Financial Projections: The Bottom-Up Approach [VIDEO]
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Financial projections cause headaches to many entrepreneurs. The main purposes of this article are clarifying the major doubts around this topic and giving guidelines on the methods, the mindset to adopt when computing projections and the tools and tips that may be useful in the process.
The two main methods to calculate financial projections
There are two main, widely adopted approaches to estimate financial projections:
- bottom-up: it is also referred to as “inside-out” because it starts by estimating internally available resources to then project them into the future.
- top-down: or “outside-in”, because it starts from external data on the market size and then estimates market share and revenues target you can achieve to then workout subsequent implications for your organisation.
Which method is most suitable?
The key differences between the two approaches lay in their assumptions. The choice depends then on the purpose of the projections.
The main assumption of the bottom-up approach is that you will be able to sell everything you are able to produce. This does not imply that companies do not raise capital or use external financing. However, they mainly use internally generated cash-flows to grow their business. The purpose of the projections may be, for instance, to assist internal management or exit planning.
With the top-down approach, the main assumption is that the resources to get to a certain growth path, revenues or market share target are available and easy to acquire. In other terms, it implies that you are going to be able to raise capital to reach those milestones. This is the reason why this method is most suitable for startups in the process of raising capital, thus estimating resources to achieve certain goals and growth.
The bottom-up approach to financial forecasting
This method is generally adopted when the company is growing organically and revenues are capped – there is a maximum potential to the revenues. The longer the company has been around, the easier it would be to estimate costs of new growth and related revenues, increasing the forecast’s precision.
A practical example
Let’s take for example an ice-cream factory. Your production plant allows you to produce 1 million ice-creams per quarter, and you are able to sell them for 1 euro each. The main assumption in this case is that you will be able to produce that volume and that you will be able to sell all of it.
You can then produce a certain number of products and serve a certain number of clients. If you want to raise your turnover to 2 million, you will probably need to invest in the production plant, either by external financing resources or by waiting a certain amount of time to generate the necessary cash.
Still, every time you increase the maximum volume you can produce, there is a cap on the potential revenues. This doesn’t mean that this type of business is not scalable or that you cannot reach a very high turnover, but the growth path is not like the traditional hockey-stick. It is more predictable and it looks like ladder, where every step is represented by the maximum capability your organisation can reach without additional investments.
Make your projections using this Free Financial Projections Template, an already made Excel spreadsheet with clear and simple guidelines to follow in estimating your future numbers.
What is your experience with financial projections and which questions would you like and answer to? Let us know in the comments!