FP&A: The Under-Appreciated Part of the Finance Organization
The FP&A team focuses on explaining “Why did something happen?”, “What’s possible?” and “What is likely to happen in the future?”.
Many business leaders, including CEOs, don’t fully appreciate the breadth of tasks a top-notch finance department executes.
Most employees, when asked to describe what jobs are done by the finance function at their company, would likely list some mix of the following activities:
Closing the books
Producing financial statements
Working with the auditors
Sending out invoices
Collecting payments
Paying vendors
Funding payroll
Compliance: paying taxes, filing other necessary paperwork
All of these are correct answers.
And, all of these tasks are done by the “Accounting” function within a finance organization.
The work done by the accounting function describes “What” has happened in a business. The “what” takes the form of financial statements showing financial performance for a period of time. And the team typically compares the current period financial statements to those from a prior period to show changes over time.
There is another part of the Finance team that goes by the acronym, “FP&A”, which stands for Financial Planning and Analysis.
In this post I will address the critical and often underappreciated role of the FP&A function.
The FP&A team focuses on explaining “Why did something happen?”, “What’s possible?” and “What is likely to happen in the future?”.
In short, FP&A analyzes historical data to explain why things happened as well as predicts what is likely to happen in the future.
The primary goal of the FP&A team is provide analysis that helps the Leadership Team and Board of Directors make better decisions. This is accomplished through two discrete tasks — financial analysis which provides inputs and sanity checks for financial planning.
Financial Analysis
Financial analysis involves combining and manipulating detailed financial and operating data.
The precursor to analysis is understanding the major business processes in depth and dissecting each process down to its key constituent parts. The business process analysis involves understanding the key inputs (actions taken by employees or customers) as well as the intermediate steps leading to an output.
The greatest effort is devoted to analyzing the go-to-market process (lead/trial to close/purchase to renewal/additional purchase) as this process drives revenue and cash generation, which in turn determines how much a company can afford to spend on people (salaries), marketing, rent etc.
The business process analysis is then turned into a financial model. The “model” can range from a few lines of calculations in excel for a simple analysis to tens of workbooks and thousands of lines of data for a multi-year, detailed business plan.
Part I. Financial Analysis: Combining “What” with “Why”
(1) Tracking Key Performance Indicators (KPIs) — KPIs are the business drivers or metrics that really matter for your particular business. They are created by understanding how each of your business processes works and then determining what measures will be important indicators of the financial health of that process and the overall business. Ideally at least some of these KPIs are “leading indicators”, meaning they inform management on likely future financial results.
Creating KPIs often involves going into detailed, back-up financial data not reported anywhere individually in the financial statements (for example, the revenue and expenses for a particular segment of customers). Often these financial metrics are combined with operational data (such as customer count, sales cycle lengths, # of employees etc.) to offer insights and assist with decision-making.
It is most useful when these KPIs are tracked over time and displayed graphically so one can clearly see if performance in individual business drivers is improving, worsening or staying the same.
(2) Reporting — Done on a weekly and monthly basis, reporting compares the actual results (both the financial data from the accounting team and operational data from other systems tracking customers, usage etc.) to the budget. And then, the reports created should explain what drove the key variances to budget or changes over with the prior period, if a budget doesn’t exist for that data point or that time frame.
For example when bookings or revenue exceed budget, it is the responsibility of the FP&A team to explain why that happened. In a direct to consumer company, the FP&A team determines whether the cause was a higher realized price, a higher volume of new customers acquired or a higher repeat customer purchase rate. If analyzing a B2B business, the questions explored may include (i) were there more leads, (ii) more sales people in the field, (iii) higher quota achievement by the sales team, (iv) higher average contract value etc. Often multiple factors can be at work and FP&A aims to quantify the impact of each factor.
And then, even more importantly, the FP&A team aims to determine if this occurrence is a one-time event (nice) or a likely-to-recur event (awesome). The answer to this “second why” question influences future corporate decisions, because if a positive variance is going to continue in perpetuity, Leadership might be willing to invest a lot more in hiring or marketing.
Part II. Financial Analysis: Determining “What’s Possible” and “What If”
(3) Benchmarking—Business leader and investors want to understand how well a business is doing. That of course begs the question, how well compared with what. Benchmarking comparing the performance of your business to other similar businesses using standardized metrics. Benchmarking allows the FP&A team to answer the question about how well the company is performing compared to other companies in the same industry or compared to other companies with a similar business model. Benchmarking also assists in identifying processes or metrics where performance improvements are possible and prioritizes where the operational leadership should focus their efforts.
(4) I Have a Great New Idea, “What If…” — Employees at all levels may come to their managers and recommend changing an established business process. If this proposed change would have significant financial implications, often the FP&A team gets involved in this “what if” analysis. An example might be a “what if” analysis around changing the incentive compensation for account executives. The goal is to both understand the behavioral/motivational implications for the sales team and the financial implications for the company assuming different levels of future performance.
Financial Planning:
Financial planning is critical to arrive at a thoughtful allocation of resources (both people and money) against the goals that Leadership and the Board of an organization set out to achieve. Detailed financial planning allows a business to determine whether the goals it hopes to achieve are reasonable and if these goals can be achieved within the financial and time constraints prescribed by the Board.
Part I. What Is Likely to Happen in the Future
(5) The Budget (Our Hope and Best Guess for the Future)—The FP&A team also undertakes planning, which includes the detailed annual budget and longer-term (typically 5-year) forecasts. The annual planning effort typically lasts for many months in the second half of every fiscal year, and is updated as part of any fundraising exercise.
The key inputs into the planning process are based on a number of separate analysis tasks performed over the course of the year, including the business process analysis, the budget vs. actual historical performance reporting, the KPI tracking and the benchmarking work.
Acknowledging that every financial plan and budget is going to be the wrong, it is the goal of the FP&A team to produce a budget that balances realism while being motivating and still a stretch to achieve. The benchmarking of your company’s actual historical performance against comparable companies and against prior budgets is critical and serves as a sanity check on what is likely and possible regarding future performance.
Part II. What If Things Evolve Differently
(6) Sensitivity Analysis—This involves running a series of “what if” scenarios to forecast the financial implications of future performance being different from the budget. As an example, it is critical to know the impact of both the revenue organization beating budget and missing budget under specific circumstances. The what if scenarios modelled out that create a miss or a beat to the budget might include: (i) more or fewer hires; (ii) better or worse performance per person; (iii) price changes (upward or down); or (iv) other important performance drivers.
Knowing the implications of changes in important performance drivers such revenue retention, average order or contract value, or quota achievement for the new logo team on cash burn helps the Leadership determine when and what changes to make in planned hiring and spending for the year. And it informs that Board when the company may need to raise additional funds were performance to materialize in a different way the forecast.
Building the FP&A Function
Companies that build world class finance organizations combine high quality accounting with top-notch FP&A skills.
An excellent FP&A function requires hiring people who combine the understanding of business processes and how value creation happens with financial acumen, excel modelling skills and some accounting knowledge. However, soft skills and attitude may be the most important element in a great FP&A hire. I look for people who are genuinely curious about how different businesses function and interested in learning about how the most successful companies reached their pinnacle.
Founders, once you transition from purely product building to scaling the business and have hired go-to-market talent, I advise you to hire at least one dedicated, qualified FP&A professional. This hire will provide insights to assist in better decisions and more efficient growth. FP&A is an under-appreciated part of a finance team and a worthwhile investment fairly early in the life of every business.