Financial Projections 101
Financial Projections 101
 
 
       

Creating financial projections for your business, particularly for a start-up, is both an art and a science. Although investors and lenders want to see cold, hard numbers, it is tough to predict your financial performance three years down the road, especially if you are still raising seed money. Regardless, a short- and medium-term financial projection is a required part of your business plan if you want serious investors’ attention.

     

Go Beyond the Income Statement

The income statement (or profit-and-loss statement) is a standard measuring tool used to convey your projected revenues and expenses. A good financial projection also will include a projected balance sheet, which shows the breakdown of assets, liabilities and owner’s equity. In addition, it will include a cash flow projection, which reveals the actual movement of cash through your company in a given period.

 

Your financial projections should include estimates of how much money you plan to borrow and interest repayments on those loans. Additionally, be sure to follow the Generally Accepted Accounting Principles, or GAAP, which are set forth by the Financial Accounting Standards Board, the private-sector organization responsible for setting financial accounting and reporting standards in the U.S. If financial reporting is new territory for you, have an accountant review your projections.

 

Provide Short-Term and Medium-Term Projections

You should be able to offer investors:

 

  • A short-term projection of the first year, broken down by month
  • three-year projection, broken down by year
  • A five-year projection. Don’t include this one in the business plan, since the further into the future you project, the harder it is to predict; however, have it available in case an investor or lender asks for it.

 

When projecting growth, consider the state of the market in which you are operating, as well as trends in raw material and labor costs, and whether you foresee needing additional funding in the future.

 

  • Avoid volume discount pricing.  If your product/service costs X, don't casually assume that the more you sell will always lower your company's overall costs year after year.  Sales growth costs money.
  • Compare results to your industry.  A common mistake of startup entrepreneurs is to prepare projections in a vacuum. If for example, you are starting a restaurant with super high projected profit margins, you better have a good reason why you can produce this exceptional result.  Investors and lenders will compare your projections to established reality.  Similarly if you tell investors that one day a corporation will pay 3 times your projected revenues to buy your business, find at least one recent transaction to support your position.
  • Don't force the numbers.  It is true that seed and early stage investors seek out reasonable opportunities to earn rates of return over 30% to 40% before opening their checkbooks. 
  • Still, it's not worth backing into artificial sales and expense numbers just to reach assumed rate of return, sales growth or profitability goals. Lenders expectations are usually lower since they are more interested in long term growth and revenue instead of short-term goals.
  • Pay attention to your best work.  If your projections represent an honest assessment of profitability and sales growth, and you don't think the numbers are big enough to attract investors or less demanding lenders, don't abandon the work in favor of the fantasy-like "blue sky" projections.  Good projections can be good fortune tellers (or loss of fortune tellers too).  Maybe this business idea or approach is not really worth your money and personal sacrifice?  After all, not all product ideas make good businesses.
  • Know your gross profit margins.  As a consumer product manufacturer or service provider and marketer, your product's investment viability will be judged initially by its gross profit margins.  Be prepared to provide an itemized cost of goods sold to support your projections.
 
 

Where to start?

Your projected financial statements should be based on:

  • An analysis of your company’s historical financial data or the financial data of other similar businesses.
  • Knowledge of your industry and general economic trends.
  • An estimate of how a proposed financial package will change the future events in the company.


Sources of information on which to base your projected revenues and expenses include:

 

  • Suppliers to your industry
  • Government statistics
  • Trade Organizations
 

Revenues for retail stores can be projected based on the number of customers per hour multiplied by the average purchase multiplied by the number of days per month and hours per day the store is open.

 

 

6 days x 10 hours x 3 clients x S 12.50 = $2,250.00 per week

$2,250.00 per week x 4.33 weeks = $9,742.50 per month

 

There is no "right" way to arrive at projection totals. Use the method that results in the most likely attainable figures which can be substantiated.

 

Another method would be as follows: You are planning to open a retail flower shop. Checking with trade associations you find that the Retail Florist Trade Association of America has statistics that document that the average annual gross revenue of retail florist whose square footage is between 1,800 & 2,500 (as an example) is $120.00 per square foot. If your store will be 2,000 square feet and similar in market conditions, you can reasonably project your store will gross $240,000 per year. If further the florist association statistics detailed gross revenue percentages by month such as 20% in December, 10% in January, 15% in February, etc., these numbers would provide you with reasonable projections for each month of operation.

 

For a new business, projections are the only way to justify the loan because there are no historical records of the company to demonstrate that the business can repay the loan out of profits. For new businesses the projections demonstrate your ability to repay the loan.

 

Financial projections should be supported from figures collected from the experience of other similar businesses or industry data. Support for the figures is essential. Most lenders require the loan be paid back from proceeds of the business itself. Estimates will never be correct, but sales projections are necessary to determine if the business has a theoretical chance of success and repayment of the loan. Actual sales will depend on the ability of the manager as well as the product / service - that is why the lender relies on other important considerations such as evaluation of management.

 

With gross sales revenue projected, cost of sales can be projected using a markup. Most industries have a normal markup. Your decision to follow the trend, markup at a higher rate or lower rate will depend on you. Make sure you find out what the normal markup is for your industry.

 

Some expenses can be estimated easily, others require a little more speculation. Some expenses such as insurance and lease payments can be determined by talking with vendors. Utility costs can be determined by asking the utility company for an energy survey or an estimate based on previous occupancy. Other expenses such as payroll or travel will require a little more judgment. Other expenses like interest cost and depreciation cost can be calculated by using simple math. The PADD providesExcel spreadsheets that can help you to calculate those costs. You will also find spreadsheets that can be used to prepare the financial projections itself: Please click here to go to our forms section.

 

Substantiate your projections by including the source or basis of estimates in your assumption statement. The more definite the estimate, the more acceptable the projections will appear to the loan officer.

New businesses must rely on solid judgment in creating projections. Keep in mind your projections must be reasonable for your industry, type of business, location, customer segment, etc. Don’t expect a lender to approve pie-in-the-sky financial projections. Lenders tend to shy away from overly optimistic projections. Your objective is to produce realistic and attainable projections.

Your pro forma financials should provide clear answers to the fundamental questions:

 

  • What major capital purchases will be needed? Property? Equipment? When?
  • What changes will be needed in operating cost expenditures? When?
  • What personnel-cost changes are expected? When?
  • When will the operation break even?
 

Example

A closed down retail store in prime location is available to rent / lease for $28,000 per month, including water and heat. The renter will be responsible for electrical costs. The store does not have any inventory but some equipment left that the new renter can use. The applicant is proposing to open a home furnishing / household items store and is requesting a $468,000 loan with a term of 10 years and a 9.50% interest rate. The loan proceeds will be used to purchase inventory, more equipment, provide some Working Capital as well as allow for a month prepayment in leases.

 

Total Project Costs are $520,000 and the applicant is providing 10% ($52,000) as equity injection. Note that most lenders will not provide a 10 year term for a loan that is mainly used to purchase inventory, but for the ease of this example, a 10 year term was assumed.

 

 

 

 

Income Statement

The income statement (profit and loss statement) shows the revenue, expenses, and net income (or net loss) for a period of time.  Net income is the amount by which total revenue exceeds total expenses.  The resulting profit is added to the retained earnings account in the balance sheet (accumulated earnings of a company since its inception less dividends). 

 

A net loss reduces the retained earnings account.  The projected income statements demonstrate that your business has the ability to earn profits over time.

 

 

 

 

   
   

 

Balance Sheet

(Usually, PADD requires only a Pro-Forma Balance Sheet; other lenders may require up to 3 years of projections!)

The balance sheet is a statement of financial position that shows total assets = total liabilities + owners' equity. Financial position refers to the amount of resources (i.e., assets) and the liabilities of the business on a specific date. The purpose of the balance sheet is to report the financial position of a business at a particular point in time (usually at year end).

 

Owners' equity is the residual interest, or the amount of the assets to which the owners have claim because creditor claims (liabilities) legally come first. Owners' equity in a business derives from two sources:

 

(1) Paid-in capital, which is the investment of cash or other assets in the business by the owner or owners; and

(2)  Retained earnings, which are the accumulated profits of the business less the losses and withdrawals.

 

 

 

 

   
   

 

Cash Flow Statement

(For informational purposes only; PADD usually does not require a Cash Flow Statement!)

Revenue does not necessarily mean receipt of cash (money received), and expense does not automatically imply a cash payment (money paid). Net income and net cash flow (cash receipts less cash payments) are different. For example, taking out a bank loan generates cash, but this cash is not revenue since no merchandise has been sold and no services have been provided. Loan repayments consume cash, but do not reduce income - they are recorded as a reduction to liabilities.

 

In our income statement example (above), although net income for Year 1 was $33,194, cash flow was $77, 547. The beginning cash balance in Year 1 was $33,150. Cash flow in Year 1 was $77,547. Add the two, and the ending cash balance in Year 1 becomes $110,697. Your statements "tie together." This is a simple check potential investors and lenders will perform.

 

 

 

 

 



 

 

Page last updated on Fri, 17 Jan 2014 17:26:00 GMT.