Using historical data, benchmarking to develop a financial forecast

A financial forecast is a rolling monthly assessment of a company’s performance compared to its budget goals. By tracking progress monthly against an annual budget, a company can determine what it needs to do to stay on track and meet year-end goals.

“It’s also a decision-making tool management uses to guide a business,” says Michael Stevenson, managing partner at Clarus Partners. “It can help determine if and when equipment, head count, etc., should be added to manage the timing of any such moves, and it helps companies better understand their cash needs.”

Smart Business spoke with Stevenson about creating financial forecasts, what information to include and what not to do.

Who should be involved in the development of a financial forecast?

Whoever is responsible for company finances is essential to the process. And if there isn’t someone, consider bringing in a consultant to help. Either person should know the tax implications of any financial investments and the impact on cash flow. That can be used to temper conversations around investments so that the full financial consequences can be understood before action is taken.

Additionally, the company’s management team should participate because they have knowledge of the strategic plan and the budgeted financial goals for the company over the next few years.

What data should be used to assemble a financial forecast?

It’s typically easier to pull together fixed/variable expense information and then add revenue projections. Use as a base three to four years of historical data to reveal seasonal fluctuations in both revenue and expenses.

As for revenue forecasts, use the company’s current sales forecast — what’s in the pipeline and where the company wants to grow revenue — to make revenue projections. Balance that against economic, public and industry data to determine if the forecast makes sense.

What is the important historical data to gather when forming a financial forecast?

Consider at least three years of historical data from a profit and loss (P&L) perspective. Look at the cost of sales and determine whether gross margin is stable, increasing or declining. What is a target gross margin percentage? If the company is selling work at lower gross margin than targeted, is it worth it? Ask these questions in the context of gross profit percentage; selling, general and administrative expense as a percentage of revenue; and how these expenses grow with revenue.

Tie your P&L projections into a balance sheet forecast and check the cash balance and working capital. In a financial forecast, it’s best to have working capital that covers expenses on P&L for two and a half months in case revenue is lower than expected.

What is the important benchmarking data to include in a financial forecast?

When benchmarking against industry data, do so against companies that are of similar size and in the same geographic region. The important data to consider is revenue growth, gross margin percentage, EBITDA, and benchmarking working capital and receivables in terms of day sales outstanding.

Collecting receivables every 60 days but paying bills every 30 days creates a ‘cash gap’ or a cash flow problem. In a growing company that cash gap between assets and liabilities can get big enough that it must be funded with either a line of credit or a loan.

What are some common financial forecasting mistakes?

It’s a mistake to create hockey stick projections without the related infrastructure increase. For example, a company may be growing at 5 percent annually then decide it wants to grow at 15 percent, but does so without acknowledging the necessary increase in expenses to meet that goal. Infrastructure and personnel must grow to support higher revenue goals or a company won’t have the resources to make the climb.

Many companies also fail to consider the tax impact of an investment. Any time money is made there are tax implications, even in a pass-through organization.

Budgeting and forecasting help companies make good decisions. Sticking to them gives companies a higher survivability rate than those that fly by seat of their pants.

Insights Accounting is brought to you by Clarus Partners