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Doing Financial Projections - DOC


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									Yale School of Forestry & Environmental Studies                            Kroon Café

                         Doing Financial Projections
What You Need
       Clear ideas about the purpose and audience for your projections.
       Understanding of the key drivers of financial results for the business.
       Some knowledge of accounting & financial statement analysis:
       Skill in using spreadsheet software -- such as Excel
       Creativity, attention to detail, and good judgment.
       A lot of time.
Some Warnings
O   Most people starting new businesses are much too optimistic about the
    future financial results of their business. Their energy and enthusiasm cloud
    their judgment. They underestimate the time it takes to get things done,
    and how much things will cost. Over-optimistic expectations often lead to
    underestimating how much money they need to finance initial losses.
O   Once a business really gets going (in Year 2 or 3), doubling the size of the
    business each year is about the maximum a good CEO really can
    achieve. Even growth that fast (double every year) is extremely difficult to
    manage. Most successful businesses do not grow faster than 100% per year,
    nor do they need to.
Getting Started
O   Financial projections should include the following kinds of final “output”:
       Income Statements
       Balance Sheets
       Sources and Uses of Cash Statements (Cash Flow Statements)
O   The invention of spreadsheet software has made financial statement models
    easy to create and even easier to play with. Follow this link for a simple
    projection model template.
O   In practice, though, you will likely have to build your own income statement
    model. The key drivers often are unique to the particular situation. You can
    use the template model, however, to help calculate Balance Sheets, Sources
    and Uses of Cash, plus do some Statement Analysis – just by inputting your
    custom income statement, and making some simple assumptions.
O   It is usually best to do monthly projections for the first two years, then
    quarterly after that. Add the periods up, and present the annual summaries to
    potential financing sources.
   Yale School of Forestry & Environmental Studies                   Kroon Café

   Income Statements:
Monthly Projections           Month 1 Month 2 Month 3 Month 4 Month 5 Month 6
Cost of Goods Sold
Gross Profit
Sales & Marketing Expense
General & Admin Expense
Operating Income
Depreciation Expense
Interest Expense
Net Income (Loss)

   Key points:
   o Revenues & expenses are independent of cash payments. Recognize them
     when a transaction happens, not when cash comes in or goes out (maybe
     much later).
   o Cost of Goods Sold are the direct costs in producing your service –
     materials, installation costs, customer service, maintenance, etc.
   o Revenue – Costs of Goods Sold = Gross Profit
   o General & Administrative are support costs, like finance, HR, IT, top
   o Gross Profit – Sales & Marketing – General & Admin = Operating
     Income, also known as Operating Cash Flow
   o Following these conventions allows for comparison of your projections with
     other similar business’ results.
   o Depreciation expense spreads out the cost of property, plant and equipment
     – over its useful life.
   o R&D costs?
   Making Assumptions
   O    Start with the monthly numbers for Year 1. For any business raising
        money, making your numbers in your first year of projections is really
        important. If you, as management, miss these numbers you may:
           1. Run out of money too soon,
  Yale School of Forestry & Environmental Studies                           Kroon Café

         2. Get fired and/or
         3. Not be able to raise more money.
      If 1) or 3) happens, you will probably go bust.
  O   Consider the macroeconomic situation when building your projections:
         Overall economic growth rate of GDP during projection period
         Economic recession(s) - timing, duration
         Rate of inflation
         Level of interest rates
  O   Tackle the Income Statement first. Project your number of customers
      based on the key revenue driver. Project monthly sales – for twelve
Monthly Projections      Month 1    Month 2     Month 3 Month 4        Month 5   Month 6
Customers                0          0           11        20           45        77
Revenues                 0          0           3         6            13        26
  o Next, think through the 12 months of costs associated with these sales:
         Cost of Goods Sold – materials, installation              costs,   inspection,
         maintenance, regulatory costs, billing system
         Selling costs – sales people, advertising, travel, web site
         Administrative Costs – Management, office space, supplies, utilities,
  o Points to remember:
         You may not have any revenues for the first few months – as you build the
         system, sign up customers, etc. – but you will still have expenses. Model
         Don’t forget to figure in one-time start-up costs (incorporate, write a
         business plan, licensing, permitting fees, getting regulatory approval, etc.)
         If you have more than one product or service, model them separately,
         then total them.
         Be sure to model total headcount and include cost of benefits (20-25% of
         salary, typically). You should allocate personnel costs into Cost of Goods
         Sold, Marketing & Sales and General & Administrative, based on function.
         Rental space can be: (Headcount x Avg. Sq. Ft. Per Person x $ Cost Per
         Sq. Ft.)
   Yale School of Forestry & Environmental Studies                                        Kroon Café

   o Your projections might look something like this:
Monthly Projections           Month 1 Month 2 Month 3 Month 4 Month 5                          Month 6
Revenues                      0            0            3            6              13         26
Cost of Goods Sold            0            0            1            3              6          13
Gross Profit                  0            0            2            3              7          13
Sales & Marketing Expense     4            5            7            9              11         12
General & Admin Expense       4            7            9            11             13         16
Operating Income              -8           -12          -14          -17            -17        -15
Depreciation Expense          1            1            1            1              1          1
Interest Expense              1            1            1            1              2          2
Taxes                         0            0            0            0              0          0
Net Income (Loss)             -10          -14          -16          -19            -20        -18

   o Then, add up your 12 months of projections.
        Annual Projections        Year 1       Year 2       Year 3         Year 4         Year 5
        Sales                     150
        Cost of Goods Sold         77
        Gross Profit               61
        Sales & Marketing         102
        General & Admin           140
        Operating Income          (181)

   Operating income is an estimate of how much money will need to raise – on top
   of the cost of any property and equipment you must buy. Does this number
   make sense? Are you losing enough money (have you remembered all your
   costs)? Are you losing more money than you can raise?
   o Building out future years, two approaches:
            Continue estimating growth of customers from month to month, quarter to
            quarter. Or
            Pick a break-even year – the year your operating income exceeds costs
            and you don’t need outside fina ncing to survive. Take this approach if
            there is a year by which you must break even. If, say, banks or investors
            require that you reach break even by year three, figure out: What would
            this take – in sales?
Yale School of Forestry & Environmental Studies                          Kroon Café

    Annual Projections        Year 1   Year 2      Year 3    Year 4      Year 5
    Sales                     150                  800
    Cost of Goods Sold        77                   350
    Gross Profit              73                   450
    Sales & Marketing         102                  195
    General & Admin           140                  210
    Operating Income          (169)                45

     Figuring out what your break-even year looks like, and when it will occur,
     probably is the single most important part of making a good set of projections.
     With either approach, remember to increase costs with sales. A common
     mistake, for example, is to forget to add personnel as the business grows.
     And, as personnel increases, so may rent, supplies, utilities, insurance, etc.
O    Compare your Income Statement numbers to similar companies to figure
     out if your break-even, and projections in general, are reasonable, Calculate
     profit and cost margins by dividing all categories by sales:
               Annual Projections         Year 3         As a % of
               Sales                        800             100%
               Cost of Goods Sold           350             44%
               Gross Profit                 450             56%
               Sales & Marketing            195             24%
               General & Admin              210             26%
               Operating Income             45              6%

     Look especially at the gross and operating profit margins, and at the
     categories of costs. At this stage of your business, your profit margins
     should not be higher than similar operations – nor your cost margins
     lower. Does your business differ in key respects? If so, can you explain
     why? If not, you are probably being to optimistic.
     If your projections look reasonable, smooth in the year(s) between Year One
     and your projected break even year. Project out past your break-even year.
     Do not grow faster than people will believe. Consider a 50% annual growth
     rate in revenues, as a first cut. Remember to increase costs as you grow.
 Yale School of Forestry & Environmental Studies                                        Kroon Café

 O     Next, Some Assets
       Transfer the Income Statement totals to the model template, or construct your
       own Balance Sheet and Sources & Uses model. Typical key items:
Category                    Numbers Expressed As:               Examples:
Cash in Banks               % of Sales                          3% of Sales
Acounts Receivable          % of Sales                          Sales x 1/6 (60 Day Turnover)
Inventory                   % of Cost of Goods Sold             Cost of Goods Sold x 10%
Fixed Assets                Formula                             Yr. = Last Yr. + CapEx - Deprec.
Other Assets                % Sales                             1% of Sales
Accounts Payable            % of Costs of Goods Sold            Cost of Goods Sold x 1/6
Accrued Expenses            % of S&M + G&A Expense              S&M + G&A Expense x 1/12

       Other reasonable links or relationships are possible. You want the balance
       sheet to grow in line with the growth of the business. Balance sheets
       use cash, too.
       One also needs to project the Capital Expenditures (Property, Plant,
       Equipment purchases) and some Depreciation Expense.                 Include
       replacement costs for failed as well as worn out equipment. Set Depreciation
       Expense as a percentage of Net Fixed Assets as of the end of the previous
       year. The template assumes an average rate of 10 years.
       The template model will use this information to complete a “Sources and
       Uses of Cash” Statement and generate a large number in the “Necessary to
       Balance” line of the Balance Sheet.
       Necessary to Balance is not an accounting category. Instead, for each
       Year, “Necessary to Balance” represents the amount of financing that
       you need. You must assume that you will sell equity or borrow debt, or some
       combination -- equal to the amount of “Necessary to Balance.” For example,
       in the template attached, the business needs to raise $900,000 to finance the
       first year of operations.
       If Necessary to Balance shows extra cash (versus a need for financing), you
       can pay this out in dividends to your investors – or add it to your cash account
       cell. The second is probably more realistic in the case of a new business.

     Net Fixed Assets from last year, plus Capital Expenditures minus Depreciation, this year.
     Other Assets might include prepaid insurance or rent, intangible assets, etc.

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