The most valuable companies in any industry earn above average profits, grow at least as fast as others in their market, and demonstrate that they can predict their results based on a set of reasonable assumptions about market conditions.
Unfortunately, many lower middle market and smaller companies do not attempt to forecast their future results, thereby missing a great opportunity to determine what really drives results in their business.
In preparing a forecast of future results, we believe the value of the process is as important as the output. To predict the future, you must make assumptions. Improving your accuracy and becoming more comfortable with your assumptions requires the hard work of really understanding your business, and that will make your business better.
We highly recommend establishing an annual process in which you forecast your results for the next two to three years and then review and adjust the forecast at least semi-annually.
8 Benefits of Preparing a Financial Forecast
You’ll know what to measure
It seems irrational, but many business owners do not analyze their revenue streams in sufficient detail to know which products and services truly drive their financial results and why customers buy those products and services from them.
All revenues are not created equal. Some products and services generate big revenues but produce poor gross profit margins and therefore consume an outsized portion of administrative costs. Businesses that focus on the things they do well and forego “chasing” revenues in other industries or far-away markets tend to be more profitable.
Conversely, some businesses fail to emphasize certain areas of their business until they truly realize how potentially profitable those areas could be. For example, we have seen engineering companies that were reluctant to perform procurement services for their customers or only charged modest pass-through mark-ups of 3% to 5%, which in some cases did not cover their costs. Often, companies adjust their strategies after seeing how other firms have embraced the procurement function to generate much higher gross margins.
You’ll know what you need
Too often, business owners set a growth target without thoughtfully considering the implications of the target. Such implications may include:
• how many new people will need to be hired
• education and experience new hires should have
• what training new hires will need to receive
• what new software tools and/or support from third parties may be required
By determining not only the growth goal itself, but also the resources required to meet the goal, you’ll be able to create an action plan for success. That plan will include initiating the hiring process, creating training programs, and engaging third-party resources well ahead of the need. When owners fail to initiate these supporting activities, the ability to achieve the growth target is delayed, or unfortunately, sometimes even abandoned.
You’ll know your capacity
Similar to #2 above, creating a forecast of future results will require you to think deeply about your physical facilities and their available capacity. This includes warehousing and production facilities, as well as work space for support and service professionals.
By considering these issues in advance, you’ll have the opportunity to reconfigure space. You may also replace older and larger equipment with new equipment that provides higher outputs and a smaller physical footprint. Sometimes it is necessary to reconfigure office furniture or create personnel policies that allow telecommuting and/or adopt “hoteling” for generic office space.
Initiating LEAN processes in your manufacturing, service delivery, and/or back office functions may help you streamline your space.
If all else fails, you may truly need to secure new facilities and plan an expansion or relocation.
Regardless of the outcome, thinking through these issues as part of your annual planning process insures that your growth will not be limited by your inability to produce more products and services in your current physical space.
You’ll know what’s not working
When you allow your business to roll along from month-to-month and year-to-year without evaluating what is and isn’t working, you’ll inevitably find your company supporting old initiatives that have run their course or never really worked in the first place.
Taking the time to determine the revenue produced by (and more importantly, the contribution to gross- and net profitability of) various pieces of your business will help you determine you’ll know what needs to be re-energized or maybe even abandoned. It’s a good practice to use the annual process of preparing a financial forecast as an opportunity to act on those products and services that are not working.
The process also includes examining your customer list for “D” level customers, who take all your time but produce few profits.
You’ll know what you don’t know
As you identify your business’s key drivers of revenues and profitability and the resources it takes to generate those results, you’ll inevitably discover gaps in the availability and/or quality of your data.
For example, you can’t determine whether a product or service is profitable if you don’t have adequate cost accounting information available.
Going through the process of preparing a financial forecast will enable your company to change processes and to gather data that will be valuable for the future.
You’ll know how much money you’ll need
Your forecast of future results shouldn’t be limited to just your income statement. You should also create a projected balance sheet to understand the implications of your growth plan on working capital and capital expenditures.
For example, if you believe there is an opportunity to increase the revenues of a part of your business by 25 percent, you may need to expand your line of credit in order to support the resulting growth in inventories and accounts receivable. It’s much better to alert your banker of this need far in advance than to wait until the day before you have a payroll you cannot meet.
Begin laying the groundwork with your banker as part of your planning process. This way, if you sense your banker will not be supportive of your plans, you will have time to address those items that are giving your banker pause or to search for a new banker with a different appetite for lending.
You’ll know what’s costing you
Like unprofitable products and services that tend to continue if left unattended, administrative costs such as selling, general, and administrative expenses tend to continue (and even to grow) over time if left unchecked.
In companies that have failed to comb through their overhead expenses, we often find abandoned utilities contracts for space no longer owned or leased, services such as mobile phone contracts or connectivity or cloud computing services which are no longer being used, or benefits being paid on employees who are no longer at the company.
Other examples of excess costs include continued attendance at trade shows that are no longer relevant, rental equipment that is no longer used but has never been returned, and personnel who support now abandoned product or service lines, or whose responsibilities have shrunk or have been automated over time.
By looking closely at these expenses and at the underlying business purpose of each expense as part of your annual planning process, and by implementing frequent check-ins during the year, you’ll ensure that administrative costs remain relevant and do not grow out of control over time.
You’ll know how to approach growth
The primary strategy of your annual forecast relates to how you’re going to achieve your goals, particularly your revenue growth goals.There are three primary ways to grow the revenues of any business:
1. Secure your fair share of the growth in the overall market for your products and services – i.e. the tide in your industry is rising, so all market participants are (or should be) growing.
2. Take market share away from your competitors. To grow in a flat market or to grow at a faster rate than your competitors, you will have to take business away from them. This is typically accomplished through identification and effective marketing of product and service differentiators.
3. Acquisition of additional market share. This is similar to taking market share from your competitors, but instead of competing for (and winning over) your competitors’ customers, which typically takes a long time, you purchase your competitor and increase your market share all at once, hoping to achieve a return on your investment through future cash flows from those customers.
Developing an approach to these strategies is pivotal to how you will run your business in the future. Often business owners have a desire to grow quickly, say at 10 to 15 percent a year for the next three years, but they do not consider that their market is only growing at three percent.
Developing a strategy to achieve this additional growth will guide your actions and help you understand the implications on your headcount, facilities, and working capital.
There are many barriers that keep owners from creating an annual forecast. Many owners claim they do not have either the time or the financial personnel who are sufficiently competent to tackle the process. One of the primary barriers is fear. Leaders do not want to be wrong, and a forecast, by its very nature, will not be exact. However, many leaders (especially the successful ones) also recognize the tremendous benefit of overcoming that fear, planning for future success, and moving closer to their desired financial goals.