Every small business grows into a successful enterprise through diligent financial planning, projection, and analysis. But, when it comes to filling applications for business loans, the process becomes somewhat daunting as well as challenging for entrepreneurs. In fact, an RBI report stated that around 70% of the SME loan applications get rejected owing to lack of clear financial projections.
Therefore, financial projections offer a comprehensive view of a company’s financial performance. It helps lenders to assess the risk of lending money to a business. Understanding the need for such documents and manner of preparation can make the loan application process smoother. Read further to know more about financial projections, its purpose, manner of preparation and common mistakes to be avoided while applying for a bank loan.
Meaning and Purpose of Financial Projections
Projected financial statements could be defined as the estimations made in regard to the organizational expansion and growth in future. Projections are created on the basis of well-informed assumptions regarding business operations, operating circumstances, and market dynamics. Some of the primary purposes of projected financial statements are-
- To aid in budgeting and resource allocation, as well as setting financial targets and benchmarks to track success.
- To simulate the possible financial effects of various business choices or tactics, such adjustments to prices or the introduction of new products.
- To illustrate a business’s potential for expansion and financial success, which is essential for persuading financiers to contribute capital.
- To evaluate a company’s credibility, prospective performance, and loan repayment ability.
- To aid internal management in tracking progress, identifying prospective financial issues, and making necessary adjustments.
Projections for Business Loans
Inclusions of Financial Projections for Bank Loan
Some of the core components required for financial projections for a bank loan in India are detailed below. We have also tried to explain why these particular documents are required by the banks.
Projected Profit and Loss (P&L) Statement
The Projected Profit and Loss (P&L) Statement, commonly known as the Income Statement, anticipates the project’s financial performance for a certain period (typically next 3-5 yrs). It lists projected sales, expenses related to making those sales, and, at the end to essentially determine profit or loss overall.
Why Banks Need Projected P&L Statements
Banks use projected income statements to examine a project’s core earning capability and intrinsic profitability. It assists them in determining whether the business concept is feasible and able to produce sustained predictable revenue.
Projected Balance Sheet
A pro forma balance sheet or a projected balance sheet is a kind of financial statement which estimates the equity, debt, and assets of an organization with the goal to help analyze its financial situation at a future date.
It depicts predicted financial shifts in relation to strategic objectives, financial patterns, and operational procedures, assisting businesses and investors in understanding future financial health, planning for investment or loans, and arriving at informed decisions regarding future financial structures.
Why Banks Need Projected Balance Sheet
A stable and long-term financial trajectory shows increasing net worth over the anticipated period. Banks require a projected balance sheet for organizations to assess the relationship across assets and obligations, in particular the debt-to-equity ratio, or leverage.
Projected Cash Flow Statement
Strong profit and loss statements does not usually mean adequate funds in the banks. However, cash flow statements of a business show actual movement of funds drawing attention to possible earnings or shortfalls. Projected cash flow statements track anticipated flow of real funds into and out of the business during a certain period. CFS statements rely solely on liquidity availability to satisfy obligations once they become due.
Why Banks Need Projected Cash Flows
Banks use these statements analysis to rigorously verify the income generation potential of a business while sustaining operations, investing funds and making loan repayments on time.
Break-Even Analysis (BEP)
The Break-Even Analysis determines the point at which a project’s total revenues equalize its overall expenses (both fixed and variable). This is an important measure of the bare minimum of sales activity needed to remain afloat. In other words, it shows the bare minimum sales threshold required to prevent losses.
BEP can be calculated as-
BEP (in Sales Value) = Total Fixed Costs / Profit Volume (PV) Ratio
PV Ratio = (Contribution Margin / Selling Price) * 100
Contribution Margin = Sales – Variable Costs
Why Banks Need to look at Break-Even Analysis (BEP)
As a measure, the BEP helps banks to get a better understanding of the project’s risk profile. A lower BEP indicates lesser sales required to be viable, rendering it more secure. Banks also look at the ‘Margin of Safety’ (the difference between predicted and break-even sales), which indicates how far sales can fall before the project begins incurring losses.
Debt Service Coverage Ratio (DSCR) Projections
The Debt Service Coverage Ratio (DSCR) is an important financial metric that assesses the project’s capacity to meet debt commitments with operating cash flow. It evaluates the difference between the funds readily accessible for debt servicing and the total amount needed over time to shell out back principal and interest.
Formula for Debt Service Coverage Ratio (DSCR) calculation-
DSCR = (Profit After Tax + Depreciation & Amortization + Interest on Term Loan) / (Interest on Term Loan + Principal Repayment of Term Loan)
It is to be noted that the specific numerator components may differ depending on the bank. Some may choose to employ a version based on PBT + Interest or EBITDA.
Why Banks Need Projected Debt Service Coverage Ratio (DSCR)
Banks use the Debt Service Coverage Ratio (DSCR) indicator as a clear indicator of repayment capacity. Different lenders may have changed DSCR standards (ranging from 1.25x to 1.75x or more depending on the project’s risk and industry).
Debt Service Coverage Ratio (DSCR) indicators who remain consistently above threshold limits throughout the loan term assure the bank that the venture will generate adequate cash flows to adequately service the projected debt. On the other hand, Debt Service Coverage Ratio (DSCR) projections lower than the recommended level poses lending risk for banks.
Steps to Create Projected Financial Statements for Bank Loan
STEP 1 – Gather Necessary Financial Documents
Collect all required financial documents before beginning the preparation of financial statements for the bank loan report. Verify that every financial document is correct and up to date. Update any statements older than a few months to reflect a business’s current financial status. Also, attach any supporting documentation, such as bank statements or receipts, etc. Having all applicable financial documentation readily available may speed up the loan process creating a positive image for the applicant business.
STEP 2 – Create a Profit and Loss Statement
The steps involved in creating a business income statement are as follows:
- List total revenue- This includes any funds received from services, sales, and other sources.
- Deduct cost of goods sold (COGS)- COGS is a measure of the direct expenses related to manufacturing goods or services. The difference between COGS and total revenues will help to calculate Gross Profit.
- Enumerate operating costs-It comprises marketing, rent, utilities, salaries, and other expenses related to managing the business.
- Figure out Operating Income: Determine operating income by deducting gross profit from total expenses.
- Make additional adjustments by deducting expenses or adding extra revenue sources, to find out net profit or loss.
STEP 3 – Create a Projected Balance Sheet
Follow steps as provided below to create projected balance sheet-
- Undertake an in-depth analysis of assets and liabilities- Start the process by conducting an in-depth analysis of the business assets and liabilities categorizing current as well as non-current assets and liabilities separately.
- Include equity and ownership structure- Specify breakdown of the equity structure of the business entity including initial capital contribution, additional investments and overall retained earnings.
- Review Calculations- Make sure that the projected balance sheet adheres to the accounting formula Assets = Liabilities + Equity. Check calculations twice to verify everything is in order.
- Present the information clearly- Organize the balance sheet and present it clearly. Always remember to include subtotal for each category to include assets, liabilities, and equity to be divided into headings. Use data comparison from past years to indicate changes in the financial health of the business over time.
STEP 4 – Generate a Cash Flow Statement
- Make a cash flow statement by classifying all cash inflows and outflows into three categories- financing, investing, and operating.
- List the initial bank balance for the time period first. Subsequently, add or deduct the net cash flow from every activity category to arrive at the net cash growth or reduction. Lastly, to calculate the period’s ending cash balance, add this net change to the initial cash balance.
When compiling a cash flow statement for a loan application, businesses should prioritize demonstrating potential to generate positive cash flow from operating activities. Healthy cash flows from operating activities reflect business’s potential to sustain operations while repaying debt. However, businesses with negative cash flows from operating activities should have sufficient explanations and strategies for future cash flow improvement. Further, review calculations for their accuracy by ensuring the final cash balance matches the real cash position at the end of each period.
STEP 5 – Include Supplementary Financial Documents
Apart from the projected financial statements, it would be a good idea to attach the following necessary documents to allow the stakeholders a more comprehensive picture of a business’s financial health-
- Account Payable and Receivables- Accounts receivable and payable reports indicate a company’s capacity to efficiently collect funds from consumers and pay bills on schedule. These reports organize unpaid bills and invoices usually in 30-day increments. Such reports illustrate a company’s capacity to successfully manage cash flow.
- Existing Debt and its terms- Businesses having existing loans should include details such as loan term, repayment schedule, due dates and lender information, etc. It can help lenders to determine borrower’s repayment history and ability to secure new loans.
- Collateral details- While pledging collateral to secure loan, an organization should submit a list of assets and information such as their value, state, and ownership status, etc. It will help lenders to evaluate the lending risk and decide adequacy of the collateral.
- Supporting documents- Other than projected financial statements, businesses could submit other supporting documents like licenses and permits, business contracts, etc. or any other similar can help a business’s legal standing and growth prospects.
STEP 6 – Verify projected Financial Statements
Once projected statements are prepared, make sure to check the information and all the calculations more than once. Lenders may become concerned and are less likely to approve a loan in case of any error/s or mismatch in the details. In such cases, the loan applicants should address the concerns and offer timely justifications.
The accuracy and transparency of information provided will illustrate that the organization is aware of its financial situation and has growth prospects in near future. In addition, it will boost the investor’s trust in their capacity to efficiently handle loans.
STEP 7 – Consider seeking professional assistance
Businesses struggling financially or those who lack experience with accounting principles should consider working it out with financial experts. Such professionals can help them to highlight their strengths, ensuring adherence to accounting guidelines, making correct projections and presentation of financial data in an effective manner.
However, the requirement for a professional might vary depending on area of expertise, experience in particular industry, proven track record in helping clients to secure loans etc. Seek references and assess their qualifications to be sure that they possess the abilities and expertise needed that meet their business needs. Bankkeeping has worked with various sectors and its advanced software is equipped at not just managing debt but also reducing the over debt burden of a business.
Checklist for Accurate Financial Projections for Bank Loans
- Accurate and Transparent Information- While preparing projected statements, the business entity shall make sure accurate, complete and up to date information throughout the documents.
- Growth Potential and Positive Trends- Always strive to demonstrate the strong performance areas and competitive advantages of the business. Also, emphasize on data suggesting rising sales or expanding market share over a period. Additionally, give a synopsis of the manner in which borrowed funds will be used to support organizational growth.
- Be Prepared to Answer Questions- Contemplate the queries a lender may have concerning financial projections, such as historical performance, anticipated future performance, or certain items. Be prepared to provide data or trends using papers such as strategic plans or market analyses.
Common Mistakes to Avoid while Projecting Financial Statements
Highly optimistic Sales Forecasts-
Businesses offering overly optimistic sales data without any proper market analysis, reasonable capacity evaluation, and any clear go-to-market strategy could be regarded as unreliable by lenders.
Neglecting Expenses and Costs-
Using obsolete supplier quotes, or failing to take into account certain expenses (like upkeep, repairs, bank fees, advisory fees, and emergency funds), or not bothering to account for the impact of inflation on the costs could lead to significant losses later.
Neglecting Work Capital Needs-
Regardless of whether a project seems profitable, inadequate cash forecasts for stocks, receivables, and vendor terms of payment may culminate in severe cash flow issues.
Inadequate Assumption Documentation-
Failure to properly document and justify underlying assumptions (e.g. rate of growth, cost inflation, collecting periods) limits the bank’s capacity to analyze reliability of the estimates.
Basic Calculation Errors-
Mathematical errors, incorrect spreadsheet formulas, and broken cell links undermine the analysis’s authenticity and competence.
Not accounting for the impact of loan repayments-
Failing to account/accurately account for the impact of loan repayment (principal as well as interest payments) in the projected statements can impact on profitability and cash availability of the business entity.
Conclusion
As a result, financial projections are well-organized reports that offer a comprehensive overview of a company’s operations and financial situation. It might take a lot of effort and time to create precise financial estimates that adhere to strict banking regulations.
However, avoiding certain common mistakes, reviewing statements thoroughly and whenever required, taking professional assistance could ensure loan approval for borrowers. Businesses that present accurate, well-organized, and meticulously prepared statements reflect financial responsibility and enhance lender confidence.
FAQs
How do financial projections factor into a bank’s decision to approve a business loan?
Financial projections are predictive models of a company’s financial future, detailing expected income, expenses, cash movements, and financial position. Banks depend on these projections during loan assessments to gauge whether a business can generate sufficient funds to repay the loan.
Business financial projection should be for how long a period?
It should cover a minimum of 3-5 years projections or as per the lender guidelines.
Can financial projections be self – prepared without professional help?
It is prudent to seek help from a professional like a chartered accountant etc. as it will cover a wide aspect of business financials and may require a lot of time and reiterations.
Why do loan applications get rejected?
One of the reasons could be poor financial projections.
Banks may reject the application on various grounds starting from credit worthiness of the company to the future economic conditions that are likely to negatively impact the business. But in most cases, it is due to common financial projection mistakes like unrealistic assumptions or inconsistencies and errors in the projected financial statements.
How to ensure financial projections for bank loans are accurate?
Keep projected numbers realistic. Account for inflation and other exigencies as per the market dynamics. And most importantly recheck for calculation errors, omissions and anomalies.