Business Plan Financial Projections [Simplified] — Income Statement Edition
Financial projections are the backbone of a solid business plan; and for most soon-to-be entrepreneurs, they’re also a major source of stress. What a lot of people may not realize is that once you finish writing the other sections of your business plan, everything you need for the financials is sitting right in front of you. It’s just a matter of putting it all into place.
This article breaks down the process of preparing income statement projections, provides a step-by-step example, and highlights a few things to keep in mind during the process.
Getting Started
Financial projections use numbers to show what the rest of the business plan explains with words. The financials shouldn’t say anything that isn’t already described in the written portion, and vice versa (everything in the written portion should be reflected in the financials). Both parts should tell the same story.
When you’re ready to get started, carefully read through each section of your business plan and highlight every single piece of quantitative information. Some quantitative data doesn’t show up as a number, so it’s easy to overlook. Take your time. Keep an eye out for words like split, share, and double. Highlight anything, and everything, that has a monetary impact.
For example, highlight the section of your operations plan that says the number of full-time employees will double every year for the first three years. This will remind you that the amount of salaries and wages expenses in Year 2 should be twice the amount it was in Year 1.
Highlight the section of your sales & marketing plan that says products will be sold with a warranty. This will remind you to include a line item for warranty expense on your income statement.
Projecting the Income Statement — Line by Line Example
Line 1 | Gross Revenue — Our imaginary company will only sell one type of product. According to the sales forecast in our sales and marketing plan, we expect to sell 10,000 units in the first year, for $30 each.
Multiply the expected sales volume (10,000) by the product’s selling price ($30) to calculate the gross revenue ($300,000).
Line 2 | Sales Discounts + Returns —Sales discounts and customer returns reduce the amount of sales revenue our company gets to keep at the end of the day. Sales discounts and returns are usually estimated based on a percentage of gross sales. Depending on your industry, that might be as low as ½% or as high as 10% of gross sales. For the purposes of our example, we’ll say 2% of gross sales ($300,000 x 2%) will be returned or discounted, for a total of ($6,000).
Line 3 | Net Sales Revenue —The total amount of sales discounts and returns ($6,000) is subtracted from gross revenue ($300,000) to calculate net revenue ($294,000).
Line 4 | Cost of Goods Sold — There are a lot of different ways to calculate this number. Ideally, the cost of goods sold should be calculated based on how many units were produced (from your production schedule). For our example, we’ll assume that the number of products sold is the same as the number produced.
Multiply the number of units we expect to produce during the year by the amount it will cost us to make each unit. The unit cost should include materials, direct labor, and allocated production overhead. In our example, it costs our company $10 to produce each unit. The total cost of goods sold would be 10,000 units multiplied by $10 per unit, for a total of $100,000.
Line 5 | Gross Profit — The total cost of goods sold ($100,000) is subtracted from net sales revenue ($294,000) to calculate gross profit ($194,000).
Line 6 through 11 | Operating Expenses—All costs that aren’t included in the cost of goods sold amount should be listed as operating expenses. This usually includes salaries and wages (Line 6), administrative costs (Line 7), repairs and maintenance (Line 8), depreciation (line 9), and professional fees (line 10). After listing each expense separately, include a line for the total operating expenses (Line 11).
Line 12| Earnings Before Interest and Taxes (EBIT) — The operating expense total from line 11 ($20,000) is subtracted from gross profit ($194,000) on line 5 to calculate the amount of earnings before interest and taxes ($174,000).
Line 13 |Income Taxes — In our example, we’ll assume the federal tax rate is 21%. The amount of earnings before interest and taxes from line 12 ($174,000) is multiplied by the tax rate (21%) to calculate income tax expense ($36,540).
Line 13 |Net Income —The estimated income tax expense calculated above ($36,540) is subtracted from EBIT ($174,000) to calculate net income ($137,460).
Inflation — When projecting what our numbers will be in the future, we have to consider inflation. The spreadsheet excerpt below is from the Bureau of Labor Statistics website, and shows the expected percentage price increase consumer goods for the next ten years.
Since our projections extend 5 years into the future, we are concerned with the period from 2020 through 2024. During those 5 years, the average inflation rate hovers around 2.5%, so we need to increase our numbers by 2.5% every year (except the base year).
Besides inflation, the only other difference between Year 0 and Years 1–4 is the sales volume. In our example, our sales plan mentioned sales are expected to grow by 10% every year. Starting with our base year sales forecast of 10,000 units, 10% annual growth would mean the sales volume in Year 1 will be 11,000 (10,000 units plus 10% growth), and then 12,100 (11,000 units plus 10% growth) in Year 2, and so on.
When you’re finished with the projections, refer back to the highlighted items. Remember, you want to ensure that the financials are telling the same story as the passages and figures you highlighted.
Put it Into Perspective
Looking at the financial statements of an established company in your industry is one way to judge the reasonableness of your numbers. Public companies are required to submit quarterly and annual financial statements to the Securities and Exchange Commission (SEC), all of which are accessible through their Electronic Data Gathering Analysis and Retrieval system.
Since a public company will undoubtedly have more revenue, ignore the dollar amounts and focus on their relative proportions. Calculate net income as a percentage of gross revenue (net income divided by gross revenue) for a few different companies, and see how your numbers compare. Chances are, if you have a higher net income percentage than a well-established public company, you either overestimated your sales numbers or underestimated your costs.
Key Takeaways
By identifying everything in your business plan that has a financial impact first, and then tackling the income statement projections one line item at a time, what used to seem like an overwhelming task can suddenly feel much more manageable.
Painting an accurate financial picture of what a business will look like in the future is no easy task. Financial projections are definitely something you will need to discuss with a professional accountant before moving forward.
