Starting a business is an exciting time, but one that can come with some uncertainty. Writing out your business plan helps to increase your success significantly in addition to reducing some of the worries by getting all the ideas out of your head and organized on paper.
Financial projections are an essential component of the business plan to provide a realistic view as to whether or not your business is financially viable for success.
By creating financial plans, you are also able to test some of your assumptions to see the financial impact and analyze whether your business idea is feasible.
What are financial projections?
Financial projections (sometimes referred to as pro forma) are an essential part of a business plan. They are used to forecast a business’s expected sales and expenses and analyze the financial feasibility of the company. These forecasts evaluate past trends, current market conditions, and future expectations. They will also take into account regional sales potential and growth strategies and examine external and internal costs, such as the cost of customer acquisition and the amount of money you can afford to pay team members and yourself.
While it may be tempting to skip this step, not completing it could be costly.
Why are financial projections important?
The financial section of your business plan are one of the most critical steps in starting a small business. These figures help show you whether or not your business has a reasonable chance of being profitable. If your company does not reflect a profit based on your projections, you may have to make some adjustments. Financial projections can also help determine realistic price points and sales goals. They can also show you whether or not a profitable market even exists for the product or service you wish to provide.
The sales forecast is also useful in analyzing cash flows from accounts receivable and accounts payable to ensure the company has enough cash to operate.
Another reason financial projections are important is when requesting funding. The bank will review whether you have realistic financial projections before making a business loan.
How to create financial projections?
It is important to understand that financial projections are simply the best estimates you can determine based on information available.
These figures are next to impossible to predict accurately. While this financial forecast can’t predict how the business will perform in the future, it will provide the analysis to make informed decisions and plans for the business.
Financial projections are typically shown as a 12-month projection in the first year and by quarter in the second year and third year.
To begin with, your business plan financial projections, start by focusing on your revenue potential and likely expenses.
1. Create sales projections
Projecting sales projections (also known as revenue projections) for a new business is difficult, especially if you are new to the type of business you are starting. They are a few approaches you can consider when preparing the sales forecast. Some companies will have multiple sources of revenue. To make these easier to follow, each revenue stream is often put on a separate line in the projections.
Average household spending – The Consumer Expenditure Survey program from the U.S. Bureau of Labor Statistics (scroll down to the Annual Calendar Year Tables) provides data on the expenditures of U.S. consumers. Using the average household spending multiplied by the population in your target area, you can come up with the total potential sales. Try not to get too carried away with your target area as it will have a significant impact on potential sales.
Using the BLS data, you can look up how much people spend on food and beverages (such as food at home, food away at home, bakery products, alcoholic beverages, etc.), appliances, apparel, education, reading – and the list goes on. This information can be assessed against demographic information such as age, income, education level, occupation, race, religion, and more.
Not only can you use this data to provide useful because you can use it to
gauge the feasibility of your business. For instance, if there are three competitors in your market, and you need 10% of the market to make an adequate profit, this may be a good indication your business would be successful. If you needed 80% of the market, it would likely be much more challenging.
Trade associations – Depending on the industry you are starting your business in, it’s likely there is an industry association. Do a Google search for “[type of business] industry association” or even find a Facebook group to join and ask questions. Many industry associations have statistics and formulas you can use to estimate sales. Make sure to reference your work, so the bank or prospective investors know you didn’t come up with these numbers out of thin air. Be sure to do your own due diligence as these numbers may be overly optimistic.
Menu of services – Another way to project sales is to create a list of services to assess how many jobs you can do in a day and the pricing of each job.
For instance, if you own a car detailing business and it takes 4 hours per vehicle to detail, you may be able to do up to two vehicles per day, ten vehicles a week or 40 vehicles a month (you could squeeze in a few more in a month, but let’s keep the math easy for now).
Each vehicle brings in an average of $100 for a total monthly sales revenue of $4,000. Let’s say that after subtracting rent, utilities, supplies, advertising, etc, you are left with $2,000. Now you find that best case, you have a profit of $2,000, and by working 8 hours a day, you would make $12.50 per hour. Now you have to ask yourself that in this best-case scenario where you have clients lined up each and every day and you are making $12.50 per hour, is this business worth your time?
Regardless of how you project sales, be sure to explain the key assumptions in the business plan so the reader can follow the math!
2. Factor Accounts Receivable
If you sell to customers on credit, they may not pay for the purchase for 30, 60, or 90+ days after taking delivery. Not projecting accounts receivable can be a big mistake since you still have to pay for raw materials, employees, utilities, etc. Even worse, a certain percentage will pay even later, or worse, not at all. Not managed properly, a growing business can even go bankrupt because there isn’t enough cash being generated to pay the bills.
3. Project operating expenses
Next, project the monthly operating expenses of the business. Some expenses are going to be easy to estimate, such as fixed costs like rent, insurance, utilities. Other expenses need to be carefully examined as they can make a large difference in the projected profit.
The biggest expense for most businesses is the cost of goods sold, sometimes called COGS, cost of sales, or cost of inventory. This is the cost to produce the item being sold, such as the raw materials to produce it. A typical example is a wedding band sold at a jewelry store. The sales price to the customer may have been $1,000, but the jewelry store purchased it for $700. The cost of goods sold in this instance is $700. Many times COGS is represented as a percentage, which in this example would have been 70% ($700 /$1,000).
You can often find the average cost of goods for most businesses by searching for industry publications.
Another major expense for most businesses is employees. This number can be found for many industries as a percentage of sales; however, we would recommend you create a list of the positions needed, number of employees for each position, number of hours worked, and wages. By comparing the industry average with your own list, you can have some confidence your numbers are in the ballpark.
Make a list of the monthly expenses and the cost for those expenses to use later in the financial statements.
After getting the sales projections completed, you will also want to look at seasonality. Seasonality refers to the fluctuations in monthly sales. Some businesses will be affected more by seasonality than others, but it is important to analyze because it may show your business will run out of cash. Lenders and potential investors will expect some seasonality, but if you have a business that has steady sales, be sure to explain why your sales are consistent.
In most areas, landscapers are a common business that has fluctuating sales. The spring and fall are really busy, while in the winter, there is little to no work.
5. Financial projections
With the sales projections, expenses, and seasonality now out of the way, creating the pro forma financial statements are actually pretty straightforward.
Business plan financial forecasting is typically set up to show a three-year outlook. Depending on the project, especially if it is one that has a significant amount of research and development time before revenues start to come in, some banks and lenders will occasionally want to see a five-year outlook.
There will be three financial statements to create:
- Cash flow statement – Similar to a detailed view of a checkbook, the
projected cash flow statement looks at cash coming in and cash going out of the business. Cash flow projections usually look at the first year broken out into 12 months, and the following two years by quarter.
- Profit and loss statement – Also referred to as an income statement, this statement is an annual estimate of the taxable profits (or losses) of the business. The numbers in the P&L statement are similar to the cash flow statement; however, depreciation and amortization are also included.
- Balance sheet – Not every bank will request a proforma balance sheet for a start-up business. The balance sheet is similar to a personal financial statement that looks at assets and liabilities to determine the net worth.
The balance sheet is projected at the end of each year.
6. Sources and uses of funds
The sources and uses of funds section provide an overview of the financing activities, use of working capital, loan repayments, and how the money is spent.
The sources section is a list of where the money is coming from to fund the project. This will commonly have a line for the amount of a bank loan, equity investment, and the amount of the owner’s investment.
Keep in mind when preparing this for the bank that most banks will want to see the business owner invest 15%-25% of their own funds in a start-up business.
The uses section provides details of all the startup costs for the business. Items are usually put into categories such as:
- Real estate
The amount in the sources section should equal the amount in the uses section.
Financial Projection Templates
There are free financial projection excel templates that can be found online. Business planning software like LivePlan has a guided approach (like Turbo Tax) to creating financial projections that are pretty thorough and easy to use.