May 6, 2022
If you’re thinking of starting a new business, you’ll need a business plan. The key to that business plan is a start-up financial projection. This is your roadmap to success. Without it, you’ll receive no funding. Yet, even if you’re not seeking external finance, you should take the time to develop a financial projection. It’s worth the effort since it will help you to set realistic goals for your business and put your business on the path to success.
A financial projection should provide a basis for making decisions on whether the business is viable. It should combine current historical data with market and industry trends and conditions to provide direction for the future.
What Are Financial Projections for Start-ups?
A financial projection is a statement of planned income and expenditure given one or more assumptions. It is what you expect to happen in your business based on a set of hypothetical conditions.
Most start-ups will create a short-term and long-term financial projection. The short-term plan is broken down into monthly statements and projections and typically covers a year. Investors will also want a long-term plan, covering three to five years. A quarterly plan will suffice for years two and three and an annual plan will do for years four and five.
What Is the Purpose of Financial Projections for Start-ups?
The main purpose of a financial projection is to secure investment to get the business off the ground and to ensure that your start-up is financially viable. Most businesses require investment income long before they start to bring in income. Prepare your business plan and financial projection with the end-use in mind.
Financial projections are used for the following purposes:
- Internal use – The financial projection should show that your business has the potential to become financially successful.
- Investors – Your investors will want to know when they can expect a return on their investment.
- Loan applications and lines of credit – The most common form of external funding for small businesses includes loans and lines of credit. To secure a loan, you will have to explain exactly how you plan to spend the money and when you can repay the loan.
Research and Assumptions – the Basis of Financial Projections for Start-ups
According to the Small Business Advocacy Office, only two-thirds of US businesses with employees will survive the first two years in business and half the first five. You can give your business the best chance of survival by studying market dynamics and planning ahead. Know the numbers before you risk your money on a venture destined to fail.
It is reasonably easy for existing businesses to develop a financial projection, as they have historical data to fall back on. For new businesses, the process is somewhat trickier.
If you’re an entrepreneur hoping to start-up, you will have to put in a lot of research. The goal of the research is to understand the competitive environment and the target markets. Competitive analysis is vital to understanding the size of the market, the competitors, margins, and barriers to entry.
How to Make Realistic Assumptions
You will have to build your financial projection on some assumptions and prove to the investors that these are realistic. They will want to know the basis of your assumptions which must support your numbers. Assumptions may be made based on any of the following:
- Market research
- Supply contracts
- Price validation
- Web traffic
- Economic data
What to Include in Your Financial Projection?
Every financial projection includes three key elements. These are:
- An income statement – also known as a profit and loss statement
- Balance sheets
- A cashflow forecast
The Income Statement
Your income statement will include all the information on expected income, the costs of earning that income, and the resultant profit. This is the document in which the investors will show the most interest. To create an income statement, you will need the following information:
- Revenue – the amount of money you will collect from the sale of your products or services.
- Cost of goods sold – the direct costs of producing and selling your products and services.
- Operating expenses – also known as overheads. These costs include start-up costs, rent, utilities, salaries, legal costs, and more.
- Total income – this is your profit. It is the difference between revenue and expenses. This is the number that shows whether your business has any chance of success.
- Income tax – calculate the taxes on your income using tax tables.
- Interest payments – the amounts that your business pays for external funding.
- Net income – the amount that your business earns after paying interest and tax. It is the real indicator of sustainability.
Your balance sheet will summarize the financial position of your business at a point in time. It will include the following information;
- Assets – this includes machinery, patents, inventory, cash, accounts receivable, and fixed property. Assets contribute to the company’s worth.
- Liabilities – these are amounts owed by your business. Liabilities usually include accounts payable and outstanding loans.
- Equity – the difference between the assets and the liabilities is the equity. It represents the value owned by the investors in the company. It is typically shown as retained earnings.
Cashflow projections are invaluable because they show when the business will have money available and when it will run short. Many businesses fail because they don’t have the cash to continue operations. A cash flow projection will highlight these deficits. This document also shows investors when they can expect returns on their investment.
A cash flow statement has three components, namely:
- Operational cash flow – related to the day to day running of the business.
- Investment cashflow – associated with capital expenditure and the sale of assets.
- Financial cash flow – created by financing activities. These include loans and interest payments.
Items to include on your cashflow projection:
- Cash revenues – this shows expected revenue inflows. You can forecast this amount using sales projections based on market research.
- Cash disbursements – amounts needed to pay expenses in each financial period.
- Cash revenues less cash disbursements – management relies on this document to make informed spending decisions and to manage debt.
In compiling your cash flow statement, you will have to make some assumptions about the payment terms for both debtors and creditors. Terms can vary from cash to 30, 60, and 90 days, making major inroads into your cash flow.
The Importance of Financial Projections for Start-ups
Financial projections form an essential part of any business strategy. Unless you make business decisions based on sound financial projections, you could end up incurring more costs than your income can support. You can also use your financial model to experiment with changes to the strategy. For example, you may use it to compare pricing or resource changes and their effects on the overall profit.
Financial projections help you to establish when you will need financial assistance. They can help you to make decisions on the right time to invest in capital equipment and they assist with cashflow monitoring. They can alert you to the need to increase product prices or increase production plans.
Most start-ups need investment capital and your start-up financial projection will form the basis of your presentation to potential investors. It should prove your ability to pay back the loan with interest.
A word of warning: make sure that your financial projection is as realistic as possible. Investors will use your start-up financial projection as a basis to compare your actual performance against the forecast.
If your actual performance lives up to your projections, you will have proved to investors that you understand your business. This could inspire them to continue investing when your business starts to grow.
Approaches to Financial Projections
There are two types of projections
· Bottom-up projections – use forecast sales orders then multiply these numbers by the average planned price by product line or category. The result is the projected revenue. The bottom-up approach takes into account such factors as production capacity.
· Top-down projections – look at the market size and potential market growth and then make an assumption on the size that the business will take. The company will factor in internal strengths and weaknesses in determining their market share.
The top-down approach allows businesses to look at the entire market and its potential. For start-ups, this is the easier approach because they lack historical data on which to build sales forecasts. Top-down projections are often also more optimistic so start-ups may prefer this approach when seeking external funding.
In addition to a bottom-up and top-down approach, we also think there are different ways to approach projections for different types of businesses. We outlined 2 sales projection methods for businesses that are primarily driven by capacity and businesses that are primarily driven by a customer sales funnel.
How to Build a Financial Projection for Your Start-up
Now we get down to the nitty-gritty of how to develop a financial projection. Though we detail a step-by-step approach to creating your financial projection, you will likely progress back and forth through the process.
You may, for example, notice that your cash flow doesn’t support an increase in headcount. This may lead you to return to your income statement to re-examine some of the resource utilization and production plans.
The development of a financial forecast requires the following steps
Your financial projection starts with a sales forecast. Your sales forecast must consider the following questions
- What is the size of the market?
- How market share can you reasonably expect?
- What growth rate will apply?
- How will you price your products?
- What is the cost of the goods sold?
Presumably, by the time you get to creating your financial projection, you will have completed your market analysis. You will understand the industry and the competition. You will have selected a market segment and set a realistic market share goal.
The demographics of the market will help you to understand market trends. It may also help you to make decisions such as where to set up your business and how to effectively market your product. An understanding of seasonal trends and economic factors that could impact sales projections is essential if you are to build a realistic financial forecast.
Break the sales into components such as product lines or target markets. This will make scenario planning easier and will give more credibility to your sales forecast.
To calculate the sales revenue, set the number of sales and the amount of revenue that you will achieve if you achieve the planned market share.
Before you start your expense forecast, you will have to consider your investments. What equipment will you need and what facilities? Will you buy or lease? How much will your website cost? What will your legal costs be and what human resources with you employ? You will need money to launch your business long before you earn a profit, which is why you will likely need investors to help you to get started.
Expenses fall into two categories:
Cost of Goods Sold
The total expense directly related to a unit of a product sold makes up for the cost of goods sold. These expenses include components and raw materials that go into the product, and products bought for resale. It also includes direct labor and utilities used in the production and sale of a product.
The COGS is a very important figure for any business owner since it represents the minimum price of the product to break even. Anything over the breakeven price goes toward paying off the overheads and contributes to profit.
Savvy managers continuously monitor the COGS to reduce these costs as a small reduction can have a major positive impact on the bottom line. Include these costs on the sales forecast spreadsheet as they are directly related to the sales. These costs are, therefore, easy to calculate.
General costs like rent, utilities, general marketing costs, and equipment are operating or overhead costs. Operating costs consist of both fixed and variable components. Your operating expense forecast should include:
- Expected costs
- Possible contingencies
- Increased expenses based on planned growth.
Subtract the cost of goods sold from your total revenue to find your gross profit for each forecast year. Deduct total operating costs to ascertain your total annual net profit.
Return on Investment
investors will want to know when they can expect a return on investment. To work this out, calculate how much money you need to start your business. Now compare this to your forecast revenue. You start to make a return on investment when you make a profit. You can use your financial forecasts to give investors a time at which they can expect a return on their investment.
Best Practices for Effective Financial Projection Startup Reports
Do Your Research
Understand the industry. Know the competition and ensure that your forecast is realistic and achievable. Before you can build up a credible financial projection, you will have to make several assumptions. To make assumptions you’ll need an in-depth knowledge of the size of the market, customer demand, competitive pricing, and competitor behavior.
Lack of market knowledge can lead to bold projections and costly mistakes.
Use a Start-up Financial Projections Template
Though you could use an Excel spreadsheet for your financial projection startup reports, there are better options. Here at ProjectionHub we provide50+ CPA prepared start-up financial projection template that are easy to use and tailored to specific industries.
When you’ve completed the template, send it back to us and the ProjectionHub team will vet it and provide you with feedback. When you consider the importance of your financial projection start-up reports, why compromise?
Create Several Scenarios
Prepare at least three scenarios as follows:
- A base plan – this is what you expect to happen.
- An upside plan – a plan if growth is better than expected.
- A downside plan – your worst-case scenario.
Creating scenarios will allow you to consider various alternatives. It will force you to consider what could go wrong, but it will also give you a chance to weigh up opportunities for growth and development. It will also indicate to investors that you have considered the market conditions and made plans for the future.
Include Bullets with Assumptions
Include bullet points with key assumptions related to revenue and expenses. Show how the assumptions change from one year to the next. This is where you factor in changes for growth including headcount increases, and capital expenditure. These assumptions will also show economic changes like inflation and interest rate changes.
Include the Breakeven Point
If your business isn’t profitable at first, as many aren’t, make sure to indicate the breakeven point. This is the point at which your income exceeds your expenses including interest.
The Bottom Line
Financial projections provide business owners and investors with a roadmap for the future. They provide a strategic plan that you can use to manage revenue and costs to ensure the financial health of your business.
Your financial projection should be a living document. It doesn’t belong as a bottom draw. Update and monitor it continuously to ensure that your business is meeting its goals. As you update your business plan and your financial projection for start-ups, revisit your plan and make changes to meet changing market demands.