Financial forecasts are built in part on best guesses. Planners and analysts combine recent and historical business performance with seasonal and business cycle trends to predict financial performance scenarios that can help leaders make critical strategic decisions, like whether to expand into new markets or spend on major marketing campaigns. Forecasting is a scientific discipline, but ultimately, past performance cannot predict future outcomes, requiring decision-makers to embrace some degree of risk when using them to inform long-term plans.
This challenge compounds during economic uncertainty. Underlying assumptions about the stability of the macroeconomy or the buying power of suppliers can be unreliable. Moreover, the appetite for business risk often shrinks within a contracting economy, layering additional uncertainty on the reliability of the forecast.
Nevertheless, your business needs to plan for the future. To adjust your forecasts to better reflect periods of uncertainty, consider reweighing your variables, expanding the cases you plan for, and bringing in members across your organization to get the clearest possible picture.
Elements of a Financial Forecast
When building financial forecasts, you start by looking at your past business data and trends to anticipate how your position will change for financial metrics like cash flow, expenses, profits, assets and liabilities.
“A forecast basically incorporates budgeted plus actual results of an organization to provide a direction of where the company is going,” says Kirsha Campbell, CPA and president of The Boutique Accounting. “When used correctly, it is very useful for being able to change strategy and implement innovative decisions.” The standard elements for a financial forecast include:
A Forward-Looking Time Horizon
A 12-month horizon is common, but you may need to look multiple years in the future to help with large financial decisions, like business investments.
A financial forecast is always lined with uncertainty. After all, business and economic environments are never free from change and unknown circumstances.
—Kirsha Campbell, president, The Boutique Accounting
“Most businesses employ some variant of autoregressive forecasting, which means the forecast is based primarily on historic trends,” says Bryce Bowman, founder of People 1st Advisors. “For instance, if sales have historically grown by 5% each year, then a true autoregressive forecast would result in 5% forecast growth for the next year.”
You should also consider your industry as a whole. What’s the total possible market? Do you have a competitive edge versus the industry? “Be aware of the environment your business operates in. What are the factors that affect your business, your buyers and your suppliers?” says Campbell.
A Reflection of Your Strategic Choices
The model should also reflect your upcoming business decisions. Will you be more aggressive with investments? Cutting costs? Trying to improve margins? These changes should be part of your model assumptions.
The Trouble with Uncertainty
While those elements worked well in normal conditions, the pandemic has thrown a wrench in the system. As you can imagine, past trends are likely no longer applicable given the strange year. “The global pandemic resulted in unexpected shifts in consumer demand, which made it nearly impossible to use historic data to forecast sales,” says Bowman.
While the economy has begun to recover and vaccines are being distributed, Bowman still warns that business owners should anticipate other pandemic related swings. It’s also hard to forecast far into the future, 12 months and beyond, given all these possible dramatic changes in the near future. As a result, business owners need to rethink their approach for forecasting.
Ways to Adjust Your Forecast
While managing uncertainty won’t be easy, there are some strategies you can use to get more out of your forecasts:
Create Multiple Scenarios
One way to increase your chances of being right is to make multiple forecasts: one optimistic, one neutral and one cautious for your predictions. That way you can start thinking how your business would react to each one, versus predicting one scenario and scrambling when it doesn’t happen.
Review the Latest Data and Trends
As noted, past market data and trends may no longer apply. Track the ongoing results for your own business and update your forecasts as necessary. For example, you could see how much your sales have changed this year and you could use that growth rate for your model, versus historical trends. You should also watch industry news to see how market trends have changed.
Update More Frequently
“The days of 12-month fiscal plans are over,” says Ben Richmond, country manager at accounting software company Xero. He recommends checking your results and updating your forecasts monthly and even weekly to see what way the numbers are trending. “You should have your positive scenario and your doomsday scenario and constantly be asking yourself: Why one am I tracking towards?”
Consider Which Factors Are Impacted by Pandemic Issues
The pandemic had a much larger impact on some issues than others. Consumer demand has taken a big hit, whereas other parts of your financial statements, like long-term debt costs, may not have been impacted as much. Take this into account for your forecast.
Prioritize the Most Important Metrics
Given that forecasting is more challenging than ever, you may want to simplify your forecasts by concentrating on the areas that are most important to your short-term success. Is it sales? Lowering capex to free up cash? Improving profit margins? Aim to make these forecasts as accurate as possible even if it means less time analyzing others.
Make It Collaborative
As you put together your forecast, consider meeting with leaders from other key departments besides finance, including sales, marketing, supply chain and HR. They could give you on-the-ground insights to help make your numbers more accurate.
An Effective System for the Future
While the business landscape has been challenging, this won’t be the only time you need to deal with tough modelling conditions. “A financial forecast is always lined with uncertainty. After all, business and economic environments are never free from change and unknown circumstances,” says Campbell.
That’s why developing these habits and understanding how to manage uncertain conditions will help your business forecasting today as well as in the future.
Photo: Getty Images
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