Planning is a continuous process; everyday business owners create and adjust short- and long-term plans. Short-term plans are tactical in nature and are designed to adapt to normal operational challenges and opportunities. Longer-term plans, because they are more strategic in nature - like whether to expand operations, purchase new equipment, or hire more personnel - requiring decisions that could have major financial implications for the company. Financial forecasting is often the key to making smart business decisions.
At the simplest level, financial forecasting is based on assumptions and estimates. Sales forecasts, production forecasts, and cash forecasts are some of the most commonly-used financial planning tools. The goal is simple: by analyzing historical data and market research, and making a few key assumptions, financial forecasting is used to create plans for the future of the business.
The Importance of Assumptions
While data is important, making some assumptions is required. Since no one can predict the future, the models created rely on assumptions about what may happen: whether sales will increase or decrease and by what percentage; whether labor, materials, costs, etc., will increase or decrease and by what percentage; whether interest rates and the availability of capital will fluctuate, etc.
Assumptions are educated, informed, and directionally-accurate "guesstimates.” Many companies build financial forecasts using a variety of assumptions, taking into account different levels of projected results. For example, a sales forecast could be built showing a growth in sales of 5%, 10%, 20%, or even reduced sales of -5% or -10%. The key is to model different scenarios and gauge the potential impact on operations and on financial performance - assumptions are a necessary part of building those models.
While existing businesses can rely on historical data that can, in part, indicate future results, new or start-up companies are forced to make a number of assumptions. That's why a comprehensive business plan based on a broad range of financial models is so critical.
The most basic assumption is usually future sales.
Sales drive a business - without sales, there is no business. The sales forecast attempts to predict sales so that other operational requirements can be determined. In order to estimate sales, most companies look at sales histories and other known factors that can influence future sales. For example, market research could show that several competitors have dropped out of the marketplace, making increased sales possible. On the other hand, the company may have decided to drop an under-performing product line, ensuring that sales will dip, at least in the short-term.
After data is collected and analyzed, sales volume is predicted. Often, companies also include projected price levels in the sales forecast, since price has a dramatic effect on profitability. Most companies develop several sales forecasts based on incremental changes in anticipated sales. A "target" sales figure is used to drive most other models, but plus/minus sales figures can also be used to model the effect on operations. For example, a projected 10% growth in sales could be accommodated by current production capacity; if sales grow by 20%, more capacity will be required, allowing the company to create proactive contingency plans in case sales exceed the forecast.
Again, accurately predicting the future is impossible. The sales forecast is simply the company's best estimate of future activity and, in most cases also serves as a goal for the company. Even though the sales forecast does require at least some amount of guesswork, without a sales forecast there is no real way to create estimates for other operational needs - like production.
The production forecast is based primarily on assumptions made in the sales forecast. The first step is to build a production plan based on anticipated sales. Doing so is relatively simple, since a good sales forecast predicts sales volume by month or even week. Using sales volume as an assumption, a production forecast is built to meet demand. If capacity is flat but sales volume includes spikes, a production plan could be developed that creates excess inventory to meet seasonal swings in volume, or the company could plan to use overtime or to outsource certain services to meet demand.
Once the production forecast is developed, other operational plans can follow: whether new equipment is needed, if/when new employees are required, the timing of materials and supplies purchases, etc. Costs can then be determined, and profitability can be evaluated - again, all based on a few key assumptions.
In effect the sales forecast and the production forecast create the foundation of a budget. Think of it this way: if you know sales volume and prices, and you know the costs of producing, marketing, and distributing what you sell, then you have created a blueprint for operations and financial performance.
The cash forecast is an estimate of future cash inflows (revenue) and outflows (expenses). Once sales forecasts and production forecasts are complete, the timing of many expenses is known: Wages, supply costs, utility costs, etc. The sales forecast should also provide a prediction of sales and therefore revenue. The cash forecast creates a breakdown of revenue and expenses by time period to show whether the company will have sufficient funds on hand at any given time to meet operational needs.
For example, due to anticipated volume swings the company may need to ramp up production in August, purchasing greater than normal levels of materials and supplies and working heavy overtime. Sales of the items produced will not occur until October, and payment for those items will not be received until November. As a result, cash flow could be a major problem, requiring the company to borrow money to cover operating costs or to draw funds from cash on hand.
Without a sales forecast, production forecast, and cash forecast, that type of financial and operational planning would be impossible, and the company may not have sufficient funds to meet sales demands.
A few things to keep in mind about financial forecasting:
- Forecasting is based on historical data and educated guesses. If the market changes significantly, historical data and "accumulated wisdom" will be of little use in predicting future events.
- Forecasting is based on assumptions; always develop a variety of forecasts based on different assumption scenarios and create contingency plans for each scenario.
- The longer-term the forecast the more inaccurate it will usually be. Nothing is certain but change - especially over the long term.