A well-built structure relies on a solid foundation. This is obvious. What might not be as obvious is that a well-built financial forecast also relies on a solid foundation. What is the foundation of the financial forecast? Let’s start by examining what it is not.
A financial forecast should not start with a budget based on a chart of accounts. The account codes in a chart of accounts are not strategic enough to be useful categories for forecasting. And a budget, while setting targets, is not tied closely enough to the business plan to be a good starting place for a strategic forecast.
A solid financial forecast precisely reflects the business plan and the metrics that capture the financial goals of the business. The building blocks of a business’s story form the foundation of the financial forecast.
Building blocks for strategic financial forecasting
We know that the main components of a financial forecast are the revenue, direct costs, and expenses for a business, with the result being a measurable gross margin and net profit. With those in place, a forecasted cash flow is the final, crucial piece.
In order to properly forecast those basic items, we must know two things: the goals of the business owner, and what is reasonable for the business based on its own history and normalized industry standardards. Those two things combined should allow us to project forward a smart assumption of the business’s financial plan.
The goals of the business owner are determined during the planning stage—the “getting to know the business” stage.
During this stage, a good strategic advisor should be uncovering the business owner’s personal goals for the business, her notion of the business opportunity, the value proposition, and the sales and marketing plan to support it. Those things identify the goals of the business and lay out the value proposition.
History and benchmarks
The history and benchmarks set a baseline for what the business should reasonably be able to achieve. Using 12 to 36 months of history, the strategic advisor should determine the business’s unique patterns for revenue, gross margin, net profit, and ratios for major expense items to revenue, and then compare those to industry standard benchmarks for the same data. The objective here is to qualify the goals with real, historical data in order to arrive at a reasonable financial projection.
With these building blocks in place, the strategic advisor should have no problem laying out a financial forecast for the next 36 months. Beyond 36 months, a yearly or quarterly look is perfectly fine.
The following is a list of the building block numbers every solid financial forecast needs:
- Quarterly revenue targets
- Quarterly gross margin targets
- Expense to revenue ratios for major expense categories like sales, general and administrative, and indirect labor
- Quarterly net profit targets
Building the financial forecast
With the initial forecast built, the fun actually begins! No forecast is complete on the initial working. The gross margin and net profit probably won’t represent the ideal, desired growth plan for the business.
The strategic advisor works with the numbers, shifting expenses, direct costs, and maybe even revenue where necessary, to represent the ideal growth plan for the business. This growth plan should be one that represents the business owner’s goals, their value proposition, their sales and marketing plan, and can support a positive or neutral cash flow.
The end result then is not just a financial forecast, but a roadmap for the business. Management decisions should tumble out of the forecast as tasks ready to act upon. Is it time to place the inventory order for the new revenue stream? Time to hire a new salesperson? Time to purchase that new piece of equipment?
The financial forecast will tell you. All the answers are there—as long as you build it with a solid foundation.