Financial forecasts are one of the most important business planning tools, if not the most important planning tool available to a company’s managers. Without a sense of where you are expecting your business to grow (or shrink) over some period of time, it is unlikely that your management team will be effective in executing on the company’s plans. Too many times I have seen business leaders operate without forecasts in place, either because of the time required to develop a forecast, or the lack of insight that may exist into the drivers of business value. Forecasting is not a luxury for a successful business; it is a necessity.
When developing a forecast, there are several best practices that I highly recommend executives consider as they develop their models:
- Begin with the end in mind. Imagine trying to shop for a recipe without having decided what you plan on making for dinner. Effective business planning requires some expectation of what the end game will be: a sale of the company to a strategic or financial buyer, a capital raise to aggressively grow the business, or creating a lifestyle business for you and the company ownership. Each of these desired outcomes would demand a distinctly different approach to cost structure, growth and capitalization.
- Have multiple versions of your forecasts. Perhaps there is not a defined outcome that all owners agree on. Although investor alignment is extremely important for effective decision making, having options along the way allows management to redirect the company to potentially capitalize on market opportunities. There are strong arguments for “staying the course” in a business and as many for taking advantage of “game changing” windows. Considering all of the options available provides for flexibility, which is usually what differentiates good companies from great companies.
- Be conservative but also plan for the worst (and best). Building a base case that has “conservative” forecasts and assumptions is most common and practical. Having an understanding of what the downside risk is if the business fails to achieve its goals gives a view into how to weather “economic storms” more effectively. Conversely, not understanding the impact that hyper growth can have on cash flow and capital needs is where most business leaders miss the mark. One of my favorite business quotes comes from David Packard of Hewlett Packard, “More organizations die of indigestion than starvation.”
- Plan from above and below. Building a forecast can be done either from the “top down” or the “bottom up”; I suggest you create both views as a sanity check on the forecasts. I once had an analyst working for me develop a model that showed stellar growth and justified it with “conservative” assumptions. The team and the analyst were very enamored of the forecast until I asked for a market share view of the model. That view showed that the company would grow from <1% market share to over 30% of the addressable market in less than 3 years. That may have been possible; most likely it was unrealistic. We tapered the forecast down to a more reasonable market share target and ended up within 5% of our forecasts after that 3 year period.
- Keep assumption to a minimum. The one thing about forecasting that I always tell people is that I am 100% certain that the forecasts I build will be wrong. The trick is how wrong they will be. My mantra is that a good model should be within a 5% deviation up or down (overshooting your forecasts is sometimes as bad as missing the numbers entirely; it speaks to how well you understand the market and your business). To keep within that tight of a target requires fewer assumptions, not more. This may seem contrary to some. The more assumptions that are used to forecast, the more assumptions there are to be wrong. Save the mass assumptions for economic and profitability models; use macro level assumptions for an effective forecast to keep a strong hold on the potential variances without oversimplifying the models.
- Don’t wander too far into the future. When I worked at a Fortune 50 company, we created forecasts ranging from 12 months to 10 years. Long range planning has its place and is important in addressing Tip #1 above. Almost every startup forecast that I reviewed in venture capital decks includes that long term “hockey stick” growth; if you are seeking investors it is necessary to show that long range potential. However, rarely do investors put stock into them. The challenge is that any forecasts over 18 months into the future have too much variability and volatility to be effective for managing the business. I recommend having a 3 year forecast for a board of directors and investors with an 18 month forecast for internal management.
- Roll with the punches. All forecasts should be rolling. That means that unless the forecasts are revisited and recast on a quarterly and sometimes monthly basis, they can become stale and outdated quickly. Assumptions change. Markets shift. Opportunities present themselves. Having a proper review rhythm internally ensures that the business is not allowed to get too far off track from the longer term plans. An effective rolling forecast does require strong accounting practices and processes so that reporting does not lag far behind actuals. And don’t forget to recognize the difference between cash and accrual basis either (more on this for a future post.)
Bottom line for forecasting is to maintain the link between strategy and tactics and keep the forecast handy at all times. Share it with everyone in the company so there is alignment throughout on goals and objectives, both short and long term. And most of all, always challenge your assumptions.
Josh Tabin, the Technology Practice Manager in our vcfo Houston office, distills 22 years of operational and financial executive experience in this post.You can reach Josh at firstname.lastname@example.org.