Thursday, May 26, 2011


clip_image002 clip_image004This article was written by John Seelinger and Howard Hawkins, SCORE Orange County Management Counselors

Today’s small business owner is often challenged to prepare financial projections either as part of a business plan or at the request of a bank to complete a loan application. The task obviously varies given the history and type of business (product or service), and the financial sophistication of the owner. The projections include the three basic financial statements, and a narrative covering assumptions and external factors that can influence future results. The assumptions support the financial numbers explaining their derivation such as historical trends and could include hypothetical assumptions about future courses of action the business might consider. These assumptions could range from new products or services, personnel changes, or new marketing plans.

The underlying goal of the projections is to convince the reader of two very important details: the business will generate sufficient cash flow to (l) repay debt and (2) provide efficient Return on Investment to insure success for the owner. Before undertaking the task of preparation it is important to confirm the bank’s requirements, especially the number of years to be shown, and whether the periods should be monthly, quarterly, or annual. Banks today generally prefer three years of projections with the first year divided by months or quarters, and the two succeeding years shown on an annual basis.

Given the length of time in business, it is best to show the figures as accurately as possible, and avoid showing numbers in hundreds or thousands. To include a “disclaimer” might be a legal protection, but an experienced lender realizes the numbers are on a best efforts basis, and are subject to change through the normal courses of internal and external factors. Their analysis will result in questions requiring support. The three basic statements are generally accepted and understood throughout the banking industry. The preparation of the statements by a small business can range from CPA prepared to internal methods such as “QuickBooks.” The latter provides a method of providing the statements in an organized and consistent manner, and is most cost beneficial to a small business. The business owner must conform to a consistent pattern of inputting the data in order to prepare a periodic statement to review the progress of the business. Without that, the necessary decisions may be delayed, and a lender is going to look for how often the owner uses the statement information to manage and react to required changes depending on internal and external factors. There are other sources that can be used to prepare the projections and “keep the books”, but the important thing is to do it and be consistent.

The three statements must be consistent with either cash or the accrual method. The doctrine of constructive receipt of income must be consistent. How is income recorded? Upon an order or upon the actual receipt of payment from a customer. The recording of income should be explained with the assumptions, and is certainly a point of certain verification by the lender in his analysis.

The three statements are linked as to their relevance, and some lenders may rely more on the cash flow projections as it is the support of the ability of the business to generate cash to repay any debt. However, their purpose is important in balancing the support necessary for a positive credit analysis. The purpose of the balance sheet is to show the financial position of a business at a particular point in time. The most usual date is at the end of the accounting year. It shows assets (current and fixed/long term), liabilities, and owners net worth/equity. Total assets equal liabilities plus equity. Owners’ equity is the residual interest, or the amount of the assets to which the owners have claim because creditor claims (liabilities) legally have priority. The equity is derived from two sources: (l) paid-in capital which is the contribution of the owners in cash or assets; and (2) retained earnings, which are the accumulated profits (transferred from the income statement) less any losses or withdrawals.

The Income Statement or Profit and Loss shows the revenue, expenses, and net income (or net loss) for a period of time; monthly, quarterly, or annually. The projected income statements support the ability of the business to earn profits.

As stated previously, the Cash Flow Statement will probably bear the most analysis by the lender. Cash flow can come from investments or financing, but it is the operating cash flow (net income plus non-cash depreciation/amortization) that is available for debt service. A bank loan generates cash but is not revenue. Loan payments consume cash, but do not reduce income only liabilities. Most lenders prefer a cash flow presentation showing the addition of debt to support operating expenses, and net income that is available for debt service. The loan payments can be shown and deducted. The margin over the loan payment and the cash available for debt service is the “cushion” the lender will evaluate in their credit analysis.

It might be preferable to show two sets of statement projections. One could be the most reasonable based on historical trends, and the other the most conservative. The latter would reduce the cash flow to show that even in a reduced performance the firm still has the capacity to meet the loan payment required.

Up to this point we have concentrated on internal projections, using the firm as the basis for the forecasts. External data can also be used to support the factors of data specific to the type of firm, including its industry, market, or the general economy. Industry information for external comparisons is readily available through many sources. Public libraries are a treasure of information. The business librarian can assist using zip codes, county, and city information to provide a great variety of comparative data. The 2010 census data is just now becoming available.

Two internet sites: “” and “” are the sites to be explored for any particular industry data one is interested in. To begin one needs to enter the North American Industry Classification System (NAICS) code for any particular industry. This system, adapted in 1997, supplanted the older Standard Industrial Code (SIC), although the latter is still used by many government agencies.

Industry trade publications coupled with specialized conferences and conventions can provide up to date information. The internet today is a growing source. Link on to “Google”, and almost any question can be answered. Universities offer public access to their specialized research in business topics.

There are two main considerations to keep in mind when doing projections: they must be reasonable and they must be consistent with the narrative in your business plan. If they just show yearly totals of income and expense spread evenly over twelve months, questions arise about the thought put into them, and the credibility of the projection is questioned. Every business has fluctuations and projections should reflect this. Projections should be in line with industry data mentioned above; any variation, positive or negative, should be supported in the narrative. Finally, particularly in the current economic scenario, it is very difficult to increase gross profit margins. Unless there is strong support in the narrative explaining how this can be done, projections showing margin enhancement along with the increasing sales will be subjected to challenges. Sales, income, and profit growth can be achieved with consistent margins that, after all, are a ratio, and not absolute numbers.

Well constructed projections absolutely are great management tools. However, lenders vary as to their requirements. Inquire as to what the lender wants, and in what detail. Loan collateral is often required, and if required may result in more relaxed projections. Some lenders, for lesser loan amounts, perhaps under $100,000, may use credit scoring which could reduce the reliance on projections. If a borrower is seeking credit for an amount in the lower five figures, projections rarely are the critical item in the loan approval process.

Finally, prospective borrowers/business owners must “own” their projections. If the business owner brings an accountant, and defers all questions to this third party, he or she loses credibility and the lender may have doubts about the borrower’s ability to truly understand their business prospects necessary for the proper cash flow to service the debt obligations.