Proper financial forecasts will help you develop operational and staffing plans that will help make your business a success.
Here’s some detail on how to go about building financial forecasts when you’re just getting your business off the ground and don’t have the luxury of experience.
When you’re in the startup stage, it’s much easier to forecast expenses than revenues. So start with estimates for the most common categories of expenses as follows:
If you’re like most entrepreneurs, you’ll constantly fluctuate between conservative reality and an aggressive dream state which keeps you motivated and helps you inspire others.
Rather than ignoring the audacious optimism and creating forecasts based purely on conservative thinking, you embrace your dreams and build at least one set of projections with aggressive assumptions. You won’t become big unless you think big! By building two sets of revenue projections (one aggressive, one conservative), you’ll force yourself to make conservative assumptions and then relax some of these assumptions for your aggressive case.
By unleashing the power of thinking big and creating a set of ambitious forecasts, you’re more likely to generate the breakthrough ideas that will grow your business.
After making aggressive revenue forecasts, it’s easy to forget about expenses. Many entrepreneurs will optimistically focus on reaching revenue goals and assume the expenses can be adjusted to accommodate reality if revenue doesn’t materialize. The power of positive thinking might help you grow sales, but it’s not enough to pay your bills!
The best way to reconcile revenue and expense projections is by a series of reality checks for key ratios. Here are a few ratios that should help guide your thinking:
What’s the ratio of total direct costs to total revenue during a given quarter or given a year? This is one of the areas in which aggressive assumptions typically become too unrealistic. Beware of assumptions that make your gross margin increase from 10 to 50 percent. If customer service and direct sales expenses are high now, they’ll likely be high in the future.
What’s the ratio of total operating costs–direct costs and overhead, excluding financing costs–to total revenue during a given quarter or given year? You should expect positive movement with this ratio. As revenues grow, overhead costs should represent a small proportion of total costs and your operating profit margin should improve. The mistake that many entrepreneurs make is they forecast this break-even point too early and assume they won’t need much financing to reach this point.
If you’re a one-man-army entrepreneur who plans to grow the business on your own, pay special attention to this ratio. Divide the number of employees at your company–just one if you’re a jack-of-all-trades–by the total number of clients you have. Ask yourself if you’ll want to be managing that many accounts in five years when the business has grown. If not, you’ll need to revisit your assumptions about revenue or payroll expenses or both.
Building an accurate set of growth projections for your startup will take time. When I first started my company, I avoided building a detailed set of projections because I knew the business model would evolve and change. But I regret not spending more time on business planning since I would have avoided several expenses along the way. The company’s board of directors now requires me to prepare quarterly updates to our financial projections. Now when I lapse into fits of audacious optimism, the projections force me to forecast what these dreams mean for the company’s bottom line.