The Facts About Financial Projections

Normal people hate financial projections because of their off-putting formats and buzzwords. Really, it's just a matter of making good estimated guesses about what you're going to be selling, what it'll cost and what your expenses will be.

Let's go over a few simple points that generate a lot of unnecessary errors in business plans. These are simple facts--accounting conventions, in some cases--that answer a lot of entrepreneurs' frequently asked questions. Don't let your business plan look bad because of easy-to-fix errors.

Before I start, take a breath. Don't glaze over when you see financial terms. They aren't that hard, and they are that important. Stick with me.

1. Tax law allows businesses to establish so-called fiscal years instead of calendar years for tax purposes. For example, your fiscal year might go from February through January, or October through September. Use "FY" (as in "FY07") to specify the year in your plan. The year is always the year it ends, not the year it starts, so any fiscal year that started after this past January 1 is FY08.

2. Understand sales on credit and accounts receivable. When your business sells anything to another business, you usually have to deliver an invoice and wait to get paid. That's called sales on credit, which has nothing to do with credit cards, but plenty to do with B2B sales. When you make the sale and deliver the invoice, the invoice amount increases sales and accounts receivable. When that money gets paid, it decreases accounts receivable and increases cash.

3. Separate costs from expenses. Costs are normally the cost of sales, also called cost of goods sold and direct costs. Costs are the money you spend on whatever you're selling, like what a bookstore pays to buy books. Expenses are regular running expenses like rent and payroll--expenses you'd have whether or not you had any sales.

4. Don't call your investment "venture capital" unless it comes from one of the few hundred actual VC firms. If you're getting venture capital, you'll know it. If not, just call it investment.

5. Don't confuse assets with expenses. Early entrepreneurs think their companies look better if they have a lot of assets. One common example is wanting to take money spent on programmers and pretend that paying a programmer is buying an asset. Take my word for it: You don't really want that. It's better to expense those development expenses. That lowers your tax bill and makes your balance sheet look better, because you don't have fake assets.

6. The two main accounting standards are either cash basis or accrual; accrual is better because it gives you more accurate cash projections. It seems counterintuitive, but cash basis isn't as good for predicting cash. The difference is timing. In accrual, the sale happens when you deliver the goods or perform the service. In cash basis, the sale happens when you get the money. In accrual, you owe the money when you receive the good or service, regardless of when you pay. In cash basis, you don't show what you owe until you pay it. I strongly recommend accrual because it's much more realistic. Real businesses don't pay in cash; they pay later.

7. Pro forma is just a dressed up way to say projected or forecast. It's one of those potential daunting buzzwords that really isn't that complicated. The pro forma income statement, for example, is the same as the projected profit and loss or the profit and loss forecast.