Running out of cash is the biggest risk a growing business faces. There are three instances when the risk is much higher.
We’ve been in business for over 16 years. I’ve been studying what makes businesses successful (or not) for much of that time. These are the lessons I’ve picked up.
You have a much better chance of survival if you can anticipate problems with your business strategy, planning, and operations. Unfortunately, many business owners rely on very simple projections and assumptions when planning. Guessing leads to poor decisions based on overly optimistic or inaccurate numbers.
A sound financial model can help you:
- Understand what factors drive profit for your business.
- Determine how fast you can grow and not run out of cash.
- Compare your current and projected (future) performance relative to your peers.
- Perform some what-if scenarios (within the constraints of the model)
- Better understand the interaction between your three key financial statements:
- Balance Sheet
- Profit and Loss
- Cash Flow
- Mitigate the risks you are taking during a significant business change.
Here are three scenarios where you really should have a good financial model.
Scenario 1 - Start-up Planning
Most start-up planning is pure fantasy. You have no track record, so you make a bunch of assumptions and forecast your financials for 3-5 years or more. You might use some business planning software to fill in the numbers and perform some of the calculations for you.
A much better approach is for someone who knows the realities of your business and can set up a better model based on what other companies like yours have done. This model can incorporate industry benchmarks as well. For a realistic model, the inputs need to consider the management team’s strengths, your market, your offerings, and your ability to penetrate the market and gain enough market share to become profitable.
If you are a start-up in new, unexplored territory, use a model based on well-chosen comparison companies.
Make sure your model contains results for your:
- Base or anticipated scenario
- Your worst case scenario
- Your best case scenario
Many people ignore the “what if we are wildly successful?” scenario and therefore, are oblivious to the risks of unplanned, high-growth early in the business.
As a start-up, the model is still mostly speculation but building the model, or having one built for you, forces you to understand your business a lot better. This knowledge is invaluable to a budding entrepreneur.
Scenario 2 - High Growth Mode
A lot can go wrong very quickly during high growth. In general, you are adding a lot of new customers, employees, products, and services very quickly. With this many moving parts, there are a lot of fires to put out. You may miss the early signs of bigger problems thinking they are just growing pains.
If your bills (including payroll and rent) come due before you have the cash in the bank to pay them, you can become insolvent. This crisis can occur even if you are profitable on paper.
Additional volatility can happen if:
- Your business is cyclical
- Your work is project based
- Payment terms are longer than 30 days
- Most of your revenue comes from new business rather than recurring or subscription-based business
- You are in a volatile industry
- There are dramatic changes in external factors.
Scenario 3 – A Major Change in Your Business
When you are opening a new location, starting a new line of business, or launching new products or services, it is essential that you understand the impact and risks.
If you have been in business for a while, you will either raise some capital or decide to finance the change out of existing cash and profits. It helps to think of an initiative like this as operating a start-up within your more mature business.
- What is your burn rate on that new portion of the firm?
- How long before it will be profitable?
- What is the risk that you could run out of cash?
- When will you cut your losses if something goes wrong?
If you are also growing quickly, you have several considerations to factor in at the same time.
Limitations and Considerations
If you are a spreadsheet whiz and have enough financial and business experience you might be able to build this model yourself. If you are a mere mortal, you are probably better off having a professional involved. Don’t delegate and disappear though. You need to be involved.
Also, consider the impact of the various areas of your business and the current talent available in your organization. For instance, you might have big sales targets, but you might not have a lot of marketing or sales experience in your current team. Hiring and training take time.
It never hurts to get another set of eyes or three on your business plan and model. This input isn’t to derail you, but to make sure you have all the major factors in front of you. Just keep in mind that even a great model is not the real world.
Then you need to execute. Things will change. But with a good financial model and continuous tracking, you will be in a position to make better decisions.