One of the most common errors in business planning is confusing planning with accounting.
They are two different dimensions. Accounting goes from today backwards into time in ever-increasing detail. Planning, on the other hand, goes forward into the future in ever-increasing summary and aggregation.
Understanding this difference helps you work with and understand the educated guessing you need to do to make projections — specifically, the sales forecast, expense forecast, and eventually the profit and loss, cash flow, and the rest of the financial forecast — into your business planning.
Accounting has to be correct, to the last detail. You use it to pay taxes. Forecasts in a business plan aren’t correct, by definition (see your business plan is always wrong).
I like to use the 1994 movie Stargate starring James Spader and Kurt Russell, to illustrate the difference between planning and accounting.
In the movie, some fictitious freak of nature had opens up a strange, luminous gate between two dimensions. On one side of it was the world as we know it. On the other side, a strange, alien world, like nothing we’d ever seen. I like the idea because it reminds me of the difference dimensions that are planning and accounting.
If that strikes you as theoretical or conceptual, perhaps a bit impractical, think again. This is important. It can save you needless headache and stress. It helps keep you in the right dimension, understanding that the financial projections in your business plan are not meant to be built in excruciating detail.
A Simple Example
Take the balance sheet here, a sample taken from Wikipedia. The so-called balance sheet is a standard financial report, listing the assets and liabilities and capital of a business at the end of some specific day, month, year, or whatever. Assets are good — things you own like cash and land, or money owed to you like accounts receivable. Liabilities are debts, money you owe, which is why you see things that are “payable” –- meaning you’re going to have to pay them –- as liabilities. Capital is what’s left over. It’s called a balance sheet because it’s magic, the magic of double-entry bookkeeping: the assets are always exactly equal to the liabilities and the capital.
Is this an accounting report or a projection in a business plan? You can’t tell. It looks exactly the same, either way. However, in truth, they are different dimensions.
Accounting Collects Records of Transactions
Accounting goes backward from today into the past in ever increasing detail.
If it’s accounting, then every number shown in a balance sheet is actually a summary report of a database full of transactions. The cash balance is like your checkbook balance; it’s the result of adding up all the deposits and subtracting all the checks. What they call accounts receivable is the sum of all the amounts of money owed to you by all your different customers, a report of hundreds, maybe thousands of different transactions. You make a sale, leave an invoice, wait to get paid, then finally get paid, record the transaction, debit cash and credit accounts receivable, and so on, through a collection of specific transactions. The $52,000 reported as land value might be what you paid for land, but it might also be the resolution of dozens of land transactions, selling some, buying others, and that’s the balance.
Liability balances, like assets, are built from bottom up in accounting by keeping track of all the transactions and summarizing the end result. Notes payable might be dozens of small trade bills sitting on a spike somewhere, or a loan from the bank, in which case it’s related to the starting loan amount less the total of all the principal payments.
I hope you get the idea: accounting is a huge collection of summarized past transactions. Focus on any number in an accounting statement and you should be able to zoom in on more detail, down to each individual transaction.
Planning Makes Reasonable Educated Guesses
Planning goes forward from today into the future in ever increasing summary and aggregation.
Now consider, if you will, that same illustration as part of a business plan, making an educated guess of what the balance will be two or three years from now. Don’t even try, not for a second, to think that you’re going to estimate cash by estimating the details of thousands of transactions and adding them up. You’re not going to estimate assets by guessing what you’re going to buy, and when (not to mention depreciation, so pretend I didn’t). You’re not going to estimate debts by guessing when you will take out each loan, exactly what you will purchase, and when. That’s impossible — and silly. You’re going to find some way to guess your cash, your assets, and your liabilities, based on larger educated guesses tied logically into the major flows, like sales.
We’ll be working together later on how you can make reasonable estimates, but for the sake of illustration, I have some of examples to explain the difference in dimensions:
- Accounts receivable means money owed to you by customers. You make the sale but you deliver an invoice, and wait to get paid; that’s the way it goes in business-to-business sales. So you need to guess how much money will be sitting there, at important points in the future, waiting to be received. Every dollar in accounts receivable is a dollar less cash, because it was booked as sales but you don’t have the money. You don’t however, try to guess all the specific sales transactions with all the specific customers and add them all up and figure out where the total will be two or three years from now. Instead, you guess what percent of sales involve invoices and waiting, and then you guess how many days on average you have to wait, and you can do some numbers tricks to make an educated guess.
- You don’t guess what you’re going to owe by adding up all the imagined bills from some guessed-at future purchases. Instead, you estimate how much you’re currently paying out in expenses as a percentage of sales and payroll or some other measure, then estimate about a month’s worth of that as payables.
I’m not going to belabor the examples because I think that’s already enough to make the point. You have to make some logical guesses.
Why Does This Matter?
Every so often I encounter somebody trying to manage the minute details of projected interest expense to allow for several different loans with differing rates and terms as part of a business plan. Or I find somebody trying to guess assets by guessing the detailed purchase dates and values. And then there are people trying to project future accounts receivable by customer, guessing each customer’s future sales and payment patterns.
The problem, of course, is that is really hard to do. You can spend a lifetime calculating details and never get as close as you would with a good estimate.
Compare the levels of certainty: Let’s say interest is normally a percent or two of total expenses, and expenses are normally something like two-thirds of sales. If your sales estimate for future years is within 5 percent either way, you’re doing way better than most. How wrong can you go with a simple estimated interest rate, and how much does that affect your projections? Aren’t we talking about tiny percentages of expense, in a system that has to estimate other elements that have hundreds of times more uncertainty?
I consider this a problem of what I call levels of uncertainty, which is a matter of how correct you expect to be. For example, assume it’s Spring of 2008. When your accounting report says your sales were $2,893,712.07 for 2007, and you put that number into your tax reports for 2007, you expect it to be absolutely correct. You have accounting software and professional accounting help, and you enter all the records, so you assume that the number is correct. That’s presumably a very low level of uncertainty. Even a $10,000 difference between what you see on the accounting report and what actually happened is very bad. On the other hand, when your 2008 business plan says you expect to sell $5 million for 2011, that’s an educated guess with a relatively high level of uncertainty. While your accounting for past sales in a tax report is a disaster if it’s off by $10,000, your projected $5 million sales for three years from now has so much uncertainty to it that you’re probably very pleased to end up within $500,000 of that number you estimated in 2008 when you finally do get actual results for 2011.
Now take that same idea into more detail, using the example of specific interest expenses. Interest is deductible from income before you pay taxes, so if it’s already 2008 then your accounting should be telling down to the last penny what you paid in interest expense in 2007. Let’s just take as an example that you paid $21,093.76 in interest for 2007. There is no margin for error. The interest expense for the whole year is the sum of all the separate interest payments paid for whatever different loans were involved. On the other hand, if it’s 2008 now and you’re estimating what your interest expenses will be in 2011, you can’t possibly expect to be exactly right. And — most important — you should not try to calculate interest expenses in the future like you do for the past, by knowing all the loans you have and all the different interest rates and adding them all up. That kind of detail in projections just doesn’t work. A simple estimate will do.
I suggest we think about this for just a second. Does it make sense that business planning is about projecting the future so exactly that using a simple average estimated interest rate applied to your projected liabilities isn’t good enough? Do you really have time to be modeling the detailed impact of multiple hypothetical interest rates on multiple hypothetical loans as part of a projection that depends on an estimated sales forecast?
Planning is for making decisions, setting priorities, and management. Accounting is also for information and management, of course, but there are legal obligations related to taxes. Accounting must necessarily go very deep into detail. Planning requires a balance between detail and concept, because there are times when too much detail is not productive.
Good News: It Makes Things Easier
This is really good news for business planning. What it means is that you don’t have to paint a picture of your financial future by detailing every brick in every building. You can do it with a broad brush. That doesn’t make it less realistic, in fact it will usually make it more realistic, at least that’s what I’ve seen while working with thousands of people on thousands of business plans.
We’re human. We work better at imagining the future in scale than at building it brick by brick in our mind.
A Final Word of Warning
Seeing the difference between planning and accounting is particularly hard for well-trained accountants to handle. They learned to build reports from the bottom up, from the detail, and it can drive them crazy when you make estimates using percentages and algebra and plain common sense for something they’ve learned to build up from painstaking detail.
More important than driving them crazy, unfortunately, is that sometimes this dimensional discomfort can make the accountants so unhappy that they’ll say your estimates are wrong. In these cases, they are often misunderstanding what it means to be projecting the future in summary instead of counting the detail in the past. Forgive them — they mean well — but don’t let them drive you crazy either. Stick to the planning.