financial forecasting for small business

Financial Forecasting for Small Business

10 min read • Mar 16, 2022 • James Woodruff

If you don’t know where you’re going, how will you get there? When you’re running a small business, you need a map that keeps you on the right road to reach your goals. 

Otherwise, you’re just working hard every day and hoping things will turn out for the best. The bad news is that they rarely do.

That’s where financial forecasting for small businesses steps in. There’s even free accounting software for small business to make the forecasting process easier for you.

What is financial forecasting? 

Financial forecasting is the first step in determining where your business is going. It’s based on which products and services you think you’re going to sell in the future, how well your employees will do their jobs, and how you’ll control expenses to make a profit. 

Forecasting uses the historical performance data of your business to predict its performance in the future. 

Financial forecasts can give you a picture of how your business will perform in the future in best-case, worst-case, and normal scenarios. These forecasts form the foundation for preparing budgets and sales schedules as part of a business plan.

A financial plan is used to construct the three basic financial statements for a business: an income statement, balance sheet, and cash flow statement. 

Sales forecast: Create a sales projection on either a monthly or quarterly basis. Also include sales projections of each product or service and the specific cost of goods sold for each one. 

You need to know which products give you the highest profit margins so you can focus your sales budgeting and marketing efforts on those items. 

Expense budgeting with fixed and variable costs: Expense budgeting includes fixed expenses such as rent and insurance premiums and the variable cost of labor and materials. 

These expenses may change as a company increases revenue, expands to new locations, or hires additional employees. 

Income statement: Forecasts for income statements can change depending on the sales product mix, costs of production, marketing costs, and different pricing strategies to meet competition.

Preparing different income statements for various conditions can give you an idea of the profitability of your business for multiple strategies.

Balance sheet: Assets and liabilities present the financial health of a small business with different strategies. For example, some strategies may require that the company carry higher inventory and support increased amounts of accounts receivable. 

Depending on the company’s profit margin, the company may need to obtain short-term financing to support the buildup in current assets. Financial forecasts will show you what your company will look like in these circumstances so you can plan in advance if you need to obtain financing.

Cash flow statement forecasting: How will your decisions affect your cash flow statement and the amount of cash in your bank accounts?

A company that is experiencing rapid increases in revenues with low net profit margins may not generate enough internal cash inflows to have enough working capital to support the resulting increase in assets. 

Financial forecasts are critical to planning your cash flow forecast to make sure there’s always enough cash to pay expenses, regardless of the circumstances.

Break-even analysis: The first performance benchmark is to calculate how much sales volume is needed to cover fixed costs. 

This is the absolute minimum that must be met, otherwise, the company would be operating at a loss. Financial forecasting will show you how your break-even revenue levels will change under various strategies.

How to write a financial forecast for your business 

Follow these steps to create a financial forecast for your business. 

 

Step 1 – Review your historical financial performance

Start by taking two or three years of historical financial statements and analyzing the results. Look at the future sales growth and gross profit margins by product. 

Are you satisfied with your sales levels? Do you need to revise your marketing strategy or increase the intensity of your sales efforts?

Are you happy with your gross profit margins? Do you need to analyze each product’s cost of production to find ways to improve efficiency or lower costs? 

It’s important to go through each one of your company’s financial ratios (liquidity, asset efficiency, profit margins, and debt leverage) and identify those that need improvement. 

If you see, for example, that your current ratio is consistently less than two to one, you could use the forecast to predict the results of improving receivables collection efforts or lowering inventory levels. 

Step 2 – Create a baseline projection

Using your historical data, make a baseline projection for future sales, expenses, and profits you would expect under normal conditions to construct likely financial statements.

For example, if sales have been increasing at a 10% rate for the past several years, you could reasonably assume that sales will go up another 10% next year. If total expenses have been rising at a 9% rate, you could safely project the same increase for the coming year.

By just making straight-line projections on historical data, you can create a baseline financial projection you can use to test the results of various strategies. 

As an illustration, suppose you want to expand your product line. You could start by modifying the baseline projection to see the effects of increased new product sales and the related costs of production on profits.

Step 3 – Take into account factors that might change the baseline

You’ll need to consider both quantitative and qualitative factors. Qualitative factors might include market trends, changes in your industry, possibilities of new government regulations, and the estimated strength of competitors. These are subjective assumptions not based on hard data.

For quantitative projections, you could use something as simple as taking historical data and making straight-line forecasts into the future. 

Step 4 – Forecast different scenarios

After you’ve completed your baseline financial projection, start thinking about what goals you want in your business plan. 

Consider different scenarios. What happens if the economy turns down or if a new competitor appears? How will these events affect your future sales, profits, and cash flow? What actions will you need to take?

Considering different scenarios will help you prepare your business to deal with these challenges. It’s much better if you’re prepared beforehand rather than being caught off-guard and having to scramble. 

Uses of financial forecasting

Financial forecasting shows how your business will grow over time, how much net profit you expect it to make, and how its financial condition will change.

You can use financial forecasting to:

Plan for the future

Once you’ve decided on your strategy, you can use your financial forecasting to turn your objectives into actions and realities. 

Suppose you want to pay down your debts. A forecast can show how much cash will be generated, where it will come from, and how quickly you can liquidate your loans. 

If the debt repayment plan is too slow, you can adjust the forecast and make the changes needed in your operations to increase the cash flow. You may need to change your product mix or find ways to cut expenses to meet the debt repayment schedule you want. 

As your company grows, you may need to add additional employees. You may find that you’ll need more salespeople, warehouse personnel, or more administrative support. A forecast will identify when you’ll need the new employees and how much cost they’ll add to your payroll.

If growth requires additional capital equipment, the forecast will identify how much equipment is needed and when it will have to be in place. At the same time, you can begin to solicit price quotes and develop a plan to pay for the purchases.

Establish realistic goals

It would be nice to have a business that projects a sales growth rate of 10%, 20%, or 30%. But is that realistic?

You may find that your company isn’t generating enough internal cash flow to support the rapid increase in assets that come with high growth rates. 

If your business is already leveraged with debt, you might not be able to get additional financing to support the growth. In that case, you’ll need to scale back your dreams to a more realistic goal. 

Show to potential investors and lenders 

Financial forecasting is an excellent way to show investors and lenders that your company is financially healthy and would be a good investment for outside parties. 

Lenders want to feel comfortable that you’ll be able to repay a long-term loan or manage a business line of credit. You can establish credibility as a small business owner by presenting a well-thought-out cash flow projection that shows them how you’ll be able to repay a loan. 

In addition, you could present different forecasts that show how you’ll still be able to repay the loan even if things don’t go as planned.

Lenders want to believe that you’re in charge of your business and know how to handle different types of business financing.

Investors want to know that they’re going to get a good return on their money to justify taking the risk of making an equity investment in your company. A realistic forecast will show that the company is capable of generating a good return on equity and that the return is likely. 

What tools can help you forecast your financials?

You can make the number-crunching required by financial forecasting much easier by using accounting and planning software designed for making financial projections. 

You can even try out different “what-if” scenarios. Financial planning won’t be time-consuming or tedious with these tools.

These software apps will typically come with a set of key performance indicators (KPIs) — such as monthly sales, gross profit margins, EBITDA, liquidity ratios, and inventory turnover — that monitor the performance of your business. 

KPIs are like looking at the instruments on the dashboard of your car except, in this case, the indicators are measuring business performance.

You don’t have to purchase expensive accounting software at first. You can try out this free small business accounting app. While Lendio’s software does not have financial forecasting features at this time, carefully managing your cash flow is a great first step.

Conclusion

After you’ve decided on your strategy and have prepared your financial forecast, you can use these schedules and budgets to guide the activities of your business plan to your desired goals. 

Monitor the actual results and look for deviations from the plan to make corrections. This is like driving your car down the road and it drifts off the pavement. You then make a correction to get back on the road. It’s the same idea with your business. 

Some KPIs you can monitor weekly, and others you look at on a monthly basis. 

Resources

  1. Entrepreneur: “Preparing for the Future With Better Financial Planning for Small Business
  2. SCORE: “3 Basic Financial Statements You Need to Keep Track of Your Money
  3. Inc.: “Financial Ratios
  4. Entrepreneur: “3 Reasons to Stop Creating Financial Reports Manually
  5. Forbes: “The Value of Key Performance Indicators

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James Woodruff

James Woodruff has been a management consultant to more than 1,000 small businesses over the past 30 years. This background has given him a foundation of real-life experiences for his freelance writings on business topics. James has written extensively for PocketSense, Sapling, Bizfluent, SmallBusiness.Chron.com, and Work.Chron.com. He previously had his own firm that specialized in financing exports from the United States to clients in Central and South America. James received a Bachelor of Mechanical Engineering from the Georgia Institute of Technology and an MBA in finance from the Columbia University Graduate School of Business.