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Financial Reporting

Implementing a Forecasting Model

Practical advice when considering the implementation of a forecasting model to enhance your business’s financial management.

Christiaan Vorster

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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:

Amount Estimated Likelihood
Definitely Rxxx 95%
Confident Rxxx 80%
Possibly Rxxx 65%

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
Actual Prior forecast
Prior year actual Actual
Budget
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.

Christiaan Vorster CA (SA) is a financial management consultant and heads up the business advisory Business Growth Africa. He focuses on the SME sector, specialising in business valuations, strategic planning and budgeting and forecasting. He also facilitates numerous executive courses in South Africa, Europe, Africa, and the Middle East. Email Christiaan at Christiaan@businessgrowthafrica.com

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Financial Reporting

Financial Metrics In The Business World – Keeping An Eye On KPI’s

The results and findings after each analysis, using the relevant metrics, then create a premise for strategising and executing specific tactics needed to improve, uplift, as well as highlight where increased attention should be directed.

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Monitoring sustainability and the condition of a company’s business model plays a key role in the overall performance and success of an organisation. If these are given the required attention, it would enable easy identification and corrective protocol to eliminate or curb potential problems or detriments.

One of the accounting metrics serving this functionality are Key Performance Indicators, better known as KPI’s. Metaphorically speaking, you could say that just as an Electrocardiogram would monitor your heart, so to would specific KPI’s measure up the health and activity of particular areas of a business. This ultimately leads to a fine-tuned route to achieve financial success.

The two main relative KPI’s would be Financial and Non-Financial. The former would assist in portraying a full view landscape which proves critical when it comes to competitive advantage. These provide quantifiable accounting metrics that are simple to analyse, hence easy to act upon.

An example would be the Debt to Equity Ratio – a ratio calculated by looking at a business’s total liabilities in contrast to the shareholders’ equity. This indicator is vital, helping to keep focus on the financial accountability.

Related: What These 5 Digital KPIs Say About Your Business

The latter, being Non-Financial KPI’s, are measures not quantifiable in monetary units. Typical non-financial KPI’s would range from product and service quality to human resource management. Also an essential avenue to keep a consistent tab on in order to maintain an ardent image.

A critical element in forming these metrics would be ascertaining what is important to the organisation at hand. The development of KPI’s should be part of an overall strategic management process that connects the mission, vision and strategy of a business. Keeping in mind the goals, both in the long and short term.

Aside from the metrics relating to KPI’s, the most crucial aspect in financial management would be accuracy. Processes that aren’t efficiently controlled along with inaccurate data input, will inevitably have an adverse effect on the business and also leave a window open for measurement inversion. Imagine executing massive plans based on incorrect results and information. This could jeopardise any business severely. Furthermore, the most advanced metric structure proves futile if the information used to ascertain a desired result lacks accuracy. Hence, any enterprise must ensure that there are always effective controls in place with heightened scrutiny over accuracy levels. Regular checking procedures and reconciliations at set intervals need to be structured to maintain this.

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Entrepreneur Today

Small Business Has A Critical Role To Play In The Economy – But Entrepreneurs Need Better Financial Skills

While government is stepping up to support small business more than ever before, the sector will not thrive unless entrepreneurs are also equipped with the financial tools to optimise their organisations – UCT Associate Professor Mark Graham.

Entrepreneur

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The role of small business in promoting growth and development has shot to the top of the agenda this year with both President Ramaphosa in his inaugural SONA and Minister Malusi Gigaba in his budget speech highlighting the critical role of this sector of the economy.

Globally, SMMEs are recognised as one of the key drivers of economic growth and job creation – and it is clear that the small business sector has led the world out of several global recessions – but in South Africa, the sector is under-performing.

Entrepreneurs need help to become sustainable

Recent data from the Global Entrepreneurship Monitor shows that South African entrepreneurship lags behind that in similar economies. And for every 1.5 people who were engaged in early-stage entrepreneurial activity in SA in 2016, one was exiting a business.

According to Mark Graham Associate Professor in Accounting at the University of Cape Town, typical reasons for business failure include: insufficient start-up funding, incorrect pricing for products or services, growing too quickly or prematurely, and inadequate cash flow.

Related: How to Improve Your Company’s Financial Management

“We need entrepreneurs to run their businesses successfully so that they can be sustainable,” he says. “Most of these issues can be addressed through a proper understanding of financial and accounting principles and concepts to help entrepreneurs run their businesses better.”

A growing understanding of financial principles

Graham, who runs the Finance for Non-Financial Managers programme at the UCT Graduate School of Business (GSB), emphasises that finance and accounting terms are really just a language that uses numbers to tell a story about a business.

“If you understand the fundamentals of financial principles you will be able to analyse what is happening in any organisation,” says Graham.

“Concepts like profit and cash flow are basic to business. However, people are often surprised to find that while a business can be extremely profitable, there may be a cash flow problem that will soon bring it to its knees.

Most people don’t know the basics of financial reports, what the right capital structure (i.e. the mix of debt and equity) might be. By getting to grips with concepts like working capital management and cash flow vs profit, business owners and managers can give themselves the best chance of success.”

Financial literacy is key to entrepreneurial success

Jannie Rossouw, head of Sanlam’s Business Market, agrees that financial literacy is key to entrepreneurial success and has argued that it should be integrated into the school curriculum so that future business owners can understand critical concepts like the time value of money.

“It is imperative that SA starts to spend significant time and resources to address the need for access to quality education aimed at those who want to pursue entrepreneurship and business ownership. We shouldn’t only start teaching these skills at the tertiary level,” says Rossouw.

And it is not just entrepreneurs that would benefit from a better grasp of the basics of finances, says Graham. All businesses should invest in developing the financial skills of their people – especially those in managerial roles.

Related: Create Financial Statements… Properly

“It is important for everyone working in business to understand the basic language of business and demystify the jargon – which is one of the things that the course I run at the GSB seeks to do,” he says.

“Feedback from previous course participants shows that people really appreciate being able to see how the numbers are telling a story about the health – or lack thereof – of a business and that this helped them make better business choices.”

Financial tools are needed to optimise businesses

“Sustainable small businesses have big potential to make a significant contribution to the SA economy and put a dent in the unemployment figures. So when Gigaba said that by enabling new businesses with new ideas to emerge and thrive, ‘we are radically transforming patterns of production in the economy’ he is not wrong.

But unless serious steps are also taken to equip owners and managers with the financial tools to optimise their companies, we will find that despite more proactive government policies and funding, the small business sector will still not thrive.”

Related: Want To Know Your Numbers? 3 ACCA Accounting Online Courses Your Can Take For Free

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Financial Reporting

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.

Jason Sive

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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.


Related: Financial Focus For Your Business In Different Growth Stages

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

financial-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.

Related: 3 Ways Emerging Entrepreneurs Run Financially Sound Businesses

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.

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