Financial Projections (Chapter 20)

We talked about budgets in the previous chapter; now let's talk about financial projections. Budgets are typically used as an internal management control tool and are updated quarterly, or should be. Financial projections, on the other hand, are more often static estimates (or guesses) of future performance over a specific time period. These projections are frequently used in presentations to various financing sources or as part of a company's long-term strategic plan.

I've not only prepared hundreds of financial projections for my clients over the years, but I've also reviewed hundreds more. That has given me insight into the preparation, validity, and application of future financial forecasts. In this regard, recall the discussion of the word “conservative" in Chapter 10.

Is "Pro Forma" Latin for BS?

Is your pro forma projection accurate and defensible and likely?

Many of those exaggerated market projections for the company's products or services are based on some exaggerated or unrealistic or overly optimistic view of the market for the company's products or services.

I've also seen projections that say, "If we can just sell our widgets to 1% of the 330 million people (as of 2022) in the United States, we'll all be wealthy." However, there is no cost-effective way to reach all 330 million people.

Don’t make revenue projections based on the total market size; instead, focus on the market you can actually reach and sell to. Then, in the projections, show how you'll reach and sell to that market, as well as the cost of doing so.Furthermore, almost no one expects a loss, even if losses are unavoidable in the short term. Don't lie to yourself when preparing financial projections; be realistic about the future and what your company can actually accomplish in a given time frame and with the resources available.

After you've compiled your revenue projections, which should always be the first step in financial forecasting, you'll want to focus on the expenses that will be required to achieve those sales levels.Some expenses, such as direct material costs, will vary directly with revenue. Others, such as rent, will remain fixed and will not rise in tandem with rising sales until a future plateau is reached. Others will be semi-variable, meaning that they will rise in tandem with rising sales but not in proportion to the percentage increase in revenue. Supervisory and administrative salaries, most selling expenses, and business liability insurance are all examples of semi-variable costs.

It's critical to recognize which expenses fall into each of those three categories and treat them accordingly when preparing projections. If, for example, you show occupancy costs as a constant percent of sales, any experienced person reviewing your projections will discount them.

Examine each line item in the projections to ensure that it changes in a realistic amount and pattern over time.

For most forecasts, start with a detailed revenue forecast for each product or service category. Then calculate the number of employees and associated compensation costs required to generate those revenues, including direct labor as well as sales and administrative salaries. To obtain that information, first create line item schedules for each category of personnel, based on the number of people, and then convert those schedules into dollars, including all payroll taxes and employee benefits.

Forecast the other direct costs and related gross profits levels after completing the revenue and personnel costs for the projections. Estimate selling and administrative expenses only after the top half of the income statement projection is complete.After I've completed all of that work and have a first draft of the projections, I run them through the "Lee Rust Reasonability Check." Is the projected outcome reasonable as a whole, and are the individual estimates that make up the projections based on reasonable assumptions?

The financial forecasts will gain validity by including a high level of line item detail and supporting many of the line item estimates with descriptive notes, rationale, and assumptions. They won't be dismissed out of hand as overly optimistic or based on implausible assumptions.

It's a good idea to convert your income projections into balance sheet forecasts once they're finished. As a result, you'll have to think about things like the average collection period or the expected number of days in your accounts receivable and inventories. Investments in fixed assets required to produce the projected level of goods or services, as well as the various categories of liabilities required to support the increase in assets that will accompany the projected increase in revenues, must all be considered.

Finally, make a detailed cash flow analysis out of the balance sheet. Because such cash flows are rarely included in projections, this will come as a pleasant surprise to anyone reviewing them. Use the "Reasonability Check" to double-check the overall projected results.I heard a while back that the true purpose of financial forecasts is to make astrology look acceptable. Make sure that analogy doesn't apply if you're ever asked to create a set of financial projections for your company.

One good way to do that is to have a series of Leading Indicators that you measure, monitor and manage. Finances are Lagging Indicators. Leading Indicators include retention and attrition of customer and employees; activities and behaviors that lead directly to acquisition rates of new customers; pricing and service models, etc. Go to www.CoFinSol.com for more key leading indicators.