To run a business successfully and ensure constant growth, an entrepreneur must regularly evaluate and update his/her budget, measure the same against the set goals, adjust the spending, and seize opportunities accordingly. Preparing a financial projection is quite crucial for every business owner. Besides providing insight for small businesses to plan for the future, financial projections help entrepreneurs anticipate the possible financial needs in the future and the best times to make capital expenditures. Technically, a financial projection is a type of pro forma statement that explains what a business can expect, based on hypothetical situations created using the available facts and data. It often helps an entrepreneur to effectively monitor cash flow, strategically change product/service pricing, and even modify production plans when needed.

Besides, financial projections help funds-seeking entrepreneurs prove their creditworthiness to lenders. Financial projections ensure the lenders a better understanding of the applicants’ businesses, by explaining how the revenue is generated, where money is spent, etc. Also, financial projections help one to understand the potential of his/her business. For example, when an entrepreneur has been witnessing his/her sales volume steadily increase by 10% every year, for the last 18 months, it can be assumed that the business is growing constantly. In such a situation, a financial projection needs to be made to anticipate if the growth will continue, so that inventory plans, hiring decisions, marketing expenditures, etc. can be made accordingly. Business plans and financial projections always go conjointly.

The success of a company highly depends on how well the owner manages the financial aspect of the business. One can use a financial model to make a financial projection, which will help him/her anticipate if and when the business will make a profit. To make a financial projection, one must consider sales revenue estimates, costs of sales or cost of goods sold(COGs), operating costs, gross margin and sales increase by product line, capital expenditures, interest rates on debts, income tax rate, accounts receivable collection plan, inventory turnover, and the usefulness or depreciation of the current assets. Either a financial model or a summary of the company’s expenses and earnings is required to make a financial projection.

Steps to make a financial Projection for a small business:

  • A sales forecast needs to be made. It must include the factor/s that are driving the sales and an estimation of the number of units the company will sell in the coming years. But, the sales-affecting factors like seasonality, etc. need to be considered as well.
  • A detailed expense budget needs to be created. The budget must comprise all the costs associated with sales and operating expenses. The cost of sales or cost of goods sold (COGS) is forecasted by considering all the data available on the latest income statement.
  • An income statement projection needs to be created by linking the assumptions, about how product cost, fulfillment expense, customer service, merchant fees, and operating expenses will change as a percentage of revenue in the coming years, to the formulas built in the income statement. A financial model can be used to forecast the net revenue, COGS, gross profit, gross margin, operating expense, operating profit, and operating margin. A projected income statement comprises all these forecasted numbers.
  • A cash flow projection needs to be prepared. Showing the monthly cash inflows and outflows for a specific period like 3 months, 6 months, 12 years, etc., a cash flow projection deciphers if the company is profitable and/or when to expect profit.
  • A balance sheet projection needs to be made. It shows the worth of a business at any given time. On a balance sheet, cash flow projections are considered assets, and accounts payable and debt are viewed as liabilities.
  • The projections need to be used for planning. Projected financial statements help an entrepreneur to make capital expenditures and analyze the impact of various business strategies.
  • Finally, the projections need to be compared against the actual results to find out if any further modification needs to be made to reach the set target. There are many accounting and planning software that help to make financial projections. 

Reasons financial projections are crucial for SMEs and start-ups:

  • As SMEs and start-ups are often tight on capital, they must be careful with their finances.
  • Small businesses usually have a comparatively smaller amount of time than large corporations to gain profitability before they run out of capital. 
  • SMEs many times have to depend on external funding to continue operating and grow. Financial projections help fund-seekers to convince lenders about the potentiality of their businesses. Also, these enable entrepreneurs to take spending decisions wisely.
  • As start-ups are considered high-risk investments, many investors want to get assurance on the right usage of the borrowed funds and require the loan-seeker to present a financial projection.

Summary:

Small businesses and start-up owners must create financial projections to estimate their companies’ future financial performance, make strategic decisions, and secure funding from finance/loan providers. Companies that fail to show good financial projections often find it difficult to prove their creditworthiness to lenders. However, one must make realistic assumptions about the future, use historical data and conservative estimates in the projections, and regularly review and update the same. This makes sure that the projections are the closest to accurate.