Financial projections are the estimates of the future financial performance of a business.
Planning out and working on your company’s financial projections could be one of the most crucial things you do for your business. The results, the financial projections, are often less important than the process itself. If nothing else, strategic planning allows you to come up for air from the day-to-day of running the company, and allows you to take stock of where your business is, and establish a clear course to follow.
Regular planning also helps your company deal with change, both inside and outside the company. By constantly re-evaluating your company’s strengths, markets and competition, you could do a better job in recognising problems and opportunities. You can react to new developments, rather than simply plugging along.
Where do you begin with Financial Projections?
A. The Income statement
It starts from a company’s income statement (i.e. from sales to net profit), you have the details of the historical financial information, and it is usually the case that you would prepare the financial projections based on these information (then apply certain growth rate depending on the circumstances). Obviously you would adjust for certain one-off items (i.e. not to include them in the financial projections, we call it the normalisation), and in some cases where the company is relatively new and therefore there is no such information, then they will have to prepare the financial projections based on their best knowledge / estimate.
1. Revenue (Sales)
In most cases revenue are the products of price and the units sold (i.e. P x Q). When preparing the financial projections, the historical sales immediately before the first year of projection could be an easy point of reference. Depending on the business plan, the revenue is often projected to be higher in the future (assuming the business is operating on a going concern basis). The increase is driven by either the price or the quantity sold, or both. For more stable and mature businesses, one would normally make reference to the inflation rate or the nominal GDP growth for the growth rate assumption.
A useful tip is that, if the business is operating at almost full capacity, and its size is not likely getting any bigger (at the same time assuming there are not much investments to be made in enlarging its capacity), the revenue would be likely be driven by the price and therefore inflation rate would be a better reference for growth rate. On the other hand, if the business is highly associated with the performance of an economy (i.e. luxury goods), nominal GDP growth is a good starting point.
Having said that, there are cases where the business is not at / going to be a stable stage (i.e. they could be a unicorn or a business where the industry is going to fade out anytime). Individual assessment of the business growth (revenue wise) will be crucial in such case. Say for a start-up company where the business is expected to grow rapidly for a certain time period before an indication of slowing down, one could make use of the H-model in estimating the growth rate (for details, please refer to the article related to the H-model). As for a declining business, you expect the company to close out in the foreseeable future and the financial projections would be trending downward (the business would not enter the terminal year calculation).
2. Cost of Goods Sold (“COGS”) / Cost of Services
COGS is like a mirror image of revenue, the higher the revenue, the higher the COGS. COGS is usually expressed as a Percentage of Sales. Revenue and COGS grow proportionally.
If you expect the company to obtain economies of scale and improved operating efficiency in later years, then COGS as a percentage of sales should go down (and hence higher gross profit margins will be achieved).
3. Gross Profit – Gross Margin
It is important to sense check if the projected gross margin is reasonable. To do so, refer below:
a) Check against the historical level of gross margin – you probably would have a gut feeling of what level of gross margin could be achieved by looking at the historical financial statements (of say past three years); and
b) Check against the comparable companies’ gross margin – you could look at the gross margin of companies that are comparable to your company, then make inference of the statistics you obtain from these data (i.e. using minimum / maximum / average / median). If you have been consistently outperforming / underperforming the market, it is worth investigating the reasons behind it so that you can have a clear picture of your business.
4. Sales, General and Administrative Expenses (“SG&A”)
SG&A includes selling expenses, rental expenses, utilities expenses and miscellaneous expenses, etc. Generally speaking, they should not be substantially different from the previous years and if they do, a proper explanation is required.
We normally check the SG&A-to-revenue ratio to see if it is reasonable. Like gross margin, you could check against the historical level as well as the peers’ performance.
5. Depreciation & Amortization (“D&A”)
One of the most important sub-sections is the D&A, D&A could be under COGS / SG&A (i.e. if it is directly related to production such that allocation is feasible, it could be under COGS). D&A is a non-cash item (i.e. it is an expenses that reduces profit but it has no cash outflow).
Other than D&A, there are other non-cash items that required ‘add-back’, for instance, provision for bad debt, impairment and gain / loss on disposal of fixed assets, etc.
The (corporate) tax rate assumed is reference to either statutory tax rate or effective tax rate.
For simplicity, the tax rate is often used in the accounting profit (i.e. profit before tax). However, there are differences between the accounting book and the tax book such that there are timing differences of the tax payable to the relevant authority, this would increase / decrease the deferred tax liability balance.
The tax loss carried forward could be used to offset the future accounting profit.
7. Net Profit – Profit Margin / EBIT Margin / EBITDA Margin
Similar to sub-section 3. above, it is important to sense check if the projected Profit Margin, EBIT Margin, EBITDA margin is reasonable. To do so, refer below:
a) Check against the historical margins – you probably would have a gut feeling of what level of margin could be achieved by looking at the historical financial statements (of say past three years); and
b) Check against the comparable companies’ margins – you could look at the margins of companies that are comparable to your company, then make inference of the statistics you obtain from these data (i.e. using minimum / maximum / average / median).
B. Certain Balance Sheet Items
For determining business value using the DCF approach, you will need to forecast the following:
Capital Expenditure (“Capex”)
To forecast Capex, it is advised to make reference to the business plan (if any) for any major expansionary Capex (e.g., investments in plants or machinery).
It is also advised to forecast a maintenance Capex, which would equate to the amount of D&A each year.
Net Working Capital (“NWC”)
As for NWC, we could actually work out the future balances by performing the tri-financial statements analysis, or we could simply perform certain ratio analysis in getting the results we needed.
Now that you have the financial projections ready, you can go ahead and determine business value using the DCF Approach here