How to Make Financial Projections and Their Importance

By Indeed Editorial Team

Published June 18, 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

When creating a business plan, it's important that a business has a foundation on which to base it. Financial projections are a key component of this foundation, providing a business with an appreciation of its future financial performance so it can make better-informed decisions. If you're planning a career in business or business finance, it's important that you understand the role of financial projections and how to create them. In this article, we define financial projections, explain how to make financial projections, and discuss why they're important.

What are financial projections?

It's important to understand what financial projections are before learning how to make them. Financial projections are a tool that management and stakeholders use when making business decisions. They're forecasts of an organization's financial statement data, such as revenue and expenditure. When calculating them, a business takes into consideration internal data and external market factors. Most financial projections rely on three key projections, an income projection, a balance sheet projection, and a cash flow projection. The following are two types of financial projections that businesses predominantly use:

  • Short-term projections: Typically, short-term projections relate to one year and include a month-by-month breakdown.

  • Long-term projections: When businesses think about long-term projections, they generally relate these to the next three to five years. These projections are especially relevant when completing strategic planning or looking to encourage investors.

Related: What Is Forecasting? (With Definition and Different Methods)

How to make financial projections

When looking at how to make financial projections, you can use the same criteria, whether a business is new or established. The main difference is whether it bases its projections on historical data or whether it's looking to start new, in which case some market research may be necessary. The following steps may help when looking to develop financial projections:

1. Create a sales projection

Sales projections play a significant role in determining forecasts relating to revenue and profit. For an established business, the basis of a sales projection is its records of past sales. By analyzing historical data, a company can determine the factors influencing sales and incorporate this information into the projection. A business without historical data can research the sales of others in the same field. It's also important to consider the external factors that might influence sales. External factors are generally those that a business has little control over. They might include:

  • Legal and regulatory changes

  • Current and projected market conditions

  • Tax changes

  • Consumer confidence

  • Inflation rates

  • Economic outlook

2. Create an expenses projection

Organizations follow the same process when creating an expenses projection. For an established business, this involves listing all fixed and variable expenditures. Fixed expenditures are relatively straightforward and stable. Most of the time, this simply involves listing them and calculating the total. A variable or one-off expenditure, such as replacing damaged stock when a warehouse floods, can be harder to calculate, as it's often challenging to predict. Most businesses add a premium to the fixed expenditure to account for this. For instance, a common amount that businesses add is 15%.

3. Create a balance sheet projection

A balance sheet incorporates assets, liabilities, and equity balances. Many of these remain the same from year to year, meaning a company can calculate them using historical data. It's important to add any planned purchases and the associated costs to the balance sheet. A new business may use market research to assist it in identifying and valuing future assets and liabilities.

Related: How to Define and Measure a Key Performance Indicator

4. Calculate the income projection

The income projection uses the information from the previous forecasts and details the income from sales. A business then calculates the cost of the goods. To calculate this, add the costs of the goods in stock and subtract the total of any additional purchased goods, freight costs, direct labour, and indirect costs. This income projection might determine the projected number of goods sold multiplied by the cost per item. This is the projected net operating income.

To calculate the projected net operating income, deduct projected expenditure from the gross profit. If a business is planning to sell or dispose of any assets, then add or subtract the projected gain or loss. You can also add any projected income from interest here. The total figure is the projected net income of the business.

5. Create a cash flow projection

The final projection to calculate is the cash flow projection. Cash flow relates to income and expenditure. It's a summary of all the cash-related activities, and it shows how a business plans to spend its money. A cash flow projection is especially important when looking for investors or funding.

6. Determine the financial needs

Once you've determined the financial projections, it's important to compare them to the business plan. This determines whether the business plan is realistic. If it looks as if the projections are lower than the cost of the business needs, then it's necessary to consider how the company plans to fund the shortfall. Often, this requires additional borrowing. Alternatively, it may be necessary to amend the business plan.

Related: What Is Strategic Planning? (With Benefits)

7. Use the projections for planning

One strategy when making financial projections is to include projections for different scenarios, such as an optimistic scenario and a pessimistic scenario. By creating projections that consider different situations, you're able to plan better for the effect of each one. This allows a business to consider how to plan to increase the likelihood of achieving the most favourable projections.

8. Plan for contingencies

It's important to plan for unexpected events. This has the potential to render financial projections void. One way to overcome this is to factor a contingency into projections. A figure that many businesses use when accounting for contingencies is the cost of operating for 90 days. A company may then show this figure in its financial records as cash on hand.

9. Monitor the projection

Projections aren't definitive. A business can update or amend them to reflect a potential change in circumstances. The key is recognizing that something may have happened to change the projections. A company might monitor its financial reporting to determine any amendment. If there are notable variations, it might be necessary for the company to recalculate its projections, as the original information is no longer relevant.

Related: Demand Planning: Definition, Importance, and Helpful Tips

Why are financial projections important?

Financial projections are an important tool for many businesses. There are several reasons why they're important to an organization, including:

Informing future planning

Financial projections are important when planning future business operations or creating a formal business plan. They impact almost all aspects of a business' planning phase, including:

  • Resource allocation

  • Capital expenditure

  • Employee development

  • Staffing

  • Company ownership and shares

  • Investments

Supporting the case for funding and investment

A business uses financial projections to promote itself to investors. Potential investors assess these projections to inform decisions regarding whether they invest in a company. They're especially important to a start-up company that may not have any past or current data to demonstrate its investment worth.

Illustrating creditworthiness

When financial institutions are considering extending credit to a business, the availability of financial projections can be persuasive. As with a business looking for investors, a new organization that's yet to establish a financial history might provide a projection to the financial institutions to show that any lending is affordable. Other organizations might use projections when determining whether to extend a line of credit.

Acting as an early warning system

Financial projections can act as an early warning system if a company uses sound data to create its forecasts. When a company doesn't perform in line with its projections, it suggests that something has changed or is changing and is impacting the business. Often, changes of this nature can be a warning sign, especially if a business is performing well, although not at its expected level. A good management team looks to explore what has changed to determine if this is something they have control over.

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