This is a common question I get from ProjectionHub users. There is no simple answer but there are some basic principles I can share.
Who are the Projections For?
Depending on who the projections are for, you will need varying levels of accuracy. Here are some differences in your projections based on how the projections will be used.
Investors – Primarily concerned with your business model in general. They will want to know what your margins are and what your market potential is. See my answer on Quora titled “How to Calculate Market Potential for a Startup”
Lenders – Concerned with financial ratios. Will review your projected and current balance sheet to compare assets vs. debt, and cash balance to current liabilities, etc.
Planning Purposes – If you are creating projections in order to determine if you have enough cash to survive, or to find out when you will need more capital, you will need to improve your accuracy.
Here are 3 ways to improve the accuracy of your financial projections:
1. How to Improve Revenue Projection Accuracy?
In order to improve the accuracy of your revenue projections I recommend that you focus on 3 specific areas that will impact your final forecast.
Sales Cycle – The most common mistake is probably an overly optimistic outlook on your sales cycle. In other words, how long will it take from the time you met the potential customer to the time you closed the sale. You might project a 30 day sales cycle and it turns out that it takes 120 days. This will make a huge difference in your revenue.
Market Potential – You might think that “Everyone” is going to want your product or service. Rather than assume your target market is Everyone, I recommend that you use the Google Adwords Keyword Tool to find how many people are searching for keywords relevant to your product or service. I gave a detailed explanation of how to do this with Google Adwords on Quora. Check it out.
Pricing – Lastly, your pricing will dramatically impact your revenue. You might be able to sell a thousand units if you price the product at $5, but maybe you could sell 500 units at $50 a piece. Although your units sold is cut in half, your revenue increases 5 times over at the $50 price.
2. How to Improve Expense Projection Accuracy?
In order to improve the accuracy of your expense projections I recommend that you focus on the following 2 areas:
Cost of Goods Sold – Your cost of goods sold is the most important expense to get right. Why? Because when you are off, you are off every time you sell a unit or a billable hour. For example, if you make a $1 mistake on how much it will cost to produce your product, it quickly becomes a $100,000 mistake when you sell 100k units. It sounds much worse to make a $500 mistake with your monthly rent, but it actually will only cost you $6,000 of the 12 months of the year. Cost of goods sold is variable, so the more units you sell the more important it is to improve the accuracy of your COGS projections.
Bad Debt Expense – It is easy to forget to include bad debt expense within your expense projections. But every business, every industry can expect to have some bad debt. Sometimes customers simply don’t pay. The other important thing to remember with Bad Debt expense is that it is variable as well. The more you sell, the more bad debt you are likely to have. You should try to find what an average bad debt expense percentage is for your industry. Maybe it is 3% of sales, maybe it is 10% of sales. Whatever it is, try to be accurate here, or this expense could wreak havoc on your projections.
3. How to Improve Cash Flow Projection Accuracy?
In order to improve the accuracy of your cash flow projections, I recommend that you focus on the following 3 areas:
Days to Get Paid – This is definitely the most common cash flow projection mistake. No one realizes how long their customers will take to pay their bills. Depending on your industry and the size of your customers you could be waiting up to 100 days to get paid. This just kills your cash flow. Many startups and small businesses end up factoring their receivables with companies like our partner Lendio. You can actually sell your invoices at a discount for cash now. So if you have a $50,000 invoice out to a customer, you might sell it for $47,500 in cash now rather than waiting 60 or 90 days for that customer to pay. You can find a factoring company that fits your needs at Lendio here.
Days to Pay – While your customers may not pay for 90+ days, your vendors will likely require you to pay within 30 days or less. When you are a startup, you probably won’t get good terms with your vendors. Don’t assume you can wait 60 days to pay your vendors, if you do it will likely kill your cash flow projections.
Sales Cycle – I know I already mentioned this above in the revenue projections section, but I wanted to reiterate how important this is. One of the most common ways for cash flow projections to end up way off, is to be too optimistic with your sales cycle. Do you really think it will only take 30 days from the time you meet a potential customer to the time that you close the sale? This is a dangerous assumption to be optimistic about. As you watch how long it takes to close a sale for your initial sales, tweak your projections to reflect that sales cycle.
At the end of the day the answer to how accurate should your financial projections be, is… it depends. It depends on the purpose of the projections and your audience. I recommend that you start with a very basic set of financial projections, and improve accuracy as needed. If you have any specific questions about your projections, please feel free to reach out to me at email@example.com