Financial forecasting
A financial forecast acts as a roadmap for a business to achieve its goals.
By combining sales goals and expense needs, together with other assumptions such as cash collection days and payment timings, the business can see into their future on critical elements like profit and cash and even equity.
Done right, a financial forecast provides a forward-looking view two, three, even five years into the future. This kind of view is incredibly important for small business owners to make confident decisions now that will carry their business forward and reach their goals.
4 key steps to build a strategic financial forecast
1. Understand your business goals
The goals of the business owner are determined during the planning stage. (In our world the “getting to know the business” stage.)
During this stage, have a broad conversation with the business team about their goals for the business. The goals include the obvious ones, like revenue and profit, but also include the notion of business opportunity, the value proposition, and a sales and marketing plan to support it. Those pieces will have a direct impact on the revenue potential for the business. With this in mind working with a Strategic Business Advisor here is beneficial to facilitate the strategic conversation and guide the conversation towards creating a clear and effective strategy for the business.
2. Keep the forecast reasonable through benchmarks and history
A business’s financial history and industry benchmarks set a baseline for what it should reasonably be able to achieve.
Using 12 to 36 months of history, determine the business’s unique patterns for revenue, gross margin, net profit, and ratios for major expense items. Then compare those to industry-standard benchmarks for the same data.
The objective here is to qualify the goals with real, historical data in order to arrive at a reasonable financial projection. Seasonality is a particular trend to watch, as well as anything else that forms a pattern.
The numbers every solid financial forecast needs:
- Quarterly revenue targets
- Quarterly gross margin targets
- Expense to revenue ratios for major expense categories like
- sales,
- general and administrative, and
- indirect labour
- Major fixed expenses like
- rent or
- debt servicing
- Quarterly net profit targets
- AR and AP average terms
With this knowledge, you should have all the information needed to develop a smart, and strategic financial forecast. Begin with profit and loss, and specifically the sales, or revenue numbers. Next, bring in direct costs, and then expenses (fixed first, then variable). The whole time you should be monitoring net profit. Adjust the forecasted P&L when necessary to keep the net profit on target.
For most small businesses, a monthly forecast for 24 to 36 months is typical. Beyond 36 months, a yearly or quarterly look is perfectly fine.
3. Recognize that a financial forecast evolves over time
Once the initial forecast is built, the real fun actually begins! No forecast is complete on the initial working. The gross margin and net profit probably won’t represent the ideal, desired growth plan for the business.
With a basic forecast in place, in the meantime continue to work with and analyze the numbers, shifting expenses, direct costs, and maybe even revenue where necessary, to model the ideal growth plan for the business. The growth plan should be one that represents the business owner’s goals, their value proposition, their sales, and marketing plan, and can support a positive or neutral cash flow.
Depending on the business, it could take 3 to 6 months of shifting, and comparing forecast to month-end accounting data, to arrive at a solid plan. And even then, by design, the financial forecast should evolve as the business grows and changes. Working with a Strategic Business Advisor at this stage of
4. Use the financial forecast to grow the business
Finally, the end result is a true roadmap for the business. Management decisions should tumble out of the forecast as tasks ready to act upon.
- Is it time to place the inventory order for the new revenue stream?
- Time to hire a new salesperson?
- Time to purchase that new piece of equipment?
The financial forecast will tell you. After all the answers are there in the plan. It’s not a report about past performance or a static baseline budget. It’s a plan and should be used as such!
In conclusion, according to Geoff, “Working with a strategic business advisor can be beneficial as they will help facilitate the forecasting process and provide guidance and expertise in creating accurate and realistic forecasts. They assist in identifying trends and patterns in the data, as well as assessing the potential impact of external factors such as changes in the market or economic conditions. Furthermore, they help to develop scenarios and contingencies to prepare for different possible outcomes.” Continuing Geoff adds “In addition, they provide guidance on how to develop a strategy to respond to the forecasted outcome. This is done by creating an action plan and setting measurable goals to ensure the forecast is achieved or to mitigate the negative impact of a negative forecast. At last a strategy executed successfully” said Geoff Fairhurst, highlighting his vision “We help you see what you can’t necessarily see right now.”
To find out more about how to implement this practice easily in your business schedule your complimentary Virtual Business Planning appointment here.