Financial Planning: What is it and why should I have a sound financial plan?
Hello everyone!
It's been 3 weeks since my last post. It's time to write another one.
This second post is about Financial Planning in general, about what it is and why it's so important.
The differences between financial planning for new versus mature businesses
Over the course of the last year, I´ve been talking to many people about the service I want to offer. I was surprised to discover that the people I had spoken with without any finance background believed that my service was about creating financial projections for a business plan.
I realised I needed to more clearly identify my services and today I would like to take a moment to explain the differences between financial planning in the context of:
A business plan at the beginning of your business and
An Operational Plan (OP) & budget for a more mature business
In summary, a financial plan for a business plan is a forecast focusing on company level without any (or with limited) relevant financial information from your past, and thus is missing an important ingredient to ensure a higher level of predictability.
Financial Planning & budgeting for a mature business is much more in-depth and often based on a mix of historical data and assumptions considering your business strategy and your market outlook. Your budget is prepared by various contributors (bottom-up approach) and will thus also serve as targets for these contributors. Significant deviations from these plans will usually require prior approval from management.
Ultimately, these targets can be also used for bonus purposes and for performance analysis (actuals vs. plan).
Value of financial planning & budgeting
So why should you invest your and your employees´ valuable time to prepare a financial plan? Here is a list of potential benefits detailing why a realistic financial plan is so critical:
Pricing
A clear forecast for your unit & overhead costs will help you to set your pricing.
Your product owner (or controller) should be able to forecast the unit cost reliably.
But the final price needs to consider both cost factors to avoid selling your product at a loss (unless you use a penetration pricing strategy to enter a specific market).
A reliable forecast can ensure you are adjusting your price accordingly.
Steering Operations
The Financial Plan is also often called “Operational Plan” as it’s based on detailed operational inputs, and prepared by each team.
The Financial Plan ensures all teams are aware how they can contribute to the collective success
(especially if targets are linked to compensation schemes).
The finance team will also have a clear view on the Working Capital Cycle and will help the operational teams to optimise the production cycle to avoid any funding gaps.
Risk Management
A structured process to review your operational & financial plan for the upcoming year(s) should improve your early risk anticipation capabilities.
Risk mitigation measures can save your company a lot of headaches, resources and cash.
Financial confidence
The better you understand your business & operations, the better you can anticipate and prepare for some obstacles, the more confident you and your investors will be.
Self confidence based on data (or reliable forecasts) will help you to stay in control, lead your employees, interact with investors and steer your company towards your goals!
Valuation & Funding
Investors care about the idea, its market potential & test results and the team involved for very good reasons.
However, they also value a high probability of success and minimising risks.
Cash Flow projections and risks are major factors impacting your valuation.
Estimating your burn rate and fume dates will help you to decide when to raise capital and how many funding rounds you will require in total.
An unfavourable term sheet based on an unrealistic valuation can significantly impact future funding rounds (imagine you give too much ownership to an early stage investor due to unrealistic valuations and there isn't sufficient room for other investors later on).
I hope this short overview gives you a general idea about financial planning and budgeting and its value.
Please feel free to leave a comment or question in the comments section below. Or reach out to me if you would like to discuss it offline!
See you soon!
Jānis