What is a Financial Forecast?
A financial forecast consists of several projected financial statements, sometimes called pro forma statements. These statements lay out a plan that should make sense to the business owner, banks, and any other interested parties, like angel investors.
Typically, 3 statements form the heart of a financial plan: an income statement, a cash flow statement, and a pro forma balance sheet.
Generally, these statements should be completed in order. The income statement explains how much money flows in and out of your business, while the cash flow statement uses this information to show how you will make a profit (or a loss) over time. Finally, the balance sheet predicts assets, liabilities, and equity using data from the other documents. Once finished, you should be able to show how your business will change over time.
Why is financial forecasting important?
For a small business owner, it always makes sense to take a formulaic approach to understand how your business should grow over time. A financial forecast provides you with benchmarks and goals that you should revisit regularly. In most cases, a small business owner should look at creating a financial plan that forecasts at least the next 6 months to a year.
However, it is prudent to make a plan that stretches even further into the future. Most banks and angel investors want a detailed financial plan that covers a period of 2 to 5 years. Many small business owners opt to create a plan for this extended period in case they find themselves in a cash crunch and need a loan or fundraising – it is far less stressful to create a financial forecast at the outset of business than when you are scrambling for funding.
It is recommended to revisit and update a financial forecast once per quarter or when a major event occurs.
Financial forecasting is not accounting.
Perhaps the simplest way to comprehend financial forecasting is by understanding what it isn’t – financial forecasting is not the same as bookkeeping.
Accounting looks backward – your books should show what you earned and spent in reality. Financial planning looks to the future, which is much more complicated than assuming what happened last year will happen again this year. However, you will likely refer to your past accounting in creating your predictions.
Understanding Your Income Statement
Your business’ projected income statement is probably the part of the planning process you will spend the most time on. When you have a solid understanding of this document, you have done much of the legwork of calculating the other two. Basically, the income statement compares revenue versus expenses over time in various scenarios.
Determine your expenses.
If you are like most small business owners, you probably have a more solid understanding of your expenses than your revenue. Therefore, it may make the most sense to start with listing your projected operating expenses for the next few years.
You should differentiate between operating expenses and your cost of sales, i.e., expenses directly linked to the product or service you provide. Some examples of cost of sales, or Cost of Goods Sold (COGS), include raw materials, storage, or the cost of a freelancer completing a service for a customer. We will look at COGS when projecting sales.
Some of these future operating expenses might already be set, like if you have signed on with an internet provider for a fixed price over the next year.
Other common operating expenses include rent, advertising, employee salaries, and insurance.
Break down operating expenses into monthly increments even when forecasting years into the future.
Project your sales and COGS.
Projecting sales is an art of its own – look at patterns from your past to get a sense of your future. Pay attention to how your sales change season-to-season and month-to-month – do you see a large bump in sales during the holidays, or is your business busiest in the summer months?
If you don’t have much data to pull from, you can still form an idea of future sales. Read trade publications and talk to your vendors. The United States Small Business Administration has local agencies called Small Business Development Centers that offer free small business counseling, as does the nonprofit SCORE.
Calculate how your sales will grow with increased production.
Increased sales also mean increased costs, known as Cost of Goods Sold (COGS). Calculate your COGS by adding the cost of your inventory at the beginning of a year (or another period) to the cost of purchases related to manufacturing. Then subtract the cost of the remaining inventory at the end of the period for your COGS.
The cost of purchases includes raw materials, labor needed to manufacture a product, and storage. For a service-based business, these costs could be how much you pay yourself, an employee, or an independent contractor to complete a unit of service.
Your COGS will be another expense. You shouldn’t double dip with COGS – operating expenses that aren’t directly related to the creation of a product or service should be listed elsewhere in your income statement.
Outline a production schedule.
Forecast your production schedule within your income statement. This step will be necessary when completing a cash flow statement. If you haven’t yet started production, you should estimate how much inventory you need to start and when you need it. For established companies, look at how to schedule your production to support your monthly sales goals.
Even if you don’t produce or resell goods, create a monthly cost schedule. Do you have to hire new freelancers for a traditionally busy time of the year? How do your business costs change over time?
Think about possible scenarios.
Your income statement is the place to contemplate how the economy and other outside factors will change in the next few years.
Is a big box store in the process of building a new location near your business? Maybe you will have to boost your marketing budget to stay in your customers’ minds.
Upcoming legislation, demographic changes, and wider economic trends can impact your business. Are local legislators looking at raising the minimum wage? Is the number of students at a local university growing? Will you have to offer higher salaries because unemployment in your area is low?
You can create 3 different income statements – a regular scenario, a best-case scenario, and a worst-case scenario.
In the regular scenario, outside factors will be minimal and your business will grow at a rate similar to previous years.
In the best-case scenario, outside factors break in your favor. There’s an influx in your customer base, for example, or you can find good workers at a wage that you prefer. Make a forecast based on a reasonable best-case scenario for the future.
Do the inverse for worst-case scenario predictions. What if production is delayed and your city raises the minimum wage all at once? Though it probably isn’t too useful to have a business plan that forecasts the apocalypse, create a statement that shows what would happen if things don’t go as planned.
Understanding Your Cash Flow Statement
Now that your income statement for the next few years is complete, you need to determine what your input and output of funds will look like for your future.
Being profitable is great, but it’s not a guarantee of future success without a plan. Bringing in revenue is different from having cash in your bank account. You need cash on hand to pay your rent, buy needed supplies, and cut your employees’ paychecks.
Look at your monthly revenue compared to your monthly expenses, paying careful attention to when you need to make specific payments. This exercise will illustrate when your cash flow will be an issue.
Where is funding needed?
It is normal to foresee future cash crunches – this scenario is partly why you are putting together a financial plan in the first place.
Outside funding can be a salve for your cash flow issues. Use your cash flow statement to explore how a bank loan or an angel investor would help you grow. Add potential debt repayments as an expense, and note how extra surpluses could be used to pay off more of a loan.
When used responsibly, financing can be a mechanism to boost your company; it allows you to cover your operating expenses while increasing production.
This information will be required to get loans or investments, so spend some time on determining realistic cash flow. It is best to create 3 different cash flow statements for your 3 different scenarios.
Creating Your Pro Forma Balance Sheet
Using data from the income statement and the cash flow statement, you can put together your balance sheet. The balance sheet compares your assets, liabilities, and equity in order to predict how your business will change over the years.
List your forecasted assets from operating activities, financing, and investing. Also list your liabilities, such as debt repayments. Include any equity you plan to put into the business.
When predicting future loans or investments, be realistic and make sure you include information to back up any guess. If your credit score is low, it’s unlikely that you will be approved for a $500,000 loan from a bank. If you are a first-time business owner and your company is less than a year old, an angel investor probably won’t write you a $1 million check.
Noting your predicted assets, liabilities, and owner’s equity for each year will provide an idea of how these factors will vary year by year.
Reviewing All the Numbers
After you finish your income statement, cash flow statement, and pro forma balance sheet, compare the three documents. Make sure they sync with each other.
You can check your business’ viability with an “acid-test ratio,” also known as a quick ratio. Add up your cash, cash equivalents, marketable securities, and accounts receivable. Now compare this number to your current liabilities as a ratio. Typically, a 1:1 ratio is pretty healthy. If your quick ratio is higher than 1, your company should have greater liquidity.
If your quick ratio is less than 1, it means a cash shortage could easily imperil the company.
Finally, remember that all of these forms are living, changing, dynamic documents. They should be reviewed and updated every quarter, or every time a significant event occurs for your company. As time passes, you will have a better idea of how your regular, best-case, and worst-case scenarios are playing out.
Leveraging Your Financial Forecasting for Growth
Once your financial forecasting is complete, you can get a better handle on how and where your company can grow. You can foresee when you will likely have times of plenty and times of pain. Utilize this information to find the best times to take your business up a level.
Just by completing a financial plan, you are on your way to finding funding for your company’s growth because any bank will require this information for a loan. The plan will show you where financing can help you grow by providing incoming cash flow to cover expenses while you expand. You should depend on financing to accomplish long-term growth goals, not to keep your company from going underwater.