Lee Rust, Owner, Florida Corporate Finance
Over the years, I’ve not only prepared hundreds of financial projections but also reviewed hundreds prepared by others. That has given me an insight into the preparation, validity and use of such financial views of the future. In that regard, let me mention the use of the word “conservative.”
If someone built an apartment building in the worst section of your town and used the cheapest materials possible, the sign in front of that building would say, “Luxury Apartments.” That’s because the word “luxury” is virtually always used to describe any apartment building. I’ve also rarely reviewed projections that were not described as “conservative,” even if they were wildly optimistic. Just don’t use that word in relation to any financial projections you might compile. It may not only be wrong but can also adversely affect a reader’s reaction to the projections. People who review projections on a regular basis see that word too often and don’t believe it when they do.
In addition, most of the “conservative” projections I’ve reviewed follow the hockey-stick pattern that shows the past, short-term, flat performance of a company followed by an overly dramatic increase in revenues and profits projected for the future. Many of these hockey-stick projections are based on some exaggerated view of the market for the company’s products or services. “If we can only sell our widgets to 1 percent of the 300 million people in the US, we’ll all get rich.” But you can’t reach all 300 million of those people cost effectively. Don’t ever base revenue projections on total market size but on the market that you can actually reach and sell. Then describe how you will reach and sell to that market and show in the projections a realistic cost of doing that.
Also, almost no one projects a loss even if short-term losses are inevitable. When preparing financial projections don’t lie to yourself, be realistic about both the future and what your company can actually accomplish during a set period of time and with the limited resources that may be available.
After you compile the revenue projections, which should always be the first step in financial forecasting, then work on the expenses that will be required to reach those levels of sales. Some of those will vary directly with the revenue, such as direct material costs. Others will be fixed, such as rent and will not increase with increasing sales until some future plateau is reached. And others will be semi-variable, that is, they will increase with increasing sales but not in proportion to the percent of revenue increase. Good examples of semi-variable costs are supervisory and administrative salaries, most selling expenses and business liability insurance.
In preparing projections, it is extremely important that you recognized which expenses fall into each of those three categories and treat them accordingly. Any experienced person reviewing your projections will discount them if, for instance, you show occupancy
costs as an ever-changing percent of sales. Review each line item in the projections and make sure each change over time in both a realistic amount and pattern.
For most projections, after starting with a detailed forecast of revenues, I then estimate the personnel costs that will be needed to generate those revenues, including direct labor and both selling and administrative salaries. For those personnel costs, I usually
include line-item schedules of personnel by number of people and then convert those into dollars including all payroll taxes and employee benefits.
After completing the revenue and personnel costs for the projections, I then forecast the other direct costs and related gross profits levels. Only after that top half of the income statement projections is complete, do I then estimate the selling and administrative expenses. After all of that work is done and the first draft of the projections is available, I then subject them to the “Lee Rust Reasonableness Check.” Taken as a whole, are the projected results reasonable and are the individual estimates that make up the projections based on realistic assumptions?
By including a high level of line-item detail and supporting many of the line item estimates with descriptive notes, rationale and assumptions, the financial forecasts will gain a sense of validity. They won’t be rejected out of hand as being too optimistic or based on assumptions that are not feasible.
Once the income projections are complete, it’s then wise to convert those into balance sheet forecasts. That will force you to consider such factors as the average collection period or the anticipated number of days in your accounts receivable and inventories. Investments in fixed assets necessary to produce the level of projected goods or services will also need to be considered as well as the various categories of liabilities needed to support the increase in assets that will accompany the increase in revenues.
Finally, convert the balance sheet into a detailed cash flow analysis. That will come as a welcome surprise to anyone reviewing your projections only because cash flows are so rarely included. And again, use the “Reasonableness Check” to verify the overall
projected results.
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