How to create realistic financial projections for your first year in business
What do entrepreneurs and weathermen have in common? Their job requires them to predict the future, and for anyone who checks the weather app on their iPhone will know - a lot of the time, they get it wrong, really wrong.
It’s easier for the weather lot, though. If they get rain and sun mixed up, the worst that can happen is we get a little bit wet. But in entrepreneurship, if you predict bundles of profit but actually get a whole lot of loss, then you’ll be out of a business. In fact, miss managing your cashflow can turn your business on its head even if you’re doing well – it’s the biggest killer of startups around, like a horrible startup mass-murderer.
So how do you make sure you’re making the best guess when it comes to predicting your financial projections in your first year in business? We asked Virgin StartUp mentor and man who’s helped launch many businesses, Darren Craig, to write us a guest blog on how he does it.
“As a mentor, I see so many entrepreneurs complain that building forecasts with any degree of accuracy takes too long. Some see this as a waste of their time and that this time could be better spent developing or selling their product.
Also as an experienced entrepreneur, I can tell you that without investing some time in this, means that your new shiny business stands little chance of success and you will not find any investors willing to put money into your business unless you can provide them with forecasts. The first three-year forecast is important, but the most crucial one will be for year one. This will help you not only manage the business, but give you a set of figures that you can measure sales and costs against, as well as start to understand if the second and third-year forecasts are reasonable assumptions.
So how do you build your three-year forecast and most importantly plan for year one?
Put down your expenses first, not revenues. It’s easier to start with expenses than revenue, because it’s something that you have a lot more control over. Revenue on the other hand is a lot harder to estimate, due to the fact that there are a lot of external factors that you cannot control. So, start by building a list of common categories of expenses. Your accountant (if you have one) may call these ‘accounts’ See some examples below:
- Legal/Insurance fees
- Postage Costs
- Office Rent
- Utility Bills
- Phone Bills/Mobile Phone/ Internet Costs
- Advertising & Marketing
- Cost of Goods Sold
- Direct Labour Costs
Forecast revenues with both a conservative view and an aggressive view. Most entrepreneurs will move between a conservative reality state and an aggressive dream state, which helps keep you motivated and helps you inspire others around you… including your potential investors.So don't ignore your optimism and end up creating a forecast based only on your conservative view. You risk demotivating you and your team or end up not getting the getting the investment you need.I would recommend that you follow your vision and build two sets of revenue projections. A conservative view as well as an aggressive view. Remember, one of the most important rules in a start-up, is THINK BIG! By building two sets of revenue forecasts (conservative, aggressive), you’ll start to make conservative assumptions that you can relax a little for your aggressive forecast.
Check the key ratios to make sure your projections are sound. After making aggressive revenue forecasts, it's easy to forget about expenses. Many entrepreneurs I meet, optimistically focus on reaching revenue goals and assume the expenses can be adjusted to accommodate reality if revenue doesn't come through. Positive thinking might help you grow sales numbers, but it's not enough to pay your fixed overhead costs.
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 you:
What's the ratio of total direct costs to total revenue during a given quarter or given 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 5% to 60% for example.
Operating profit margin. What's the ratio of total operating costs - direct costs and overheard, 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 smaller proportion of total costs and your operating profit margin should improve. The mistake that many entrepreneurs make is that they forecast this break-even point too early and assume they won't need much financing to reach this point.
Headcount per client. If you're a solo 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 solo player--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 start-up will take time and many revisions as you build out your experiences. When I started my first company, I didn’t build a detailed set of forecasts because I knew the business model would evolve and change. However, I regretted not spending more time on business planning and I would have avoided several expenses along the way as a result….and kept a tighter control of my expenses as the business grew.
To find out more about Darren Craig, follow him on Twitter @darren_craig