Business' Crystal Ball

Financial projections are a valuable tool for businesses to evaluate ideas

by John B. (Jay) Hoover, CPA

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:

Balance Sheets
Income Statements
Cash Flows
Financial Ratios
Sources and Uses of Proposed Funds (borrowed or invested)
Tax Analysis
Summary of Significant Assumptions

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 = ½ 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 to 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 the managing partner of Baker, Sullivan & Hoover, PLC, a certified public accounting firm in Nashville, Tenn. Hoover is a member of the Tennessee Society of Certified Public Accountants, the state professional organization for more than 8,000 CPAs in government, education, industry, business and public practice and its Nashville Chapter. TSCPA's Nashville Chapter is one of eight chapters across the state with more than 2,900 members in 20 counties. For more information on small business issues, visit the Tennessee Society of CPAs' Small Business Resource Center on the Web at www.tscpa.com.