Neither is particularly exciting—especially when you compare it to the idea at the core of your business. And yet, to grow and scale, you’ll need capital.
For external funding, financial projections help convince lenders and investors that your business will not only be profitable but also offer them a return on investment. For internal purposes, accurate projections enable you to budget for your new business as well as benchmark your milestones.
Comparing your actual financial statements to your projections is referred to as variance analysis. With this analysis, you’ll be able to see if your business is consistently falling short of your projections or surpassing them.
If your projections are falling behind, then you’ll need to make some changes by raising prices, cutting costs, or rethinking your business model. Conversely, if your immediate revenue exceeds your pro forma income, then you may need to hire employees, expand your facility, or seek financing sooner than you expected.
What forecasts should I make first?
To establish credibility with prospective investors and lenders, pro forma statements should ideally show projections three years in advance. There are two key forecasts to put together.
1. Sales forecast
Project your sales out for at least three fiscal years. Include monthly sales for the first year, then quarterly for the following two years. How many customers can you expect? How many units will be sold? What is the cost of goods sold? How will you price your products? Sales projections can forecast revenue. And when the cost of goods sold is also taken into account, gross profit can be estimated for each of those years.
After accounting for all of your operating costs, subtract this from your gross profit to calculate your actual profit — otherwise known as net income (or profit). Operating expenses can be calculated based on your expense budget.
2. An expense budget
Operating expenses are any expenses that businesses incur performing their normal business operations. These include both fixed costs (i.e. rent for your location) and variable costs (i.e. marketing expenses). You don’t need to do an incredibly detailed breakdown, such as listing the cost of every office chair. But you do need general figures.
What financial statements are included?
Financial projections include three financial statements that are fundamental to achieving better financial performance for your business:
1. Income statement
Otherwise known as a profit & loss statement. This focuses on the company’s revenues and expenses, generated during a particular time period. The four key items included in the income statement are revenue, expenses, gains, and losses. Adding these four gives you the net income, which is a measure for profitability.
In the first year of business, you’ll want to create a monthly income statement. For the second year, quarterly statements will suffice. In the following years, you’ll just need an annual income statement.
2. Cash flow statement
The cash flow statement helps you understand how a company’s operations are running. It goes into more detail on how much money will flow into and out of your business in the form of income and expenses.
Three key components of a cash flow statement include cash flows from operating, investing, and financing your business activities.
- Operating activities: Cash flows from operating activities reports cash inflows and outflows from day-to-day business operations. It includes any changes made in cash, accounts receivable, depreciation, inventory, and accounts payable.
- Investing activities: Cash flows from investing activities is used for a company’s investments into the long-term future. Investing activities includes cash inflows for sales of assets, and cash outflows for any purchases of fixed assets, such as property and equipment.
- Financing activities: Financing activities show a business’s sources of cash from either investors or banks, as well as expenditures of cash paid to shareholders. At the end of each period (e.g. monthly, quarterly, or annually), you’ll total it up to show either a profit or loss.
The income statement and cash flow statement are both connected by net income. The statement of cash flows requires a reconciliation of net income and cash flow from operations. Net income, or profitability, is calculated in the income statement, which is used to begin the cash flow from operations category in a cash flow statement.
3. Balance Sheet
The balance sheet shows a general overview of your business’s financial health and includes assets, liabilities, and owners’ equity in a specific period of time (usually at the end of the fiscal year). Here’s a brief overview of each component:
- Assets: An asset is a resource with economic value that a business owns and believes will provide a future benefit. Examples of a future benefit include generating cash flow, reducing expenses, or enhancing sales. Assets usually include cash, inventory, and property.
- Liabilities: In general, liabilities are obligations to someone else. Most commonly, they are debts that arise during business operations. It normally includes accounts payable and loans. Liabilities can either be short-term (within 12 months) or long-term (longer than 12 months).
- Owners’ equity: After paying all liabilities, any amount left over is placed in this section. It’s usually classified as retained earnings, which is the sum of all net income earned minus all dividends paid since inception.
Balance sheets are split between assets on one side, and liabilities and owner’s equity on the other side. The total dollar amount of assets must equal the total dollar amount of liabilities plus equity. Therefore, the formula for a balance sheet is assets equals liabilities plus owners’ equity (Assets = Liabilities + Owners’ Equity). Typically you will create an annual balance sheet for your financial projections.
Projecting three years into the future should enable you to forecast the break-even point, which is the point at which your business stops operating at a loss and begins to turn a profit. Most startups break even in about 18 months, although that threshold will vary based on your business model and industry.
Along with your financial statements and break-even analysis, include any other documents that help explain the assumptions behind your financial projections.
How to create financial projections
The challenge for any entrepreneur is creating financial projections when your business is not yet running on its own. Therefore, you do not have any historical data to give you a better sense for future projections. However, with a little market and industry research, you’ll actually have a lot of data to work with to help you create realistic financial projections. Here are some things to consider.
Use your own industry experience
You may have worked at a similar business within the same industry before striking out on your own. In this case, you will probably have an idea of what realistic financial projections look like, how long it will take to scale, what growth rate is ideal, and what profit margins are normal within your industry.
Work with an accountant who knows your industry
An accountant will know what type of expenses, sales, and profits a well-run business in your industry can expect and will be able to help you come up with realistic financial projections.
Do market research to develop a sustainable business model
Industry associations and publications can help you compile accurate financial data.
Look at publicly available information such as Census.gov to better understand your target audience. Find assistance from small business advisors and mentors, through SCORE or your local Small Business Development Center (SBDC).
Be optimistic but realistic
Investors and lenders know that your financial projections aren’t set in stone, but you do need to make sure they are realistic. Lending institutions and investors have seen too many entrepreneurs who are overly optimistic about their own businesses.
As a small business owner, your figures will be scrutinized by banks and investors to ensure the business is legitimate and has the potential to grow.
Finally, understand the types of financing you’re seeking with your financial projections. Investors are more willing to take risks, as long as you can prove your proposal is backed by hard data. Lenders, however, are more cautious. They don’t need your business to be the next Google so long as you are able to pay back the loan payments on time.
By carefully gathering information and striking a balance between optimism and realism, you can create financial projections that not only guide your business but can help you obtain the right type of financing as you grow.