Many businesses are preparing to enter a new financial year.  As they do it is worth thinking about the importance of the financial forecast.

It’s primary role is to predict whether the business will have enough cash to keep going during the year to come.  And, as such, it is a vital source of information for business owners, lenders and investors.

Of course, it must be as accurate as possible.  But to be accurate you need to think of forecasting as, not just making financial projections at the start of the year, but as an exercise that you apply all throughout the year.

So, as we approach a new financial year, here are a few tips to help you to forecast as accurately as possible.

1. Forecast revenue, and budget costs.

Start by forecasting revenue.  Once you are as clear as you can be about your revenue forecast, you can then budget your costs in order to bring them in line with your revenue.

Many businesses use the words ‘forecast’ and ‘budget’ inter-changeably, but they mean different things.  Revenue depends upon factors many of which are out of your control (e.g. the economy).  So, a bit like the weather, this is something to be forecasted.

But expenditure lies very much within your control.  This is something that you can therefore budget for.  And by keeping your expenditure budget in line with your revenue forecast you can exercise control over how much cash you have in the business.

2. When you forecast revenue, use several scenarios.

Imagine you run Mrs Miggins chain of Patisserie and Coffee shops.  Your biggest ‘drivers’ of revenue will be the number of people who come into your shops and the amount they purchase.  Last year’s footfall figures will be helpful, however they can’t be used in isolation.  The local town centre may have changed, you might have a marketing campaign lined up, plus a new on-line service.

So it’s important to think about the ‘sales funnel’ and the ‘social media funnel’.  E.g. for sales in the shops:

  • Start by researching the size of your realistic market (the number of people who could be in walking distance of one of your shops plus the number of potential customers you are reaching out to with your marketing campaign).
  • Estimate the proportion within each group likely to walk into one of your shops.
  • Estimate of the likely purchases each group will make and the number of times they might return to repeat the purchase.

And, for the social media funnel, very much the same:

  • Start with the size of the on-line audience likely to see your advert;
  • Estimate the proportion likely to click to find out more;
  • Estimate the proportion of this group likely to purchase.

Taken together, this should bring you to an ‘expected value’ for revenue for the year.

That’s a good start, however, it’s a calculation based upon a series of assumptions, some of which might be overly-optimistic or overly-pessimistic.

So, it is worth listing out all the assumptions that you have made (e.g. the size of each realistic market) and, for each, provide both an optimistic estimate and a pessimistic estimate.

Repeat the forecast calculations using both sets of estimates for each assumption.

You should end up with a range of forecast values.  The number at the top of the range represents the most optimistic view of the year ahead.  And the number at the bottom, the most pessimistic view.  The expected value is still your forecast, but the size of the range indicates how much confidence you can have in that value.

If the range is large, revisit each of the assumptions involved and gather as much intelligence as you can to refine the numbers involved.

3. Create an expenditure budget.

With a revenue forecast in place it should be much easier to predict your expenditure.  Firstly, some costs (e.g. product costs) will be closely linked to your drivers of revenue.  Others will be relatively fixed, e.g. premises and equipment lease costs.

Start with a budget that reflects the most pessimistic view of the year, and then add to it the additional expenditure required should the year turn out to be better.  This will help you plan ahead to delay spending in more discretionary areas should unforeseen circumstances strike and the year turns out to be less favourable than you had hoped.

4. Keep a note of all your assumptions, and check for credibility.

The forecast needs to be maintained as the year progresses.  It helps therefore to always keep a note of your assumptions handy, and whenever an unexpected event happens (bad weather, regulation change, transport disruption) check to see whether your assumptions still hold true.

If they don’t, then work through the forecast again, but this time with a revised set of assumptions.

There will also be key ratios that relate to your business, most of them financial in nature.  E.g. revenue per square metre, gross margin per customer, stock turnover, mean order quantity.

Once forecast and budget are in place, calculate these ratios for the year ahead and compare them with other businesses within the sector, and with past performance.  If they seem to be out of line, check your assumptions once more.

5. Regularly re-evaluate.

Every month or every quarter throughout the year compare your actual revenue and expenditure with your forecast for that point in the year.

If there is a sizeable difference in either revenue or expenditure, either positive or negative, investigate why and be prepared to re-forecast.

This is when the discipline you exercised when creating your first forecast will reap benefits.  If the exercise had remained at a very high level and didn’t involve analysis of the drivers of revenue and cost in the business you will find it hard to know what to do when gaps between forecast and actuals emerge.

However, if you have that depth of understanding then differences between the forecast and actuals can be highly instructive.  Your existing assumptions might need to be changed.  Or you might have experienced events that you hadn’t planned for.  Either way you will be equipped to figure out what their impact means for the remainder of the year and you will be able to adjust your expectations accordingly.

In othe words, you will be maintaining a highly relevant and accurate forecast.

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Paul Clarke
Director
Develin

Paul is a presenter on the professional development programmes for BPP, CIMA and ICAS on subjects ranging from forecasting analytics and budgeting practice to data visualisation and machine learning.  He is also a Business Intelligence specialist providing Management Information and Business Intelligence solutions for organisations across all sectors.

If we can help you to develop your budgeting and forecasting practice, in developing financial models to support your strategic planning, or in making better use of data with which to predict the future, then please contact us:

T:  +44 (0)333 8000 825
E: paul.clarke@develin.co.uk