Wednesday, March 9, 2011

Planning for Success – Every Business Needs a Financial Forecast

Although it can be exhilarating to take a detour on a vacation and explore the world with no particular destination in mind, meandering without a plan isn’t a good business strategy.  Successful businesses are actively engaged in planning on a constant basis, and today’s software makes it easier than ever to forecast and model all sorts of assumptions and scenarios.  I’ve developed many financial forecasts over the years for clients, ranging from near term cash flow forecasts to five year strategic business models.  Whatever the approach, the point is that planning is essential to business success.

Understand first, Model Second
I seek to understand the business in plain English first, before attempting to model it.  I sit with a variety of key people in the business and ask many questions.  How does this business work, what and how are we selling?  Where is the product or service we’re selling coming from, what is needed in terms of labor and materials, will additional space or equipment be needed, how about marketing and promotion?  Who are the buyers of the product or service and how long is the cycle from cash disbursement to provide the product to cash collection after delivery?  Understanding the entire business stream from beginning to end in a conversational way first saves hours of modeling time afterwards.  I’ve learned to ask many, many questions to understand the factors that will most impact the outcome.   I’ve also learned to involve managers from all departments of the company in the forecasting process; everyone really does have a different point of view and all are necessary and important to the business itself.

Managing Infinite Assumptions
There are numerous assumptions involved in any attempt to predict the future; more than need to be modeled, actually.  Product mix, volume and pricing are only the starting points.  The key to a workable and reasonably accurate model is to understand which assumptions will have the most significant impact on the outcome.  Pareto’s principal, known as the 80-20 rule or the law of the vital few, is useful for the forecasting exercise.  This means 80% of the result is driven by 20% of the inputs; e.g., 80% of our revenue is generated from 20% of our customer base.  Whittle down the assumptions to the handful that really matter; this makes the entire model much more useful.

The Forecasted Financial Statements
I always forecast a complete set of financial statements – balance sheet, income statement and statement of cash flows.  I have many supporting tabs, such as product specifics for mix and volume, headcount and other inputs.  With a complete set of forecasted financial statements, I can be sure I’ve considered all drivers of cash flow that come from the balance sheet as well as the income statement.  I recommend a very useful book, Creative Cash Flow Reporting, for ideas on alternate presentations and analysis of cash flow.

Measuring Results
A forecast is only useful if we can regularly measure ourselves against it over time.  Most accounting software allows the budget to be loaded into the software, so the reporting of budget to actual results can be automated in the report writing feature of the software.  Being able to react to actual results that are behaving differently than expected is a critical reason to prepare a forecast in the first place.  

For most of my clients, I set up simple processes to measure actual to forecasted sales on a daily basis, with weekly and monthly summaries.  Cash is the same; measured and reported to key decision makers daily.
The comparison of the complete financial statements is done monthly, usually by the 5th - 10th day after month end.  Developing a consistent timeline and report format is critical to making the information useful to decision makers.

Remaining Flexible
The reality of business is that new ideas come up suddenly and require quick action.  A new market opportunity presents itself, an acquisition bubbles, market share can be expanded based on changing external factors.  It is critical to be able to quickly assess the possible financial impact of various outcomes, given changed assumptions.  When a business already has a good forecast modeling process in place, it is a simple task to save as a new version and model changing assumptions.
So enjoy your next road trip and allow yourself to drift off the beaten path to explore unexpected surprises.  When it comes to your business, however, planning really is the key to achieving your financial goals.