Notice the valley from June to August between the peaks of April and October.  The same thing happens every year in this business – it is fairly predictable.  Even though it is predictable, this seasonality can still create financial stress every year.  Let me be even more clear – this seasonality causes gyrations in cash flow that are difficult to stomach.  Let me explain this phenomenon, then I will share a few steps every entrepreneur can take to reduce such financial stress.

CASH FLOW AND SEASONALITY

Let’s start by talking about July, the lowest level of revenue all year.  The company shows a significant net loss every July because its low revenues and gross profit fall way short of covering the overhead and fixed costs of the business.  Yet, counter-intuitively, this is usually when the balance of cash in the bank account is the highest.  Why?  Because in July the company is collecting all of the April and May receivables but paying out very small amounts of variable costs (because the revenue volume is so low in July).  Although this may not sound all that stressful, it is when we talk about August through the rest of the year…

You see, as the volume of the business goes back up, there are very few receivables to collect from the summer months but variable expenses sky-rocket.  This is a huge cash drain on the business, and July is stressful because the entrepreneur is wondering if they will have enough cash to handle August through the end of the year.  Ultimately, this expansion in the working capital cycle returns to more efficient levels and the cash inflows catch up with the outflows by the end of the year.  The business returns to more steady cash flows until the next summer.  Please know that when I say stress, I am referring to the worries and concerns about making payroll, servicing debt, and meeting any other financial obligations that we worry about when our cash flow is not steady.

WAYS TO REMOVE THE FINANCIAL STRESS

1. Have a Budget and Review it Every Month -At the beginning of every year we implement a well-thought-out and planned budget for the entire year.  This takes into account the seasonality of the revenues and costs as well as projects the total overhead and fixed costs of the business.  This also projects the balance sheet and statement of cash flows so we can understand how all of this will impact our cash.  We review our budget after every month to make sure we are on track.  We also usually implement a “break-even” budget so we can ensure that if we are under-performing on our plan for the year we can still see that we will not lose money when the year is over.  This is especially useful to know when the slow times come – even though the business is not profitable during this time we can see whether or not we are still on track to make a profit by the end of the year when revenues come back up.

2.     Short-term Cash Flow Projections -We always keep at least 90 days of cash flow projected based on our current receivables, payroll, and other items as well as our revenue projections for that period.  This is updated weekly and reviewed by the management team.  It is amazing how few entrepreneurs fail to implement this simple yet often overlooked “stress-reduction tool.”

3.     Plan Financing for Cash Shortfalls -With the business mentioned above, it is a well known fact at the beginning of every year that we will not have enough internally-generated cash to handle the upturn after the summer.  So, we determine how much cash flow we will need and make sure to have a line of credit in place to cover the shortfall.  Even though credit is tough for entrepreneurs these days, there are plenty of banks willing to loan to this company.  The company has a proven track record, it understands its seasonality and can communicate to the bank exactly what will happen with its cash flow through the year, and it has an attractive asset (the receivables) and strong personal guarantor (the entrepreneur).  This company is very “bankable.”

4.    Resist the Temptation to Diversify into Non-Core Competencies - Some might look at the chart above and think it would be best to try and increase revenue during the summer months to solve the cash flow challenges of the business.  While this is great in theory, it is typically impossible in practice without compromising the core competencies of the business and, ultimately, hurting more than helping the company.  As entrepreneurs, we need to embrace the seasonality of our business as well as our core competencies and not deviate from them.  Understanding, budgeting, and planning are usually more effective than diversification.

CONCLUSION

The keys are summed up in the last sentence – understanding, budgeting, and planning.  The more you do of those three the less your financial stress will be in your seasonal business.  Reducing this stress will free you up to grow your business or spend time doing other things you love.

In a classroom of a well-respected business school today I asked: “Please define business model.”  I received the same initial reaction I do from most – some blank stares and a few who started to raise their hands but then realized they didn’t really have much to offer.  Finally a brave soul took the plunge with something like this: “It’s the way a company runs and operates.”  That sure seems to be part of it, but aren’t we missing something?  A few more students offered suggestions that were similarly vague and generally lacking.

My definition is simple – a business model is how your business makes money.  Period.  It is the accumulation of all of the sales, marketing, operations, administration, R&D, finance, and everything else that goes into a business – all the strategies and tactics – that determine if the company makes money or does not make money.  Most definitions are like the ones above – mentioning different parts of running a business but failing to describe it as the company’s overall plan for making a profit.

Understanding this simple and quick definition, here is my two-pronged philosophy for entrepreneurs and their business models:

First, every entrepreneur can pick whatever business model they want.  Second, eventually our efficient market will determine the superior business model for each industry.  Those who innovate the best model for their industry will most likely win.  Those who quickly adopt to this model will likely survive.  And those who stay entrenched in their out-dated and archaic models will die.

In our competitive business environment, the best entrepreneurs are the ones that innovate the best business models in their respective industries.  I don’t know how many of them can give a quick and precise definition of the term business model, but one thing is for sure – they get it!

An article entitled How to Create a Budget in BusinessWeek prompted me to recollect some of my experiences with helping people who have the above attitude towards budgeting gain a new appreciation for the process and, more importantly, the results the process can generate. 

I have and will continue to make this guarantee to any business in any industry anywhere in the world: if you follow the “best practices” steps to creating a financial plan and operating budget for the next twelve months and you track your monthly progress against that plan, you will know more about your business than 80% of your competitors know about theirs.

Why can I make that promise?  Because the things learned in that twelve months are so revealing in terms of the most effective business model and other competitive advantages that the company cannot help but begin to develop and implement the right strategies for making the business more successful. 

Why do most businesses fail to implement this process?  I have found that the two main reasons are lack of discipline and lack of resources.  This process requires a great deal of disciplined time, including the discipline to review your results against your budget EVERY month.  The budget is worthless if we do not do this.  The focus of this monthly analysis should be on the variances in the budget.  We need to know WHY we varied from our budget.  What can we learn from that?  What can we change to improve our performance in that area?

Some companies lack the resources to be able to analyze their historical data and then easily track their progress.  Perhaps they do not have an accounting system in place, or perhaps they do not have anyone that knows how to properly operate their system.  The accuracy of the numbers is certainly a critical element to making the budgeting process a successful experience.  So, having the right staff and a functioning accounting system are critical to this process.  Even QuickBooks allows its users to enter in budget information and then run reports to track the monthly progress and variances.

If anyone reading this post doubts me, I challenge you to try it for 12 months.  In my experience as a part-time CFO for many emerging companies, the value derived from our busgeting process and reports has improved the bottom-line dramatically.  I think you’ll experience similar results.

A company has a new opportunity and they create a financial model to try and forecast how their general assumptions for this opportunity will materialize.  Specifically, they made significant assumptions about the direct labor costs of the opportunity based on the historical performance of their other product lines.  Less than two months into receiving real data against which they can either validate or invalidate our assumptions, they began receiving feedback that the employees were under-paid and that their competitors had better compensation programs available.  How was this missed in the model?

First of all, let’s be clear that this is not the first or last time something has or will be missed in a financial model.  They are based on assumptions, not fact, and, therefore, are subject to error.  The most inaccurate assumption made was that the number of units per direct labor cost was off by a large margin.  We could break it down to show that on average during the first 2 months 1.33 units were produced per person per day.  The model assumed that a minimum of 2 units would be produced per day.  With a piece-rate structure to the compensation program, this meant the employees of the company were taking home about 1/3  less pay for the same amount of work as the company’s other products. 

This company quickly made adjustments to the business model, and realized that even with a change in the production rates the new opportunity would be very profitable.  As such, they changed the compensation program, the employees were happy again, and the company is profiting from their new product line. 

So, what take-away can we gain from this story?  Labor is almost always one of the two most expensive inputs into a business.  It, unlike any other asset of the firm, is often the most critical of all of the inputs.  If we want the best output, then we need to make sure to help our employees win within the structure of our business and financial model.  If our employees cannot win in a model that helps only the company win, then the company should not pursue the opportunity.  Small business financial help is available for companies that need guidance in building their financial and business models around their people.

THE DIFFERENCES
Financial modeling/forecasting usually takes a big-picture approach and avoids too many details. The model is used to assess opportunities and the cause and effect of major business decisions. The model is often expressed in terms of yearly performance.

An operating budget, in contrast, is mired in the details. It needs to tie directly to the accounting system’s general ledger, or chart of accounts for QuickBooks users, and is usually a month-by-month forecast of the activities of each account for the next 12 to 24 months. Use of the operating budget includes analysis of the budget vs. actual performance each month.

HOW & WHY SHOULD THEY CORRELATE?
A business needs to have both a financial model and an operating budget. An operating budget without a long-term model/forecast leaves a company pretty directionless and lacking the ability to understand the impact of business decisions on financial performance. A financial model without an operating budget is a “pie-in-the-sky” dream that is not founded in reality. There is no way to track progress towards accomplishing the goals and objectives, if they are even outlined, and it is almost impossible to hold anyone accountable. Every business should have both.

The place where many companies go wrong is that they do not actively use both of them and ensure they “feed” into one another. For example, let’s assume we have modeled $5,000,000 in sales for 2009 but our operating budget calls for $3,500,000. This discrepancy is large and invalidates one, the other, or both!

The operating budget needs to validate and complement the assumptions made in the financial model, and vice-versa. In fact, the monthly review of the budget vs. actual performance can often generate valuable information about our assumptions and can justify changes and updates regularly to the financial model.

For example, let’s assume we project a 50% gross profit in our 5-year financial model. Due to changes in the economy, increasing material prices, and a slight change in mix of products, our gross profit is coming in every month at 45%. We find and track this in our operating budget analysis each month. Since the trend seems to be consistent, we may make a decision to update the gross profit assumption in our financial model.

CONCLUSION
With an understanding of the differences between a financial model and operating budget, we can see the need to bridge the gap between the long-term planning and short-term budgeting so that they complement each other. While this requires some effort and often the expertise of a full or part-time CFO, the result is always a competitive advantage in terms of a more effective execution of our business model. That means more cash flow and better profitability that your competitors, which results in a sustainable competitive advantage.