For many entrepreneurs who are passionate about what they do or plan to do, many attempt to skip over the part that causes headaches and that is “financial projections”. What everyone, yes I mean everyone, needs to realize is that this is the part no one can escape and not only that it is critical to the operation and sustainability of a business. There are many important aspects we can go over but one effective ways to become more competent in doing your financial projection is to be aware of the common mistakes your fellow entrepreneurs have made and learn from them. They’re either too conservative, too aggressive or they really have no idea how they got to their estimates. I will elaborate on five common mistakes below.
1. Top Down Assumptions
One of the worst mistakes you can make when developing financial projections is to start from the top and work your way down. Your projections should be bottom-up. A common top down approach is to say that the total market is a billion dollars and you think you can get 1% of the market. Here is an example of a fatal top-down assumption provided by Projectionhub.
“I want to start a coffee shop. Starbucks makes $1.5 million in profit per store each year at their coffee shops. I should be able to do at least half as good as Starbucks because my coffee and my service are better. Therefore I will project an annual profit of $750,000 next year.”
You will expose your flaws clearly by having making an assumption based on a top line number. You don’t just get the amount of customers Starbucks get. You will have to research and analysis of the region you are opening your business, the consumption rate of coffee in the area and even people’s standard of living. After you obtain information about your market, then you can decide to what extent of the market share your target would be.
Another major problem is that there are major costs associated with generating $750,000 in revenue. Starbucks corporate office spends millions on marketing and branding each year. Top down financial projections like this example simply don’t work when you try to compare yourself to a national brand.
2. Stating, “These Projections are Conservative”
This is by far the most common mistake that entrepreneurs make with their projected financial statements. There is no other statement that will send investors the other way faster than by calling your projections conservative. According to Adam Hoeksema, “Everyone thinks their pro forma financial statements are conservative and yet according to the Bureau of Labor Statistics of new businesses that started in 1994 or after only between 50 and 55% of those businesses are still in business after 5 years.” Also, one thing to keep in mind is that investors know that startups are risky so there is no point in makeing statements that are over-conservative.
3. Assumptions Not Based on Data
One way to also combat the assumption that is discussed above is to back your assumptions up with data. Projectionhub gives a good illustration. If you are selling flower vases online. You might assume that the average American has at least 1 flower vase in their home, and they probably buy a new one every 10 years on average. The problem is that you have no idea how many of those potential customers will shop for a flower vase online. Those might sound like reasonable estimates, but there is a far more accurate way to estimate your market potential for selling flower vases online.
4. Misunderstanding Cost of Goods Sold
It is easy to misunderstand and miscategorize expenses in Cost of Goods Sold. COGS are the expenses that you would only incur if you sold a product or service; whereas, an expense that you would incur whether you made a sale or not is a fixed expense or operating expense. Cost of goods sold can be defined as follows: All the costs incurred to purchase the raw materials, to produce the final product, and to ship the product to a point where it can be sold. With that in mind, let’s compare that with “Cost of goods sold for a services business”. Since you don’t actually have a product to sell, you won’t have costs for raw materials or labor to produce the product. Instead, you may have labor costs to provide a service. As a basic rule of thumb you should simply ask yourself “Would I incur this expense if I did not make a sale today?” if the answer is “yes, you would still have the expense even without an additional sale”, then it is not a COGS expense.
5. Excluding Depreciation
Depreciation is a non-cash expense, but it is an expense nevertheless. Many of your assets will decrease in value each year, and will need to be replaced eventually. Including depreciation expense in your financial projections demonstrates that you are thinking long term about the business, you expect to be around for a while. This is a good sign for bankers and investors.
Additionally, banks will likely take some or all of your assets as collateral for a loan, so they will want to see the current value of the asset, the useful life of the asset, and the depreciation expense connected to that asset each year.
Equip your great ideas with solid financial planning and projection and start simply by avoiding these basic mistakes.
About the Author
This article was written by Seven Zhang.