Developing a rolling forecast matched to your business cycle. Applying the information gathered to the overall strategic planning process

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1 Introduction Management accounting differs from many other finance professions in that it necessitates looking not just towards the past but also towards the future. Developing a consistent and thorough system of forecasting is a valuable step to reaching well-thought-out decisions. Choosing among forecasting methodologies Developing a rolling forecast matched to your business cycle Applying the information gathered to the overall strategic planning process Why Forecasting is Important To start to see the importance of forecasting we ask with the question Has there ever been a profitable company that has been placed into receivership or liquidation and never recovered? Answer: Of course there has - because it is not lack of profit that gets the creditors knocking on the door it is lack of cash. We live day to day by the funds in the bank account, not by a theoretical profit statement that may be out of date. Decisions made on partial / poor / incomplete / incorrect / no information Lots of businesses prepare an annual income and expense budget, but plenty of these businesses fail to prepare a financial forecast, the therefore miss out on much of the value in the forecasting process. The difference between what I would consider a budget and a financial forecast lies largely in the calculation and integration of financial data and underlying assumptions. A forecast provides a business planning and analysis tool which can be used for: Scenario analysis including testing best and worst case scenarios Sensitivity testing and looking at the impact of changes in key assumptions, e.g. gross margin, large expense lines, labour costs Better risk management Better decision making (evaluating investments, strategies, etc.) Helps decision makers see the costs to grow (or the costs of not growing) Cashflow planning and management throughout the year, through the use of an updateable rolling forecast model that can be updated and re-forecasted each month or quarter with actual results Analysis and review of movements in key balance sheet items, e.g. and increase or decrease in inventory, the impact on business cashflow and the change in key financial ratios Better understanding the cashflow movements of the business, including key cashflow cycles such as forecasting capital expenditure or large / bulk inventory purchases Providing a better view of the businesses working capital cycle Compared to a budget, which simply sets out a benchmark against which incomes and expenses for the year can be compared. P a g e 1

2 I ve seen many large, complex and changing businesses operating with poorly prepared forecasts, or worse, no forecasts at all. This results on management decision making based on partial, poor, incomplete, incorrect or no information and poses a significant risk to the business. Failure to forecast may be due to a number of excuses, but the cost of not forecasting in invariably going to be greater than investing in a robust forecasting system. Inability to access good systems Lack of support from managers / team members Research / purchase / design a new system Need the finance team to educate on the uses / advantages of forecasting Lack of buy in from management Need the finance team to educate on the uses / advantages of forecasting Crystal ball gazing attitude and a belief that forecasting can t be done accurately and therefore can t be any use You don t see the benefits or don t think you need it You didn t choose the system and don t trust, understand it or like it Your business is too different or too complex Lack of time, resources or knowledge Investment into building a robust forecast structure and defining key assumptions / drivers T This comes down to clearly understanding your business Every business will benefit in some way from financial forecasting Either learn to use it, fix it or change it Use a tailored system or enlist the help of a specialist to design an excel based model Main investment is upfront in selecting, designing and populating the forecast Ongoing updates should be integrated into the month end process Financial forecasting does require an investment in both time and money but in today s competitive, ever changing environment can you really afford not to? Where to Start? Financial Forecasts need to be: Understandable Relevant Reliable Comparable Information used should be: Reasonable Supportable P a g e 2

3 Scenario(s) presented must be; feasible and represent your proposed course of action not be too wide or the information will become less useful / meaningful Reporting periods should coincide with those used for annual historically generated financial statements. Creating the Forecast Your financial forecast should comprise a Forecast Statement of Financial Performance, Forecast Statement of Financial Position, Forecast Statement of Cashflows and supporting notes and calculations. The financial forecast should follow the same format as your monthly reports. The Forecast Statement of Financial Performance should separately show: revenue finance costs depreciation / amortization profit and loss from JVs and associates tax expense net profit or loss classification of expenses based on either the nature of the expense or their function within the entity The Forecast Statement of Financial Position should separately show: current assets non-current assets current liabilities non-current liabilities equity (with separate disclosure of minority interests and distributions to owners) The Forecast Statement of Cashflows should separately show: interest dividends tax payments and receipts other major classes of receipts and payments (Note : Failure to prepare the statement of cashflow may affect the integrity of bank balances as calculated for the balance sheet and the usefulness of the projections). Deciding your Key Assumptions Aside from selecting which system to use, the biggest challenge most people face with preparing a financial forecast is in determining the inputs. This is particularly hard in cases where a business is growing, expanding, changing markets, launching new products, etc, and most businesses do not just want to just do the same as what they did last year! P a g e 3

4 Assumptions need to be: Consistent Reasonable Supportable; and may be based on: o past performance o feasibility studies providing objective collaboration o other information generated from the economic and operating environment (e.g. market surveys and industry statistics) o detailed analysis of an area of activity or operations o expertise and experience of staff and advisors A few of the key inputs you will need to think about are: Sales growth / seasonality Margins (consider breakdown by revenue streams) Overhead expenses (include a review of any changes to current, especially large items such as rent and wages) Debtor collection rates (e.g. average number of days by when payment is received) Creditor payments (e.g. average number of days by when payment is made, use of trade finance or debtor factoring facility) Inventory movements (e.g. purchasing cycles, are large orders required for some or all products, shipping times / goods in transit, inventory carrying amounts, additional inventory that may be needed to achieve sales growth) Loan interest and capital repayments (any expected future changes, or example and increase in interest rates) Depreciation rates (should be based on the actual rates being used) Capital expenditure Shareholder drawings Provisional tax (provisional payments based on uplift or estimates and terminal payments) The best approach is to try and break down and source data as much as possible. For example, when setting the sales forecast consideration should be given to: What is the current size of the market? Is it stable / growing / shrinking? How much market share could your business take? Who are your key competitors and what activity are they currently undertaking in the market? Historically, what trends have you seen, e.g. long term shifts, seasonality, the impact of events external to the market? What strategies have the management team decided, when will they be implemented and what are the potential impacts of these? For example: In the construction sector you may look at trends in building consents For a retail business you can access retail statistics and monthly spends across different categories (e.g. Retailwatch) P a g e 4

5 Statistics New Zealand provides population and community statistics including data on the education sector, environment, health, central and local government and a range of industry sectors. Look at your businesses own historical data, e.g. number of customers, spend per customer, buying habits, etc. Look for changes, trends and trends in changes. Think about where your growth is going to come from and how you are going to achieve it? Increase number of customers how? Increase spend per customer how? Increase frequency of purchasing how? Improve efficiencies (margin) how? Strategic Forecasting Strategic value in the financial forecast can come from: Assessing funding / working capital requirements Assessing the strategies / feasibility of growth targets Assessing the impact of seasonality on business profitability and cashflow Assessing the cost to grow / implement strategic plans Scenario testing Sensitivity analysis The forecast should be integrated with the strategic plan and the business plan, both when setting up the forecast and also at a reporting level. Forecasting Solutions There are a wide range of forecasting solutions available, ranging significantly in cost and complexity. It is important to use a solution that is appropriate for your needs and your business model as an overly complex system will end up costing you time and money. Ledger Based ERP / tailored systems Dedicated budgeting, forecasting and management reporting systems, e.g. Forecast5 Excel based / spreadsheet solutions Focus is on data / setting budgets Often provides basic variance analysis but is typically not an analytical tool Complex, costly and take time to research and implement Usually limited to big corporate solutions Often functionality and flexibility but offer a good option where a lack of skill or resource precludes an excel or spreadsheet based system Allows greater flexibility Required excel / spread sheeting expertise If not well managed the accuracy / integrity of the forecast may be compromised (e.g. through excessive changes / updates, poorly inputted actuals, incorrect roll forward, etc) P a g e 5

6 Rolling Forecasts How likely do you think it is that part way through the year all balance sheet items are going to be sitting at exactly the same amounts s what you predicted at the start of the year? A rolling forecast involves not just forecasting to the current year-end position, but also looking to the next financial year, and forecasting 12 to 18 months (or more) into the future. A rolling financial forecast is: Always looking at least months into the future Monthly or at least quarterly review of all forecast periods Confirmation that the data and operational targets are still consistent with the strategic plan Replaces the annual budget process as there is always a forecast on the go A typical rolling forecast process would comprise: Setting the initial forecast will involve: Research and selection of your forecasting model / methodology Define inputs and assumptions Create the financial forecast The initial forecast should be go 12, 24 or 36 months out depending on your business cycle and the timing of any planned strategic initiatives Subsequently, each month or quarter you should update the financial forecast with your actual results, review and roll forward key balance sheet items and reforecast your statement of cashflows based on new opening position (cash, debtors, creditors etc). Your financial forecast reporting should align with you existing financial reporting periods, i.e. monthly, quarterly, six monthly and annually, with appropriate variance analysis undertaken each time the actual results are reported. Your analysis should include: Comparing the initial budget, latest reforecast and actual results Analysing variances Analysing the impact of further changes / movements KPI Reporting P a g e 6

7 Regular reforecasting helps ensure that the financial forecasts remain in alignment with the strategic plan, the business plan, key actions at the board and operational levels and any changes in the current operating environment. Key staff should be involved in setting and reviewing forecasts with commentary regularly provided to the management team detailing any reforecast changes. Don t be tempted to over-reforecast! Reforecasting should be quarterly or six monthly, but not monthly! With the incorporation of regular reforecasts, the rolling financial forecast should always be projecting at least 12 months ahead. Conclusion An integrated financial forecast provides much more than simply a tool for the analysis of incomes and expenses. Integrating financial forecasting can add value and minimise risk with significant benefits through improved decision making and planning. P a g e 7