Financial projections are important for entrepreneurs – helping you ascertain if the opportunity is likely to be profitable, commit appropriate resources, and gain external finances. Estimating uncertain events however is not easy – there are a lot of assumptions embedded within projections. This article explores some common mistakes when making financial projections.
Mistake 1: Extrapolating from very small numbers
Small success is great – and you should definitely celebrate it. But, it is easy to extrapolate from very small initial success and see very big numbers.
In the early stage of a business you may see quick sales growth: Maybe one month your sales are 20% higher than the previous, and maybe you even see this happening for a couple of months in a row. Quickly you do the math, and realize that if your 20% month-on-month growth continues, you will be about 9 times your current sizes a year from now (i.e., 1.2^12), and an incredible 56,000 times your current sizes in about 5 years (i.e., 1.2^60)!
These hockey-puck, exponential growth projections are not uncommon, but almost never materialize. The key danger is that you are projecting from a very small starting point, and while it is not uncommon to see relatively high growth rates early on, it is a lot less common to see high growth rates continue month after month.
Mistake 2: No basis for your assumptions
Another real danger of market sizing is the sometimes huge assumptions that are built-in. Some of the most inaccurate market sizings start by assuming that 1% or 5% or 10% of a particular group of people will buy or use your product – with little basis for the assumption.
Mistake 3: Projecting what you need or want to happen
Another mistake with projections is to back work the numbers to give the answers that you need or want to happen. While on the face this seems a silly approach to financial planning, it is an easy trap to fall into. You may yourself know what you need to achieve – and from this, convince yourself that the various different assumptions that you have made to achieve these forecasts are plausible.
Mistake 4: Taking your projections as fact
Another danger with financial projections is that you begin to take the projections as fact. The documents that initially made clear that these figures incorporated a lot of assumptions, get forgotten, and suddenly the forecasted market size is considered to be a fact.
While there is often a need to act based on projected numbers (for example setting up appropriately sized operations based on the forecasts), it is also important to be aware of the limitations of the projections and to periodically update the forecasts as new information is obtained.
One of the worst situations to be in is to use your projections as a basis to ignore any information that is not in keeping with what you forecasted. Don’t lose sight of the speculative nature of early forecasts – look to verify and challenge your assumptions, rather than dismissing information that is not in line with your assumptions.
Mistake 5: Using others projections to justify yours
A final danger with projections is to fall into the trap of using others’ uncertain estimates to justify your own. While projections of others can have value – helping to triangulate what you are thinking, a key danger is that one very uncertain estimate is used to validate another very uncertain estimate.
Particularly in new markets where there is a lot of uncertainty regarding the future state of the world, it is important to recognize that everyone’s estimates are likely to be full of uncertainty. Groupthink can set in, with over-confidence placed in multiple very uncertain estimates.
Final thoughts: Be able to justify the assumptions
While accuracy is clearly important when considering financial projections, it is also important to be able to justify those assumptions. When pitching your projections to possible investors, as much as anything it is important that you can confidently explain why you believe in the numbers you expect.