To make strategic business decisions for your startup, you need to have an idea of the revenue and expenses over the coming months and years. But how can you predict your business’s future financial performance? While you can’t know for sure, you can make reasonably accurate predictions and create your plans accordingly by building financial projections.

In this article, we cover all the basics you need to start generating startup financial projections. You’ll learn how to define financial projections, the key situations when you need to use them, and the steps to creating financial projections for your startup.

“While you can’t know for sure, you can make reasonably accurate predictions and create your plans accordingly by building financial projections.” 

What are startup financial projections? 

Startup financial projections are a forecast of a business’s future income and outgoings. Creating projections usually involves building versions of the key financial statements (cash flow statement, P&L or income statement, and balance sheet) for points in time several months or years in the future to show how your cash, revenue, and expenses are likely to look.

As part of these projections, businesses model how their finances may look as a result of hypothetical changes such as a merger or IPO. Depending on the approach you choose, you can build financial projections based on information about your industry and market or your business finances to date.

Financial Projections ≠ Financial Forecast Or Financial Model

It’s not uncommon to see and hear financial planning terminology used incorrectly. While the terms ‘financial model’, ‘financial forecast’, and ‘financial projections’ are closely interlinked, they are not interchangeable.

We’ve outlined these three commonly-used (and misused!) financial planning terms below to provide clarity on how to use the different tools or processes.

Term

Definition

How It’s Used

Financial Model

An abstract representation of a real-world financial situation. A financial model is a tool to forecast a business’ future financial performance under specific conditions.

• Generating financial forecasts and projections
• Estimating the valuation of a business

Financial Forecast

The result of examining a company’s historical data to estimate future financial outcomes, using a financial model. A financial forecast uses assumptions based on historical data that you can expect to happen (repetitively) in the future.

• Informing budgets
• Informing hiring decisions

Financial Projection

The result of a forecasting exercise to estimate a business’s future income and expenses. A financial projection is based on what you think will happen in the future, not merely a simple extrapolation of the past track record.

• Strategic business planning
• Fundraising

2 Reasons Startup Financial Projections Are Vital

Creating financial projections for startups can be time-consuming and complex, so what makes it a worthwhile use of your resources? Two key startup functions require accurate financial projections.

1. Startup financial projections form the basis of business strategy.

If you’re not basing your startup’s plans on sound financial projections, you might make decisions that incur more expenses than revenue, causing the business to run out of cash. Realistic projections help you build a financial plan for your startup business, for example, determining the investment you need to deliver on revenue growth targets and setting an appropriate expense budget. Plus, by changing variables in the financial model—such as altering product pricing or team headcount—you can see how these factors will affect the projected revenue and expenses.

2. Startup financial projections are key to securing funding.

Financial projections reveal whether startups have a chance to generate enough profit to survive. These insights help potential investors decide if a startup is a worthwhile investment, making them an essential part of any fundraising presentation. Investors will compare the business’s actual performance against the initial projections included in the business plan, so they must be as realistic as possible. If your financial projections turn out to be accurate, this shows you have a solid understanding of your startup’s opportunities, capabilities, audience, and market, inspiring confidence in investors and making the company attractive for further investment as you grow.

However, if your startup’s performance is consistently out of line with your projections, it indicates to investors that you don’t understand the market or the business’s potential and could jeopardize your chances for further investment.

How To Build Financial Projections For Startups

1. Decide on an approach to your projections. 

There are two main approaches to financial projections: top-down and bottom-up. Each approach is generally used at a different stage in a business’s growth and has its benefits and drawbacks. ‍

Top-down projections

Bottom-up projections

Calculations

Analyze the market segment the business is targeting and set a goal for the market share you want to achieve. Project the number of sales and amount of revenue you will generate if you achieve this goal as well as the expenses of running a business at this scale. Compare margins to market segments or competitors.

Extrapolate from data on the business’s finances and sales to date to predict how your expenses and revenue will change.

Advantages

Provides a long-term view by focusing on targets you want the business to achieve.

Offers more accurate predictions of how the business will continue to perform. Better “item-level” forecasting.

Drawbacks

Makes a lot of assumptions about the business’s performance so are likely to be less accurate. .

Lacks the ability to reflect the business’s ambitious long-term targets.

Very early-stage businesses might not yet have enough data points to build projections using the bottom-up approach. While it is possible to use data from your competitors to build bottom-up projections, every business operates differently—so we don’t recommend taking this approach. Top-down projections are a better fit for early stage startups.

With either approach, on-target projections aren’t based only on financial data. The business’s cash inflows and outflows depend on factors including product pricing, promotion, the level of customer demand, and the number of competitors in the market. So for startups, in particular, it’s important to understand your potential market and to know your competition.

‍A common mistake startups make is to assume they’ll perform at the industry average even when they’re just starting out and only have a handful of customers. Founders who don’t yet know the market well will often make overambitious projections, leading to decisions that harm the business.

2. Gather input from your team. 

To ensure you have all the necessary information and perspectives to build realistic financial projections, consult these team members:

• The business’s owners. The startup’s owners or founders can contribute an in-depth understanding of the business’s needs, the market, and the available opportunities to create sound projections.
• The Sales VP or a sales leader. Since startup financial projections are based on the business’s potential future sales, you need to involve a team member who has expertise and insight into sales strategy and potential.
• The CFO. The CFO can apply both knowledge of your finances and experience of helping businesses scale to inform your projections. If your startup doesn’t yet have a CFO, you can work with an outsourced CFO service to build financial projections.

3. Generate projections for each financial statement.

Using your chosen approach—top-down or bottom-up—predict the sales your business will generate and the expenses you will incur at a specific point in the future (for example, six months or one year ahead). Your sales projection needs to take into account seasonality, the health of the economy, and how your industry as a whole is performing. Your expense projection should include any fixed expenses that will remain the same (for example the rent on your office space) as well as a prediction of variable expenses that will change in proportion to your sales and business growth (for example payroll and cost of sales).

Based on these assumptions, project how the startup’s three key financial statements will look.

• The profit and loss statement (also known as the income statement or P&L)reflects the business’s financial performance over a specific time period. Your P&L projection should include predicted values for:
  • Revenue
  • Cost of goods sold (COGS)/Cost of sales (COS)
  • Operating expenses
  • Operating profit
  • Non-operating expenses
  • Non-operating profit
  • Net income
• The balance sheet shows a snapshot of the business’s finances at a particular point in time, including all assets and liabilities. Your balance sheet projection should include predicted values for:
  • Assets—current, non-current, and fixed assets
  • Liabilities—current and long-term liabilities
  • Equity—retained and current earnings, and common and preferred stock
• The cash flow statementshows the movement of cash in and out of your business. For early-stage startups, it’s particularly important to project your cash flow to see how much runway you have before you run out of money. Your cash flow projection should include predicted values for:
  • Cash from operating activities, including accounts receivable and accounts payable, inventory, and depreciation
  • Cash from investing activities, including sales of assets and purchases of fixed assets
  • Cash from financing activities, including incoming cash from investors or banks and outgoing cash paid to shareholders
  • Change in cash and cash equivalents

Source: https://www.zeni.ai/blog/startup-financial-projections