How to Improve the Accuracy of Financial Forecasts

Every spring, I read and review dozens of business plans as a member of an angel investment group and a judge at several business plan contests. I love it.

The plans I’ve seen are better than ever this year. But, for some reason, their financial projections are the worst I’ve seen.

How can the plans be better while their financials are worse? 

I think product/market fit, defensibility, scalability, market need, and management experience are much harder to fix than bad financials. A good business with poor financial projections will survive and grow.

Still, it’s a shame. The worst, and by far the most common mistake, is absurdly high profitability. So, in honor of this epidemic of bad financials, here’s my five-step plan for better financial projections.

1. Start with a sales forecast

Make it bottoms-up, always; never tops-down. This means you start with unit and price details and build up to sales from specific, concrete assumptions.

For example, if it’s a website, base your forecast on metrics you and others can compare to other websites, such as unique visits, page views, and conversions. If it’s a product going through distributors to retail stores, look at the number of stores you can reach and the distributors required to reach them, and forecast units per store per month.

Never get caught forecasting a market by assuming the total market size and then projecting your market share. That doesn’t work. Nobody who matters believes it.

Do it monthly for 12 months, then annually for the second and third year. Think of it as a spreadsheet with months and years horizontally across the top and category names vertically along the left-hand side.

Your sales forecast should include your direct costs (also called unit costs) and costs of goods sold (or COGS). This is how much it costs you in direct costs, unit costs, per units sold. These are costs you don’t pay if you don’t sell. They go up and down as sales go up and down.

If you have no idea, don’t throw your arms up in frustration; don’t say “but it’s a new business, how could I know?” Break it into unit economics and unit assumptions.

Get some comparisons from similar industries to show you what gross margin (sales less costs of sales) might be, and average profitability. Google “standard financial ratios” for leads, and don’t expect to pay more than $100 for one industry profile.

And if you still have no idea, then:

1. keep your day job; or 2. find some partners who know the industry.

2. Forecast running expenses

We call these operating expenses, such as rent, utilities, payroll, advertising, websites, travel and so forth. Again, if you have no idea, you need to find financial profiles, take in a partner, talk to somebody who’s done it before, or maybe keep your day job. You don’t want to have no idea.

This is also a spreadsheet, with the same months and years as in the Sales Forecast horizontally across the top, and the categories vertically down the left side.

By the time you’re done with expenses, you’ve got everything you need to do an estimated profit or loss analysis. The standard format starts with sales, then subtracts direct costs to calculate gross margin. Then you subtract operating expenses to calculate profit before interest and taxes (called EBIT, with the E standing for “earnings.”)

If your projections have profits higher than 10 or so percent of sales, you’re not done. Either you have underestimated your costs or expenses, or you have an unusually strong business. It’s almost always the former.

Hint: No matter what industry you’re in, if your pretax profits are more than 15 percent, then I suggest you subtract 15 percent from your projected profits and add that amount back into operating expenses as marketing expense.

Having profits too high usually means you aren’t projecting all your expenses. And marketing is where most people underestimate expenses. Besides, in a real business, well-spent marketing expenses are better than profits because they grow your business, which makes it more valuable over the long term.

3. Startup costs

Make a list of expenses you’ll have to pay before you start. Common startup expenses are legal expenses, website development, logos, signage, fixing up a location, computers and so on. Then make a list of assets you’ll need.

Those are things like vehicles, equipment, furniture, startup inventory, and starting cash in the bank.

The cash in the bank is the toughest. If you look at your running profit and loss, that will give you an idea. You have to have money to support your early losses. Read the next step and then revisit it.

4. Understand cash flow

Unfortunately, making a profit doesn’t mean you have cash in the bank. The biggest problems here are business-to-business sales, which typically mean you get paid a month later, and product businesses, which normally have to buy things to sell before they sell them.

If you’re a business that paid two months ago for what you sell today and will be paid for that three months from now, then cash flow is both critical and unintuitive. You’re going to need money in the bank (you can call that working capital) to handle running expenses while you wait to sell stuff and get paid for it.

On the other hand, If you’re selling to people who pay immediately in cash, check, or credit card, especially if you’re not putting money into buying and keeping products, then cash flow is more predictable.

Ironically, some of the worst cash-flow problems come with high growth rates.

If you have no idea, and you do have business-to-business sales and inventory, then look at templates, software, books, tutorials, or somebody who can help you. Don’t take cash flow for granted, even if you expect to be profitable.

5. Review and revise regularly

Yes, you should forecast for 12 months and the two following years, but no, don’t expect your forecast to be accurate. They never are.

You do the financial forecasts so you can set expectations and link spending to sales, but that’s just the start. Review your results every month. Compare actual results to what you had planned. And make corrections.

Final thought: all financial projections are wrong, by definition. We’re human and we don’t predict the future accurately. So don’t expect accuracy.

Go for plausibility, and then follow up with a regular plan versus actual analysis, review, and revisions. We call that management.