Financial forecasting is something pretty much every entrepreneur knows has to be done, and also something many entrepreneurs don’t understand. The problem, I think, is that entrepreneurs (and a fair number of investors, for that matter) often confuse two quite important but very different forecasting tasks, to wit financial budgeting and financial planning. While both of these are important management tools, they are very different in terms of both form and utility.
The Financial Budget is a short term (12-18 month), detailed projection of dollars in (from where) and dollars out (for what). Budgets inform management of the nuts and bolts of the business, and answer questions like “when do we run out of money, and what are the key cash-in/cash-out variables re the same” and “how do we match needed investments in the business (new hires, marketing expenditures) against what cash-in variables.” In the early stage high impact business – much less so for more mature business – budgets are very much living documents: while it is sometimes useful, and often makes for a good chuckle, to compare the budget as of January with the actuals the following January, budgets are frequently updated over the course of the budget horizon. Things almost always happen too fast in the startup world to expect a budget made in January to remain static for more than a few months. Balancing necessary management accountability issues against rapidly changing business realities is difficult but ultimately the essence of a solid budgeting process and tool in the start-up environment. Finally, budgets should tie more or less line to line against a start-up’s accounting reports, and be based on real-time estimates of actual costs.
While budgets are detailed, short-term operational planning and accountability tools that generally evolve more or less continuously as new information becomes available, financial plans are generally longer term (think 3-5 years) event-driven (think capital campaigns) documents based on assumptions about key business drivers rather than line item costs. Financial plans are typically prepared to support a fund raising event, and are designed to give a potential investor a realistic (if not very precise) picture of how the business can plausibly build value for its investors over a reasonable investment horizon. Once the fund raising event is consummated, the associated financial plan is generally set aside: when the next fund raising campaign comes along, a new financial plan will be developed more or less from the ground up. (Not that your investors will not want to remind you of financial performance that fell short of the financial plan.)
Financial plans generally do not tie to accounting reports. Instead, they are largely formula driven (e.g. customer support headcount based on number of customers) and focused on key business drivers (say cost of customer acquisition) vs. specific spend estimates (e.g. dollars invested in SEO). Financial plans are thus significantly less detailed than budgets, and while there should be a general sense that the financial plan is consistent with the financial budget, there isn’t line-to-line mapping of the budget and plan. While it can be helpful, now and again, to audit a financial plan by looking behind some of the numbers to see if they are plausible when mapped against budgeting categories, the plan is fundamentally a strategic planning document, as contrasted with the operating nature of the budget.
In general, then, when thinking about the financial aspects of a business plan, startup and early stage entrepreneurs should be careful to distinguish – in terms of purpose and form – between financial budgeting and financial planning. The budget challenge is fundamentally about creating a detailed12-18 month tool for managing the business’ cash resources; a tool that will evolve as often as monthly, while at the same time give managers (and investors) a tool for evaluating management’s operating performance. The challenge with the financial plan, on the other hand, is creating a plausible strategic financial model based on key business drivers to support (convince) prospective investors to fund the business on appropriate terms.