The only constant in the global market is uncertainty. While larger organizations can more easily weather fluctuations in market conditions, less established businesses are more vulnerable. Fortunately, they can protect themselves with effective forecasting. Forecasting can strengthen your business plan or improve your financial management, which puts your organization on a more financially secure path. That’s why it is essential for entrepreneurs to understand the basic techniques of financial forecasting for startups.
As the owner of a startup, you will need resources to grow and scale. Precise forecasts may be the key to convincing investors and lenders that external financing will make your project profitable. Forecasting also helps you organize internal operations in a more profitable way, whether through sales budgeting or evaluating different areas of the enterprise. In order to help you make the most of your organization and resources, we will briefly explain the importance of financial forecasting, how it works, and how it benefits your enterprise.
What is financial forecasting, and why does it matter?
Generally speaking, financial forecasting for a startup is the process of calculating an enterprise’s future income and expenses. As a rule, financial forecasts are based on historical data and reflect expected changes in external market conditions. Depending on the issue at hand, you may create a variety of short, medium, and long-term forecasts to answer crucial questions about your business. Short-term options focus on the first year of the firm’s operation, while long-term calculations cover 3 to 5 years.
According to the U.S. Bureau of Labor Statistics, there are almost 32 million small businesses offering various goods and services across the country. Notably, about 20% of these firms fail during the first year of operation; after five years, the figure reaches 50%.
CBInsights specialists decided to find out what factors most often lead to bankruptcy. According to their research, the most common factors include:
- Launching a business whose offers did not have stable demand (42%)
- Cash flow problems (30%)
- Challenges with costs and pricing (18%)
- Lack of precise financial planning and business model (10%)
Competent forecasting allows us to solve most of these problems. Clearly, financial forecasting is an essential business practice that more owners would benefit from properly enacting.
Financial projections are closely related to budgeting. If you have computed that profit will increase by $20,000 in a year, you may budget to allocate capital properly, e.g., you can spend $12,000 on equipment and $8,000 on an advertising campaign. Effective budgeting is crucial for success.
How to create a financial forecast for a startup business
Financial forecasting for startups is a multi-step task, and the most difficult step is usually obtaining data. According to auditing firm Ernst & Young, there are a few primary ways to receive forecasting information: based on the market share you want to capture (bottom-up) or existing data (top-down). Experts advise using a bottom-up forecasting method in the short term (up to 2 years) and top-down in long-term projections (up to 5 years). With these options in mind, let’s go through the main stages of creating a practical financial model.
Conduct deep market research
Market research helps you to better understand your industry when launching a business. This process helps you form a target audience to consume your commodities, which you can then use to form a profile of the ideal customer. This small step will help you predict profits as you consider consumer trends.
Forecasting expert Sean Heberling, the SEO of Marion Street Capital, reports that his company once helped an automated manufacturing enterprise create and conduct a survey of its potential customers known to other organizations in the industry. The team at Marion Street Capital encouraged respondents by providing anonymous copies of other companies’ responses, allowing them to compare results with other enterprises in the industry. Using forecasts based on the survey, Marion Street Capital helped the client secure $25 million in investments. Of course, this is just one example of the tremendous economic power of forecasting.
Collect relevant financial data
In order to make predictions, you first need to summarize your revenues and expenditures into a workable estimate. If you are making financial projections for a startup, this requires some guesswork. Most importantly, you should ensure that your estimates are based on verifiable data. If you have historical information, you can simply export capital inflows and outflows for the last 12 months into a spreadsheet. When estimating salary projections, you can use the Glassdoor database.
Determine spending
Your organization’s spending budget represents how much you plan to spend during your first years of operation. It is essential to anticipate all operating and overhead costs of running your business. According to financial experts, it is best to divide between fixed and variable expenditures, as this helps you to more efficiently plan your budget and increase profitability.
Palo Alto Software founder Tim Berry advises that lower fixed costs provide less risk. This may be theoretical in business school, but it is all too tangible when you are actually signing a check to get your organization running. In addition, you should keep in mind that your spending will vary depending on the stage of development. You will likely have higher marketing costs when you are just starting out, compared to later on in your business’s operations.
Calculate Return on investment (ROI)
Your return on investment, or ROI, is the capital you will receive after paying your bills and investing in a growth strategy. To calculate ROI, you should determine how much money you must spend to launch a business and compare this value with predicted earnings. This indicator is necessary to convince potential investors that your organization is profitable, and that they may benefit from investing in your vision.
Setting a Time Frame
Choosing the period when you will receive ROI simplifies the interaction with investors and helps you set and track goals. For instance, you can consult income and expense forecasts to help you predict when your business will break even. This goal will help you to implement advertising campaigns, as well as determine your pricing policy and the optimal moment to launch your startup.
Main components of financial forecasting
Your organization’s financial forecast paves the way for the creation of three key fiscal documents. Let’s take a look at how each of these statements may help with your company’s plans for development:
- The profit and loss statement contains data on income and expenses. It provides valuable data on actual or projected results for your organization’s operations. Investors use this report to assess the financial health and performance of your firm.
- The capital flow statement demonstrates the inflow and outflow of capital in the enterprise. Management applies insights from this document to provide debt control, capital risk management, working capital preservation, renewal of investments, and other important fiscal controls. The movement of financial resources is critical when discussing startups, as it is directly related to the burn rate. If you don’t have a clear idea of your company’s cash flow projection, your enterprise will sink faster than you realize.
- The balance sheet summarizes the firm’s assets and obligations. This document can be compared with the income statement, given the different periods of validity of securities (the ownership of assets and liabilities does not fit into the same financial period indicated in income reports).
We recommend that entrepreneurs analyze each report individually to identify potential hazards and growth opportunities. For example, if the forecast shows a significant increase in the gross profit of the enterprise. you should review your spending to see if it’s worth investing the extra profit in hiring more people or implementing other development measures.
A few recommendations on how to form financial forecasts
At first glance, creating an economic forecast seems rather simple; after all, it combines different projections in a fairly straightforward way. Still, there are some precautions you should adopt in order to obtain the maximum return on capital:
- Update forecasts regularly: your original forecast may indicate that you’ll reach $700,000 monthly recurring revenue in 3 months, but notice leads are visibly declining. In this situation, it might be worth revisiting your financial plan based on the reduced number of leads. Updating your forecasts will ensure that your predictions are not based on outdated information.
- Create multiple financial projections for a startup: many entrepreneurs make the mistake of drafting only one financial plan. Business may go better or worse than expected, so you must understand the algorithm of actions and have several projections at your disposal.
As a business owner, you may be wondering about the many variables that can affect your financial forecasting, such as sales force performance, conversion rates, market conditions, and macroeconomic factors. Fortunately, there is no need to consider every factor or obsess over creating ideal projections. Actually, creating the perfect forecast is impossible, as there is always some simplification and estimation involved.
Final words
Generating forecasts can be a time-consuming and intricate task, especially if you, like many other business owners, lack extensive experience in this area. It is important to remember that your financial specialist can only generate accurate financial projections based on error-free accounting information. However, despite the paramount importance of accurate financial records, many startups choose to handle their accounting internally in order to lower costs.
If you would rather delegate the creation of documents and forecasts to seasoned financial experts, BooksTime may be the best solution. Our dedicated team offers a full range of CFO and accounting services for startups and small businesses, all with the speed, security, and convenience of state-of-the-art accounting software. With BooksTime, you can be sure that your financial calculations are correct, up-to-date, and complete!
