According to Bloomberg’s infamous, mythical study, 8 out of 10 businesses fail in their first 18 months.
The Bloomberg figure has been shown to be nonsense, but business failure statistics given by other sources still report business closure rates of 20-40% within the first 2 years of trading, which is still a very high failure rate.
In this article, I’m going to explore one of the ways to avoid the financial pitfalls many businesses find themselves in. I’m going to talk about not just having a financial plan – but understanding the discipline of testing it.
There are myriad reasons why such a large proportion of businesses don’t succeed, but for small businesses cash flow problems are one of the most common reasons. There are practical ways to stave off cash flow problems – but much better if they can be avoided in the first place.
Making and testing a startup financial plan
Spending time thinking about the future of your business and planning out the financial consequences of different future scenarios is a good way to foresee and understand the successes and dangers that could lie ahead.
I’m going to be talking about more than just making a financial plan – I’m talking about testing it.
Let’s assume that you have made a financial plan. It includes projections of the 3 key financial reports – the Cash Flow, Income Statement and Balance Sheet. Depending on the size of your business this plan may be between 2 and 5 years in length.
Having a plan like this gives you an idea of where you are heading. You’ll find more about these financial plans and how they can help you in, A beginner’s guide to financial reports, and what they reveal about your business.
For an existing business, your assumptions will be based on existing data from your accounts – how much you’re making, the direct costs associated with your sources of income, your regular costs, levels of debt and assets and investments the business owns.
There is one major factor common to the startups I have worked in, and probably almost universal to all startups to be fair. This factor, which can be deadly to a young business, is overestimation of sales volume.
So the first test for your financial plan is simple. Run the numbers for your plan again, but reduce your sales forecasts.
If you are a planning a new business, cut them especially harshly. It sounds defeatist – but it’s actually prudence. If your expectation is a higher sales volume or faster sales ramp-up than you actually get, you will be much better prepared if you have considered this lower estimate in advance.
How long can the business survive making minimal sales? Is it worth pursuing the same product or sales strategy at low sales volume, or does the absolute necessity of keeping the business’ lights on mean that after a certain point you will have to change tactics, seek investment, or take out a loan?
Each of these alternatives will have knock-on effects on your planning – include them and work through all of the potential likely scenarios.
It will be useful to have your financial plan broken down into several sections or groups of activities.
For example, if you are an existing business with a tried and tested product, but are launching a new product, you will want your financial plan to clearly separate these income streams so that you can easily understand and flex them independently of one-another.
In addition to simulating the effect of lower than expected revenues, don’t forget to project the full consequences of higher revenues – will selling more mean that you need to hire more staff, make bigger orders, or perhaps switch suppliers?
These are definitely positive problems – but each will have an impact on your cash flow, and if being very successful raises your costs you will need to be careful that this doesn’t result in a lack of ready cash at some point.
We’ve talked about how as you sell more, direct costs related to that sale may also rise. But there will also be rises in other costs to the business. These are likely to be a slower creep in price increase, though this will depend on the market your business is in.
While you should be on guard against high sales expectations in the short term, rising costs are usually a longer term consideration. If your concern is the next few years then rising costs will be a small part of your plan. But when planning over a longer period, or anticipating financial changes from world events, rising costs may be very pertinent.
When planning for rising costs, your assumptions will be based on your business and its suppliers.
How on earth do you plan for an expected cost!? It may sound like an impossible task – but there are ways to simulate this when making a financial plan.
Your plan should ideally be flexible enough that you can drop in an unexpected cost and see the ramifications of it at different points in the plan.
For example, if your business relies on some expensive machinery or computers, having to replace these ahead of their expected replacement date would constitute an unexpected cost.
There may also be costs that are not already considered elsewhere in your business plan. If you become involved in a legal dispute, or are forced to face a fine this is (hopefully!) not going to be part of your financial plan. But ensuring that there are no points where the business struggles to have ready cash should be enough of a contingency to account for this.
Changing the timing of financial activities in your plan does not deal with a particular part of the plan, like sales or costs, but is a general method for testing how the plan reacts if certain things happen earlier or later than predicted.
Alas, delays are more common than things happening too quickly! But both can have a big impact on your business plan.
If the business has to postpone the start of a new project or product this could have knock-on implications for many activities associated with that project or product. You may not need additional staff or equipment until later, but any increase in revenue will likely also come later in your plan.
Having the financial side of new projects or products separated out in your plan is a good method for testing changes in timing. If everything is listed together it can be hard to pick apart the financial activities directly involved in a project.
Changes in timing could be simpler though. As mentioned above, changing the date on which equipment needs to be replaced should be a simple test to run in your plan.
Hiring new staff is a big cost, where a month can have a large impact on your cash flow – so test your plan and ensure you can afford to make new hires comfortably.
While changing when financial activities take place can be used to model different business decisions as described above, there is another key timing that can be adjusted.
There is often a material difference between when money is owed and when it is paid. Sometimes called ‘payment days’ this is the difference between when you sell a product or deliver a service and when you get paid for it.
You should test increasing the period before you are actually paid for goods and services – as particularly delayed payments can prove dangerous for the business’ ability to cover its costs.
Try different approaches
When testing a financial plan, don’t be afraid to try out new and innovative ideas as well – you are not just here to test whether your business is in danger of failure after all.
Experiment with your financial plan and you may find better ways to operate in the future.
About the author
This article has been written exclusively for ByteStart by Robin Booth of Brixx.com the financial forecasting app that turns your ideas into numbers.