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Bottom up: The value of financial projections

Morris Kaplan
Smarter Writer

Morris Kaplan is a former finance and venture capitalist who writes for entrepreneurs and professional services firms

Morris Kaplan
Smarter Writer

Morris Kaplan is a former finance and venture capitalist who writes for entrepreneurs and professional services firms

The problem with projection is that it is based on forecasting, which is far from being an exact science, so smaller and under-capitalised businesses must think from the "bottom-up"

In the world of venture capital and private equity investing there is a mantra: beware of the top-down projection. This is where the visionary entrepreneur simply takes a global market number and projects a tiny market share as their projection of future revenue. This is silly, and if the intention is to make up numbers that look good to investors, it is counterproductive and will end up ruining any application for funding.

piggy banks racing

The harsh truth about projections

Increasingly, the same applies to bank finance. Many business owners have been used to operating their business accounts with a degree of leniency from the bank. Often a phone call to a bank asking for a line of credit for $10, $20 or $50,000 was considered on a customer’s credit history. Today any application for funding, particularly for funding in excess of $100,000, will require a comprehensive statement of financial affairs including cash flow and P&L projections.

When it comes to financial projections know that bank managers and investors don’t believe your financial projections, whatever they are. So it’s best to at least look sensible.

The point of financial projections is to tell a story with numbers and to get the reader across the line whether they are a bank or an investor or a future partner. The other party isn’t interested in the precision of the numbers, but he or she is interested in what the numbers say about the viability and sustainability of your business, and if it’s to support a loan application, the business’s capacity to repay the debt.

The pillars of projections

Your projections must be defensible and based on sound bottom-up data. That is, there must be a foundation for them. If the business is a start-up then the projections need to be based on realistic forecasts of activity. If the business is going to go from zero to $1 million in 18 months, then what resources (sales force, marketing budgets, supply chain costs, material and capex and the like) are needed?

Here are two approaches:

  1. One for presenting your five-year financial projections which are long term and which determine the capital equipment and assets needed to go forward.
  2. The other being for presenting your 12-month operating plans which will have at its core the cash funding requirement to meet the plan and which should therefore have a month by month cash flow.

The five-year forecast – although far less reliable than a 12-month forecast – is necessary to make explicit the driving factors behind your revenues and expenses as you move through start up and growth and demonstrating a clear understanding for what is required in terms of product development, market penetration and head count. As Lewis Carroll once said, “If you don’t know where you’re going, any road will get you there.”

“Bottom-up” is not a difficult concept to grasp: it’s brick by brick, sale by sale, employee by employee, rather than building a model from the top down.

Validating assumptions

Sometimes you don’t have the foundation for a projection. This is where research can play a role. Some industries will have benchmarks for such categories as gross margins or the typical spend on marketing.

For example, you might find that most companies spend 25% on sales in your category.  This can therefore be a defensible target on any projection.

We all overestimate how much we can accomplish in a month. Make sure your projections are tempered by real world experience. If your industry has listed companies operating, then their financial statements can represent business models similar to yours, letting you to get an idea of what is realistic. If your projections are wildly different than other highly successful companies, then your assumptions are probably off.

The job as business owner as well as the job of banker or investor is to test assumptions. That is the basis for projections. They need to be tweaked, and often.

The numbers must survive simple questioning

  1. Do the capital requirements shown in your projections match the funding you are asking for?
  2. Do you know how many customers you have to land to generate the revenues you are projecting?
  3. Do you know how long it takes and how much it costs to acquire a customer?
  4. Do you know what resources will be required to support customers?
  5. Do you know how much you will have to spend to stay ahead of the competition with your product or service offering?

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