Making Financial Projections
Reviewed, August 2009
Vincent Amanor-Boadu, Ph.D.
Department of Agricultural Economics
All business is about the bottom line, period! Regardless of the lofty rationales of social good and community well-being, if the financial outlook is bleak, nothing else happens. A former chairman of IT&T, Harold Geneen, is quoted as saying “to be good at your business, you have know your numbers – cold.” While this may be oversimplifying a very complex activity, it is important for stakeholders in the business to have a clear and cold view of the “numbers.” Financial projections are just what the name is – projections. They relate to the future and differ from accounting numbers which are based on the past. The purpose of financial projections is show what the business is capable of realizing in revenues and profits, given the assumptions about its potential costs, market size, prices, etc. We also use the financial projections to develop a series of ratios that help us make economic and financial judgments about the business’ potential – growth patterns, return on investment, return on equity, required investment, financing methods, etc. Because of the temporal effect on business success, it is important to conduct the projections are over a reasonable time frame. For example, if the plan is about starting a specialty orchard, the financial projections should cover the period from planting to marketing fruits – about five to 10 years. However, if it is about making a specialty baked product, then a three-year outlook may be acceptable.
The major aspect of financial projections is their assumptions. They rely on assumptions about activities in the functional segments of the business. For example, how much production is going to occur and what is the unit cost of production? What are the input prices that will confront the company and how much are its customers going to pay for the product? We may assume particular market conditions (from the market analysis) that allow us to make certain statements about prices, quality and volumes which will influence the financial projections we make.
Articulating and specifying the assumptions allows for them to be challenged and improved. Testing these assumptions against industry conditions is always helpful. For example, identifying the industry’s best cost of production may facilitate specific assumptions to be made about the business’ production cost. Similarly, the going price for the product or its substitutes offer some credible foundation about assumptions made about prices. Indeed, assumptions underlying the business plan will be judged by known information about those variables.
Many financial projections are presented as if they are accounting information, but nothing can be more misleading. In developing financial projections, it is important to recognize the impreciseness of the assumptions underlying the projections and therefore present some indications of the risks of being wrong. In the Future Beef Operations’ case, it was assumed “profit margins will be $266 per head compared to an industry average of $125.” Is the $266 average, and if so, what was its estimated standard deviation? The distribution information around estimates will help stakeholders, especially management, appreciate the extent of the risks associated with the initiative so ameliorative steps can be taken to address them.
It is strongly suggested that financial projections are developed using a spreadsheet because of the flexibility it provides. The approach suggested is to begin with the assumptions table, which explicitly specifies all the assumptions that are going to be used in the projections: sales, prices, production costs, marketing costs, equity, interest rate on long-term debt, equipment productivity, number of employees in specific areas of the value concentrics, wages, marketing, etc. The assumptions table feeds directly to the financial projections for the income statement, balance sheet and cash flow statements. The assumptions table should also provide information on the perceived distributions for the numbers so that their impact on the financial results can be assessed. Finally, they should also feed into the scenario worksheets so that it can capture the “what if” results and compare them to those related to the mean or average assumptions. The principal advantage of a spreadsheet is its ability to allow us to quickly make changes and get instant results without having to redo things. This approach is summarized in Figure 6.
Different software products have been developed to facilitate most of the tasks associated with financial projections. Some of them will not only present the results in preformatted tables of financial statements, but will graph them and report ratios as well as scenario analyses results. Additionally, there are online tools that help with the preparation of financial projections. For example, Kansas State University’s Ethanol Prefeasibility Evaluator allows an assessment of the feasibility of an ethanol plan using alternative assumptions. This tool can provide significant inputs for the assumptions table if the business is ethanol production. Because of the increasing ease of access to tools for developing financial projections, there is now little or no justification for not preparing comprehensive business plans that provide the fundamental information required by different stakeholders to make sensible, credible, and effective decisions.
Figure 6: Summary of Developing Financial Projections
The accuracy of financial projections is extremely important for a new business because the organization’s future is going to be influenced by decisions made using these projections. For this reason, it is very important that those developing these projections pay critical attention to their assumptions, and challenge the distributions that are applied to variables. Thus, they should not only know how to put financial projections together, but also how the business functions in its marketplace – from input supply, through processing and outbound logistics, to the consumer marketplace, as well as how decisions at each stage are made. Thus, the cascading approach assumes that the financial projections are developed only after the organization’s functional analysis is completed, because its strategies will be clear then.
Given all the assumptions supporting the financial projections, it is important to know the “critical control points” for specific variables and their implications for the business. For example, what levels of sales will cause cash to decline to a point where the company has difficulty meeting its short-term financial obligations? This links the income statement to the cash flow projections and provides insights into where periodic hurdles are in the organization’s life. It also allows management to prepare for such declines so that they can take ameliorative actions to minimize their impact on the organization’s finances. Because of seasonality in sales and other variables, it is prudent to present the financial projections for monthly, quarterly and annual formats. This can provide insights into how the “critical control points” for different variables can be managed in the short-run to ensure long-range projections are achieved.
As indicated earlier, different stakeholders of the business may have different expectations of information. For this reason, it is important that the information developed in the financial projections sessions are organized to different levels of aggregation for the different stakeholders. For example, while the banker might be particularly interested in the cash flow statement, the investor will probably be more interested in the annual rate of return on investment or the balance sheet. Investors will be interested in assessing the internal rate of return for the investment since it measures their compensation for the risk that they bear with the investment. Similarly, the net present value from the investment will be of interest to investors, bankers, managers and other stakeholders because it determines the worthiness of the time value of their investment. Management and other stakeholders may want to compare the projected return on sales and other profitability ratios to the industry norms to determine how the company stands among its peers. This comparison may lead to a review of strategies, assumptions and other pertinent planned decisions.
In summary, the financial projections are driven principally by the assumptions that are used to develop them. Therefore, it is only prudent to state assumptions clearly and present then in a format that allows others to challenge them as well as understand their direct and indirect impact on the projections. Additionally, analyzed scenarios must be presented along with their results and associated changes in assumptions. These allow transparency in how strategies influence financial and other business performance indicators. Indeed, in the process of developing the projections, it may become necessary to revisit the strategies section because of incongruity between certain strategies and the projected results. This suggests that the functional analysis step and the financial projections step of the strategic business planning process may be iterative. Planners should not be resistant to this iterative approach because the real world is hardly certain in any dimension.