Blueprint for a Successful Business

By Edward F. Saroney III

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Many business owners attempt to build a business without a financial forecast because they trust their instincts. This may provide short-term success, but can result in long-term failure. Often a company has financial problems long before the owner or management realizes the extent of the trouble, at which point it’s usually too late to turn the company around.

Although financial forecasts do not guarantee success, a forecast does signal for immediate attention to problem areas. Responding to problems quickly increases the business’ chances for long-term success.

A projection is different from a forecast. A financial projection, unlike a forecast, assumes the business will undertake some major change. Generally, financial projections should be prepared for start-up businesses as well as existing businesses that are contemplating a major investment, such as the acquisition of another company, the development of a new product line, a major equipment purchase, or some other significant capital expenditure.

Financial projections enable management to make smart business decisions before expending company resources or incurring debt. Given certain assumptions, management can assess the risk of debt payback for a significant capital expenditure. For example, assume a business is considering an acquisition and the financial projection indicates the debt payment will be tight. With this information, the owners can renegotiate the purchase price, renegotiate the payment terms, or reconsider the purchase altogether.

A comprehensive financial forecast or projection includes the following documents, broken out on a monthly basis:

• Forecasted or projected statement of operations;
• Forecasted or projected statement of cash flows;
• Forecasted or projected balance sheet; and
• Statement of significant assumptions.

Some companies prepare only a forecasted statement of income, erroneously believing that this will be adequate to provide them with the information they need to be successful. Cash flow forecasts are also essential. Although actual monthly operations might proceed in line with an annual income forecast, a negative cash flow might hamper an company’s ability to continue with its plans. Possible reasons for a cash flow crunch include the following:

• Poor billing of work in progress;
• Inadequate collection efforts; or
• Insufficient lines of credit.

If a company prepares a comprehensive financial forecast, such problems will be immediately apparent and can be addressed. Unaddressed problems can result in a company leaving money on the table and risking its financial solvency. In addition, upon reviewing the forecast, management would have learned important information about the company’s operations and gained confidence that its operations were under control.

Nonprofit organizations also need financial forecasts and projections to ensure their success and continued existence. Because nonprofits typically operate under a tight budget, they sometimes hesitate to spend the necessary dollars for the preparation of a financial forecast. Because of their very thin equity base, however, a grasp and understanding of an organization’s complete financial position is paramount. The board of directors of a nonprofit organization has a fiduciary obligation to exercise due diligence. Lack of a financial forecast can call into question the board’s judgment and ultimately lead to an organization’s downfall.

Financial forecasts and projections are also critical for banks’ loan officers. Bankers generally insist on detailed projections before approving any start-up business or business acquisition loan. Bankers should also require financial forecasts from existing clients. If a business’ profits begin to erode, bankers will typically review the historical financial statements and discuss possible reasons with the business owner. Historical information, however, does not provide the banker with information on the future solvency of the business. The financial forecast is what alerts the banker to critical issues that need addressing. The banker can then make an informed decision about the banking relationship.