Projected financial statements take into account past financial trends, market conditions, possible changes and management expectations to arrive at a future financial picture.
Accounting alone only looks at past financial data. That is, the expenses you’ve already incurred and income you’ve already earned. As well as the assets and liabilities you currently have on the books.
While this information is critical in assessing your company’s results and decision making, it does not give you enough insight into your future performance.
Think of accounting and bookkeeping as step one. Your business has dozens if not, hundreds or thousands of transactions monthly. In order for you to make any sense of it all, you need bookkeeping to organize this information into financial statements.
And those financial statements are reviewed regularly to help you make profitable decisions. But how can you measure the impact of those decisions? How can you see the financial picture those decisions will make?
Projected financial statements.
Consider your projected financial statements as your step two in the accounting and bookkeeping process.
You want your business to have longevity. Apart of that is planning and preparing for the future. Projected financial statements help you do just that.
Breaking Down Projected Financial Statements Further
Projected financial statements are also called pro forma financial statements. The term pro forma simply means “as a matter of form”.
In the business world, pro forma, or projected financial statements, are typically used to focus on certain figures, such as sales or profit.
Projected financial statements are most effectively used to examine the effects of a particular decision.
For example, if you are considering adding a new product line, you would use pro forma financial statements to see how the addition would impact your business overall.
Projected financial statements look similar, if not, the same as regular financial statements. So when examining them, you’ll see the same accounts and structure as you would on your normal statements.
Pro forma financial statements can consist of a balance sheet, profit or loss, cash flow statement or more. Most statements that are produced to reflect present financial information can be translated to present future information.
You can see what your business is projected to look like at some point in the future. Planning never seemed so easy!
Why Projected Financial Statements Should be a Regular Part of Your Accounting?
You guessed it. Planning. Projected financial statements help you plan for the future.
Given the many different decisions and scenarios you’re faced with every day, projections help you decipher between them all. This allows the decisions you do make to be backed by numbers and financial analysis.
Let’s think of it this way. When you make a major decision in your personal life, how do you go about choosing the best option?
First, you examine the possible options and their corresponding outcomes. From there, you choose the option with the most favorable results.
You need to have this sort of analysis as part of your business decision making as well.
Projected financial statements is the way to review your possible outcomes before making a decision. While no projection is perfect, having one mitigates the risk of uncertainty and losses.
Projections Vs Forecasts: What’s the Difference?
Projections and forecasts are not one and the same. Though, people tend to use these terms interchangeably. Maybe even yourself!
The difference between the two is slight, yet significant.
Remember when we said projected financial statements are used to help assess a possible business decision? A financial forecast operates differently.
Instead, a financial forecast only takes into account current conditions and expectations to arrive at a future value.
Clear as mud? Let us explain.
Financial forecasts are predictions of future financial performance based on today’s facts. If nothing were to change in your business, what would your numbers look like? That’s a financial forecast.
On the other hand, a financial projection considers a hypothetical course of action. In our previous example, we considered adding a new product line and how that would impact your financial results.
At larger companies, financial forecasts are what’s provided to external users. For example, if you are seeking outside funding from investors or banks, financial foreasts are used to assess your company’s sustainability.
In general, you should expect the objectives in a forecast to be met.
Again, projections have a speculative element. An element that is not true today but if it was, what would that look like?
Financial projections are more geared towards internal users to aid in decision making. However, certain external users, like investors, may want to see the financial impact of a particular decision. A financial projection would show this.
You could also think of projected financial statements as a way to answer ‘what if’ questions.
“What if I added a new service?”
“What if I invested in new equipment?”
“What if I took out a bank loan?”
“What if I added a new employee?”
The list goes on.
Both financial forecasts and projections have important roles in your business. It’s important to understand the difference between the two and how to use them. Both can be used to drive profitability and growth within your business.
How to Prepare Projected Financial Statements?
Preparing regular financial statements can be hard. So there’s no doubt that projected financial statements have its difficulties.
This is where the help of a CPA or CFO comes to play.
Full-time CFOs can be pricey for a small business. But consider hiring a part-time CFO. They have the expertise a full time CFO would have at a small fraction of the price.
In either case, there are some general steps a CFO does to prepare projected financial statements.
1. Examine comparative reports. Assuming you have accounting and bookkeeping records, the first step is comparing results across periods.
Compare this year’s profit and loss to last year’s, and the year before. What trends do you notice?
Has profit increased? Why?
Did you implement any major changes during this time? And how has it impacted your financials? By what percentage?
This exercise should be done for each of your main financial statements. (I.e. profit and loss, balance sheet, cash flow statement, etc.).
2.Safely make assumptions. The primary purpose of projecting your financial statements is to present ‘what if’ scenarios and make decisions based on those projections.
Not every account on your financial statement is impacted by a ‘what if’ scenario. Therefore, you should safely assume those accounts will remain the same or deviate at the same rate historically.
For example, if you want projected financial statements prepared to show the effects of a new service line, your rent expense is not likely impacted by this.
Therefore, if you pay $500 per month for rent, you should expect that amount to be the same on your projected financial statement.
The same is true for other accounts. Not every account would be dependent on your ‘what if’. These accounts are considered independent variables.
Adding to this example, maybe your rent expense consistently goes up 3% per year. This should be reflected in your projected financial statements.
Even though rent expense is independent of adding a new service line, history shows that it increases 3% per year.
3. Make projections on relevant accounts. Once independent accounts have been projected from step 2, it is time to make reasonable projections on the other accounts.
Again, using our adding a service line example. Consider which accounts would be impacted.
How are sales affected? Expenses? Assets?
Would there be any new accounts added? Are there any that would be eliminated?
Answering questions like these will help in the preparation of your projections.
Coming up with the actual number of sales or expenses the new service line will earn or incur is the trickiest part.
Your business trends, ratio analysis, market conditions, and risk analysis should all be employed to arrive these numbers.
Once your projections are complete, you have more leverage in making the best possible decisions for your business.
Your CFO’s Role
Ratio analysis, risk analysis, and financial trends are just a few concepts that can sound foreign to a non-financial expert. Yet, these are the necessary elements for preparing a financial projection.
A CFO has the expertise, resources, and education to apply these concepts without you having to delve too deep in the details.
A CFO does more than preparing your financial projections. They are responsible for the monitoring and management of your company’s financial performance.
Their job is to learn and understand the details of your financial situation and provide strategy to grow your business.
Their specific duties vary from company to company. Based on your needs and goals, they will deliver the appropriate level of service to your business.
Limitations on Projected Financial Statements
As with anything that concerns the future, uncertainty exists. Uncertainty is the core limitation placed on projected financial statements. There are other limitations that you should keep in mind.
Though a thorough analysis should be performed before actually projecting out data, circumstances do exist that could alter expectations.
The analysis and calculations could be reasonable but some unforseen situation occurred such as a recession or new competitor.
This is why it’s important that your projections are conservative and adaptable to changes.
Because financial projections focus on a ‘what-if’ scenario, a business owner might lose sight of other areas of the business.
In the case of adding a new service line, an owner might neglect their other service lines. This can cause those areas to experience negative side effects.
Make sure to continue to monitor all areas of your business, even when implementing a decision based on projections. It’s counterproductive to grow in one area of your business but decline in every other area.
Developing projected financial statements takes time. Time to gather financial data, market conditions, competitor information and more.
Time that you may not have. Especially, if you’re a non-expert in this area.
What ends up happening is your projections end up being wrong, incomplete or just not done. But if you want to see growth and expansion in your business, preparing financial projections should not be ignored.
Instead, consider hiring a part-time CFO. They have the time, knowledge and know how to accomplish this for you.
Now that you know what projected financial statements are, you should have a clear understanding of why you need them for your business.
The reason is to make smarter, better, more profitable business decisions.
Too many business owners blindly make decisions without any real rationale or evidence to back them.
There’s no surprise as to why so many businesses fail. It’s because of the lack of financial insight.
Don’t let this be you.
Use the financial information your business is producing to effectively plan and prepare for the future.
Every decision you make should make financial sense. In addition, you should have at least an idea of what the financial consequences of those decisions are.
This is what projected financial statements do.
Preparing them is not easy and there’s a good bit of financial analysis and research that goes into it. Which is why you should hire a part-time CFO for your business.
Part-time CFOs are cheaper than full-time ones but still have the knowledge you need to make good business decisions.
You need more than a bookkeeper or tax accountant. You need a part-time CFO.
Here at LYFE Accounting, we have experienced and knowledgeable CFOs ready to help you through every financial decision.