Developing financial projections can seem like a monumental challenge, especially for emerging businesses that have little track record. After all, if you are operating at a loss with $0 revenue, how can you project a future state in which you have millions in revenue and are operating profitably? While financial modeling can be an inexact science, it can be incredibly helpful in pushing you to think about the future state of your business. Entrepreneur typically build a financial model in conjunction with their business plan. We suggest revisiting and updating your financial model as you reach milestones and plan for future growth. Assumptions are the key to any financial projections model. Before developing an overly complicated Excel model, give some thought to the key levers for your business.
Identify your revenue streams first (i.e. advertising, product sales, subscriptions) and the key elements for each. This can be as straightforward as price times quantity sold equals revenue. In a subscription business think about price points of your products and your target number of customers. If you have an advertising based business, consider metrics such as number of advertisers, impressions, and CPM. To help inform your assumptions so that they are more than just guesses, you should look at the overall market and comparable businesses. How long did it take your competitor to reach $1 million in sales? What price are they charging? Even better yet, do a beta test of your product to see sales response on a limited basis. If you have little confidence in your assumptions, create assumptions for multiple scenarios by developing your best guess, an optimistic case and a pessimistic case.
Expense assumptions are often much more straightforward than revenue assumptions. Start with cost-of-goods sold, then consider sales, marketing & distribution expense. It’s important to think about how your expenses relate to your revenue. For example, if you are going to ramp up your sales, do you need a significant marketing budget? Then factor in your technology, people, office, and other expenses. Expenses tend to go up over time, so factor in annual raises and adjustments for inflation of 3 to 5% annually. Be sure to be comprehensive and include expenses such as payroll taxes, healthcare expenses, and a small miscellaneous cushion.
The Actual Model
Setting up the model is the complicated part, unless you are an Excel whiz. The key output of your financial modeling is income statement projections for the next 3 to 5 years. Try to link up as much as possible through formulas that reference your assumptions (ideally assumptions can be on a separate worksheet in the same Excel file). Generally, you can use simple formulas such as multiplying price and quantity. Occassionally, you’ll need to use more advanced functions such as the IF function and others. I color code my entries such that all hard-entered inputs are in blue, and all formulas are in black. Then I know never to update any numbers in black because they are just calculations that adjust in real-time. Beyond an assumptions worksheet and income statement worksheet, you might also consider separate worksheets for listing out your headcount, cash flow, balance sheet, and a depreciation schedule.
Making Sense of the Output
The fun part is to see revenue growth, operating income, and required investment based on the final model. Be sure to troubleshoot and make sure that your results make sense. Assuming that your formulas are all linking up properly, consider how your business looks to an investor. How much do they need to invest and what is the expected return? Are you able to surpass revenue milestones of $1 million and/or $10 million? Do you show a healthy revenue growth of 15+ %? Do your operating margins make sense in years 3 – 5 (i.e. are they reaching the 20 to 30% range)? Are you able to reach profitability by the 2nd or 3rd year of projections? How much investment is required to fund your business for the next 18 months? Be sure that your expectations are reasonable. I’ve seen some projections that are unrealistically optimistic and show margins twice those of Google. You might need to find additional market data to inform your assumptions and make adjustments so that your financial projections model is both reasonable and compelling to prospective investors.
View A Financial Model Presentation for Startups