Although no business owner has a crystal ball to predict future earnings and expenditures, a set of thoughtful projected financial statements can provide benchmarks for planning and financing. Together, a pro forma income statement and a projected balance sheet provide an idea of what to expect if your assumptions are sound and offer a road map for short- and long-term strategy.
TL;DR (Too Long; Didn't Read)
A projected income statement will show how much cash you expect to have coming in and left over at the end of an upcoming period. A projected balance sheet will show how your anticipated earnings or losses play out in terms of debts, assets and cash on hand.
Creating Projected Financial Statements
A projected statement of financial position should be based on real information rather than wishful thinking. The more accurate the information you incorporate, the better your chances of creating useful and meaningful projections.
- Use past information as the basis for assumptions about the future. Your books from previous accounting periods can provide numbers telling what percentage of revenue you typically spend on direct costs such as materials and payroll. They can also help you project fixed costs, especially if your business infrastructure is reasonably stable and costs like rent and utilities aren't going to change significantly during the projection period.
- Do research to back up assumptions for new projects. If your business is new or if you're launching a new product, you can still gather information to ground your projections in reality. Your local library will have information about demographics in your area, and this will help you to develop an idea of how many potential customers you may be able to reach. City and county offices can provide data about similar businesses that may affect or compare with your company's performance outcomes.
- Create projections for a range of outcomes. Of course you're hoping for and expecting unbridled success, but your project may take a while to get off the ground, and it may not even gain traction at all. Do a series of different projections showing best-case, worst-case and medium-case scenarios. These different versions of your projected financial statements will help you prepare for a variety of possibilities by showing how much you have to earn to break even and under what circumstances you may need extra capital.
Making Income Statement Assumptions
An income statement summarizes your revenue and expenses during a particular period and calculates your net earnings based on these numbers. It will include lines for variable costs or those that fluctuate directly relative to the volume of business you do and also fixed costs such as rent, which stay steady as your sales increase. A projected income statement shows how much you expect to spend and how much you expect to earn and breaks these areas into categories such as wholesale, retail sales, materials and payroll expenditures.
The assumptions behind a projected income statement will affect the information you input and the outcomes you receive. It seems reasonably safe to assume that variable costs such as labor and materials will stay reasonably consistent as a percentage of your variable sales.
However, there are situations when this may not be the case, such as if you achieve beneficial economies of scale or if the cost of essential materials suddenly increases. Although you can't always predict these developments and events, you can at least insulate yourself from some uncertainty by understanding the assumptions you're making and the ways they may be problematic.
Income Statement Assumptions for New Businesses
If your business is brand new, you won't even have past income statements to use as the basis for future projections. Industry and market research can provide valuable starting points, but there are still many critical unknowns that will affect the actual outcomes. It's unlikely that your projected income statement will accurately reflect all the ways your business will unfold, especially if you have very little entrepreneurial experience. However, the process of creating a projected income statement is a valuable exercise to help you think through problems and possibilities and to prepare you for launching your company.
Making Balance Sheet Assumptions
A balance sheet is a snapshot summary of your company's financial position at a particular moment in time. It lists everything you own on one side and everything you owe on the other side and then summarizes the relationship between the two in a calculation called "owner's equity." Creating an actual balance sheet is reasonably straightforward: You check the money in all of your bank accounts as well as your cash on hand, and you compare it with the balances due to individuals and on loans and credit cards.
However, like income statements, balance sheets are actually founded on a series of assumptions that should be kept in mind to avoid a false sense of security. A projected balance sheet could easily be built with the assumption that every cent you earn will increase your net worth, but you could buy equipment or inventory that ends up being useless.
Balance sheets also include subjective items such as good will, which put a dollar figure on your company's intangibles and are based on assumptions about how others will perceive the real worth of your reputation and information systems.
Balance Sheet Assumptions for New Businesses
If you're just starting out, you probably won't have a clear idea of how your sales will translate into assets. At the very least, be aware of the assumptions you're making when you create a projected balance sheet for a startup business, such as how quickly you will pay off debt, and include footnotes detailing these premises. This document isn't supposed to be a magically accurate prediction but rather a tool to help you foresee how loan-worthy your venture will appear to lenders and when you may need extra capital.
Using Projected Financial Statements
A projected balance sheet and income statement will come in handy when it's time to make decisions about how to grow your company. Your pro forma income statement is your opportunity to map out expected costs relative to anticipated income so you can see whether a product or project you're contemplating is financially viable.
Your pro forma balance sheet can give an idea of how your strategies for financing this move will show up as debts and assets. Preparing these statements for a number of different points in the future, such as one year and three years, will give you long-range perspective on your venture.
Lenders and investors will ask to see projected income statements and balance sheets before providing funds. This requirement gives them the opportunity to see whether your assumptions and expectations are realistic and whether your project is a risky or sound investment. The requirement to provide these statements also provides the basis for conversation, as they raise questions and you provide answers that show the strengths and weaknesses of your projections.
Striking a Balance
When creating a projected balance sheet and income statement, try to strike a happy medium between confidence and realism. Use these documents to show your company's potential to grow and pay back the financing you're seeking, but also offer numbers that are well researched and firmly rooted in reality. The better you're able to chart a course between practicality and optimism, the better you'll be able to convince a lender or investor of the worthiness of your project.