The Fundamentals – Financial Forecasting

When assessing business lending applications, financial forecasts are one of the key pieces of information that lenders will ask for.

The underlying reasons they want this are three-fold; they provide:

  1. management’s expectation of the future financial performance of the business and its ability to meet loan repayments;
  2. a benchmark against which the actual future performance can be assessed (i.e. were prior forecasts reliable or not?); and
  3. an insight into the management capability of the business operators (i.e. are they able to produce quality forecasts, or is the business “run by the seat of their pants”?).

Any business seeking funding should want to impress their bank or lender on all of the above points, which raises the question – “what makes a good forecast?”.

There are five keys to producing an ideal financial forecast:

1. Comparable to Historicals

The forecast of future financial performance should always be comparable to the historical performance of the business.  This is especially the case when it comes to Gross Margin and Operating Expense line items. 

For example, if the historical average Gross Margin has been 60%, the forecast should maintain roughly this figure unless there are valid, reliable and clear reasons why this would change.

The same applies to the Operating Expenses of the business; whilst these may bounce around a little from year to year, businesses don’t tend to see large changes in expense line items unless there have been clear changes in the business. On this point, it’s important to note that bankers will always take a very conservative view towards “we intend to change” (where costs are forecast to reduce) versus “we’ve already changed” – as in, if you haven’t already done it, they usually won’t believe that you will.

2. Underlying Financials

Clear explanations should underpin any significant changes in any of the core Cash Driver movements (sales, margins, expenses, debtors, creditors, inventory) as to what assumptions have been made.

For example, where Sales are forecast to grow by 20% in the forecast against a relatively flat historical performance, it would be necessary to provide the assumptions as to why this will likely occur (e.g. a new geographic area, new product line or additional sales staff).

3. Be Realistic

Digging further into the first two points, the question will always be asked – “is this realistic?”.

This can be a challenging step for business owners to assess and always have a degree of subjectivity. The natural spirit of the entrepreneur can cause a tendency to be highly confident in their own strategies and expected outcomes. Unfortunately, bankers – and particularly credit managers – tend to have a natural tendency towards being conservative.

4. Stress Test

The final step with any forecast is to undertake a “Stress Test”, also known as a “Sensitivity Analysis”. Simply put, this means running some alternative budgets based on “what if it doesn’t go to plan”. 

A stress test can be undertaken on various inputs – Sales reductions, margin reductions, increases in Operating Expenses, changes to exchange rates or interest rates.

How the forecast should be stressed will depend on the industry and business specifics – for example, a drop in sales of 10% might be highly unlikely for one business, but for another, it might be more realistic to forecast a 30% drop.

One of the most beneficial tests to perform in this stage is a “breakeven” analysis – that is, determining the levels at which sales, margins or operating expenses would change and for the business to still maintain profitability and its capacity to meet all cash commitments.

5. Three-way Forecasting

Forecasts prepared by business owners will tend to just be a profit & loss forecast. For a relatively stable, low-growth and simple business, this may suffice. However, if a business is experiencing relatively high growth, or carries a material level of debtors, creditors and inventory, then the business’s profitability can look VERY different to the net cash flow of the business.

In such instances, a “three-way forecast” is necessary – (1) profit & loss, (2) balance sheet and (3) cash flow – which will show how much capital is needed, subject to the various inputs.

Putting these together isn’t so simple, though, so this is usually where it’s appropriate to bring in a professional to build the forecast.

As with many aspects of finance & business, forecasting is part art and part science.  The key is to take the time to engage with the right people to support the preparation of a meaningful, useful and realistic budget.

If you need some assistance with financial forecasting, STAC Capital can put you in touch with several capable and trusted partners to support you.

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