Where’s your business headed?
Many owners, including those who own large companies, don’t invest enough time in answering this question.
If you’ve had success as a business owner, you have a sense about what you need to do to generate sales and turn a profit. However, the best way to maximize your business results is to create an annual budget, that budget should include forecasts of expected outcomes.
Why It Matters
Forecasting your business results requires a detailed look at your company operations, and the assumptions you’ve made about key variables in your organization.
Consider these reasons for business forecasting:
- Profitability: Forecasting helps you to create a realistic plan for reaching profitability. The work it takes to forecast your sales, costs, and profits make your plan more precise and achievable.
- Capital needs: Capital is the money invested in your business to purchase assets. Assets refer to a resource used to generate revenue (sales). Cash is an asset, along with fixed assets, such as machinery and equipment. You can create a forecast to determine the assets you’ll need to operate your business, based on predictions you make about your level of sales and costs.
- Stakeholder reporting: A stakeholder is a company or individual that is impacted by your firm’s financial results, and stakeholders need to know where your company is headed. Creditors want to know if you’ve created a plan to operate profitably because you need profits to repay a loan. Investors, on the other hand, want to own a company that can generate a profit, so that their investment increases in value. Creating a budget with detailed forecasts will help to satisfy the concerns of stakeholders.
Make the commitment to generate business forecasts, so that you can address each of these issues.
Three Key Forecasts
There are three types of forecasts that every business should generate during the annual budget process: income statement forecast, balance sheet forecast, and a forecast for cash flow.
Each forecast relates to a financial statement that your business should generate both monthly and yearly.
Let’s assume that Sally operates Sunrise Landscaping and that she is creating a budget for the upcoming year. In order to create a useful budget, Sally generates these forecasts:
- Income statement: The income statement is based on this formula: (revenue – expenses = net income, or profit). To forecast the components of the income statement, Sally thinks about the price she charges for a particular service, like installing a flower bed and the costs related to that service She also estimates the total amount of sales for the year, based on her industry experience and prior year results.
- Balance sheet: The balance sheet formula is (assets-liabilities = equity). Sally’s decisions about the income statement forecast impact the balance sheet. If Sally forecasts $700,000 in total sales, she must forecast how much of the $700,000 will be paid in cash each month, and how much will be posted to accounts receivable. Both cash and accounts receivable are balance sheet accounts.
- Cash flow: Finally, the statement of cash flows reports on cash inflows and outflows during the year. The majority of Sally’s cash activity is related to company operations, such as purchasing supplies (sod, flowers, mulch) and collecting cash from sales. If Sunrise Landscaping purchases a new piece of equipment, the cash outflow is an investing activity. A financing activity refers to raising capital to operate the business, and repaying capital to investors or creditors. Business owners should forecast cash inflows and outflows by month.
In addition to these three reports, you should create a forecast for capital expenditures, or “cap-X”. Most businesses must purchase or replace expensive assets over time, and your cap-x plan documents how you’ll pay for the assets.
If Sally must replace a truck in three years, she needs set aside company earnings to pay for the truck or plan on borrowing money for the purchase.
If you use accounting software, your system can produce each of these financial statements. Generate each of these financial reports, and use them to start creating forecasts for your next business year.
Qualitative vs. Quantitative
Broadly speaking, forecasting methods can be defined as qualitative, quantitative, or a blend of the two methods.
A qualitative method means that the business owner uses market research, and surveys to assess the needs of customers, and what people are willing to pay for their product or service.
Assume that Sally analyzes her competitor’s websites and determines that six firms in the area offer tree removal. She surveys her existing customers about her competitors, and she discovers that the average price paid for removal of a 20-foot tree is $400. Sally can use that information to price her tree service removal business.
Quantitative analysis, on the other hand, focuses solely on the data available, and not on human feedback. If Sally is forecasting the labor hours required to install a flower bed and plant flowers, she can analyze the labor hours needed for the same type of work in the prior year. Only the data is used to create a quantitative forecast.
In reality, most business forecasting involves both qualitative and quantitative analysis. Sally may price her tree service removal business using market research, and compute the labor cost based on similar work performed in the prior year.
Your goal is to generate a forecast that considers both prior year activity and current business conditions.
Business forecasts make assumptions about sales, costs, and cash flow, based on current market conditions, your historical results, and your knowledge about the industry.
The forecasts are a part of your annual budget, which is a critical tool you need to operate your business effectively.
Once the business year starts, you need to compare your actual results to your forecasts each month. This process, which is called variance analysis, allows you to make changes that can improve your results. Sally may be able to increase the price of her tree service removal work if she notices a higher demand than she forecasted.
Make the time investment to create a budget with forecasts so that you can increase your sales and profits.