Building financial forecasts for SaaS

Learn enough to be dangerous with this short tutorial



Getting started


Overview

This brief tutorial demonstrates how to create a useful financial forecast using SumSavy. If done well, reasonable financial can help you get funded, manage cash, allocate spending, set goals and inform important decisions. We’ll explain important concepts and provide useful tips from experts. No financial background or experience required. It takes ~15 minutes to complete the tutorial.

You can follow along live by signing up for a free account and using our template forecast to start. Learning is doing.


Approach

Each section covers a different piece of a good financial forecast. Sections should be read sequentially. We’ll use a fictitious company (XYZ co.) as an example throughout the tutorial. Both this tutorial and SumSavy have been created based on our guiding principles. In the appendix we also cover valuing a company, a common use for financial forecasting but not explicity part of the process.


Follow along

To foster learning and make the tutorial interactive we encourage you to follow along using our template forecast. Once you log in, select Build new forecast => Build from template => Save. This brings you to the forecast dashboard which has useful charts, tables and assumptions (figure 1). Throughout the tutorial you can enter numbers in the Assumptions section and click Update to see results instandly and play around. We'll reference the corresponding sections of Assumptions and tables with tabs throughout the tutorial.

Figure 1

SaaS sales cost forecast assumptions




Forecasting revenue


Revenue can be unpredictable and difficult to forecast. We’ll talk about methods to forecast revenue (revenue drivers) then how to account for uncertainty (scenarios).


Revenue drivers

Revenue is commonly forecasted using a "bottom's up" approach. This method forecasts the individual components (“drivers”) which make up revenue separately then derives revenue from the resulting pieces. Estimating the drivers is usually more intuitive (with greater data available) than trying to estimate revenue in aggregate, especially when its components are changing at different rates. However, drivers are frequently correlated (e.g. price, volume) so also make sure the implied revenue growth seems reasonable. For XYZ, like many SaaS companies, the key revenue drivers are paying customers and average revenue per customer. Currently average revenue per customer for XYZ is $20 but subscribers are slowly upgrading to higher priced packages. For each year, we can estimate the number of paying customers based on the beginning number of paying customers plus the number of new paying customers acquired minus the number of lost, i.e. stop paying, customers ("monthly churn rate" of ~4%). XYZ primarily acquires its customers by converting them from free sign-ups (currently 10,000 registered users) to paying customers (currently 1,000). We therefore estimate new paying customers by applying their conversion rate ("paid conversion rate" of currently ~14%) to new monthly signups (currently 1,000) and forecasting new signups based on monthly growth ("monthly new signup growth" of 14%). We enter these estimates in the corresponding fields under the Revenue tab.


Scenarios

Scenarios are permutations of your assumptions. Scenarios are very helpful when growth is volatile or uncertain. Use scenarios to see potential revenue outcomes. For XYZ we’ll create three scenarios: base case, upside case, downside case. The base case follows the current revenue trajectory but tapers down over time. The upside case assumes XYZ’s growth investments yield accelerated growth. The downside case assumes XYZ hits obstacles. Growth rates differ largely in later years given greater uncertainty the further in the future we extrapolate. Try several scenarios to see the impact in real time.


Estimating expenses


Companies usually have a bit more control over their expenses when compared to revenue. We’ll cover types of expenses, how to forecast them and how to account for uncertainty.


Fixed vs. variable costs

There are two main types of costs: variable and fixed. While imperfect, its helpful to categorize costs as fixed or variable since it helps determine the method we use to forecast those costs. Variable costs directly connected (or highly correlated) to revenue or its components such as number of customers or units sold. Payment processing fees, delivery charges, customer support costs, customer acquisition costs (CAC) are all examples of variable costs. We usually forecast variable costs as a percentage of revenue. Fixed costs are not strongly tied to revenue so may remain unchanged or grow differently than revenue or number of customers. Headcount costs, professional services fees, rent / facilities costs, tools and subscriptions are examples of fixed costs. Fixed costs are usually forecasted as a fixed value each year or an annual growth rate is applied to a baseline value. We'll discuss each cost group, also called "line items", below.


Headcount costs

Headcount costs are those related to the company's employees and are usually the largest expense. Headcount costs include salaries, bonuses, benefits, taxes (payroll), expense allowances (travel, entertainment, phone), facilities overhead (rent, office supplies, meals, etc.).

We estimate headcount costs by first estimating the headcount for each department for each year. Forecasting headcount by department is discussed further in the corresponding sections below. Its difficult to predict exactly when each hire will be made so we use the average headcount (starting headcount + year end headcount)/2 for the year for each department. We then use the average annual headcount by department to determine compensation costs by applying the department's average salary and bonus (as a % of salary). For XYZ, annual average salaries range from $50,000 to $75,000 and bonuses from 10% to 15% by department. Employee benefits ("Benefits") and related payroll taxes are not insignificant so we need to account for those too. These are usually a correlated to compensation costs so we forecast them as a fixed percentage (usually ranges from 10%-20%) of the total compensation cost and for XYZ this number averages 15%.

Travel, entertainment and expense allowances ("Travel & entertainment") are common for employees. For XYZ this averages $100 per employee per month. Another major headcount related cost is rent, facilities and office supplies ("Rent / facilities"). These expenses tend to be correlated with the number of employees. For example, rent expense is a function of office size which is dependent on the number of employees in the office. Accordingly we forecast this as a monthly cost per employee. For XYZ, monthly rent and facilities costs about $3 / sq. ft. with each employee averaging 200 sq. ft. (national average) inclusive of common space. We enter these assumptions in the appropriate fields in the Headcount tab.


Cost of sales

Cost of sales are the main variable costs of the company. They are the costs of running a customer on the platform and typically include payment processing fees, hosting, content delivery network fees, bandwidth, and customer support costs (personnel, systems). Since they are variable most of these costs (excluding customer support costs) are forecasted as a percentage of revenue. For XYZ, payment processing fees are ~3% of revenue and hosting and related operations costs are ~6%. Customer support costs are primarily headcount costs (see above). Its helpful to estimate customer support headcount as a ratio of number of customers. For XYZ, a customer support representative can oversee 900-1,100 paying customers given its low-touch model. We can estimate year end customer support headcount by dividing ending paying customers by ~1,000. We enter these assumptions in the appropriate fields in the Expenses tab.


Sales and marketing

Sales and marketing costs include headcount, customer acquisiton costs, promotions, events, sponsorships, vendors costs, contractors. Customer acquisition costs ("CAC") are the marketing costs such as search engine marketing (SEM) or other advertising / selling costs to acquire a new customer. These are usually variable costs by definition so are forecasted based on new customer growth. For XYZ, CAC is primiary SEM and advertisign costs and averages $0.50 - $1.00 per new customer sign-up. XYZ also spends $1,000 on other advertising and sponsorships to increase its brand awareness ("other marketing"). These are difficult to tie directly to new customers and are a fixed budget every year so we forecast them as a fixed cost. Headcount for sales and marketing depends on the company's strategy and customer acquisition model so its difficult to provide a general ratio or guideline for forecasting headcount for this function. We enter these assumptions in the appropriate fields in the Expenses tab.


Research and development

Research and development include expenses for the product, engineering, design, technical operations and related team. These are primarily headcount related costs but also can also include tools, subscriptions and contractors ("other R&D"). For XYZ, year end headcount is estimated based on the product roadmap and some fixed amounts ($2,000 then roughly doubling each year) for tools and subscriptions. We enter these assumptions in the appropriate fields in the Expenses tab.


General and administrative

General and administrative costs primarily include executive and administrative headcount (finance, HR, admins, facilities, CEO), service provider (legal, accounting/tax, recuriting) fees, rent / facilities costs and other general operating expenses. All these expenses are primarily fixed costs so are forecasted accordingly. Forecasting rent / facilities costs was discussed previously (see Headcount costs). Headcount depends on the complexity of the company's operations and what it chooses to outsource to service providers so its difficult to provide a general ratio or guideline for forecasting headcount for this function. Professional service (legal, tax, accounting, recruiting, etc.) usually have some minimum amount and while it is building corporate infrastructure it isn't unusal to double each year while the company is less than $10 million in revenue and under 100 people. XYZ currently has $10,000 in professional service costs and has some small fees (~$2,000 in bank, insurance, other fees). They expect it to double each year as they grow and add 1-2 heads per year to this department. We enter these assumptions in the appropriate fields in the Expenses tab.


Sanity checks

Benchmarks (or norms) are a great way to sanity check your expense forecasts. Using data from a group of similar companies who’ve already been down the growth path helps to reduce guessing. Learn more about benchmarks. Expenses usually vary by revenue stage so compare the percentage of revenue for each department above (cost of sales, sales & marketing, etc.) to the benchmark range. Its ok if your expenses are outside the range its just helpful to have a good reason why.


Non-operating expenses

Non-operating expenses don’t relate to the core business operations. These can include interest, taxes, financing fees or accounting charges. We’ll address relevant non-operating costs in others sections but ignore those that obscure a true picture of business performance.


Cushion

Create a cushion for expenses. There will be small expenses you may miss or aren’t worth trying to estimate. Unexpected costs almost always arise. The cushion line is a practical approach to account for these costs. We usually forecast the cushion as a percentage of the operating expenses. XYZ, is growing quickly so there will likely be new costs that arise. We use a 10% cushion and enter it in the appropriate line under Expenses tab.


Assessing profitability


There are many ways to measure profit. We’ll cover where to find them and their uses.


Profit & Loss

The profit and loss statement, also called the “income statement”, is a financial statement that summarizes revenues, expenses and profits. It shows useful trends and relationships between these items. The Profit & Loss table has three profit metrics: gross profit, EBITDA, net income. Gross profit is the profit after most variable costs (in cost of sales) have been deducted and shows if we’re losing money on every customer/item/unit sold. Net income shows profit after all costs. We prefer EBITDA and cash flow to assess profitability (discussed below).


EBITDA

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, Amortization. EBITDA equals revenue minus expenses related to business operations. Its goal is to show the profitability of a company's normal operations. It can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions so it is a popular way to look at profitability. It’s intuitive to view profits as a ratio or percentage of every revenue dollar earned (“margin”).


Cash flow: the real bottom line


Cash is critical to keep a company operating and growing. That’s why we call it the real bottom line. The cash flow statement shows the annual change in cash beginning with net income (from Profit & Loss) its shows all additional cash-related changes. It can be found in the Cash flow table and we'll discuss each of the items in further detail below.


Accrual accounting

Professional accountants use an accounting method called “accrual accounting” for a company’s books. This method causes some financials (revenue, expenses, profits) to not reflect actual cash transactions and adds complexity. We’ve ignored translating the plan into the accrual accounting method since our primary goal is to create useful forecasts for decision-making not formal financial statements. XYZ is small and keeps their books on a cash basis no adjustments have been made.


Capital expenditures

Also called “capex”, these are larger cash expenses to purchase or upgrade physical assets such as property, equipment, facilities. They usually last several years so are treated differently from operating expenses on the P&L. Capex is usually forecasted as a percentage of revenue since its correlated with production or customer growth. If these costs are small or irrelevant ignore capex. XYZ has equipment costs for servers/hardware which is ~5% of revenue. We enter this assumption under capital expenditures in the Cash flow tab.


Working capital and cash taxes

Working capital is a measure of a company's short term liquidity (accounts receivable, inventory, cash) or its ability to cover short term liabilities (e.g. accounts payable). As a company grows these accounts grow and give way to timing differences between things like revenue, cash collections and cash payments. We need to account for this in our cash flow and do so through change in working capital which usually runs a few percentage points of revenue. Cash taxes depend upon a number of factors such as company structure, location of incorporation, revenue distribution by geography and historical losses. Consult your tax accountant for a forecasted cash tax rate. XYZ has normal working capital at ~%1 of revenue and some tax loss carryforwards for a few years. We enter these assumptions in the appropriate fields in the Cash flow tab.


Cash and debt


Cash balance

The plan automatically calculates the year-end cash balance implied by the forecast. The only required assumption is the starting cash balance. XYZ had ~$500K in cash at the end of last year. We enter this under the Balances tab. Review the cash balance implied by your forecast to insure sufficient cash on hand. What is sufficient cash? Many recommend enough for at least three months of expenses at any time. XYZ’s plan exceeds this threshold. A negative implied cash balance means a need to raise money or reduce expenses. We’ll discuss this scenario in a later section.


Debt balance

If your company has debt you can incorporate that into the forecast. XYZ does not so it was omitted. Enter the outstanding debt balance and its annual percentage rate under the Balances tab. SumSavy doesn’t currently support amortization payments of debt. However, the table and chart show cash relative to debt to make sure you can meet debt obligations.


Financing activities

We discuss more about capital raising below but SumSavy provides a way to incorporate planned cash infusions (e.g. equity raise) or distributions (e.g. dividends) in your forecast. XYZ plans to raise an additional $250,000 in financing in 24 months. We enter these assumptions under financing activities in the Balances tab.


Financing


Using projections

A financial plan or forecast is frequently requested by potential financing sources including investors, lenders or potential acquirers. The plan is often discussed and serves many purposes including:


Evaluate an investment

A financial plan is useful for investors or potential acquirers to understand the economics of your business and how you think it will grow. They may have a different view but usually use your plan as an important starting point.

Anchor valuation

Companies are often valued based on their expected financial performance. A five-year financial plan is the basis of most standard methods for valuing a company. We discuss valuation later in the tutorial.

Align expectations

A financial plan can become a set of expectations for investors or lenders and a concrete yardstick to measure the company’s performance over time.


Capital raising

A financial plan can help guide investor discussions about the amount and timing of future capital raises. Use the Cash & Debt balances chart or the Balance Sheet table to see when the cash balance becomes negative (when more capital is needed) and how negative it becomes (how much capital is needed). Try different beginning cash balance amounts to see your runway. This can be helpful if capital was recently raised or capital raising is constrained. Without additional financing XYZ has a negative cash balance in year two of ~$200,000 so plans to raise $250,000 in 24 months to insure a sufficient cash balance.


Next steps


Congratulations! You’ve learned to create practical financials plans and use them to make sound decisions. Even in the face of change or uncertainty. If you haven’t already, sign up now and start using SumSavy for your financial plans. We’ll let you know as we add useful features and new learning material. Don’t hesitate to Contact us with questions or suggestions. Now get planning…





Appendix: Valuation


Methodology

Companies are frequently valued on a comparables (“comps”) approach. It has three steps. First, similar companies with a market value (such as listed on a public stock exchange) are selected. Second, their market value is divided by an appropriate financial metric (revenue, EBITDA, cash flow) to create a ratio called a 'multiple'. We further discuss selecting multiples below. Finally, the appropriate multiple is applied to the corresponding metric of the target company (metric x multiple = valuation). Common types of multiples to value non-public companies are revenue, EBITDA, and unlevered free cash flow. The appropriate multiple type depends on the company's financials and its peer group. Other common valuation methods include discounted cash flow (DCF), option pricing model (OPM), and economic value added. These are generally used on large public companies or are more theoretical in nature so we won’t focus on them.


Selecting multiples

There is rarely a perfect comparable so identifying a group of companies with similar characteristics is common. Usually your competitors or companies in the same industry sector are a good place to start. If this group is very large, narrow down to those with similar financial characteristics like revenue growth or profitability (EBITDA margin). If your industry sector is new or their aren't public competitors you can look at other SaaS companies with congruent operating characteristics (customer base, business model) or financial characteristics. To help, we've provided valuation multiples for SaaS companies.


Applied example

Now let’s value XYZ. First we navigate to the valuation module. Select MODULES (top) => Valuation. First we need to select a range of multiples from the market comps. We focus on the 2016 ("forward") multiples for revenue and EBITDA from the market comps. The corresponding multiples seem to range from 5-6x for revenue and 24-28x for EBITDA. We enter them into the appropriate fields in the Valuation assumptions table (figure 2). We also enter the last year (year 5) revenue ($8.7M) and EBITDA ($1.7M) from our forecast as well as the Year 5 beginning (year 4 ending) cash ($1.7M) and debt ($0) balances. We see the results update instantly under Valuation summary.

Figure 2

SaaS sales cost forecast assumptions


SumSavy estimates the total value of the company, or what an acquirer would need to pay someone to buy it (“Enterprise value”). We prefer this measure of value. The value of the equity (“equity value”) may differ due to the company’s cash and debt (see more). Valuation (and our multiples) use next-12-months ('NTM') metrics. Applying the multiples to year 5 (last forecast year) gives a value range for the company at the end of year 4 / beginning of year 5. XYZ is profitable and not over investing in growth so the EBITDA valuation method is the most relevant. The appropriate method can vary by industry or the company’s situation. EBITDA or cash flow may be irrelevant if they are negative or depressed due to proactive growth investment in headcount or other expenses ahead of revenue. The EBITDA method implies an enterprise value of $41-48 million in four years if XYZ’s forecast materializes and multiples remain unchanged.









Better forecasting ahead