Financial projections – need or obligation?
Updated: Mar 9, 2020
I am surprised to see that often enough the managers or entrepreneurs asking for financial projections fail to see their purpose. How often have you seen projections that were drawn just because that was the requirement from investors or potential partners? How often have you sensed that the company representatives put pressure on those building projections to ensure that numbers look good?
The way I see it, this is deceiving both for potential partners and the organisation. The time put into building projections is reflective of the management's commitment, of the organisational culture and the attention given to the business strategy. It is unreasonable to expect an employee or consultant to build such projections without input from those running the business. It is also against the interests of the company.
First of, creditors and investors will challenge estimates which will end up being a time consuming process for both parties with the end result being mistrust in the company.
Secondly, projections should be seen as a great opportunity to test the business model and show cast your readiness. Financial projections are just another way of presenting your story - your value proposition, your product market fit, your marketing channels, your operational strategy all need to be reflected into the financial model. It is a two-way process in the sense that:
on one hand, building these forecasts might determine one to reconsidering some aspects of the strategy;
on the other hand, the exercise adds clarity and serves in setting objectives. You know with added precision what to aim for and what to keep track of along the process. For start-ups or cash strapped companies it also serves to estimate the runway.
In my opinion trustworthy estimates have several characteristics:
They are built by incorporating the performance metrics monitored on an ongoing basis. Whilst the exact approach will depend on the profile of the business the aim is to build on data that reflects your customer experience, engagement, retention etc. This will ensure consistency with the company’s strategy and contribute to effective objective setting. See the circularity here? When setting objectives you have to be specific and to be specific you have to understand how figures influence each other. Feed your focus because that will drive your actions and determine your outcome. Targeting a revenue of x mn does not count as a good objective and building a P&L forecast on a top-of the head revenue estimate is not a good approach; they both have to be linked to your value proposition. More about objective setting here.
They account for different client categories if applicable and they reflect sector/market expectations; growth doesn't happen in a vacuum and you should seek to identify market trends.
They highlight the main assumptions and how these were tested (or will be tested).
They include stress testing of main variables and they serve to identify execution risks.
They are based on consistent assumptions; fixed costs are a common source of noise as some forecasts unrealistically assume that they will remain unchanged even as the revenue increases significantly ( in this scenario one might need additional staff, space, marketing, different software, higher automation, IT resources etc).
They cover a period appropriate for the maturity of the business and of the market; it is hard for instance to build accurate 10 years projections in a fast changing market or for an early start-up;
They include income, balance sheet and cash flow forecasts which are consistent with each other.
In a nutshell, building a projection should be seen as an obligation for growth planning not as a part of a fund-raising process disconnected from business planning.
"I think that intelligent forecasting (company revenues, earnings, etc.) should not seek to predict what will in fact happen in the future. Its purpose ought to be to illuminate the road, to point out obstacles and potential pitfalls and so assist management to tailor events and to bend them in a desired direction. Forecasting should be used as a device to put both problems and opportunities into perspective" (Peter Condill)
Oftentimes a third party might be involved in building the financial model but this shouldn't mean a complete delegation of responsibility. Collaboration and open communication is needed to fully understand the business model, collect the relevant data and build a model that can really help the company.
Will your stakeholders take your forecasts for granted? Probably not. Oftentimes they do expect realized figures to deviate from estimates and yet what matters is that you planned diligently and that you have a strategy rather than just some ideas. Don’t let perfect be the enemy of the good. It is fine to refine estimates as time passes and new information becomes available; the new an old numbers will be part of the decision making process.