Clients engage a fractional CFO for several reasons. The one I hear the most is wanting to get a better idea of what their future cash flow will be. Many times, I am talking to them after they have done an extensive Google search of how to exactly determine that. While forecasting is the answer, the thought of building one scare most people away.
The reason they are talking with me is often that they are overwhelmed with the prospect of building out their own forecast. Accountants and others in finance have made forecasts too complicated for small businesses. I have seen some beautiful forecasts in Microsoft Excel that have every bell and whistle you can think of. As an Excel geek, I love looking at well-built spreadsheets.
But forecasting is an inexact science in the first place. I often tell my clients that if I can forecast your revenue with an accuracy of 90%, then I think we’re doing great. According to the WSJ, “the median Wall Street forecast from 2000 through 2020 missed its target by an average 12.9 percentage points. If we can forecast revenue within 90%, that often means that our cash flow is fairly accurate.
So, the implied accuracy of forecasting is somewhat of a misnomer – building a better spreadsheet isn’t necessarily leading to more accurate forecasts. Forecasting becomes less intimidating when you are only trying to get within 90% of the target.
Whether you take a shot at your own forecasting or not, it is helpful to have a background in its methods. This article is going to give you some tips to help you better improve your understanding and gain some comfort around the topic.
Why Are You Forecasting?
I won’t include this in the four tips….look at this as a “free” tip. When you are developing a forecast you need to determine what your goal is first. If the forecast is for potential investors, that looks much different than a cash flow forecast.
If you know up front what you are trying to accomplish from a forecast, you can better determine what factors or important and how long the forecast should be. Most times a forecast is used for internal purposes. If that is the case, then make sure that the forecast you develop works for you.
Remember that accuracy is both your friend and enemy. A forecast needs to be accurate to be useful. However, remember your forecast will be wrong. That is right, no matter how much time is spent on your forecast, it will most likely be wrong. And that is OK. A forecast that is used to help shape strategy doesn’t need to be 100% accurate.
Forecasting needs to be a repeatable process – you don’t want to have to take hours to update your forecast. In that sense, accuracy can work against you. Sure, getting your forecast to be 95% accurate instead of 90% accurate can be useful. However, if you plan on updating this each month and that extra 5% accuracy takes 10-15 hour to achieve, then you need to determine if it is worth it.
Why is 90% OK?
Listen, some of my CFO brethren will read this and chuckle that I am only aiming for a B+ on my forecasting. However, a 10% revenue difference on a forecast often leads to a 3-4% difference in cash flow.
Let me paint a picture for you. Imagine a world where in a short hour you could update your rolling 90-day forecast. That 90-day forecast would tell you what your cash balance would be in 30, 60, and 90 days from now within 3-4%. You could then spend your time on strategies to either conserve or increase cash. And this process was easily repeatable.
The alternative is a 1-day planning session each month where you scour the internet looking for metrics to plug into your forecast. Once the forecast is done, if you don’t like the result, it takes hours to adjust the mechanics of your forecast. Yes, your revenue is 95% accurate (in some months), which leads you to…..a 2-3% difference in the forecasted cash balance. Soon, this process becomes so cumbersome you drop it altogether.
Which method sounds more appealing?
Tip 1 – Forecasting is Less Reliable the Further You Look Out
I have had many business owners ask me to build them a 24 or even 36-month forecast. Many CFOs will be happy to do this. I will tell you it is a waste of time in most cases.
Building a forecast over 12 months does nothing but paint a picture of what could happen. It can be helpful in illustrating how a certain strategy could possibly impact your finances. However, there are hundreds of assumptions that must come true for that length of a forecast to be accurate. Many of those assumptions are not even considered by the forecast. For example, most forecasts built by CFOs rarely ever consider any external factors outside of potential inflation.
I like 12-month forecasts because we can all operate within a 1-year window. However, I love 90-day forecasts even more. A forecast that shows 3 months can be highly accurate and very quick to build. Why are these quicker to build? You generally have a good idea of the trends occurring in your business over the next 90 days. The assumptions that need to be made are readily available. While general business conditions can change fast, typically over 90 days external factors are relatively stable or can be more easily foreseen.
My first tip is to start with 90 days of a forecast and work within that for a good amount of time before extending your timeframe longer.
Tip 2 – Forecasting Revenue Can Be Easy
There is no more important line item to forecast than revenue. Revenue is the largest source of cash. Further, revenue often dictates a large portion of what your spending will be.
I have seen several complex models for forecasting revenue. At the most simple level, I tell business owners to just use last months revenue as their forecast. While I take steps beyond this when forecasting revenue, for the owner that just wants a quick answer, start here.
Do you want to get a little more accurate? If we are talking about a 90-day period, you can generally determine a reasonable revenue forecast by taking the following steps:
- What was the revenue last month? Use this as a starting point.
- What was revenue for the same month last year? How did it change from the previous month? Is there any seasonality?
- What external factors will affect revenue? For instance, if your business is dependent on kids and school starts next month, how will that affect your revenue?
- What internal factors will affect revenue? For instance, are you implementing a 3% price increase? Are you introducing a new product? Are you hiring a new salesperson?
- Hypothesize how each internal and external factor will affect your revenue. Will an increase in interest rates cause you to sell 2 fewer houses? Will your price increase change revenue 3%.
With just that information alone, you now have a back-of-the-napkin calculation of what revenue will be. You might feel much more comfortable if you had a spreadsheet with 20+ factors. However, remember that high-paid Wall Street Analysts with much fancier spreadsheets are still only getting a “B”.
Tip 3- Skip the Small Details
There are several important line items on a forecast. There are also line items that are not important.
I had a client write me a lengthy email once detailing how they thought my estimate of office supplies expense was “significantly” off. I had an estimated $200 per month spend. After their lengthy reply, I agreed that we should increase it to $300. If the purpose of a forecast is to aid in decision-making, this change did little to help.
I often see forecasts that take great lengths to forecast out every financial statement line item. If any of these line items were off by 100%, it would have no impact on the overall forecast.
Businesses have 7-10 line items that should be deeply analyzed. Everything else can be grouped together and forecasted as a fixed expense over the life of the forecast. Categories that can be grouped together often include things like bank fees, office supplies, dues and subscriptions, meals and entertainment, and other G&A-type costs.
Save your time and concentrate on the items that will matter to your business.
Tip 4 – Start with the Income Statement, End with the Balance Sheet
Almost all new clients that come to me make the same mistake. They forecast their income statement and assume that net income equals cash flow. There are several issues with this.
First, the timing of payments must be considered. In several situations, a business will invoice a customer but not get paid for several days. Similarly with expenses, they will receive an invoice but wait a few days to pay. Both of these will affect cash flow but are not reflected by only forecasting the income statement.
Second, there are several transactions that never show up on the income statements. For instance, the purchase of new equipment or the repayment of debt. These items often only have a balance sheet accounting impact but also affect cash flow.
Lastly, most owners I know don’t have a defined plan for how monies flow to and from them and the business. They might need money on a Monday so they take a distribution. They need money again 8 days later so they take a little more. Typically, these transactions do not show up on the income statement.
When forecasting, it is important to account for items that will impact cash but don’t necessarily show up on the income statement.
Putting it All Together
This might seem like a lot – and it can be. However, the most effective forecasting tools I have had with small business clients are one Excel tab with about 50 rows of data and calculations.
One final tip – if this all sounds like too much, just start with revenue. Get some confidence in your process by just concentrating on forecasting your revenue. If you track your methodology over time, you’ll be able to compare your actual results to your estimate. With these comparisons, you can continually refine your method.
Once you get confident with your revenue, move on to the next incremental steps (cost of goods sold if you are keeping track ).
Lastly, you might have read this article and your head is still spinning. In that case, contact us and we can walk through this and figure out a solution that works for you.
Krieger Analytics Can Help
Running a small business can feel overwhelming. When you are analyzing business strategies, it can be good to have a professional at your side. Our CPAs at Krieger Analytics are trained in analyzing markets to determine which steps you should take to grow your business. Whether you need an accountant to get your business off the ground or if you need a CFO to help you get back on track, Krieger Analytics has someone for you.
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