Financial projections are essential for any business, even if it’s not yet generating revenue. A variety of specific methods exist for performing this task, but they can generally be classified into top-down and bottom-up approaches. Financial analysts often use both methods as checks upon each other.
Top Down Projections
A top-down method of estimating future financial performance uses general parameters to develop specific projection numbers. You’ll often use a top-down approach to determine the market share that your new business can expect to receive. You might start with the market value of your product, narrowing it down to a particular location as much as possible. You would then assume that your business will receive a specific portion of that market and use that estimate to generate a sales forecast.
A top-down approach is comparatively easy since the only parameters it really requires is the total market value for your area and the market share you expect to receive. This method is most useful for checking the reasonableness of the projections resulting from a bottom-up approach. However, top down projections aren’t recommended for preparing detailed forecasts.
Example
Assume for this example you plan to open a business in an area where the total annual sale value of your product is $2 billion. You believe that your business might get 0.01 percent of that market, resulting in annual sales of $200,000. Note that your financial projection is entirely dependent upon the accuracy of your estimate on the product’s market value and your market share. Furthermore, the top-down approach doesn’t you to ask “what if” type questions.
Bottoms Up Projections
The bottom-up approach uses specific parameters to develop a general forecast of a business’s performance. This method might start the number people you expect to pass by your business each day, also known as footfall. You would then estimate the percentage of footfall that will enter your store and make a purchase. The next step is to estimate the average value of each purchase to project your annual sales. Bottoms up projections are based on a set of individual assumptions, allowing you to determine the impact of changing a particular parameter with relative ease.
You may use a bottom-up approach to select a location for a new business. You can obtain an accurate estimate of the footfall by direct observation. You can also observe similar stores in that area to estimate the percentage of footfall that are likely to enter your store. The prices that your competitors charge will give you a good idea of the price you can expect to charge.
Example
Assume for this example that an average of 10,000 people pass by a particular location each day. About one percent of this traffic in this area enters a store and makes a purchase, and the average total of each sale is about $5. The expected annual sales revenue in this example is therefore 10,000 x 0.01 x 5 x 365 = $182,500. You can then refine this estimate by considering additional factors such as price changes, closing on weekends and seasonal fluctuations.
