerous handles and levers that you can pull. Your job as an entrepreneur is to understand which levers to pull in order to move as quickly as possible. And financial plans help you do just that.
You will identify what drives success for your business. Is it really how many new customers you can generate each month? Or is it how often a customer orders? Or is it the costs of raw materials? Can you pay your own salaries with 100 customers, 1,000 or 1 million?
And don’t worry too much about accuracy: The whole exercise is about taking an educated guess and understanding how the pieces of the puzzle fit together. You will later take this guess and validate it in the market through iteration, customer development and experimentation.
But where to start? Let us walk you through a step-by-step exercise on how to develop your financial plans. Don’t worry, we will support everything with examples to make it transparent. In the coming months, we will further deep-dive into topics like sales planning, costing or investment planning. So stay tuned.
Whatever you do, keep in mind that the whole exercise is not about predicting the future. It is about taking an educated guess and understanding how everything fits together.
1. Planning your Sales
Start with your ambitions for the future and talk about how quickly you will find new customers/users and make money. This includes asking yourself the following questions:
- How many customers can I attract each month?
- How much does each customer buy?
- How many customers come back to order again? How often and frequently do they come back?
- How many do not come back?
- What are your total sales?
People love complex language because it serves as a code. If you can speak the code, you belong to the group of cool guys. Don’t worry, we decode some of the most used words for you here as well. We call that “Bullshit Bingo”.
Don’t forget VAT!
When planning sales, many entrepreneurs forget the value-added tax (VAT). In many countries, VAT is a substantial amount of your sales. As an example: Your customer is paying you 100 EUR per sale. But from those 100 EUR, you will need to pay VAT – either now or later as you grow depending on the laws in your country. Let’s assume your country charges 20% VAT. That means that out of the 100 EUR, 17 EUR are VAT (100 EUR divided by 1.2). Those 17 EUR do not go to your business but will have to be paid to the state. It leaves you with 83 EUR to play with.
2. Variable Costs
Variable costs are costs that increase with the number of products and customers you have. There are many types of variable costs but we will talk about the two most common costs below: Costs of Goods Sold and Customer Acquisition Costs.
Cost of goods sold (COGS)
Producing a product or service has a cost. It may be raw materials that you have to buy, worker wages or fees you have to pay for each product you produce and sell. These variable costs are called “Costs of Goods Sold”. They are critical for the success of your company because of COGS per unit are higher then your net sales per unit, you are effectively making a loss on each product you sell.
So for example, if you are selling vegetables from farmers on a fresh market, you will need to buy the vegetables from the farmers in the first place. The price you pay those farmers is part of your COGS. The logistics costs such as gas for the pickup truck are also part of COGS because they increase as your sales volume increases. Obviously, it is important that you sell the products at a higher price than what you had to pay.
Customer Acquisition Costs (CAC)
This cost type is quite unique mostly to e-commerce and online startups. But the concept can be equally applied to other businesses – especially if you are attracting your customers through online activities. CAC measures what it costs you to acquire one paying customer.
Why is that important? If you cannot make enough money from each customer that you attract to cover the costs that it takes to acquire that customer, you are back in the loss-making business.
Example: You are trying to sell concert tickets online. You are acquiring customers via Facebook ads and your sales funnel looks like this:
- 0,24 EUR Costs per Click (Facebook ads are usually on a per click basis so each click costs you 0,24 EUR)
- A user has to click about 4 times until she actually finds a concert that she is interested in
- 20% of the people that find a concert they are interested in actually purchase from you
That means: Your customer acquisition costs are 4,80 EUR (0,24 EUR x 4 divded by 0,20). So if you cannot make more than 4,80 EUR from a concert ticket (or can lock in the customer for future purchases), you cannot make a profit from your business.
3. Gross Margin
The gross margin is simply your net sales minus your variable costs (COGS, CAC, etc.). It tells you how much money you are actually making from each sale.
4. General & Administrative Costs (G&A)
General and administrative costs cover the fixed expenses of your business. They cannot be directly linked to a sale or a product. And you have to pay those costs – no matter if you sell 1,000 products or zero. What types of G&A you have can vary across sector and industry but below is a list to think about when doing your financial planning.
- Rent, Utilities, Telecom
- Sales, Marketing, Public Relations
- Repairs and Maintenance
- Office expenses (supplies, etc.)
- 3rd party (legal, accounting, …)
- IT Expenses (Hosting, Software Licenses, etc.)
- Other: Freelancers, Travel costs, etc.
EBITDA is short for “Earnings before Interest, Taxes, Depreciation and Ammorization“. Or how I like to call it: Your profit except for the other stuff you have to pay but frequently forget about. EBITDA is simply your Gross Margin minus G&A. Remember, Gross Margin is your Net Sales minus your variable expenses so the full formula looks like this:
- Gross Sales
- less VAT
- = Net Sales
- less Variable Cost (like COGS, CAC, etc.)
- = Gross Margin
- less G&A
- = EBITDA
To keep it simple: If your EBITDA is positive, you have a good business case. In simplified terms, this is the indicator whether your business is profitable or not. To get to net profit, you have to deduct depreciation and amortisation (a more complex accounting topic that we will go into later), any interest payments and incomes as well as taxes.
5. Plan your cash flow
All of the above items are items of the so-called “profit and loss statement” (or P&L). Plan those items on a month by month basis at least for the first year of your startup. Ideally, you want to have a three year cash forecast – or at least that is what investors will look at.
The P&L gives you an expense-overview but not a cash overview. Confused? Fully understand. Without going into too much accounting details (and horribly simplifying), the P&L tells you when you receive or send invoices and the cash flow tells you when you pay them.
So for example: You send an invoice to a client in January but usually, they only pay one month later. So the P&L will show revenues in January while your cash only comes in February.
Make sure that you think about when you actually need the cash. It is very common for startups to get into financial problems when they don’t monitor their cash enough.
Review and play with your forecast
When you are done with your forecast, take a closer look. What drives your profits? What do you have to do to increase your margin? Is it possible to increase sales as quickly as you think you can?
Change a few assumptions (like price, number of customers, COGS or G&A) and see how this “moves the needle”, i.e. how it changes your profit. That is how you find out what really matters – and quite often it is something startups have not thought about.
If you don’t feel comfortable with it or if you need more information, get someone to help you. If you don’t have anyone, feel free to reach out to us. Not only do we love to work with startups but we also have access to over 150 mentors that love working with startups, too. So just send us an email and get the discussion started.
Also check out our financial planning template for startups. It’s super easy to use and you can adapt it to your needs. And it’s absoltely free of charge. You can download it here.