Are your profits better or worse than you projected 12 months ago? If you don't know — or if you didn't do a projection — you may be missing a key component of your business model: finance.
This article continues my series on the managerial, operational, and financial aspects of running an ecommerce business. To date, the series consists of the following installments.
- Who Needs an Ecommerce Strategy, Anyway?
- What's the Value Proposition of Your Ecommerce Company?
- Choosing Sales Channels to Reach Target Consumers
- 7 Key Ecommerce-Infrastructure Decisions
- Building the Right Ecommerce Team for Success
Finance Is Important
My background is in sales and marketing. As a small business owner — my wife and I previously owned a family of jewelry-related ecommerce businesses — I quickly learned that understanding finance was critical. There are several things I realized as our business grew.
- You’ll never have too much cash.
- Your revenues will be different than you expect, for better or for worse.
- Your costs will always be higher than you expect.
- Your cash flow needs to be managed outside of your accounting system.
- You can model your business in a spreadsheet without being an Excel expert.
If you are starting a business, in a high growth phase, or desire to raise additional capital, you need to develop a set of financial tools to analyze your business's revenue, costs, profits and cash flow.
A Financial Model, Really?
How many smaller ecommerce owners prepare an annual budget or revenue forecast? I’m guessing less than 50 percent do this. If your business is big enough to have a chief financial officer, these activities are occurring on a daily basis. That’s because financial modeling is critical to your business success, and someone needs to at least keep an eye on forward-looking financial models.
Let’s say you want to add a promising new product line that could increase revenues. But you are not sure what the overall return on investment will be. As a starting point, you’ll need to look at the cost of the initial inventory and associated carrying costs. You’ll need to evaluate the revenue potential and ramp-up period. You’ll also need to evaluate (a) loading the products and content into your ecommerce site, (b) promotional and launch costs to reach your target market, and (c) the impact on your fulfillment or other business processes — like customer support.
Finally, you’ll need to assess the investment’s impact on your cash flow. Will you have the cash available to support the new products? Will it take away cash from other important marketing or operational initiatives?
How to Model Your Business
There are many different ways to approach this. You should consider consulting a financial advisor for templates and more specific advice for your business. I will share some of the things I did to manage the process.
In addition to keeping a good handle on our income statement and balance sheet, I used several Excel spreadsheets to further plan and model different aspects of our business.
Start with the basics: Set up a projected budget for the next 12 months. If you have historical data, simply start with your last fiscal year's results. Add formulas to subtotals and totals so you can begin to forecast new revenue and cost numbers. You can make this as simple or complex as your skills allow. But your goal will be to enter some basic targets like growing your revenue by a given percent, while keeping costs even with inflation. You’ll want to make sure to add any new projected revenue streams, as well as planned investments in personnel, equipment, marketing, website, and other areas of your business.
Your budget should be very thorough and include everything — down to the bottom line profit. Spend time getting your revenue projections correct. Your cost of goods sold will be tied directly to sales. Those are two key projections that are worth getting right.
On the cost side, start with items that are tied closely to your revenue projections. To improve sales 10 percent, for example, will you need to increase your marketing expense? Moving things like supplies expense forward and adding 5 percent for inflation may be adequate.
The goal here is to make sure that you are still hitting your profit objectives, to give you the baseline budget to model a few different scenarios.
You should be prepared to make changes to your budget on a monthly basis to reflect learned realities from your business and economic conditions.
Cash Flow Projection
Once you’ve completed your budget, you will be ready to build a cash flow model. Remember that cash flow is related to your budget and your income statement. But it's on a very different schedule. The goal is to project when you will receive cash from your sales, as well as when you pay your bills. If you do cash sales, your model will be easier to develop than if you invoice your customers with terms.
Likewise, if you pay expenses as your receive the products or services — versus paying your vendors on terms — your expense modeling will be easier. Many retailers are flush with cash after the holiday season, but very lean on cash just before the holidays as they ramp up inventory and promotion.
My cash flow model included weekly revenue projections. On the outgoing side, I listed all our vendors and planned monthly expenditures. So, rather than categorizing by expense type like you do in your budget, actually list who the bills will be paid to and in which period. Things like payroll can be aggregated into a single payment.
Once you have set this model up, you will see where you will have cash flow deficits or surpluses during the year. If you maintain this model diligently, you will have a very accurate representation of your cash flow position on a weekly and monthly basis.
Scenario Planning Tools
Once you have completed a solid budget and cash flow model, you can begin to develop more robust tools to actually model different scenarios. I liked to plug-in “worst case" and "best case” scenarios. You can do that by adding variables to the spreadsheet for things like “revenue growth,” “new products,” and similar items. I also maintained separate spreadsheets for payroll, pay-per-click advertising, and other marketing expenses — so I could roll those into various models quickly.
This is the fun part of financial modeling. Don’t be afraid to analyze new revenue streams. Raise your prices by 5 percent. Stop giving away free shipping and project what impact that will have on your revenues. A year or so ago I thought about raising our shipping costs by about $1 for “non-free” shipping orders. By modeling the impact we thought it would have on our orders, we decided the several hundred dollars we would make in shipping revenue was not worth the risk of losing those orders altogether.
None of these tools happen overnight. You will develop them over time and continue to improve them. The important thing is the thought behind the spreadsheets, versus focusing on building them.
If you need to qualify for a lease, a loan, or seek investments, having a solid financial model is a critical component. Showing a past ability to predict your business results is important. Don’t wait until you need money to start doing these activities.
In the end, you will want to look back and see what worked or not, and look forward to what you project will work in the coming months and years.