When starting a new business, a financial forecast is an important tool for recruiting investors as well as for budgeting for your first months of operating. A financial forecast is used to predict the cash flow necessary to operate the company day-to-day and cover financial liabilities.
Many lenders and investors ask for a financial forecast as part of a business plan; however, with no sales under your belt, it can be tricky to estimate how much money you will need to cover your expenses. Here’s how to begin creating a financial forecast for a new business.
[Read more: Startup 2021: Business Plan Financials]
Start with a sales forecast
A sales forecast attempts to predict what your monthly sales will be for up to 18 months after launching your business. Creating a sales forecast without any past results is a little difficult. In this case, many entrepreneurs make their predictions using industry trends, market analysis demonstrating the population of potential customers, and consumer trends. A sales forecast shows investors and lenders that you have a solid understanding of your target market and a clear vision of who will buy your product or service.
A sales forecast typically breaks down monthly sales by unit and price point. Beyond year two of being in business, the sales forecast can be shown quarterly, instead of monthly. Most financial lenders and investors like to see a three-year sales forecast as part of your startup business plan.
Create an expenses budget
An expenses budget forecasts how much you anticipate spending during the first years of operating. This includes both your overhead costs and operating expenses—any financial spending that you anticipate over the course of running your business.
Most experts recommend breaking down your expenses forecast by fixed and variable costs. Fixed costs are things such as rent and payroll, while variable costs change depending on demand and sales, such as advertising and promotional expenses. Breaking down costs into these two categories can help you better budget and improve your profitability.
"Lower fixed costs mean less risk, which might be theoretical in business schools but are very concrete when you have rent and payroll checks to sign," Tim Berry, Founder and Chairman of Palo Alto Software, told Inc. "Most of your variable costs are in those direct costs that belong in your sales forecast, but there are also some variable expenses, like ads and rebates and such."
Project your break-even point
Together, your expenses budget and sales forecast paint a picture of your profitability. Your break-even projection is the date at which you believe your business will become profitable, when more money is earned than spent. Very few businesses are profitable overnight or even in their first year. Most businesses take two to three years to be profitable, but others take far longer: Tesla, for instance, took 18 years to see its first full-year profit.
Lenders and investors will be interested in your break-even point as a projection of when they can begin to recoup their investment. Likewise, your CFO or operations manager can make better decisions after measuring the company’s results against its forecasts.
[Read more: Writing a Business Plan? Here's How to Do It, Section by Section]
Lower fixed costs mean less risk, which might be theoretical in business schools but are very concrete when you have rent and payroll checks to sign.Tim Berry, Founder and Chairman of Palo Alto Software
Develop a cash flow projection
A cash flow statement (or projection, for a new business) shows the flow of dollars moving in and out of the business. This is based on the sales forecast, your balance sheet, and other assumptions you’ve used to create your expenses projection.
“If you are starting a new business and do not have these historical financial statements, you start by projecting a cash-flow statement broken down into 12 months,” wrote Inc. The cash flow statement will include projected cash flows from operating, investing, and financing your business activities.
Keep in mind that most business plans involve developing specific financial documents: income statements, pro formas, and a balance sheet, for instance. These documents may be required by investors or lenders; financial projections can help inform the development of those statements and guide your business as it grows.
Tools and templates for financial forecasting
You can easily build a financial forecast using a spreadsheet; Google Sheets has a free annual budget template you can configure for your business. You’ll also find templates from vendors like Smartsheets or Rows. SCORE offers a free template for startup businesses.
Look for a template that has built-in formulas to flag unrealistic projections or inconsistencies in your predictions. The best templates include a revenue forecasting section, a cost breakdown of variable and fixed expenses, a cash flow projection, and a break-even analysis. Some can be linked to your business bank account so you can pull data from and update your analysis as you start operating.
There are also many software tools designed to simplify and automate financial forecasting. Prophix, Anaplan, and Fathom are all affordable, user-friendly financial planning software tools. Look for a tool that syncs with your accounting software and bank data to reduce manual entry.
[Read more: 5 Financial Planning Tools for Small Businesses]
How to adjust financial forecasts as your startup grows
Once you launch your new venture, you can start collecting real data to inform your financial projection. As your business grows, update any assumptions you made about sales growth, customer acquisition costs, market size, and pricing based on the latest data and industry benchmarks. Adjust your model to reflect new revenue streams, expanded markets, or changing cost structures.
The assumptions you made as the baseline of your financial forecast need to be challenged. Compare your actual performance (revenues, expenses, cash flow) to your previous forecasts to analyze where your assumptions were off and why. Use these insights to refine your approach for future projections.
Common forecasting mistakes to avoid
As one analyst at EY notes, entrepreneurs tend to be optimistic. It’s a mindset that helps get new ventures off the ground but can often lead to overconfidence in forecasting. As a result, one of the most common mistakes is inaccurate revenue projections. Use key word research to get a better picture of demand—and therefore, revenue—for your product or service.
It’s also a common error to only map out one scenario. Instead, create best case, worst case, and base case projections. “What if you launch six months later? What if sales do not ramp up as expected? What if your costs turn out to be double of what you expected? Answering such questions helps you anticipate how your cash flow, profitability and funding need are impacted in a less optimistic scenario,” wrote EY.
Finally, don’t underestimate your expenses, especially when first starting out. It’s common to overlook or underestimate operating costs, overheads, and unexpected costs that pop up. This leads to budget shortfalls and financial strain. Make sure you build in contingency buffers and regularly update expense assumptions as you go.
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