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Persuasive Projections
Predicting the future is never easy.
But by following these dos and don'ts for financial projections, you can
avoid some common mistakes
By Paul
A. Broni
It doesn't matter
whether you're applying for your first bank loan or your fifth, or whether
you're seeking venture capital or debt financing. Sooner or later, you'll
have to prepare a set of financial projections. Lenders will look for
a strong likelihood of repayment; investors will calculate what they think
is the value of your company.
In my past 10
years both as a banker and as a financial consultant, I've seen many entrepreneurs
-- despite the best intentions -- make mistakes on their projections.
The good news is that the most common mistakes are easily preventable
if you know what to look for. Here are my top dos and don'ts:
- Don't
provide only an income statement; include a balance sheet and a cash-flow
statement, too. It's understandable that you're focused on sales
and net income, but your banker or investors will also want to know
how much money you intend to leave in the business as retained earnings
and how much additional debt or equity financing you'll need -- if any
-- to grow your company.
- Do provide
monthly data for the upcoming year and annual data for succeeding years.
Many entrepreneurs prepare projections using only monthly data or only
annual data for the entire three- or five-year period. Don't. Use monthly
data for the first year. After that, use annual data. The financial
results of your first year will probably end up being different from
your projections, so there's no point in thinking that you can accurately
forecast monthly results for the years after that. This is an instance
where less is more.
- Don't
provide more than three years' worth of projections unless your lender
or investor has asked for them. This is an extension of the less-is-more
concept. Let's face it: it's a stretch to accurately forecast your company's
sales or net income for even three years out. Only in cases in which
you're looking for long-term financing for equipment or real estate
is it likely that your banker will want longer-term projections.
- Don't
provide more than two scenarios in your projections. Loan officers
and investors are already drowning in paperwork, so do what you can
to make their lives simpler. We've all seen projections with the following
three scenarios: base (or likely) case, worst case, and best case. I've
also seen super case and break-even case. My advice is to prepare just
the base case and the break-even case. The base case should show what
you realistically expect the business to do; the break-even case should
show how low sales could go before the business begins to lose money.
- Do ensure
that the numbers reconcile. Everybody knows that assets must equal
liabilities plus equity. But all too often entrepreneurs will simply
plug a figure into the equity slot to make things settle up. That's
wrong. If your bank is doing its homework, your banker will check the
math. If the equity numbers don't add up from one period to the next,
you'll be asked to explain. Even though everyone makes mistakes, that's
one you want to avoid because it makes you look sloppy. Also, if after
the mistake is corrected your company has a smaller net worth than you
originally presented, your banker or investor may think you were being
intentionally misleading. Not good.
- Don't
be too optimistic about sales growth or gross and operating profit margins.
All bankers and investors want to do business with ambitious entrepreneurs,
but there's a big difference between a realistic business plan and fantasy.
While it's true that companies that have low revenues can grow their
sales quickly in percentage terms, it may not be realistic to assume,
for example, that your business can double in size every year. That
rate of growth would turn a $500,000 company into a nearly $16-million
business in only five years. And although that can happen, it
is definitely not the norm. Also, entrepreneurs often try to convince
lenders that as their company grows it will achieve economies of scale,
and gross and operating profit margins will improve. In fact, as the
business grows and increases its fixed costs, its operating profit margins
are likely to suffer in the short run. If you insist that the economies
can be achieved quickly, you will need to explain your position.
- Do account
for reasonable interest expense on the income statement if you have
debt on your balance sheet. That sounds simpleminded, but you'd
be surprised to learn how many people forget to do it. If you expect
to have an average loan balance outstanding of, say, $500,000 over the
year, and your forecasted average interest rate is 9%, you need to budget
$45,000 for annual interest expense. Don't budget less than a realistic
amount; this is one line item where you're always better off coming
in under budget.
- Don't
include every individual line item for each expense, asset, and liability
figure. Although your banker or investor will probably be interested
in knowing details about sales from major product or service lines,
as well as the direct cost of sales associated with them, keep to the
basics in other categories. With operating expenses, those would be
salaries and payroll taxes, lease and rental expenses, depreciation,
amortization, and any other kind of expense that consumes more than
10% of revenues. Also, don't forget to distinguish the owners' compensation
from that of nonowners, particularly if you and your co-owners are drawing
above-market salaries as a means of reducing business income taxes.
With assets,
focus on cash and investments, accounts receivable, inventory, the
major categories of fixed assets (including capital-lease assets),
and any amounts due from shareholders or affiliated companies. Also,
be sure to include any other assets that you consider material, such
as patents or licenses.
Identifying
liabilities is straightforward. You should have one line item
for all accrued expenses and a line item for each of the following:
accounts payable, a revolving line of credit, term loans, capital
leases, amounts due to related parties, dividends payable, and income
taxes payable. Finally, if your business has deferred revenue (meaning
that you collect cash from your customers before having actually earned
it), add a line for it in liabilities as well.
- Do include
with your projections the assumptions that you used, and be able to
explain and defend them. In addition to the income statement, balance
sheet, and cash-flow statement, you should provide a one-page summary
that explains your assumptions about revenue growth; cost of goods sold;
operating expenses; interest expenses; turnover of accounts receivable,
inventory, and accounts payable; capital expenditures; dividend policy;
and income-tax rates. Also include any ancillary information that has
an impact on the financial success of your business. Examples of that
might be your projected employee head count and office or warehouse
space requirements.
Paul
A. Broni is a managing director of Mercury Partners, a finance and
business consulting firm in Rockville, Md.
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