A prerequisite for every business is to maintain a sound business plan that includes meaningful financial projections. This is especially important for startup companies since their failure rate in the first year of operation is extremely high and #1 reason for failure is the startup ran out of cash. Financial projections help companies get insight into their cash requirements, identify key risk factors, and map various ways to success under different scenarios. The gold standard for projections is an integrated 3 statement financial model.
Vision without action is a daydream. Action without vision is a nightmare.
Japanese proverb
This article explains why every business requires a solid financial plan. You will learn what is understood under financial projections, their importance, the difference between a business plan and a financing plan, their interrelationship, and the best practices for creating projections.
What is a financial projection?
A projection is a forecast of a company’s income statement, balance sheet, and cash flow statement. The term “pro forma statements” is commonly used to describe financial projections. Forecasting is about coming up with the best estimate for key drivers that have a major impact on a company’s finances.
Projections are based on internal company data, market data, and expectations about the future. The availability of reliable information is crucial to come up with an appropriate input. One popular forecasting technique is to use historical patterns/relationships to determine forecast drivers.
Every startup and small business needs a financial plan
The production of financial projections for a small business can have substantial benefits. It enables you to evaluate your business viability, anticipate problems before they occur, and establish a clear course of action to generate growth and achieve profitability under different scenarios. It’s not just a number-crunching exercise but a vital element of your company’s overall strategy and goal setting. I strongly believe that startups that neglect their finances in the early days have much less chance to succeed than those that invest in getting deep insights into the economic viability of their business model or business idea.
The quality of your financial plan also allows you to differentiate yourself from your competitors and impress potential investors. Since first impressions are the most lasting ones, you must develop a polished plan. Some of my clients told me that their investors were blown away by the quality of my work.
The development of projections is a technical skill that requires accounting knowledge, a solid understanding of the company’s business model, and knowledge of financial modeling techniques and best practices. While some entrepreneurs can make solid projections by themselves, others better involve a financial professional/certified management accountant. All too often, financial models are bulky, incomprehensible, incomplete, and contain modeling errors.
The gold standard for financial projections is an integrated 3 statement financial model. This is a model where every change in one place of the model affects the other parts since all the financial statements are interlinked.
The difference between business and finance plans
There seems to be quite some confusion about the difference between a business plan and a financial plan. The terms are often inappropriately used as synonyms.
A business plan is a blueprint to achieve success. It deals with the company’s competitive environment, mission, strategy, goals, organization, and financials. While financial projections are an essential cornerstone of every business plan, the business plan covers much more than solely numeric forecasts. I wrote a comprehensive article on the essential components of a winning startup business plan here.
The financials are a specific section of the business plan that should reflect the company’s strategy and assess the feasibility of the strategy being pursued. A business plan without quantitative information is unconvincing. It is hyper-important to rely on an integrated financial model for your business to increase greatly your odds of success, identify and mitigate key risks on time, and avoid running out of cash. Without projections, you are simply navigating blindly.
Best practices for creating a robust financial plan
1. Define the purpose and the time horizon
Financial plans can serve several functions, and their format depends on their purpose. It can be used for operational, fundraising, or valuation purposes. While large portions of the financial plan are identical, some material differences can exist. You might not want to disclose every tiny detail of your business to an external party. For example, the bill of materials and payroll expenses are particularly sensitive. Also, a discounted cash flow model (DCF model) is probably not required if you are not interested in your company’s valuation.
Financial projections cover the short-term, the long-term, or both. The level of detail of short-term projections is much higher compared to long-term financial plans. This is explained by the increased uncertainty surrounding the distant future.
- Short-term projections (12-24 months): A breakdown by month is important for a company to ensure it has sufficient cash to fund its growth plan in the short run, especially for new businesses. Knowing when to hire your next employee or when is a good time to pour fuel on marketing and sales efforts can help you avoid a cash crisis.
- Medium-term and long-term financial projections (3-5 years): They are better suited to help you answer when your company will become profitable, whether you can service your debt obligations, and exhibit the size of the opportunity.
The financial projections that I craft for my clients usually span five years. The first two years are broken down by month, while the final 3 years are usually by year. If the company is tight on cash or has a very seasonal business model, the medium-term and long-term financial projections might need to be forecasted monthly. Projections beyond 5 years usually have very limited value because there is too much uncertainty associated with these forecasts.
2. Develop an integrated 3 statement financial model
Before you start creating your financial model, realize that a model is a forecast that constantly needs to be tweaked. We operate in a highly complex and volatile economic environment where conditions can change in a blink and project timelines can shift for various reasons. If you end up getting a 100% accurate forecast, it was most likely by chance. I strongly advise that you focus on the core of the financial model before you add additional layers of complexity.
A common misconception is that the financial plan is the sole responsibility of finance. While a financial professional is the most obvious candidate to produce the model, they rarely possess the latest operational insights. That’s why it is important that sales, HR, production, marketing, etc. get involved and provide accurate inputs.
To build your financial model, collect your financial records, if any. In addition, gather information from business partners (sales, HR, marketing, etc.) and industry data. All this information can help you to create a good forecast.
For new businesses, creating a forecast is much harder because their financials are highly volatile, and historical data are absent. If this is the case, compose a list that distinguishes between your fixed expenses, such as rent and payroll, and your variable expenses. While the distinction between fixed and variable expenses can get a bit blurred, you want to have an overview of significant, recurring expenses your startup incurs. Fixed expenses remain constant irrespective of your company’s turnover, while variable expenses fluctuate according to your level of sales.
Most financial modelers will start with forecasting the income statement. The profit-and-loss statement (P&L) gives an excellent overview of the financial performance of the company over a specific period. However, forecasting demand and the cost of goods sold/cost of service is one of the most crucial and complex areas to model. Not only because it can have an enormous impact on the other financial statements, but also because there is an enormous variety of different revenue models with distinct underlying drivers. In addition, you will need to tie your sales, marketing, general and administrative expenses (SG&A), R&D, interest expenses, and taxes to your summary P&L.
The balance sheet shows the company’s financial position on a specific day. It shows the amount and composition of the assets and the capital structure of the company. The capital structure comprises equity, current and non-current liabilities. It is important that your asset structure and capital structure match. Long-term assets should be financed with long-term sources of funds.
The last statement of the integrated 3 statement financial model is the cash flow statement. The cash flow statement reconciles the cash position at the beginning of the period with the cash position at the end of the period. In other words, it shows the sources and uses of cash. Since profit is not equal to cash flow, you can perfectly run into cash flow problems if your growth is too aggressive or when your working capital requirements are too high.
A key takeaway is that an integrated 3 statement financial model is so powerful because of (1) the inter-linkage between the financial statements and (2) the information that they provide is complimentary.
3. Visualize your most important data
Financial models can become very complex and overwhelming. That’s why it is recommended to visualize the most relevant data and include some key metrics. It helps digest the information better. For example, I have created the following dashboard with key metrics for a Subscription as a Service (SaaS) company.
4. Stress-test your business model by including various scenarios
It might be useful to develop alternative scenarios aside from a base case scenario. Since financial forecasts will be off-target, it is important to assess the actions that are required to be successful under each scenario, especially under adverse conditions. This is also known as stress-testing the base case.
5. Use variance analysis to identify and improve your financial projections
A financial plan is an estimate of your company’s future financial position and performance. That’s why it is important to compare your budget with your actual results. This process is called variance analysis. By understanding where the differences are coming from, you can enhance the accuracy of the projections. You will also discover new insights along the way and ensure that your company remains on track to meet its KPIs.
Executive summary
A business plan and a financial plan are complementary to each other. The financial projections should reflect the company’s business model and strategy. A financial plan helps companies to identify key risk factors and monitor their financial position and performance under different scenarios. The gold standard for financial models is an integrated 3 statement financial model.
Your model should also be aligned with its purpose and time horizon. The assumptions/inputs should be provided by various business partners, such as sales, production, and marketing. It is also a good idea to develop different scenarios to assess their impact and to include graphs and key metrics in a dashboard.
Since financial modeling is a highly technical skill that requires accounting knowledge, a solid understanding of a company’s business model, and modeling skills, it might be very beneficial and time-saving to involve a finance professional/certified management accountant. All too often, financial projections are not user-friendly, not exhaustive, and erroneous. If you need help with your model, please feel free to get in contact with me.