May 9, 2022
A business plan is only as good as its financial assumptions. These are the key input data that your financial projections will extrapolate from and will form a picture of the future of your company. With a robust method of researching for these assumptions, and then the corresponding analysis of the available data, you’re left with more accurate assumptions, leading to a more realistic picture of your financial future.
Conversely, with weak assumptions from lack of sufficient research or bad analysis, you can get a dramatically different output that doesn’t remotely reflect reality. When looking for outside investment, these are the skills a savvy investor is going to value in an entrepreneur. So how best to improve your assumptions? Keep reading for the answer.
Any entrepreneur, startup founder, or young company is going to need to form detailed financial reports, including forecasts and projections of the financial situation to come. These documents rely entirely on input data to extrapolate from, and these data are based on historical records and key assumptions.
The accuracy of these financial assumptions determines the accuracy of the output of these projections, and since the divergence from reality increases over time, it’s important for them to be as accurate as possible to precisely depict a realistic situation in the future.
The importance of these assumptions comes into play significantly when trying to attract capital from outside. These investors or lenders will be looking closely at your assumptions as a metric of your credibility; strong assumptions show you’ve done your due diligence and you know what you’re talking about. Weak ones will greatly harm your chances of success.
Here we’re going to go over the basics of financial assumptions, what they’re for, and common mistakes people make with them.
The Role of Financial Assumptions in Forecasting
In business planning, forecasting is a crucial step in visualizing how a company will perform in the future. Companies forecast future outcomes based on past and current data, using assumptions.
Forecasted elements of a financial plan include revenue, margin, and expenses, among others. When done accurately, these forecasts allow businesses to:
- Predict future expenses
- Make budgets
- Make informed decisions about the direction of the company
- Plan growth and financing options
However, accuracy requires more than just historical data; it’s important to input the rate of change over time correctly, and this is where assumptions come in.
Essentially, assumptions are educated guesses about the nature of your business and its market, and how these will affect future outcomes in your forecasts. As projections reach further into the future, the need for accuracy of the input assumptions increases. Small mistakes become significantly larger over time, and this skews projections to the point of making them worthless.
For investors to take notice, you’ll need accurate and well-thought-out assumptions that aren’t plucked from thin air. We’ll go into more detail about how to find these assumptions shortly, but first, let’s consider why accuracy is so important.
The Importance of Accuracy in Financial Assumptions
The financial statements of a business plan are an indication of the company’s profitability. They are the strongest display of the worthiness of investment that your company has, therefore, they’re going to need to be founded on accurate assumptions.
Even with relatively accurate initial figures, long-term projections can still be way off the mark. Essentially, any forecast is a calculation with decreasing accuracy over time, which is why they usually don’t project out past time frames of longer than around five years. Take the following example:
Let’s say you’ve done the research into the market, into the reducing costs of production over time, the rapid expected growth of your company, and the increase in value you’re going to make to your product or service over the next few years. What comes out is an assumed increase in revenue projected into the future.
If you assume your total revenue will increase by 20% over 5 years with a starting revenue of $20,000, the first-year outcome will be $24,000, an increase of four thousand dollars. The fifth-year outcome will be $49,767; an increase of almost thirty thousand dollars.
If your initial assumption is off by only 5% in either direction, the first year will show a difference from the above forecast of $1000, either returning $23,000 or $25,000 at the low and high ends, respectively.
This isn’t a huge amount of money at this stage, so a misjudgment of 5% seems reasonable. However, if we extend this effect to the fifth year, an error of 5% brings a difference of either $9,500 or $11,268 to what you had projected, depending on whether your assumption was low or high.
If you’re smart or lucky enough to have made a conservative assumption, you’re now $11k better off. On the other hand, if you were too hasty and overestimated in your assumption, you may now owe somebody over $9k.
So, the effect of an assumption is greater with distance from the starting point. This means that when you’re designing a business plan to show to potential investors, they’re going to be very critical of your assumptions in order to assess the chances of their ROI in your company.
Regardless of whether you assumed low or high, if there’s a discrepancy that becomes obvious to investors, it will make them question the rest of your estimates and how accurate you will be in future calculations.
Therefore, accurate assumptions are critically Important to not only the precise understanding of the state of your company in the future but any chances of investors taking you seriously. Without good assumptions there is no forecast. Without a forecast, there’s not going to be any investment.
If your business is going to be relying on VC or other investors helping out, you’re going to find yourself out of luck. So, with that in mind, let’s take a look at some of the classic assumptions you’ll need to make when designing your forecasts and projections.
Key Financial Assumptions Examples
Building a business plan relies on numerous assumptions. These are the where, when, and how’s of your company, and will create projections in order for you to know where to direct your energy. The most important assumptions are called key assumptions, and without these, it’s going to be impossible to make informed decisions on the direction of your company.
Changes in assumptions can dramatically alter the outcomes of your forecasts. If you assume, for example, that your product or service is going to have a decreasing churn rate - or loss of customers - over the coming years of service improvement, you have to know what that rate is going to decrease by each year for your forecast to be of any use.
It’s worth thinking about these assumptions in terms of how you will persuade investors to commit. Here is a list of some of the areas in which key assumptions are needed for financial planning, for use as financial assumptions examples:
- Market – There’s no business without a market. This assumption isn’t so much a financial one as a general business one, but it has strong financial implications.
By the time you come to financial planning for your startup, you should know who your ideal customer is and how you’re addressing their pain points.
You should also know how much they’re willing to spend on your product or service, which will come in handy for your income statement and cash flow projections.
- Cost of production - Production cost changes over time. Even if it’s simply an increase in outgoings to match an increase in demand, this needs to be assumed. Usually, production costs can be reduced as economies of scale come into play, but regardless, it’s easy to overlook some data here.
Calculating production costs involves covering rent for manufacturing spaces, materials, utilities such as power and water, and essentially every little thing that goes into the manufacture of your product or provision of your service. Obviously, these will be more or less complicated depending on the type of business you’re running.
This step is crucial for the following revenue and costs to be accurate.
- Cost of Sales – This one is closely related to the cost of production and there may be some overlap in these costs such as labor, so separate them as you wish, however, make sure to calculate the cost of distribution; shipping, handling, marketing, etc. it’s possible to combine these assumptions under production and sales for convenience.
- Cost of Administration – This is a monthly expenditure covering all the outgoings related to your workforce and company maintenance. Payroll needs to be financially covered by any income or capital funding you’re expecting and this includes any bonuses you’re expecting to put out. One key assumption regarding bonuses will be in their timing, should you choose to pay them, and this needs to be factored into projections for costs.
- Pricing – This assumption should be made with detailed research backing it up. Since pricing alone can make or break your company, investors are going to want to see how you came up with your figures here. The costs of sales and production are going to determine your range of pricing options.
To accurately calculate prices, you’re going to need to understand how much value your product or service has to your customers, which is where the key assumptions from the Market section above come in. Pricing needs to match the value of what you’re offering, so this is the opposing force to the production and distribution costs, since it will always be pulling your price down towards its value, while costs of production and distribution will be pushing it up.
- Sales Forecast – For every different service or product that you’re offering, a sales forecast needs to be calculated. For an accurate sales forecast, you’re going to need to know the desired sales funnel in detail and how long the conversion process will take. These assumptions need to be backed up by your market research.
Further, you’re going to have to make assumptions on when your sales will complete; this means how long banking processes will take, etc. These assumptions will be critical to accurately forecast your profits in your financial plan.
- Cash Flow – This section will involve numerous key assumptions. Capital will hopefully be flowing into the company from numerous streams, and these need to be calculated well in order to project financial coverage of the aforementioned costs.
Timings of loan payments, loan repayments, cash equity, and others need to be reliably assumed to make sound predictions in these cases. Interest adjustments or early repayment fees are also things to take into consideration, and if you will be offering customer credit, this will create more complexities to look into in terms of when you’ll see that capital again.
These are some of the major areas in which financial assumptions are necessary, and their need for accuracy is obvious. An accurate assumption comes down to reliable and robust research and analysis practices, and for these, it’s important to follow the best practices of business planning, and consider expert help where needed.
Of course, the specifics of these areas and their significance to your company will depend entirely on the type of service, product, business, or market you’re involved with. As such, there’s no standard template, but there are some key practices worth following.
Why There are no one-size-fits-all Financial Assumptions
Startup founders and entrepreneurs need to provide convincing projections of the financial state of the company over the following years to reassure investors that their capital will be returned. They do this by creating robust assessments of their current state and the state of company and market metrics as accurately as possible and factoring them into projection calculations as assumptions.
The best way to begin building your financial assumptions is to consider them from the perspective of an investor. If you’re looking to put down a significant investment in a project you’re going to want to guarantee your ROI, and to do that, you need to be persuaded of the project’s profitability.
Every company is different, and every market has its own needs and challenges. This is why there’s no strict financial assumptions template to follow, but by following these four basic principles, you’ll be closer to developing more accurate assumptions.
At the planning stage of a company, the historical financial data simply won’t exist. This reduces the power of the financial assumptions, and even further necessitates their precision. The trouble is, this is a lengthy process. AQPC showed that even financial analysts spend almost half their time collecting and validating data, and they’re experts at it.
This means you have to expect a grind. If you’re going it alone with this process, make sure to get a handle on your research methods, and which areas to focus on and in the right order. This is a topic for its very own article, but the point is, expect to dedicate and schedule a lot of time for this part of the process.
So we know the research is important, but how do you go about it? For costs of manufacturing, meeting with suppliers is essential to get written quotes for supplies covering any wholesale discounts that might be available. Then, for marketing and distribution, studying your market in depth is crucial to making accurate assumptions about the value of what you’re offering and how much it’ll cost to get it out there.
Find out exactly where and how to look, and gather the necessary data on all the elements your company needs to be able to predict. From this, you will work on the analysis.
There are definitely ways to go this alone, especially if this relates to a field you’re familiar with, but the option to use outside help shouldn’t be overlooked. ProjectionHub offers a range of services that can help with the financial planning process. From basic projection templates to detailed, expert guidance and tailored forecasting spreadsheets specifically designed for your business, there are a lot of useful options that can help speed up the process and improve your accuracy.
Finally, show your workings! If you’ve spent the due time and energy collecting and analyzing the data, it’s not going to matter if you can’t demonstrate how you came to the conclusions you did. Putting in the work is how you get accurate assumptions, but describing your process is how you persuade others to trust them.
Financial forecasts are the backbone of a business plan for investors. They’re a demonstration that you’ve done your homework and you know what you’re doing, and with bold claims, there comes the need for strong evidence.
Making assumptions is the key to any projection. Assumptions about change over time, consistency over time, and any other incomings and outgoings that you anticipate as part of the process. The accuracy of these assumptions is what makes or breaks a business plan, as they hold the key to future, long-term investment as well as countless other business choices made by decision-makers.
If this seems like a daunting task, don’t’ worry. There are countless opportunities to take advantage of expert help with services like ours at ProjectionHub, which provides templates and expert advice to get you started.
Accurate assumptions should not be underestimated. Putting in the work at this stage of your financial projections will pay dividends and command great respect from investors.