Financial projections are made up from three financial statements, the balance sheet, the income statement, and the cash flow statement.
Here are 16 things to know about creating financial projections which should give you a better understanding of what’s included in the three financial statements, and how they relate to each other.
- Balance sheets show the financial position of a business at a given moment in time (usually at the end of an accounting period), and change every time an accounting transaction takes place.
- A balance sheet must always balance and the layout of the balance sheet reflects the accounting equation Assets = Liabilities + Owners Equity.
- Inventory is created by incurring costs. These costs are shown on the balance sheet as an asset, under the heading of inventory until the goods are sold. When the goods are sold, the costs are transferred as an expense to the income statement under the heading of cost of goods sold.
- Long terms assets in the balance sheet are costs incurred on capital items used in the business such as machinery and equipment. These costs are transferred to the income statement over the lifetime of the asset as an expense called depreciation.
- Liabilities and owners equity are used to provide finance to fund the acquisition of assets.
- Retained earnings belong to the owners of the business and together with capital injected by the owners (usually as cash), forms the equity of the business.
- The income statement shows how income for the period was earned.
- The basic form of the income statement is Revenue – Expenditure = Net Income.
- To make the income statement more informative, expenditure is separated into cost of goods sold, operating expenses, depreciation, finance costs, and tax expense, and a subtotal is drawn after each type of expenditure.
- Revenue – Cost of goods sold = Gross margin
- Gross margin – Operating expenses – Depreciation = Operating income
- Operating income – Finance costs = Income before tax
- Income before tax – Tax expense = Net income
- Net income is the profit of the business which belongs to the owners, and is either distributed to them (usually by way of dividend) or is retained in the business as retained earnings.
- The income statement explains the movement in the retained earnings account between the opening and closing balance sheets.
Cash Flow Statement
- Net income from the income statement is the starting point for the cash flow statement as it forms part of the cash flows from operating activities.
- As the financial projections are prepared on the accruals basis, net income itself is not the same as cash and needs to be adjusted for changes in inventory, accounts receivable, and accounts payable. In addition, certain items included in net income, such as depreciation, have no cash effect and need to be adjusted for. You can see these adjustments taking place in the top part of the cash flow statement in our financial projections template.
- While cash flow from operating activities is internally generated by the business from its trade, the cash flow statement also includes externally generated cash flow under the heading cash flow from financing activities, which shows cash flow from outside sources such as loans from banks, and capital injected by the owners.
- Cash is also spent on the purchase of long term assets such as equipment and machinery, which is included under the heading of cash flows from investing activities.
- The cash flow statement explains the movement in the cash balances between the opening and closing balance sheets.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.