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Financial Forecasting 101
Most of us have experienced a family trip that did not go quite as planned, especially if it’s a road trip.
The destination is entered into the GPS and the trip begins. In summertime there is sure to be road construction. With road construction usually comes a detour.
The GPS helps map out the best route around the construction to get you back on the correct road to your destination. In the business world, the destination comes from the budget and the GPS acts as your forecast.
When businesses start their fiscal year, they want to achieve a certain financial result.
Sometimes they want to increase net income or expand to new markets.
Regardless of the objective, the arrival at that financial destination rarely happens without challenge. To overcome the financial challenges, businesses utilize forecasting to guide them and keep things on track.
Forecasts are used in many industries, from service based to manufacturing to construction. The ability to forecast and adjust course is critical to meet your budgeted goals. In this post we’ll explain why financial forecasting is important, explain how to set up a forecast and provide an example.
What is financial forecasting, and why does it matter?
Financial forecasting is the estimation by management of financial outcomes. Those outcomes are adjusted for historical experience and known future events. The forecast is adjusted periodically throughout the fiscal year to provide clear guidance to management. The forecast allows management the ability to make changes in operations for challenges as they arise
Business Forecasting 101
Forecasting starts with using the budget information. The budget is designed to indicated where the company wants to wind up in 12 months. It is the culmination of all activity for the fiscal year.
Starting with the budgeted number management will then work back to the first month to develop the forecast. The forecast guides the company through each month, and should have the ability to do what-if scenarios.
The first 12 months of the forecast will look very similar to the budget. All revenues and expenses will be mapped out. The revenues will be based on the most finite level possible, such as production level. The expenses will be broken out between variable costs, which should follow the revenue, and the fixed costs.
Each month management will start to get a feel for the financial direction of the company. Management will perform a budget to actual analysis to review past finances. Then, the forecast will be adjusted to align the company with the budget.
If revenues are falling short, management can adjust production. If expense is forecasting to be too high, they can be adjusted and scaled back if necessary.
The more time management has to adjust revenues and expenses, the more likely they will be able to position the company to meet the budgeted net income.
To illustrate how the forecast can work, assume that Sample Company’s management has budgeted operating profits of approximately $240,000 for the fiscal year ending June 30, 2020.
A budget and forecast were created in May 2019 and management starting tracking at the start of the fiscal year.
Now, lets assume in December 2019 management became aware that a major winter storm cut off part of their customers and sales are projected to be flat for December 2019 – February 2020.
Original forecast before the winter storm:
If no actions taken with by management, Operating Profit will drop to approximately $192,000.
Using the forecast, management can adjust the expenses in December to compensate for drop in sales so the company can still have $240,000 in operating profit at year end.
In the above example, if management did nothing when they found out about the sales drop, the company would miss the budgeted operating profit by over $50,000. However, because they identified the deficiency, they were able to map out cost reductions and get the company’s financial goals back on track.
If you are just starting out in building the company’s forecast and you have never produced one before, consider:
- Identifying the seasonal trends in your business. Many forecast programs take a linear approach—the increase is consistent month over month. If you have a seasonal business, you need to adjust for the busy times and the slow times. Without adjusting for seasonality, the company won’t have an accurate picture.
- Obtain benchmark data to determine the overall goals. Many industries have benchmark data available regarding sales, gross margin, and net income. Utilize these benchmarks when first designing the forecast. The overall benchmarks can help with the format until a finite forecast can be developed.
- Make sure you have a budget. If there is no budget, then there is no way for management to accurately forecast and guide the company.
Outsourced Financial Forecasting
Performing a financial forecast can be daunting and overwhelming. Some managers simply do not have the time to grow their company and maintain a forecast. Outsourcing the financial forecast is a viable option. Many virtual CFO firms run and maintain forecasts. If the owner decides to utilize a virtual CFO firm there are a few important items that must be done:
- Ensure information supplied to the firm is accurate. If the firm does not perform any other accounting services for the client, it is critical all information supplied is complete and accurate.
- Notify the firm once a major event has happened or is projected to happen. Various ‘what-if’ analysis can be run on the forecast to give management enough perspective to proceed.
- Continue to perform an internal budget to actual analysis every month. The forecast will help guide the business to the yearly goal. However, the budget to actual analysis still needs to be performed to identify any inefficiencies or opportunities.
Tips and Recommendations:
- Set-up the forecast template at the same time as the budget. The more finite the factors in the forecast, the easier it will be to make adjustments during challenging times.
- Update the forecast monthly and when unforeseen events happen. Quick adjustments allow management to maneuver the company back to the overall budgeted goal.
- Continue a budget to actual analysis. This analysis will help identify inefficiencies and is another form of internal control.
The forecast helps management navigate around the ‘detours’ that come up in a fiscal year. Utilize the forecast to arrive at the fiscal year end goal.
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