Financial Projections Explained (Even If You’re Not a Numbers Person)
If you missed my post on financial vocabulary for people who hate numbers, I recommend starting there. It’s where I explain financial terms in plain, easy-to-understand English.
Numbers not your fave?
Perhaps you’re the kind of person who would rather avoid this part of your business and let someone else deal with it… the ol’ “Let’s not and say we did” strategy.
As much as you may not want to hear this, it’s crucial for you to learn the basics. That way you’ll understand what your bookkeeper, accountant, CFO or investors are talking about. And it’s an absolute necessity if you’re going the DIY route.
Today’s post is the next in my series designed to help you not only get comfortable with financial projections, but understand them.
I promise I’ll take it slow.
Before we dive in…
I tend to use the words statements and projections interchangeably, but I don’t mean to mislead you. Even though it’s a common practice (sorry!), it’s important that you know the difference.
Statements typically refer to historical financial information. Projections refer to future, estimated financial information.
Startups always use financial projections at the outset. Once you launch, your accountant will prepare statements for you to see how your business performed (financially) during a previous time period.
I also use the terms statements and spreadsheets interchangeably here.
The spreadsheets I use.
When it comes to business plans and pitches (including pitch/slide decks) there are five spreadsheets I use. In the interest of taking it slow, I’m going to begin by simply naming them.
1. Equipment List*
2. Balance Sheet*
3. Profit & Loss Statement (also known as a P&L or Income Statement)
4. Cash Flow Projections
5. Sources & Uses of Funds
*Used with some (but not all) startups.
However… not every spreadsheet is relevant.
Not every spreadsheet is relevant to every startup. For instance, there are times when an equipment list or a balance sheet may not be necessary. Here’s what I mean.
Some startups need to purchase equipment and some don’t. For example, if you’re opening a bakery, you may need to buy refrigerators, ovens, display cases, etc. If you’re building an app or consulting business or you’re outsourcing the manufacturing of your shoe line, then an equipment list is likely irrelevant.
Balance sheets, among other things, list assets and liabilities. Since most startups have neither when they launch — because they’re starting at zero, yes? — then a balance sheet is typically irrelevant. (More info on what a balance sheet is will follow later in this post.)
Why no Breakeven Analysis?
You may have noticed that a breakeven analysis isn’t on my list. That’s because I don’t think it’s especially helpful for startups.
Financial projections are, by nature, educated guesses; but as far as I’m concerned, doing a breakeven analysis for a startup is simply a wild guess. In all the years I’ve been advising startups, I’ve never had an investor ask for one.
The five spreadsheets explained.
Now that you know what the five spreadsheets are, I’m going to explain why they’re so useful. You may be thinking they exist only to torture you, but I swear that’s not the case.
So let’s take a closer look.
1. EQUIPMENT LIST
An equipment list itemizes the name, model, and cost of each piece of capital equipment needed for your startup. Capital equipment is used for the manufacturing, delivering, storing or selling functions of your business, but doesn’t include equipment that’s replaced annually (or more frequently), and doesn’t include anything you sell to customers (like power tools if your business is a hardware store — that’s inventory).
Why it’s useful: It forces you to identify the equipment your business requires, as well as how much it will cost to purchase, deliver, and install it.
2. BALANCE SHEET
A balance sheet lists the assets, liabilities, and equity of a company, and is used to calculate how much the business is worth. The balance sheet is a snapshot in time — a single moment in time — as opposed to profit & loss or cash flow statements, which show a period of time.
Why it’s useful: It shows what a company owns and what it owes, even if only for a single moment in time.
3. PROFIT & LOSS
A P&L shows when sales (also called revenues) and expenses are incurred during a specified period of time. It’s based on the most fundamental accounting equation: Revenues – Expenses = Income.
In other words, a P&L shows your sales, the expenses related to producing or buying what you’re selling, and the expenses related to running your business.
Why it’s useful: It shows how much money was made (profit) or lost (loss) during a specific period of time.
4. CASH FLOW
Think of the cash flow statement as your company’s checkbook register, but in the form of a spreadsheet. Cash flow statements show exactly when revenues and expenses flow into and out of your company’s bank account during a specific period of time (as opposed to profit & loss statements, where they appear as of the invoice date — more on that later).
Why it’s useful: It shows your startup’s ability to pay its bills. In fact, I think this is the single most important spreadsheet for any business.
5. SOURCES & USES OF FUNDS
The name describes it perfectly. On the spreadsheet the sources section shows who is loaning money to or investing in your startup (and how much). The uses section shows how you plan to spend that money.
Why it’s useful: It shows how much money is needed to launch your startup and where that money (or capital) is coming from.
IMPORTANT: Your cash flow projections and (if relevant) your equipment list need to be done before you can complete this spreadsheet.
The importance of being realistic.
Many startups build their financial projections with the goal of raising money or securing a loan. Every entrepreneur believes deep in his or her heart that their business will be a success, but if you’re operating under the assumption that if you build it, [they] will come* then you’re doomed from the start.
A seasoned investor or loan officer can spot unrealistic assumptions a mile away; and if you’re self-funding, what good will it do to be unrealistic?
So being realistic, even pessimistic, is a must.
More importantly, your assumptions need to be defensible. That means you have to be able to explain and defend them based on sound reason, not emotion. You may be surprised, but this is more important than the numbers themselves. Investors are focused more on how you think than on the numbers in your projections.
Another way to think of it: investors invest in people rather than ideas.
Finally, your numbers need to support your story. You can’t talk about your plans for product development without allocating funds to cover prototypes (for example). So be sure that your story and your financial projections are consistent with each other.
*Field of Dreams, 1989
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