Given the broad and diverse impact that the COVID-19 pandemic has had on the economy since 2020, it’s become apparent that a comprehensive and maintained operating model can position lower-middle-market companies to successfully sustain operations — especially in unprecedented circumstances. An operating model can be defined as a detailed set of projected financial statements developed with the intent to map out what future execution scenarios look like in terms of achieving a company’s overall strategic objectives. It is a living, breathing tool that integrates all aspects of a company’s operations into a cohesive strategic execution plan. This should not be misconstrued as a “financial model,” the distinction being that a financial model is a reporting tool that often only summarizes what has occurred in the past and forecasts the future based on historical trends.
Why an Operating Model Is Critical
Strategic Alignment
It will serve as an operational playbook that ensures that organizational leaders are rowing in the same direction. A well-maintained operating model will bridge the gaps among the visionaries, operators and finance team, and transform the company’s strategic vision into an executable plan that thoroughly considers all aspects of the business. Each of the company’s functional leads, from business development and IT to HR and staffing, should incorporate their individual plans to be aggregated by the CFO/finance team.
Financial Forecasting
It will project monthly cash flows and cash balances and help determine how much capital your business needs, as well as the optimal capital structure necessary to maximize company value. For example, if one of your company’s strategic objectives is to buy a large piece of machinery to expand capabilities and break into new customer sets, an operating model will help determine the best way to finance that purchase. It also will enable you to understand if your business generates enough cash flow to service debt associated with that capital expenditure under given scenarios, or if an equity infusion would be a more prudent option.
Risk-Management
It will allow management to stress-test different scenarios, providing detailed insight into what would happen to cash flow and profitability under each. This might include the loss of a major customer or customer segment, loss of a key vendor, tightening margins on major contracts, or a potential macro event.
Future Positioning
It will ensure that your company is prepared to access the capital markets for potential strategic acquisitions or internal initiatives and favorably position your company for a potential future sale. Lenders and investors will take great comfort in knowing that all aspects of your operations have been carefully thought through, beginning with defensible revenue projections, leading to a higher valuation and/or cheaper and more flexible capital.
Creating an Operating Model
Arguably, the most effective way to build an operating model is by using a top-down approach that starts with the overall go-to-market strategy of the company. This would include the associated top-line revenue and gross margin forecast, followed by a forecast of the operating expenses needed to support that revenue and gross margin forecast. Once operating income projections have been developed, a balance sheet will need to be forecast to create a summary of cash flows.
Forecast Revenue and Gross Margins
The revenue and gross margin forecast should come directly from the company’s contract/order backlog and the CRM system used by the business-development team. The build-up should have two basic categories of revenue that feed the projected income statement in the operating model:
- A current backlog of existing contracts, projects or purchase orders (depending on the nature of products and services offered). Each project, contract or order should have its own line item identifying customer, product or service, total value, etc., with monthly revenues and gross margins forecasted for the projection period.
- A new business pipeline of opportunities in various stages of the business-development process, each with its own probability of occurring. Each opportunity should have its own line item as described above, with the understanding that these monthly revenue and gross margin forecasts will be less concrete and should be probability-weighted.
Building revenue projections in this way allows all users of the model to see the granular top-line build-up and understand the degree of revenue visibility that is embedded into the projections. This is critical in the capital-raising and sale processes previously mentioned, as lenders, investors and buyers will offer higher valuations and better terms to companies that have a high degree of revenue visibility.
Forecasting revenue and gross margins requires careful collaboration between leaders within the organization, such as for any services business, HR and recruiting needs to confirm whether the required direct labor talent can be procured at the forecasted rates to achieve the projections.
Estimate Operating Costs
An operating cost build-up also requires careful thought and collaboration between functional area owners to determine the required level of infrastructure to support the company’s growth strategy and revenue projections. Leaders should consider whether:
- more space or an additional office location will be needed;
- another finance or HR professional will be required at some point;
- the current IT infrastructure is adequate and, if so, for how long;
- the marketing budget is adequate and sustainable; and
- more bid and proposal professionals will be needed and when.
Once these types of considerations have been addressed, the associated costs can be incorporated into the model for the entire projection period.
Forecast the Balance Sheet
After the income statement has been carefully developed down to operating income, the next item to address in the operating model is the balance sheet. All balance-sheet accounts can be forecasted at this point, other than the monthly cash balances, which will ultimately flow from a cash-flow summary.
- The forecasted revenue, COGS/direct labor, and operating expenses can be used to forecast the current balance sheet accounts and, thus, working capital requirements of the company. For example, if the accounts receivable balance typically runs at 50 days of sales outstanding, then this metric can be applied to the forecasted revenue to arrive at the monthly AR forecast. Again, collaboration among company leaders is critical to forecasting working capital. Is a new large contract or customer coming online with longer payment terms? Is there a new business line that will require building a significant inventory of products? Once all current accounts on the balance sheet have been forecasted, you will be able to calculate the amount of working capital needed to achieve the company’s strategic goals.
- To forecast long-term liabilities, current and projected debt-amortization schedules that calculate debt principal payments and balances by month can be used. The debt-amortization schedules should calculate interest expense that will flow into the income statement — and, to the extent known, any one-time, nonrecurring income or expenses should also be incorporated into the income statement along with income taxes to arrive at net income.
- Long-term assets on the balance sheet can be forecasted with a capital expenditure and depreciation schedule. This schedule should start with existing long-term assets and their associated accumulated depreciation and future depreciation. Next, you can use this schedule to forecast future capital expenditure requirements (both growth and maintenance), associated depreciation schedules, and any sales of long-term assets.
- Shareholders’ equity on the balance sheet should start with current levels and add monthly net income to the retained earnings balance. Finally, any additional equity raised can be incorporated into paid-in capital in the month that it occurs.
Summarize Cash Flows
Once the balance sheet is complete — except for cash balances — a summary of forecasted cash flows outlining all cash movements from operating, investing and financing activities can be created.
Starting with net income, add depreciation expenses, subtract increases in working capital, and subtract capital expenditures. This will result in the monthly net cash flows before financing activity. From these balances, add any cash from debt- or equity-raises, and subtract all principal payments from the debt-amortization schedule to arrive at the total change in cash. These changes in cash can be added to the prior months’ cash balances and should flow to the balance sheet.
Conclusion
With the functioning operating model completed, company management will now have a tool that can be used to integrate all aspects of a company’s operations into a cohesive strategic execution plan. The tool can be used to plan and stress-test any scenario related to company strategy, capitalization or a macro event, and will better prepare your business for future success.
As the post-pandemic economy begins to take shape, it is imperative that leadership teams have a tool that enables them to thoroughly weigh the impacts of new strategies and new ways of doing business. A well-developed operating model will elevate general strategic-planning discussions to a fully modeled plan of action under any scenario.