The importance of forecasting
Forecasting business revenue and expenses is more art than science. Many entrepreneurs do not do financial forecasts because it can be both overwhelming and time consuming. However, planning and working on your business’s financial projections each year could be a vital component for overall growth and success.
Strategic planning allows you to step away from the daily problems of running a business and take stock of where the company is, and where it’s going. It particularly allows you to establish a course of action.
The main reasons to project your financials are:
- A plan translates goals into targets.A financial plan defines the criteria for successful outcomes. It’s not only a predication – it’s a commitment to achieving targeted results and gauging progress according to milestones.
- A plan provides vital feedback and control.Variances from projections provide an early warning of problems. If (or rather when) variances do occur, the plan can then provide a framework for determining the financial impact and effects of corrective actions.
- The plan can anticipate problems.If rapid growth will create a cash shortage because you have over-invested in receivables and inventory, the forecast will show this. It will also show you which milestones need to be met this year in order to meet next year’s projections.
It’s also worth noting that the results of forecasting (the formal projections) are often less important than the process itself, which helps you to critically review your business.
Budgets vs forecasting
Before you begin your forecasts, understand the relationship between budgeting and forecasting.
A budget is a financial document that is used by a business to project future income and expenses.
Forecasting is a planning tool that helps management cope with the uncertainty of the future. It is an expectation that relies mainly on data from the past as well as assumed figures.
Note: forecasting is a management tool. It is not simply a rolling budget.
Types of projections
Depending on your business’s objectives and situation, you’ll more than likely need to develop several types of projections. There are four main types of financial projections: Current year or rolling 12-month periods by month; A long-range, strategic plan looking at three to five-years; Annual budgets; and cash forecasts.
Forecasts should be updated on a regular basis, and they should have a rolling component. This means that as a month or quarter ends, another month or quarter is added to the forecast. Updates can be monthly, quarterly or even six monthly, depending on the type of forecast and the company’s needs.
1. The current year or rolling 12-month model
This forecast should be updated on at least a monthly basis. It is your business’s main planning and monitoring vehicle. The information in this model is also the base for other projections.
2. The three to five-year long-range strategic model
The 12-month forecast above reflects short-term expectations and can be used for tactical plans. This long-range model takes that a step further and incorporates the strategic goals of the company. This should not be a simple extrapolation of the numbers of the current year. A strategic planning process should accompany development of the ‘out year’ projections.
Budgets typically cover one year and they translate goals into interim targets and detailed actions. They should include specific details such as staffing plans and line-item expenditures, and be consistent with the goals of the business’s long-range plan. Whether or not the same model can be used to prepare a 12-month forecast as well as the budget depends on the size of the business. However, unlike forecasts, budgets should be frozen at the time of approval.
4. Cash forecasts
Cash forecasts break the budget and 12-month forecasts down into even greater detail. The focus here is cash flow – not accounting profit. This forecast needs to be able to capture fluctuations within a month, and in order to do this, periods as short as a week are needed.
All projections should be broken down into months for at least one year, and should include a balance sheet and an income statement. Expenses can be summarized by either department or major expense category. Line-item details are reserved for the budget and unnecessary in this forecast. However, cash needs to be clearly identified. You could add a separate statement of cash flows, and if your financial statements report financial rations or expenses as a percentage of sales, calculate and report these as well.
Here’s how you can get started with financial forecasts. Once you are familiar with the basics you can implement more in-depth forecasts that can then be used for high-level strategy planning.
1. Start with expenses, not revenues
It is much easier to forecast with expenses instead of revenue. Once you are familiar with forecasting you can use revenues. To begin, start with estimates of the most common categories of expenses.
Basic rules of thumb when forecasting expenses:
- Once you have estimated advertising and marketing costs, double them. These are two expenses that always escalate beyond expectations.
- Legal, insurance and licensing fees are difficult to predict, so triple them.
- Keep track of customer service and direct sales as a direct labour expense.
2. Be aggressive and conservative in forecasting
It’s important to be realistic and conservative, but you wouldn’t have become an entrepreneur if you weren’t able to embrace your dreams as well. Don’t ignore this optimism. Build at least one set of projections based on aggressive assumptions – thinking big will help you become big.
Good short and long term financial plans allow you to control your cash flow instead of the other way around.
Effective financial budgets include a short-term month-to-month plan that generally last one calendar year, as well as a long-range, quarter-to-quarter plan. This is needed for financial statement reporting. You should always start preparing your next budget two months before the fiscal year end to allow enough time for information gathering.
The long range plan
The long range plan should cover at least three years, although many go up to five years. They can be quarterly or annual. They should also be updated each time a short-range plan is prepared.
The short-term plan
This is an annual, month-to-month plan. Some business owners prefer leaving the budget fixed. Others adjust the budget according to financial occurrences that happen throughout the year. Whichever you prefer, don’t get so wrapped up in your budgeting process that you forget to do business. Financial management is important, but it’s a planning tool, not an actual function of the business.
The income statement and balance sheet
It’s important to budget for both the income statement and the balance sheet. This will enable you to consider potential cash flow needs for the entire business – not just as they pertain to expenses and income.
An example is a business that purchases machinery to extend a product line – how does this impact your cash flow? Budgeting on the income statement alone does not allow a detailed analysis of the impact of potential capital expenditures on the business’s financial picture.
Step one is setting up a plan for the following year. This should be done on a month-to-month basis, and you should begin by establishing specific budgeted rand levels for the various categories of your budget.
Sales numbers are critical in this respect, as they will be needed to compute gross profit margin, which in turn will be needed to determine operating expenses, as well as the inventory levels and accounts receivable needed to support the business for the year.
Income statement budgets must be prepared first, followed by the balance sheet, and then the cash flow statement. This is because you can’t prepare a pro forma balance sheet without an income figure, and cash flow projections require both income statement and balance sheet numbers.
Creating a budget
1. Analyse your current budget and your prior year’s budget
You need to know where your starting point is. Use a simple format for your budget based on the profit/loss formula: Income less cost of sale, less overhead expenses net income (profit)
2. Use budgeting tools to assist you
Pastel has a great budget format ready for you to use. It is based on your profit/loss format.
3. Realistically assess your budget
Have an objective third party review your work. Business owners tend to overestimate income and underestimate expenses. An impartial eye could pick this up. You must also document how you arrived at your estimated numbers. Your predictions must have substance, which will allow better variance analysis when your actual figures vary from your projected figures.
4. Compare your actual activities with budgeted activities
This should be done on a monthly basis. The comparison is where your budget’s real value lies.
Hot tip: Budgeting is a precaution. It allows you to risk-proof your business. It allows you to quickly recognise if sales are going down or expenses are going up, so that you can identify course corrections. Budgeting is about the process, not only the numbers. It’s about watching expenses, so that you can ensure sales outweigh expenses, and therefore that you are making a profit.
Developing a great budget
Here are nine tips that will help you develop an excellent budget.
1. All budgets are wrong – yours will be too
Budgeting is at its core guesswork – calculated guess work, but guesswork none the less. What’s important to remember is that it doesn’t need to be a 100% accurate guess to be vital to management. Budgets are there to help you – and your team – correct course.
2. The review process is crucial
Budgeting itself is not what makes this a worthwhile business tool – it’s the regular reviews that compare budgeted expenses to actual expenses that make this invaluable.
3. The review schedule is vital
Always set a schedule for a budget review once it’s complete. This includes when, where and who will attend the meeting. Everyone working on the budget also builds a peer process and incentivises sticking to the budget.
4. Keep assumptions visible
Your first agenda item in review meetings should be to question what’s changed. Sticking to a budget isn’t always the best course. Based on changes, you can choose the right course of action.
5. Keep it simple
Budgets should be summarised, simple to read and visible. If you divide information into lots of detailed categories, all you see is trees, and management needs to see – and understand – the forest. Build your budget so that you can summarise it and aggregate it.
6. Use tools
Make use of the great tools that Pastel has on offer, but don’t forget that budgeting is about the process of formulating a plan – and then having the discipline to stick to it.
7. Match accounting reports to key management items
It’s called a chart of accounts, and it means categories that match control and responsibility, and the information you can manage later on. Accounting is detailed – budget management needs summaries of categories and more aggregation. You can set up your budget so that you can see strategic priorities, and you can break it up into areas of control and responsibility. At a glance everyone knows what’s important, and what they’re responsible for.
8. Consistency matters
When you stick to categories over time, it’s easier to see trends. By changing too frequently, you’ll lose where you started from, and you won’t be able to measure progress well.
Don’t make the mistake of bringing a product or service to market without fully understanding the total costs involved, particularly with regards to the prices you can charge for what you are offering.
Before you launch a new offering you should determine how profitable it will be. The same break-even analysis tool that evaluates new products or services can also be used to analyse existing offerings.
The break-even analysis
In a nutshell, break-even analysis is a simple way of determining how much of a product or service must be sold in order to generate a profit.
Here are three key points to keep in mind before you get started:
- Every business has fixed costs that must be paid every month, regardless of whether sales take place
- All products and services have variable costs that are incurred during the production and delivery process
- Semi-variable costs are costs that go up and down, depending on the level of business activity – all businesses have these.
Note: After all costs have been deducted, the product or service yields a profit. This profit contribution must then be divided into the ‘fixed costs’ described above to determine how many units the business must sell to break even.
Before you can conduct an accurate break-even analysis, you need to carefully examine the costs and prices within your business. This includes understanding exactly how much a product or service costs to deliver, as well as how much you charge for it. You should also always include and deduct all miscellaneous operating expenses.
Step 1: Analyse every product and service you regularly sell
Make a list, starting with your largest volume seller, ending with your smallest. Calculate each unit’s average sales price, as well as its total cost.
Step 2: Determine your return/profit percentage
Calculate your net profit on each unit, as well as the cost of investment to produce and sell it. What is the percentage of profit of each sale?
Step 3: Organise your products by priority
This should be done according to contribution to profitability, and each important product or service should be analysed. You need to determine:
- Your most profitable offering
- The volume of sales of each offering
- Total profit per unit sold, after deductions (direct and indirect expenses)
- Total profit contribution of each offering.
Many entrepreneurs actually discontinue offerings after conducting a thorough profitability analysis because they see that they would be better off investing their time and money elsewhere.