As an entrepreneur you spend months, even years coming up with ideas to start or grow your business.
By creating financial projections, you have the opportunity to see the potential financial impact of your ideas. Your financial projections (also known as your financial model) will help you understand the viability of your ideas and help investors grasp the potential ROI (return on investment) of funding you.
In this article we will show you how to create a financial model for your startup or growing company. You will learn what to include in your financial projections, why they are important and how you can create them effectively.
What are Financial Projections?
Your business plan’s financial projections will be the most analyzed part of your plan by investors and/or banks. While never a precise prediction of future performance, a good financial model outlines the core assumptions of your business and helps you and others evaluate capital requirements, risks involved and rewards that successful execution will deliver.
Having a strong framework in place also will help you compare your performance to projections and evaluate how your business is progressing. If your performance is behind your projections, you will have a framework in place to evaluate the effects of lowering costs, increasing prices or even reimagining your model. In the happy case that you exceed your projections, you can use your framework to plan for accelerated growth, new hires or additional expansion investments.
Hence, the use of financial projections is multi-fold and crucial for the success of any business. Your projections should include three core financial statements – the income statement, the cash flow statement and the balance sheet. The next section explains each statement in detail.
What Do Financial Projections Include?
The Income Statement
The income statement is also referred to as a profit & loss statement and showcases your business’s revenues and expenses for a certain time period.
To create an income statement, you first will need to chart out a sales forecast by taking realistic estimates of units sold and multiplying them by price per unit to arrive at a total sales number. Then, estimate the cost of these units and multiply them by number of units to get the cost of sales. Finally, calculate your gross margin by subtracting the cost of sales from your sales.
Once you have calculated your gross margin, deduct items like wages, rent, marketing costs and other expenses that you plan to pay for to facilitate the operations of your business. The resulting total represents your projected operating income, which is a critical business metric.
Plan to create an income statement on a monthly basis up until your projected break even, or the point at which revenues outpace total expenses and you reflect operating profit. From there, annual income statements will suffice.
Consider a sample income statement for a retail store below:
|Profit and Loss||Year 1||Year 2||Year 3||Year 4||Year 5|
|Direct Cost of Sales||$2,528,406||$2,982,315||$3,405,430||$3,775,033||$4,062,261|
|Taxes and Benefits||$136,500||$143,325||$150,491||$158,016||$165,917|
|Professional, Administrative & Merchant Fees||$108,214||$127,640||$145,749||$161,568||$173,861|
|Total Operating Expenses||$1,003,587||$1,073,599||$1,143,223||$1,210,885||$1,274,566|
The Cash Flow Statement
As the name indicates, a cash flow statement details the cash flowing in and out of your business. The cash flow statement incorporates cash from business operations, but also includes cash inflows and outflows from investment and financing activities to deliver a holistic cash picture of your company.
Investment activities include items like purchasing land or equipment or research & development activities that aren’t necessarily part of daily operations. Cash movements due to financing activities include cash flowing in a business through investors and / or banks and cash flowing out due to debt repayment or distributions made to shareholders.
For any specified time period, you should total all these three components of a cash flow statement to arrive at a total ending cash balance. Constructing a strong projected cash flow statement will ensure you anticipate capital needs to carry the business to a place of sustainable operations.
Below is a simple cash flow statement for the same retail store:
|Cash Flow||Year 1||Year 2||Year 3||Year 4||Year 5|
|Cash from Sales||$3,607,119||$4,254,682||$4,858,315||$5,385,603||$5,795,374|
|Total Cash Inflow||$4,322,119||$4,254,682||$4,858,315||$5,385,603||$5,795,374|
|Direct Cash Spending||$2,919,493||$3,416,009||$3,879,994||$4,287,090||$4,606,345|
|Cash for Payables||$528,729||$627,273||$679,465||$728,872||$773,385|
|Increase in Inventory||$163,862||$12,721||$10,891||$8,613||$5,964|
|Purchase Long-Term Assets||$500,000||$0||$0||$0||$0|
|Total Cash Outflow||$4,127,085||$4,056,003||$4,570,351||$5,024,575||$5,385,694|
|Net Cash Flow||$195,034||$198,679||$287,964||$361,028||$409,680|
The Balance Sheet
A balance sheet includes your business’s assets, liabilities and owner’s equity for a certain period of time and provides a snapshot in time of your business performance. Assets include things of value that the business owns, such as inventory, capital and land. Liabilities on the other hand are legally bound commitments like payables for goods or services rendered and debt. Finally, owner’s equity refers to the amount that is remaining once liabilities are paid off. At the end of the day, assets must total – or balance – liabilities and equity.
Your startup financial model should include annual balance sheets that show the changing balance of assets, liabilities and equity as the business progresses. Ideally that progression shows a reduction in liabilities and an increase in equity over time.
While constructing these varied financial projections remember to be flexible. You likely will need to go back and forth between the different financial statements, since working on one will necessitate changes to the others.
Below is a simple balance sheet for the retail store:
|Balance Sheet||Year 1||Year 2||Year 3||Year 4||Year 5|
|Total Current Assets||$358,897||$570,297||$869,152||$1,238,793||$1,654,437|
|Total Long-term Assets||$450,000||$400,000||$350,000||$300,000||$250,000|
|Total Miscellaneous Assets||$15,000||$15,000||$15,000||$15,000||$15,000|
|Liabilities and Capital|
|Total Liabilities and Capital||$823,897||$985,297||$1,234,152||$1,553,793||$1,919,437|
How to Create Financial Projections?
When it comes to financial plans, simplicity is key. Your financial projections do not have to be overly sophisticated and complicated to impress, and convoluted projections likely will have the opposite effect on potential investors. Keep your tables and graphs simple and fill them with credible data that inspires confidence in your business plan and vision. The below tips will help bolster your projections.
Create a List of Assumptions
Your financial projections should be tied to a list of assumptions. For example, one assumption will be the initial monthly sales you achieve. Another assumption will be your monthly growth rate. As you can imagine, changing either of these assumptions will significantly impact your projections.
As a result, tie your income statement, balance sheet and cash flow statements to your assumptions. That way, if you change your assumptions, all of your financial projections automatically update.
Below are the most common assumptions to include in your financial model:
- For EACH key product or service you offer:
- What is the number of units you expect to sell each month?
- What is your expected monthly sales growth rate?
- What is the average price that you will charge per product or service unit sold?
- How much do you expect to raise your prices each year?
- How much does it cost you to produce or deliver each unit sold?
- How much (if at all), do you expect your direct product costs to grow each year?
- For EACH subscription/membership you offer:
- What is the monthly/quarterly/annual price of your membership?
- How many members do you have now or how many members do you expect to gain in the first month/quarter/year?
- What is your projected monthly/quarterly/annual growth rate in number of members?
- What is your projected monthly/quarterly/annual member churn (the percentage of members that will cancel each month/quarter/year)?
- What is the average monthly/quarterly/annual direct cost to serve each member (if applicable)?
- Cost Assumptions
- What is your monthly salary? What is the annual growth rate in your salary?
- What is your monthly salary for the rest of your team? What is the expected annual growth rate in your team’s salaries?
- What is your initial monthly marketing expense? What is the expected annual growth rate in your marketing expense?
- What is your initial monthly rent + utilities expense? What is the expected annual growth rate in your rent + utilities expense?
- What is your initial monthly insurance expense? What is the expected annual growth rate in your insurance expense?
- What is your initial monthly office supplies expense? What is the expected annual growth rate in your office supplies expense?
- What is your initial monthly cost for “other” expenses? What is the expected annual growth rate in your “other” expenses?
- Assumptions related to Capital Expenditures, Funding, Tax and Balance Sheet Items
- How much money do you need for Capital Expenditures in your first year (to buy computers, desks, equipment, space build-out, etc.)
- How much other funding do you need right now?
- If you require funding, what percent of the funding will be financed by Debt (versus equity)
- What Corporate Tax Rate would you like to apply to company profits?
- What is your Current Liabilities Turnover (in number of days)
- What is your Current Assets excluding cash (in number of days)
- What is your Depreciation rate
- What is your Amortization number of Years
- What is the number of years in which your debt (loan) must be paid back
- What is your Debt Payback interest rate
Create Two Scenarios
You should use your assumptions to create two sets of financial projections that exhibit two very different scenarios. One is your best-case scenario and the other your worst-case. Investors are usually very interested in how a business plan will play out in both these scenarios to better analyze the robustness and potential profitability of a business.
Conduct a Ratio Analysis
Gain an understanding of average industry financial ratios, including operating ratios, profitability ratios, return on investment ratios and the like. You can then compare your own estimates with these existing ratios to evaluate costs you may have overlooked or find data to support your projected performance. This ratio analysis helps ensure your financial projections are neither excessively optimistic nor excessively pessimistic.
It is easy to get carried away when dealing with estimates and you end up with very optimistic projections that will feel untenable to an objective audience. Investors are quick to notice and question inflated figures. Rather than excite investors, such scenarios will compromise your legitimacy.
Create Multi-Year Projections
The first year of your financial projections should be presented on a granular, monthly basis. For subsequent years, annual projections will suffice. It is advised to have three- or five-year projections ready when you start courting investors. Since business plans need to be succinct, you can add yearly projections as appendices to your main business plan.
You should now know how to create financial projections for your business plan. In addition to creating your full projections as its own document, you will need to insert your projections into your business plan. In your executive summary, Insert your topline projections, that is, just your sales, gross margins, expenses, ebitda (earnings before interest, taxes, depreciation and amortization) and net income). In the financial plan section of your business plan, insert your key assumptions and a little more detail than your topline projections. Include your full financial model in the appendix of your plan.