How to Forecast Revenues and Expenses for Realistic Financial Projections
I think we can all agree that financial projections are a key tool for any startup. More often than not, though, founders view them as a “necessary evil.” Which is a shame, really, since they provide benefits that help ensure your startup not only survives, but grows to healthy profitability.
Good estimates help you avoid business-crippling problems like running short on cash or getting your pricing wrong. They’re your secret weapon for heading off unpleasant “rookie mistakes” in every area of your larger financial picture — cash flow, profit margins, budgeting and more.
But they can also play an important role in winning over investors. That’s because for them it’s more about the thought process behind the numbers than the numbers themselves. When it’s clear you’ve thought through all the important factors, trust levels go up.
So let’s take a look at how to estimate revenues and expenses for your financial projections and set your business up for success.
The importance of educated guesses.
At the end of the day, your financial projections will only be as good as your assumptions. By definition, financial projections are estimates or forecasts of what you’re expecting to happen financially in your business. When it comes right down to it, they’re guesses about the future.
However, the fate of your business depends on how educated — how informed — your guesses are, which is why you need to put on your critical thinking hat rather than pulling numbers out of thin air or falling back on wishful thinking.
No one — not even investors — expects financial projections to be 100% accurate. What they do expect is that they’re thorough, reasonable, realistic and that you’re able to justify them. In fact, the more attention you give this process, the more realistic your numbers will be, leaving you with fewer unhappy surprises down the road and better odds of success.
How to estimate revenues.
When it comes to estimating, it’s all about the details. That means your revenues can’t just be a lump sum that shows how much money you expect to come in. Instead you’ll need to show:
- Separate line items for each product and service you’re offering (or category of products and services).
- Separate line items that account for refunds, returns and discounts, if they’re relevant to your business.
You’ll do a much better job of this if you do some legwork and talk to vendors, suppliers, prospective customers — and yes, even your competitors. The advantage is that you’ll learn more about what you need to factor in and what you should expect when the rubber hits the road. You may even learn a few things to help improve whatever it is you’re selling (and how you’re selling it).
You’re not expected to know everything about financial projections at the outset — but in order to succeed, you need to be continually learning how the financial side works.
How to estimate expenses.
The good news is that estimating expenses is easier than estimating revenues. That’s because expenses are based on things that other people sell, so you can research actual numbers. It still takes some legwork, but the payoff is worth it because you’ll have more realistic numbers in the end.
So go ahead… call the waste management company, the Internet service provider and the credit card processing company. Call a few website developers. Call some insurance agents to find out what kind of liability premiums you should expect.
Another benefit to making these calls: you’ll be able to identify companies with competitive prices and great service. If you’re not sure who to call, ask friends, acquaintances, even people in your industry who you’ve never met. If you want to speak directly with a supplier, go ahead; there’s no reason to be shy. You may be surprised by how helpful people are, even competitors.
As you’re pulling together your revenue and expense numbers, don’t forget to account for cyclical patterns that occur during the year. For instance, retail sales are typically higher around holidays, especially at the end of the year. If your business relies on fuel for, say, delivery vans, prices tend to be higher in summer than in winter. By staying on top of the natural rhythm of your industry, your estimates will improve.
Two tips to help keep your projections realistic.
Before you get started estimating your revenues and expenses, there are two things you can do that will help make things easier for you.
1. Connect with your inner pessimist.
As an entrepreneur, you’re naturally programmed to believe that your new business will be a resounding success and people will eagerly buy from you when you open your doors. This is a great mindset to have, as that positive outlook and optimism keeps you motivated even when things get tough.
But when it comes to your financial projections, it’s important to rein yourself in and find your inner pessimist. To be frank, operating under the “if you build it, they will come” theory is a recipe for disaster. Ultimately, your assumptions have to be based on sound reason, not emotion.
Plus, no matter how swimmingly your business goes, things can happen that are out of everyone’s control. Natural disasters, pandemics, financial crises — they can come at any time and hurt everyone’s business, not just yours.
Your projections will benefit from a healthy dose of pessimistic thinking. Not only will it keep you from overestimating on the positive side, but it will also encourage you to set aside a few months of operating budget as a cushion. This way, if the unexpected does happen, your business will have a fighting chance.
2. Keep up with current events and broad economic trends.
Because economies are so interconnected and interdependent — locally, nationally and globally — it’s important to stay informed. Pay special attention to consumer spending as well as buying habits — how they’re changing and how they’re not.
I encourage you to read articles that cover more than your industry or region, such as The New York Times, The Wall Street Journal, The Economist and Time magazine. Depending on your industry and location, perhaps you should be reading China Daily, The Guardian and The Times of India. Keep your eyes on the news, on blogs and magazines. This is where you build the “educated” part of educated guesses.
Estimating Low, Realistic and High.
Getting into the right headspace for estimating involves becoming a little like Goldilocks. This number is too high. This one is too low. Which one is just right?
While your final assumptions will be a fixed number, you don’t have to find that number right off the bat. I find it more helpful to use a 5-step approach to get into the right frame of mind for choosing my final estimates. Here’s how it works for revenues (it’s the same for expenses):
Step 1. Make a table.
You should create a row for each category of products and services you’re offering. And don’t forget things like gift cards or other not-so-obvious sources of revenue.
Step 2. Create three sets of numbers.
Label three columns as Low, Realistic and High.
Step 3. Assume a run of bad luck.
Start with the Low column and visualize experiencing a surprising run of bad luck. Imagine new competitors coming along who have aggressive pricing you can’t match, suppliers who don’t deliver on time, a sales team that turns out to be lazy and unproductive and market segments that stubbornly won’t grow. Consider what your “bad luck” numbers would be for each line item, and fill those in.
Step 4. Assume everything goes your way.
Imagine that all of your marketing efforts hit just the right people at just the right time and you negotiate fantastic pricing with your vendors and your sales team is a group of unbelievable rock stars. Enjoy the dream sequence playing out and put those numbers in the High columns.
Step 5. Now it’s time to get real.
After filtering out the worst-case scenarios and the too-good-to-be-true fantasies, think about the most realistic, yet slightly conservative scenario. From a cold start, this can be hard to figure out because you’re fighting against being too pessimistic on the one hand and overly optimistic on the other. Somehow, the numbers become more realistic after getting a taste of too hot and too cold, so you’ll be better equipped to land on “just right” for your financial projections.
Finally, speak with a qualified accountant.
Once you’ve finished your spreadsheets and looked over your numbers with a clear head and a sober eye, you’ll have better initial financial projections than the majority of entrepreneurs. However, you should never underestimate the value of having a trained professional go over your projections before sharing them with other people.
Accountants are a valuable resource because they’re trained to:
- Help you develop strategies to (legally) reduce your annual tax burden
- Catch any miscalculations
- Explain anything you don’t understand
Never be shy or embarrassed about asking your accountant questions, no matter how basic they seem. I promise, they don’t expect you to know everything. Your job as a founder is to tap into every tool, resource and trained professional that can give your business a leg up.
And if you think you could benefit from having a startup advisor build your financials — or help you write a business plan — then go ahead and take a moment to look at how I can help you and your startup.
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