Table of Contents
What are Financial Projections?
Financial projections are forward-looking estimates of a company’s financial performance. Businesses use them to forecast future revenue, expenses, cash flows, and financial health over a specific period, usually spanning from one to five years.
There are six main types of financial projections:
- Revenue projections estimate future sales revenue based on market analysis, historical data, industry trends, and changes/continuities in the company’s marketing and sales strategies.
- Expense forecasts assess future fixed and variable costs for budgeting and financial planning.
- Cash flow projections predict cash inflows and outflows over a certain period to highlight a company’s ability to generate cash and stay solvent.
- Profit and loss projections, also known as income statement projections or P&L projections, forecast net income by subtracting projected expenses from projected revenues.
- Balance sheet projections project the company’s financial position at a future date, showing assets, liabilities, and equity.
- Break-even analysis determines the point at which a company’s revenues cover its expenses and start generating profits.
Businesses create financial projections to understand market conditions, plan for revenue growth, and identify potential issues that could impact their financial performance. Accurate projections help them make informed decisions about investments, expansion plans, hiring needs, and other strategic initiatives.
- Business plan financial projections
- Financial forecasts
Scenarios That Require Financial Projections
Projections are a core part of the financial planning and analysis (FP&A) process. Companies create them for a variety of purposes, which include:
- Devising a business plan or go-to-market strategy
- Creating a budget for the quarter or year
- Assessing profitability
- Setting sales targets based on revenue and expense projections
- Pitching to potential investors for funding
- Applying for a business loan or credit line
- Monitoring progress toward financial goals and targets
- Evaluating the feasibility of a proposed project
- Determining potential outcomes of an M&A transaction
Financial forecasting is also the basis of more complicated analyses, such as sensitivity and scenario analysis, which help businesses plan for different market conditions and evaluate potential risks. They’re also the starting point for forecasting models like regression and time series analyses, which compile and analyze historical data to generate more granular predictions.
Importance of Financial Projections for New Businesses
New and emerging companies don’t have a whole lot of (if any) financial data to go off. But there’s a lot of pressure for them to demonstrate financial viability and potential growth prospects to attract investors, secure funding, and get the business off the ground.
In this case, financial projections play an even more crucial role in providing insights into what the company could potentially achieve with proper funding and execution. Despite not having historical data, startups can still create forward-looking financial statements based on market research, product validation, and data-driven assumptions about their target market, competition, and pricing strategy.
For these types of companies, though, a different approach is required. With limited historical performance data, they’ll rely primarily on:
- Preliminary market research and analysis
- Understanding of industry trends
- Competitive analysis and benchmarking
- Product differentiation
- Market size, customer base, and target audience estimates
- Cost projections based on business plan specifics (e.g., R&D, production, and marketing expenses)
- The founders’ experience and expertise
- User tests, focus groups, crowdfunding, and other forms of product validation
It’s also worth mentioning that securing funding at this stage will often come down to what angel investors think of the founders and whether they have a notion the product will succeed. For that, detailed financial projections are a great way for business owners to show they understand their current position and are driven to get the business off the ground.
How Startups Use Financial Projections
Startups don’t only rely on financial projections. Since there’s a lot of uncertainty in the startup world, it’s more about being adaptable.
But, for preliminary planning purposes, startups use them to:
- Create a business strategy
- Map out a financial plan
- Assess and mitigate risks
- Prioritize GTM strategies
- Make product decisions
- Optimize their pricing model
- Plan for their first hires
Once sales execution commences, they’ll continuously collect data on sales performance and customer preferences, which they’ll use to gauge the efficacy of their product, marketing, pricing, and customer targeting strategies. Gathering this information is what helps them iterate on their strategies as quickly as possible.
After the first six months or year of operation, they’ll have more concrete data to work with. They can then build more granular projections that help them with:
- Securing funding
- Cash flow management
- High-level decision-making
- Resource allocation
On an ongoing basis, startup founders use financial projections to monitor performance, refine their market positioning, and investments in product development, marketing campaigns, and sales infrastructure. Eventually, they’ll also use them to devise an exit strategy or move toward an IPO.
6 Steps to Create Financial Projections
1. Take care of preliminary research.
Before creating a projection, you need to conduct research on your industry, target market, and competitors (insights you need to run your business). Before you can understand sales potential, the costs of achieving it, and the strategies it takes to get there, you have to know your total addressable market and customer segments.
From there, creating financial projections is all about adding context to that info with your business’s numbers — how much you’ll sell, for how much, over what period of time, and how much it’ll cost you to do that (given your current or proposed operating model).
2. Start with a sales projection.
Before you can examine your business as a whole, you need to have a foundational understanding of the revenue it’ll generate over the next year. That’s why you start with a sales projection.
New businesses don’t have historical data to extrapolate from, so they use a combination of market research, product validation, and educated guesses. The longer you’ve been doing business, the more reliable your sales data is.
Beyond previous performance, consider the following factors:
- The value of your current market segments
- Your average deal size or average order value
- The economy at large
- Supply chain vulnerabilities and risks
- Industry downturns
- Taxes and tariffs (plus new government policies that could impact your industry)
You’ll also want to consider your product or service’s value proposition, competitive advantage, and anything that could benefit your company in the future. For example, technological improvements, an increasingly differentiated product, or strengthening relationships with suppliers could help you outperform competitors.
3. Create an expense projection.
Once you know how much you can expect to sell, you can evaluate what it’s going to cost to achieve that. You have to account for direct and indirect costs.
In this context, direct costs are those associated with manufacturing and selling products or services (cost of goods sold). They’re typically variable costs that fluctuate with production volume or sales activity — the more you sell, the higher your cost.
These could include:
- Raw materials
- Inventory and packaging
- Manufacturing labor
- Engineering and product development
- Software development and maintenance (for SaaS companies)
- Marketing expenses that can be attributed directly to sales efforts (e.g., advertising costs, trade show fees, sponsorships)
- Sales team salaries and commissions
Indirect costs are those not directly related to your product or sales but necessary for business operations. They’re usually fixed costs — they don’t change regardless of production volume (unless, of course, you need to scale past their capacity).
Here are a few examples:
- Rent and utilities
- Office supplies
- Employee salaries (non-sales staff)
- Marketing expenses that can’t be directly attributed to sales efforts (e.g., branding, PR)
- Admin and compliance costs (e.g., accounting, legal fees)
Something always comes up, so it’s best to add an extra 10% to 15% on top of your direct and indirect costs when projecting your business expenses.
4. Create your balance sheet projection.
The balance sheet projection is what gives you a clearer look at your company’s financial health in relation to its assets, liabilities, and equity. You’ll use it to plan for inventory management, accounts receivable, accounts payable, capital expenditures (e.g., new equipment), and other investments.
As a startup without existing assets and liabilities, you’ll have to make reasonable assumptions about your cash on hand, current debt (if any), projected expenses, and capital investments. Your balance sheet will change significantly over the next few years as you build your business and pay off any debts.
For businesses that have been in operation for a few years, this is more straightforward. Use this year’s balance sheet (and previous ones), along with the data you’ve gathered in the first three steps, to project assets and liabilities over the next 1-3 years.
Assuming you currently use a cloud-based accounting software, all this information should be readily accessible.
5. Add in your income statement projection.
Businesses use the income statement to declare their profits and losses over a period of time. You’ll use it to evaluate profitability, solvency (can you pay off debts?), and liquidity (how much capital you have on hand).
On an income statement, you can see revenues and expenses, plus the difference between them: profit or loss.
- Revenue is money your company makes from sales, rent payments, investments, and other sources.
- Cost of goods sold (COGS) is the direct costs of your product or service.
- Gross profit = revenue – COGS.
- Operating expenses are the costs that support business operations. They can include rent, utilities, software licenses, and other administrative overhead.
- Non-operating expenses may include interest payments on a business loan or income taxes.
- Net profit = gross profit – operating and non-operating expenses.
Projecting your bottom-line profitability given your expected revenue and costs will give you an idea of your business’s overall financial health, including how profitable certain sales and marketing initiatives might be. Plug different scenarios into your income statement projection to guide decisions on pricing, product development, and cost-cutting measures for the next year.
6. Create your cash flow projection.
Cash flow projections forecast how all your money will move into and out of your business. Your cash flow statement is intertwined with the two others (and projecting it is no different) — it shows when cash balances will rise or fall during a period.
By extension, it will also show banks and investors how much cash you may need to borrow, whether you’ll be able to pay it back, and if you’ll have a cash surplus to reinvest in growth.
To calculate your cash flow projection, you’ll need to consider:
- Cash on hand
- Expected revenue from sales
- Customer payments
- Inventory purchases and raw material costs
- Manufacturing or software development overhead
- Employee salaries and benefits
- Office expenses (rent, utilities)
If you’ve been operating for at least six months, creating a decently accurate cash flow projection for the next six shouldn’t be too difficult. You’ll have enough historical data to make reasonable assumptions.
Best Practices for Making Financial Projections
Creating accurate financial projections is both a science and an art. While there are mathematical models to guide the process, projecting future financial performance also requires creativity, experience, and intuition.
A few tips can help make your projections more accurate:
- Do research within and outside your company walls. Use historical data, current performance, and future growth and GTM initiatives to take an objective approach. Also assess where your industry is headed as a whole and where customer demand is likely to shift.
- Be conservative, but not too conservative. Avoid wishful thinking or overly optimistic projections. A lot of startups fall into this trap, not considering the fact that as they mature, YoY growth will gradually slow down.
- Create multiple scenarios. Definitely consider best- and worst-case scenarios. But also build a middle-ground scenario that’s most likely to happen.
- Use a bottom-up approach. Start with low-level (individual) performance data and build up to overall revenue projections rather than relying on top-down estimates.
- Involve experts from different departments. Collaborate with sales, marketing, product, finance, and customer success teams to gather input across the customer and product lifecycle and validate your assumptions.
Regularly assess your projections’ accuracy. Over time, you’ll either realize your financial forecasts were on point or completely missed. Either way, you’ll learn something valuable. Inaccurate projections mean you’ve missed a crucial element in your analysis — for example, a certain segment of your market that’s behaving differently than you expected.
People Also Ask
What are the key metrics of financial projections?
The key metrics financial projections use are gross profit margin, return on sales (ROS)/operating margin, net profit margin, operating cash flow (OCF), total debt/total assets, current ratio, net working capital (NWC), and inventory turnover.
What is an example of a financial projection?
Let’s say a SaaS company wants to forecast its financial performance for the next three years. Its finance team would use historical data of past revenue and expenses, trends (e.g., seasonal demand), current performance, and projections for future growth to predict their expected revenue, costs, and ultimately their profitability in each year.
What is the best financial metric to evaluate a company?
A company’s bottom-line profit margin is the best financial metric to evaluate a company. While there are plenty of other measures, companies with higher profit margins (for their industry) are typically more efficient and financially sound, making them better investments for shareholders.
What is the difference between financial projections and forecasting?
The two terms are often used interchangeably (and they sometimes mean the same thing). By definition, a financial projection is an estimate of future financial performance based on assumptions and supported by historical data. Businesses can play around with different variables to see how they’ll impact their financials.
Forecasting, on the other hand, generally refers to predicting the future based on historical trends and patterns, without making any changes to the variables. In this case, financial forecasting gives a scenario with resources, cash flow, and sales volume the company could reasonably expect.