Financial forecasting for startups

What is financial forecasting?

Financial forecasting means predicting the performance of a startup business, usually over the first three years. Of course, nobody can exactly predict the future. But just as meteorologists forecast the weather with relative accuracy given certain patterns, financial forecasting can be useful when it's based on solid research and realistic assumptions. Examples of a financial forecast include revenue projections, expense estimates and cash flow statements.

Why bother with financial forecasting? Potential investors may want to see when revenues are predicted to equal expenses—the breakeven point—and the company starts making a profit. They might also want to see how a startup manages cash flow, since the company needs to pay ongoing bills even in its early, unprofitable stages. Meanwhile, lenders use a financial forecast to determine a startup's creditworthiness. The four types of financial forecasts typically include sales forecasts, expense forecasts, breakeven analysis and cash flow projections.

Beyond the needs of outsiders, a financial forecast gives you, the founder, a window into what you can expect as you grow your business. Financial forecasting is distinct from financial planning; while financial planning involves setting long-term goals and strategies, financial forecasting focuses on predicting specific financial outcomes based on current and past data.

Keep in mind that financial forecasting is not accounting, which looks at actual past or current performance. That said, forecasting employs many familiar accounting terms and will generally use the past accounting performance of similar companies to make educated guesses about your startup's future. Financial forecasts are important because they help plan for the future, make informed decisions and attract investors by providing a realistic picture of future financial health.

Experts usually divide financial forecasts into four parts: sales, expenses, breakeven and cash flow. To calculate a sales forecast, you can multiply the number of expected units sold by the price unit, adjusting for factors like market condition and historical data. Here's a closer look at each.

Forecasting sales

In the real world, sales depend on many factors including the viability of your product or service, pricing, marketing strategy and the overall economy. In a financial forecast, you're mostly addressing the theoretical market share—that is, assuming your product or service is innovative, fills a need and is priced competitively, who are the potential customers?

Investors often refer to this as the total addressable market (TAM). For example, let's say you've invented a new, portable way to monitor heart arrhythmia that will make it easier for patients to send real-time data to their doctors and minimize ER visits. How many patients might benefit from this device? How many cardiologists are likely to prescribe it? What current products or solutions are you aiming to replace—and how many of those products are sold every year?

Back up your forecast with data from the existing marketplace, perhaps even doing your own test marketing and surveys. Above all, be realistic: Inc. magazine reports that sales forecasts showing a classic "hockey stick" pattern—a short period of slow, flat sales followed by a long, steep increase—rarely happen in the real world. Forecasting this pattern can leave investors skeptical.

The US Chamber of Commerce recommends forecasting your monthly sales by unit and price point for the first two years, then providing quarterly estimates beyond that.

Plotting expenses

Broadly speaking, there are two types of expenses: fixed and variable. Fixed expenses include administrative salaries, rent, mortgage and other loan payments, insurance, taxes and other bills that don't substantially vary monthly. As such, they are relatively easy to predict.

Variable expenses can be trickier because they rise and fall with sales. Examples include advertising and promotions, sales commissions and the cost of raw materials and production associated with manufacturing your product. If your product is a service, you'll also have variable costs such as customer support and ongoing tech upgrades. These costs vary because the more you sell, the more you may spend—although you may be able to factor in lower marginal increases due to scale as your business grows.

Note that if your three-year forecast predicts strong sales growth, you'll also need to account for an increase in your fixed expenses, since a growing company will probably need more employees and infrastructure.

Estimating the breakeven point

Once you've forecast sales and expenses, simple math helps you determine your breakeven point—when sales equal expenses and you're ready to start making a profit.

You may read that breakeven typically takes a startup from two to three years, but the truth is that there is no "correct" timeframe. According to Tipalti, a procurement management software company, Facebook took five years to reach breakeven; Amazon nine; Tesla 17—which looks like a long time until you consider Toyota, which took 26. An extended breakeven point isn't necessarily a negative: Some companies choose to invest more of their revenue in research and development, one of those variable expenses that can put off profitability, hoping to garner larger future gains. But if your breakeven point is far in the future, investors will likely want to understand the strategy behind that decision.

Importantly, investors care about the breakeven point of the overall business, not your personal breakeven as a founder. In other words, you might be paying yourself a nice salary and, in that sense, "profiting" from your startup. But if the business is still spending more than it's taking in, breakeven is down the road. In fact, one way to get the business to its breakeven point is by paying yourself less—or nothing at all.

Potential investors may likely be laser-focused on cash flow projections, which inform you how much cash you'll need to get the business up and running. If your startup can't pay its bills during the early stages, you'll likely be "out of runway" and need more cash infusions (whether loans or equity).

Forecasting is for you, too

Financial forecasting isn't just about satisfying investors and lenders. Arguably its greatest value is to you, the founder, because it forces you to focus on your startup's trajectory.

To be truly useful to you, a financial forecast should be a living document. Update it regularly, perhaps every six months, as business conditions change; after all, a forecast is only as reliable as the underlying assumptions it's based on in the end.