Business owners desire financial projections to be reasonable; however, financial projections are frequently marred by unsustainable conclusions and/or calculation errors. Regardless of whether financial projections are based on analysis of long-term contracts, historical growth trends, or per-unit sales, the following areas of financial projections are frequently error-prone:
- Revenues. Revenues are sometimes projected to increase beyond the company's current capacity to support such revenues. Financial projections need to consider the necessary investment for additional capacity (such as warehouse/office space, equipment levels, and human capital). Many of these issues can be reasonably addressed by projecting appropriate investments in fixed assets and working capital. Therefore, projecting balance sheets in conjunction with projected income statements will assist in the determination of projecting appropriate capacity levels;
- Common Error of Omission. Financial projections sometimes fail to consider certain economic and/or statutory changes impacting the subject company and its industry. It is not uncommon for financial projections to utilize historical interest rates with respect to variable interest rate debt when current and/or projected interest rates should be used. Other times, specific industry changes (such as new taxes, significant changes to commodity costs, or incorporating a conversion cost to comply with regulatory requirements) are ignored in financial projections. These factors, which, at times, may be somewhat difficult to estimate need to be considered in financial projections to reasonably reflect the company's expected future operations; and
- Significant Deviations from Historical Behavior. Significant deviations from historical behavior should be supported with sufficient evidence, including historical growth trends, management’s growth expectations, and economic and industry growth expectations. Frequently, significant deviations from historical behavior are not supported by sufficient evidence and/or expectations. There are numerous methods in which to analyze historical behavior, such as ratio and trend analysis, profitability trends, relationships between financial metrics and operational data. The key point is how to best use historical performance as a proxy for future expectations.
Nobody knows what the future holds, which makes the preparation of financial projections difficult. Being aware of these issues, however, will hopefully offer some guidance when in preparing financial projections based on reasonable and sustainable assumptions and/or estimates.
For more information on Business Valuation contact your MarksNelson Smart Valuation Professional at 816-743-7700.