1. Stating “These are Conservative” – I wanted to start with the most annoying financial projection mistake that nearly every entrepreneur is guilty of. Entrepreneurs ALWAYS say, “These financial projections are very conservative.” Here is the problem, 99% of entrepreneurs say that their financial projections are conservative, but many sources say that 50% of startups fail within the first 5 years of business. No one would start a business if their financial projections showed that they would go bankrupt in 5 years, and yet 50% of businesses go out of business. This means that for many of you, your financials are not conservative at all.
Additionally, your banker or potential investor should be the one to analyze your financial projections and make a determination as to whether or not they are conservative.
I encourage you to make conservative projections; however, there is no need for you to tell your audience how conservative you were, it is a major turn off.
2. No Assumptions Listed – Another mistake that many business owners make is that they do not include their assumptions with their projections. When you create a set of financial projections you are making dozens of assumptions. Some of those assumptions might not be that important because they make a small impact on your bottom line.
For example, you might assume that the price of stamps will go up 3 cents per year, but you only send out 1,000 envelopes per year, so even if your assumption is wrong, the price of stamps will have little impact on your bottom line.
On the other hand, some of your assumptions can have a huge impact on your bottom line. If you have a fleet of vehicles that service your customers, then the price of gas is an important assumption. If your fleet of vehicles requires 20,000 gallons of gas each year and the price of gas spikes $1, you are now $20,000 less profitable. For this business the price of gas is an important assumption.
You will make a number of assumptions as you complete your financial projections. Your audience probably doesn’t care if you are off by a penny or two on the price of a stamp, so don’t worry about listing that assumption, but for assumptions that have the potential to impact your bottom line in a significant way, make sure to include a listing of important assumptions with your financial projections.
3. Top Down Assumptions – One of the fatal flaws that many entrepreneurs make while creating financial projections is making top down assumptions. Your projections should be bottom-up. Let me give you an example of a fatal top down assumption.
“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.”
There are a couple of problems here.
- Bankers and potential investors will look at this and immediately know that you don’t understand your industry of your business. You can’t just assume a top line number. In order to generate a $750,000 profit next year how many coffees will you need to sell? At what price? How are you going to get those customers? Don’t say that you will have a great service, or that your coffee is better. Your assumptions need to be based on data, when possible. For example, “there are 100,000 people in my city, 14% of people buy coffee from a coffee shop, I will need to capture 37% of the market in my city in order to generate a $750,000 profit next year.” Now you can outline a plan to demonstrate exactly how you intend to capture that 37% market share.
- 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.
4. No Scenario Analysis – You should build your financial spreadsheet model in such a way that you can analyze various scenarios. You will want to be able to easily change assumptions so that you can analyze your financials for various scenarios. For example:
The assumption numbers in this table can be changed which will automatically populate your financial projection profit and loss, cash flow statement, and balance sheet with the new projections. This will allow you and/or bankers/investors to test various scenarios. Since some of your assumptions will certainly be wrong, most bankers and investors will want to see how the financial health of your company changes when they push and pull at your assumptions.
5. Assumptions Not Based on Data – The last assumption based mistake that many entrepreneurs make is creating assumptions that are not based on data. For example, you might sell 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.
You can use the Google Adwords Keywords Tool to determine how many times keyword phrases related to “flower vase” are searched for on Google each month.
This data shows that there are 74,000 monthly searches for “Flower Vase” on Google, and many more searches for related keyword phrases. This is a much better way to build your assumptions based on data.
6. 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. Here is a short 4 minute video that explains COGS in detail.
7. No Written Explanation – Many times a set of financial projections includes a profit and loss statement, cash flow statement and a projected balance sheet, but there is no written narrative that explains and justifies the projections.
You should include an extensive written explanation with your assumptions and your financial statements. If you are able to find financial information for your competitors, you should include that info, and explain why you believe your projections are different whether they are better or worse than the competition.
8. No Bad Debt Expense – Business owners commonly exclude bad debt expense from their budget. Bad debt expense can vary greatly depending on industry, but there are few industries where you collect every dollar of revenue earned. Will 2% of your customers fail to pay, or will 7% fail to pay? This is an important consideration, and failing to include this line item in your forecast can be a warning sign for potential investors.
9. Excluding Loan Payments – This is probably the worst mistake you can make on your loan application, forgetting to include your loan payment in your financial projections. If you are applying for a loan, you should estimate the interest rate, amount, and length of loan to come up with a projected monthly payment.
Bankers want to know that you have the cash flow to make your loan payment each month. Additionally, bankers want you to consider your loan payment as your very first expense each month. Your loan payment should come before you pay your own salary, of before you spend a dollar on meals and entertainment. Excluding the loan payment from your projections sets a bad tone with any banker.
10. Excluding Taxes – Taxes can be a huge expense for a profitable company. Depending on where you are and your corporate structure you might expect to pay 25% or more in taxes. This might not be as important for a banker because the bank will get paid before taxes, but an investor is paid after taxes. If you project a million dollar profit next year, but forget to include 25% tax rate, that is a $250,000 difference for your investors.
11. 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. Learn more about depreciation here.
12. No Wiggle Room – If your financial projections leave no “wiggle room” investors and bankers are going to be nervous. Leaving no margin for error means that if even one assumptions is wrong, you could go bankrupt. Typically, banks don’t take those kinds of risks, so if your projections are that fragile, you may want to focus on seeking risk tolerant investors.
13. No Contact Information – I constantly remind entrepreneurs to include their contact information on every page of their financial projections. Your financials are probably one of the most likely sources of questions for a banker or investor, so make sure to include your name, email address, phone number and mailing address on each page of your financials.
14. No Breakeven Analysis – When you create a breakeven analysis you are determining how many units you must sell in order to breakeven, in other words your revenue and expenses are equal. A breakeven analysis can help you determine how many units you must sell each day, month, and year. Here is an example of a breakeven analysis for a blog that I recently wrote.
15. Excluding Founder Salary – If you want to operate a sustainable business, then at some point you need to take home a salary as the owner. If your projections never include a salary for yourself, your bankers and investors are going to recognize that you can’t continue to operate this way forever. If the business can’t afford to pay you and still make a profit, then this probably is not a business that a bank or investor would be willing to put money into. Eventually, it is doomed to fail, so make sure to include a modest salary for yourself to demonstrate truly realistic financials.
There you have it! 15 financial projections mistakes that entrepreneurs and small business owners commonly make.
About the Author: Adam Hoeksema is the Co-Founder of ProjectionHub which helps entrepreneurs create financial projections without the need to have a PhD in spreadsheet modeling.