Know What You Need: Practical Use of Financial Projections
One of the biggest differences between being a shareholder of publicly-traded stocks and an investor/owner of a privately-held business is the disparity in degrees of influence and access to information between shareholders of stocks (low influence, relatively little information), and owners of privately-held businesses (high influence, information fire-hose). Influence and access to information together should provide the ability to look forward and project financial performance with confidence.
Yet, there is a notable irony in the near uselessness in form but over-abundance in quantity of financial projections in the form of analyst estimates for stocks, and the necessity but notable scarcity of meaningful financial projections in privately held companies. While we can do very little about the problem with projections for publicly-traded stocks, in this post I will cover the major issues as I see them. I will also discuss how owners and managers of privately-held companies can learn from public companies’ mistakes to get the most value out of projections with the least complexity, and provide a link to a spreadsheet model that you can use to try out these concepts.
THE PROBLEMS WITH ANALYST ESTIMATES
In public markets, a “tail wagging the dog” scenario has arisen, in which companies actively target quarterly analyst EPS (Earnings Per Share, also known as Net Income) and Revenue/Sales estimates for fear that stock prices will plunge if they miss estimates (or don’t beat them enough). Targets can be met the good old-fashioned way, by growing revenue and increasing profitability; through financial engineering techniques such as buying back shares; or through accounting by accelerating or delaying recognition of revenue and costs. It turns out many if not most companies have decided that earnings are much easier to manage with precision by utilizing financial engineering and accounting shenanigans.
Most analysts will tell you — some only under hypnosis — that CASH FLOW is much more important in determining the health and value of a company than revenue or earnings alone. If you are curious, just run a Google search on “cash flow vs. earnings.” For a discussion on why, see one of my previous posts. Notice though, that free cash flow is not one of the primary measures for which analysts provide estimates.
The impacts of this fixation on reporting favorable earnings relative to estimates rather than focusing on generating healthy cash flow is apparent when we compare cash flow per share to earnings per share of publicly-traded companies over the last 12 months (first chart below). The average difference is 34.4%, compared to an average 5.4% difference between actual and analyst-estimated Earnings Per Share (second chart below). 
The focus on earnings is deeply ingrained in corporate America and Wall Street, and is unlikely to be changed without a significantly compelling reason. Investors must be able to communicate within the earnings paradigm, while investing based on sound and thoughtful fundamental analysis with cash flow as the focus. But the question remains: If the CEO’s and other executives of these companies know their businesses half as well as their private company counterparts know theirs, why don’t they provide meaningful cash flow projections? We believe one plausible part of the answer is that, at the end of the day, their salaries and benefits depend on meeting earnings estimates, not on generating sufficient cash flow to fund operations and maintain access to outside capital.
NO CASH FLOW. NO PAYCHECK.
Why should an owner of a privately held business be concerned at all about quarterly EPS? The simple answer is: they shouldn’t. Earnings are paper profits; cash flow is what businesses have (or need) in order to fund operations or acquisitions, service outstanding debt, and/or pay distributions to shareholders. Earnings alone are likely only relevant for tax planning purposes. Private company CEO’s usually aren’t compensated based on earnings per share, because they pay themselves based on cash flow. This means that if there is no cash flow, there is no paycheck.
What all companies need a firm grasp of is the timing and amounts of sources and uses of cash. Financial statements demonstrate this information on a historical basis, which is one reason many of the owners my firm has worked with find statements severely lacking for management purposes. I understand this issue acutely, but the fact is that financial statements also provide a historical basis and framework for forward-looking financial projections, and that is what is covered below.
A SIMPLE APPROACH TO PROJECTIONS
There are two primary financial statements that I will discuss here: the Income Statement and the Balance Sheet. The Income Statement measures revenue/sales, costs, and expenses over a specific period of time, resulting in a calculation of Net Profit (Earnings). Projecting only the Income Statement won’t get you to a meaningful set of projections, but it will get you closer. You will also need to consider the Balance Sheet. I have included this link to a very simple spreadsheet template you can download to put together your own projections and experiment with the process. But, one step at a time. First, the Income Statement.
Where to start: You can use an Income Statement report from your accounting software as a template for projections if you don’t want to download the one I linked to, or if my template is overly simple. Most desktop and online software packages allow you to export reports straight to Excel, or Google Sheets, which will save you time.
In the beginning it can be simpler to categorize various line items into chunks, based on function. For example, salaries and wages, payroll tax, benefits, and any other personnel-related expenses can be chunked into a Personnel line item. Before deciding on the frequency of projections, try one month. As you work through that month, you may find that it makes sense to project weekly, bi-weekly, or quarterly.
Determine Baselines: Some companies base Income Statement projections on an average of the trailing twelve months; some painstakingly schedule out revenue and expenses to incorporate project-based billing schedules, seasonality, and expected changes within the business. For example, my business pays its business license fee in February, so I only project a business license fee for that month. Anything is better than nothing, but as you begin to rely on projections to manage your business, you will probably drift towards more detailed estimates for items that are estimable and critical to the health of your business.
After you have projected all line items for the month, subtract Total Expenses from Total Revenue to calculate your projected profit for the month. If you made it this far, you’ve made it to where Wall Street would say you can stop. But, you’re not doing this for them, you’re doing it for yourself. To get meaningful information, you’ve got to go further by projecting the Balance Sheet.
THE RIGHT KIND OF BS FOR YOUR PROJECTIONS
The Balance Sheet measures the Equity, or Net Worth, of your business for accounting purposes. It is a snapshot in time of your assets and liabilities, and as such it shows you a scorecard of your business at some specific point in the past. So, what use can it be in helping you manage forward? What we need is to understand the change in Balance Sheet line items, because they represent sources and uses of cash that are not captured in the Income Statement.
For example, let’s assume you have $100 of receivables at the beginning of a month. You make $5 of sales during the month, but you don’t expect customers to pay you until they have to, which is 30 days from now. But, during the month your customers do pay $20 they already owed at the beginning of the month. The net change in receivables (5–20=15) represents a source of cash in the amount of $15. For growing businesses, this change often goes in the other direction, causing them to end up with less cash than they would have otherwise expected.
This example points to an important, and counter-intuitive rule: a positive change in any asset other than cash, represents a use of cash. The reverse is true for liabilities: a positive change in any liability represents a source of cash. Once you have projected the Balance Sheet line items, calculate the change from the previous period Balance Sheet for them all. Subtract the change in liabilities from the change in assets, and subtract that from the profit you calculated from your Income Statement projection. One important step to include is that if you have included any non-cash expenses such as Depreciation of Fixed Assets or Amortization of Intangible Assets in your Income Statement Projections, ADD THEM BACK. The resulting figure is the number that matters the most: CHANGE IN CASH.
SO… NOW WHAT?
Now you have projected the change in cash over a month of operations, which means that you also have an estimate of your cash balance at the end of the month. It also means you are leaps and bounds ahead of your peers. Yet, your work doesn’t amount to much if you don’t use the projections. In order to do that, your next step will be to project the subsequent 2–11 months, using your first month’s projections as a framework. Here are a few ways you can make the most of your projections, though there are undoubtedly more:
- Compare your projected results to your actual results at the end of each period to find areas for improvement within your business.
- You will also find areas to improve your projections in subsequent periods by comparing them to your actual results. While it can be frustrating to spend time and effort working on your projections only to find they were wrong, the trial and error process will provide value over time by testing the validity of assumptions you already use to run your business today.
- Use your Projections as a way to make decisions about capital allocation. The intentional allocation of capital to maximize returns is a next-level skill that many companies never achieve. If you see that your business will have a cash shortage in the future, you know you must make preventative changes, or go find external capital from investors or banks. If your projections are telling you that you will generate cash in excess of what you need, you can think through the best use of that capital. You can do one or a combination of four things, which I like to frame as an acronym: SAID (Spend, Acquire, Invest, Distribute). FYI: those are not listed in order of importance or preference.
- Develop goals and motivate your team by aligning incentive plans with your projections. Does your team mistakenly think you’re the physical embodiment of the Monopoly Man? Do they have any idea how the different parts of the business impact its ability to survive and thrive? Think about how you can share this information with them in a way that helps them understand (a) the risk involved in business ownership, (b) how you manage that risk with their financial security in mind, and © how they can share in the reward of exceeding expectations of performance in generating healthy and growing cash flow.
This post explains how the use of financial Projections can help business owners run their businesses better, but you will only really believe it if you try it and stick with it. As I mentioned above, feel free to download and use the template I’ve linked to, here; or make your own. To be clear, I am not providing legal or tax advice — you will need to get that separately from your attorney(s) and CPA(s), respectively. The template is provided for the purpose of illustrating concepts I covered in this post, which relate to the financial management of your business from a practical valuation-based perspective. If you find the template useful, or if it raises questions that I did not address in this post, please let me know.
 We limited the y-axis to a range of -100% (low) and 100% (high) in both charts, but the actual range is much wider for both.