How to Prepare Accurate Financial Forecasts
Preparing accurate financial forecasts is one of the most important management tasks for business owners. All major business decisions should stem from these forecasts -- from how many employees to hire and whether to borrow money to how to control costs and take advantage of expansion opportunities.
You’ll reap many benefits by taking the time to prepare a financial forecast, including better cash flow management, more accurate and consistent pricing, higher profitability, and a greater chance of obtaining bank financing. To get a bank loan, for example, you need to show that your company can generate enough revenue to pay expenses, make a profit, and repay the loan. An accurate financial forecast is key to demonstrating this.
Most banks want to see financial forecasts that cover at least the next two years. Keep in mind that behind every forecast lays certain assumptions, so be prepared to explain the assumptions.
Financial forecasting: revenue and expenses
To get started making a financial forecast, look back at your recent financial history. The past 6 to 12 months are especially relevant, as recent historical trends often predict the direction your business is headed in. Make revenue projections on a pro forma (or projected) income statement, which should flow through to a pro forma balance sheet and cash flow statement.
Forecasting revenue first, rather than expenses, allows you to determine what costs are necessary to support your projected sales level. Start with sales from the previous year and adjust these either up or down depending on what you expect to sell during the forecast period.
The next step is to identify all your business expenses, which include any costs incurred in the operation of your business and the manufacture and delivery of your products or services. Go back and look at prior years’ expenses and project these forward, making adjustments to reflect rising or falling costs and anticipated business growth.
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Categories of business expenses
The three main categories of business expenses include:
1. Onetime and capital expenses: These consist primarily of startup expenses, such as permits and licenses, office furniture, and computers and telephones. While these expenses generally aren’t budgeted for the future, you may want to factor capital equipment upgrades and replacements into your long-term cost projections.
2. Operating expenses: These are the primary ongoing expenses of operating your business. Also known as selling, general, and administrative (or SG&A) expenses, they can be further divided into fixed expenses -- those you must pay every month regardless of your level of sales, such as overhead -- and variable expenses, which change from month to month based on sales volume, marketing, and other factors.
3. Cost of goods sold (or CGS): These are the direct costs of manufacturing and delivering your products or services.
When you make revenue and expense projections, err on the conservative side. Forecasts are just estimates of the future, so it’s good to have a margin for error in case your actual costs are higher or revenue is lower.
Crunching the numbers
Your financial forecast should be an integrated model that ties together the income statement, cash flow statement, and balance sheet. If you make a change to your revenue forecast on the income statement, for example, this should automatically change accounts receivable projections on the balance sheet and collected cash on the cash flow statement.
Forecast your future SG&A and CGS expenses for at least the next three years, and enter these forecasts on your pro forma income statement. Subtract CGS from total sales to determine your projected gross profit and then subtract SG&A expenses and taxes from gross profit to arrive at net income, or bottom-line profit.
