9 Common Mistakes with Business Financial Projections

I was glad to be asked about common mistakes with financial projections. I read about 100 business plans a year for angel investment and business plan competitions. Here are the most common mistakes I see in business forecasts.

1. Unrealistic profitability

Most of the business plans I see project profits too high, or profits too early. In the real world, startups choose growth or profits, not both. The plans I see are aimed at angel investment. And for that, the investors win on growth, not profitability. Think about it: If a startup is profitable early on, it doesn’t need investors.

2. Underestimated market expenses

Many successful tech businesses, especially software and web businesses, spend 30% or more of sales on marketing.

Don’t underestimate development expenses, testing, certifications, and expenses of regulations.

If you are selling physical products, don’t underestimate the impact of selling through channels. Distributors and retailers take their margins and often demand admin and co-promotion expenses. Distributors often pay very slowly, like six months or so after receiving the goods.

3. Applying a small percentage to a large market

That doesn’t work. Nobody gets half a percent of a $10 billion market. Instead, sales forecasts should be built on drivers as assumptions. Drivers might be web visits and conversions, emails sent, paid search terms, or, for physical products, channel assumptions such as distributors, chains, stores, and sales per store.

4. Large sales growth with a limited headcount increase

If you are going to sell $100 million in the fifth year, get a clue: you won’t do that with only $2 million in employee expenses. Divide your projected sales by your headcount, and compare that to industry benchmarks.

For most industries, $250,000 per employee is really good. If you are getting $2 million per employee, that doesn’t mean you’re going to be that efficient.

It means you don’t understand the business.

5. Confusing profit and cash

Having a profit doesn’t mean you’ll have cash in the bank. Good startup financial projections need to include cash flow. Always. For more on that, see points 4, 6,

Businesses selling to businesses (B2B) normally sell on account. A sale generates not money directly but money owed, to be paid later, which goes on the balance sheet as Accounts Receivable, or AR. Every dollar in AR shows up as sales in the P&L but not in cash.

Many plans underestimate the length of the sales cycle and expenses related to selling directly to enterprises.

Many plans underestimate the cash flow affect of inventory. Every dollar in inventory is a dollar that hasn’t yet shown up in the P&L but may have already affected cash balances.

6. Not linking the three statements

Income (also called Profit and loss), Balance, and Cash Flow are interactive. If the model doesn’t reflect a change in one of the three with a related change in the other two, then it’s incorrect. For example, a change in sales should affect not just profits but also balance and cash.

A change in inventory might or might not affect cash—depending on whether it’s been paid or remains in Accounts Payable—but won’t affect profits unless there are related expenses for storage, etc. Interest on debt is an expense that affects Income and Cash Flow but not directly on the Balance.

Repaying principal on debt affects Balance and Cash Flow but not profits. and so forth.

The image above reflects standard accounting and bookkeeping, also called GAAP (generally accepted accounting principles). In the Western world, financial models don’t have the luxury of ignoring GAAP. If they don’t adhere to standards, they aren’t useful and aren’t even correct.

7. Assets must always equal liabilities plus capital

This is the force behind point one, the need to link the three statements. The best test of a good financial model is this essential equation: assets less liabilities equals capital. If it doesn’t, then the model is off. Also, the various related equations: capital plus liabilities equals assets. Liabilities equal assets less capital. These must always be true.

So even simple changes flow through the system, and in a good system, those changes properly reflect the essential equations, which are always true. If I keep my three projections separate or have only one or two of the three, then I lose the value of the ultimate error check.

8. Underestimating expenses

Very common problem with projected financials. Many vastly underestimate marketing expenses, admin expenses, etc. A founder should have a reasonable idea of general spending patterns in the industry they are in.

I’ve often seen plans projecting 2–5% marketing expenses to sales in web and software industries that spend 30–40% of sales on marketing. I’ve seen plans that show less than $1 million in admin expenses including salaries in a business making 20 million and up in revenues. That doesn’t happen.

The quick key is profits. Real businesses make 5–10% profits on sales and, once in a blue moon, significantly more than that. Growing businesses generally make low profits or none at all because growth and profits don’t normally coexist well. You pick one or the other, not both.

Projections showing high profits almost always vastly underestimate expenses. The projections do not show what a good business it will be but rather that the founders don’t know the business well.

9. Overestimating cash

The first problem with overestimating cash is why you would need investment if your business generates such huge amounts of cash. If you generate cash, you don’t need investors.

Furthermore, if you generate cash, investors don’t want you, because you’ll never need to exit. Bottom line: no, you are not going to generate cash during your early growth stages. Growing startups absorb cash. They generate growth with deficit spending, and they need new cash (investment) to finance the deficit.

The other, possibly more important, problem is that these rich cash projections always miss the impact of financing inventory and Accounts Receivable. They don’t understand sales cycles or the difference between making the sale and getting the money.

The errors compound each other. Failing to include realistic expenses leads to unrealistic profits, which then create unrealistic cash in the projections.

The good news here…

… is that for a startup, these problems are way easier to fix than problems with the team, the product, the market, the scalability, the barriers to entry, and the path to exit.