What Business Owners Should Know About Financial Forecasting
04 January 2023
Is your business ready to tackle the challenges and opportunities that lie ahead in 2023? Financial statements show how a company has performed in the past. But historical data doesn't necessarily predict future performance, especially in an uncertain, volatile market. As part of your planning, it's important for management to prepare forecasted statements.Make Reasonable Assumptions
The purpose of forecasting is to obtain the most realistic picture possible of a company's future performance for as far out as management can look. Forecasts provide important information that can be used to make decisions, such as:
- When working capital shortages are likely to take place — and whether the line of credit is sufficient to bridge cash flow gaps.
- How much inventory, including raw materials, parts and finished goods, the company should purchase each month.
- Whether the company has the right mix of employees to meet its operational goals — and how it should remedy any deficiencies (or excess capacity).
- Which fixed assets should be retired (or acquired).
A forecast is typically organized using the same format as the company's financial statements: an income statement, balance sheet and cash flow statement. Most conclude with a statement of assumptions that underlie key numbers in the forecast. A detailed forecast of revenue drives many of these assumptions.
Roll with the Punches
Managers use forecasts in their annual budgeting and strategic decision-making processes. But many budgets and business plans are out of date before the end of the first quarter. That's because today's complex, dynamic marketplace is almost impossible to forecast with certainty. As a result, many companies have replaced traditional annual budgets with rolling 12-month forecasts that are adaptable and look beyond year end.
Creating a meaningful rolling forecast necessitates ongoing comparisons between forecast and actual results. This enables management to unearth and respond to weaknesses in forecast assumptions and unexpected changes in the marketplace. For example, a retail store that suffers a data breach could experience an unexpected drop in revenue. If the company maintains a rolling forecast, it would be able to revise its plans for temporary inventory decreases, as well as technology and marketing cost increases related to remedying the breach.
Consider External Market Conditions
Almost all forecasts begin with historical financial results, but that's only a starting point. These days, you can't automatically assume current revenue and expenses will grow at a constant rate commensurate with inflation. Management needs to evaluate the marketplace for emerging external threats and opportunities. For example, health care providers need to anticipate how emerging government regulations, including the CDC and FDA guidance, will affect their future revenue and expenses.
Examples of other external obstacles that management can't change, but may need to factor into forecasts, include rising energy costs, evolving weather patterns, and changes to tax and labor laws. On the other hand, changes in technology — including the growing popularity of social media and smart devices — may create marketing opportunities that proactive businesses can use to their advantage.
Savvy managers watch how competitors are performing under the same market conditions. In an evolving market, the performance of competitors — especially market leaders — is often more meaningful than historical results.
Evaluate Forecasting Risks
Once you've developed your preliminary forecast for 2023, consider performing a sensitivity analysis to identify which components are most critical to your business's success (or failure). Sensitivity analysis starts with a base case scenario. Then assumptions are changed — one at a time — to see how the changes flow through the financial statements.
An input is more "sensitive" and, therefore, has high forecasting risk if a small change in the assumption has a large effect on the bottom line (or asset values). If the most sensitive variables in your forecast are also the most unpredictable, you may need to monitor the situation closely to minimize problems.
Forecasts vs. Projections
The terms "forecast" and "projection" are often used interchangeably. But there's a noteworthy distinction, according to AICPA Attestation Standards Section 301, Financial Forecasts and Projections:
Forecast. Prospective financial statements that present, to the best of the responsible party's knowledge and belief, an entity's expected financial position, results of operations and cash flows. A financial forecast is based on the responsible party's assumptions reflecting the conditions it expects to exist and the course of action it expects to take.
Projection. Prospective financial statements that present, to the best of the responsible party's knowledge and belief, given one or more hypothetical assumptions, an entity's expected financial position, results of operations, and cash flows. A financial projection is sometimes prepared to present one or more hypothetical courses of action for evaluation, as in response to a question such as, "What would happen if…?"
In a nutshell, a forecast shows expected results based on the expected course of action, and a projection shows expected results based on various hypothetical situations that may or may not occur. Your company may issue projections — which offer less of a commitment — if it's uncertain whether performance targets will be met.
Team Effort
Forecasts that employees perceive as dictatorial mandates are doomed to fail. Reliable ones are based on input from all functional areas, including finance, sales and marketing, operations and human resources. Cross-functional collaboration on forecasts can help you balance predicting demand with planning for supplies, catching errors and omissions, and achieving companywide buy-in.
Getting input from your financial advisor helps, too. In addition to providing objective market data, experienced financial professionals understand financial reporting and offer fresh perspectives that can breathe new life into your company's budget or business plan.
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