4 Top Tips for Better Financial Forecasting
As an entrepreneur with a new startup business, you’re often operating in a whole lot of uncertainty. Financially speaking, you will have to accept uncertainty and be comfortable working in an environment where forecasting can mean a large range of possibilities. That said, you can still take steps to create a better forecast and help plan your business activities and needs into the future.
The number one purpose of your forecast is to provide some predictability for yourself so that you can make good decisions. Before anything else, you should determine how you want to forecast. Accountants will often use accrual-based financial reporting which means that a sale or expense is recorded when you sell the product or perform the service, and not when the cash is received or disbursed.
Remember, it takes time to collect cash you are owed and likewise, often the invoices you will receive can be paid a month later. For a new business with no cash, you may want to create and focus on a cash-based forecast instead of an accrual basis forecast. As you grow, you should have both. For more cash flow forecasting tips, see my earlier article on Cashflow 101.
How To Build a Good Forecast
Get the right tools. You’ll need some way to easily make and change your forecasts. Starting out, the best option is a spreadsheet so get familiar with how they work. Using formulas and variables will greatly simplify your life so get to know the basics. Once you have some history of sales and costs, it may be time to upgrade to an accounting package such as QuickBooks. With its automated features and reporting capabilities, QuickBooks can help you create a forward-looking budget based on past trends.
Understand Your Business and What Drives Revenues and Costs (bottom up approach)
Start from scratch and use revenue and cost drivers whenever possible. A revenue or cost driver is a unit of activity that causes a change in revenue or cost.
As an example, let’s say your business produces shoes. On the sales front, your revenue driver is the amount of shoes you sell and the cost you sell them at. On the costs front, your cost drivers might be the amount of material and the cost of the material to produce the shoe. Other cost drivers are the number of hours it takes to make one shoe and the wage of the employees producing the shoes.
Cost drivers allow you to turn all your products and services into smaller components and attach a price to each. You can then make forecasts based on what you know about each cost driver on a monthly, quarterly, or annual basis. If you’re ever planning to seek investment, chances are an investor will appreciate how well you know and understand your business based on how well you define your revenue and cost drivers.
Adjust Forecasts Often
Adjust your forecasts frequently based on your experiences and results. While your first projection may be overly optimistic or pessimistic, you’ll soon begin collecting real information about sales and costs. Use the real information to update your assumptions about revenue or cost drivers. If you thought you would sell 500 shoes but you only sold 50, then update your forecast to something more reasonable until sales begin to take off.
Keep Forecasts Simple, Realistic and Useful
When starting out, keep things simple. Look at your core business and show the path to profitability. If things aren’t looking good, take some time to re-evaluate your drivers and make decisions that will help increase profitability.
Be realistic. No matter how great your idea, unless you are pretty unique you aren’t likely to get 10% of the known market in year one and 20% in year two. Making such assumptions might make you profitable on paper but rarely in reality.
At the end of the day, you want your forecast to be useful for decision making. Your forecast should tell you how profitable you may be and what variables need to change in order to become more profitable. Only once you know these performance indicators, can you take action through more sales, increasing a product’s price, or reducing costs. Factor in your forecasts when building your expansion strategy for new products or territories. Keeping a close eye on your forecasts will let you know if you’re moving too fast or too big.
The information in this article is for educational and information purposes only and should not be relied upon for decision making. Always seek the expertise of a professional advisor or accountant prior to making any decisions.