The first and most important question is «what about cost planning?»
In my experience, I notice that many founders of even fairly large startups do not pay enough attention to cost planning when building their financial models. Usually entrepreneurs, having a good understanding of the market and their product, give quite relevant forecasts regarding future revenue. But little is the cost block as important as the revenue block. After all, the most important formula on which any business is built at all times is profit equal to income minus expenses. And if we are talking about business planning, we can get into a situation that at first glance a profitable business is on the verge of bankruptcy only because of insufficient attention to cost planning at the launch stage.
The classical financial model necessarily includes P&L (profit and loss statement). It is important to formalize the framework of this report correctly, since it is from it that all further key calculations of financial planning and evaluation of the project then follow.
This report is built from consecutive blocks from top to bottom:
1) The first block is the revenue block. Its result is revenue, i.e. the sum of all receipts from all types of activities for a certain period (usually by months or by quarters).
2) Next comes a large expense section consisting of consecutive blocks:
- Variable direct costs– expenses that relate directly to the product itself, i.e. cost. The simplest example is if you are a furniture store and your business consists of purchasing furniture at the factory and selling it at retail, then your variable direct costs are the amount spent on purchasing furniture at the manufacturer for a specific reporting period.
- Fixed (conditionally permanent) direct costs are also expenses that relate directly to the product, but not for each unit of production, but, for example, batches or purchased for a certain period. An important difference from indirect costs is that there are no fixed direct costs at the moment when the company does not release its final product.
Gross profit (margin) is the difference between Revenue and direct expenses (variable and conditionally constant). In classical business, gross profit is usually considered as the difference between the revenue from all sales and the cost of all sales. In the case of IT, it is more correct to talk about direct costs, i.e. those costs that relate directly to the product being sold, and their amount depends on the quantity of the product being produced and/or sold.
- Variable indirect costs – costs that, unlike direct costs, cannot be directly attributed to the cost of the product, and at the same time are not constant, i.e. they change from the volume of products or over time. Indirect costs are distributed proportionally between different types of products on a certain basis.
- Fixed indirect costs – costs that also cannot be directly attributed to the cost of the product and do not change depending on the volume of production or within a certain period of time.
Operating profit (EBITDA) is the difference between gross profit and all indirect costs.
- Taxes, Depreciation and Amortization, interest on loans and borrowings.
Net profit is the difference between EBITDA and, accordingly, the last block of cost items (taxes, Depreciation and Amortization and interest).
Thus, the consistent construction of the forecast for all these blocks gives us the visibility of the calculation of the most important key performance indicator, i.e. the net profit of the business. Some of the blocks may be missing, some may be expanded internally, but the most important thing is to understand that margin, i.e. gross profit, is far from the final financial result. And that planning all costs by blocks is extremely important for building a successful business at the earliest stages.
Therefore, when building a financial model, first of all, work out the issues of the distribution of planned costs according to the above scheme. This will give correct key indicators and a final assessment of the business.
The second question is – will the amount of investment attracted cover your cash gaps?
The forward-looking cash flow statement (CF) is best suited to answer this question. Which, in my opinion, is the second most important component of any startup financial model. It shows all incoming and outgoing cash flows for a certain period of time, but most importantly – accumulatively. Ie, this report will show you where cash gaps are possible. The cash gap is the state of the company when there are no funds to repay the mandatory expense item. Most importantly, the forward-looking cash flow statement allows you to see the maximum minus on the availability of funds for the entire planning period, and, therefore, show the minimum required amount to cover this minus.
The third question is – what are the income figures based on?
The best way to do this is a detailed and consistently tabulated sales funnel or any calculation and justification of sales volumes and projected revenue amounts. There are no specific rules or standards by which the developers of financial models should calculate the forecast of sales and revenue, but I prefer to transfer to a tabular form all the available input data and everything that we can predict in advance. Since we cannot know the future for sure, I encourage you to do several scenarios. Usually there are three of them – pessimistic, basic and optimistic. And in the pessimistic scenario, we introduce our key parameters, which we can predict based on marketing research, but underestimating them by 30-40%. And, if, choosing this scenario, our final indicators of the financial plan (net profit, availability of funds in accounts, and so on) if they do not fall into the negative, it means that our project is quite stable, and we are ready for risks.
The fourth question is how do you assess the value of the company?
If the model does not contain a block with an estimate of the company’s value, then it is not clear why the founders made the model at all. The basic method of evaluating a startup at the planning stage is the discounted cash flow (DCF) method.
The advantage of the DCF method is that here the assessment is based on future results, which is ideal for startups that probably have not yet shown significant results, but have the potential for growth. The disadvantage of this method is that the evaluation result is very sensitive to the source data used for calculations. But nevertheless, this is the most common method of evaluating IT startups. Other methods of business evaluation (cost-based, comparative, and others) are not applicable in this case. DCF considers the value of a company as the sum of its future cash flows, reduced to the current value of money through a discount rate. The sum of these discounted cash flows is NPV.
NPV is an abbreviation for the first letters of the phrase “Net Present Value” and it stands for net present value (to date).
Thus, if the founders can answer these four questions, we can say that their project is sufficiently developed financially, and has a chance of success!
Author: Roman Fisenko
Financial manager in Glocal LLC in5 Dubai incubated