Financial Projections: Setting the right assumptions and interpreting its results
As a business owner, your brain has 100 different ideas to grow and expand your business.
Some of these ideas are winners but many are not. How do you decide which option is the best for your business?
Smart business owners use financial projections to do the heavy lifting because they can help you:
- Assess multiple strategic decisions and assumptions that could impact future performance
- Calculate how much additional equity or debt is needed meet your growth plans
- Help lenders assess whether they should extend a business loan
- Plan well ahead so you don’t run out of cash
If you’ve never used a financial projection model before, you’re in luck.
That’s exactly what I’m covering today.
Let’s go!
In this issue, you will learn:
- How to get a financial projection template for free
- Key considerations when setting forecasting assumptions
- How to properly interpret the results
- What to do with your financial projections on an ongoing basis
**GET YOUR FINANCIAL PROJECTION MODEL FOR FREE**
I’ve created a free financial projection model to help you make better business decisions.
No accounting or excel experience required. Just follow the instructions within the model.
Click Here to download the financial projection.
Setting the right forecasting assumptions
Now that you have a projection model, it's time to plug in your assumptions.
If you’ve just started your business, making financial assumptions is hard because you have limited historical data (and experience) on hand. While the accuracy of the projection depends on the assumptions, that's exactly the beauty of financial protections. You don't always have to be right. That's what entrepreneurship is all about.
Let’s start by using revenue forecasting as an example. For product/service-based businesses, you should consider:
- What's the price of each product for sale?
- How much will it cost to produce one unit of sale?
- How many units you expect to sell each month? What is the expected growth rate?
The growth rate is the trickiest question to solve. Here are some points to consider:
- Determine the total market size (number of potential customers) and estimate your company's penetration in this market size based on your current sales.
- Quantify your customers purchasing capacity and see if it aligns with your offering.
- Estimate your marketing success rate on converting new sales.
- Sense check your growth rate against the your market niche's growth rate to see if it lines up. Your business doesn't operate in a vacuum, so you need to know how trends will impact your growth rates.
It's clear that as you're making financial assumptions, finding the right balance between granularity and flexibility is very important. It’s easy to get caught up in a the finest nuances of granularity.
If you are too granular and caught up in the smallest details in your assumptions, your plan may become overly complex and inefficient as you scale up.
If assumptions are made too broadly, you risk having inaccurate forecasted results, which doesn’t reflect your vision and will lead to a poor business decision.
When you have an existing business, you can use the financial statements as a baseline metric and assume growth rates based on your experience.
The key point here is that no matter what assumption you make, you still need to interpret the projected results to see if it makes sense.
Interpreting projection results
Now that you’ve completed a financial projection, how do you make sense of it? What should you be looking for? Is this the performance you were expecting?
The key for you is to fully understand how your inputs translate into the output.
As a commercial banker, here are the three main items I look for when reviewing financial projections:
- Profitability
Generally speaking, most business project themselves to be profitable.
If the assumptions produced an unprofitable business, this is a sign that there are areas within the business (or assumptions) that needs to be fixed. Is there a problem with the gross margins? Can the company reduce its operating expenses while maintaining the expected sales?
On the other hand, if the company is profitable beyond your expectations, this can also be an issue. While it’s great to be profitable, you need to be realistic on the potential outcome. Are your growth rates forecasted too aggressively? Do the expense growth rate assumptions support the growth rate of the company?
- Cash Flow
Cash flow is the lifeblood of the company. If the company runs out of cash, it will not survive.
Look into the cash flow statement and understand the main sources and uses of cash. If cash balance dwindles over time (or the line of credit balance gets larger over time), it may be a sign that the company is growing beyond it's means. Growth is financed through three different channels: reinvested profits from the business, shareholder/equity injections, and debt financing. If a profitable company runs out of cash while growing, shareholder injections or debt financing are the only options.
Understanding the drivers of the cash balance will help you understand how to better control the debt levels. Look into the assumptions around timing of cash collection and payment; the goal is to speed up cash collection and delay cash payments. Also, look into the debt obligations of a term loan (i.e. mortgage, equipment, vehicle loans) to see if the burden of their principal and interest is weighing down the company.
- Leverage
The leverage of the company is a good proxy on assessing the company’s level of risk. Generally, leverage is calculated as the total debt divided by total equity.
To fund the company's growth, businesses first tap into debt financing. The more debt accumulates, the higher the leverage, and the greater the business risk.
When debt levels become unproportionately higher than equity, servicing the loan’s interest and principal payments will eat away at the profitability and cash flow of the company.
To tackle this problem, tweak the assumptions to reduce the leverage by reducing the amount of debt or increasing the amount of shareholder injection.
This is the beauty of financial projections. You can model out all possible scenarios without putting your business at risk of playing these out in real life.
Using the financial projections over time
Once you've settled on a business plan using the financial projections, it's highly recommended to maintain and update your financial projections on a regular basis. Quarterly updates are recommended.
Remember that change is the only constant in life. Businesses will change, customer preferences will change, the economic environment will change.
You will also need to update your assumptions over time to adapt to changes within your business.
Tweak the assumptions inside your financial projection model to start the process again.
Conclusion:
Building a robust financial projection isn’t just a number crunching exercise.
It’s used to build out your vision in the form of financial statements using realistic assumptions against growth objectives.
Using this information, better decisions are made to navigate uncertainties, capitalize on opportunities, and sustain long-term success.
Take my financial projection model for a test run for a sneak peak into your company’s future.
That’s all for today. See you next week.
Cheers!
Lawrence
That's it for this week. Thank you for reading Financing Journey. See you next Saturday.
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