Just like a weather forecast lets you know that wearing closed-toe shoes will be important for that afternoon downpour later, a good financial forecast allows you to better anticipate financial highs and lows for your business.
Neglecting to compile financial projections for your business may signal to investors that you’re unprepared for the future, which may cause you to lose out on funding opportunities.
Read on to learn more about financial projections, how to compile and use them in a business plan, and why they can be crucial for every business owner.
- Financial forecasting is a projection of your business's future revenues and expenses based on comparative data analysis, industry research, and more.
- Financial projections are a valuable tool for entrepreneurs as they offer insight into a business's ability to generate profit, increase cash flow, and repay debts, which can be attractive to investors.
- Some of the key components to include in a financial projection include a sales projection, break-even analysis, and pro forma balance sheet and income statement.
- A financial projection can not only attract investors, but helps business owners anticipate fixed costs, find a break-even point, and prepare for the unexpected.
Understanding Financial Projections and Forecasting
Financial forecasting is an educated estimate of future revenues and expenses that involves comparative analysis to get a snapshot of what could happen in your business’s future.
This process helps in making predictions about future business performance based on current financial information, industry trends, and economic conditions. Financial forecasting also helps businesses make decisions about investments, financing sources, inventory management, cost control strategies, and even whether to move into another market.
Developing both short- and mid-term projections is usually necessary to help you determine immediate production and personnel needs as well as future resource requirements for raw materials, equipment, and machinery.
Financial projections are a valuable tool for entrepreneurs as they offer insight into a business's ability to generate profit, increase cash flow, and repay debts. They can also be used to make informed decisions about the business’s plans. Creating an accurate, adaptive financial projection for your business offers many benefits, including:
- Attracting investors and convincing them to fund your business
- Anticipating problems before they arise
- Visualizing your small-business objectives and budgets
- Demonstrating how you will repay small-business loans
- Planning for more significant business expenses
- Showing business growth potential
- Helping with proper pricing and production planning
Why Forecasting Is Critical for Your Business
Financial forecasting is essentially predicting the revenue and expenses for a business venture. Whether your business is new or established, forecasting can play a vital role in helping you plan for the future and budget your funds.
Creating financial projections may be a necessary exercise for many businesses, particularly those that do not have sufficient cash flow or need to rely on customer credit to maintain operations. Compiling financial information, knowing your market, and understanding what your potential investors are looking for can enable you to make intelligent decisions about your assets and resources.
Key Financial Statements for Forecasting
The income statement, balance sheet, and statement of cash flow are three key financial reports needed for forecasting that can also provide analysts with crucial information about a business's financial health. Here is a closer look at each.
An income statement, also known as a profit and loss statement or P&L, is a financial document that provides an overview of an organization's revenues, expenses, and net income.
The balance sheet is a snapshot of the business's assets and liabilities at a certain point in time. Sometimes referred to as the “financial portrait” of a business, the balance sheet provides an overview of how much money the business has, what it owes, and its net worth.
The assets side of the balance sheet includes what the business owns as well as future ownership items. The other side of the sheet includes liabilities and equity, which represent what it owes or what others owe to the business.
A balance sheet that shows hypothetical calculations and future financial projections is also referred to as a “pro forma” balance sheet.
Cash Flow Statement
A cash flow statement monitors the business’s inflows and outflows—both cash and non-cash. Cash flow is the business’s projected earnings before interest, taxes, depreciation, and amortization (EBITDA) minus capital investments.
How To Create Your Financial Projections
Here's how to compile your financial projections and fit the results into the three above statements.
A financial projections spreadsheet for your business should include these metrics and figures:
- Sales forecast
- Balance sheet
- Operating expenses
- Payroll expenses (if applicable)
- Amortization and depreciation
- Cash flow statement
- Income statement
- Cost of goods sold (COGS)
- Break-even analysis
Here are key steps to account for creating your financial projections.
The first step for a financial forecast starts with projecting your business’s sales, which are typically derived from past revenue as well as industry research. These projections allow businesses to understand what their risks are and how much they will need in terms of staffing, resources, and funding.
Sales forecasts also enable businesses to decide on important levels such as product variety, price points, and inventory capacity.
Income Statement Calculations
A projected income statement shows how much you expect in revenue and profit—as well as your estimated expenses and losses—over a specific time in the future. Like a standard income statement, elements on a projection include revenue, COGS, and expenses that you’ll calculate to determine figures such as the business’s gross profit margin and net income.
If you’re developing a hypothetical, or pro forma, income statement, you can use historical data from previous years’ income statements. You can also do a comparative analysis of two different income statement periods to come up with your figures.
Anticipate Fixed Costs
Fixed business costs are expenses that do not change based on the number of products sold. The best way to anticipate fixed business costs is to research your industry and prepare a budget using actual numbers from competitors in the industry. Anticipating fixed costs ensures your business doesn’t overpay for its needs and balances out its variable costs. A few examples of fixed business costs include:
- Rent or mortgage payments
- Operating expenses (also called selling, general and administrative expenses or SG&A)
- Amortization and depreciation
- Utility bills
- Insurance premiums
Unfortunately, it might not be possible to predict accurately how much your fixed costs will change in a year due to variables such as inflation, property, and interest rates. It’s best to slightly overestimate fixed costs just in case you need to account for these potential fluctuations.
Find Your Break-Even Point
The break-even point (BEP) is the number at which a business has the same expenses as its revenue. In other words, it occurs when your operations generate enough revenue to cover all of your business’s costs and expenses. The BEP will differ depending on the type of business, market conditions, and other factors.
To find this number, you need to determine two things: your fixed costs and variable costs. Once you have these figures, you can find your BEP using this formula:
Break-even point = fixed expenses ➗ 1 – (variable expenses ➗ sales)
The BEP is an essential consideration for any projection because it is the point at which total revenue from a project equals total cost. This makes it the point of either profit or loss.
Plan for the Unexpected
It is necessary to have the proper financial safeguards in place to prepare for any unanticipated costs. A sudden vehicle repair, a leaky roof, or broken equipment can quickly derail your budget if you aren't prepared. Cash management is a financial management plan that ensures a business has enough cash on hand to maintain operations and meet short-term obligations.
To maintain cash reserves, you can apply for overdraft protection or an overdraft line of credit. Overdraft protection can be set up by a bank or credit card business and provides short-term loans if the account balance falls below zero. On the other hand, a line of credit is an agreement with a lending institution in which they provide you with an unsecured loan at any time until your balance reaches zero again.
Frequently Asked Questions (FAQs)
How do you make financial projections for startups?
Financial projections for startups can be hard to complete. Historical financial data may not be available. Find someone with financial projections experience to give insight on risks and outcomes.
Consider business forecasting, too, which incorporates assumptions about the exponential growth of your business.
Startups can also benefit from using EBITDA to get a better look at potential cash flow.
What are the benefits associated with forecasting business finances?
Forecasting can be beneficial for businesses in many ways, including:
- Providing better understanding of your business cash flow
- Easing the process of planning and budgeting for the future based on income
- Improving decision-making
- Providing valuable insight into what's in their future
- Making decisions on how to best allocate resources for success
How many years should your financial forecast be?
Your financial forecast should either be projected over a specific time period or projected into perpetuity. There are various methods for determining how long a financial forecasting projection should go out, but many businesses use one to five years as a standard timeframe.