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13. Reviewing Financial Projections
It’s critically important to review your financial projections, to make sure they are reasonable and achievable in the near-to-medium term. Both growth rate assumptions and economic cycles are two biggest pitfalls to bear in mind.
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Lesson Goal (00:04)
The goal of this lesson is to learn how to review financial projections and identify possible issues with these projections.
Reviewing Revenue Growth (00:34)
Revenue growth rates are usually one of the key assumptions of any financial projection. This is because many of the other assumptions on the Income Statement and Balance Sheet are based on revenue.
High projected revenue growth rates can create steep revenue targets for a company. This happens because of the compounding nature of growth rates. Over the course of multiple years, a small difference in growth rate projections can create a large difference in revenue projections, especially in later years.
In our example, MarkerCo’s consulting business is projected to grow rapidly, driving a large increase in revenue in future years. The company needs to be confident that there is enough room in the market for them to grow by this amount. If not, the growth rates should be revised downwards in the Excel model.
Reviewing Expenses Growth (02:22)
When a company projects large revenue growth, it’s important to know how they propose to fund this. Typically, companies need to spend money on marketing to acquire new customers and grow revenue, but this is sometimes not accounted for in financial projections. In our example, MarkerCo is projecting an increase in sales and marketing expenses, but they may need to increase this further by adjusting the Excel model.
Analyzing Other Metrics (03:22)
Many metrics in financial projections are based on a percentage of revenue or cost of sales. As a result, these measures will appear healthy if revenue growth is strong. This highlights the importance of accurate revenue growth rate projections.
An important factor when making financial projections is the economic cycle. Many businesses are strongly dependent on growth in the wider economy. It may be unrealistic to project prolonged growth in revenue if the economy is close to the top of the current cycle.
Once you've completed your financial projections it's critically important that you review and sense check these projections, to make sure that what you've calculated seems reasonably achievable by the company in the near-to-medium term. In particular, growth rate assumptions have a habit of generating very steep revenue targets for a company. When reviewing financial projections I like to visualize the numbers on charts. To intuitively get a feel for what I'm predicting is reasonable. Let's start with our main assumption which is revenue growth. Revenue growth often causes difficulties with financial projections, due to the magic of compounding growth rates. In the following screen I have a company that generates 50 million in revenue in 2007. The different lines show revenue numbers over the next 8 years based on different growth rates, 30%, 20% and 10%. As you can see a 30% growth rate results in 400 million in revenue by 2015.
Whereas a 10% annual growth rate results in revenue just over 100 million. Always be careful with compounding growth rates when you're building your financial projections. Now let's take a look at revenue from MarkerCo. In this chart, I've split revenue by consulting in red and hardware in black.
Hardware stays pretty constant over the next 5 years. Consulting on the other hand grows very quickly and is the main engine of growth. Based on this chart, will more than treble between 2015 and 2020.
This is a very aggressive assumption. Unless we're clear that there's a lot of the market left to capture or that the company plans to move into new markets or there's a lot of room to grow within existing customers. If you are unsure about your projection and want to revise it downwards, then it's as easy as returning to your excel sheet and adjusting your revenue growth rates accordingly. Growth rate assumptions I find are always the most important financial projection to check. As we tend to base most of our income and Balance Sheet assumptions from this number. When you do see large growth rate assumptions, such as in this example, it's important to understand what's funding this potential growth, typically found in sales and marketing expenses. When companies want to grow very quickly they need to spend more money to acquire new customers and may not be accounting for this in their projections. In this chart, I show a consulting revenue for 2012 to 2020 based on the primary axis. And I show sales and marketing expense, as a black line based on the secondary axis. Thankfully, it appears that my projection shows an increased sales and marketing spend at a reasonable rate in recognition of the ambitious growth targets for the consulting business. However, this may not be enough and we may need to adjust the sales and marketing expense upwards even further. To do this we can simply go to our model and make the necessary changes to the assumptions. Most of the assumptions in our model that create projections are items based on a percentage of revenue, percentage of costs of goods sold, etc. So typically our operating metrics such as gross margin, profit margin, or days receivable, are not normally in bad shape. Growth rates however, can deceive us. Primarily due to the magic of compounding interest that I showed earlier. In addition to growth, I also like to sense check EBIT, Cash and Cash Equivalents and Total Assets over time. These again act as a sense check to make sure my financial projections are reasonable. Lastly, it's critically important to be aware of economic cycles when building your projections particularly if the industry in question is very dependent on economic growth. For example, the steel industry. When you see a revenue chart like this example going up and to the right, it's tempting to continue that line into the future in your projections. However, if this is the top of the business cycle it's unlikely that growth will continue at this rate in future years. While learning to build financial projections is a very important skill in itself. Your knowledge of the business is prospects and the dynamics within the market are crucial to ensuring that your financial projections are reasonably accurate.