What is the first step in financial planning?

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Key Takeaways

Financial planning refers to the process of documenting a startup's present financial condition, as well as setting financial goals and subsequent strategies for achieving those goals. We can also think of a financial plan as a document that acts as a roadmap for your startup's financial development. It depicts where the startup is right now, where the founders want it to go, and how they plan to get there.
There are a few key steps involved in the financial planning process: you must go over your strategic plan again, create monthly/weekly financial forecasts, determine your financing requirements, create a contingency plan in case your financial situation suddenly worsens, and finally, compare actual results to your estimates throughout the year to evaluate if you're on track or if you need to make adjustments to your financial plan.
Financial planning is quite important as it helps in managing cash flow, estimating financial requirements, prioritizing expenses, assessing feasibility, obtaining funding, and variance analysis.

A detailed financial plan could highlight the opportunities that competitors might ignore and potential constraints that should be considered in a company's growth goals.

As the startup grows, new obstacles occur and unanticipated crisis strikes - but an excellent financial plan keeps you focused and on track throughout it all. It aids in straightforward communication with employees, investors, and the development of a transparent startup.

Thorough financial planning establishes the groundwork for building a long-term business. Research suggests that startups with significant growth year after year are more likely to create a financial plan than their counterparts. This kind of foresight can be vital in the long run, especially during periods of economic uncertainty. This is why a startup founder should develop a financial plan to facilitate the growth of their company.

In this post, we will look at not just the definition of financial planning but also discuss its significance, benefits, limitations, and the steps to create an effective financial plan.

What is financial planning?

Financial planning refers to the process of documenting a company's present financial condition, as well as setting financial goals and subsequent strategies for achieving those goals.

We can also think of a financial plan as a document that acts as a roadmap for a startup's financial development. It depicts where the startup is right now, where the founders want it to go, and how they plan to get there.

Some people confuse budgets with financial plans. The two documents, however, are not interchangeable. Financial plans include budgets and other critical data such as detailed analyses of a startup's assets, cash flow, income, and revenue estimates, expenditures, and other data that help paint a picture of a startup’s financial health.

Longer-term objectives, such as particular growth targets, are also usually included in financial plans, as well as potential hurdles that must be overcome to accomplish those goals.

Why is financial planning important?

Among the most crucial things that an early-stage startup requires is a financial strategy. It is a roadmap, a guideline, and a reminder of your objectives – what you want to accomplish in the short and long term. It sets out your potential costs and attempts to explore ways to manage them. Investors, bankers, and creditors usually will not set up a serious meeting until you have a proper financial plan in place for your startup.

The following are some benefits of financial planning:

Cash flow management

The revenue of most startups fluctuates from season to season and should be factored into an effective financial plan to avoid long-term shortages of cash. Having a cash cushion allows your startup to weather a bad season and come out on top of less-than-desirable revenue performances. Careful financial planning can result in good tax planning, prudent cash flow spending, and careful budgeting.

Estimate finance requirements

According to the Small Business Administration, a financial plan helps forecast how much money is needed and when. If you do not have enough money to launch your startup, you may have to start on a smaller scale than previously planned. The financial plan also shows you where there is a gap. To avoid a cash shortfall in the face of key expenditures, adjust your revenue and spending predictions or make sure that you have access to other sources of financing, such as your savings or a loan.

Prioritize expenses

Financial planning can also assist you in prioritizing your expenses. Conserving financial resources is critical in small enterprises like early-stage startups. A well-thought-out financial plan can help you choose which areas require immediate funding and which can wait for a bit until a better opportunity arrives. Even the largest firms in the world go through a process of prioritizing spending based on meticulous cost/benefit analysis.

Provides feasibility

When you first think of launching a startup, you usually expect that it will be successful and that everything will go according to plan. However, many founders and early-stage startups discover after launch, the success may be more elusive than expected. Developing a business plan, along with a financial plan, is in essence, a feasibility study of what it takes to actually succeed.

The financial plan will spell out possible situations such as:

The required resources are out unattainable
The founding team lacks experience
The market is currently too volatile

These are just a few of the potential shortcomings that the financial plan might indicate. For example, you may discover that the price you intend to charge for your products or/and services is far greater than that of your competitors. There’s really no end to the list of potentially fatal problems that startups might have to encounter in their journey.

Variance analysis

Monitoring actual outcomes versus the line-item budget in the financial plan is one of the most important aspects of business finance, as it allows you to make whatever changes are necessary to get back on track. If you are not hitting your income targets, for example, then it could be due to several reasons, such as your predictions being off the mark or your marketing strategy not turning out to be as effective as you imagined. It is crucial to understand the fundamental assumptions that went into the estimates to figure out why they were off. This is known as first-principles thinking, an approach to problem-solving famously championed by Elon Musk. To put it another way, you need to know what you did well and where you went wrong.

Obtain funding

Investors and lenders want to examine the business plan, as well as the financial plan, which includes predictions and assumptions. The loan or investment being sought will not likely be granted if the financial plan is unrealistic, which is a common mistake made by startups. You must also ensure that you understand how to prepare and read balance sheets, income statements, and cash flow estimates.

Overall, the financial plan exists to assist you in tracking your progress. When a startup founder is engrossed in the day-to-day operations, it is easy to lose sight of progress. Whether it is carefully reviewing the raw data or analyzing it, the financial plan allows the founder to know precisely what is going on.

In short, if a startup wants to run successfully for years to come, it must have rigorous business and financial plans that are revised regularly.

Limitations of financial planning

The majority of financial planning is based on estimating and forecasting approaches such as future assumptions and historical data.

Financial planning has constraints due to the unpredictability of the future, among other elements that are beyond the management's control. After all of your hard work, these constraints may require you to adjust your estimations as the project progresses. As a result, you should be aware of such constraints and limitations.

The following are some of the most common financial planning limitations:

Future Uncertainties

Financial planning is based on assumptions about the project's future elements. The nature of the future is inherently uncertain, and things rarely go as planned. Thus, the accuracy of financial planning gets severely harmed by the uncertainty of future events.

Time-consuming and costly process

Financial planning is a time-consuming and costly activity. It also necessitates the application of new technology as well as the collective experience of several professionals, making the process costly.

Most of the time, startups either do not want to invest in financial planning or they do not have enough time to do so correctly, resulting in inaccurate and incomplete planning. This can be circumvented by breaking the project down into phases and then planning each phase separately.

Lack of Accuracy in Underlying Data

Financial planning is the projection of future events based on historical data or research. Financial planning findings may be skewed if the data on which they are based is incorrect. So, as a founder, you should understand that the authenticity and integrity of the underlying data are critical to ensuring the accuracy of your financial plan.

Rapid Changes in the Environment and Policies

Sudden changes in government rules and regulations regarding the economy can hurt financial goals. Even a “perfect” financial plan may become a failed financial plan if it lacks the flexibility to adapt to such changing circumstances.

Other external factors

External elements such as war, natural disasters, and other events that are not directly related to stakeholders in your startup's strategy but that may hurt your planning are exceedingly difficult or impossible to forecast.

To overcome these limits, you should take precautions, such as purchasing insurance to avoid losing money as a result of these problems.

What are the steps involved in the financial planning process?

As a founder, you must project revenue and outlays for the following months, rather than only looking at what has occurred. Your forecasts serve as a warning system that allows you to plan for cash flow deficits, identify financing requirements, and determine the optimal approach to project scheduling.

The financial plan helps you track finances, allowing you to track your progress and avoid problems before they can arise. To make your financial plan, follow these six steps:

Go over your strategic plan again

The strategic plan for your startup should be the starting point for financial planning. At the start of a new year, take into consideration what you want to achieve and ask yourself the following questions:

Can you expand? Or Is it necessary to expand?
Is there anything more you need?
Is it necessary for you to hire more employees?
What impact will the strategy have on your cash flow?
Will you require financial assistance? If so, how much will it cost?

Then calculate the financial impact over the next 12 months, including major project investments.

Create financial forecasts

Create monthly financial estimates by documenting your expected income based on sales forecasts as well as projected costs of labor, supplies, overhead, and other expenses. (If your startup's cash flow is limited, you might wish to establish weekly predictions.) Put the expenses for the projects you identified in the previous step into the formula.

You can do this using simple spreadsheet software or features from your accounting program. You should not expect sales to turn into cash immediately. Therefore, only enter them as cash if you expect to be paid (based on your previous experience).

Prepare a projected income (profit and loss) statement as well as a projected balance sheet. It is a good idea to include a variety of scenarios in your projections — such as “most likely,” “optimistic,” and “pessimistic” — to assist you in predicting the effects of each scenario.

When creating financial projections, it is a good idea to obtain advice from your accountant. Also, ensure you go over the plan with your accountant, as you will be the one seeking financing and discussing the plan with your lender or investor, not your accountant. You want to be sure you thoroughly understand the plan's content and can answer questions.

Arrange funds

Determine your financing requirements using your estimates. Make an appointment with your financial partners to review your alternatives ahead of time. Bankers will be more confident in their financial management if they have well-prepared projections.

Create a contingency plan

What would you do if your financial situation suddenly worsened? Having emergency funds on hand before you need them is a good idea. Maintaining a cash reserve or having enough room on your line of credit are two options you could explore.

Monitor

Compare actual results to your estimates throughout the year to evaluate if you're on track or if you need to make adjustments. Also, by monitoring, you can identify financial issues before they get too serious. This way, you have time to make adjustments to the financial plan and execute it in a way that offers the maximum chances of success.

How does financial planning assist you in achieving your objectives?

Creating a financial plan will allow you to demonstrate your creditworthiness to potential lenders when seeking financing for your startup. Even if you don't plan to take out a loan for expansion, excellent financial planning may help you conceptualize your startup's financial health along with helping you start working toward particular growth goals.

A detailed financial plan may also help you establish what's realistic, based on your startup's historical performance, or establish estimates that are based on concrete facts. A financial plan plays a big role when you plan to expand in the following areas (to name a few):

Diversifying your startup with new products
Shifting into a brick-and-mortar setup
Recruiting more team members

Many founders fail to achieve their objectives because they do not plan for expansion ahead of time. Even successful companies might fall into the trap of expecting growth to happen by itself when, in reality, it typically takes a long-term, purposeful effort to launch a startup with sustained growth.

Almost every founder without a proper financial plan has, at some point, felt nervous about expanding and growing their startup. On the other hand, financial planning can be a great shot in the arm, giving founders the courage to pursue chances that they might not have seriously considered otherwise.

If you’re interested in a financial plan template, this might be a good resource for you!

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