If you run a small business, you know the struggle. You’re constantly on the move, juggling meetings, calls, emails, and handling social media ads while waiting for the food delivery.
It’s an exciting and dynamic environment. However, you also want to make sure the business is on the right track from a financial perspective.
What if we run out of cash? How to analyse and track performance? How to implement that 5-year strategy from the pitch deck?
If you’re confused about all of this, you’re not alone.
We know that corporations have robust and well-structured planning processes in place. That said, many fundamental principles also apply to small businesses.
I’d like to walk you through a simplified financial planning process that suits well the needs of a small organisation:
Set strategic goals → Build a financial model → Create a budget
As you see, it starts with setting or reviewing strategic goals, and these plans are reflected in a financial model. Subsequently, the model’s output is used to create a budget.
Let’s take a closer look at each stage.
Table of contents
Set strategic goals
Before diving into number crunching, we must make sure the long-term goals are relevant and align with the business’s mission.
Ask yourself:
- What would we consider success in the next three to five years?
- Should we introduce any new products or services?
- How will our competitors react?
- How can we serve our customers better?
- What risks do we face, and how can we manage them?
Once you determine which goals are worth pursuing, confirm they are SMART — ‘Attract 15 new business customers before the end of the year’ is better than ‘find more customers’.
Big goals can be broken down into more specific actions and plotted on a timeline (Gantt charts are great for that).
Additionally, link each objective to a Key Performance Indicator (KPI) — a quantifiable, outcome-based metric that you will track monthly to measure the progress.
By the way, you can involve team members in the process as well. You’ll set more achievable goals, and, as a bonus, this will give the team a sense of ownership and boost their motivation.
Build a financial model
The next step is to translate the strategy into numbers. For that, you’ll need to create a financial model.
It’s based on the three core financial statements:
- An income statement (or statement of profit and loss): shows revenue and expenses over a given period, usually a fiscal year. It also tells the net result — whether your business has made or lost money.
- A balance sheet (or statement of financial position): displays assets and how these assets are financed — through debt or equity. It’s a snapshot of what the business owns and owes at a specific time.
- A cash flow statement (or statement of cash flows): shows how much cash is generated and used, which helps to assess the business’s ability to pay bills. Similarly to the income statement, cash flows are aggregated for a specific period.
All three statements are used together to understand the financial health of your business.
But what exactly is a financial model?
In simple terms, it’s a forecast of financial statements. Its purpose is to tell you how the business is expected to perform in the future.
Most financial models are created using spreadsheets. You can download an Excel or Google Sheets template suitable for your industry.
First and foremost, establish the planning horizon for your model. Often, it’s a period of three to five years, aggregated on an annual basis. You can start with a shorter time frame and increase it in the future.
Estimating how things will play out can be challenging, especially if the business was established recently or is undergoing dynamic growth. However, you don’t have to worry about this now. Try to come up with a forecast to the best of your knowledge.
Here’s how to do it.
1. Forecast the income statement
Make assumptions about future revenue and costs, keeping in mind the strategic goals you defined previously. Consider these questions:
- What drives revenue growth?
- Are we going to make any long-term investments?
- Should we raise additional capital?
- How many more employees should we hire?
- What about marketing, product development, administrative, and tax expenses?
Analysing past financial records could help you to make reasonable assumptions. Go further than the financial statements — for instance, you can review bank statements, loan agreements, payroll registers, and asset and liability ledgers.
Then take the current income statement and create projections for each line item. You can create separate sheets for more complex forecasts, such as revenue and payroll.
2. Forecast the balance sheet
Next, fill in the balance sheet by calculating accounts receivable, accounts payable, and inventory. Add net profit from the income statement to the equity section.
3. Forecast the cash flow statement
In the cash flow statement, we have to show the actual cash movement. To do that, take the net profit figure from the income statement and adjust it for non-cash transactions. The result should equal the difference between opening and closing cash in the balance sheet.
Note: if you’re unsure how financial statements are interrelated, skip the balance sheet and the cash flow statement for now. Forecasting the income statement is more important than the other two reports, especially if you’re light on assets and long-term commitments.
4. Calculate financial ratios
You can calculate ratios (such as net profit margin, quick ratio, and inventory turnover) to help you analyse the forecasted performance. Select a few of the most relevant ones for your industry.
5. Create a summary
Build a few charts and tables to summarise the key outputs of your model. For example, you can visualise a revenue trend, a breakdown of expenses, and cash at hand. The summary will also help you spot any errors made in the model.
Create a budget
Now that your financial model is prepared, it’s time to create a budget.
Somehow, budgeting sounds far less exciting than building a financial model. However, it’s basically a roadmap for the near-term future — often for 12 months — to help the organisation stick to the plan.
A good budget includes these elements:
- Revenue. Preferably, divided into major streams and product or service types.
- Fixed costs. These costs remain constant in the short-term, irrespective of the number of goods produced or services rendered. Most day-to-day expenses will fall into this category: rent, salaries, software licenses, loan payments, and insurance.
- Variable costs. Contrary to fixed costs, variable costs depend on the output. Examples include sales commission, shipping costs, and raw materials used in production.
- One-off expenses. These are major expenses that arise from non-operating activities, such as accounting and legal fees, purchasing and selling equipment and vehicles, and relocation.
Your task is to create monthly targets for each element, which will align with the projected income statement (the one you prepared in the financial model, remember?).
Start with revenue, then take each expense type separately. If the business is seasonal, take that into account.
When you finish allocating amounts to each line item, step back and look at the whole picture. Does the budget seem realistic? Did you set money aside for unforeseen events? Are there any factors you possibly didn’t take into account?
You may have to go back and refine your financial model (or even adjust strategic goals), which is perfectly fine — unexpected things will happen, and the purpose isn’t to capture all of them.
The most significant value of budgeting is in the process itself, which makes us think about how to achieve the goals practically.
Also, you will become more accurate in your estimations over time as you understand revenue and cost drivers better.
What’s next?
Congratulations, your financial plan is ready.
You’ve done a lot of work. Be proud of yourself — now you’re well-equipped to quickly course-correct when needed.
Now you need to set a routine to track the performance.
Set time aside in your schedule, preferably shortly after the month’s end, to go through the figures in the management team.
As you review each line item, compare actuals with the budget.
Pay attention to both positive and negative variances in absolute and percentage terms. Are they in line with your expectations? If anything seems suspicious, investigate the cause.
Example: let’s say you noticed an increase in advertising expenses. You extract the bank statement and discover several payments for a Google Ads campaign, which is no longer relevant. You inform the marketing manager to stop running the ads immediately to prevent the cash drain.
Similarly, don’t forget about the trends. Even minor month-on-month deviations can lead to significant differences over the year.
In the final part of your review, consider the overall performance. How does the bottom line compare to previous periods? Do you expect any events that can impact your business? Are you on track with KPIs linked to strategic objectives?
And always write down the reasons and actions you decide to take. This way, you can refer to your records when you need to update the financial plan — which you’ll do with ease next time.
