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Every business owner knows that a business plan or investor pitch would be incomplete without a comprehensive financial projection. This tool is used to convey a startup's projected financial performance, usually in terms of annual, quarterly, or monthly financial statements. It provides a clear picture of the startup's financial health and growth potential, demonstrating the startup's understanding of its market, its business model's viability, and its strategies for achieving its financial goals.
Financial Forecasting: A Weather Analogy
When you examine a weather forecast, you acknowledge that it is not an absolute guarantee of future weather conditions. This is due to the myriad of variables that influence the weather, making it impossible to predict with complete accuracy. The forecasted high and low temperatures may deviate slightly, and while you can anticipate the likelihood of precipitation, you understand that there will be variations.
Just as the reliability of a weather forecast decreases the further it extends into the future, the same principle applies to financial projections. A weather forecast for tomorrow is likely to be more accurate than a forecast for ten days from now due to the increasing uncertainty and variability over time. Similarly, a financial forecast for the next quarter is generally more reliable than a forecast for several years ahead.
In financial forecasting, as in weather forecasting, the further out the forecast extends, the more it becomes a general guide rather than a precise prediction. It's based on current and short-term observations, compared against similar financial patterns from the past to predict future outcomes.
However, you wouldn't plan your outfit for a day ten days ahead based on today's weather forecast and stick to it rigidly. Instead, you would monitor the weather forecast as the day approaches and adjust your outfit accordingly based on the updated conditions. Similarly, in financial forecasting, as the forecast period approaches, adjustments may be necessary to align with the actual financial conditions.
Despite the inherent uncertainty in forecasting, both in meteorology and finance, it remains an indispensable practice. For startups, crafting a realistic yet ambitious revenue projection is not merely an exercise in number crunching. Rather, it is a demonstration of the startup's ability to understand its market position, set demanding yet achievable goals, and plan strategically for the future.
A well-reasoned financial forecast reflects the startup's ability to balance optimism with realism. It shows that the startup can set high targets while remaining grounded in the realities of its market environment. This balance is crucial in maintaining credibility with potential investors and financial institutions.
Just as we wouldn't disregard a weather forecast due to its inherent uncertainty, we shouldn't dismiss the importance of financial forecasting in guiding a startup's financial strategy and decisions. Despite the uncertainties, these forecasts provide valuable insights that can help startups navigate their financial journey, manage risks, and seize opportunities.
The Art of Financial Modeling
Top-down financial modeling starts with the big picture, such as the total market size or the overall economy, and then breaks it down into smaller, more specific components. This approach often involves estimating the total market size for a product or service and then determining what share of that market the startup can capture.
On the other hand, bottom-up financial modeling begins with the smallest units, such as individual sales or customers, and aggregates them to form a larger picture. This approach often involves estimating sales volume based on factors like pricing, sales channels, and marketing efforts.
While both approaches aim to provide accurate financial forecasts, they differ in their methodologies and focus areas. Top-down modeling is more focused on market conditions and external factors, making it more suitable for startups operating in well-defined and established markets. Bottom-up modeling is more focused on the startup's internal operations and capacity, It allowing startups to understand their sales potential based on their operational capabilities and strategies.
How to Create A Top-Down Revenue Forecast
At first glance, top-down financial modeling appears to be a simple and clean approach. For example, a startup might begin by estimating the total market size for its product or service, then determine what percentage of that market it can reasonably expect to capture based on factors like competition, pricing, and marketing strategies.
Understanding TAM / SAM / SOM
Creating an accurate top-down model hinges on having precise data for the total market size. There are a number of market research tools a financial modeler can use to figure out the total market, but here at Masterplans, we almost always start with IBISWorld.
But before we go any further, we need to explain the concepts of TAM, SAM, and SOM, which are the foundation of top-down financial forecasting.
- TAM (Total Addressable Market): This is the total market demand for a product or service, or the total revenue opportunity that is available to a product or service if 100% market share was achieved. It provides a broad overview of the potential for a product or service.
- SAM (Serviceable Addressable Market): This is the segment of the TAM that is within your product's geographical reach and can be realistically served by your company. It is a more refined and realistic view of the market potential than TAM.
- SOM (Serviceable Obtainable Market): This is the portion of the SAM that can be realistically captured and served by a company's product or service in the near term.
Now, let's apply these concepts to a practical scenario:
Consider the scenario where you're launching a local artisan cereal company. According to IBISWorld, the total cereal market in the United States (TAM) is valued at $12 billion annually. As a market entrant, your initial objective may not be to compete with industry giants on a national level. Instead, your focus might be on a localized and potentially niche market within the total U.S. market, such as organic artisan granola.
One method to estimate the local market size is to use population data. For instance, if you were to launch in Portland, Oregon, with a population of 2.5 million, you could deduce that its cereal market represents about 0.75% of the national market, equating to approximately $90 million. This would be your SAM.
However, even with a rough estimate of the local market, determining the potential market share for artisanal granola can be challenging. IBISWorld reports that oat cereals make up around 20% of the overall market. Therefore, it would be prudent to limit the Total Addressable Market (TAM) for oat-cereal consumers in Portland to approximately $18 million annually.
However, it's important to recognize that you may not be able to compete for the entire market share. This realization brings us back to our initial point: the cereal industry is dominated by major players. According to our reliable IBISWorld report, 80% of the market is controlled by Kellogg, General Mills, Post, and PepsiCo. This information provides us with a Serviceable Addressable Market (SAM) of $3.6 million.
The challenge then becomes determining a reasonable Serviceable Obtainable Market (SOM). What percentage of the SAM can your startup realistically capture? Could it be 5%? Or perhaps 2%? These are the questions that startups must grapple with when forecasting sales.
The primary reasons many financial modelers favor top-down models is due to the realistic boundaries they establish. Essentially, top-down forecasting sets an upper limit on potential sales. For instance, if your cereal forecast projected sales exceeding the total market share, it would immediately signal an unrealistic expectation. This approach not only demonstrates that you've conducted thorough market research, but it also transparently showcases the logic behind your calculations, thereby enhancing the credibility of your forecast.
How to Create A Bottom-Up Revenue Forecast
Bottom-up forecasting is a method that starts at the smallest unit and scales up to a sales forecast. This granular approach focuses on the operational capabilities and internal factors of a business, making it particularly useful for startups and small businesses.
Let's illustrate this with our cereal company example. We know that our artisanal kitchen can produce 200 units per day and operates 5 days a week. This production capacity, combined with the selling price per unit of $10, allows us to calculate potential weekly revenue of $10,000. By extrapolating this, we can estimate monthly and annual revenues.
However, revenue is just one part of the financial picture. To get a more accurate forecast of the financial health of the business, we also need to consider the Selling, General & Administrative expenses (SG&A). These are the costs associated with selling the product and managing the business, including marketing, salaries, utilities, rent, and more.
Subtracting the SG&A from the total revenue gives us a more accurate picture of the potential profitability of the business. This is a crucial step in the bottom-up forecasting process, as it allows us to account for the costs of doing business, not just the revenue.
While your production capacity might allow you to produce 500 units of granola per week, it doesn't guarantee that you will sell all 500 units. Overproduction can lead to waste if the granola goes unsold and eventually spoils. And inventory loss is worst-case scenario for a small business like this.
Once you've calculated your total costs and expenses, you can determine your break-even point — the number of units you need to sell to cover your costs. However, breaking even shouldn't be your end goal. Setting a sales target that allows you to cover your costs and generate a certain percentage of profit gives you a new, higher target to aim for in your sales.
A Hybrid Approach: Combining Bottom-Up and Top-Down Forecasting
In the quest for the most accurate and credible financial forecast, incorporating elements of both top-down and bottom-up forecasting often yields the best results. This hybrid approach takes into consideration not only the macro-market size and share but also the micro-level business capabilities.
Let's consider the hypothetical scenario of a cereal company. After conducting a thorough market analysis, we've identified that the serviceable obtainable market for our product stands at about $3.6 million. This represents the top-down component of our forecast, indicating the total revenue potential within our target market.
Simultaneously, by analyzing our business operations, we understand that our maximum production capacity limits us to generating $520,000 in revenue. This figure represents the bottom-up component, derived from tangible operational data.
By showcasing both these metrics — the potential market share from a top-down perspective and the realistic production capacity from a bottom-up standpoint - we create a more comprehensive and credible forecast. This dual approach provides stakeholders with a clear understanding of the company's potential revenue growth while setting realistic expectations based on operational constraints.
The hybrid approach demonstrates a holistic view of the business's prospects. It ensures that while the eyes are set on the market's potential, the feet are firmly grounded in operational realities. This method creates an informed balance between ambition and feasibility, increasing the odds of securing stakeholder buy-in and paving the path towards sustainable revenue growth.
Beyond Revenue Forecasting
While a precise revenue forecast is crucial, it's only the starting point of a comprehensive financial model for startups, like our hypothetical cereal company. From here, it's essential to extrapolate other financial statements to gain a complete picture of the company's financial health:
- Cash Flow Statement: Cash flow projections help identify these cash inflows and outflows, enabling the company to manage liquidity and maintain smooth operations. In our cereal business, we may need to purchase raw materials in bulk to produce the cereal, which would require an outlay of cash. However, payment from vendors might not arrive until weeks after production. This time lag is accounted for in a your cash flow statement so your can avoid a cash crunch.
- Balance Sheet: A balance sheet provides a snapshot of the company's financial health at a given moment. Let's imagine the cereal company has a warehouse full of granola-making equipment (assets), a bank loan for a packaging machine (liabilities), and funding from an angel investor (equity). This information is relayed on the balance sheet.
- Income Statement: For our cereal company, the income statement would start with the revenue from cereal sales and deduct the cost of raw materials to show the gross margin. Rent, marketing, labor, and any other operating expense would be subtracted to arrive at the net income. This comprehensive view of profitability is vital for understanding the overall financial performance.
Together, these elements extend beyond revenue forecasting to paint a full picture of the cereal company's financial trajectory. This complete financial model helps the company strategize effectively, anticipate future needs, and present a solid case to potential investor or lender.
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