Building a Dynamic Financial Forecast for Your Business
One of the questions that I ask my clients as we are preparing to work together to perform a valuation of their company is “do you have a three-to-five-year forecast - something that looks out beyond the current horizon?”
I ask this because valuation is a exercise, and a key element in valuing a business requires the use of an income-based approach that considers the future cash flows of the business.
A great deal of the time, the answer to my question is “no - we don’t forecast.” Or maybe “we have an estimate for the rest of this year, but that’s it.”
This isn’t just coming from small companies - many large and presumably more sophisticated companies are not forecasting in a meaningful way, if at all.
This really shouldn’t surprise me after all this time, and yet it still does.
The ability to predict, prepare and plan for the company’s future is a critical skill set. I understand that predicting the future seems impossible, and forecasts may not be met, but the exercise of constructing a forecast is always worthwhile.
A well-constructed financial forecast can serve as a roadmap, enabling businesses to make informed decisions, allocate resources effectively, and better-navigate uncertainties. It also is a critical component in assessing a company’s value.
Why is a Financial Forecast Important?
A financial forecast is essentially a projection of a business’s future financial performance, including revenue, expenses, and profitability. It provides insights into potential growth, margin expansion / compression, capital needs, and other areas requiring attention. Here’s why a financial forecast is vital for any business:
- Strategic Planning: A forecast allows you to set achievable goals, make informed strategic decisions, and allocate resources appropriately.
- Investor Confidence: Investors and lenders often require a forecast to gauge the viability of your business and its potential for growth. Your ability to obtain funding may rest on the quality of your forecast. If you’ve got a loan, the forecast will also help with debt covenant compliance.
- Cash Flow Management: Forecasting helps manage cash flow effectively, ensuring that the business has enough liquidity to cover operating expenses.
- Risk Mitigation: By identifying potential challenges and risks in advance, you can take proactive measures to mitigate their impact.
- Performance Assessment: Actual results can be compared against forecasts to gauge a company’s performance and identify areas for improvement.
Step-by-Step Guide to Building a Financial Forecast
Gather Historical Data
Begin by collecting historical financial data from your business, including income statements, balance sheets, and cash flow statements. This data will serve as a foundation for your projections.
Identify the key assumptions that will drive your forecast. These can include factors like sales growth rate, pricing strategy, customer acquisition costs, profit margins and market trends. Ensure that your assumptions are realistic and can be easily explained when inevitably questioned by third parties.
Pro tip: if you’re using a spreadsheet to build the forecast, consider putting all of the assumptions on a separate tab to allow for flexibility.
The Classic “Hockey Stick” Forecast
Project revenue based on your key underpinning assumptions. Consider different revenue streams if applicable, and break down projections by product or service categories. Take into account seasonality and any potential external factors that might influence the assumptions. And no hockey stick forecasts, please.
Estimate your operating expenses, including fixed costs (rent, salaries, utilities) and variable costs (materials, marketing, commissions). Categorize expenses and consider how they might change as your business grows. A convenient way to sometimes think about this is to estimate certain expenses as a percentage of revenue. Also consider any necessary capital expenditures.
Income Statement Projection
Combine your revenue forecast and expense projection to create a projected income statement. This will provide a clear picture of your expected profitability over the forecast period.
Balance Sheet Projection
Forecast your assets, liabilities, and equity. This helps you understand how your business’s financial position will evolve over time. Ensure that your balance sheet remains balanced (Assets = Liabilities + Equity).
Cash Flow Projection
Based on your income statement and balance sheet projections, create a cash flow forecast. This will help you manage your cash flow effectively and identify potential periods of cash needs. The 13 week cash forecast is a common tool used to improve cash management and cash flow projections.
Perform a sensitivity analysis by adjusting your assumptions to see how changes in variables impact your forecast. This provides insights into the robustness of your projections and helps you prepare for different scenarios. Building the model in a way that allows for ease of adjusting assumptions will allow you to pressure-test the business to understand a variety of potential outcomes.
Review and Refine
Regularly review and refine your forecast as you gather more data and insights. Think of it as a “living document” and adjust your assumptions based on actual performance and market conditions. A good test for the reasonableness of assumptions is to compare historic measures with what’s being forecasted. Significant variations will identify areas to explore further, as will trend analysis.
Communicate and Monitor
Share your forecast with stakeholders, such as investors, lenders, and key team members as required. Keep them updated on actual performance compared to projections. If deviations occur, analyze the reasons and adjust your forecast accordingly. As discussed in the video above, sharing a robust financial model with investors can not only help you to get a deal done, but possibly get it done on better terms.
A well-constructed financial forecast is a powerful tool that helps businesses to plan strategically, make informed decisions, and identify challenges. By following the step-by-step guide outlined in this article, you can build a robust financial forecast that serves as a roadmap to the future for your business. Remember that flexibility is key, as the business environment is constantly evolving, and your forecast should allow you to incorporate these changes and evolve with the business.
Don’t get stuck in the trap of “we can’t project with accuracy so we don’t do it.” It’s important to understand where forecasts go astray.
Identify your path to CFO success by taking our CFO Readiness Assessmentᵀᴹ.
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