Financial forecasting is a rarely enjoyable, yet critical practice when running a business. If you are managing a small business of your own, this chore likely falls to you personally. Financial forecasters must walk a fine line between excessive optimism on the one hand, and over-cautiousness on the other. Both of these extremes present their own risks: in the case of the former, you will leave yourself unprepared to face any setbacks or unfortunate events that may occur; in the latter, you may undersell your business to such a degree that it is unattractive to lenders or investors.
Your financial forecast works like a compass, keeping your business on track for success. Not only that, but it is a reflection of both the business itself and your abilities as a planner and a doer—two things that will be of interest to investors and lenders. Above all, financial forecasts should be realistic, and here are a few tips to achieve that desired accuracy.
ANTICIPATE THE WORST, AND HOPE FOR THE BEST
There’s no use forecasting for the easiest situation—i.e. if things were to continue as they are now. Of course, that requires the least amount of critical thinking, but it is also likely the least realistic scenario. Things will change. In the next one, three or five years, the government will pass new legislation, businesses will open and close their doors all around you, bus routes will change, apps will appear . . . any number of things could have a significant effect on your earnings and expenses. You should forecast for the best and worst case scenarios, as well as the likely in-between.
Forecasting for all conceivable scenarios will give you the deepest understanding of your financial situation, as well as prepare you to answer tough questions that may be posed by investors when they’re assessing your business.
BEGIN WITH EXPENSES
Our imaginations tend to run wilder when it comes to revenue than expenses, and costs are therefore a great place to start. Rent, utilities, advertising, salaries, communications—these are basic costs that your business will incur for, well, as long as it is in business. Start with these fundamental expenses to get a solid base for your forecast; these will be some of the most reliable figures in your forecast, and you might as well have a solid foundation.
Next, you can move to variable costs, values that will shift substantially based on performance or other factors. These expenses should include things like labor costs, cost of goods sold, supplies, customer service, and packaging. You should forecast these values according to your three scenarios.
CHECK YOUR RATIOS
There are several financial ratios that are useful for checking the reality of financial forecasts. These are helpful tools to strip away hopeful thinking and doubts to reveal the bare figures.
- Checking your gross margin ratio (gross profit over net revenue) is particularly useful for checking your best-case scenario. Seeing the ratio jump remarkably from one scenario to the next may suggest that your estimates need refinement.
- The acid-test ratio, or quick ratio (liquid assets over liabilities) is a great way to check your business’ ability to survive your worst-case scenario.
IF YOU’RE NOT SURE, ROUND UP
Forecasting is exceedingly difficult to get exactly right, especially if you are new to the process, or to business in general. There are certain expenses that even seasoned business owners routinely underestimate. Therefore, if you’re not sure about a certain expense, it is always better to overestimate than underestimate. In particular, marketing, advertising, licensing, insurance, and legal fees are particularly fickle and elusive—play it safe and double your estimate for these values to ensure that you budget accordingly.
MAKE YOUR ASSUMPTIONS EXPLICIT
In a financial forecast, you are calculating figures based on considerable amounts of conjecture and assumption. Factors that we routinely assume will behave as we expect are overall market performance, competitors, regulations, and technological advancement. When consulting your forecast in the future, you may subconsciously take numbers associated with these elements as absolute fact in order to justify costs or free up assets for a particularly attractive purchase. Don’t allow yourself this potentially destructive fallacy.
Make notes about your assumptions to clearly identify them as such. This will save you a lot of grief brought on by misinformation. It will also provide investors with a clearer impression of your finances, as well as assuring them that you are an aware and pragmatic leader.
REVIEW AND REASSESS
Financial forecasts should not be expected to remain unchanged once finished. In fact, they should never truly be finished at all. Your financial forecast will begin with many unknowns and assumptions (hence the multiple scenarios), yet through regular review, reassessment, and revision, those assumptions can gradually be firmed up, or otherwise slashed completely. Your business is dynamic, and your forecast should keep pace. The best way to keep your financial forecast realistic is by keeping it up to date. Fill in the blanks as they become apparent. You should aim to revise your forecast at least once per quarter, though you may also wish to do so after any relevant major occurrence.
Again, this will not only improve the accuracy of your forecast, but it will also assure investors and lenders that you are on top of your finances.
Financial forecasts do become easier with experience, and your estimations will prove more accurate over time. The accuracy of financial forecasts relies in no small part on the ability to spot upcoming change, as well as an understanding of costs associated with all areas of business, and these are things that come only with hours logged.
It is said that it takes 10,000 hours of practice to become a master of something—anything—so if you want to master financial forecasts, you should strive for frequency. Not only will this practice improve your accuracy, but forecasting more frequently, in the beginning, will also give you chances to catch errors and inaccuracies quickly!