What is a Financial Projection?
Financial projections are a way to make concrete and detailed plans for future expenses and income. This makes it easier to compare the likely effect of different decisions taking into account the risks involved. Financial projection as observed by Fintalent’s financial projection consultants, is also good as a planning technique before entering a business venture or buying property.
Why are financial projections useful?
In order for a business to make a profit it needs to spend less than it makes. At the same time, in order for the business to pay its staff salaries, rent and buy materials and supplies, it needs to make money. In practice, these amounts can be very different as they depend on the way in which a business is run (ie. how much it spends on stationery and cleaning supplies). As a result of these differences, businesses need methods of planning their expenses so that they can budget carefully enough to ensure that their income is sufficient every month.
Financial projections are used by businesses as a tool to help them plan more accurately than they might use their income. This helps them budget better and to take into account all the possible expenses that could be incurred. It makes it easier for business owners to see the possible effects of different decisions on their business and to make plans accordingly.
The best time to make financial projections is before spending money. They are very useful during the early stages of planning, before you have made any major purchases. Financial projections can also be performed mid-way through a business, after you have already bought things but before buying something new that could significantly alter your costs or income (such as buying a second hand item which is cheaper than buying brand new).
The process of financial projections
Financial projections are a form of budgeting; they are used to plan the monthly business expenses and income. This involves making predictions about how likely it is that different things will happen, how much they could cost, and what will happen to that cost if they do occur. They are based around a formula: variables (things the business can control), costs (the things the business has to do) and results (the results of actions). These three things often go together in one model, or three separate models for each variable. Outcomes can be measured at different levels, such as gross or net (i.e., profit made but also money spent on paying bills). They also quantify risks by recording how likely it is that a particular outcome will occur.
A financial projection provides a way to make estimates based on the best information available. This means that any inaccuracies in the amounts and assumptions can be easily identified and corrected. It is also possible to compare different models fairly easily, by looking at the various ways in which they could arrive at different amounts, or draw conclusions from them such as whether a particular change should be made to reduce costs or increase income.
Financial projections are often referred to as budgeting models because they provide a way of taking all the information available and working out how it might affect future business income and expenses. This allows business owners to focus on where they are well-placed to make savings or increase income and can ensure that they focus on improvements that make the most difference.
Creating a financial projection requires information about the variables, costs and results. There are different ways of making this work depending upon what information is available. However, it is critical that the financial projections are realistic and reasonable; it is not useful to predict huge changes in order to provide a reason for slightly better profits or for reducing your expenses. It also needs to be realistic about how much is spent – if you go over budget in one area (such as household bills) then you will probably have to compensate for this by either spending less in another area or increasing your income.
There are two major mistakes that people make when creating financial projections. The first is not calculating the right costs; it is important that you do this to stop the risks of going over budget. The second mistake is wrongly predicting the result; people often try to predict small and insignificant events, such as whether it will rain or whether there will be a power cut. These events, while they might potentially cause a problem, only have an impact on your income and expenses if they happen in large numbers – such as a heavy snowfall cutting off electricity, or an unexpected illness.
Basics of financial projections
The first thing to do when creating a financial projection is to decide what the variables, costs and results will be. These are usually simple one word descriptions, such as ‘salary’, ‘supplies’ and ‘profit’. It is better if you choose words that are not interchangeable; for example, it wouldn’t be useful to set up three variables that all meant the same thing (ie. ‘salary’, ‘wages’ and ‘payments made by customers who owed money on credit cards or loans’). It is also useful to think about who will be involved – for example, if you are creating a financial projection for a family it may be better to set up the variables as ‘salary income’ and ‘salary expenditure’ rather than your own wages. It is also worth thinking about when the variable will happen – this may affect the way in which it is recorded. For example, will you pay a supplier every month or only once a year?
Once you have decided what each variable means you need to work out how much they might cost in different circumstances. This will be different for each variable and you will have to decide what each item represents. For example, you might work out a salary budget by thinking about how much of your salary you need to put aside every month to pay essential bills, and how much additional money you would like to save each month (after paying salaries).
You then need to think of how likely it is that the variable will actually happen. You can do this by looking at the cost of each variable, as it is unlikely that they will all happen – but it is worth considering how much they might cost if they did. You can also look at the issues that might affect whether or not certain events occur and look at what could change these costs or risks. For example, you may want to increase your profit by £5,000 but this is unlikely and you will have to include extra costs for tax and VAT.
You can also work out how much the event may cost, either based on the current costs or thinking about what would be a reasonable outcome if the event happened. This is a complicated process that needs to take into account the outcome of the event in addition to any extra costs – for example, £200 extra in materials if you decide not to purchase some stock but it turns out that you have sold a large order of stock – this could lead to your business making £600 more profit than it would have done otherwise.