Financial Projection Definition
The financial projection shows forecasts and predictions on the financial estimates and numbers that range from revenues and expenses pertaining to financial statements and takes external market factors and internal data into account.
- The determination of the right financial projection depends on external factors namely economic conditions and market sentiments.
- The internal factors that are inculcated into the projection are the current business position and available historical data that is utilized to derive consistency.
- Help the stakeholders provide comprehensive estimates of chosen line items.
- Generally, they are formed as part of the executive summary.
- These statements can be described as forward-looking statements.
- It gives management a concise idea and image of how would the company perform.
How to do a Financial Projection?
Let us take the example of the Income Statement of ABC Company. It is anticipated that the revenues are going to increase by 25 percent from the base year revenues. The cost of sales for the projected income statement would be 65 percent of projected sales.
The operating expense amounted to 15 percent of the sales generated by the business and the interest expense amounted to be the same as compared to the base year income statement. The interest expense for the base year was reported at $2,000. The business is taxed at a rate of 25 percent. Help the management prepare a projection on the income statement. The base year income statement is as follows: –
Prepare the Projected Income statement as displayed below: –
Step #1 – Initialize the revenue estimates, asset position, liabilities position, and base it on the revenues or the existing asset size of the business. In the above example, revenue estimates are to be increased by 25 percent with respect to the base year.
Step #2 – Baseline the cost of sales, basis the revenue estimates determined above, and as shown in the example below.
Step #3 – Calculate the gross profit as the difference in revenues and cost of sales.
Step #4 – Determine the operating expenses as 15 percent of the sales or the revenue estimates.
Step #5 – Determine earnings before interest and taxes by taking up a difference between gross profit determined in step 3 and operating expenses at step 4.
Step #6 – Deduct the base-lined interest income as assumed from the prior year from the results of step 5 to arrive at the earnings before taxes.
Step #7 – Deduct the taxes from the earnings before taxes to arrive at the profit after taxes. The taxes are determined as the 25 percent of earnings before taxes as determined in step 6.
The following shows the calculation on the income statement as shown below: –
The following would be the projected income statement: –
Elements of Financial Projects
The financial projection can be termed as a summarized financial model. It could be based on assumptions and estimates as well as growth functions. A projection can comprise of the income statements, cash flow projections, and balance sheet projections.
#1 – Income Statements
The income statement normally comprises of estimates and projections on revenue and expenses along with net income.
#2 – Cash Flow Projections
The cash flow projection normally comprises of revenues collected in cash form. The disbursements of cash display all the expenses incurred by the business on a cash basis.
#3 – Balance Sheet Projections
The balance sheet projects or describes the net worth of the business. Projections can be prepared for the assets, equity, and liabilities of the balance sheet. Assets represent items that are of economic value and importance for the business. Liabilities represent items that the business owes to the creditors.
Equity is normally determined as the difference between the assets and liabilities. The expenses present in the income statement can be based on the percentage of revenues. The taxes can be assumed as the rate prescribed by the government. The assets and liabilities of certain types can also be based on the prior year asset position or prior year sales achieved by the business.
- The financial projection is a concise financial model. Helps in the determination and planning of the requirements of working capital for the success of the business operations.
- The projection is one of the important inputs utilized in the preparation of Strengths, weakness, opportunities, and threat analysis. It is also a supplemental report utilized for industry analysis.
- In the absence of the actual financial statements, projections can be shared by the business to their stakeholders and creditors.
- Doing so ensures retention in investor confidence and helps businesses getting new investments for their new projects. The financial targets are metrics that the business has to meet for success and survival in the competitive environment and industry.
- The financial projections allow the top management to detect early warning signs with respect to the business performance and allows a business to catch potential deviations for the business.
- It helps in the preparation of the budget for different departments and business units working under a bigger organization.
- It gives a clear picture of the management of how the company is going to perform.
- Projections help in making strategic decisions on business operations and growth.
- The financial projections become reference statements along with available financial statements for the lenders and creditors.
- The lenders and creditors take the projection into account as a basis for making further investment decisions towards a basis.
- It helps the management establish targets and establish early warning signs related to business performance.
- It provides summarized information to the stakeholder in the absence of financial statements and if they wish they can ask the business to present detailed financial projections to see whether the business has the intent to meet their business targets.
The financial projections are a decision-making tool for the management and creditors. It is basically a concise financial model that shows forecasts basis the estimates as determined by the management itself. It may be used by lenders and creditors to base their investment decisions.
This has been a guide to Financial Projection and its definition. Here we discuss how to do step by step financial projection along with importance and benefits. You may learn more about financing from the following articles –