We’ve covered a few lessons on the importance of financial reporting and forecasting:
- Why should a tech startup care about financial reporting?
- Elements of financial reporting of a growth company
- How can lagging and leading indicators be used in financial reporting?
- Chopsticks metrics: How to make your metrics actionable?
As a CFO, it is my responsibility to watch the company’s metrics like a hawk. I can almost instantly spot discrepancies and notice when something isn’t heading in the right direction because I know exactly what to look out for.
As a founder, having a solid background in finance gives you the leverage to make better strategic decisions for the company. The more you know, the easier it is to plan, strategize, navigate, and iterate.
Companies are created because someone believed in an idea or a vision that can revolutionize our lives. But, sadly, many founders also lack the financial knowledge that can help keep their company afloat for long enough to see it take off.
That’s okay. It’s not easy being a founder. Let alone understand finance like a CFO (it takes years of practice to get there) or even just catch up on finance jargon. So if you’re feeling overwhelmed because there are so many things to look at, you’re not alone.
The easiest way to start is first to understand which pieces of information you need to look out for in your forecasting. In this lesson, we’ll take a look at the three main elements of your Profit & Loss (P&L) forecasting:
1. Staff cost forecasting
This is typically the highest cost of running a company because it is more than just paying wages and all other expenses surrounding a hiring process. It’s the reason most companies instinctively opt to shrink their teams when they run into financial challenges.
While that may be the easy way to reduce cost, shrinking your team shouldn’t be your first choice because your employees are your most significant assets in moving your company forward. There are other ways to increase revenue, and it starts with proper and accurate forecasting. So let’s break it down.
Your staff cost is reflected in three areas:
For example, the COS for SaaS businesses typically includes the following cost centers:
- Wages of Support staff
- Wages of Customer Success staff
- Payment processing expenses
- Hosting expenses
Your penultimate goal is to grow your revenue faster than your COS. That means driving a profit. If your staff cost is higher than what you’d initially budgeted for, you can either:
- Increase revenue by acquiring more customers; or
- Make internal adjustments such as reshuffling your resource allocation; or
- Invest in self-serve onboarding, so you don’t have to increase headcount in your customer success team.
2. Sales and revenue forecasting
Revenue forecasting tends to be the biggest headache for many startups because it takes time to build a solid Monthly Recurring Revenue (MRR) base. Unfortunately, that means your metrics are also fluctuating until you find the secret sauce to lower your churn.
Not having a solid MRR base and a high churn poses a threat to your cash runway. This is a big ‘Uh-oh’ moment because the old saying ‘Cash is king’ holds very true here (and I wasn’t referring to Johnny Cash).
Cash runway is one of the most challenging factors in getting a startup running. Most companies have limited working capital and cash-in-hand to start with. Limited access to cash means they also struggle to find scalable growth.
The big question is: How do you direct your KPIs in the right direction with the limited amount of cash in hand?
In this case, you can use your Average Revenue Per Account (ARPA) and your Churn to help you determine your revenue streams and gaps within your business.
Let’s say you offer a monthly subscription plan of $200, and your churn rate is 10%. While churn is inevitable, your goal is to reduce your churn rate by half. Because lower churn means higher MRR and Net Revenue Retention (NRR).
We’ll assume that your customers are leaving because your pricing is too high.
They may need your product but are not ready to pay for that subscription plan yet. To reduce churn, you can:
- Make more features available at the same price. Your customers get more than what they are currently paying for; or
- Unbundle and build a pricing package based on an upselling pathway that starts low (in this case, $100 per month) but allows them to upgrade through add-ons that suit their needs.
Suppose your sales conversion rates, ARPA, and Monthly Recurring Revenue (MRR) show improvements after this pricing change. In that case, it means that your previous starting pricing was too high for many customers to start using your services.
On the other hand, if your ARPA still doesn’t improve, it means that you need to improve other areas, such as your customer service or the product itself.
Your goal is to acquire as many customers as you can and then focus on retaining them to grow your Net Revenue Retention (NRR) – retaining a customer is ALWAYS cheaper than acquiring new ones. The higher your NRR, the better.
3. Expenditure forecasting
Any kind of expenditure is recorded as costs in your P&L statement because they are related to ongoing business operations to keep your doors open. Let’s take your Operating Expenses (OpEx) as an example.
The three main areas of your OpEx are:
- Marketing and Sales (M&S)
- General and Administrative (G&A)
- Research and Development (R&D)
For example, any costs incurred in product development fall under your R&D category. R&D refers to any kind of activities companies undertake to innovate and develop new products. This includes payroll, software, and tools needed to run your research and development, etc.
As a benchmark, the average spend for this area is approximately 23% of your revenue. Let’s say you’re generating $25,000,000 in annual revenue with a growth rate of 50%. You’ll probably need to invest around 25% of your revenue in R&D to retain customers.
However, that’s not always the case. The total amount of resource allocation varies vastly depending on the stage of your SaaS business. For example, suppose you’re an early-stage startup in a highly competitive market. It is only natural that you dedicate more extensive resources to this area to drive growth and capture/maintain market share.
Assuming you’re currently generating $1,200,000 in annual revenue, you have revenue growth of 120%. It means there is a demand for your product.
In this case, you might consider investing approximately 40% of your revenue in R&D to develop your product further and grow your customer base. Your growth rate takes precedence during the earlier stages.
Your goal is to be cashflow positive as soon as possible but not necessarily EBITDA positive. This is because EBITDA doesn’t account for the ways you finance your company’s operations and grow your business. But you can determine the underlying profitability of your company by looking at your EBITDA margin. It shows investors how much operating cash is generated in relation to all revenue earned.
It’s normal to have a lower or negative EBITDA during the earlier stages of your startup, and in high growth phases when you’re investing heavily in growth. A negative EBITDA is acceptable as long as all the rest of your growth metrics are looking healthy and your revenue is growing fast.
Your P&L forecast also gives you an insight into your gross margin. Your goal is to increase your gross margin rate as much as you can. This metric helps identify where your cashflows and revenue streams are coming from (and when) before making your next big strategic decision and resource allocation.
The most significant benefit of P&L forecasting is, you can utilize it to redirect your KPIs in the right direction even with minimal cash. It’s the foundation of your growth metrics.
Also, the main stakeholder who is most interested in your P&L forecast? Your investors.
Go deeper: Fundraising – It’s all about preparations
My final reminder would be, the more you know, the easier it is to plan, strategize, navigate, and iterate. As always, never look at any metrics in isolation.