By Raffi Yousefian | Published 12/9/2020 01:15:45 PM
For any venture to achieve success, it’s absolutely imperative to establish goals at the outset. Begin with the end in mind, as they say. And yes, knowing those goals is critical – but that’s not all. The harder task is figuring out how to achieve them.
According to a 2017 Concentric survey, over three-quarters of companies surveyed agree that the process of forecasting, which uses historical data to make projections, is critical to future success. However, when asked about their own methods, only 13% believe themselves to be effective at forecasting.
Every organization (regardless of size) should have a minimum 12-month financial model to understand how business decisions will affect them going forward. This financial model provides direction to corporate management, a board of directors (if applicable), and the entire team. The model clearly illustrates what the organization is trying to achieve, along with the implications of any steps taken – so everyone works in sync. So how does this process work?
Developing a Forecast
The process of forecasting takes an organization’s historical and current financial data and uses it to estimate future financial outcomes. In order to create an informed forecast, it’s necessary to dive deep into the organization and all of its financial inputs and outputs.
That means understanding sources of revenue and funding, expenses, salaries & wages, direct operating expenses, occupancy costs, and general & administrative costs. Any time funds are flowing into or out of an organization, it’s important to know what they are, how much, when, and what’s driving them.
In many cases, this starts with a company’s sales process – what it looks like currently, and what types of activities are happening to drive sales. For example, if the company has a set marketing plan, you can then project a set amount of revenue. That process can be broken down further to understand revenue & expense drivers, and variable & fixed income.
Modeling Financial Statements
With a financial forecast in hand, you can start modeling financial statements. The process of financial modeling provides the opportunity to evaluate whether operating, investing, and financing plans are both feasible and internally consistent. Modeling takes financial forecasts and uses them to build a predictive model, helping the company make sound business decisions.
Modeling calculates the financial forecast’s impact on the organization’s income statement, balance sheet, and cash flow statement. For example, if you’ve created a forecast that estimates X revenue and Y expenses for the next 3 years, you can use those numbers to understand what the profit & loss (P&L) statements and balance sheets will look like in 2021, 2022, and 2023.
Financial modeling isn’t limited to one scenario either. Organizations can try several different models to understand the outcome of each one. One model can assume that everything the organization hopes to achieve happens. The marketing strategy succeeds, the company gets a certain number of leads, and the company then converts some percentage of those leads to clients. That’s the best-case model. You can also look at models where the company achieves 75% or 50% of its target activities, creating middle-case and worse-case models.
Creating a Budget
Developing a financial forecast and modeling out financial statements enables the next crucial step: creating an organizational budget. Budgeting clearly outlines an organization’s expected spending, based on learnings from the forecasting and modeling processes.
After reviewing the financial models mentioned above, let’s say the organization decided to choose the middle-case model. Based on that middle-case model, management and stakeholders will be able to see what their financial statements look like. They can then set the budget based on that moderate scenario, to be approved by management (the board of directors, investors, or partners).
The budget will typically include as much detail as possible. It’s not just a set spending amount – it breaks down spending into categories with detailed explanations of assumptions. Over the course of the year, the organization as a whole will report against the budget. Each department will benchmark what they spend against the budgeted amount, showing budgeted vs. actual spending. The differences between budgeted vs. actuals can be used to re-forecast down the line, and the whole process starts over.
Want to see how the process of financial modeling works? Here are a few sample scenarios from our clients:
Example 1: Tech Startup
RY CPAs worked with a traditional services company that built an in-house platform and created their own online marketplace application. The company transitioned from being services-based to tech-based and decided to raise venture capital to increase growth exponentially. Their goals were to increase sales within a specific vertical, expand market share, and prove scalability of their technology.
After raising a $5M seed round, management realized they needed additional support. Investors were demanding a lot more information from them – including both current financial statements and future projections.
RY CPAs dug deep by tapping into the company’s sales model, understanding revenue drivers, and determining variable and fixed costs. Based on this data, they were able to forecast both P&L statements and balance sheets for several years into the future. And this model could change over time: if the company’s marketing plan wasn’t working or they lost a big contract, management could see when they would run out of money. They could then determine what changes to make based on the updated model.
With financial forecasts, modeled financial statements, and a detailed budget, the technology startup was able to execute on their strategy and grow their revenue by 400% within the anticipated timeline of reaching a Series A funding round.
Example 2: Non-Profit Organization
A non-profit organization engaged RY CPAs with the dual goals of setting an organizational budget and knowing where they would be financially at each year-end for the next 5 years.
The non-profit’s revenue is sourced from grants from government entities, foundations, and high net-worth individuals. Some grants come with restrictions.
Based on restricted and non-restricted donations, RY CPAs mapped out the total organizational budget, including which funds could be spent on which spending categories. Starting with forecasted revenue (in this case, donations), the firm worked backwards to determine a budget.
The non-profit also wanted to know how much they were spending against their budget (budget vs. actual), and how much they’ve committed to spend. For example, if the non-profit has contracted to spend $50K on an outsourced CFO, this expense must be included in the committed budget. Monthly budget meetings ensured that any changes in grants and donors were updated immediately.
To understand end-of-year (EOY) financials for the next 5 years, RY CPAs created a revenue forecast. It was broken out into several scenarios including secured revenue (pledged donations), highly-likely revenue, and prospective revenue. With this forecast, the executive director of the non-profit could see how much the organization would need to raise in donations to get through the next 5 years.
With this framework in place, the non-profit was able to understand exactly how much funding they needed to raise to deliver on their mission in 5 years. This visibility made it possible for them to increase their funding and annual budget by 30%.
For Growth-Oriented Organizations, Financial Modeling Has a Major Impact.
The ability to develop a financial forecast, model financial statements, and create a budget can mean the difference between success and failure. Investors want assurances that their proposed funding infusions will drive ROI. Donors want to know how an organization uses its funds to fulfill its mission – and how it will continue to operate over time. This detailed analysis in the financial arena can help organizations shift more investors and donors to sign on the dotted line.
At RY CPAs, we use financial modeling to help growing organizations understand their true potential. Our seasoned experts consult with clients to create an accurate financial picture for today and tomorrow. Contact us to learn how we can help your unique organization succeed.