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Starting an enterprise is risky. About one in five new businesses fail within the first two years, according to the Bureau of Labor Statistics.
To avoid this dismal fate requires diligent planning, careful monitoring of financial records, and forward thinking in order to predict how the company will fare in ever-changing market conditions. Put simply, you need to analyze the past if you want to win the future.
Luckily, there’s some time-tested tools that can help you stay ahead. Specifically, you need to master the art (and science) of building solid financial projections. In this post we will break down what that entails.
Read more: Venture Capital vs. Venture Debt-What's Best for Startup Founders
Financial projections are your company’s roadmap to the future.They use your company’s current financial state of play to analyze what your business will look like in one, two, or even five years ahead.
Financial projections offer a detailed analysis of things like cash inflows, outflows, revenues, and expenses.
They form a core part of any sound company’s decision-making process. They can help determine when to launch new products, bring on new staff, take out a loan, or pull the trigger on new investments, to name just a few examples.
They’re often the best early warning sign that your business has gone off track, allowing time to course correct.
It’s not just the actual company that needs to analyse these projections. Detailed financial projections can win the confidence of investors and lenders who want to be certain that their money will be returned or will grow.
Better projections can also help your financial advisors give you better advice, and win over partners, stakeholders, and top talent, like senior executives.
In other words, financial projections play a dual role, serving as a tool for both internal planning and public communication.
Financial projections can include a dizzying array of data, but ultimately there are a few core concepts that companies fall back on. They include an analysis of the business’s income statement, cash flow statement, and balance sheet. We’ll consider each in turn.
An income statement is also known as a profit and loss statement, or P&L. It’s meant to provide a quick look at the overall profitability of the company by analysing revenues and expenses over a defined period of time, like a quarter or a year.
Income statements typically include things like:
1- Revenues - money earned from selling goods and services before expenses.
2- Cost of Goods Sold (COGS) - how much it costs to produce those goods and services, meaning items such as cost of labor and raw materials.
3- Gross Profit - Subtract the COGS from revenues and you will have your gross profit, which is what you earned after covering direct costs.
4- Operating Expenses - These are the other costs involved in running your business. It includes things like marketing, rent, office supplies, insurance. Usually these expenses are divided between those that are fixed each month (like rent) and variable expenses (like marketing for a new sales campaign).
5- Operating Income (EBIT) - Take your gross profit and subtract it by your operating expenses, and you will have your operating income. It’s sometimes referred to as Earnings Before Interest and Taxes, or EBIT.
6- Other Income and Expenses - This includes gains and losses from things like selling assets or other non-operating income or expenses.
7- Net Income - This is your company’s net profit or loss after accounting for all revenues and expenses. If revenues exceed expenses, you’ve made a profit.
A cash flow statement tracks the inflows and outflows of cash over a defined period of time. It offers a snapshot of the company’s liquidity.
Cash flow statements can be broken into three parts:
This tracks cash inflows and outflows from daily activities. Things like sales from goods and services, payments to suppliers, salary payments, and payments for expenses like rent or manufacturing costs.
These are the inflows and outflows from longer term activities, like asset sales, or large purchases like new equipment or investments in new ventures.
This is where you track the inflows and outflows associated with managing debt and equity. Things like new lines of credit, issuing stock, paying back loans or paying out dividends to shareholders.
Tallying up these activities allows you to derive two important metrics:
- Net Cash Flow - This is the sum of the three activities above. If it’s positive, you have more cash coming in than out, a sign that your business is sustainable.
- Free Cash Flow - This is the cash that a company has on hand after it has accounted for operating expenses and maintaining its capital assets.
Finally we have the balance sheet, a financial statement that details what a company owns, owes and the amount invested by shareholders.
It has three core components:
1. Assets - Everything the company owns or controls. Current assets refer to assets that can be used or converted into cash within a year, like accounts receivable, bank balances, and inventory available for sale. Non-current assets are longer term, like buildings and land.
2. Liabilities - What the company owes to others. Current liabilities must be settled within a year, like accounts payable, lines of credit, and short-term loans. Non-current liabilities are due beyond a year, and include things like mortgages, bond payments, and pension payments.
3. Equity - This is the value of the company after subtracting liabilities from assets, and is a type of measure of net worth. This includes things like paid-in capital from owners or shareholders, retained earnings, and treasury stock (shares repurchased by the company).
Read more: Balancing Equity Dilution and Growth
- Regularly update your figures: The world, and your business, is constantly changing. If you’re not revising your figures and updating your projections to reflect new conditions, you’re a step behind.
- Be very detailed: Breaking your projections down into smaller, more manageable pieces will help make your analysis better.
- Use historical data: Your past performance must be used to inform future projections whenever possible so it's grounded in reality.
- Create different scenarios: Consider the best case, the worst case, and what’s most likely.
- Be realistic: Overly rosy projections lose credibility with investors and anyone who is evaluating the company.
- Use accounting software: like QuickBooks or Excel to streamline your process.
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
