A strong financial forecast is at the heart of any successful Strategic Advising relationship. Many people assume that reporting is the most important, but the forecast provides the roadmap, and therefore the basis for advisory services.

Reports and key performance indicators (KPIs) do provide useful information, but a rock-solid forecast provides the plan, and measuring it is how you can help your clients make better decisions. By comparing the forecast to the accounting actuals, and understanding the variance, you can help your clients identify problems in their business, which is what productive advisory services are all about.

Building a forecast requires balance

I love building financial forecasts! Truly. Not only are they a means to strategic planning, but the work is fun. It’s one part creativity, one part structure. There’s nothing quite like producing this roadmap for a business based on its historical performance, its needs, and its goals, and then adding a dash of hope (or guts, as some would say). All of that together becomes strategy.

If I allow myself to be cute, I might say: (reality + needs + goals) x vision = strategy.

I know, right? But there’s some truth there.

To create a great forecast, you have to start with the building blocks—the structure.

The structure of a forecast is comprised of the basic financial components: revenue, direct costs, expenses (fixed and variable), AR and AP timing, debt servicing and other assets and liabilities. The components of the profit and loss statement are usually completed first, and then if possible cash flow and balance sheet. Utilizing a cloud-based software application to sync with your accounting data and assist you with the forecasting calculations will make your job easier.

In order to properly forecast those primary components, a Strategic Advisor must understand the goals of the business owner, as well as what is reasonable for the business, based on its own history and normalized industry standard benchmarks.

Those two things are distinct and important, and understanding them will allow you to make smart assumptions. Always remember, at its core, a forecast is about assumptions. It’s not accounting, and it’s not budgeting in the traditional sense. Forecasting is making educated guesses about what is reasonably possible, and using financial modeling to turn the guesses into projections.Balance and Creativity

The creative process makes building a financial forecast very rewarding. You work within a framework of the client’s business model, but you also add your own financial instinct and know-how. Sometimes, your drive can push a business beyond where they thought they could go, and also help an owner understand the financial potential in their business. This is what makes forecasting uniquely different from budgeting. Budgeting is usually very conservative, and it’s much more granular. Forecasting is about potential. What’s possible? How can we get there?

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The primary steps to building a financial forecast

1. Understand the business owner’s goals

The goals of the business owner are determined during the planning stage—your “getting to know the business” stage.

During this stage, the Strategic Advisor should have a broad conversation with the business owner about their goals for the business. The goals include the obvious ones, like revenue and profit, but they also include their notion of the business opportunity, the value proposition, and the sales and marketing plan to support it. Those pieces will have a direct impact on the revenue potential for the business.

2. Keep the forecast reasonable through benchmarks and history

A business’s financial history and industry benchmarks set a baseline for what it 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 business owner’s goals with real, historical data in order to arrive at a reasonable financial projection. Seasonality is a particular trend to watch, as well as any other trends that form patterns.

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
  • Major fixed expenses like rent or debt servicing
  • Quarterly net profit targets
  • AR and AP average terms

With this knowledge, the Strategic Advisor should have all the information they need to develop a smart, and strategic financial forecast, piece by piece, beginning with profit and loss, and specifically the sales, or revenue numbers. Layer in direct costs next, and then expenses (fixed first, then variable). The whole time you should be monitoring net profit. Adjust the forecasted P&L where necessary to keep the net profit on target.

For most small businesses, a monthly forecast for 24 to 36 months is typical. Beyond 36 months, a yearly or quarterly look is perfectly fine.

3. Recognize that forecasts evolve over time

Once the initial forecast is built, the real 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.

With a basic forecast in place, the Strategic Advisor works with the numbers, shifting expenses, direct costs, and maybe even revenue where necessary, to model the ideal growth plan for the business. The 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.

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Depending on the business, it could take 3 to 6 months of shifting, and comparing forecast to month end accounting data, to arrive at a solid plan. And even then, by design, the financial forecast should evolve as the business grows and changes.

4. Use the forecast to grow the business

The end result is a true 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. It’s not a report about past performance or a static baseline budget. It’s a plan, and should be used as such.

I often liken this process to solving a mystery. And who doesn’t love a good mystery?! You have facts, clues, and evidence in the building blocks you’ve established by understanding your client’s goals and doing the benchmark research.

It’s actually a fun process to methodically work through the pile of information, building one bit at a time, asking the next logical question of the data set (and your client), until you have arrived at the best possible scenario: a financial forecast for this business. Not just any business, but this business.

Summarized tips for better financial forecasting

1. Remember, forecasting isn’t budgeting!

Forecasting and budgeting are two different things.

Budgeting is about setting limits on spending, usually at a granular level. Budgets are also for a shorter time span, typically yearly or half-yearly, and are not meant to be updated based on what is actually occurring in real time.

Financial forecasts are meant to be strategic, so they cover broad categories. Forecasts are meant to be updated regularly based on new information about the business.

2. Communicate with the business owner

In fact, my rule is: The business owner owns the sales forecast (often called the “top line”), and I own the expenses.

As much as possible, let the business owner predict and own their sales (revenue) goals, and then you help to ensure the expense side is realistic, using all the historical accounting data and benchmarks as a basis.

It’s their forecast, after all—it should reflect their goals. If their goals don’t pencil out, you’ll need to work with them on a version that does, but you have to flesh out their goals with them.

3. Always have a baseline

Know what they have the ability to do based on historical performance. Know what others in their industry do. Know industry standards like gross margins, burden rates, and ratios for major expense categories to revenue.

For instance, what is the ideal rate for SG&A expenses as a percentage of revenue in their industry? A good forecast is always grounded in reality.

4. Don’t forget about hidden costs associated with the growth

This is where your expertise from your profession and your intimate knowledge with their books really comes in. Use that expertise and that knowledge together to be sure everything is thought through.

If the client decides to take on a new revenue stream, be sure you help them think through all the new types of costs associated with it, and anything that might be unique for their business. Also, be sure you think about their resources and partners—who and what they rely on to run their business. Those add huge depth to a good strategic plan, adding revenue or saving expense sometimes if leveraged correctly.

5. Know when it’s time to update, and when you shouldn’t

This is crucial, and a skill developed over time, and with your clients. Know when it’s time to make an adjustment to the forecast, versus providing feedback and working with your client to change their business process.

For instance, if a revenue goal isn’t being met, be sure to work through all the reasons why before deciding it is unrealistic. If gross margins are off, dig into why. That’s where the advising part comes in.

6. Be mindful of price and value to your client

Be sure you’re setting up your tiered pricing to take into account the value of forecasting to your clients. Your firm can be profitable with this work for sure, but you have to charge for it, and be sure your clients understand the value it will bring them.

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Kathy Gregory

Kathy Gregory

Kathy Gregory has over 20 years of experience in business development, including: financial forecasting, strategic planning, process development, project management, and mergers and acquisitions. She has worked in public and private, small to mid-size organizations doing business development, and strategic planning and implementation, working with executives, boards and their investors. At LivePlan Kathy runs the specialized program for Strategic Advisors. She is a graduate of the University of Oregon.