The value of most businesses is the sum of the present value of the cash flows expected to be generated in the future. Amazingly, many entrepreneurs and new business owners are unable to provide a set of financial projections or budgets and the underlying assumptions. Many believe that growth of the business will just happen and that they will react to that growth by paying the bills, making purchases, etc. The most successful small business owners prepare, in advance, a forecasted income statement (or budget) and balance sheet that detail: expected revenue growth over the next three to five years, cost of goods sold, fixed costs or overhead, profitability, and how this translates into cash flow, the need for additional asset purchases, etc. The financial projections may show, for example, that the business will not reach break-even in the first year and that the business will incur financial losses that will use cash on hand or require additional cash infusions to continue operations and pay the bills. The financial projections may also reveal that the company is unable to service any debt or generate sufficient cash flow to enable the owner to take a salary. All of these are significant problems that a relatively simple set of financial projections should reveal to the new business owner.
On the flip side, many startup business owners do create a set of financial projections, but they are based on underlying assumptions that are unrealistic. For example, some startups may be expected to experience rapid growth in the first few years; however, there is a limit to that growth and the ability of the business to sustain that growth. With growth of a startup come certain expenses that should be anticipated, such as the need for additional staffing, supplies, purchases of raw materials, etc. Failure to plan and anticipate this can lead to cash flow problems. Cash is king for any business. Lack of cash or lack of access to funds to support operations can quickly lead to bankruptcy and closure of the business.
From a valuation perspective, the lack of financial projections, or providing unrealistic financial projections without supporting assumptions, suggests to the business appraiser that the entrepreneur is “wet behind the ears” or fails to understand the implications and necessity of financial planning. Typically, this has a negative effect on the likelihood of success and therefore, on the current and projected value of the business.