The start of the New Year is the ideal time to implement one of the most powerful financial management tools in business: a reliable financial forecast. It’s a tool designed to help you answer questions like:
- What’s likely to happen financially over the next six to twelve months?
- What are the key drivers of our financial performance this year?
- Will our company be weaker or stronger financially at the end of this year?
Creating a forward-looking view of financial performance is the secret for turning financial information into valuable insight. And providing insight to your management team, Board of Directors, owners, lenders and others is not only wise – it’s a surprisingly effective way to drive your profitability and cash flow higher this year.
Most people whip out a spreadsheet and start plugging numbers into a forecast only to realize there is more to the forecasting process than meets the eye. That’s why I have organized the process into three phases: plan, create and present.
Planning is about putting the foundation in place so you can build a forecast that adds value for the company. Creating is about the actual work of developing assumptions and putting numbers in the forecast. Presenting is about how you turn the forecast into insight for your leadership team and others interested in, or invested in, the financial success of your company.
In this post, I’ll walk you through the steps involved to properly PLAN your financial forecast. In future posts, I talk about the CREATE and PRESENT phases.
There are a number of important steps to walk through before you drop the first number into your forecast. This is where you plan and design the ultimate end product and build a foundation that will support your forecasting goals.
Here are the steps:
- Set the objectives
- Consider the audience
- Decide on format and periods
- Identify the key drivers (financial and non-financial)
- Think big picture
- Review the 5 rules of forecasting
- Pick your software tools
Set the Objectives
Step one is to write down the primary goals and objectives of the forecast you're about to create. This is the “begin with the end in mind” step. It helps you define what success will look like once the forecast is complete.
Here’s an example. In my outsource CFO work, before I begin a new engagement, I have a discussion with my prospective client about what they're trying to achieve. I write down the one to three big picture objectives we want to accomplish and get the client's buy-in that I've captured the essence of what we need to accomplish. There’s something magical about narrowing the objectives to just one to three and actually writing them down and talking about them upfront.
In one client engagement, the objective relating to forecasting said this:
“Implement a reliable financial forecasting/projections process that can be updated monthly.”
The CEO was growing the business and wanted to create a more metrics driven organization. The forecast would help her plan and manage the key drivers/metrics of financial performance at the overall company level. Then she planned to drive that same kind of focus down to the more operational levels of the different divisions of the company.
She was increasing the number of locations and taking on more debt to help finance the growth. She knew the company had to become more focused on the key drivers of financial performance to ensure the growth was profitable and to help her manage the risk associated with taking on more debt. The forecast was a central part of how she would more closely manage both performance and risk on a monthly basis.
So think through and write down the one to three key goals or objectives you want to achieve by implementing a financial forecasting process in your business.
Consider the Audience
It is very important to consider the audience for the forecast. Who is going to receive the forecast? Who will be making business decisions based on the forecast?
Here is a summary of the different audiences, or end users, you may have:
- Board of Directors, Shareholders, Lenders. This group is focused on carrying out their oversight role and monitoring their investment or loan. They are generally not involved in the day-to-day activities of the company. So the forecast information they receive should be highly summarized and it should shine the light on the key drivers of financial results.
- CEO. The Chief Executive Officer is focused on company-wide results. They want to use the forecast to link the vision and strategy of the company to the financial goals and the likely implications of achieving those goals. They will use the forecast to make important strategic decisions. This is where having a forecast that models a full set of financial statements by month is a huge asset.
- COO. The Chief Operating Officer is more operationally focused. They need information to help them make specific investment and resource allocation decisions. The forecast would be more narrowly focused because the intent is to support a specific decision rather than model a full set of financial statements.
- Prospective lenders or investors. This group is generally not familiar with the company and may not be familiar with your industry. They are trying to decide whether to invest or lend money. Since they are unfamiliar with the company, the forecast needs to be very focused on providing insight about what drives financial performance. And the forecast period is generally longer than what you would present for internal purposes.
Decide on Format and Periods
There are two important decisions to be made regarding a forecast: the format of the forecast and the time periods you'll be forecasting. By format, I am referring to the essence of what you will be forecasting. It could be:
- Sales by division or product
- Revenue and expenses for a specific project or initiative
- Cash flow using a cash-in and cash-out perspective
- A full set of company-wide financial statements including the income statement balance sheet and statement of cash flows
- In a company with multiple legal entities, deciding whether to forecast at the legal entity level then roll the results up into a combined or consolidated forecast
By time periods, I am referring to whether you forecast by week, month, quarters, or years, and how far out the forecast will go. The objective you wrote down, and the audience for the forecast, will likely give you the answer to both format and time periods.
Identify the Key Drivers (Financial and Non-Financial)
Identifying the key drivers of financial performance is an eye-opening exercise. Let’s say you are forecasting monthly sales. Think for a minute at a very summary level while you are looking at the sales number. What two numbers could you multiply together to arrive at sales?
- For a retailer it might be number of customers times average ticket = sales.
- For a law firm it might be hours incurred by attorneys times average billing rate = sales.
- For a wholesaler of fuel it might be gallons of fuel sold times average selling price per gallon.
You want to do this exercise at the most summary (highest) level possible. Notice how the key drivers almost always include non-financial data (like number of customers in the retail example, hours worked in the law firm example, and gallons sold in the fuel wholesaler example).
You will be using these key drivers when you develop your forecast assumptions.
Think Big Picture
Forecasting is a “top down” rather than a “bottom up” exercise. It’s almost the opposite of how actual (historical) financial statements are created. This is where many accountants get tripped up. Creating historical financial statements is a process of gathering and recording thousands of transactions and reporting the results in the form of financial statements. Forecasting, or modeling, a full set of financial statements is about hooking the vision and strategy of the company up to the likely financial implications of achieving that strategy. It’s about painting a picture of what the financial results will likely be based on knowledge and intuition rather than actual transactions.
You have to take yourself up to the 30,000 foot level and look down on the business financially as you forecast. The big picture is what you want to shine the light on rather than the nitty-gritty detail. Otherwise, you will get lost in detail and complexity.
Review the 5 Rules of Forecasting
Creating a reliable financial forecast does not have to be a difficult process. It is really a matter of using a few basic principles together with your intuition and knowledge about the business. Here is a five-step process for creating a forecast you can trust.
Forecasting Rule #1: Think Decision-Making, Not Precision. One thing stopping you from creating a forecast is worrying about what happens if your forecast is wrong. As mentioned above, transaction processing and creating historical financial statements in the accounting department is about being right. (Here, precision is your friend.) On the other hand, forecasting is about improving the company’s ability to make wise decisions. (Here, precision is your enemy.) As you create and use forecasts, think decision-making, not precision.
Forecasting Rule #2: The Near Future Almost Always Looks a Lot Like the Recent Past. One of the biggest mistakes CFOs and CEOs make in creating a forecast is that they start with a clean slate. They pull up a blank spreadsheet and begin thinking about what the first month in the forecast will look like. But you unhook yourself from reality when you do that. The first step should be to drop in actual results for the last six to twelve months. Have the revenues and expenses been coming in the way you expected them to? Can you see a trend developing? Are you surprised by any of the numbers now that you are looking at the last six months of actual results next to each other?
Forecasting Rule #3: Consider What Is Changing. Once you have a good view of what the financial results have been over the last six to twelve months, you want to look at some of the factors that can make the next six to twelve months vary from the historical results. Things like seasonality, a change in service or product mix, whether you have been expanding geographically, etc.
Forecasting Rule #4: Be Conservative. Because we know the forecast will not be perfectly accurate, the challenge is keeping it in the “ballpark” since a wildly inaccurate forecast will hurt your credibility. You do that by being conservative in your key assumptions. You know your estimates will not be perfectly accurate. So you want to err on the side of being conservative. That way the surprises are pleasant rather than unpleasant.
Forecasting Rule #5: Use the “Smell Test.” An important step in mitigating risk when creating a forecast is to give it a serious reality check, what I like to call a “smell test." Once you have a completed draft of the forecast, step back and look at the resulting financial statements. Are they consistent with your general expectations? Are they in line with actual results and the plan? Do they make sense given your intuition and knowledge of the business? The smell test is a quick way to check that nothing unexpected has made its way into your numbers.
Pick Your Software Tools
Your forecasting software/tool has to perform a number of functions. Among others, it should:
- Include the underlying logic for forecasting (or modeling) a full set of financial statements
- Provide the ability to forecast with financial as well as non-financial data
- Import historical (actual) financial results
- Display graphical views of data and trends
- Report both historical and forecast results in reports, report packages or exports
- Be easy to update and maintain each month
- Make your monthly financial reporting a snap
My forecasting software of choice is a SurvivalWare. It is a powerful financial analysis and forecasting tool. It works well for small companies as well as large and complex companies. There are other forecasting tools available on the market. Some are web-based and some are desktop tools.
Of course, spreadsheets are a common tool for all things financial. The primary problem with spreadsheets is they become too clunky and difficult to maintain. In addition, the underlying logic for modeling a full set of financial statements is complex and must be developed and working properly before you can begin the actual forecasting work.
A reliable financial forecast will help you create the visibility and clarity you need to drive your company to a bigger and brighter future. The planning step will help you create a solid foundation and help you get started on the right foot.
In future posts, I’ll show you the step-by-step process for the next two components of financial forecasting – the Create and Present phases.
January is a perfect time to begin looking ahead and create a financial forecast, and not just to look at historical financial statements.