Recently I was asked to review some financial projections that had been developed to raise funding for the expansion of a business. The spreadsheet was prepared for the purpose of showing a potential investor the financial returns that could be expected if the person invested money into the business.
The projections showed that, with the financial backing, the company would begin to make huge profits starting immediately. There would be rapid and significant increases in sales and margins. And these gains would begin once the investment funds were received.
After a quick review of the numbers, I was reminded of a phrase that I coined several years ago: “It is much easier to make money on a spreadsheet than it is in real life.”
No matter how fancy and complex—and aesthetically pleasing—a spreadsheet may appear, the projections that are outlined in it are only as good as the assumptions underlying those projections. Such financial estimates would be much more accurate and valuable if the preparers spent more time validating the assumptions and less time on fancy formulas and beautiful formatting.
Whether it is for investment purposes, for budgeting, for your bank, or any other reason, I encourage you to carefully examine the assumptions that are being used when you prepare or review financial projections.
Here are some practical steps you can take to develop valid assumptions and a forecast that is based on fact.
- Start with history. Use a historical P&L of the business or a company in the industry as the starting point for the projections. If gross margin has traditionally been 40%, it is not likely to suddenly jump to 55%.
- Make sure you understand the market you are in. Whether you like it or not, if you are in a low margin industry, you are likely to have low margins. If your projections are based on higher margins, be reasonable with the projected increase. Also, don’t assume that you will never have to cut prices and lower your margins. As competitors see and copy what you are doing, your profits may need to shrink. Remember, in almost all industries, margins contract over time due to competition.
- Be careful with aggressive forecasts of rapid increases in sales. Sales don’t increase because we wish them up. It takes a strategy, a process, and hard work to obtain new customers and new orders. Wishful thinking for the sake of forecasts won’t make it happen.
- Projections for new products or new services often underestimate the cost of developing and launching the new venture. In addition, the launch process seems to always take longer than anticipated. After you build your base scenario, change the assumptions based on longer lead times and a slower sales ramp-up. See how these things impact your profitability. Or see how they affect the profitability of your target company if you are an investor.
- After you complete your base scenario, ask yourself—and others if possible—what could go wrong and cause you to miss both your revenue and expense projections. If everything has to go exactly right for your venture to succeed, then it is not likely that you will meet your projections.
- At the same time, carefully look at the projections and compare them to other data in your industry. The idea is to see if others are more efficient than you. If they are, try to figure out why and then take actions to increase your profitability. Make a list of these opportunities so you can focus on them.
- Finally, don’t put all of your good news into the projections or the budget. Remember, the goal is to have results that exceed expectations. It is better to be conservative when setting expectations and exceed them than it is to set expectations high and simply meet them or even miss them. If expectations are too aggressive, then the chances of meeting or exceeding the forecasts is unlikely.
Spreadsheets can be valuable business planning tools. But they are only helpful if they are based on reasonable expectations. If the numbers are not grounded in reality—if they reflect overly optimistic assumptions about growth and margins—then these same spreadsheets can, instead, lead to poor decisions and poor investments.
Remember, sound assumptions are the key to a spreadsheet that has value.