So you’ve heard of bookkeeping and accounting, but what is financial planning and analysis (FP&A), and why is it important?
This is the second article of a three-part article series on how to think about entrepreneurial finance. This article will provide you with the basics and principles of FP&A.
What is financial planning and analysis?
Simply put, FP&A is the process of determining how your company will afford to achieve its vision, strategic goals, and objectives. While accounting is about looking backwards, FP&A is about looking forward.
In the world of startups, you can tell just how important planning is by looking at some of the companies with no revenue and huge valuations – much of the company’s value comes from its projected future earnings. It’s safe to say that no matter the size of your company, you are going to need to engage in budgeting, forecasting, and analysis that supports major decisions of its executives.
Building the financial talent you need in a startup or small company is a gradual process. In a new venture, the FP&A function is often handled by the founders with outsourced assistance. As the company grows, the controller or CFO will often be in charge of FP&A. And as the company becomes larger, a full-time FP&A team will most likely be a valuable investment.
The increasing magnitude of financial complexity, employee count, revenue, and outside funding are the drivers of the evolution of the financial infrastructure in the startup. Generally speaking, with venture funding in hand, more than 30 employees, and/or generating solid revenues (€5-20 million), it’s time to think about formally instituting a FP&A department within your company.
FP&A will be an integral part of finance and accounting, whether in-house or outsourced. The FP&A manager will assist with the preparation of internal and external reports, materials for the board of directors, monthly financial analysis material and provide ad-hoc planning and analysis for the organization.
In a well structured company, the controller will manage financial accounting, and the FP&A person(s) will be in charge of management accounting (article coming soon).
The workflow of an FP&A manager includes:
- Creating systems and processes on a daily basis
- Short-term cash flow analysis and forecasts
- Routine analysis of internal controls
- Creating and analyzing financial models and simulations
- Anticipating scenarios about the company’s cash flow and financial projections
- Implementing monthly, quarterly, and annual growth strategies
Generally speaking, the FP&A manager will be in charge of the processes that support an organization’s business health and strategy, and ensure basic financial survival.
And make no mistake, while being very good with numbers, the FP&A function requires a surprising amount of communication skills. FP&A is also part of the professional approach used when searching for debt or equity capital, and when presenting your ventures to investors and lenders.
The modern finance function
The bad news about FP&A is that the work can be boring. The good news is that it’s quickly becoming more interesting. FP&A professionals are in essence storytellers. Using numbers as their language, they provide insights into the future by connecting the dots, thus unlocking value.
In other words, FP&A is about anticipation – making sure you get answers to questions that link planning and analysis to choices and strategic business decisions. FP&A answers strategic questions, ensures good accounting, analyzes product profitability, and of course, it’s used to determine how much money your venture needs, when is it needed, and how long will it last.
Any size company can benefit from engaging in FP&A activities, even if you have to outsource them at first. The “F” in FP&A speaks for itself; the finance function is just part of a broader company responsibility to plan, acquire, and manage capital to efficiently run the business.
Finance professionals can serve a wide variety of areas within an organization. Below, I’ll go over the process that financial planning (“P”) and analysis (“A”) encompasses, and highlight its key parts.
The “P” in FP&A
Accountants record the historical results, and then the FP&A professionals take this information and analyze it and explain the historical performance (the “A” in FP&A). Then they forecast future period results using the insights learned from the analysis (the “P” in FP&A).
The core of the FP&A role really lies in the ‘planning’ aspect of it, because it not only involves forecasting how the bottomline will change over time, but also includes contributing to a solution on how to close the financing gap.
The purpose of financial planning is to indicate the venture’s potential and to present a timetable for financial viability. The financial plan is basic to the evaluation of project, and it needs to represent your best estimates of financial requirements.
To make sure the value chain, the cash cycle and the other economic fundamentals make sense in terms of the business opportunity and overall company strategies, try to get answers to the following questions:
- What are your gross and operating margins?
- What is your profit potential?
- How durable is the stream of profits?
- What are the variables that go into determining pricing and produce profits?
- What are your fixed, variable and semi-variable costs?
- What assets are used and will be used in the business?
- How many months to break even given your proposed financing?
- How many months to reach positive cash flow?
- When will you run out of cash?
- Can you foresee any significant changes in cash flow as you grow?
Important note: always document all assumptions supporting the pro-forma (projected) numbers and financials, such as the assumptions made in timing of collections and receivables, terms of payments to vendors, planned salaries and wage increases, anticipated increases in any operating expenses, seasonality characteristics of the business, and so forth.
Also, in high-growth environments, organizational development is often a key factor, so don’t forget to include staff assumptions as well. More employees will bring about more complexity and the need for more financing.
Keep in mind that to estimate cash flow needs, always use cash-based rather than accrual-based accounting, that is, use real time cash analysis of expected receipts and disbursements.
And finally, you should update your capitalization table showing ownership and invested equity based on the external funding requirements needed to drive transformation and growth.
The “A” in FP&A
The analysis part of FP&A is about understanding the financials of your business, both quantitatively and qualitatively – sometimes finance is not about money. These are some of the basic questions you should be asking yourself and that financial analysis can help you answer:
- How long does it take to get a customer to buy your product?
- How much cash do you need to get to the next milestone?
- How much do we spend on marketing in order to generate the revenues we’re looking for?
- How long will it take to convert a prospect into a paying customer?
Here are the basic activities involved in financial analysis that you need to know:
Analysis standards. The analysis needs to cover three years, including current and prior year income statement and balance sheets, if applicable; and profit and loss forecasts for three years ahead, including pro forma income statements and balance sheets, and a break-even chart.
Cash flow analysis. During the start up years, usually the level of profits will not cover operating needs financially, and the cash inflows often do not match the actual cash outflows on short term basis. Detail the amount and timing of expected cash inflows and outflows. Determine the need for and timing for additional financing and indicate peak requirements for working capital.
Break even chart. A chart showing the level of sales and production that will cover all costs, including those costs that vary with production, highlighting opportunities to take advantage of scale costs and those that do not.
Specify assumptions. Along with the schedules, you must specify the assumptions behind such items as sales levels and growth, collections and payables periods, cash balances, or cost operations.
Sensitivity analysis. It’s also standard to perform a sensitivity analysis, such as for example what would be the effect of a 20% reduction in sales from those projected or 20% higher level of productivity costs, and which could prevent the venture’s sales and profit goals from being attained.
Also, describe how you will report costs and how often, who will be responsible for the control of the various cost-elements, and how you will take actions on budget overruns.
And finally, highlight the important conclusions, including but not limited to maximum amount and timing of cash required, the amount of debt and equity needed, and how fast any debt can be repaid.
10 of the best FP&A principles to keep in mind
- A good plan. Easy to understand and simple to execute financial planning often determines whether a venture will succeed or fail – a good plan is a very powerful tool. (1) First define the core of the business opportunity and the strategy for seizing it, (2) then begin to examine financial requirements in terms of -assets needed and -operating needs, and (3) finally identify the details.
- Business opportunity always leads and drives the business strategy, which in turn drives the financial requirements, the sources and deal structures, and the financial strategy.
- Creativity plays a very important role in financial planning. As an entrepreneur, you need to look creatively at your venture and consider alternative ways of launching and financing it.
- FP&A is continuous cycle, and unless the company ceases to exist, the FP&A process never stops. The financial life cycle determines the capital available over time for different types of firms at different stages of development.
- The financing strategy is ultimately determined by the available alternatives –so the principle is obvious: ideally, raise money when you do not need it.
- Cash is King, and cash-flow is Queen, referring to the immense importance of cash in the overall health of a startup or new business – cash is the lifeblood of a new venture. Lack of cash management is one of the most cited causes of company trouble.
- Building a brain trust of the right mentors, advisors and coaches is one of the entrepreneur’s most valuable secret weapons, so reach out.
- Use other people’s resources (OPR), it can be as simple as anyone or anything available that will help promote your project. Control of resources rather than ownership of resources is the key to a ‘less is more’ resource strategy. Bootstrapping is about relying on the minimum possible to proof that you can bring cash into the business.
- Spreadsheets (a double-edged sword) are nothing more than pieces of accounting paper adapted for use with a computer. While computer-based analysis is a great resource, it’s also a source of problems for entrepreneurs who have the impulse to get carried away with schedules and calculations before applying facts based on an understanding of the business.
- Analysis should be grounded in sound perceptions about an opportunity, if not, it’s almost always inaccurate. If the business opportunity is not well defined, ‘playing with the numbers’ is just that – playing.
The bottom line – performing FP&A is critical to the success of any business
Entrepreneurs in high-growth companies distinguish themselves with leading entrepreneurial practices in marketing, finance, management, and planning. But often in a new and emerging company, the finance function is nothing more than a bookkeeper or an outsourced accounting firm, and this leads to situations like lack of real cash management.
FP&A is a resource in itself, and it’s quickly becoming a source of competitive advantage for companies by increasing efficiencies in operations and use of capital, often leading to a huge potential boost – i.e.higher startup valuations and more access to talent. Good forecasting means good prediction of future outcomes and a better strategy-setting.
So, either founders learn the language of accounting & finance, or they have someone on the team who does. But generally speaking, founders will not get very far without a basic understanding of accounting (the language of business), FP&A (storytelling with numbers), and management accounting (the performance of operations).
A founder with a good understanding of the finance function will be in a much better position to drive their venture to success, no question about that.
I hope this article has been a helpful guide to understanding the role of financial planning and analysis at a startup company, and at any new business for that matter, and how the FP&A function plays a major role in supporting decisions made by a company’s CEO, CFO, and executive team.