Your financial forecast includes your best guesses about the future of your business based on a set of assumptions about what you expect to happen down the road. A carefully thought-out financial forecast can help guide many of the decisions you make, from hiring new employees to managing your inventory.
It can also help you know how much money you need on hand, called your cash reserve. A cash reserve is one important way businesses plan to weather economic storms. It contains money you can draw on at any time to meet operating expenses in case of a shortfall in revenues.
When business is going well, it’s always wise to build up your cash reserves. When you start a new business, many experts advise that you have a reserve equal to at least six months of your projected expenses. The more conservative you are in your projections — and the more cash you can set aside — the stronger your position in the event of a downturn.
How much is enough? Your financial forecast can help guide you to the best answer. Here are descriptions of the three basic parts of a financial forecast and tips on how to make the most informed estimates.
Pro forma income statement
Pro forma is one of those Latin phrases that sounds more complicated than it is. In this case, pro forma refers to anything you’re going to estimate in advance. So your pro forma income statement estimates your revenue, expenses, and profit: one, three, or even five years in the future.
You may even want to subdivide the first few years into quarterly projections to allow you to monitor progress in short-term increments during the early days of your company’s life. To estimate your financial future, start with these steps:
If you’ve been in business for a while, get together past income statements to serve as a starting point in making future projections.
If you’re just starting your business, you won’t have a financial history to fall back on. Instead, search out people in similar businesses, go to trade shows, do online research, and find consultants who can give you guidance. It’s work, but if your financial projections end up close to the mark, the results will definitely be worth it in the end.
Carefully consider every business assumption that goes into your financial forecast. Make sure you know what each one is based on. For example:
If you’re assuming that the economy will grow at a given rate, state the growth rate on which your plan is based.
If you believe that you can raise the cash you need from at least three different funding sources, be specific.
If you’re almost certain that a new technology is going to completely change the way your industry does business, explain your reasoning.
If you think competition will increase in a certain segment of your market, say so.
At the end of each quarter or year, take time to go back to your pro forma income statements to compare actual financial performance with projected performance. Make notes indicating where you were right and wrong. After all, practice makes perfect.
Estimated balance sheet
The difference between an estimated balance sheet and the real thing is that the estimate projects what you will own, what you will owe, and what your company will be worth year by year — looking ahead four or five years. Projecting those numbers sounds tough, and it is. Do it anyway. Even if your projections prove to be less than perfect, they provide you with a financial road map.
Start by listing the assets you think you’ll need to support the growth you’re looking forward to. Then think about how you’ll pay for those assets, and that means making major decisions about how much debt you’re willing to take on, what company earnings you’ll be able to plow back into the business, and how much equity you need to invest in the future.
Projected cash flow
Want five good reasons to project your cash flow? Well, here they are. When you have a good sense of how cash will flow in and out of your business, you can
Anticipate inventory purchases to meet seasonal business cycles.
Take advantage of discount- and bulk-purchasing offers.
Plan equipment and building purchases to meet your growth needs.
Arrange financing if you’re going to need it — whether that means recruiting investors, assuming long-term debt, making a personal loan, or establishing a short-term line of credit with your bank.
Stay in control of your finances by anticipating cash needs before they arise and meeting obligations in an organized, timely way.
Many large companies do five-year cash flow projections.
Without a financial forecast, your business plan is incomplete. In the financial review section of your plan include your pro forma income statement, estimated balance sheet, and projected cash-flow statement along with the business assumptions behind your projections. Then review and revise your forecasts on a regular basis.
Your financial forecast just happens to be one of the most important — and fragile — parts of your business plan. Be able and willing to change it when the business circumstances around you change.