Building Forecasts from the Bottom Up

Image by Nattanan Kanchanaprat from Pixabay

Once revenues start rolling in, entrepreneurs have nothing to worry about.  Right? After all, the market has verified that their business model is sound.  What could possibly go wrong?

Well, actually, many things can go wrong.  One of my late father’s favorite sayings was, “The single biggest cause of business failure is success.”

Entrepreneurs who are unprepared for the challenges of growing a business can often derail even the most promising business model.

So how should you plan for growth?

The first step is to make sure how big you really want and need your business to become.

Reverse Income Statement

The best tool I have found to engage in smart planning for growth is to use what I call a bottom-up income statement.  Rita McGrath and Ian McMillan called the process Discovery-Driven Planning in their classic article about this technique first published in HBR in 1995. (Here is a more recent summary of this class article).  I learned it from my late father back in the 1970s.

The basic logic is this: start with how much you want to make when planning for the growth of your business.

Let me offer an example based on using this tool to help my daughter Maggie and son-in-law Matt when trying to figure out how big to grow their commercial painting business, Harpeth Painting.

Bootstrapped Beginnings

Matt had bootstrapped Harpeth Painting.  Initially, Matt kept his day job with a commercial construction company to support their family.  He worked on the new business mornings, lunch hours, nights, and weekends.  Having identified a niche in the market and executing the startup well, the business grew steadily during its first year.

Right around the first anniversary of the launch of Harpeth Painting, our daughter gave birth to their third child.  Harpeth Painting was doing well.  Its cash flow could make up for the salary he had been earning, and they had accumulated a good cash balance in the new company.

Maggie said, “We now have three kids, including a new baby.  It is time for you to work only one job!”

So Matt took the leap of faith and quit his “day job.”

How Big is Big Enough?

Three years into the growth of the company, Maggie came to me wanting help to determine how big they needed to grow the business.  It was doing well, but they just weren’t sure how far to take its growth.  They had no real aspirations to build an empire or even a big company.  They just wanted to earn a financially stable living from it.  The business had grown to about 25 painters.  Any bigger would require that they start to invest in some administrative positions to help them out.

Maggie and I met in my office and began to whiteboard a financial model for their business.

Step 1:  What are your financial needs and goals?

I asked Maggie how much they needed to take home each month to live comfortably.  The business was already generating enough income so that number was their current personal budget.  We only added a bit to this number for cushion.

Next we added income tax to that number, as their company is an LLC.  We put a little extra in this estimate, as well.

Finally, I asked what they intended to save each month.  Their business is one that will not have much if any value when they are ready to retire.  If they have equipment, or even a building of their own some day, this will have value.  But Matt is the business.  All of the work they get is built off of his relationships.  So that means that any savings for retirement, college, etc., etc., has to come from the cash flow of the business over time.  Maggie gave me their target savings, which was a reasonable amount.  I doubled it!

We now had the foundation of the financial plan to guide the growth of their company.

Step 2:  Overhead

Their business has a fairly simple overhead structure.  Matt and Maggie both draw a paycheck. The company rents space for trucks, equipment, inventory, and an office for Matt.  They have a couple of people on salary.  We also added in marketing, insurance, and so forth.  They are both dedicated bootstrappers (the apple doesn’t fall far from the tree for either of them), so their overhead was all quite reasonable.

Sometimes when I do this technique, I find lots of bloated expenses in a business.  Not this time!

With overhead and what they need to make from the business, we now know how much gross profit (sales minus variable expenses/COGS) the company needs to earn.  Add everything up we have so far, and we have that target for required gross margin.

Step 3: Required Sales

To determine sales required to reach the financial aspirations of the owners, we use this formula:

Required sales = Required Gross Margin/Gross Profit Margin

Let’s look at this with completely hypothetical numbers.

  • Overhead = $20,000 a month
  • Required earnings for the owners = $10,000 a month
  • Estimated income tax from pass through income from the LLC = $5,000 a month
  • Estimated monthly personal savings goal for owners = $5,000 a month

Required Gross Margin = overhead+earnings goal+pass through taxes+ savings goal

  =20,000 + 10,000 + 5000 + 5000

  =40,000

Gross Profit Margin  =  20%

Required Sales = 39,000 / .20

       = $200,000 a month in revenues

So for this hypothetical example, the company would need to maintain annual revenues of about $2,400,000 to reach all of the owner’s personal goals from the business.

“So We Don’t Need to Grow Anymore?!”

When I did this with Harpeth Painting’s actual numbers, Maggie was delighted.  As it turns out, the current size of the business is at 50% more than they need to hit their targets.

That was great news, as they had just met with their two supervisors, and all of them agreed they loved the current size of the company.

Step 4: How Much Cash?

Maggie’s next thought was that she was not sure they wanted to take out enough cash to meet their savings goal quite yet.  Their business model required putting out cash up front for jobs, and they would rather not do this with their line of credit unless absolutely necessary.

So the last step was to determine how much cash they needed to have as an average balance to meet the working capital needs of the company.

My rule of thumb is that every business needs to have a goal of at least 30 days operating cash on hand.  That means that if no cash comes in for 30 days there is enough cash in the bank to cover that period of time.

Given the cash flow challenges of a commercial painting company, I recommended at least 60 days cash on hand and 90 would not hurt.  I believe personally that six months would not be an excessive amount.

Some argue that this is poor asset management, as cash really earns nothing. For me, having cash in the bank helps me sleep well at night.  That is a value much higher than any interest I might be able to earn.

Moral of the Story

Rather than growing the business simply because you can, know how big you need it to be to meet your short and long-term needs.  Life is short.  There is more to life than running a business.  Don’t get me wrong.  I love being an entrepreneur.  However, I also love being a husband, a father, and a grandfather.  We love to travel (hopefully someday soon), I love to golf, and I love to spend time with Ann.  All of that takes planning when you’re an entrepreneur, and the bottom up income statement can help!!