What You Need
*
Clear ideas about the purpose and audience for your
projections.
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Understanding of the key drivers of financial results
for the business.
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Some knowledge of accounting & financial statement
analysis:
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Skill in using spreadsheet software -- such as Excel
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Creativity, attention to detail, and good judgment.
*
A lot of time.
Some Warnings
O Most people starting new businesses are much too
optimistic
about the future financial results of their business. Their energy and enthusiasm cloud their
judgment. They underestimate the time it takes to get things done, and how much things
will cost. Over-optimistic
expectations often lead to underestimating how much money they need to finance
initial losses.
O Once a
business really gets going (in Year 2 or 3), doubling the size of the business each year is about the maximum a good
CEO really can achieve. Even growth
that fast (double every year) is extremely difficult to manage. Most successful businesses do not grow faster than 100% per year, nor do they
need to.
Getting Started
O Financial
projections should include the following kinds of final “output”:
*
Income
Statements
*
Balance Sheets
*
Sources and
Uses of Cash Statements (Cash Flow Statements)
O The
invention of spreadsheet software has made financial statement models easy to
create and even easier to play with.
Follow this link for a simple projection model template.
O In
practice, though, you will likely have to build your own income statement
model. The key drivers often are unique to the particular situation. You can use the template model, however, to
help calculate Balance Sheets, Sources and Uses of Cash, plus do some Statement
Analysis – just by inputting your custom income statement, and making some
simple assumptions.
O It is
usually best to do monthly projections for the first two years, then quarterly
after that. Add the periods up, and
present the annual summaries to potential financing sources.
Income Statements:
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Monthly Projections
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Month 1
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Month 2
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Month 3
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Month 4
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Month 5
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Month 6
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Revenues
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Cost of Goods Sold
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Gross Profit
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Sales & Marketing Expense
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General & Admin Expense
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Operating Income
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Depreciation Expense
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Interest Expense
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Taxes
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Net Income (Loss)
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Key points:
o Revenues & expenses are independent of cash
payments. Recognize them when a
transaction happens, not when cash comes in or goes out (maybe much
later).
o Cost of Goods Sold are the direct
costs in producing your service – materials, installation costs, customer
service, maintenance, etc.
o Revenue – Costs of Goods Sold = Gross Profit
o General & Administrative are support costs, like finance,
HR, IT, top management
o Gross Profit – Sales & Marketing – General &
Admin = Operating Income, also known as Operating Cash Flow
o Following
these conventions allows for comparison of your projections with other similar
business’ results.
o Depreciation expense spreads out the cost of
property, plant and equipment – over its useful life.
o R&D
costs?
Making Assumptions
O Start with the monthly numbers for Year 1. For any business raising money, making your
numbers in your first year of projections is really important. If you, as management, miss these numbers you
may:
1. Run out
of money too soon,
2. Get
fired and/or
3. Not be
able to raise more money.
If 1) or 3) happens, you will probably go
bust.
O Consider the macroeconomic situation when building your
projections:
*
Overall economic growth rate of GDP during projection
period
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Economic recession(s) - timing, duration
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Rate of inflation
*
Level of interest rates
O Tackle the Income Statement first. Project your number of customers based on the
key revenue driver. Project monthly sales – for twelve months....
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Monthly Projections
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Month 1
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Month 2
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Month 3
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Month 4
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Month 5
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Month 6
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Customers
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0
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0
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11
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20
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45
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77
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Revenues
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0
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0
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3
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6
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13
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26
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o Next,
think through the 12 months of costs associated with these sales:
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Cost of Goods Sold – materials, installation costs, inspection,
maintenance, regulatory costs, billing system
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Selling costs – sales people, advertising, travel, web
site
*
Administrative Costs – Management, office space,
supplies, utilities, insurance
o Points
to remember:
*
You may not have any revenues for the first few months
– as you build the system, sign up customers, etc. – but you will still have
expenses. Model this.
*
Don’t forget to figure in one-time start-up costs
(incorporate, write a business plan, licensing, permitting fees, getting
regulatory approval, etc.)
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If you have more than one product or service, model
them separately, then total them.
*
Be sure to model total headcount and include cost of
benefits (20-25% of salary, typically). You should allocate personnel costs into
Cost of Goods Sold, Marketing & Sales and General & Administrative,
based on function.
*
Rental space can be: (Headcount x Avg. Sq. Ft. Per
Person x $ Cost Per Sq. Ft.)
o Your
projections might look something like this:
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Monthly Projections
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Month 1
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Month 2
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Month 3
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Month 4
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Month 5
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Month 6
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Revenues
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0
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0
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3
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6
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13
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26
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Cost of Goods Sold
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0
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0
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1
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3
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6
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13
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Gross Profit
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0
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0
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2
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3
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7
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13
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Sales & Marketing Expense
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4
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5
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7
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9
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11
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12
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General & Admin Expense
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4
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7
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9
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11
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13
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16
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Operating Income
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-8
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-12
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-14
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-17
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-17
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-15
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Depreciation Expense
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1
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1
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1
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1
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1
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1
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Interest Expense
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1
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1
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1
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1
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2
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2
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Taxes
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0
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0
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0
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0
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0
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0
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Net Income (Loss)
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-10
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-14
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-16
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-19
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-20
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-18
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o Then,
add up your 12 months of projections.
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Year 1
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Year 2
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Year 3
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Year 4
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Year 5
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Sales
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150
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Cost of Goods Sold
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77
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Gross Profit
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61
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Sales & Marketing
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102
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General & Admin
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140
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Operating Income
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(181)
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Operating income is an estimate of how much money will
need to raise – on top of the cost of any property and equipment you must
buy. Does this number make sense? Are you losing enough money (have you remembered
all your costs)? Are you losing more money
than you can raise?
o Building
out future years, two approaches:
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Continue estimating growth of customers from month to
month, quarter to quarter. Or
*
Pick a break-even year – the year your operating
income exceeds costs and you don’t need outside financing to survive. Take this approach if there is a year by
which you must break even. If, say, banks or investors require that you
reach break even by year three, figure out: What would this take – in sales?
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Annual Projections
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Year 1
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Year 2
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Year 3
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Year 4
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Year 5
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Sales
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150
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800
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Cost of Goods Sold
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77
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350
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Gross Profit
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73
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450
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Sales & Marketing
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102
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195
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General & Admin
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140
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210
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Operating Income
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(169)
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45
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Figuring out
what your break-even year looks like, and when it will occur, probably is the
single most important part of making a good set of projections.
With either approach, remember to increase costs with
sales. A common mistake, for example, is
to forget to add personnel as the business grows. And, as personnel increases, so may rent,
supplies, utilities, insurance, etc.
O Compare your Income Statement numbers to similar
companies to
figure out if your break-even, and projections in general, are reasonable, Calculate profit and cost margins by
dividing all categories by sales:
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Annual Projections
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Year 3
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As a % of Sales
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Sales
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800
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100%
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Cost of Goods Sold
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350
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44%
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Gross Profit
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450
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56%
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Sales & Marketing
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195
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24%
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General & Admin
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210
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26%
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Operating Income
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45
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6%
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*
Look especially at the gross and operating profit
margins, and at the categories of costs.
At this stage of your business, your
profit margins should not be higher than similar operations – nor your cost
margins lower. Does your business differ
in key respects? If so, can you explain
why? If not, you are probably being to
optimistic.
*
If your projections look reasonable, smooth in the
year(s) between Year One and your projected break even year. Project out past your break-even year. Do not grow faster than people will believe.
Consider a 50% annual growth rate in revenues, as a first cut. Remember to increase costs as you grow.
O Next, Some Assets
*
Transfer the Income Statement totals to the model
template, or construct your own Balance Sheet and Sources & Uses model. Typical
key items:
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Category
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Numbers Expressed As:
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Examples:
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Cash in Banks
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% of Sales
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3% of Sales
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Acounts
Receivable
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% of Sales
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Sales x 1/6
(60 Day Turnover)
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Inventory
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% of Cost of
Goods Sold
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Cost of Goods
Sold x 10%
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Fixed Assets
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Yr. = Last Yr.
+ CapEx - Deprec.
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Other Assets
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1% of Sales
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Accounts
Payable
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% of Costs of
Goods Sold
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Cost of Goods
Sold x 1/6
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Accrued
Expenses
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% of S&M +
G&A Expense
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S&M +
G&A Expense x 1/12
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*
Other reasonable links or relationships are
possible. You want the balance sheet to grow in line with the growth of the business. Balance sheets use cash, too.
*
One also needs to project the Capital Expenditures (Property,
Plant, Equipment purchases) and some Depreciation Expense. Include replacement costs for failed as well
as worn out equipment. Set Depreciation
Expense as a percentage of Net Fixed Assets as of the end of the previous year. The template assumes an average rate of 10
years.
*
The template model will use this information to
complete a “Sources and Uses of Cash” Statement and generate a large number in
the “Necessary to Balance” line of the Balance Sheet.
*
Necessary to
Balance is not an accounting category.
Instead, for each Year, “Necessary to Balance” represents the amount of
financing that you need. You must assume that you
will sell equity or borrow debt, or some combination -- equal to the amount of
“Necessary to Balance.” For example, in
the template attached, the business needs to raise $900,000 to finance the
first year of operations.
*
If Necessary to Balance shows extra cash (versus a
need for financing), you can pay this out in dividends to your investors – or
add it to your cash account cell. The
second is probably more realistic in the case of a new business.
