If you are trying to start a new business, one of the first things that is required to get the ball rolling is a request for funds from the bank (unless your own money). So, in most cases a financial projection needs to be submitted to the bank. This is a major source of my clients: Startups that need financing from a bank. Investors usually want to see financial projections as well.
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We know that a projection is no guarantee of profit as there is no way to predict all the chaos that can happen, but it still has a good place to return to when things start to get out of wack and you need to return to the base financial plan. It can also be really good at gauging the potential outcomes, especially if there are market capacity constraints (like maximum seats available, maximum memberships available (private golf course for example) or a fitness center. This means someone can come in and see if everything goes exactly perfect, what are the best possible financial outcomes and then scale back from there based on expectations of reality and timing.
Banks require financial projections from startups seeking funding for several key reasons, which are largely centered around assessing risk, understanding the business model, and evaluating the potential for repayment. Here are the primary reasons why financial projections are important:
1. Risk Assessment
- Measure of Viability: Financial projections help banks assess the viability of a startup. By examining projected revenues, expenses, and cash flow, banks can determine whether the business is likely to be sustainable and profitable over time.
- Credit Risk Evaluation: Banks use financial projections to evaluate the credit risk associated with lending to a startup. This involves analyzing the startup's potential to generate enough cash flow to cover loan repayments.
2. Understanding the Business Model
- Insight into Operations: Financial projections provide insight into how a startup plans to operate, generate revenue, and manage costs. This helps the bank understand the business model and the factors that will drive its success or failure.
- Market and Competitive Analysis: Part of the financial projection involves analyzing the market size, target customers, and competition. This information helps banks gauge the startup's potential to capture market share and sustain growth.
3. Repayment Capacity
- Debt Service Coverage Ratio (DSCR): Banks calculate ratios like the DSCR from financial projections to assess a startup's ability to repay debt. A higher ratio indicates that the startup can comfortably make loan payments from its operating income.
- Cash Flow Analysis: Banks look at projected cash flow to ensure that the startup will generate enough cash to cover its operating expenses, including loan repayments, without running out of money.
4. Strategic Planning and Commitment
- Evidence of Planning: A well-prepared financial projection shows that the entrepreneurs have thought carefully about their business strategy, growth plans, and potential challenges. It indicates a level of commitment and preparedness to run a successful business.
- Milestone Setting: Financial projections help set milestones and goals that banks can use to monitor the startup's progress post-funding. Achieving these milestones can also be a condition for future funding rounds or credit line increases.
5. Compliance and Regulatory Requirements
- Due Diligence: Banks have a regulatory responsibility to conduct due diligence before extending credit. Financial projections form a part of this process, ensuring that the bank is lending responsibly and in compliance with banking regulations.
Conclusion
For banks, financial projections are a critical tool in the decision-making process for startup funding. They offer a quantitative way to evaluate the potential success and financial health of a startup, ensuring that the bank's capital is allocated to ventures with a sound business model and a solid plan for growth and profitability. This careful evaluation protects both the bank's interests and those of the startup by ensuring that only viable businesses receive funding that they can realistically repay.
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Article found in Startups.
