Predicting the future is hard. But when you're making financial projections, that's exactly what you need to do. You can avoid some of the most common mistakes by following this list of dos and don'ts.
By Paul A. Broni | Apr 1, 2000
Business 101
Predicting the future is never easy. But by following these dos and don'ts for financial projections, you can avoid some common mistakes
It doesn't matter whether you're applying for your first bank loan or your fifth, or whether you're seeking venture capital or debt financing. Sooner or later, you'll have to prepare a set of financial projections. Lenders will look for a strong likelihood of repayment; investors will calculate what they think is the value of your company.
In my past 10 years both as a banker and as a financial consultant, I've seen many entrepreneurs -- despite the best intentions -- make mistakes on their projections. The good news is that the most common mistakes are easily preventable if you know what to look for. Here are my top dos and don'ts:
- Don't provide only an income statement; include a balance sheet and a cash-flow statement, too. It's understandable that you're focused on sales and net income, but your banker or investors will also want to know how much money you intend to leave in the business as retained earnings and how much additional debt or equity financing you'll need -- if any -- to grow your company.
- Do provide monthly data for the upcoming year and annual data for succeeding years. Many entrepreneurs prepare projections using only monthly data or only annual data for the entire three- or five-year period. Don't. Use monthly data for the first year. After that, use annual data. The financial results of your first year will probably end up being different from your projections, so there's no point in thinking that you can accurately forecast monthly results for the years after that. This is an instance where less is more.
- Don't provide more than three years' worth of projections unless your lender or investor has asked for them. This is an extension of the less-is-more concept. Let's face it: it's a stretch to accurately forecast your company's sales or net income for even three years out. Only in cases in which you're looking for long-term financing for equipment or real estate is it likely that your banker will want longer-term projections.
- Don't provide more than two scenarios in your projections. Loan officers and investors are already drowning in paperwork, so do what you can to make their lives simpler. We've all seen projections with the following three scenarios: base (or likely) case, worst case, and best case. I've also seen super case and break-even case. My advice is to prepare just the base case and the break-even case. The base case should show what you realistically expect the business to do; the break-even case should show how low sales could go before the business begins to lose money.
- Do ensure that the numbers reconcile. Everybody knows that assets must equal liabilities plus equity. But all too often entrepreneurs will simply plug a figure into the equity slot to make things settle up. That's wrong. If your bank is doing its homework, your banker will check the math. If the equity numbers don't add up from one period to the next, you'll be asked to explain. Even though everyone makes mistakes, that's one you want to avoid because it makes you look sloppy. Also, if after the mistake is corrected your company has a smaller net worth than you originally presented, your banker or investor may think you were being intentionally misleading. Not good.
- Don't be too optimistic about sales growth or gross and operating profit margins. All bankers and investors want to do business with ambitious entrepreneurs, but there's a big difference between a realistic business plan and fantasy. While it's true that companies that have low revenues can grow their sales quickly in percentage terms, it may not be realistic to assume, for example, that your business can double in size every year. That rate of growth would turn a $500,000 company into a nearly $16-million business in only five years. And although that can happen, it is definitely not the norm. Also, entrepreneurs often try to convince lenders that as their company grows it will achieve economies of scale, and gross and operating profit margins will improve. In fact, as the business grows and increases its fixed costs, its operating profit margins are likely to suffer in the short run. If you insist that the economies can be achieved quickly, you will need to explain your position.
- Do account for reasonable interest expense on the income statement if you have debt on your balance sheet. That sounds simpleminded, but you'd be surprised to learn how many people forget to do it. If you expect to have an average loan balance outstanding of, say, $500,000 over the year, and your forecasted average interest rate is 9%, you need to budget $45,000 for annual interest expense. Don't budget less than a realistic amount; this is one line item where you're always better off coming in under budget.
- Don't include every individual line item for each expense, asset, and liability figure. Although your banker or investor will probably be interested in knowing details about sales from major product or service lines, as well as the direct cost of sales associated with them, keep to the basics in other categories. With operating expenses, those would be salaries and payroll taxes, lease and rental expenses, depreciation, amortization, and any other kind of expense that consumes more than 10% of revenues. Also, don't forget to distinguish the owners' compensation from that of nonowners, particularly if you and your co-owners are drawing above-market salaries as a means of reducing business income taxes.
With assets, focus on cash and investments, accounts receivable, inventory, the major categories of fixed assets (including capital-lease assets), and any amounts due from shareholders or affiliated companies. Also, be sure to include any other assets that you consider material, such as patents or licenses.
Identifying liabilities is straightforward. You should have one line item for all accrued expenses and a line item for each of the following: accounts payable, a revolving line of credit, term loans, capital leases, amounts due to related parties, dividends payable, and income taxes payable. Finally, if your business has deferred revenue (meaning that you collect cash from your customers before having actually earned it), add a line for it in liabilities as well.
- Do include with your projections the assumptions that you used, and be able to explain and defend them. In addition to the income statement, balance sheet, and cash-flow statement, you should provide a one-page summary that explains your assumptions about revenue growth; cost of goods sold; operating expenses; interest expenses; turnover of accounts receivable, inventory, and accounts payable; capital expenditures; dividend policy; and income-tax rates. Also include any ancillary information that has an impact on the financial success of your business. Examples of that might be your projected employee head count and office or warehouse space requirements.
Paul A. Broni is a managing director of Mercury Partners, a finance and business consulting firm in Rockville, Md.
Please e-mail your comments to editors@inc.com.
