Introduction
Financial forecasting is easy! I’m just kidding; it isn’t easy. However, while you do it – depending on your market – you may feel either giddy about the possibilities or disappointed if it isn’t displaying a potential return on investment. Either way, you asked a loaded question, and there may not be enough space on Quora’s hard drive for the answer; However, I will try.
Indicate Target Market
Before you begin financial forecasting, the first thing you need is a solid indication of your target market. For instance, my company’s target market is businesses in Florida with revenues between $5 Million and $20 Million and require software to operate. Without software, businesses would not be able to function. This part would be your demographic.
If you’re targeting Business-to-Customer (B2C) like Snapchat, Twitter, etc., you must narrow your demographic based on annual income, behaviors, personality, sex, race, religion, etc. If you’re targeting Business-to-Business (B2B) like Amazon Web Services, FreshBooks, etc., your demographic should be narrowed down based on annual revenue, industry, number of employees, etc. Again, this must be done first before moving forward.
Investors must know that you have seriously considered your market and revenue potential.
Narrow Market Size
Now, let’s say you narrowed it down to a market size. For example, your app is for females between the ages of 18 – 25 that have internet access and are working professionals in the upper-class San Francisco area. Yes, you want to get that granular, if not more. You’ve come up with a figure of market size of 200,000. This is where you start to get busy with financial forecasting. You plan on attacking the entire market over a span of a year because you don’t have the money at the moment, but you’re building this plan to show the investors why you need their money.
For the next 12 months, you will market to 16,667 (200,000/12) potential customers a month. If you use various forms of advertising and marketing, you would need to create a “sales funnel” assumption as to how many customers reach the purchasing point of your “sales funnel.”
To explain the sales funnel… Your market to 10 potential customers (leads), 8 of 10 show interest by going to your website (prospects), 5 of the eight request information (qualified prospects), 3 of the 5 need your product (committed), and 1 of the 3 purchase your app (transacted). To read more about this process, check out this MaRS post on sales funnel, Stages of the sales funnel | Entrepreneur’s Toolkit | MaRS.
Acquiring Customers
Now, there will be a “cost of customer acquisition” for each of the methods you use to market. This is what it costs to acquire one customer. You need this number to determine your actual cost to get a customer to buy. In traditional businesses, you build a widget, and for every device, there is a cost to build. However, in apps, the development is part of your fixed costs or costs from operations rather than on a per-sale basis. Your actual cost is in acquiring the users.
So let’s say that out of the 16,667 customers, you perform your funnel, and statistically, you can acquire only 1% or 166.67. If your monthly fee for the app is $20, that’s a monthly estimated revenue (at least in your first month) of $3,333 per month. Usually, the acquisition percentage increases incrementally as your company becomes more well-known.
Next, you add up all of your “Costs of Customer Acquisition” amounts for your advertising methods. According to your calculations, acquiring one customer costs you $10. Multiply that with the 166.67 customers, and you get an estimated $1667 indirect cost (cost to acquire a customer directly or Cost of Goods Sold). Subtract the cost from the revenue, and you’ll get an estimated Net Revenue of $1666 for your first month.
Determine Net Income
The next step in financial forecasting is to determine all of your fixed costs for the month. These costs can include salaries, rent, utilities, etc. Add all these to determine your fixed expenses that will be deducted from the Net Revenue. For example, you have rent at $1000 per month, utilities at $200 per month, salaries at $3000, and other expenses at $200 per month. Add those up to approximately $4400 per month. Subtract that from your Net Revenue, and you get -$2734 in Net Income (Earnings Before Interest, Taxes, and Amortization).
You don’t need to worry about the terminology right now. Interest and Amortization will not be something you’ll have to deal with at first as a startup. However, you’ll only have to deal with taxes if your Net Income is positive, but on your first month, you should be in the negative.
A key thing to realize and accept is that being in the negative in your first month is a reality. Investors question financial projections that show positive income in the first month. If that were the case, you wouldn’t be looking for funding.
Okay, so that was a look at one month. This is roughly what you should be looking at for the first month:
| Revenue | $3333 |
| Cost of Goods Sold | $1667 |
| Net Revenue | $1666 |
| Expenses | |
| Rent | $1000 |
| Utilities | $200 |
| Salaries | $3000 |
| Other | $200 |
| Total Expenses | $4400 |
| Net Income | -($2734) |
You can download these template worksheets to guide you, Financial Projections Template.
Calculate Growth
What I just showed you above is considered your income statement. However, how would you calculate your growth? The reality is it is all relative. You can research another company that has built an app using a similar model. Research their growth trajectory and use that percentage as your month-to-month growth.
Another method is to find out the annual growth in your industry and use that percentage as a track for your growth. Just be careful you convert the yearly growth percentage to months so your growth numbers can be closer to accurate. Even if it is conservative, investors like to know you’re not throwing pie-in-the-sky numbers.
Lastly, you must create a cash flow statement and a balance sheet. However, those projections are more complex and use many other assumptions like how much you’ve invested, how much equity you have, etc. Using the Financial Projections Template above; you can surmise the balance sheet and cash flow statement. Remember, you will also need to spread the monthly growth over those.
Conclusion
In conclusion, when you complete all of your projections, you’ll notice that at some point, your income statement will reach the “break-even” point where your Net Income is zero. This is your profit threshold, and if you’ve done your cash flow correctly, you should have a negative cash flow then (month). It’s practical that when you’re asking for investment dollars, you should at least ask for enough money to wash out the negative cash flow. This allows you to make it to profitability without running out of money.
Rey’s original response can be found here on Quroa.