“Why create financial projections when it is all a guess?” That is a question I hear all too often. Many entrepreneurs and small business owners have trouble making estimates and reducing the uncertainty in which they operate to a limited set of variables within a structured model. Their mistake is how they define the objective they aim to accomplish.
The goal of financial projections is not to guess the future. That is simply not possible. Rather, the goal is to define the company’s strategy for the next 2–5 years and create a mathematical representation of that strategy in the form of a financial model.
Here are 5 reasons why forecasting is key to your business’s success.
1. Sales baseline. A financial model helps company executives to formulate a sales baseline indicating which level of sales they plan to achieve in the next few years. While no one knows whether these sales numbers are going to materialize, setting concrete and measurable goals helps to crystallize the company’s strategy of how these goals can be accomplished. The question that should be asked is not “How do I know if my sales forecast for Year 1 is correct?”, but rather “What do I have to do to hit that sales forecast?” It helps to determine which factors impact revenues and which levers a company can pull to achieve its desired level of performance.
2. Budgeting. Once you set the sales goals, you can now determine the costs associated with realizing those numbers. Would you have to launch a bigger marketing campaign? Hire a PR firm? Invest in technology? Scale your operations? If you are expanding your customer base, whom are you now going to target and where? If you are expanding into new markets, which ones and how soon? The answers to all these questions come directly from your plans on how to grow your company.
3. Required expertise. Once all the related costs are determined, you can start analyzing who you must bring on board to execute that strategy. Will you need to hire an outside firm or expand your permanent staff? Which expertise do you currently have in-house and which expertise do you lack? Which information do you still need to get in order to make some vital decisions concerning the company’s direction? Who can give you that information?
4. Internal interdependencies. A model also helps you see all the internal interdependencies, and how a change in one area may affect others on both the revenue and cost sides. That is a common challenge, especially as the company grows bigger, and it’s much better to anticipate those effects than to be faced with the consequences when there is less room to maneuver.
5. Capital requirements. Finally once you have your proforma statements, you can clearly see the capital required to implement your strategy and how long it will take to start realizing returns from your investment. You can then decide whether to fund growth out of operations or external capital.
For more info on how to model business models for early stage startups, check out Course # 2.
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