Financial planning—which can take the form of the annual operating plan and budget described earlier, or a rolling forecast of longer-term projections—is an essential part of managing any business, for two reasons. First, it provides a means for measuring progress.

Second, the planning process helps to highlight the type, amount and timing for the resources (financial and otherwise) the enterprise will need to achieve its goals.

In years past, I’ve worked for and with companies that forced the financial-planning process by solving backward from a desired outcome:

“These numbers look terrible! Increase sales. No, wait—raise the price. Yeah, that’s it. The price has to go up. Hold on. Maybe we should cut overhead by 10% across the board. Would that get us to where we need to be?”

Stretch goals are fine, but stretch budgeting? The better—and correct—way to do this is brick by brick, with a set of rational and defensible assumptions that will let you build your projections from the ground up. No different than it is with personal budgeting, begin the process by focusing on the top line of the income statement—revenues (sales)—because almost everything else will follow.

For example, take a look at the year-to-year change in your sales numbers. Considering current market conditions, what can you reasonably expect to occur in the coming 12 months? Is there a seasonal element to your business? Are sales stronger during certain months than in others? If your business is on the upswing, do you expect your sales numbers to increase notably throughout the year? What about pricing? Is there an opportunity to increase selling prices as you grow? Do you expect your margins to come under pressure? Do you expect prices to remain constant throughout the year, or do you plan to run sales events at certain intervals? If your company is a service provider, are you expecting an increase in demand at the expense of your fee schedule?

If your company has multiple products or lines of business, consider undertaking the same exercise for each.

Next, consider the cost of goods sold. Are you expecting any price increases from your suppliers? Conversely, if sales are increasing, is there an opportunity to improve on your other direct costs by virtue of the productivity improvements you may be able to implement? What about related expenses such as those for transportation costs for the delivery of your raw materials? Would the increased volume provide an opportunity to negotiate a better price from your suppliers?
Now turn your attention to the infrastructure. Do you have the resources you need to achieve your sales targets? If not, how would you layer in the expenses during the course of the year(s) ahead? For example, do you need three months of lead time to recruit and train new salespeople? If so, you may want to consider commencing your recruitment efforts in January so the sales representatives are on board by the end of March if you’re planning for them to be fully productive in July.

What about the resources you’ll need to support the anticipated increased sales volume? Is your office or production space adequate? What about your office automation and production equipment? Do you have in place the staff, policies and processes that you’ll require? If not, consider the timing for these added costs and plug them into the financial projection.

Once your accountants have projected the income statement, they should begin work on the pro forma balance sheet and statement of cash flows to accompany it. At that point, you’ll have a sense of the external financing you might need to support the growth you anticipate. Of course, this will come at an added cost that needs to be incorporated into the pro forma. Just as important, it will signal to you the necessity of longer-range planning. Savvy business owners appreciate the value of having two things: a cash cushion to cover the firm’s monthly obligations when a hiccup occurs, and prearranged access to additional debt and equity capital when good (or bad) things happen.

The pro forma financial results should also be analyzed by running the numbers through the various liquidity, leverage, profitability and efficiency ratio calculations, in addition to testing their impact on the cash-conversion cycle. Doing so will help identify any faulty assumptions.

For example, the prospective overhead-cost increases required to support the growth in sales you anticipate might need to be ramped up differently than you planned. Or perhaps your accounts receivable aren’t liquidating as quickly as they have in the past, in which case you’d turn your attention to how this critically important area is being managed. Maybe you find that your company’s expenses are outpacing the rate of growth in revenues, in which case the enterprise’s operating leverage is diminishing.

Operating leverage is an important measure to track because it’s indicative of a firm’s ability to earn an increasingly higher profit from each incremental dollar of revenues. Here’s how it works.

Overhead costs are either fixed (that is, expenses not tied to fluctuations in activity, such as for rent and staff salaries) or variable (expenses that are indeed influenced by activity, such as for sales commissions and the cost of goods sold). Start-ups can benefit from expenses that are highly variable because the cost structure favors cash—the outlays are more directly tied to need. However, more mature companies can benefit from higher fixed costs if they are leverageable, where each added dollar of sales requires increasingly fewer resources to generate because the cost structure is relatively unchanging.

Excerpted from Practical Finance: A Straightforward Guide to Personal and Entrepreneurial Finance

Mitchell D. Weiss