Business' Crystal Ball
Financial projections are
a valuable
tool for business to evaluate ideas
Predicting the Future
Let’s imagine for a moment that every
business had access to a crystal ball. A mystical way, if you will,
for an entrepreneur to determine whether or not to expand his business
and how to finance it. A magical tool used to predict the merits and
possible success of a new business concept. The possibilities would be
endless. No more missed opportunities and failed business attempts.
We all know there are no crystal balls,
but did you know that there is a way to predict the future and answer
business questions like these fairly accurately? It’s called a
financial projection! Hannah Arendt (1906–75), a German-born U.S.
political philosopher wrote: "Predictions of the future are never
anything but projections of present automatic processes and
procedures, that is, of occurrences that are likely to come to pass if
men do not act. . . "
Forecasts
When was the last time you heard
tomorrow’s weather report? If you are like most, it was probably this
morning or last night. Don’t we usually call them forecasts? A
forecast is like a projection in that they both try to predict the
future. The difference is that all the assumptions in a forecast are
expected to occur. In other words, your local newspaper is forecasting
rain tomorrow because warm moist air is expected to move into the area
creating conditions ripe for precipitation. Normally, there are no
hypothetical assumptions.
Projections
In business, usually we are trying to
predict what will happen under a given set of hypothetical assumptions
or "what-if" scenarios. For example, what would a company’s
profitability look like if we added a second shift, assuming current
productivity levels and cost allocations? The hypothetical assumptions
followed the "if." All other assumptions used in such a projection
would be expected to occur given the hypothesis.
A word of caution before we go on. There
is a risk of too heavily relying on projections. The unexpected should
be expected to occur. Be mindful of the remainder of Hannah Arendt’s
quote: ". . . and if nothing unexpected happens; every action, for
better or worse, and every accident necessarily destroys the whole
pattern in whose frame the prediction moves and where it finds its
evidence."
Components of a Complete Projection
In most cases, bankers and investors
expect financial projections for a three-to-five year period in the
future, and historical statements for the past three years or since
inception if the operating period is less than three years. A complete
set of projections should include the following:
Projections for the first prospective year
should be prepared on a monthly basis. Subsequent years should be
projected on a quarterly or annual basis.
The Making of a Good Projection
Before you run off predicting the future
with business projections, keep in mind the adage "junk in, junk out."
If you use unreasonable assumptions and data, your resulting
projections will be a grossly distorted view of a future that will
likely never occur. To create valid and useable projections, you must
first clearly understand the business involved. By adding accurate
historical information, good judgment and lots of experience, you have
a good formula for reasonably predicting the future.
Understand the Business
It is imperative that you understand the
business for which you are attempting to predict the future. You need
to identify the critical factors that will ultimately lead to success
or failure. Research should be done to determine industry standards,
regulatory requirements, regional and national trends, identification
of key competition and the effect of future technological advances.
The entrepreneur should assess the strengths and weaknesses of the
business’ employees and management.
Value of Historical Information
It has been said that the past repeats
itself. This statement would lead one to the conclusion that the best
indicator of the future is the past. Historical financial information
is invaluable in projecting the future. Accountants and bankers who
review projected financial information on a regular basis know the
importance of historical information and place a great deal of
emphasis on it. One should review recent trends experienced by the
business and similar businesses to help develop growth trends for the
future.
Judgment and Experience
Enough cannot be said about the value of
good judgment and experience in deriving financial projections. It
would be wise to have your business projections reviewed by your
certified public accountant or a financial consultant experienced in
this area. Someone familiar with projections can usually spot
assumption flaws, missed costs and other issues to be considered
before you make a commitment or provide your projections to the
intended user.
Consider the 2 x 2 = ˝ rule
There is a rule of thumb called the
two-and-a-half times rule, which states that it's going to take you
twice as long as you think to do something, it's going to cost you
twice as much as you think and it's going to return you half as much
when you're done. How true this rule is depends on how reasonable you
are on the front end. Other common pitfalls to consider while
developing your projections include:
-
using financial projections as a
substitute for business planning;
-
failing the "sanity check" caused by too
much emphasis on faulty facts while failing to recognize matters of
strategic importance;
-
ignoring historic trends or performances
at the company, industry and national levels;
-
overstating market share and growth,
sales forecasts, and profit levels;
-
giving insufficient consideration to
working capital requirements;
-
underestimating costs and delays likely
to be encountered;
-
disregarding industry performance norms
and competitors' responses;
-
ignoring or discounting the validity of
generally accepted financial guidelines and ratios; and
-
making unduly optimistic assumptions
about the availability of loans, trade credit and equity.
Practical Uses for
Financial Projections
The Business Plan -
Financial Projections are a key component of any business plan.
Projections should follow generally accepted accounting standards (GAAS)
and must include properly prepared balance sheets, income statements
and cash flow statements. Bankers and investors are familiar with the
correct content, organization and presentation of financial
statements, and expect to see them in your business plan. Do not cut
corners or attempt to devise your own method of financial and pro
forma statement presentation. It may be wise to consult a certified
public accountant to help you with the proper accounting presentation.
Obtaining financing - Financial projections show lending
institutions what to expect from a particular business or business
concept. In fact, just going through the process often improves the
chances of obtaining financing. It demonstrates to lenders or
investors that you are committed to the future of the business. The
process of preparing financial projections can also shed light on
potential problem areas in the business. Another side benefit of
developing financial projections is that it forces everyone involved
to look at what lies ahead and make plans based on the results.
Buying or selling -
Financial projections are extremely valuable when buying or selling a
business. As a seller, projected earnings can help ensure that the
desired price is obtained for a business. Conversely, if buying a
business, a projection may help decide if this is the right business
at the right price. Either way, they can be used as a bargaining tool
and as a good indication of what the future may bring.
Computers and Software
In today’s information age, it is almost a
requirement to develop financial projections on a computer. The main
benefit of using a computer is the ease of calculations and the
ability to run multiple "what-if" scenarios quickly. Spreadsheet
software, such as Microsoft Excel and Lotus 1-2-3, has
been developed with this particular purpose in mind. Spreadsheet
software is generally easy to use and can be customized to fit almost
any projection need. There are also packaged software applications
specially designed for developing business plans (including financial
projections) that could be beneficial under the right circumstances.
Conclusion
Projections are a valuable tool for
businesses to evaluate ideas before large investments and commitments
are made. How many bankruptcies could have been prevented? How many
millions of dollars saved or made? Just by having a glimpse of the
most likely result of a set of assumptions, it can happen. Although
there is no way for anyone to completely predict the future, it should
not keep you from trying.
About the author:
John B. (Jay) Hoover, CPA, is a managing
member of Baker, Sullivan & Hoover, PLC, a certified public accounting
firm in Nashville, TN. Hoover is a member of the Tennessee Society of
Certified Public Accountants and serves on its Small Business
Committee. TSCPA’s Small Business Committee works on a statewide level
to organize and implement programs to provide assistance to small
business enterprises. For more information on small business issues,
visit the TSCPA’s Small Business Resource Center on the web at
www.tncpa.org.
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