Financial forecasting3rd September 2012

Let’s be clear why we do forecasting. The time when projections were prepared just to please a banker to tick a box are long gone. In fact that banker probably made good use of them, but they were rarely used for business improvement. And business improvement is why financial forecasting is now so vital.

Rubbish in, rubbish out…

The greatest skill in preparing a forecast is in setting the variables that go into it. The accuracy and relevance of these assumptions is the single most important feature, and setting these clearly, with sound reasoning and justification, should be paramount in any forecast.

These assumptions cover all areas of the forecasts, from sales and purchasing costs, terms and timing, stock and work in progress cycles, seasonality, costs, tax, the value of and timing of capital expenditure, financing commitments and more.

Ensure that your assumptions are set in reality rather than hope. For instance if you offer credit terms of 30 days to your customers, in reality this is likely to be treated by many customers as 30 days from the end of month in which the invoice is issued, meaning that you may be providing up to 30 to 60 days credit. And then allow for the fact that if a customer pays you once 60 days is up it may well take a few days to reach you, and possibly a few more days to clear. And even then some customers may have difficulty in paying you at all. So how does “what should happen” compare with actual experience? And having considered these things, could you improve the actual experience by tightening up terms, sharing your expectations with your customers and changing credit management procedures?

It could be that your invoiced sales are at the end of a long line of activity, for instance prospecting for sales from a membership base, or creating a pipeline of likely sales, which typically takes time to turn into actual sales. These factors should form the core base of your assumptions and forecasts as the effectiveness of the pre-sales effort is the engine-room for your revenues.

Deep thinking…

It is easy to fall into a trap of extrapolating past trends. If sales have grown 5% a year for the past 3 years, another 5% may sound reasonable, but why on earth should that be so? It may be a comfortable figure, but it needs justification.

Think back over the last few years; how much of that growth came from key customers that can be repeated? How much “growth” was actually growth in the volume of sales, and how much was down to price rises that you were able to pass on? How will sales volumes and price inflation impact on your sales this year and next? And ŵhere will that sales growth come from? What impact will your own actions and those of the competition impact on the volumes and prices and lead times that you can achieve. Be honest, and don’t be afraid to project a reduction if that is genuinely the most likely outcome.

Look at where you are seeking to achieve sales growth, whether it be a particular market of selection of clients. How do their credit terms differ from what you may have to or could offer to achieve this growth? How will this impact on the assumptions you are making? Are there better ways of growing?

Reinvent the wheel…

There are times when a business is changing only slowly, and it’s overheads are just showing inflationary increases. How very boring. This is a great time to consider how, if you had a clean start, you would choose to structure and operate the business. Does the business really need to allocate it’s resources in the way it does, or should the level and balance of spending and priorities be different? And would prospects for the business be different if you invested more in certain areas and less in others? Involve your management team in the process so they have a stake in proposing positive change.

Changes can take time…

So you’ve decided to grab an opportunity, or change something for the better. But how long will this take before you see the results? Even if you take the action now, will behaviours change overnight? Be realistic.

Assumptions done, and now for the figures…

Any good forecast shows a detailed Profit & Loss, Balance Sheet and Cashflow statement.

The Profit & Loss should be built up by division and then the whole, so that the individual components of the business, and the assumptions underlying them, can be clearly referenced. Typically a forecast could be 12 months, but there is every reason to look at the impact over 3 years or more. To allow for seasonality the forecast should at least be broken down into months, and for some weekly.

The Balance Sheet then brings together the impact of your Profit & Loss forecast with capital expenditure commitments, working capital cycles, financings, timings of tax payments etc. We always like to structure these as your accountant would structure your year-end accounts, although often using more detail. The balancing item is your bank balance.

Now to bring the two together and prove that they work together, as small mistakes in either can dramatically affect the forecast! So a cash flow is also needed, drawing information from both the Profit & Loss and Balance Sheet to identify how cash is used and generated within investing, operating and financing activities, and to prove that the forecasts balance together.

Sensitise the forecasts…

So you have a set of financial forecasts. Do a sanity check; do the results look and feel right, and how do they compare with the past? If necessary, revisit the assumptions and calculations.

Don’t stop there. Whilst we have successfully forecast a £6m turnover business to within £15 accuracy of it’s year-end profit 12 months later, it is far more likely that results will deviate from plan for good or ill. So we need to look at a sensible range of possible outcomes. What if sales decline, or margins can’t be achieved? What if stock sticks, or customers take longer to pay? What if you need to change suppliers or other disruptions occur?

I prefer a range of forecasts, applying “bullish”, “realistic” and “bearish” assumptions to achieve some stretch to the core assumptions. In some industries particularly prone to volatility a “severe bear” forecast is appropriate. These will all show differing levels of profit and cash flow, and depending on the peculiarities of your business will reveal fresh opportunities and threats that you can plan in advance for.

Don’t worry about the reams of figures. They can be clearly presented in chart form for those who find these easier to follow. This also helps to demonstrate the distinctions between the range of forecasts, and allows easy comparison with previous year’s actuals.

If any of these show unacceptable conclusions, go back to square one and reconsider the whole process until you have sufficient actionable ideas that support the required outcomes.

Stakeholder commitment…

Having gone to all this trouble to think long and hard about the business and project it’s future, don’t keep the forecast to yourself. It should be presented in an appropriate way to your funders, and to the management team responsible for delivering the performance.

True, it may be appropriate to share only stripped-down versions of the forecasts, or just the central forecast, but in my experience most respond well to being involved, and benefit from understanding how the pieces of the jigsaw fit together and their role in it.

Ongoing monitoring…

Having gone to all this trouble, it is important to sustain the benefit, and monitor actual against budgeted results. So the forecasts and your management accounts should be structured in a similar way to allow easy transfer of data between the two.

Deviations from budget have a reason, so rather than blaming the weather drill into what went right, what went wrong, and what you can do about it to sustain good performance and banish bad performance. Regular reviews also pick up trends at an early stage. These changes may affect your future funding needs, and possibly other items, so do amend the forecast as necessary to ensure it continues to be a useful tool going forward.

Those factors that have a causation impact on sales will require frequent monitoring and regular updating in your forecasts. Used as I use them a change in the potential sales pipeline will amend your revenue budgets and flow through the forecasts so that you constantly have an accurate expectation.

One final thought…

I thoroughly dislike the accounting software package forecasting tools. If you have used them, or have sales or finance staff who use them, ask yourself if they really offer all the business improvement opportunities discussed above? They can be great to minimise regular effort, and to inform forecasting models, but must be used with care to avoid limiting the rewards derived from proper challenging forecasting.

At FYI we work with many businesses to undertake or assist them with their financial assumptions, financial forecasting and monitoring in the way described in this article. Please do pick up the phone to us.