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1. Why Build Financial Projections?
Why and how do companies build financial projections? Find out about this critical analysis tool in this introductory lesson.
Why Build Financial Projections?
- Financial projections help stakeholders answer critical questions about a business
--- When will the business run out of cash?
--- When are loans due for repayment?
--- What is the value of the company?
--- Is the company in danger of losing its credit rating?
--- Does the company need to cut costs in a downturn?
The 5 Stages in Building Financial Projections
- Examine historic financial statements
- Conduct thorough financial analysis
- Develop set of future projections
- Create pro-forma financial statements
- Link financial statements together
In our previous course on financial statement analysis, we used historic information to analyze the performance of MarkerCo, a fictional company that sells both hardware and consulting services to its customers. In this course, we're going to move our analysis system further and build projections for the company over the next five years. Before we get started, let's answer a critical question. Why do we build financial projections? Well, it turns out that financial projections help management, shareholders, lenders, and potential investors answer some critically important questions about the business. For example, if the company is a startup and growing rapidly, it will need to know when it will run out of cash so that it can approach investors for a new round of funding. If a company is more mature and has quite a lot of debt on the Balance Sheet, investors may also want to know when these loans are coming due for a payment in the future and how these prepayments will affect future cash flows. When valuing a business, we often conduct a discount cash flow valuation based on the future cash flows of a business, and of course, these future cash flows rely on financial projections. Debt providers might also want to check if a company is in danger of losing its credit rating over the coming years, particularly if that company is looking to refinance existing debt, and lastly, financial projections are very important for management, particularly with regard to scenario analysis. If, for example, the market experiences a downturn in the coming years, the management will need to know if layoffs or reduced investment are required. Financial projections help management answer these questions. So how do we build financial projections? I follow a very simple five-stage process. We start by analyzing historic financial statements to see some trends in the data regarding the company's performance. I combine this with some thorough business analysis, looking at the market, the company's suppliers, customers, competitors, etc. Based on this analysis, I then develop a set of future assumptions about the business, for example, profit margin, capital expenditure, revenue growth, and so on. Based on these future assumptions, I develop pro-forma financial statements, which are financial statements based on future years, beginning with the Income Statement for, say, 2016 all the way through to 2020. Once I've built these pro-forma financial statements, I link the financial statements together so that they all move in unison, and the calculations should be changed and assumption remain correct. This last piece is always the most difficult and proves that you really know what you're doing when building a financial model. Companies place a huge value on the ability to build financial projections because the task is so integral to the running of the business. This course is the perfect introduction to building financial projections, as MarkerCo's business model is quite easy to understand, as certain complexities around tax and pensions have been removed. Let's get started building financial projections in our next lesson by identifying all of the assumptions we intend to make for the Income Statement.