You might be wondering why you need financial projections for a new business. The numbers are at best an educated guess of what is going to happen in the future, and the actual results will likely differ from the projected figures.
The purpose of the financial projections is two-fold. You need it if you are seeking to raise capital from investors. They want to see numbers that say your business will grow and there is an exit strategy on the horizon so that they can make a profit. Bank or lenders like Futurpreneur and BDC will also ask to review these numbers to see what you intend to do with the money, how the business will grow, and if you can repay the loan.
But perhaps the most important reason to prepare a financial projection is for your own benefit, so you can see how the business might turn out based on your strategies and implementation. The results of the financial projection is the most important for you as the founder. You will use it to evaluate if there really is a business that can be built from the idea. It should be a living document and it should be used as a guide to running your business.
Let’s go over the key components of what you need to include in a financial projection.
Key components in a financial projection
Sales forecast
You will need to create a sales forecast and use it to project monthly revenues for the next 3 to 5 years. The sales forecast should align with your market analysis and marketing strategy that are included in your business plan. You should conduct an in-depth analysis to study your potential market to help you arrive at realistic numbers.
The way you can make your financial projection more credible is by breaking down the figures into components, such as by sales channel or target market segment, and then provide realistic estimates of each. You are still making an educated guess of the future, but it will provide more insights when it’s broken down by individually.
Projected expenses
You should have a good idea how much it will cost you to actually make the sales you have forecasted. For this exercise it is critical to understand the difference between variable costs, fixed costs, and capital expenditures.
Variable costs help you calculate gross margin. It’s a useful metric for comparing with industry standards and other businesses in a similar industry to evaluate business performance. Companies that are competing with low gross margin may not have sufficient profits left to cover fixed costs and will likely have trouble scaling the business.
Fixed costs or overheads show how efficient you are in managing the entire company as a whole. Lower fixed costs generally mean less risk. Rents, payroll, marketing, professional fees, and maintenance are typically the largest fixed costs in running a business.
Capital expenditures are purchase of assets that will last for a long time. These include upfront costs such as renovation, equipment, and building a webpage. They impact your cash flow and profit calculation differently because you need to depreciate capital expenditures even though they are paid upfront.
The financial projections
Once you have sales forecast and projected expenses figured out, it’s time to put together the projected profit and loss, balance sheet, and cash flow statement. Many people get confused about this because the financial projections look similar to the financial statements your accountant prepares for the business. But accounting looks back in time, and financial projection is a forward-looking view, which starts today and going into the future.
Projected profit and loss is straightforward. It’s simply the forecasted sales minus variable costs and fixed costs, along with interest and taxes. However, for projected balance sheet, you need to deal with assets and liabilities and project the net worth of your business at the end of the fiscal year. The way to compile this is to start with assets, and estimate what you’ll have on hand, month by month for cash, accounts receivable, and assets like land, buildings, and equipment. Then figure out what you have as liabilities (or debts) for bills that you haven’t paid or outstanding loans.
Projected cash flow statement shows physical dollars moving in and out of the business. And you should be most concerned about this because as we all know, cash is king. It’s important to recognize the completion of the projected profit and loss and balance sheet are prerequisites to project cash flow. When preparing the cash flow projection you need to estimate how long it takes for your invoices to get paid, how long it takes for you to pay your supplier, and how long it takes for you to sell the inventory (if you sell products).
Avoid the most common mistakes
One of the biggest mistakes entrepreneurs make is to look at their financial projections only once a year (or less). What they do wrong is they focus on the projection, and once it’s done, it’s forgotten. It’s really a shame because they could have used it as a tool for managing the company. We recommend business owners to review the financial projection once a month and compare against actual results. This will help you gain valuable insights to make better business decisions.
At the end, having a financial projection for a new business benefits you, because what you don’t measure you cannot improve. This is especially true for business finance.