Financial Projections

Financial Projections– trends, trends, trends

Value depends on the future, and to justify a given valuation of any asset a manager will need to show in financial terms how much this asset is expected to generate.

Basically we need to figure out how much money the company (asset) will generate in the future; this in simple terms is projections: I am trying to understand today to guesstimate tomorrow.

Understanding today: the trends

 History repeats itself, and anyone in finance would tell you that today is the best estimate for tomorrow. After all, if nothing changes why should tomorrow be different from today? Humans, including managers, are animals of habit, and we can think of projections as carrying today’s habits, patterns, and trends, to tomorrow.

Projecting a Profit and Loss statement is simple and would generate a good picture of where the company is going.

To understand the trends we start by building a common size income statement, this is done by dividing every line item on the income statement by sales. This will help us analyze some of the financial characteristics of the company, characteristics that for example, have existed for the last five years and if management does not plan major changes, one would expect seeing them in the coming five years.

Let us build an example as that I believe will make things clearer:

Josef lives in a village in the suburbs; he has a brother working at the municipality in the urban planning department. One Saturday evening over a game of cards his brother was describing how his manager informed him that the plan to revitalize their village, build high ways next to it, and a major industrial center will be complete in less than a year!

To Josef this was an opportunity to finally embark on his dream project of opening a laundry matt in his village, he is sure that the new industrial center will attract people and given the fact that his village is the only residential spot within several kilometers, a large number of the employees will opt to live in the village, he was going to be the man who irons their shirts!

Josef used to run a successful laundry matt in his wife’s village a couple of years back, which he decided to sell for a large profit. His wife’s village is very similar to his village and he plans to use what knowledge he has to build a profit and loss statement for his new shop, these are the assumptions:

• Historical figures available for the period 2000 to 2005.
• A five-year projection from 2006 to 2010.
• Josef remembers that his gross profit margin on average was 80%, so for every AED 100 he sold he was able to retain approximately AED 80. The AED 20 mainly went to buy cleaning detergents.
• The major costs on average as a percentage of his annual sales were:
  • Staff cost him 6%
  • Electricity, water and other bills cost him 21%
  • Rent cost him 8%
  • Washing machines maintenance 5

 

• Let us assume that Josef was smart, unlike his brother which spent all of his money on a highly depreciable sports car, and has saved enough money to open the store without taking a loan. So no finance costs.

                                       

• After all of the costs have been covered, Josef used to retain on average 40% of his annual sales from the old laundry matt as Net income, and he expects the same to apply here.

 

Now if you look closely what did Josef do? He started with sales and then calculated how much of the sales he needs to cover his costs, and finally how much remains as net income. These are the trends: Let us assume that for the last five years Josef’s old laundry had the following figures:

 

Laundry	Historical
Income Statement	2000	2001	2002	2003	2004
Revenue	8,000	8,800	10,560	11,616	12,778
Cost of Sales	1,600	1,760	2,112	2,323	2,556
Gross Profit	6,400	7,040	8,448	9,293	10,222
Operating Expenses
Staff Salaries	400	440	634	929	639
Rent	800	880	739	581	1,278
Electricity and Water	1,600	1,760	3,168	1,742	2,556
Maintenance	400	440	634	348	639
Total Operating Costs	3,200	3,520	5,174	3,601	5,111
Financing Costs	0	0	0	0	0
Net income	3,200	3,520	3,274	5,692	5,111

Step 1: Create a common size by dividing all the Income statement figures by the revenues.

Step 2: Average the percentages over the historical period. This will perform two functions, first it will reduce the effect of any onetime deviation, for example in 2003 the utility (electricity and water) charges as a percentage of sales were low at 15% but the average is 21%, second it is an effective means to reflect a common pattern.  

Laundry	Historical
Income Statement	2000	2001	2002	2003	2004	Average
Revenue	100%	100%	100%	100%	100%	100%
Cost of Sales	20%	20%	20%	20%	20%	20%
Gross Profit	80%	80%	80%	80%	80%	80%
Operating Expenses
Staff Salaries	5%	5%	6%	8%	5%	6%
Rent	10%	10%	7%	5%	10%	8%
Electricity and Water	20%	20%	30%	15%	20%	21%
Maintenance	5%	5%	6%	3%	5%	5%
Total Operating Costs	40%	40%	49%	31%	40%	40%
Financing Costs	0%	0%	0%	0%	0%	0%
Net income	40%	40%	31%	49%	40%	40%

 Step 3: Calculate the revenues historical growth and average the percentage growth as well.

Laundry	Historical
Income Statement	2000	2001	2002	2003	2004	Average
Revenue	8,000	8,800	10,560	11,616	12,778
Growth		10%	20%	10%	10%	10%

 Step 4: Grow the revenue for the projection period, say next five years, using the average sales growth that we calculated in Step 3, i.e. 10%.

Laundry	Historical
Income Statement	2004	2005	2006	2007	2008	2009
Revenue	12,778	14,056	15,461	17,007	18,708	20,579

Step 5: Now that we have our projected sales figures from Step 4, and we know on average what percentages our costs are of these sales from Step 2, it becomes a matter of multiplying the average margins by the new sales (Step 2 x Step 4). For example we know that the staff salaries represented on average 6% of the sales, between years 2000 and 2004, so we could say that this would apply between 2004 and 2009. Projection should be based on logical assumptions, if we know for a fact that in 2008 management plans to hire a top-notch Laundry Scientist that will likely cost the company top dollars it makes no sense to use 6% of sales as a figure to project staff costs for that year, rather use 10%.

Laundry	Historical		Projected
Income Statement	2004	2005	2006	2007	2008	2009
Revenue	12,778	14,056	15,461	17,008	18,708	20,579
Cost of Sales	2,556	2,811	3,092	3,401	3,742	4,116
Gross Profit	10,222	11,245	12,369	13,606	14,967	16,463
Operating Expenses
Staff Salaries	639	815	897	986	1,085	1,194
Rent	1,278	1,181	1,299	1,429	1,571	1,729
Electricity and Water	2,556	2,952	3,247	3,572	3,929	4,322
Maintenance	639	675	742	816	898	988
Total Operating Costs	5,111	5,622	6,185	6,803	7,483	8,232
Financing Costs	0	0	0	0	0	0
Net income	5,111	5,622	6,185	6,803	7,483	8,232

It is simple really, just remember to use your logic and review the numbers, and don’t depend too much on the formula, sometimes you will have a small typing error and your NI in 2007 that should be 6 Million ends up being 60 Million!

In the end note the following:

• Go through the numbers one by one; to make sure that none is out of trend. If sales are growing 10% every year, it makes no sense for NI to grow 60%.
• Do not project any equation, in the above example these are the gross profit, total operating expenses, and Net income.
• Keep the revenue growth percentage as a separate cell, that way you can study different scenarios by just changing the revenue growth assumption. So if you are the advisor of the Laundry manager and he calls you asking what is the effect on the bottom line if he employs an aggressive sales strategy, growing revenues by 15% year on year, all you have to do is change the value of one cell from 10% to 15%.