The Critical Importance of Financial Projections

Wishbone atop financials

You can give up the wishbone when you build financial models.

Occasionally I hear people make flippant remarks about doing financial projections. Something to the effect of, “It’s all pie in the sky.” or “It’s just a wild guess.” or the stronger version, “They just make the sh_t up!”

I have built so many financial models I lost count a while ago. I am a huge believer in their importance and usefulness. I built  financial models when getting my MBA at Wharton, during my stint as a part-time Associate at an M&A boutique, for Enron in various capacities, for start-ups I considered investing in, for my own companies, for companies I worked for, for potential acquisitions, new projects or major investments. Whew! I even build models for publicly traded companies I’m considering a long-term investment in!

So I feel the need to do a little educating. I built a model for the investment in Enron. I was to be compensated in stock options so I thought it in my best interest to value those options. No high faluting portfolio theory. Just a straight-forward DCF (discounted cash flow) analysis. And you know what it told me? Don’t invest.

Building that model led me to examine Enron’s financials closely and to ask some serious questions in our monthly Summer Associate meeting with executive management. They didn’t like my questions and I didn’t like their answers. Although I loved the company as an intern (summer, 1997), I decided Enron threw money around way too much for me to feel comfortable with and had all these crazy structures I didn’t feel comfortable with.

This is not meant to be a treatise on my former employer (I left 1.5 years before the meltdown). Instead, that example is meant for illustrative purposes.

Yes, if you run a start-up  that’s seeking investment or if you are considering taking a stake in a startup, because there is no real history, the financial projections are more of a guesstimate. But even with a start-up, that’s not the point! The point of your financial projections is that you take the time to consider the bulk of the factors that go into calculating those financial proforma numbers. What assumptions are you making? About the market, your product, your growth rate, your expenses, your sales penetration rate, and so on? What is your company’s strategy for achieving those numbers. When you build a financial model correctly, the numbers reflect all of this.

For more mature companies with a documented performance history, the financial projections tells a similar story but with more certainty. If a company has revenue growth of 15% for four years and now shows an expected growth rate of 25%, what factors are contributing to that increase and where can I find that in the numbers? What are your assumptions and what drives those assumptions? What has changed in the market? Has your customer retention rate increased or do you intend to implement a plan to drive higher customer referrals?

Rising arrow

Most companies showing extremely rapid growth are dreaming but sometimes dreams come true!

Most of us who help businesses or who invest or acquire companies can tell when a company is presenting overly optimistic numbers. However, “overly optimistic” still has its place. Sometimes it’s really important to look at “overly optimistic” as a best case scenario. If your company grows from $2 million to $30 million in one or two years, or even more, like many successful technology companies do or non-tech companies atop the Inc. 500 list, how will you handle that rate of growth? Many companies that experience such a high growth rate grow too fast and run out of cash or p_ss off their customers by failing to deliver as promised. By creating this optimum scenario and mapping it out in a financial proforma, you force yourself to identify the costs you’d incur and the cash you’d need to meet that level of revenue.

On the other hand, what happens in the worst case scenario? What if you engage in a no-no and derive more than 20 percent of your business from one customer and that customer leaves? I’ve seen this happen several times. I personally know of a small private equity firm that purchased a company with over $20 million in revenues only to have that company lose its customer that generated 40% of the revenues. The customer was acquired by a large corporation that already contracted with a competitor. When you fail to make this out and figure out what you’d do in this horrible what if situation you could end up losing the business. Just as that private equity firm that I mentioned did.

I think that’s the point people miss about financial projections. If my company will have $10 million in revenue, I may need 20 sales people, 30 people to do the work and 20 support staff, one location, software,… If my company will have $50 million in revenue in the same accounting period, I’ll need to multiply these requirements. If my numbers increase slowly or drop (worst case scenario), creating my financial projections will identify what expenses I would likely cut to remain profitable or minimize my losses.

Financial projections and financial modeling are critical components of strategic planning. Just as with the rest of a strategic plan, the purpose of financial modeling and creating financial proformas is to get you to consider the possibilities…and take the necessary actions to address them or prepare for them.