Financial projections

For new businesses, financial projections are essential to the business planning process.

And for established businesses, financial projections are an important part of the annual budgeting process and managing your business performance. They also play an important role in long-term planning and corporate development. 

A set of financial projections is a financial model.

Every financial model will be different because they depend on the business, its circumstances and the intended use and purpose.

Financial models are used by businesses in different situations. This includes:

• The annual budgeting process
• Finance raising
• Viability reviews
• Capital budgeting
• Acquisitions
• Disposals
• Scenario planning

When raising finance, your financial model is used to help determine:

• How much money you need
• How and when the funding will be used
• The value of your business

From a funder’s perspective, the financial model helps validate the financial opportunity.

If you're using your financial model to raise finance, it's a good idea to have an integrated financial model. This would have a profit and loss account, balance sheet and cash flow statement. This ensures that the output of the model is in a format that funders are used to seeing. It also provides the information they need when deciding whether to fund your business.

This integrated model is also very useful for monitoring, controlling, and managing your trading performance.

There are three stages to develop a financial model from scratch. It involves planning, building and testing.

1. Planning

Before you start developing a financial model, understand its intended purpose and develop its specifications around this purpose.

As an example, a financial model for attracting external funding will have a different focus to a model for appraising a new product launch.

A model’s content and format should be tailored to reflect its strategic purpose and objectives. It also needs to meet the needs of its audience to ensure maximum impact.

Determine what timespan the model will cover and whether this will be on a weekly, monthly or annual basis.

When creating a model for fundraising the typical format could be monthly for a period of up to five years, depending on the nature and purpose of the funding and what the potential funders require.

A key part of the planning process is to ensure that a clear list of forecasts (assumptions) are prepared as these will form the basis of the financial model. These will include factors such as:

• Sales volume
• Pricing
• Direct costs
• Gross margins
• Headcount
• Payroll costs
• Overheads
• Capital expenditure requirements
• Customer and supplier payment timings
• Funding structure and cost
• Taxation rates
• Inflation

Your financial model should also reflect the current economic and competitive environment.

Examine your assumptions thoroughly and they should reflect your business and its circumstances. They need to be realistic and supportable, and ultimately, must be able to stand up to rigorous scrutiny.

2. Building

Once you've decided the format and timespan, and listed the assumptions, you are ready to build the model. While every financial model will be different, all models need to have the following characteristics:

• Consistency – keeping the format consistent not only makes it appear more professional, it also makes it quicker to create and easier for the reader to understand
• Standards – you need to have a working set of financial statements as your model's output and make sure these are based on current accounting standards
• Simplicity – your projections should be created using basic arithmetic and formulae. The aim is to produce a model that is transparent and easy to understand
• Flexibility – your model should be flexible enough to allow key assumptions to be changed quickly. The impact of these changes should be easy to see and measured

3. Testing

The testing and review stage of preparing a financial model involves checking the integrity and logic of the model to ensure it works correctly. It should also involve testing of a range of scenarios to work out its sustainability and the underlying risks.

Putting together worst-case projections to go with most-likely or best-case forecasts are always helpful, especially for a new business without any trading history.

By testing the robustness of your model, you help potential funders understand the relationship between variables. It also shows you have a full understanding of the competitive environment and gives confidence to potential funders who are thinking about investing in your business.

Potential funders will perform their own sensitivity analysis on your financial information, so it's important that you have a clear understanding of the key risks.

It's also important to have risk mitigation strategies in place, where appropriate, to show that your projections have been well thought-out and thoroughly tested for robustness.