Using Simplifying Assumptions to Help Keep Business Projections Real

Business projections don't need detailed modeling to project tax rates and depreciation. You can estimate by using simple percentage assumptions.
Founder and Chairman, Palo Alto Software, Inc.
May 03, 2017

Almost all business owners understand that business forecasting and projections can be great management tools when used correctly. However, too many of us make forecasting harder for ourselves by blurring the significant difference between planning and accounting. Forecasts and projection don't have to be accurate down to the last decimal, like accounting does. With forecasts and business projections, you can use simplifying assumptions to help ease the process without losing the essential value.

(A quick note: Business forecasts and business projections are essentially different words for the same things. Some people say "budgets" to describe them, most often when the forecasts involve spending.)

Forecasts can be used to help run a business. Most businesses use sales forecasts to manage interconnections between sales, costs, expenses, inventory and staffing. They also have spending budgets and cash-flow plans to help manage their money. Careful owners may regularly compare actual sales, spending and cash in the bank to their forecasts in order to track results and make ongoing course corrections.

Planning Vs. Accounting

The trouble is that the forecasts and business projections we use in planning, often called "pro-forma statements," look almost exactly like the statements we get from accounting.

Many people misunderstand the difference between accounting and planning. Accounting starts today and goes backward in time in ever-increasing detail. It has to be right, down to the last penny. It's used not just to guide decisions, but to formally report results to the government for taxes and to other legal stakeholders. Accounting reports are summary reports of data from actual transactions, collected and organized into categories. The source data is all transactions.

Avoid giving in to the temptation to judge your forecasts and business projections by how accurately they predicted the future.

Planning, on the other hand, starts today and goes forward in time in ever-increasing summary and aggregation. Forecasts are predictions of the future, but they are never literally accurate. Forecasts are collections of estimates, normally estimates of monthly totals. There is no database of transactions.

That misunderstanding can lead to a special anxiety for some people who can't shake the accounting mentality when they look forward for projections. Since accounting statements come from a database of past transactions, people think they need to generate some imaginary database of future transactions, from which they are supposed to generate pro-forma statements, forecast or projections. And that's just way too hard to do.

Using Simplifying Assumptions for Your Business Projections

I've worked with people doing forecasts and business projections for decades as a consultant, advisor and software publisher. One tip I have is changing your mindset when it comes to forecasting. 

I think the goal shouldn't be accuracy; it should instead be getting it good enough to make ongoing decisions. You can expect forecasts and business projections to be wrong, but, even when wrong, still useful for managers to analyze results and make useful business decisions. Simplifying assumptions, like the ones listed below, can help make business projections and forecasting easier, without reducing their impact on good business decisions.

1. Sales forecast and expense budget

Most businesses' accounting systems record sales in a lot of detail, broken down into specific products, services, departments and subsets. 

But with the way humans deal with the future in forecasting, I suggest you summarize. Consider simplifying your sales forecast and expense budget to deal with major lines of sales (maybe five or 10 lines) and major categories of spending. That is about as much detail as is useful in forecasting. This is equivalent to the rows in a standard forecast spreadsheet, or in specialty software. Make sure that your summaries reconcile easily with the summaries your accounting produces, so you can track forecasts versus actual results every month.

Try not to sweat the details of depreciation or graduated tax rates in the expense budget. You can use a simplifying assumption for those. Set a tax rate at whatever it has been for you in recent years. Don't try to guess future assets and depreciation schedules in a forecast; just estimate depreciation as a single estimate for the year. Then you can base it on what depreciation has been in recent tax years.

2. Cash planning

Of course your cash forecast can be an essential tool. Most of the inputs for your cash plan come straight from sales forecast and spending budgets. Using some cash management simplifying assumptions can help with creating a cash forecast.

If you have sales on credit (and most B2B businesses do), consider estimating ongoing accounts receivable balances to account for their impact on cash flow. The more accounts receivable, the less money you may have in the bank.

Instead of trying to guess future payments client by client, or invoice by invoice, consider using a simplifying assumption. You could look at average accounts receivable balances for recent months, calculate that number as a percent of sales and then apply that percentage of sales to estimate future accounts receivable balances.

Inventory, for businesses that sell products, is also important to cash management. Avoid modeling future inventory item by item. You can simplify the calculation by calculating inventory as a percent of sales in the recent past, then apply that percentage to future sales to estimate future inventory.

Avoid giving in to the temptation to judge your forecasts and business projections by how accurately they predicted the future. You can judge them instead by how much help they provide in making good management decisions. A forecast that is wrong but has a transparent assumption and good tracking can be vital to the ongoing management decisions it causes.

Read more articles on accounting.

Photo: iStock

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Founder and Chairman, Palo Alto Software, Inc.