In the business world, forecasting can often be viewed as a poor guess about what will happen in the future. Many view it as an exercise in futility, because putting "predictions" down in writing can prove to be humbling. Just ask any economist. Similar to economic forecasts, they're more often "wrong" than "right", but that doesn't mean they're not useful.
In small business, forecasting may be the most underutilized financial management tool that is available to business owners. While its accuracy may be called into question, its usefulness certainly cannot.
The best place to start with a forecast is to develop an understanding that a forecast is a forecast, and not a prediction. Think of it as a roadmap - when you use a roadmap, you want to get from point A to point B, usually employing the most expedient route possible. However, the true value of the roadmap is not the most expedient route to the destination - it's the knowledge and flexibility it provides when you encounter a detour.
Forecasting provides knowledge and flexibility to business owners that they otherwise may not have. A good forecast involves the review of business information in some degree of detail, and that detail brings to the forefront the difference between expectations that are developed by the forecast and the reality that ensues. While many people may think they already have a good grasp on their businesses, they can often be surprised when they review the actual numbers in their results versus the forecast that they constructed. It's the blur of everyday life that can cause each of us to lose focus, and the forecast can serve as a reminder of what we thought our expectations were a short time ago.
Now for the "art". The most effective forecasts, especially for small businesses, are the simplest ones. There are two types that businesses should use:
- A financial forecast to measure sales, gross margin and EBITDA for a given period, and
- A cash forecast to measure the availability of resources to fund operations.
Financial Forecasts
For the financial forecast, one only needs to routinely quantify sales and gross margins, because the other elements of an income statement (selling, general & administrative expense, interest, income tax rates, etc.) generally do not vary in the short term by amounts that are meaningful. As a result, the focus becomes "hitting the sales number" and understanding how cost variances are affecting performance on a more routine basis. However, when constructing a forecast, if you are aware of certain elements below the gross margin line that may materially change, you would obviously want to incorporate those changes.
At this point, one may ask why a budget doesn't provide this same measurement ability. There are two basic differences between a budget and a forecast:
- The budgeting process is normally a detailed process, if done properly. It's not something that you should be completing in a week's time, because it involves a good assessment of all aspects of your business and all of the resources necessary to succeed.
- A budget is a static document. Once it's completed, it does not change.
A financial forecast is a more dynamic document because it changes from month to month. A new forecast should be generated as soon as a month's sales are closed and there is knowledge about what the following months' sales will be. Many companies employ a 12-month rolling forecast to provide visibility one year out. While I am an advocate of this process, it is not a good place to start. Forecasting three months' results would be a better starting point, and once a reliable process is established, the timeframe can be lengthened.
Cash Forecasts
For cash forecasts, the data needed is often more detailed than the financial forecast. The reason for this is that actual cash resources are being measured. Once again, there is a difference between a budget and a forecast. When cash is involved, the last thing you want to do is strictly follow a cash budget when the realities (such as paying your bank on time) dictate a different approach.
When constructing a cash forecast, I find combing through the actual cash receipts and payments to be the most useful method for not getting caught short of cash. The receipts are usually measured by anticipating customer payments according to the date on which the sales actually occur and the actual terms under which those customers pay. If you give a customer 30-day terms but they always pay in 40 days, 40 days should be used to anticipate payment, not 30 days. Customer payment patterns need to be routinely reviewed as receipts may continue to slip, sometimes only a few days at a time. If you're not paying attention, you may not notice this.
On the vendor payments side, the work is a lot easier. You generally know what you need to pay, so all you need to do is schedule out the payments. If you're not using a cash forecast, you may think "I already know how to do this", but when you see the payments scheduled by week for the next three months, you get a completely different appreciation for what needs to be paid when. I've assembled countless cash forecasts over the years, and when resources are constrained, there's no better tool than a detailed payment schedule to make sure that the most critical payments are made when needed.
There's obviously a lot more detail involved in these forecasting processes than what can be described here, but the most important point is that the accuracy of the forecast is of lesser importance than the information it provides.
Nperspective has assisted many clients in improving their business results through implementing or helping with their forecasting and financial management processes. Our team members possess a wealth of experience across most industries and are well-positioned to provide strong and effective executive financial management resources to client companies. If your company or one of your clients may benefit by our experience and knowledge, contact Russell Slappey at 407.448.1781 or slappey@npcfo.com for a complimentary consultation.
