What are the critical mistakes in startup financial projections? Here is my list of five critical mistakes. It comes from reviewing more than a hundred possible startups with either detailed projections or pitches and, of course, business plans.
Good news at the bottom: these are much easier to fix than some more common startup problems not related to financial projections.
Income (also called Profit & Loss), Balance, and Cash Flow are interactive. If the model doesn’t reflect change in one of the three with related change in the other two, then it’s incorrect. For example, a change in sales should affect not just profits but also balance and cash. A change in inventory might or not affect cash — depending on whether it’s been paid or remains in Accounts Payable — but won’t affect profits unless there are related expenses for storage etc. Interest on debt is an expense that affects Income and Cash Flow, but not directly on the Balance. Repaying principal on debt affects Balance and Cash Flow but not profits. And so forth.
The image above reflects standard accounting and bookkeeping, also called GAAP (generally accepted accounting principals). In the western world, financial models don’t get the luxury of ignoring GAAP. If they don’t adhere to standards, they aren’t useful, and aren’t even correct.
This is the force behind point one, the need to link the three statements. The best test of a good financial model is this essential equation: assets less liabilities equals capital. If it doesn’t, then the model is off. Also, the various related equations: capital plus liabilities equals assets. Liabilities equal assets less capital. These must always be true.
So even simple changes flow through the system and in a good system, those changes reflect properly to the essential equations are always true. If I keep my three projections separate, or have only one or two of the three, then I lose the value of the ultimate error check.
It’s quite natural and so many of us do it: we think of financial projections as profit or loss. But that simplicity is fatally flawed. For example, when a business delivers goods or services along with an invoice to be paid later, that value goes straight into sales and therefore profit and loss; but it is not cash in the bank until it is paid. Profitable companies can go under because they have too much money sitting in Accounts Receivable waiting to be paid — and that doesn’t show up in Profit & Loss. Debt repayment doesn’t show up there either. Not do Accounts Payable or Inventory. Lots of things that cost a business money, and therefore affect cash flow, are not included in the Profit & Loss (also called Income).
Very common problem with projected financials. Many vastly underestimate marketing expenses, admin expenses, etc. A founder should have a reasonable idea of general spending patterns in the industry they are in. I’ve often seen plans projecting 2–5% marketing expenses to sales in web and software industries that spend 30–40% of sales on marketing. I’ve seen plans that show less than $1 million in admin expenses including salaries in a business making 20 million and up in revenues. That doesn’t happen.
The quick key is profits. Real businesses make 5–10% profits on sales, once in a blue moon significantly more than that. Growing business generally make low profits or none at all, because growth and profits don’t normally coexist well. You pick one or the other, not both.
Projections showing high profits are almost always vastly underestimating expenses. The projections show not what a good business it will be, but rather that the founders don’t know the business well.
The first problem with overestimating cash is why in the world would you need investment if your business is going to generate these huge levels of cash. If you generate cash, you don’t need investors. And furthermore, if you generate cash, investors don’t want you, because you’ll never need to exit. Bottom line: no, you are not going to generate cash during your early growth stages. Growing startups absorb cash. They generate growth with deficit spending and they need new cash (investment) to finance the deficit.
The other, possibly more important problem, is that these rich cash projections always miss the impact of financing inventory and Accounts Receivable. They don’t understand the sales cycles, and don’t understand the difference between making the sale and getting the money.
The errors compound each other. Failing to include realistic expenses leads to unrealistic profits which then, in the projections, create unrealistic cash.
… is that for a startup, these problems are way easier to fix than problems with the team, the product, the market, the scalability, the barriers to entry, and the path to exit.