How to Make Realistic Financial Forecasts

This is part 7 / 11 of Write Your Business Plan: Section 5: Organizing Operations and Finances series.

Business plans and financing proposals are based on projections. Past financial data can only support your projections. However, financial projections in your business plan express in common financial terms and formats how you expect the immediate future to play out the scenarios you created in the body of the plan. You can forecast financial statements such as balance sheets, income statements, and cash flow statements to project where you'll be at some point in the future.

Forecasts are necessities for startups, which have no past history to report on. Existing businesses find them useful for planning purposes. Forecasts help firms foresee trouble, such as a cash flow shortfall, that is likely to occur several months down the road, as well as give them benchmarks to which they can compare actual performance.

It's always advisable to be somewhat conservative in your forecasts.

Forecasts Aren't Forever

Noah Parsons writes in How to Better Manage Your Business by Creating a Live Forecast: "You need to revisit and update your forecasts. If your budget and forecasts from the beginning of the fiscal year are static and unchanging, it's hard to see how the changes you're planning on making will impact your business financially. It's also hard to communicate the changes you're planning to make to the rest of your team.

Static budgets don't adjust to new situations and in fact, they become more and more outdated as the year goes on. What may have been small variances at the beginning of the year can become larger and larger as actual results naturally differ.

Once a budget is stale and outdated, it's easy to ignore because it doesn't reflect the current situation your business is in. And especially during a crisis, when things can fluctuate rapidly, you don't want budgets and forecasts that you just ignore. Having them up to date can mean the difference between survival and growth, or mismanagement and dwindling performance."

Projected Income Statement

Business planning starts with sales projections. No sales, no business. It's that simple. Even if you're in a long-range development project that won't produce a marketable product for years, you have to be able to look ahead and figure out how much you'll be able to sell before you can do any planning that makes sense.

Now that the pressure's on, making a sales projection and the associated income projection may look a little tricky. So let's do it step-by-step.

First pick a period for which you want to make a projection. You should start with a projection for the first year. To do so, you want to come up with some baseline figures. If you're an existing business, look at last year's sales and the sales of prior years. What's the trend? You may then be able to simply project out the 10 percent annual sales increase that you've averaged the past three years for the next three years.

If you're a startup and don't have any prior years' figures to look at, look for statistics about other businesses within your industry. The most important question to ask is: What has been the experience of similar companies? If you know that car dealers across the nation have averaged 12 percent annual sales gains, that's a good starting point for figuring your company's projections.

You'll also need to do your due diligence to get an idea of how much volume you can expect and what factors will have a positive or negative impact upon your ability to sell.

For example, how many people can your restaurant expect to serve in a given day? Statistics of other restaurants may be hard to find, so you may have to do some research by simply watching customers enter and leave a similar type of restaurant for a couple of days during the breakfast, lunch, and dinner hours. Once you get a feel for how many people it is drawing on average, you can begin to estimate how many you may draw. Take into consideration your location vs. its location and the fact that it has regular customers who are familiar with the menu.

Statistics you can look at include how many people are within a few miles and what percentage meet your demographics. For example, a family- friendly restaurant wants to know how many families are living nearby, while a fine-dining establishment wants to get statistics on how many people with a higher income are living within a few miles of the establishment.

For retailers, the difficult part is determining how much market share you can expect. You need to factor in the need for your product in a given community, which can range from local neighborhoods to worldwide if you are selling on the web. Volume will be the toughest thing to estimate. Try to remain conservative in your estimates, knowing that you may not be selling a lot of products or services right off the bat.

Forecasting expenses is your next step, and it's much easier. You can often take your prior year's cost of goods sold, adjust it either up or down based on trends in costs, and go with that. The same goes for rent, wages, and other expenses. Even startups can often find good numbers on which to forecast expenses because they can just go to the suppliers they plan to deal with and ask for current price quotes plus anticipated price increases.

Quick Tip

When making forecasts, it's useful to change dollar amounts into percentages. So if you figure sales will rise 20 percent next year, you'll enter 120 percent on the top line of the projection. Using percentages helps highlight overly optimistic sales projections and suggests areas, especially in costs, for improvement.

Projected Balance Sheet

Balance sheets can also be projected into the future, and the projections can serve as targets to aim for or benchmarks to compare against actual results. Balance sheets are affected by sales, too. If your accounts receivables go up or inventory increases, your balance sheet reflects this. And, of course, increases in cash show up on the balance sheet. So it's important to look ahead to see how your balance sheet will appear given your sales forecast.

When you sit down to prepare a projected balance sheet, it will be helpful to take a look at past years' balance sheets and figure out the relationship of certain assets and liabilities that vary according to sales. These include cash, receivables, inventory, payables, and tax liabilities.

If you have any operating history, you can calculate the average percentages of sales for each of these figures for the past few years and use that for your balance sheet projection. You can simply take last year's figures if you don't think they'll change that much. Or you can adjust the percentage to fit some special knowledge you have about the coming year— you're changing your credit terms, for instance, so you expect receivables to shrink, or you're taking out a loan for an expensive new piece of equipment. Firms without operating history can look at one of the books describing industry norms referred to earlier to get guidance about what's typical for their type of company.

Cash Flow Pro Forma

Businesses are very sensitive to cash. Even if your operation is profitable and you have plenty of capital assets, you can go broke if you run out of cash and can't pay your taxes, wages, rent, utilities, and other essentials. Similarly, a strong flow of cash covers up a multitude of other sins, including a short-term lack of profitability. A cash flow pro forma (or cash budget) is your attempt to spot future cash shortfalls in time to take action.

A cash budget differs from a cash flow statement in that it's generally broken down into periods of less than a year. This is especially true during startup, when the company is sensitive to cash shortages and management is still fine-tuning its controls. Startups, highly seasonal businesses, and others whose sales may fluctuate widely should do monthly cash flow projections for a year ahead, or even two. Any business would do well to project quarterly cash flow for three years ahead.

The added detail makes monthly cash flow forecasts somewhat more complicated than figuring annual cash flow because revenues and expenses should be recorded when cash actually changes hands. Sales and cost of goods sold should be allotted to the months in which they can be expected to actually occur. Other variable expenses can be allocated as percentages of sales for the month. Expenses paid other than monthly, such as insurance and estimated taxes, are recorded when they occur.

As with the balance sheet projection, one way to project cash flow is to figure out what percentage of sales historically occurs in each month. Then you can use your overall sales forecast for the year to generate monthly estimates. If you don't have prior history, you'll need to produce estimates of such things as profit margins, expenses, and financing activities using your best guesses of how things will turn out.

The cash flow pro forma also takes into account sources of cash other than sales, such as proceeds from loans and investments by owners.

Cash Flow Pro Forma Is the Most Important Financial Statement

If you have only one financial statement to manage your business by—and to use in your business plan—let it be the cash flow pro forma. Only the cash flow pro forma can tell you how much capital you will need in a startup (add the startup costs, project the cash flow, then make the cash flow positive by providing capital in the indicated amount). Only the cash flow pro forma will tell you when you will need to borrow money— and how much you will need to borrow. Only the cash flow pro forma will tell you when it is time to pull the plug and bail out before you create negative value in your business.

Used as a budget, your cash flow pro forma will keep you from making spontaneous purchases, help evaluate the cost (in cash flow) of growth, hiring new people, adding facilities or equipment, or taking on more debt.

No business can prosper without a cash flow pro forma.

Finding Free Cash Flow Apps

They say there's an app for everything. You can now find cash flow projection templates in popular business applications. They may not be highly sophisticated, but they do provide the templates for several key spreadsheets. Google Docs, Intuit's QuickBooks, Pulse, and PlanGuru are among the places to look for cash flow templates. They can make setting it all up a lot easier.

Positive Cash Flow = Survival

Some key points about cash flow:

Cash flow buys time (if necessary), builds assets and profits, and keeps suppliers, bankers, creditors, and investors smiling. Without positive cash flow, survival becomes questionable. Negative or feebly positive cash flow is painful, and unless corrected will either kill a business or damage it so seriously that it never lives up to its potential. Although short periods of negative cash flow occur in almost every business, cash flows have to be positive at least on an annual basis. Some farmers do very well indeed with cash flows that are strongly negative for eleven months of the year. So do some manufacturers (especially in the garment trade). The key is that they know what their cash flow patterns are—and take steps to finance the negative periods, offsetting that cost against the occasional strong positive cash influx from operations.

Unfortunately, the smaller and more thinly capitalized the company, the less able it is to survive extended negative cash flows. This is one reason why so many startups fail. The business idea may be terrific, but sales always come much more slowly than expected while cash goes out twice as fast. And the initial investment is rarely enough to tide the business along until cash flow turns and stays positive.

How can a small business attain positive cash flow? Discipline. A cash flow budget is an unbeatable tool if followed carefully. If there is to be just one financial statement, make sure it's the cash flow pro forma. It acts at once as a cash flow budget and as a benchmark for sales.

Some people have trouble differentiating the cash flow pro forma from the projected P&L. The concept "profit" is so pervasive that it poses a barrier to understanding that positive cash flow does not equal profit (or vice versa). The example of a profitable growing company with negative cash flow succumbing to illiquidity and tumbling into Chapter 11 bankruptcy is commonly cited to disprove the identity. If the sales don't turn to cash soon enough, the company goes broke. Revenues are up, receivables are up, expenses are up, even profits are up. Yet the company runs out of cash, can't pay its bills, and becomes another cash flow victim.

Another conceptual problem is equating P&L losses with negative cash flow. A loss on the P&L can reflect a negative cash flow, but it doesn't have to. For example, publishing companies enjoy some accounting foibles such as deferred income (which suppresses sales by deferring revenues to a later period). The cash comes in December, but because the revenue is not earned until the following year, the company can show a nice loss for tax purposes, while enjoying strongly positive cash flow.

Some ways to understand cash flow (as distinct from P&L categories) include:

Students are adept at managing skinny cash flows. They postpone bill paying, share space to lower costs, use secondhand books whenever possible (if they have to pay the bill, that is), minimize food costs, and so forth. Few of them think of this as cash flow management, but it is—and of a very high order. If they want a ticket to a concert or ball game, they find a way to scrape up the cash. Very few companies are as carefully managed.
Emphasize timing. Timing is everything for cash flow—the transfers of cash, even the dates that bills fall due or when discounts can or cannot be taken. Although timing is always important in business, it is especially important in managing cash flow. A P&L can stand a bit of looseness—it doesn't matter whether a bill is received January 31 or February 10. That ten days can make a big difference in cash flow if the bill falls due before you have the cash in hand to pay it.
Compare cash flow to a checking account. Cash is deposited (cash inflow). Checks are written (cash outflow). The aim is to always have some cash on hand (positive cash flow).

The cash flow pro forma is the most important single financial statement in the business plan. Every business needs an annotated cash flow pro forma (by month for the first year, by quarter thereafter) reflecting its business idea.

Buzzword: EVA

EVA is an acronym standing for economic value added, and it's one of the most interesting financial management tools available to business owners. The aim of EVA is to find out whether you're doing better with the money you have than you could by, say, investing in U.S. Treasury bills.

EVA has been pioneered by consulting firm Stern Stewart, which has counseled hundreds of companies on how to apply EVA. And experts say that entrepreneurs in particular already understand EVA on a gut level. In any event, the basic concept is fairly simple—you measure EVA by taking net operating earnings before taxes and subtracting a reasonable cost of capital, say 12 percent.

In practice, however, it's complicated. Stern Stewart has identified more than 160 adjustments a company may potentially need to make to accounting procedures before EVA can be effectively implemented. Check them out at sternstewart.com.

How to Make Realistic Financial Forecasts Business plans and financing proposals are based on projections. Here's how to set attainable financial goals.

Key Takeaways

Forecasts Aren't Forever

Projected Income Statement

Quick Tip

Projected Balance Sheet

Cash Flow Pro Forma

Cash Flow Pro Forma Is the Most Important Financial Statement

Finding Free Cash Flow Apps

Positive Cash Flow = Survival

Buzzword: EVA

More in Write Your Business Plan

Section 1: The Foundation of a Business Plan

Section 2: Putting Your Business Plan to Work

Section 3: Selling Your Product and Team

Section 4: Marketing Your Business Plan

Section 5: Organizing Operations and Finances

Section 6: Getting Your Business Plan to Investors