How your business will perform financially over a period of three-five years is what financial forecasting all about. Crafting of financial forecast is an essential part for any business plan. It should always be prepared by an expert who has good grasp on financial modeling and crisp presentation. Preparing forecasts will help you to assess your likely sales income, costs, external financing needs and profitability. Financial forecasts helps in winning over investors or obtaining a bank loan and also to be successful in steering your business. It tells whether your business will be viable or you are wasting your time/money.
Purpose of Financial Section
Generally people get confused between the financial projections (which include profit and loss, balance sheet and cash flow) and the accounting statements which your business generates as they both look similar. Financial forecasting is not the same as accounting. Forecasting is forward looking, starting today and going forward into future where as accounting looks backward, considering historical view.
The motto of financial section is to tell a story with numbers-a story about opportunity, resource requirements, market forces, growth, milestone achievements, and profits. Your job is to create a numerical framework that complements and reinforces the vision you’ve painted with words. Prospective investors are interested in what the numbers say about the economics of your business and what they say about your understanding of your business. The goal is to tell a credible, as well as exciting, story about what your business could become.
To be credible, your numbers have to make sense on the first review. If you are suggesting that your company will grow faster or be more profitable than any company in history, you need to explain in clear terms about how it is possible. The financial model should be credible and realistic forecast of what the business can achieve.
Components of Financial Section
Always begin with sales forecast
You should set up a spreadsheet projecting sales for the period of next three years. Set up different sections for different lines of sales and columns for every month for the first year, second year and third year respectively. Ideally spreadsheet blocks should have the first block for unit sales, second for pricing, third block is for calculating sales (by multiplying units sold), fourth block has unit costs, and fifth multiplies units sold and cost per unit to calculate cost of sales (also called COGS or direct costs). Cost of sales is calculated to know the Gross margin. Gross margin is sales less cost of sales, and it’s a useful number for comparing with different standard industry ratios. If it is a new line or a new product you have to take a look on past results. Please note that this is for standard products but there can be scenarios which are very different but will not contain number of units but parameters like users, percentage of people who use a service etc.
Creation of Expenses Budget
There is always a need to understand how much it is going to cost you for actually making the sales you have forecasted. It is recommended to differentiate between fixed costs (I.e., rent and payroll) and variable costs (I.e., most advertising and promotional expenses). Lower fixed costs means lesser risks. There must be a proper estimation of interests and taxes. It is suggested to multiply estimated profits times your best guess tax percentage rate to estimate taxes. And then multiply your estimated debts balance times an estimated interest rate to estimate interest. Fees related to licenses, permits and equipment should be included in the short-term projections. There are basically fourteen financial budgets that should be prepared properly. The same budgets can be tweaked for a services model
1. Selling Price and Product Cost (per unit) Budgets
2. Sales Budget
3. Purchase Budget
4. Direct Manufacturing Labor Budget
5. Manufacturing Factory Overhead Budget
6. Ending Inventory Budget
7. Cost of Goods Sold Budget
8. Fixed Asset Budget
9. Operating Expenses Budget
10. Drawings or Dividend Budget
11. Cash Investments Budget
12. Opening Balance Sheet
13. Interest Expense Budget
14. Income Tax Rate and Budget
Develop a cash flow statement
Statement which shows physical currencies moving in and out of business is Cash-flow statement. It should be based partly on your sales forecasts, balance sheet items, and other assumptions. If you are operating an existing business, you should have historical documents, such as profit and loss statements and balance sheets from past years to base these forecasts on. If you are starting a new business and do not have these historical financial statements, you start by projecting a cash flow statement broken down into 12 months. It is always advisable while compiling these cash flow projections to choose realistic ratios for how many of your invoices will be paid in cash, 30 days, 60 days, 90 days and so on.
Income statement is your pro forma profit and loss statement, detailing forecasts for your business for the coming three years. Provide a short-term projection for the first year on monthly basis and a three-year projection on yearly basis. When projecting growth, consider the state of the market in which you are operating, as well as trends in raw material and labor costs, and whether you foresee needing additional funding in the future.
Basic requirements for preparation of projections are:
1. Opening figures included should be based on latest Mgmt/Audited accounts.
2. Shareholders Fund analyzed into Share Capital, Share Premium and Retained Profits.
3. Sales Assumptions provided by unit, price segment & geography and reconciled to pipeline.
4. Expenditure categorized into R&D, Admin and Overheads and Promoters / key managers salaries.
5. Identification of monthly and cumulative company operational deficits.
6. Sensitivity analysis may be required, detailing strategies to be implemented if sales or expenditure targets are not met.
7. Projections should identify separately Operational Cash Flow and external Cash Injections.
Deal with assets and liabilities
You also need a projected balance sheet. You have to deal with assets and liabilities that aren’t in the profits and loss and project the net worth of your business at the end of the fiscal year. Interest is in the profit and loss, but repayment of principle isn’t. Taking loan, giving loan, and inventory show up only in assets until you pay for them. So the way to compile this is to start with current assets, estimating what you’ll have on hand, month by month (only for current assets) for cash, accounts receivable (money owed to you), inventory and also fixed assets like land, buildings, and equipment. Then figure out your liabilities – meaning debts. That’s money you owe because you haven’t paid bills (which is called accounts payable) and the debts you have because of outstanding loans.
Break Even Analysis
Conducting a breakeven analysis is a matter of simple math only if you can accurately forecast your costs and sales. A company has broken even when its total sales or revenues equal its total expenses. At the breakeven point, a company has neither made any profits nor did it incur any losses. It is a critical calculation for any business owner, because the breakeven point is the lower limit of profit when determining margins.
Breakeven Analysis depends upon three assumptions, average per unit sales price, average per unit cost and monthly fixed costs. After defining these elements you can calculate the BEP with the help of the formula:
Breakeven Point= Fixed Costs/ (Unit Selling Price – Variable Costs)
This calculation will determine the number of units of product needs to be sold to break even. At this point you have recovered all costs (both variable and fixed) associated with producing your product. Above the breakeven point, every additional unit sold increases profit by the amount of the unit contribution margin.
For example, the calculation reports that you would break even when you sold your 500th unit, decide whether this seems feasible. If you don’t think you can sell 500 units within a reasonable period of time (dictated by your financial situation, patience and personal expectations), then this may not be the right business for you to go into. If you think 500 units is possible but would take a while, try lowering your price and calculate and analyze the new break-even point. At the same time look at both of your variable and fixed costs and identify areas where you can possibly reduce your costs. If your business is viable, at a certain period of time your overall revenues will exceed your overall expenses, including interest.
Lastly, going into a market with a wrong product or wrong price may make the situation tougher to hit even the beak even point.
Two Final Tips
First, never call your projections “conservative.” It is seen as a kind of an Entrepreneur Lie. Investors don’t want to see a delusional plan and are interested to see a bold plan that is well thought-out and realistic. Your job is to win the confidence of the investors by making him believe your experience management team and your bold optimism.
Second, you should always model your company on other real world successes. You don’t have to make up your business model. You should be able to model your financial projections on companies that have been successful before. Use the S-1 IPO filings of companies with business models similar to yours to get an idea of what is realistic. If your projections are wildly different than other highly successful companies, then your assumptions are probably off.