Startup Financial Forecasting 2021 – Top Down Vs. Bottom Up
Welcome back to our learning session on startup financial forecasting 2021 with Advisori Finance. In part two, I will show you techniques for creating a financial forecast from scratch. If you want to read part one on the foundations of forecasts and budgets, click here to see details and then return here to continue the series.
First, let’s learn the steps to make a financial forecast:
1. Forecast revenue and COGS
2. Budget for all expenses, such as:
1) Salary
2) Operating expenses
3) Fixed asset expenses
3. Review the numbers with your team and investors
There are two approaches to making a forecast: top-down and bottom-up.
You have a choice when making a forecast: either use a top-down approach or a bottom-up approach.
A top-down approach means we start by planning for the whole company. Usually the upper-level management, such as founders and CFOs, create the forecast. Founders and CFOs come up with the vision and goals for the new year and communicate it out to the teams. As a founder, you also give your teams specific revenue and expense targets that they’ll need to hit.
A bottom-up approach means we start by planning projects for each department, and your team leaders create the forecast. The team leaders come up with goals and plans for the new year, and collectively use that to build the forecast.
There isn’t a right or wrong approach here, you can use either one, or a hybrid approach. It all depends on what stage your startup is in and the management style. Many startups prefer a hybrid approach, which incorporates the plans and goals both from the management and the team leaders.
A suggestion from us: prepare a list of goals that your startup wants to achieve next year, before starting working on the forecasting. Take this opportunity to brainstorm with your teams, and come up with the objectives together. Here are some examples of common goals for early stage startups:
Increase revenue month-over-month by x%
Hire more engineers
Expand to a new market
Acquire x amount of new users
Achieve break-even
Research and development
Now let’s dive in and forecast:
You can start with a financial forecasting template.
Forecasting is a forward-thinking exercise, aimed at predicting and visualizing the future financial state of your company.
If it is your first time creating a forecast, it’s easiest to start off with a template. If your startup is over a year old, you can simply use last year’s P&L as a starting point and template.
All forecasts are grounded in the same two major components:
- Cash inflows (revenues, COGS)
- Cash outflows (expenses, taxes, interests, buying fixed assets, etc.)
Step 1. Project revenue and Cost of Goods Sold (COGS)
We will follow the same flow as the Income statement: from revenue to expenses. We’ll start by projecting the revenue for the products and services your startup will sell next year.
You might ask: “how do I project how much my business is going to sell?”
Take a look at your historical sales data from the most recent couple years, these are your base numbers. The assumption is that, if nothing changes, your startup will make the same amount of money as last year. Based on that, adjust the numbers up or down with the estimated cost of new projects for next year. For example, you plan to have two more marketing campaigns and the estimated extra revenue would be $50k. Add the $50k into your revenue forecast for next year accordingly.
COGS are listed under revenue on the income statement; COGS numbers are led by sales--the more you sell, the higher the COGS numbers are. Look at the cost to provide each product or service and multiply by the estimated number of units sold--that will give you the COGS for next year.
A CPA’s 2 Cents: We know it is a lot to take on, even for experienced CFOs/CPAs. We would reserve a good chunk of time to focus on financial forecasting. If you have any questions, we are here to help.
Step 2. Budget for expenses
Here is a list of sample expenses to consider:
1) Salary and wages
Salary and wages are usually the biggest expenses, especially for technology companies. Budget the number of employees you plan to hire, and make sure to put the cash aside for it so you won’t run into payroll issues.
2) Operating expenses
Next, let’s go through a more complete list of operating expenses:
Advertising and marketing
Accounting fees
Insurance
Legal fees
Office supplies
Maintenance and repairs
Rent
Travel
Utilities
Vehicle expenses
For the operating expenses, again, use historical data as the base, adding or subtracting new expenses to get to the forecast amounts.
3) Fixed asset budgets
Your planned growth can impact your fixed asset expenses. For instance, when you hire more employees, you will buy more laptops; you might even need a new vehicle for the company when business grows.
Step 3. Delegate ownership of forecasting to team leaders
In order for forecasting to be useful, each team should own a piece of it. After the initial draft of the forecast, team leaders need to be brought in for review and buy-in. For example, the sales team needs to agree and commit to the sales plan and the costs associated with it for the next year, while the marketing team needs to commit to budgets associated with the marketing campaigns.
Step 4. Review the numbers, check actuals vs. forecast
Once the forecasting is approved by upper management, you’re ready to kick off the projects.
After the first month, check what the actual numbers are on your P&L, then compare those with the numbers in your forecast. Look hard at the differences and come to understand what worked and what didn’t. This is a crucial step in the process. If revenue grows faster than expected, find out why that is so you can keep it up. If growth is slower than expected, take a look at what needs to change. If spending is higher than what was allotted in your budget, see where the extra money went. Can you cut expenses during the second month to make up the loss?
Brainstorm with your team and learn from the past. The most important part of forecasting is to learn from it and improve it as you go. In this process, “Why?” is the most powerful question you can ask. Learn from it and use it to create a path forward.
To summarize:
Now we have completed the financial forecasting exercise. That wasn’t too bad, was it? You now know how to use forecasting to steer the direction of your company.
As the founder or CFO of the company, you must set the goals your startup will achieve, define the vision, pick an effective approach to forecasting, align resources across all teams, create a business plan that excites everyone, and iterate on your strategy as changes occur.
Founders have a lot of responsibility, but we hope this guide helps with the forecasting part of that. As always, we, Advisori Finance, are here to help. Send us an email if you have questions.
