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Starting a business is an exciting time, but one that can come with some uncertainty. As long as you are properly prepared, you can increase your chances of success significantly and reduce some of the worries through smart business planning and financial projections. By creating financial plans, you are also able to test some of your assumptions to see if your business idea is feasible.
What are financial projections?
Financial projections are a forecast of a business’s expected sales and expenses that analyze the financial feasibility of the business. 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. Financial projections are essential component to the business plan in order to provide a realistic view as to whether or not your business is financially viable for success.
While it may be tempting to skip this step, not completing it could be costly.
Why are financial projections important?
Financial projections are one of the most important steps in starting a business. These figures help show you whether or not your business has a reasonable chance of being profitable. If your business does not reflect a profit based on your projections, you may have to make some adjustments. While you cannot create a non-existent market for sales growth, you can reduce expenses in other areas, such as to find more affordable real estate or to lower starting salaries. Financial projections can also help determine realistic price points and sales goals. They can also show you whether or not a market even exists for the product or service you wish to provide.
Sales projections are also useful in analyzing cash flow from accounts receivable and accounts payable to ensure the company has enough cash to operate.
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 accurately predict. 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.
To begin with your business plan financial projections, start by focusing on your revenue potential and likely expenses.
1. Project revenues
Projecting revenue 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.
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 to not get too carried away with your target area as it will have a big impact on the 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 knows 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 menu of services to assess how many jobs your 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 2 vehicles per day, 10 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 assumptions in the business plan so the reader can follow the math!
2. Project expenses
Next project the monthly expenses of the business. Some expenses are going to be easy to estimate, like rent, insurance, utilities. Other expenses need to be carefully examined as they can make a large difference in the projected profits.
The biggest expense for most businesses is the cost of goods sold, sometimes called COGS or cost of inventory. This is the cost to produce the item being sold. A common 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 are able to 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.
4. Financial projections
With the sales projections, expenses and seasonality now out of the way, creating the proforma financial statements are actually pretty straightforward.
Business plan financial projections are typically set up to show a three-year outlook. Depending on the project, especially if it is one that has a significant amount 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 by month and following 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 added in.
- 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.
5. Sources and uses of funds
The sources and uses of funds section provides an overview how the business is funded 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 the bank loan and another line for the amount the owner is investing in the business. Keep in mind when preparing
this for the bank that most banks will want to see the owner invest 15%-25% of
their own funds in a start-up business.
The uses section provides details of all the things that have been purchased and still need to be purchased 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 templates from Smartsheet, Spreadsheet 123, and others. LivePlan has a guided approach (like Turbo Tax)to creating financial projections that are pretty thorough and easy to use.