For nearly every client we work with, we create or maintain a forecast. In fact, we often recommend creating or updating a company forecast as the starting point of a client engagement. It’s a great way to come up to speed on a company while providing a clear deliverable and a chance to gauge the working relationship. If you’re thinking about hiring a part-time CFO but unsure of how to start, reach out to us about reviewing, creating, or updating your financial model.
This is the first of 2 blogs on forecasts. This blog discusses the many essential benefits a forecast provides, the second in this series describes the best practices in creating one.
A Forecast is a Dashboard for Your Company
Trying to steer your company without a forecast is like driving a car without GPS or a dashboard. You might get to where you need but you will be traveling with uncertainty about whether you’re on the right path, when you’ll arrive, or have enough fuel. Though the most basic output of a forecast is showing what you expect revenue, expenses, and cash flow to be, the benefits of a well-constructed forecast go well beyond those deliverables.
A forecast should project financial statements by month for at least the current year. It will include and dynamically connect an income statement, balance sheet, and cash flow, commonly referred to as 3 statement model. It should also extend the projections out for at least 2-3 years though those years might be presented on a quarterly or annual basis. Ideally, it includes historical financials which is useful in looking at trends. Though the next blog will discuss best practices in building a model, it’s important to mention that the model should clearly lay out key assumptions. Formulas should be tied to those assumptions so you can easily change them and do “what if” analysis.
Forecast Benefits and Deliverables
The most obvious benefit of the forecast is it projects your financial performance helping to answer critical questions such as whether you have enough cash and how profitable you project to be. For businesses whose sales vary significantly during the year, whether due to seasonality, growth, or the impact of non-recurring revenue, a monthly forecast can identify swings in cash flow and profitability in a way that annual numbers or historical financials alone can’t.
The forecast supports decisions such as how many people can you hire, whether you need to raise money or can afford to pay dividends or distributions. It can be the basis for setting departmental budgets or targets for incentive compensation plans. For multi-year forecasts, it can provide a roadmap for key milestones such as product releases, marketing campaigns, or key sales closings.
If you have outside investors or creditors, they likely will require projections. In addition to giving them visibility on your company’s numbers, the forecast is a communication tool. It lays out in hard numbers, as opposed to anecdotal terms, what your goals and how you plan to reach them. It allows your investors to track your progress and hold you accountable. When well designed with clear assumptions, it will also communicate what metrics are key and what the risks are.
In addition to financial statements, because the forecast will contain nearly all of your key numbers, you can build in a wide range of analytics and reports. Often these can be on separate tabs but connect directly to the model so that they update automatically as the forecast model changes.
Dynamic, Living Document
The forecast should also be a living document that is updated regularly as opposed to an exercise done, say, to set an annual budget. Ideally, it should be updated no less frequently than monthly. For example, if you prepare a forecast for a calendar year by month, once January financial statements are available, overwrite the projected numbers for January with the actuals. Then revise your projections for February-December so you get the most current view of the rest of the year as possible.
In addition, it can be extremely helpful to compare actuals against your original forecast. Variances can be due to timing, missed targets, changes in circumstances, or simply something that was missed in the original forecast. Digging into these variances can identify where performance needs to be improved, cost reductions needed, or ways to improve the forecasting process.
Dealing with Uncertainty
You might ask how, if the forecast is always changing, can you do a meaningful comparison of actuals against forecast. Our recommendation is to consider the original forecast a “Benchmark” or “Budget” and the current, latest, and greatest, the “Forecast” or “Rolling Forecast”. The latter means you’ll always have the most current outlook on your business, but the former means you don’t lose track of what targets were originally set or communicated.
Some people ask whether given the uncertainty in forecasting it is worth making the effort. Similarly, if budgets become obsolete, was the effort to create them a waste of time? Absolutely! If you make no effort, you will be flying blind. It is also a learning process and as you repeat it, you will get better at forecasting as well as learning what types of variables can impact your business. Finally, if a Budget or Benchmark does become unrealistic you can replace it with a more current Benchmark. Though not something you want to do frequently, plans and circumstance do change and no reason to track variances against a budget that is clearly out of date.
Another common question is whether you should build multiple forecasts, say best, middle, and worst cases. Our recommendation is to always look at multiple scenarios, especially to gauge where key risks are and what the possible impacts would be from missed targets or unexpected changes. However, when reporting to investors or setting employee targets always settle on a single plan.
Finally, you will find that the forecast file can be a valuable repository of key data and history, especially after you have worked with it for a while. You will find you add analyses over time and build history on financials, headcount and key metrics. This makes the forecast file a key and quick reference document.
In our next blog, we will cover best practices in building a forecast.
Perron & Low has been working as part-time CFOs for more than 25 years because we believe we are a great fit for smaller and emerging companies that can benefit from financial expertise without the cost and lengthy recruiting process that a full-time CFO requires. If you think a part-time CFO could be a fit for your company, please contact us at info@perronlow.com. As this article describes, building or updating a forecast can be a great place to start.