The aim of implementing a forecasting model is to enhance the financial management and decision making capabilities of any business, especially if the forecast is updated on a regular basis and a future rolling component is added during each updating period.
For example, a twelve month rolling forecast implies that after each month the forecast will be updated and another month will be added to the forecasting period. Thus, at any point in time, the business will have a twelve month forecast. The update could also be quarterly or even six monthly, depending on the business’s needs.
Listed below are a number of recommendations to take into account during the design of a forecasting model. However, before the design and implementation of any forecasting model, a number of financial planning principles have to be highlighted:
The relationship between budgeting and forecasting
The relationship between Budgeting and Forecasting needs to be clearly understood by all relevant parties. The definition of a budget is an expression, in financial terms, of the strategic and operational plans of an organisation for a forthcoming period of time. A budget is generally goal orientated and based on future strategies and plans.
Theoretically, some of the main purposes of a budget are:
- Resource allocation (linked to the strategic plan)
- Putting performance targets in place
- Control and measurement
- Putting everybody on the “same page”
- Focus on the end result for the budget period (setting overall defined financial goals).
A forecast is an expectation, based on all available information at a point in time, of what the near term future may in reality look like. It is based on actual expectations of the future without any influences (e.g. goals or targets).
Theoretically, some of the main purposes of a forecast are:
- Enhancement of management decision making processes, based on a reaction to near term future expectations,
- Ongoing value creation activities and continuous improvement of activities and processes
- Continuous improvement of the accuracy of forecasting and management information
- Behaviour changes from defensive (reactive) to offensive (proactive)
Forecasting is a planning discipline of facing reality; it aims to show the latest reality. It should be highlighted that Forecasting is a management tool in its own right based on foreseen reality and not a rolling budget based on updated goals or targets.
Responsibility and ownership of financial planning
The responsibility for all financial planning, including budgeting and forecasting, lies within the operational functions of a business, where the financial function plays only a supporting role.
Operational Heads should thus be responsible and accountable for revenues, costs and capital expenditure which fall under their sphere of responsibility. Furthermore, operational heads should only be responsible for items that can be influenced by them. The finance function’s role in financial planning is a support function to assist operational employees to compile their financial plans and forecasts according to set guidelines.
Listed below are six practical items to assist in the design and implementation of any forecasting model:
1. Forecasting horizon
The forecasting horizon of any business should be driven by the future visibility of the functions of the business. It is pointless to forecast beyond a certain point in time, as one of the main purposes of forecasting is to enhance near term decision making capabilities of operational employees. After a certain point in time, it will be better to extrapolate the remainder of the forecast rather than to predict an uncertain future.
Seeing that one of the longer-term goals of forecasting is the continuous improvement of forecasting accuracy, it is recommended that a phased approached to the forecasting horizon be implemented, always starting with a short-term focussed view (dependent on the business a one, two or three month horizon, with the rest of the period extrapolated). Thereafter, as forecasting accuracy increases, the focused forecasting horizon will increase.
2. Introducing probabilities
Due to the difficulty to predict the future, it is preferred that forecasting should always make use of probabilities. This will enhance the overall relevance of the information gained through the forecasting process. Over time forecasting ability will improve. It is advisable to start with an option of three probabilities, each with its own % likelihood (e.g. definite, confident and possibly) for example:
3. Frequency of Forecasting
Realities change every day and subsequently the forecast of a business should be updated as often as possible. It will be beneficial if a forecast can be done every month on a rolling 12 month forecasting basis. As mentioned in 1. above, the forecasting horizon will determine for how many months the forecast will be focussed, whereas the remainder will be extrapolated.
4. Forecasting detail
Forecasts should focus only on the key value drivers and key limiting factors and should not be drawn up in the same detail as budgets and management accounts. Accuracy and relevance of information should be weighed up against the time it takes to draw up management information.
For each “budget line” a separate detailed analysis should be performed of what level of detail should go into the forecast. Two methods can be applied to assist with this analysis:
- 80/20 principle, which implies that 80% of effects come from 20% of the causes.
- Putting a 10% selection criterion in place: If an item has less than a 10% impact, it is clustered together.
5. Visibility and user friendliness of reports
Usually budget and forecasts are shown in numbers and percentages. It is recommended that graphs be incorporated in the forecasting model showing the following relationships:
|Overall View||Forecast Accuracy View|
|Prior year actual||Actual|
|Actual plus forecast|
Forecasting as a management tool
More often than not the same assumptions, methods and models that are used during the budgeting process are used during the forecasting process, which should not be the case. Due to the different nature of budgets and forecasts, different assumptions, methods and models should be used.
As mentioned before, forecasting is a management tool and not a rolling budget, thus a separate detailed analysis should be performed to evaluate the assumptions and techniques needed for improved forecasting.
Build A Financial Model
Start-ups often struggle to develop a suitable financial model for their new businesses. Here are some of the most important financial modelling considerations.
All budding entrepreneurs spend long hours typing up a well versed strategy document for their new entity, as expected. However, very often there is insufficient time allocated to the crux of the business, the numbers.
Definition: Financial modelling is the process by which a firm constructs a financial representation of some, or all, aspects of its business.
For any new start-up entity the initial necessity for assessing potential returns on new investment or seeking external funding can be a daunting process. Whether you are soliciting funds from an institution, or a high net worth individual investor, the financial projections could make or break your deal.
Although you as the founder are naturally optimistic about the new venture, be mindful that most investors would rather see the worst case scenario. This allows the potential investor/banker to take a realistic view on the maximum potential losses, should the business fold in the first 12 – 24 months. As such, it is recommended to produce a low, middle and high road model, for a three to five year period.
Inputs and outputs
Most importantly, always keep in mind that your financial model is nothing more than certain inputs producing certain outputs. By designing the model correctly, a user should be able to change certain inputs to assess the impact of these changes on the related outputs (commonly referred to as a ‘what if analysis’ or ‘stress testing’ a model).
By way of a simple example, your sales revenue line for any specific month should be a function of the number of products sold, at a specific sales price.
For ease of use, both you and a potential investor should be able to adjust either of these variables in order to see how resilient the business model is, should your assumptions be incorrect.
Other basic recommendations when building your model:
- Create an assumption page, clearly defining any assumptions on which the model is built. By linking certain variables to the assumption page the model becomes robust and user-friendly.
- Be as transparent as possible, showing all formulae that lie behind calculations. This allows the user to easily follow logic through the model.
- Aim for simplicity and ease of understanding. Over-complicating a financial model with unnecessary worksheets can confuse and overload the reader.
- When inputting projected overheads, deal with each line item separately, without consolidating. This demonstrates detailed thinking, and allows discussion around each expense if necessary.
- The model should evolve with the business. You should be looking to check the assumptions made at the inception of the business, with the reality of what is achievable, after having the benefit of hindsight. By tweaking the numbers accordingly, the model becomes a more accurate prediction of the business in the future. This should be an ongoing process.
- Beware of attempting to use a generic template that may not apply to your business. Trying to customise these generic models could complicate a would-be simple model. Building your own bespoke model from scratch is the cleanest approach, even if assistance is necessary. This forces you to learn the intricacies of your model, which will hopefully stand you in good stead.
- Many books and websites recommend a myriad of options when it comes to building financial models. As a principle, lean towards the concept of simplicity, provided you are able to integrate your model into regular projected income statement, balance sheet and cash flow statements.
Are You Crunching The Right Numbers?
Measure what matters and you will find hidden money in your business.
Defining true profits
Just because you sell at a profit, is that enough to be profitable? A mistake that many business owners make is that they don’t factor in net profit when calculating selling price.
The natural tendency of business owners is to focus on sales growth rather than net profit. So, what is net profit? Profit is on paper — it is not in the bank. It is the money left over each month after deducting all the cost of sales and expenses it generates and subtract them from all the revenue it creates. Net profit is also calculated after paying a market-related salary to the business owners.
Identifying the winners
What are your profitable products or services, and which aren’t? Gross margin is the most important component of any business as it enables your business to pay its overheads, pay you and make a net profit to continue to grow and be protected from adverse economic times.
Gross margin is calculated by taking the gross profit, that is, the selling price less the cost of the product or service, expressed as a percentage over sales. Most business owners make the mistake of just measuring gross margins, and if they are being achieved, cannot understand why there is no money in the bank. To find hidden money, gross margins cannot be calculated alone.
Measuring cash flow together with gross margins for each and every product you sell or service you provide will determine which products or services make you money, and which don’t. For example, if product X has a gross margin of 33,3% and takes six months to sell, you have effectively lost your margin as money has been used to finance the product instead of being utilised to purchase more of the same products at a far higher turnaround.
Which customers make you money, and which don’t? You need to know how much of each product or service each customer has purchased from you and the gross margin earned on each of those products or services sold and how much money each one owed your business at any given time.
This analysis will determine the profitability of each customer. If your marketing efforts are directed only at those customers that give you a higher gross margin without also measuring the cash flow of that customer, you’ll be making the unwitting mistake of selling to some of the least profitable customers.
Unlike products and services, customers are people, some very nice, others either hostile or simply undesirable. If you have any hope of building a business that maximises profit, fun, and your free time, you should focus on attracting customers that respect you and your team, who allow you to use your full talents, are respectful of your time and have reasonable expectations and demands of your business.
If a customer does not resonate with you and your business, don’t deal with them, as they will invariably take a chunk of profit from your business, and that’s not a good thing, is it?
Return on investment
Your business cannot make money for you if your investment in assets increases at a faster rate than your net profit. The two assets we are concerned about are inventory and accounts receivable.
Let’s say your inventory and accounts receivable increases by R58 000 and your net profit was only R35 000 for the same year, you will not see money in your bank. Don’t fall into the trap of increasing net profit and ignoring your business’s overall investment in assets.
By measuring what matters, you’ll be amazed how you can find hidden money lying in your business.
What Makes a Good Financial Management System?
There is no one financial management system that works for everyone. However, every effective financial management system is based on a few simple principles.
Imagine for a moment you had the recipe to the best strawberry jam in the world. This recipe, a closely guarded family secret, has been passed down from one person to the next for decades. When people taste your strawberry jam, they are in raptures. They can’t get enough of it. Occasionally people even write poems about the stuff. People wait in long queues in the street just to taste it. And you’re the only person who knows how to make this product that brings in a limitless number of customers. Sounds like a recipe for success, doesn’t it?
Related: Not All Money is Created Equal
But imagine now for a moment that you have nothing to store your jam in. You have no jam jars or bottles or cans. You could make pots and pots of strawberry jam, but you have no way of bottling it.
There is simply no way to contain your precious jam. People arrive at your doorstep, eager to buy a bottle of the fruit-laden delicacy, and you have to turn them away. You offer a few good friends a lick off your wooden spoon, but you have no way of transporting any more than that.
Having no jam jars is a little like having a great business with no financial management system. You could have the best business idea, and the most talented financial staff to help you action it. But if there is no financial management system ‘containing’ the financial information of your company, then there is no way of keeping your business effective. Without a financial management system, your business is not much more than a big pot of jam.
We’ve combined our own ideas with some suggestions from Knowhownonprofit.org to help you establish good practice in the financial management of your business.
Your financial policies and systems must remain constant over time. If you establish a cash on delivery rule, for example, then your company needs to stick to that policy regardless of where you are in the cash flow cycle.
Your financial management system should create a paper trail that shows how resources have been used and who has authorized the decisions behind their use. Your system should create transparency, rather than make processes so complicated that it is difficult to determine who has done what.
The processes that your business adopts should demonstrate that your organisation values its financial resources and uses them for the purposes they are intended.
Compatibility with existing technology:
There are various bespoke financial management systems on the market, most of which come in the form of software, and all of which tout a complete financial management solution for your business. Before you spend many thousands investing in a system, make sure it is compatible with your existing technology.
What computers would be required to run the system? What level of training would employees need in order to use it? In addition, investigate who or what would be required to support the system, and at what cost.
Related: Do This to Improve Your Cash Flow
Accounting standards in South Africa are rigorous and extensive. Ensure that your financial management system complies with the latest accounting standards, and that there is a process whereby the system will be updated to reflect the latest changes, when they take place.
If you need guidance in implementing a financial management system for your company, The Finance Team can assist you. We have a team of highly qualified financial professionals who can provide you with part-time or interim advice according to your business’s needs. Together we can help you establish an effective system that will be the jam jars to your company’s secret recipe.
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