Introduction
Financial projections, otherwise known as financial models, are a way for companies to anticipate their future financial performance. Such anticipating is usually done in the form of a forecast or budget. Financial projections allow you to take strategic decisions, especially in situations where the future can become unpredictable. They also provide companies with an insight into how their financial performance will evolve over the course of time.
Benefits of financial projections include:
- Helping to identify areas of risk or opportunity within a business
- Predicting and monitoring business performance
- Anticipating changes in the market place
- Improving decision making
- Helping to manage cash flow efficiently
Modeling Best Practices
Developing sound financial projections requires the use of effective modeling strategies and techniques. By understanding the different works, best practices, and assumptions to account for, you can ensure that the models compiled are accurate and accurate, giving you the clearest financial picture of the project at a point in time.
Itemize Expected Cash Flows
One of the first steps in developing financial projections is itemizing expected cash flows. This includes determining the expected sources and uses of funds, as well as income and expenses associated with the project. Collecting accurate and up-to-date information related to cash flow will provide a foundation for building the financial models.
Determine Assumptions for Forecasting
When developing the financial projections, you must make certain assumptions for forecasting the cash flows. These include making forecasts about revenue growth, expenses, capital expenditures, and other things that might affect the cash flow of the project. All assumptions for forecasting should be carefully considered and documented to ensure the financial models are reliable and accurate.
In addition to making assumptions for forecasting, you should also consider the potential risks and opportunities associated with the project. Additionally, an understanding of the market, industry, and competitive landscape should be taken into account when making financial projections.
Traditional Methods
There are a few methods for developing financial projections that allow for a more traditional approach. These methods are reliable and dependable for any and all business types hoping to gauge the financial performance of their venture.
Analyzing Historical Financials
Making use of historical financial documents provides a useful source of information for making projections and estimations. Up-to-date, relevant financial information from current or recent businesses gives financial projectors an inside look into the performance of their venture and can easily and accurately be adapted for their own projects.
Pro Forma Approach
Developing financial projections with a pro forma approach involves creating a yearly, monthly or quarterly income statement. This statement takes into account things such as revenue estimates, variable costs, fixed costs and other items that might affect a business. With this approach, projectors are able to see a specific period of time or a time frame they have set and estimate the potential success and profits of the venture.
- Revenue estimates
- Variable costs
- Fixed costs
Advanced Methods
Developing robust and accurate financial projections requires knowledge of the available methods and estimates that can be used. With traditional methods of projecting income statements, balance sheets and cash flow statements, it is important to know where the numbers come from and how there will be changes in the expected outcomes. Advanced methods offer a variety of ways to anticipate outcomes with a greater degree of accuracy.
Monte Carlo Simulations
Monte Carlo simulations are a stochastic approach to financial modeling that, in the most basic terms, model the variability of potential outcomes of a particular decision by analyzing multiple simulations. To use this approach, estimating methods such as heuristics, queues and probability distributions are used to generate diverse models and outcomes.
Scenario Building
Scenario building is an advanced method of developing financial projections by considering different possible courses of action and their potential effects on the outcome. This involves analyzing different situations and building a model that reflects each course of action. This helps identify the most likely scenarios and their impact on the financial projections.
- Scenario building assumes that the decision maker is able to select a course of action from a set of options.
- Scenario building allows the decision maker to recognize the possible outcomes of different choices.
- The scenario chosen should have the most favorable risk-reward ratio.
If Outsourced
Businesses may decide to outsource the development of their financial projections to a specialized third party. This method of developing financial projections often requires a fee and can be a cost effective measure when the manual labor or modeling expertise needed is beyond the scope of the business. Delegation of model building to a professional can save a company considerable time, especially if unburdened by the technical aspects of the task. It is important to keep in mind that since the third party is a business, the quality of the projections are usually dependent on their reputation, so it is important to research their credentials before engaging. The following outlines some of the perspectives that this third party brings to the development of financial projections:
- Delegation of Model Building to Professional: Developing financial projections can be a time-consuming and complicated endeavor. This can be especially true when taking into account the technical aspects of building projection models. When a third party is brought in, it can help expedite the process by providing specialized expertise and by creating a more efficient workflow. The third party can work closely with the business to build the necessary models and can help ensure accuracy.
- Perspectives from the Third Party: Having a third party involved in the development of financial projections can bring valuable perspectives. The third party can provide an outside viewpoint and can bring experience from similar projects. This can help to identify potential blind spots that the business may not have considered in their own analysis. Having a skilled and knowledgeable partner can strengthen the financial projection results and provide a more accurate picture.
Check-ins and Reviewing
Financial projections can provide companies with a powerful tool for understanding future performance, allowing management and stakeholders to make informed decisions about the future. However, with any forecasting exercise, regular review and updating of assumptions is an important part of the process.
Regular review of forecasting assumptions
Financial forecasts should be reviewed on a regular basis, as future performance will depend heavily on understanding key drivers of future performance and the assumptions that underpin them. Companies should take into account any new information or changes in the external environment that could have an impact on their forecasts, and ensure that they adjust their assumptions accordingly. This could include changes in sales growth, supply costs, regulations, or customer demand.
Use of new data if available
As assumptions and drivers of future performance inevitably change over time, the use of up-to-date data can provide a clearer picture of the future. It is important to identify where new data can be used to improve accuracy and ensure that forecasts are as informed as possible. For example, sales figures from the last quarter can be used to understand the likely trajectory of sales in the future. In addition, external data sources can be useful for developing a better understanding of industry trends that may impact performance.
Conclusion
Financial projections are intrinsic to the success of any business. Knowing how to accurately calculate projections is essential to predicting future performance, managing cash flows, and understanding the viability of any proposed new plans. There are several credible methods to develop these projections; each one is useful in its own way.
The four most widely used methods to develop financial projections are:
- Accounting Methods such as Small Business Accounting, GAAP Accounting and Tax Accounting
- Forecasting Methods such as Bottom-up forecasting and Top-down forecasting
- Relative Valuation Methods such as Comparable Company Analysis and Precedent Transaction Analysis
- Discounted Cash Flow Analysis
The best method to use when developing financial projections will depend largely upon the amount of data available, the depth of analysis required, the complexity of the situation and the skills of the analyst charged with creating them. No single method is perfect, so it is best to use a combination of the approaches available to ensure the most accurate results.
Financial projections are the foundation of any successful business strategy, and the ability to accurately forecast them is essential for the long-term success of any enterprise. Regardless of which methods you choose, it is important to understand how each of these approaches work, so that you can use them to develop the best financial projections possible.