Preparing Useful Financial Projections: The Risk of Wearing Rose-Tinted Glasses
You have just completed your annual strategy session and your management team has developed five year financial projections… the growth is remarkable, profitability is amazing… but you’ve been through this before and know that it may not end up that way. How does this happen and what’s the downside of overstating projections? It’s great that you have 100% confidence that your sales team is going to grow sales by 25% each year, that margins will increase and that you will get a foreign exchange gain, but how realistic is this and how will this impact your business if you don’t hit your numbers?
A good financial model should correlate with the detailed annual budget and provide a strategic road map for where the company is going in the future and what obstacles should occur at each key milestone. The financial model is a numeric representation of your business plan. The downside to unrealistic numbers is that your stakeholders such as your lenders, investors, bonding companies and suppliers may not believe you and thus may not support your activities. Additionally, if you under-deliver you will have a credibility issue going forward with these key stakeholders and further, your own management team may feel deflated, especially if bonuses were tied to making budget.
Here are a few ideas that we have had success with:
- Stress testing: Stress test your numbers using different scenarios to show your stakeholders you have considered different sales and expense levels.
- Monthly projections: Does your model roll out monthly, taking into account seasonality of the business? This will highlight any pressure points on your operating line and production capacity. If the model assumes you will be producing at 1.2x current max capacity, have you factored in the necessary overtime, repairs or capital expenditures required to increase capacity?
- Cash flow statement: If you are able to present a detailed cash flow statement along with your income statement and balance sheet to your stakeholders this builds credibility and comfort.
- Key ratios: Include covenant calculations to understand where you are at with your lenders and demonstrate to your lenders and your investors that you comprehend your covenants and that your forecast will comply with your covenants.
- Under-promise and over-deliver: Your lenders and investors rely on the management team for reasonable projections. Trust will be built based upon your ability to deliver on what you forecasted.
- Key drivers: Include key metrics that are relevant to your business such as production, headcount, inventory and CAPEX.
- Own your model: Make sure you understand your model thoroughly and can advocate the rationales for your projections.
The next time you are tempted to sign off on high growth projections, take off your rose-tinted glasses and put on your “glass is half empty mindset” and ask yourself: What can we deliver? Are we better off issuing more conservative projections and over-delivering? What do our key stakeholders need to see to support our business growth?
Acumen works with clients to create a financial model that covers the requirements of your lenders and investors but also factors in key analytics required to manage your business more effectively.