Authored by Michael Alessi | SC&H Capital, Special Situations
While it is nearly impossible to predict a macro event with cataclysmic implications, it is feasible for an organization to prepare for such unforeseen disruptions. Given the broad and diverse impact the Covid-19 pandemic had on the economy in 2020, and that persists into 2021, 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.
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,” as the two are not synonymous. 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. This article serves to help inform leaders about how they can be better prepared for future events, unforeseen or otherwise, and how creating and maintaining an effective operating model is key to managing a business.
Why an Operating Model is Critical
- Strategic Alignment
It will serve as an operational playbook that ensures organizational leaders are rowing in the same direction. A well-maintained operating model will bridge the gaps between 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 and 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 industrial machinery to expand capabilities and break into new customer sets, an operating model will help determine the best way to finance that purchase. It 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.
Revisiting optimal capital structure theory, debt financing comes at a lower cost of capital and is less risky to the investor than equity financing, since debt holders sit in front of equity holders in the capital stack. Additionally, interest on debt provides a tax shield, making it that much less expense to the issuer than equity. However, increasing the debt burden on a company will inevitably decrease the overall cash flow of your business. This in turn heightens the chances your company will have trouble servicing that debt, further increasing the risk of insolvency, and restricting operational flexibility. An operating model will forecast company cash flows for any given debt profile, allowing executive management to make better informed decisions regarding optimal, sustainable debt levels.
- 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/gross margin forecast. Once operating income projections have been developed, a balance sheet will need to be forecasted to create a summary of cash flows that will aggregate all monthly forecasted cash from operations, financing activities, and investments.
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 (probability of win, or PWIN). 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.
The sum of each month will result in defensible revenue and gross margin projections for the operating model’s income statement.
This is critical in capital raise 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.
Keep in mind that forecasting revenue and gross margins requires careful collaboration between various leaders within the organization. For example, for any services business, HR and recruiting needs to understand and confirm whether the required direct labor talent can be procured, and the forecasted rates, to achieve the projections. Similarly, for product-based businesses, procurement or vendor managers need to ensure that the volume of raw materials can be procured at specific price levels to achieve the forecasted revenue and gross margin.
Estimate Operating Costs
An operating cost build-up for the projection period 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
- More bid and proposal professionals will be needed and when
Once these types of considerations have been addressed, the associated costs should 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 the cash flow summary (details below).
- The already 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 (AR) balance typically runs at 50 days of sales outstanding (DSO), then this metric can be applied to the forecasted revenue to arrive at the monthly AR forecast. Again, careful collaboration among company leaders is critical to forecasting working capital. Is a new large contract or customer coming on-line with longer payment terms? Is there a new business line that will require building a significant inventory of expensive 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 should be used. The debt amortization schedules should also calculate interest expense that will flow into the income statement—and to the extent known, any one-time, non-recurring income or expense 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 should be created, including those from:
- Operating activities (net income and working capital)
- Financing activities (debt schedules with new and existing debt, and any equity raises)
- Investing activities (the capital expenditures forecast)
Starting with monthly net income from the income statement, add monthly depreciation expense (non-cash), subtract monthly increases in working capital calculated from the balance sheet, and subtract monthly capital expenditures from the capital expenditures schedule.
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 for each month. These changes in cash can be added to the prior months’ cash balances and should flow to the balance sheet.
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.
About SC&H Capital
We are an investment banking firm specializing in sell-side mergers and acquisitions (M&A), employee stock ownership plans (ESOP), distressed M&A, and business valuations for middle-market companies nationally. Our Special Situations team has preserved an estimated 60,000 jobs and completed more than 600 transactions, with about 300 approved by more than 70 bankruptcy courts. Learn more >