Effective forecasting Featured

8:00pm EDT June 25, 2009

When Kreischer Miller’s Christopher Meshginpoosh encounters a company struggling with liquidity issues, he also usually finds another common problem: deficient or nonexistent financial forecasts.

By employing sound financial forecasting, a company can better anticipate and react to changes in the marketplace.

“Effective financial forecasts are an integral part of a company’s risk assessment process; if you haven’t identified the risks impacting the business and their potential economic impact, then there’s a gaping hole that could lead to dramatic swings in financial performance and liquidity,” says Meshginpoosh, director in charge of the Audit & Accounting Group at Kreischer Miller. “In a difficult or unstable economic environment, effective financial forecasts can mean the difference between building a thriving business and suffering an economic calamity.”

Smart Business learned more from Meshginpoosh about how business owners should approach their forecasting methods at a time when the outlook may be tenuous.

In such a volatile economic environment, what are the benefits of forecasting?

First of all, it’s important to understand that even minor fluctuations in key variables can have dramatic impacts. For example, a two- to three-day change in the average collection period for a highly leveraged, low-margin business can be the difference between solvency and insolvency.

In a volatile environment, it is vitally important to understand the variables that impact business performance, as well as the potential impact of changes in those variables. By building robust forecasts, management can anticipate a variety of alternative scenarios and develop contingency plans to mitigate the probability of negative outcomes.

For instance, a company can evaluate the potential impact of delays in the collection of receivables or reductions in availability under line-of-credit arrangements. If the potential impact is significant, then the company might enhance credit controls or delay unnecessary expenditures in order to mitigate the potential impact.

What is the downside of relying solely on traditional budgets?

Many companies develop budgets once a year based upon their outlook for the business at the time the budget is developed. However, even in relatively stable economic environments, unforeseen issues impact businesses throughout the year and lead to variances from original budgets. The more significant the changes in the business are, the less valuable the original budgets become and the higher the probability that an unforeseen event could have a dramatic, unwanted impact on the business.

The current economic environment has underscored the risk associated with limited forecasting tools. Many companies assumed that revenue would continue to grow at the same rate and that customers would continue to pay in the same patterns, only to find that sales fell well short of expectations and credit risk increased dramatically. These factors, combined with high near-term fixed costs resulted in covenant defaults, cash flow deficiencies and bankruptcies.

What are the significant elements to consider when developing a forecast?

It’s important to understand the key performance indicators at your company and what variables have the biggest impact on your overall performance. A forecast is not just a finance tool but an operational tool, something that you build based on detailed knowledge of each business unit or product line.

The metrics that are used to drive the forecast should be the same metrics that senior management uses to monitor ongoing performance and the same metrics that business unit managers are held responsible for managing. And a good financial forecast should include explicit identification of fixed versus variable costs, because the magnitude of the near-term risk to a business is often a function of the level of its fixed costs.

Finally, forecasts should reflect a focus on key risks impacting the business. For instance, while fuel prices have been more stable than they were a year ago, they still have the potential to have a dramatic impact on many businesses.

Because of this potential impact, many companies might consider developing forecasts that reflect alternative assumptions regarding future fuel prices in order to determine whether the risk necessitates the use of strategies such as hedging.

How can businesses develop a financial forecast?

First, it’s important to ensure that forecasts reflect the disparate nature of each business unit or product line. This means taking a close look at each significant element of the business and involving the relevant managers in the forecasting processes.

Next, it’s important to evaluate existing budgeting and forecasting processes to ensure that the processes include the definition of key variables and the evaluation of alternative scenarios. Additionally, if processes do not include periodic reforecasts of your expectations, then there is also a risk that material unforeseen variances could adversely impact the business.

Finally, it’s essential to ensure that forecasts include income statements, balance sheets and loan covenant calculations in order to ensure that financial performance, financial condition and liquidity are properly assessed.

The good news is that forecasting tools are widely available, ranging from spreadsheet-based tools to more complicated forecasting modules that interface with existing accounting and ERP systems. By carefully developing a robust forecast using one of the many types of forecasting tools available, companies can minimize the risk of unwanted outcomes, as well as maximize the probability of achieving critical business objectives.