Projected revenue

Your company’s projected revenue is based primarily on your sales forecast — exactly how much of your product or service you plan to sell. You have to think about two things: how much you expect to sell, naturally, and how much you want to charge. Unfortunately, you can’t completely separate the two projections, because any change in price usually affects the level of your sales (price up, volume down, and vice versa).

Your sales forecast is likely to be the single most important business prediction that you ever make. If you get it wrong, the error can lead to mountains of unsold inventory at one end, or a sea of unhappy, dissatisfied customers at the other — a financial disaster in the making. (And if you have outside investors, your troubles are just beginning.)

How do you make an accurate sales forecast? Start by looking at this formula:

Sales forecast = Market size × Growth rate × Market-share target

Look at the equation in this broken-down form:

• Market size estimates the current number of potential customers or units of the good.
• Growth rate estimates the speed of market growth.
• Market-share target estimates the percentage of the market that you plan to capture.

Because your sales forecast has such a tremendous impact on the rest of your financial forecast — not to mention on the company itself — you should try to support your estimates with as much hard data as you can get. Depending on your situation, you can also rely on the following guides:

• Company experience: If you have experience and a track record in the market, you can use your sales history to make a sales prediction.
• Industry data: Industry data on market size and estimates of future growth come from all quarters, including trade associations, investment companies, and market-research firms (which we cover more extensively in Chapter 5).

• Outside trends: In certain markets, sales levels mirror trends in other markets, social trends, or economic trends (a phenomenon we describe in Chapter 13).

  Even if a product is brand-new, you can sometimes find a substitute market to track as a reference. When frozen yogurt first appeared on the scene, for example, its producers turned to the sales history of ice cream to help support their sales forecasts.

After you come up with your sales forecast, multiply it by the average price that you expect to charge for your product or service. The result is your projected revenue:

Projected revenue = Sales forecast (in units of your good) × Average price

Where does the average price come from? You base your average price on what you think your customers are willing to pay and what your competitors charge (refer to Part 2 for more information on how to analyze your industry and customers).

Now put all the numbers together and see how they work. We use an imaginary company called Yenta’s Yogurt (YY) as an example. Sally Smart, the flavored yogurt product manager, starts putting together a three-year revenue projection. Utilizing industry and market data along with sales history, Sally estimates that the entire market for flavored yogurts will grow about 10 percent a year and that YY’s market share will increase by roughly 2 percent a year, with projected price increases of approximately $1 to $2 per case of 12 yogurt containers (a very positive projection — you can’t always assume that market share and prices will increase). She puts the numbers together in a table so that she can easily refer to the underlying estimates and the assumptions that support them (see Table 12-1). All of this should be done in an Excel spreadsheet (or comparable tool) so you can quickly tweak numbers and see the overall effect.

Anticipated costs

You still have to look at anticipated costs — the price tag of doing business over the next several years. To make life a little easier, you can break anticipated costs into the major categories that appear in a pro-forma income statement: projected cost of goods sold; projected sales, general, and administration expenses; projected interest expenses; and projected taxes and depreciation (flip to Chapter 11 for more details). The following list defines these categories:

• Projected cost of goods sold (COGS): COGS, which combines all the direct costs associated with putting together your product or delivering your service, is likely to be your single largest expense.

  Although the following formula may look ugly, treat it as a simple way to calculate your projected COGS. Based on the assumption that the ratio of your costs to your revenue will stay the same,

  • Projected COGS = (Current COGS ÷ Current revenue on sales) × Projected revenue

• Sales, general, and administration (SG&A): SG&A represents your company’s overhead: sales expenses, advertising, travel, accounting, telephones, and all the other costs associated with supporting your business. If your company is brand-new, try to get a feel for what your support costs may be by asking people in similar businesses, cornering your accountant, or checking with a trade association for average support costs in your industry. There also may be something online that can help you here, so don’t be afraid to use that source.

  If you have a mature business, you can estimate a range for your SG&A expenses by using two calculations:

  • The first method projects a constant spending level, even if your company’s sales start growing. In effect, you assume that your support activities will all get more efficient and accommodate your additional growth without getting bigger themselves.
  • The other method projects a constant SG&A-to-revenue ratio. In this case, you assume that support costs will grow as fast as your revenue without any increase in efficiency. Because your projected SG&A costs are higher, this is the more conservative estimate.

  An accurate SG&A forecast probably lies somewhere in between. Given what you know about your company’s operations, come up with your own estimate and include the assumptions that you make.

• Interest expense: Your interest expense largely results from decisions that you make about your company’s long-term financing. Think about what sort of financing your business may need in the future (to acquire office space, computers, machinery, and so on) and what interest rates you may be able to lock in, and then estimate your interest expense as best you can.

• Taxes and depreciation: Taxes certainly affect your bottom line, and you want to include your projections and assumptions in your anticipated costs. You usually can estimate the general impact taxes may have on the future by looking at their impact on your company now.

  Depreciation, on the other hand, is an accountant’s way of tracking the value that your purchases (equipment, tools, whatever) lose over time. As such, depreciation expense doesn’t really come out of your pocket every year. You can estimate the numbers, but don’t get too carried away.

When you plug the numbers into your pro-forma income statement and calculate your net profit, be prepared for a shock. You may discover that the profit you expected to make in the first year or two turns into a projected loss. But don’t panic: New business ventures often lose money until their products catch on and they begin to pay off some of the start-up costs. Whatever you do, don’t try to turn a projected loss into a profit by diddling with the numbers. The point isn’t to make money on paper; the point is to use the pro-forma income statement as a tool that can tell you what sort of resources and reserves you need to survive until losses turn into predicted profits.

Many online software programs can do all of your financial statement estimations for you (for example, www.quicken.com). All you need to provide are the numbers, and then the software does all the calculations and in many cases plugs in variables such as tax rates for you.

Assets

Your company’s projected assets at the end of each year include everything from the money that you expect to have in the petty-cash drawer to the buildings and machines that you plan to own. Some are current assets, meaning that you can easily turn them into cash; others are fixed assets, which take much longer to get rid of (refer to Chapter 11 for detailed asset info).

• Current assets: The cash you have on hand, as well as accounts receivable and inventories, add up to your current assets. How much should you plan for? That depends on the list of current liabilities (debts) you expect to have, because you have to pay short-term debts out of your current assets. What you have left over is your working capital.

  Projected inventories (the amount of product in your warehouse) depend on how fast your company can put together products or services and get them to customers.

• Fixed assets: Land, buildings, equipment, machinery, and other assets you can’t easily dispose of make up your company’s fixed assets. Your estimated balance sheets should account for the big-ticket items that you expect to purchase or get rid of.

  Keep an eye on how each machine or piece of equipment helps your bottom line. If you plan to buy something big, make a quick calculation of its payback period (how long it takes to pay back the initial cost of the equipment out of the extra profit that you make). Here’s a simple example: There’s a new machine out there that you can purchase for $10,000. If you buy it, it will reduce your current costs with your existing machine by $3,333 a year. So, in three years the savings equals the cost of the machine: $10,000 ÷ $3,333 = 3). Your payback period is then three years. Is the payback period going to be months, years, or decades? If the payback period you foresee is longer than you’d like, consider an equipment lease as an alternative to an outright purchase.

Liabilities and owners’ equity

Estimated balance sheets have to balance, of course, and your projected assets at the end of each future year have to be offset by all the liabilities (current and long-term) that you intend to take on, plus your projected equity in the company. Think about how leveraged you intend to be (how much of your total assets you expect to pay for out of money that you borrow). Your use of leverage in the future says a great deal about your company.

• Current liabilities: You estimate in this category all the money that you expect to owe on a short-term basis in the future. Current liabilities include the amounts that you expect to owe other companies as part of your planned business operations, as well as payments you expect to send to the tax people.

• Long-term liabilities: The long-term debt that you plan to take on represents the piece of your company that you intend to finance. Don’t be surprised, however, if potential creditors put a strict limit on how much they want to loan you, especially if you’re new to the business. In general, bankers and bondholders alike want to see enough equity put into your business to make them think that everyone is in the same boat, risk-wise.

  Before you take on a new loan, find out what kind of debt-to-equity ratios similar companies have (for help, turn to Chapter 11). Make sure that yours falls somewhere in the same range.

• Owners’ equity: The pieces of your company that you, your friends, relatives, acquaintances, and often total strangers lay claim to get lumped together as owners’ equity.

  In general, you can estimate your company’s future benefit for the owners by projecting the return that you expect to make on the owners’ investment (refer to Chapter 11 for the details). You can compare that return with the earnings of investors in other companies or even other industries.

  During the initial stages of your company, equity capital likely comes from the owners themselves — as cash straight out of the wallet or from the sale of stock to other investors. The equity at this stage is crucial, because if you want to borrow money later, you have to show your bankers that you have enough invested in your business to make your company a sound financial risk.

  Unfortunately, profits have another side — a down side residing in the red. Although you probably don’t want to think about it, your company may lose money some years (especially during the early years). Losses don’t generate equity; on the contrary, they eat up equity. So you have to plan to have enough equity available to cover any anticipated losses that you project in your pro-forma income statements (refer to the earlier section “Piecing together your pro-forma income statement”).

Top-down budgeting approach

The top-down approach to forming your budget is the simplest way to work through your company’s financial plans. The process basically begins and ends with the people in charge. If you have a small company, you may want to invite some outside people to join you and offer their viewpoints, opinions, and expertise — people you trust, such as your banker, accountant, or maybe a close business associate. The process goes like this:

1. Put the finishing touches on your company’s financial forecast, including the pro-forma income statements, expected balance sheets, and projected cash-flow statements.

   If certain pieces are missing or incomplete, try to get the information that you need or make a note that a necessary document is unavailable. (Check out the earlier section “Constructing a Financial Forecast” to form the pieces of the forecast.)

2. Meet with your company’s decision-makers (or your trusted group, if you’re self-employed) to review the financial forecast.

   Take time to discuss your general expectations about the future. Talk about the business assumptions that go into the forecast and the key predictions and estimates that come out of it.

3. Meet again to explore possible financial alternatives.

   After everyone has had a chance to reflect on the financial forecast, look at different sets of business assumptions and weigh their potential effects on the forecast.

4. Come up with revenue and expense targets for each of your company’s major business activities or functional areas (whichever is more appropriate to your company).

5. Meet one last time after you draft the budget to review the numbers and to make sure that everyone is on board.

   Put together a written summary to go along with the numbers so that everyone in the company knows what the budget is, where it comes from, and what it means.

Although top-down budgeting works well when you know all the people in your company on a first-name basis, you see the approach’s disadvantages as your company gets bigger. By including only the managers at the top, you run the risk of leaving out large chunks of the organization and losing track of your real business situation when it comes time to plug in the numbers. As your company expands, the need for a new technique becomes evident. Enter the bottom-up approach.

Bottom-up budgeting approach

The bottom-up approach to creating your budget is an expanded version of the top-down process, but it takes into account the demands of a bigger company and of more people who have valuable input. You still want to begin creating your budget by getting a group of senior managers together. That group should still spend time coming to a general understanding of, and agreement on, your company’s financial forecast. But instead of forcing a budget from the top, the bottom-up approach allows you to build the budget up through the company.

Don’t ask your group of senior managers to go on and dictate the company’s budget. At this point in the budget process, the bottom-up approach allows you to get managers and supervisors at all levels of the company involved. The process goes like this:

1. Meet with senior managers and ask them to review the company’s broad financial objectives for each of your major business areas.

   Try to come up with guidelines that set the tone and direction for budget discussions and negotiations throughout the company. (See the earlier section “Constructing a Financial Forecast” to come up with objectives.)

2. Ask the top managers to meet with their managers and supervisors at all levels in the organization.

   Meetings can start with a recap of the budget guidelines, but the discussions should focus on setting revenue and expense targets. After all, these division managers actually have to achieve the numbers and stay within the spending limits.

3. Summarize the results of the budget negotiations.

   If necessary, get the senior group members together again to discuss revisions in the financial objectives, based on the insights, perceptions, and wisdom of the company’s entire management team.

4. Approve the budget at the top.

   In this final pass, look at the overall budget not only in terms of current financial objectives, but also with respect to your larger business goals.

One final point about your organization’s budget: After you’re done with all the negotiating and “put the budget to bed,” everyone knows their budget allocation for the coming year. This implies that you’ve created an incentive tool for your managers and everyone else in the firm. Achieve the budgeted numbers, and you get a bump to your salary and bonus if the firm provides one. Most people live in the here and now, not three or five or further years out. So, to get that bonus, your team will work as hard as possible to make their numbers. But here’s the tricky part: How tightly aligned with your long-term strategy is this next-year’s budget? Suppose, for example, your long-term strategic goal is to become the perceived quality leader in your industry. Next, suppose that the budget for your operations department calls for a bonus if the managers there can cut expenses by 10 percent over the coming year. Do you want to guess which target those good folks will strive for? Whatever puts money in the pocket today.

The point: The budget is your short-term tactical tool to achieve your long-term strategic goals and objectives. Be sure you have your priorities right when doing budgeting.