Financial Forecasting Best Practices – 7 Tips for Success
Financial forecasts are critically important planning tools. In creating the forecast, research into the profitability of current operations and areas of potential expansion are essential to success. Management teams may be working very hard but challenged to make optimal operational decisions without well-defined goals and objectives. Surprisingly, many businesses continue to operate without forecasts in place, either because of the time required to develop them or a lack of insight into the business value forecasts drive. For successful businesses, forecasting is not a luxury; it is a necessity. Here, we explore several best practices and tips that should be considered in developing forecasts.
1. Begin with the end in mind.
Effective business planning requires an understanding of the desired end game for the entity. Examples of potential end scenarios include selling the company to a strategic or financial buyer, raising capital to aggressively grow the business, or creating a lifestyle business for the company’s owners. Each of these desired outcomes require a distinctly different approach to cost structure, growth, and capitalization.
2. Prepare multiple forecast views.
Different elements of leadership will often have different views of how to grow the company. To assist in the reconciliation of differing expectations on what path to take or what an outcome will be, it is helpful to create more than one forecast view for discussion. If the company has one or more investors, their preferences must be considered as well. Diligently considering different scenarios promotes flexibility and is a hallmark of great companies.
3. Be conservative (but also plan for best and worse cases).
Often you hear discussion of a best case, worst case, and most probable case resulting from a forecast exercise. Once you have an understanding of the desired end outcome for the company and agreement on areas of growth, building a base case forecast using conservative assumptions is a common and practical place to start. That will likely become your most likely case scenario. Anticipating the downside risks and impact if the business fails to achieve even the base case goals is critical and generally supports a worst-case scenario. Ensuring you have the cash reserves and a plan for expense reduction is also important in considering a worst-case scenario. Conversely, many business leaders fail to understand the challenges that significant growth may have on cash flow and capital needs. Increased cash requirements are a common pain point when exceeding plan. It is important to anticipate that and negotiate flexible debt and other facilities to support it. It is great to have the increased revenue, but potentially fatal if the company cannot keep up with the required cash flow. Many other elements such as availability and cost of staff and materials are sensitive to scenario differences, but cash is one you absolutely have to be prepared for. On that point, make sure your forecast is accrual based and NOT cash based. Business icon David Packard famously stated that “More organizations die of indigestion than starvation.”
4. Top down / Bottom up.
Forecasts can be built from the top down (goals dictated by the executive team) or bottom up (growth potential and required support activities generated by operating units). Approaching forecasting both ways is recommended and ensures communication throughout the company. This approach generally results in a negotiated plan that all parties can support. A finance professional can create any scenario that one wants to see. That is a worthless exercise without a solid basis for the assumptions and buy in from the team that will be executing it. Engage your team in developing the optimal forecast.
5. Keep assumption to a minimum.
Forecasts are imperfect. Know that going in and be prepared to adjust the plan as the year rolls out. A general rule is that a good model will be within a 5% deviation up or down. Overshooting forecasts can be as bad as missing the numbers entirely as it speaks to how well one understands the market and business. Base your forecasts on solid history, research, and facts to the greatest degree possible and keep true assumptions to a minimum.
6. Don’t wander too far into the future.
Long range planning has its place and is important to our first point of keeping the end in mind. Most startup forecasts in VC decks include long-term “hockey stick” growth illustrations to convey potential to would-be investors. Investors, however, rarely put stock into them because any forecasts over eighteen months into the future carry too much variability and volatility to be effective in predicting or managing the business. Pairing a 3-year forecast for a board of directors and investors with an 18-month detailed operational forecast for internal management is usually a sound approach.
7. Roll with the punches.
All forecasts should be rolling forecasts – revisited and recast on a quarterly or sometimes monthly basis to avoid becoming stale and outdated as conditions change, markets shift, and opportunities present themselves. A proper forecast review rhythm ensures that the business will not get off track. Additionally, an effective rolling forecast requires strong accounting practices and processes so that reporting doesn’t lag far behind actuals.
Better Financial Forecasting
Running a business without forecasting is akin to flying blind. Financial forecasts are necessary to help identify potential future influences that can affect and shape strategies, policies, and goals. Applying the best practices summarized above will support the development of an effective financial forecast model. You may also be interested in this post on business budgeting considerations, or this post on finance considerations for year-end.
In summary, effective financial forecasting maintains an objective evidence-based link between an organization’s strategy and tactics. Forecasts should be revisited frequently and shared with key stakeholders throughout the company to promote dialogue and alignment. Perhaps most important of all, continually challenge your assumptions and their impact on the future periods of your forecast.
Are you struggling with these or similar issues? If you need help implementing these financial forecasting best practices, request a consultation today from a vcfo expert. We have worked with more than 5,000 business teams in our 25 years. We would love to talk with you, hear your story and concerns, and share our experience and collective wisdom to see how we can help.