Why Is Financial Forecasting So Critical To Your Business?

Recently on the blog, I’ve been looking at “Who controls your business?” and talked about how control over your operations begins with financial visibility and the critical business numbers you need to be all over like a rash. Once you have clarity on your current performance it’s then time to start to manage your future results. You need to envision what you’d like your P/L to look like and then managing to that. This brings us to the whole area of forecasting.

Financial forecasting – A prediction concerning future business conditions that are likely to affect a company, organisation, or country. A financial forecast identifies trends in external and internal historical data and projects those trends in order to provide decision-makers with information about what the financial status of the company is likely to be at some point in the future.
(BusinessDictionary.com)

To fully understand your financial position, you need to understand at least three statements in both the past and the future. These are your Profit and Loss statement, your Balance Sheet and your Cash Flow statement.

With regards to the past, these statements show you how your business has performed to this point in time. If you understand them properly, they will also give you great insight in terms of what changes you may need to make to improve your future results.

Projecting these statements into the future, come in two forms (at least): a forecast and a budget. These two projections are related and similar but have different purposes. The terms mean different things to different people but in general:

A Budget generally expresses your intention of where you want to get to in the next year or so. It is your target and where you want to go. It is normally only prepared once a year.

A Forecast is generally updated on a regular basis, preferably every month, and gives your latest view of what you expect to happen based on the current realities.

Whatever your precise purpose in Financial Forecasting (using the term generically) it is vital for a business to be successful and has the following benefits:

To Chart A Course Of Where You Want To Get To

If you aim for nothing, that’s probably what you’ll get. A Forecast, in this case in the form of a Budget, is a roadmap of what you’re aiming to achieve and how you intend to get there. It provides a lot of insight as to the resource requirements and milestones needed to reach your goals.

My wife and I are keen dinghy sailors and are learning to sail yachts. To qualify as Day Skipper’s we did 13 weeks evening class on the theory in a classroom on dry land. Having passed the navigation and other theory, we then did a week’s practical in a yacht under the watchful eye of an old sea dog instructor off the coast of Mull in the Inner Hebrides on the West coast of Scotland. The waters in these areas are technically challenging sailing with the islands, underwater rocks and the weather coming in from the Atlantic. The day came when we were due to sail down the Sound of Iona and either my wife or I was going to have to navigate. I have to say I was rather bricking it when I looked at all the submerged rocks on the charts and the weather coming in. I was more than a little relieved when my wife was asked to navigate first for that day!

A Budget is the same as a sea skipper plotting the course of where they want to get to. There will be winds to take advantage of, obstacles to navigate, conditions to allow for and the potential for unforeseen events! If you don’t have a budget, or plan as to what you want to achieve, then don’t be surprised if you don’t feel like you’re getting anywhere.

To Measure How You Are Progressing Against Your Plan

No sea skipper, not a live one anyway, sets a course and then just sails. Survival in business, as on the high seas requires lots of checking in against your planned course, reading the instruments and making adjustments on a semi-constant basis. In business as on the sea, it pays to be paranoid!

Comparing your budget against your actual results and monitoring the Variances provides the feedback you need to take corrective action. It provides a monthly yardstick against which you can measure your actual performance as a fast feedback loop, identify your Variances from the plan and inform you on areas corrective action is required to get back on track, or hopefully improve on your plan.

Management Decisions

As a business owner and manager, important decisions need to be made on a regular basis. The accuracy and correctness of your decisions are largely dependent on your true understanding of your business position.

Solid Management Accounts and a Financial Forecast will ensure that you are as aware of your business position as possible. This will allow you to make informed decisions that will benefit your business both now and in the long run.

If you are working with accurate forecasts, you will be able to learn from the past and more accurately predict the future. It will also keep you looking ahead, making you more likely to foresee market changes and competitive challenges. Forewarned is forearmed.

Financial Requirements

Financial Forecasting plays an important role in calculating the financial needs of your business. Your business will need adequate capital. Whether it be fixed or working capital, financial forecasting will help you make accurate predictions about what your business needs to succeed.

If your business is expanding, further capital may be needed for your new venture. You would then need to have a good idea of what capital will be required to be successful.

Forecasts will help you decide if additional private equity or borrowing is necessary. If it is, these forecasts will be a necessity when applying for a bank loan or any other funding from investors.

Understand You Key Drivers And Modelling Different Scenarios

A well-constructed forecast will enable you to see what the Key Drivers of your business area. There are usually only 3-4 critical numbers in any business. If you look after those numbers, the business will generally look after you. Once you have a financial model with clear Key Drivers, you should then be able to change those to see what impact that has on the results you’re trying to achieve. It is often useful to introduce sensitivities into your forecasting and have at least best, worst and expected scenarios.

Be Prepared For Different Eventualities

A client of ours recently saw his sales drop by 25%. Thankfully several months before this, we had coached them through some scenario planning as to model how they would manage with 20% and 40% reductions in sales. Whilst this was not a great time, the client was clear about what decisions had to be made, and most importantly when.

Controlling Cash Flow

In a previous blog post, I discussed control in your business. Cash flow has a great influence on the success of your business, and if not properly managed, can start controlling your operations and decisions. Accurate forecasting helps you better manage that cash flow, anticipate and mitigate problems early on.