What’s financial forecasting?
Financial forecasting is the practice of planning for various financial outcomes of your business. You can use forecasting for overall business health or drill into specific goals, such as tracking the outcomes of an equipment purchase.
Why is financial forecasting important?
Easy – financial forecasting helps you plan for the future! Even the most basic forecast can tell you how to avoid risks or direct company resources toward growth.
Consider the Covid-19 pandemic. It’s one of the greatest disruptions businesses have ever faced. Every business, regardless of size, location, or industry, was affected. It reinforced the need for leaders to sharpen their forecasting skills. A sound forecast has many benefits – one being the survival of your business.
How to forecast
Step 1: Model how your business operates today
When creating your present-day model, consider your sales, labor, overhead, inventory turns, and the average collection period of accounts receivable. If these factors stay the same, what financial position will your business be in, in six months?
This is the business-as-usual model. It assumes there will be no major changes in the near future. Your current circumstances will continue unchanged. The model gives you a benchmark to measure against as you consider operational changes or future investments.
Step 2: Create a new forecast
Ready to play with the numbers? You can create a new financial forecast by modifying the assumptions you made in the business-as-usual model. One of the simplest ways to do this is by using a sales-based approach and connecting your costs to sales. Let’s say your labor costs average 40% of company sales. As you adjust your sales forecasts, you can predict your labor costs.
As you create a new financial forecast, connect with other leaders, department heads, or vendors for their input. Key departments include:
- Sales: Members of your sales team can share updates on current and future sales opportunities. And, they can notify you of any buying cycles or changes within your market.
- Operations: Your operational team can tell you what capacity the business is operating at. Achieving new goals or increasing workload may be a significant challenge if the business is at high capacity.
- Inventory: To create a realistic forecast, you need accurate cost estimates of materials, supplies, etc. And, you’ll need to know your existing inventory levels and your ability to secure more. With feedback from your inventory team, you can incorporate inventory-pricing trends in your analysis.
Step 3: Align your forecast with strategic objectives
In this last step, you can begin to align your financial forecast with the company’s strategic objectives and goals. Are you planning to buy new equipment that will increase productivity? Is there an opportunity to expand to a new geographic market? Consider your plans. How will they impact your financial position?
You’ll want to think about three scenarios and the outcomes that could impact your forecast in this stage.
- Best case: If you’re successful with any objective, what will the impact be? Can you sustain growth? Do you have all the resources you’ll need?
- Worst case: If we fail, how damaging will it be? How will it affect our business? Our employees?
- Most likely case: What will most likely happen? What are the potential outcomes that fall between the best and worst-case scenarios?
If you run through these scenarios, it’ll help decision-makers compare potential outcomes to the company’s business-as-usual model forecast and decide the best course of action.
Key metrics to monitor
As you build and execute your forecast, you should track a few key metrics.
- Gross profit margin (GPM): Watch your GPM as you change your assumptions. If you detect big swings, your forecast may need revisions.
- Estimated payback: How long will it take to generate enough income to cover the cost of a project?
- Cash flow: You should know how much cash you’ll need throughout the forecasted period. Do you have enough cash on hand? Will you need additional financing?
- Forecasted to actual results: Monitor your results as the forecast period and projects progress. If anything goes off course in the beginning, quickly revise your forecast.
The options for financial forecasting are endless. If your business faces a challenge or opportunity, forecasting can bring valuable insights on how to best proceed. If you’re beginning to pursue new business opportunities or make capital investments, don’t skip the planning or benefits of financial forecasting!
Have questions about creating your financial forecast? Let’s talk!