Entrepreneurs prepare financial projections to convince investors to provide funding for startups. Investors use them to determine the potential for a new company’s profitability. Budgets, forecasts and proformas mean the same as projections, and they serve the same primary purposes.
But an investor must understand that projections are just that, projections. So investors have to take future projections with a grain of salt and as a guide when making investment decisions.
Understanding the Importance of Startup Financial Projections
Investors examine startups in the same way that doctors study x-rays. They reveal the health of an organization’s financial status without regard to outward appearances. An explanation of factors that predict a startup’s chances for success gives you a basis for evaluating the safety of your investment.
As an investor, you surely want to know the income and expenses that a startup expects to experience. Payroll or rent occur as fixed expenses, among many others. Variable expenses may include the costs of selling goods, materials and marketing, among other essential items. Startups can estimate revenue by citing the potential market for a product or service.
Learning What Financial Projections Do and How They Work
When you review a startup’s business plan, you can expect to find three projections that outline the risks you face as an investor. For example, the information contains a balance sheet, cash flow statement and income statement. When you examine financial projections, you gain insight into the potential for an entrepreneur to succeed in running a business.
The value of projections comes to you as an understanding of your potential for return on investment. They show you what the business owner thinks may happen based on facts or imagined outcomes. In addition, the information needs to provide answers to questions you may have about the reliability of your investment. For example, most investors want to know what startups plan to do with a loan or equity investment they get from you. In addition, you need to know how and when they plan to pay it back or give you a return on your investment.
Examining the Components of a Startup Financial Projection
As an investor, you can expect to receive many funding requests. A systematic review lets you examine each one on a consistently factual basis. In addition, it provides a basis for comparing competing proposals. Finally, the projects that startups prepare and submit for review give you the information to accept or deny the opportunity to fund a new company.
Projections can give you a business model concept that includes goals and objectives. As factors that affect the finances of an organization, they reflect income tax planning, investments and insurance.
Reviewing the Income Statement
An income statement for an existing startup that needs additional funding for expansion or relocation can provide a yearly or quarterly report. Some startups may decide to give up equity to investors as opposed to a loan.
As an investor, when you review the statement you can judge a company’s future performance based on the income reports. As one of the vital pieces of information in the statement, it must amount to more than the costs a company incurred. In addition, it must provide the return on investment that you deserve in exchange for equity in the company.
The expense lines show you how much the company spent to create the goods or services it sells. Businesses include the cost of sales in the first expense line, and it covers everything needed to make the product or service. Operating expenses include expenditures for obligations that do not relate to production.
Checking the Balance Sheet Figures
A balance sheet tells you the most basic information that can help you decide to provide funding or not. It gives an accurate description of the assets a business owns and how much it owes. In addition, it reveals the amount of money that other investors have provided. Finally, as a statement of financial position, the balance sheet gives you a summary of a company’s status at a specified date.
Examining the Cash Flow Statement
A cash flow statement gives you a view of how much money a company receives and how much goes out. As a result, you can use it to predict the future of a company that wants you to fund their enterprise. The information that the cash flow statement must provide includes cash that comes from a company’s operations. In addition, it reflects investing activity and money that a company receives from financing projects and activities.
Assessing Startup Financial Projections
Your position as an investor lets you assess the future value of your investment based on the current data that a borrower requests. When you examine the cash flow projections, you can see where a company expects to get the money they reflect. Sources may include loans, receivables, credit lines and others. The income statement helps you evaluate a company’s potential for growth. Finally, the balance sheet can let you review the rate of return that you may expect from your investment.
Summarizing the Process
While evaluating the risk of investing in a startup may seem complicated, the financial projections can make it seem less so. An income statement with a balance sheet, along with a cash flow statement, provides the essential information to help you make an investment decision. Of course, you may choose to review much more information, but these three pieces of information provide what you need to know.