This section reviews the main methods for financial projections. The review does not cover all the components required for meaningful forecasting, but provides the main tools used for such forecasting. It is difficult to overrate the importance of financial forecasting and its significance to investors, employees, suppliers, customers, and financial institutions. Many managers, for instance, lose their positions in companies due to their failure to meet financial forecasts; many companies are denied investments due to forecasts that could not be backed by reasonable assumptions; and yet other companies are denied from large contracts because customers who are considering these contracts and request long-term forecasts do not feel confident that the company will survive the period of the engagement and be able to provide various services also after its termination (such as customer service and spare parts).
The Purpose and Importance of Financial Forecasting
Correct financial planning is an important component of business planning, and too many entrepreneurs tend to underestimate its importance. Consequently, many startups run into financial difficulties which could have been predicted and even avoided by raising more money or reducing expenses. Financial forecasting can help investors in the company make more realistic estimates of the return on the venture. By using well thought-through forecasts, the company learns what resources will be required to be raised. The main objectives of financing forecasting are the following:
General Forecasting Issues
When forecasting the revenues and expenses of a company when it enters the market, it is important to rely on the statements of similar publicly traded companies, in order to examine their cost structure and profit margins. Such an examination is crucial, since it enables one to appraise the reasonableness and soundness of the assumptions underlying the venture's financial model. In addition, it enables one to examine whether the startup will be able to compete with such companies when it goes public. For instance, if the profit margins are low due to fierce competition among many players in the market, the startup will find it hard to break into the market, unless it can present a considerable improvement on the expected products of the existing and anticipated competitors in the market at that time. Sales volumes will probably derive from the size of the projected target market. Data on the target market at the time of product launch are available from many sources some public and some in the form of reports published by research companies. In addition, in different cases, and in particular when the company is about to create a new market, tailored research that is conducted by or for the company should be used, in order to estimate the size of the potential market.
The data included in the statements of public companies should, however, be treated cautiously, since these are mostly companies that have already passed the test of investors before going public and therefore do not necessarily represent the average company in their field. Financial data and ratios may also be utilized either from publicly available sources or from quotes for similar projects with respect to employee compensation, project pricing, and so on.
Forecasting a company's scale of operations is complex, and in many cases companies will resort to technical and financial experts for such estimates. Even if the estimated market is large, and even if it is forecasted that the competitive situation of the market will not bite into the company's profitability, the company has to estimate the market share it can achieve and maintain. Determining the market share which the company can achieve is complicated, and setting targets such as "we will obtain 10% of the market" must be based on defendable assumptions. Otherwise, it will not be treated seriously by investors and, which is worse, could lead to erroneous strategic decisions by the company. A later section will discuss further aspects of market analysis.
Issues in Forecasting the Business Results of a New Company
There is no doubt that forecasting the business results of a company in its early stages of development is more of an art than an exact science. Nevertheless, financial forecasting at these stages is more important than for developed businesses. Given the scarcity of available sources of capital, the company must assess its business development decisions at every stage, while choosing the alternatives that will yield the best return for its shareholders (including the entrepreneurs). The main difference in comparison to a developed business is the level of uncertainty that may be addressed by examining different scenarios of parameters such as cost structures, market sizes, growth rates, and market profitability.
Companies must always examine scenarios that take into account the possibility of partial success. There is almost no greater hazard for businesses than managers who do not account for the possibility of partial success or failure of a project. Just like the preparation of strategy for war takes into account pessimistic scenarios such as accidents or defeat which would necessitate a retreat, companies too must prepare for scenarios in which not all optimistic assumptions materialize.
Sales Growth and Required Capital
An important component that affects a company's ability to raise capital, as well as to finance its development by using internal resources, is the growth of sales. However, it is important to understand that the substance of the growth in sales is more important than the actual pace of such growth.
Paradoxically, many companies which demonstrate a fast sales growth actually need more outside financing. The reason for this is that the company has to prepare for the increased sales by making considerable investments in equipment, manpower, raw materials, and inventory, which are made before the proceeds from the sales are received. Many entrepreneurs fail to plan their cash needs for accelerated growth and run into financial difficulties at times that are supposed to be good from the company's point of view. Although, as mentioned above, investors prefer companies with rapid sales growth, various factors could delay their investments, such as a forecast of a problematic situation on the capital market, or a projection that the pace of growth of an industry will not last much longer.
This dimension is crucial for attracting investments, as more and more investors prefer to "cut their losses" than to continue investing in rapidly growing ventures, whose future capital need on their path to profitability makes them too risky. For instance, during 2000 and 2001, many Internet ventures closed down. One of the most spectacular closures was perhaps the grocery and gasoline division of Priceline, in which more than $300 million were invested and that was shut down after less than one year of operations, as it was anticipated that hundreds of millions of dollars would have to be invested before it turned profitable, and the probability of raising this capital at a period of "hostile" capital markets was predicted to be slim. Along with companies in the public sector, there were also many spectacular failures in the public market, such as eToys, that consumed hundreds of millions of dollars before declaring bankruptcy. One of the reasons for this failure was that eToys was unable to secure additional sources of capital that would sustain it until it could (possibly) start generating net positive operating cash flows.
Utilization of Working Capital
A company's net working capital is an essential component of its operating needs. Working capital includes the company's cash, liquid securities, inventories, and short-term debt owed to the company, minus the short-term debt owed by the company. There is a natural connection between a company's working capital needs and sales since, as demonstrated above, companies must prepare for their expected sales growth by investing in equipment, inventories, or manpower, all of which require a substantial amount of cash. In addition, if the company extends credit to its customers, then the more its sales increase, so will its working capital, since the company has to finance the products it sells by its own resources or apply to outside sources for this purpose.
Companies will always try to obtain more favorable terms of credit in order to finance inventories. Thus, they reduce the need to freeze financial assets to this end. Many companies now manage to operate and grow with a net working capital that increases at a slower pace than their revenue, due to wise utilization of the cycles of accounts payable and accounts receivable, and are sometimes even able to operate with negative working capital. The computer company Dell, for instance, is often paid for the computer systems it supplies before they are even ordered from its suppliers.
Pricing and Credit Policy
An important factor in the company's business planning is estimates regarding the pricing of the company's products. Such decisions are essential as early as when the business model is structured, even before the company enters the market. In addition, the company has to update its analyses from time to time to accommodate any expected change in the competitive situation in the market, when the company's products are expected to be launched. The importance of such forecasts cannot be overrated, because no development decision is possible without examining the economic potential of such changes. Even meager changes can facilitate investment decisions.
A credit policy often seems irrelevant to companies that are not yet generating any revenues. However, determining such policy is highly significant, since in many cases it constitutes a material component of the company's business model. For instance, leveraging a model structured on production or assembly after orders are placed, enabled Dell to benefit from a steady competitive advantage in a market with narrow profit margins and intense competition. Dell's approach was to custom-build computers according to customer requirements, while relying heavily on a rapid decline in the price of components. Since the company did not stock large inventories, it was able to transfer to its customers part of the savings made from the falling prices.
In many companies, the dividend policy affects the company's cash balances. This is not the case in most startups. The principal portion of the returns earned by those who invest in the equity of high tech companies does not derive from the distribution of the company's retained earnings in the form of dividends, but rather from an increase in the value of the underlying asset, namely, the shares representing their stake in the ownership of the startup.
The reason for this is simple: Due to required heavy investments, startup companies rarely generate any earnings for a long period of time. Consequently, they have no profits and cannot distribute dividends. Alternately, even if the company could distribute dividends, in many cases the return which the company can gain from re-investing its surplus cash in the company is higher than the cost of its capital. In other words, it is better for the investors that the company will not distribute dividends. The company's value therefore derives from an estimate of its future profits (see Chapter 9 for a discussion of valuation), which value is manifested in a subsequent public offering or sale that rewards investors with revenues from the sale of their shares.