The planning and budgeting for business changes play a crucial role in running a successful company. However, financial statements like budgets, income statements, and similar documents only focus on tracking the historical transactions and current economic status of your company.
If you want to plan for upcoming economic changes, you need financial projections to forecast future income, identify and monitor risks, and secure financing for your company.
What are financial projections?
Financial projections help businesses estimate future cash flow and plan for major changes without direct investment.
“Financial projections provide a virtual view of how the company would perform based on a reliable set of assumptions about one or more deals the company is considering”, according to finance coach Tanya Taylor in a video interview with The Balance. “For example, what would the company’s financials look like if it merged with another company to create new synergies, or conversely, if it sold one of its business lines?”
These projections are usually prepared for several years in advance and used as inputs in the valuation process, according to Robert Johnson, a finance professor at the Heider College of Business at Creighton University, in a separate email interview with The Balance.
Note: Financial projections do not follow Generally Accepted Accounting Principles (GAAP), as GAAP-compliant reports must rely on historical data rather than expected cash flow.
Types of financial projections
There are three main types of financial projections, each serving a different purpose. Taylor explained these types as follows:
Projected income statement:
This type includes forecasts of upcoming revenues, costs of goods or services, and the company’s net profit.
Projected balance sheet:
These projections encompass any changes in the company’s assets and liabilities, including cash, receivables, inventory, payables, and debt.
Projected cash flow statement:
This type shows the cash inflows and outflows of the company resulting from various hypothetical scenarios.
What do financial projections do for your company?
Financial projections can significantly benefit companies by providing data for planning and forecasting upcoming economic changes, analyzing risks, securing financing, and making merger/sale decisions.
Here are some ways in which financial projections can benefit your company, regardless of the operational stage you are in:
Securing financing for your company:
Financial projections provide ways for companies to make realistic estimates about future growth rates and costs. According to Johnson, this is useful when seeking external capital (whether debt or equity) for growth. “Potential capital providers will carefully examine financial projections (and the critical assumptions used in their creation) before committing capital to the company”, said Johnson.
Evaluating potential mergers:
Financial projections provide a realistic estimate of what a merger would look like. For example, “they can help you identify redundancies and what new additions are necessary”, according to Taylor. For instance, through financial projections, you might identify that you may not need two accounting departments and HR management functions in the merger. Projections can also help you anticipate the economic changes that will come with the merger and how to ensure your company is prepared for those changes.
Risk analysis and future planning:
Hypothetical scenarios in financial projections can help analysts anticipate risks early and prepare for them before making any tangible changes. “A key element of financial projections is that they allow analysts to change one or more variables and see how the financials appear if some variables are more optimistic or less optimistic than the base case”, according to Johnson. For example, if the base case is that revenues grow by 20% over the next few years, you might want to lower the expected growth rate to 10% to see how the company’s financials appear. “This analysis is called sensitivity analysis (identifying the sensitivity of the company’s performance to various variables) and can help both internal stakeholders and potential capital providers gauge the company’s risks”, Johnson added. By using this tool, your company can come up with optimistic, realistic, and pessimistic future scenarios for its future.
How to
Preparing Pro Forma Financial Statements
Preparing pro forma financial statements is easy using many free and paid tools available online.
You can use pro forma financial spreadsheets or work with an existing template in your accounting process. “There’s no need to over-design it,” according to Taylor. “Start building the pro forma financial statements using the format of your existing financial data. If new lines are required or some lines need to be removed, make that adjustment.”
Another important thing to remember when preparing pro forma financial statements is to use reliable data and not to rely heavily on hypothetical information, so your estimates are as close to accurate as possible. Taylor suggested starting the process with actual reviewed data (if you have an auditor), or at least verified data.
Note: Your business might benefit from following the guidelines of the Securities and Exchange Commission for public companies that outline how to use pro forma financial statements, even if you are not publicly listed.
Remember that pro forma financial statements are just a tool. These statements are useful for making estimates and analyzing future risks, but they are not 100% guaranteed. So it’s best to use them in conjunction with other tools like budgets, income statements, economic audits, and more.
Frequently Asked Questions (FAQ)
Why do banks require pro forma financial statements?
Pro forma financial statements give banks information about your ability to make payments while continuing to operate your business. “The statements also provide them assurance that you understand your business operations and what can cause fluctuations in your profits,” according to Taylor.
What can I use to prepare pro forma financial statements?
Here are some key examples of tools you can use to prepare pro forma financial statements: Excel spreadsheets, sample pro forma spreadsheets, and existing pro forma templates in your accounting process.
Source: https://www.thebalancemoney.com/why-you-need-pro-forma-financial-statements-5222206
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