Business Plan Financial Projections: Stop Worrying About Being Right...

Business plan financial projections seem daunting because they are so uncertain. This very uncertainty, however, is what makes preparing them easy because you can't possibly be right. You can't predict the future. None of us can. All you can be is competent in the way you prepare your business plan projections.

Before you finalize your business plan this year, consider these six caveats to preparing your business plan financial projections:

1. Don't offer pull-out-of-the-air, "conservative" guesstimates about getting some percentage of the overall market demand or year-over-year growth.

It is a mistake to assume that business investors will appreciate your being conservative with your business plan financial projections in the early years of your business. Don't think for a Wall Street minute that presenting "conservative" business plan financial projections indicates "realism" to prospective business investors. Business investors invest for one reason: to earn a return on their money. How long the money is invested influences the amount of the return earned. Let's say a business investor wants to triple an investment. Well, if that investment triples in 3 years, the return is 44%. If it triples in five years, the return is 25%. Adding just two years to the investment period nearly halves the return! Now do you see why time is so important to a business investor? Here are a few other examples: let's say a business investor wants to:

Make 5 times an investment in 3 years = 71% return
Make 5 times an investment in 5 years = 38% return
Make 7 times an investment in 3 years = 91% return
Make 7 times an investment in 5 years = 48% return
Make 10 times an investment in 3 years = 115% return
Make 10 times an investment in 5 years = 59% return

So, while you may find it attractive to figure out how to make "just a living" until the business venture proves itself, you now understand why business investors want sales and earnings to grow absolutely as fast as possible, without being deceived, in your business plan financial projections. On the whole, business investors are risk averse only to the extent that they don't want to lose their money or tie it up in a low return investment. Typically when you make the claim that your business plan financial projections are "conservative", it usually just means that you have no idea how and why you'll achieve a certain level of sales within a certain time frame. Interesting, these kinds of estimates, provided that you've done some good thinking about market segments and overall demand, often turn out to be too low. Remember, it's just as bad to underestimate your sales, as it is to overestimate them.

2. Avoid calculating costs as a straight percentage of revenues.

Sure it's easier to do things this way, especially with Excel and other business plan financial projection software. Costs are real, however. You need to know what they are very specifically. If you've done your homework in developing your business plan, then you should already have this information, or at least the basis of it. Just estimate and calculate your costs on a product-by-product basis.

With these warnings in mind, use the following steps to develop your business plan financial projections:

Think about what percentage of the overall market share your competitors already own. Assume that they will continue their present trends in growth. (Note: some competitors may already be trending down and losing market share.) Temper your market share estimates with some discussion of how your entry into the market will affect these trends. Then, estimate the percent of total, potential demand that remains available to you.

Now, based on the limitations of your operations plans, calculate how much of this remaining available demand you can achieve. This is a very simple calculation. Start with your overall productive unit capacity and factor it by the expected yield of sellable product, then multiply these unit sales by their respective selling prices and voila, you have the revenue numbers for your business plan financial projections.

Let's take an example.

Your research indicates that 2 out of every 10 females age 23 to 55 will under go some type of non-invasive cosmetic treatment in your area. Your research also shows that this number is expected to grow 20% each year over the next 5 years. There are 40,000 females in your target market. You identified four competitors in your target market. These four competitors currently handle on average 6 procedures a day. You plan to start a non-invasive cosmetic treatment center that uses the most advanced technology and is thus capable of performing an average of 7 procedures a day. Using this data you calculate the following statistics about your market and market potential:

Total market 40,000 females x 20% = 8,000 procedures per year
4 competitors x 6 procedures x 250 days = 6,000 procedures per year
Available procedures: 8,000 less 6,000 = 2,000 per year

Your productive capacity: 7 procedures a day x 250 days = 1,750 or 21.875% of the total market. The average selling price for a procedure is $400. Thus, the revenue for the first year in your business plan financial projection would be 1,750 procedures times $400 or $700,000.

Now, let's say you're were projecting 2,200 procedures per year. This would mean that you would have to alter your operating plan to be able to perform 2,200 procedures. You would also have to demonstrate how you would capture an additional 200 procedures from your competitors. Granted this is an over simplified example, but it should give you a feel for how this process works.

Regarding price, in most cases you should have a clear idea of how to price your product or service. There are usually other, similar products or services out on the market. Unless your competitive advantage is a cost reduction and/or unless price is a critical basis of competition, just estimate the value of your improvement and add it on to the average price currently offered in the marketplace. In order to make this estimate, you'll have to be talking to potential users. Find out what they pay now. Find out how they feel about the current price. Ask them if they'd be willing to pay more and how much more. If you ask enough people, you'll get a general idea.

3. Never determine price on the basis of a margin you think is attractive.

The market will pay you only for the value you deliver, which is determined by the consumer paying the final price. It's easy to make the mistake of thinking that a 20%, 40% or even a 60% margin is great. Never considering that if the product or service you're offering provides a real advantage. If you do this, you may be grossly underestimating the price you can get in the marketplace and underestimating your business plan financial projections. Consumers don't think in terms of margins. They could care less about what you ought, "reasonably", to get for your product. That's why you must find out the most that they'll pay. This is the value of your product or service. Come up with some reasonable basis for determining this real value. Keep in mind the obvious: If the consumer's value on the final product or service is less than your cost plus a reasonable profit to keep your business growing, you're in trouble. Your business model will not be sustainable and your business plan financial projections useless.

Now calculate the costs of manufacturing and distributing your product. These costs flow directly from your revenues estimates and operations plan. How much will it cost to purchase what equipment and materials, hire what personnel, engage in what selling efforts, pay what accountants and lawyers, rent what kind of space and so forth, to achieve the revenues you're showing in your business plan financial projections. You must be very specific. Project your costs over time. Keep them tied to the units you need to sell to achieve the revenues in your business plan financial projections.

Obviously, costs and revenues work hand in hand.

4. Keep your fixed cost low.

Keep in mind that none of these revenues and the cost estimates are going to be perfectly accurate, which means the amount of profit or cash available to pay "fixed" cost isn't going to be accurate either. As a result, you can lose your shirt trying to pay for equipment, a receptionist, or other activities that don't contribute to the sole objective of making sales. Wherever possible, rent space, rent time on equipment, answer your own phones, etc. To the extent that you keep costs variable in your business plan financial projections, you can cut back when sales are slower than expected. It's the worst situation to have a big, well-furnished office with an expensive secretary who needs the job, when the money isn't coming in. High fixed costs in your business plan financial projections also send the wrong message to investors that you know more about the "form" of doing business than about actually making money.

Now pull all your numbers together to prepare the financial statements that summarize your business plan financial projections. You need three basic statements: cash flow analysis, income statements, and balance sheets. All of these come directly from the above calculations. Your cash flow analysis indicates when and what amounts of capital infusion you'll need to start and sustain your business plan. Make your income and balance sheet projections on the assumption that you'll get the capital. For the first year or two of your business plan financial projections, present each of these statements on at least a quarterly basis. Monthly is best. I suggest doing a 24- or 36-month projection depending on your growth plans and changes in the industry that you foresee. Follow these monthly or quarterly projections with annual projections till you cover a span of 5 years.

Finally, run through some "what-if" scenarios or sensitivity analysis. Though you business plan financial projections should be based on your best, and best-supported estimates of costs and revenues, you know you can't be 100% right. That's why it's important to identify those elements or assumptions of your business plan financial projections that you feel are most uncertain. Write out the nature of the uncertainty and the range you think the estimates will fluctuate up or down. Then change the estimates accordingly and re-run all your statements. Pay close attention to how your business plan financial projections, especially cash flows, change when you change each assumption. This will help you determine how much "cushion" you have available and, if business isn't going according to plan, at what point cash will become an issue.

5. Do not simply assume that costs and revenues may be "off", up or down, by some percentage.

Again, I know that Excel makes it easy to do this. For all the same reasoning as above, stay focused on the assumptions and details that make up your business plan financial projections. It's the details you need to examine for their sensitivity and their impact on the bottom line. You only need to alter those specific items that you're most uncertain about. If it's revenues that you're worried about, is it the price, the volume, or both that concerns you most? How big a swing in the estimate are you worried about, in what direction and why? If it's your cost projections that are keeping you awake at night, which cost elements and why? Things like rents and labor costs can be determined fairly accurately. But maybe you're unsure about materials or labor availability or how efficiently you can produce your products or provide your services. Maybe you'll have to pay extra to ensure their availability. This kind of thinking forms the basis for running "what-if" or sensitivity analysis on your business plan financial projections.

6.Do not include every possible business plan financial projection scenario in your business plan.

Both you and your investors need to know what aspects of the business plan financial projections are most uncertain, represent the most risk, in what direction, why, and how they affect the bottom line. Having hundreds of alternative scenarios to sort through is like a man with two watches showing two different times? he never knows what time it is. Lots of alternative business plan financial projections also indicate that you're not too sure about anything. This is an impossible way to communicate with business investors, manage your business, or make important decisions. It's much more effective to identify the risky areas of your plan, tell why and how they impact the bottom line and what actions you plan to take if they occur. This helps you and your business investors stay focused on the high impact areas and to think clearly about whether other factors should be considered as well. It also lends more credibility to your talents and increases the likelihood of your plan's success.

Finish this discussion with a summary of the critical aspects of your plan and related contingency plans. If you've followed all these steps, then you can figure out what you'll do if your actual performance turns out to be different than your business plan financial projections. Remember, you're purpose is to demonstrate to business investors that you're competent; worrying about protecting their investment and running a business, not just flying by the seat of your pants.

Mike Elia is a chief financial officer and an advisor to venture capitalists and leverage buyout specialists. For more information about business plans and raising capital for your business or to review his business plan manual, visit Business Plan Secrets Revealed.