Let’s be honest with each other.
You’re not here because you want to create a financial forecast.
You’re probably here out of necessity. You’ve probably been told this is something you should be doing or you’ve read somewhere respectable that it’s important.
Well this ultimate guide should ease you into this unpopular topic covering:
- The problem with financial forecasting
- What are the big 3 financial statements?
- What can forecasting do for your business?
- What does good financial planning look like?
- How you should approach creating your own financial forecasts
I’ll also do my best to avoid the industry jargon that plagues the topic along the way!
The problem with financial forecasting
As a business owner, your day is already full of important tasks. Tasks that directly revolve around acquiring new customers and keeping existing ones happy. Not to mention managing your team, keeping them motivated, productive and happy too!
You know, all the stuff that actually matters and makes a real, tangible difference.
Financial forecasting is associated with being time consuming and difficult. It can often be stressful too. Battling with hypothetical numbers across multiple jargon filled financial statements.
All the while taking you away from the stuff that really matters.
So why on earth do reasonable, intelligent people say you should do it?
You’d be forgiven for thinking forecasting on a regular basis has no place in the world of small business. That forecasts are purely an abstract luxury reserved for big corporations with huge finance departments.
Most people’s exposure with the topic might be a news article reporting on Apple’s quarterly business results, dissecting how they performed compared to what they forecast. Financial experts endlessly debate their decisions back and forth. They analyse the impact of recent market conditions on their financials and explain how their long term strategy might be affecting today’s results.
What’s interesting is the language these large companies themselves use, as well as the wealth of rhetoric from industry experts. It’s all couched in the context of their business strategy in relation to changes in the market, changes to the global economy, changes in local markets and changes in competitors.
These corporations are driving such big ships that to not look ahead could spell disaster for everyone involved. They have to make good decisions right now and those decisions need to be grounded in sound financial projections.
You might feel you don’t have the luxury to forecast ahead but for these big companies, they don’t have the luxury to not forecast ahead.
So the first real lesson here, is that companies don’t just complete an arbitrary quarterly forecast for the sake of due diligence. They do it to help them make the right decisions in an informed way.
If you can do forecasting well it can help you backup and explain why you make one business choice over another.
However, we’ve already said that large enterprises can afford the luxury of this activity due to having dedicated resources, whole teams of accountants and planners.
“This still isn’t a relevant activity to my small business”, you might be thinking.
Well, financial forecasting doesn’t have to be arduous. It doesn’t have to be difficult and it can be incredibly beneficial to any scale of business.
We’ll see how later in the article.
For now, let’s start understanding the traditional financial statements that are commonly used in the forecasting process.
What are the big 3 financial statements?
Forecasting, at its heart, is about making predictions over how the various activities your business conducts will perform in the next 3 months, 6 months, 12 months and beyond.
Making predictions helps you understand what impact their performance will have on the financial health of your business and your overall goals.
These predictions and results must be presented in a form that you can understand and make decisions on.
It generally means you’ll be asking lots of questions that look like this:
If I do ‘X’ activity and it performs like ‘Y’ then it will have ‘Z’ impact on my business.
Don’t let your preconceptions about requiring complex financial statements deceive you into thinking forecasting is any more complicated than this. This is what it boils down to.
Financial statements are simply a reporting tool but if you don’t understand them then they just create a barrier to the forecasting process. They must serve the above activity and not become the activity themselves.
Your goal is to make good decisions, not an incomprehensible report.
The primary financial statements do have a major role to play. If you are asking questions across the entire business then they provide a universal framework for structuring the answers.
This is where it gets complicated.
You could track the financial impact of one activity in isolation fairly easily. It’s when they all come together that you suddenly find yourself in deep water.
Each financial statement also reflects a different side to the business, telling a different story.
They work together to explain the financial health of your business in its entirety. Projecting one of them is like looking at your business through a filtered lens. You don’t get a true representation of the picture.
Right, I’ve been edging around the subject of these financial statements for long enough. Let’s take a look at the problem head on and learn exactly what each of them are all about.
Each financial statement is broken into different account categories. There are variations between details and presentation across companies but there are core areas to these reports that are universal.
Cash Flow statement
When I was learning about finance I found the Cash Flow the easiest to get to grips.
This statement simply presents all the cash flowing in and out of the business.
You could build a simple Cash Flow just by looking at your bank statement each month, so it’s a great place to start if you are new to forecasting.
A more detailed Cash Flow report will have account categories that separate out the different types of cash a business is spending or receiving. For example, has a certain cash increase come from the sale of a product or a loan from a bank?
Forecasting your Cash Flow helps you:
- Understand if you are in danger of running out of cash (and going bankrupt!)
- Understand when you can afford to invest surplus cash into growth efforts
- Calculate burn rate (the rate at which startups spend investment funds)
Profit & Loss statement
In contrast with my experience with the Cash Flow, I found the P&L harder to get my head around, initially. It’s a crucial part to understanding your financial story though! It really works hand in hand with the Cash Flow too.
I think about it like this. The Cash Flow blissfully records any cash transaction without bias. If it costs you money, it’s a negative. If you gain money, it’s a positive. It’s very black and white.
However, not all cash spending is a loss to the business. If you spend £500 on a laptop, your Cash Flow diligently records the £500 cash deduction.
However, it says nothing about the fact you just gained a laptop worth £500!
It’s certainly not a replacement to the Cash Flow because you still want to project your bank balance in the future too. There is no point in being profitable if you run out of cash!
Forecasting your P&L helps:
- Make decisions around profitability
- Work out how you’ll grow your business
- Show the true value of goods or services provided or purchased in a time frame (If you buy something in advance, the P&L only recognises the value when you receive the benefits. Another difference between the Cash Flow and P&L.)
Find out more: A Beginner’s Guide to the Profit and Loss Forecast Report
Balance Sheet statement
The Balance Sheet shows a snapshot of the business as any particular point in time. It’s probably the most jargon filled report of the three.
It’s broken into Assets, Liabilities and Equity.
As it’s so jargon filled, I won’t linger too much on this report here as it deserves more space to be explained properly.
The Balance Sheet definitely plays an interesting role in telling the story of your financial health.
Forecasting it can show:
- How risky the business is over time
- Where investment is coming from
- How the value of your business changes over time
Find out more: A Beginner’s Guide to the Balance Sheet Forecast Report
So the big 3 reports are all useful, if you can interpret what they are telling you. Unfortunately they originate in the world of accounting, giving them a reputation for complexity.
What can forecasting do for your business?
Forecasting has a number of benefits but the primary reasons look like this:
- To persuade investors to fund you
- To set targets and budgets
- To make good decisions from scenario testing
1) Persuading investors to fund your business
Nothing pushes people into financial forecasting more than the opportunity to receive funding from an investor.
They might love your company and your team. However, unless the numbers that underpin it all makes sense, the opportunity will swiftly depart.
A financial forecast will help demonstrate to investors:
- Your long term vision and strategy (often in the form of a 5 year forecast)
- Your best and worst case scenarios
- Your judgement and ability to make assumptions
- What will actually happen (last on the list)
What stands out here is that a forecast is not valued solely on its ability to predict the future. A financial forecast is always going to be wrong. It’s only a question of how wrong.
However, it does show that you are asking the right questions about the future. Crucially, you are also coming up with answers that are within the realms of realism.
That is important to an investor.
Your forecast and business plan should demonstrate to investors how you came to these conclusions:
- What assumptions did you make about your activities to get to these numbers?
- How confident are you in them?
- Are you prepared to put them to the test going forward?
This is all relevant whether you are going for funding or not. Great accuracy is never going to be possible and it’s not the purpose of the exercise.
Forecasting is a tool to help pick a path through an uncertain future.
2) Setting targets and budgets
This is one of the more practical and tangible benefits.
A 12 month cash flow forecast helps you understand your available cash each month. Many companies use this to set caps on spending so they don’t run out of cash later in the year.
You can set sales targets too but you need to be careful with how you derive them.
Let’s say you’ve budgeted £50k total costs this year. That means we need at least £50k in sales to breakeven.
With a 10% profit margin too – that makes £55k. I now have my target!
However, that 55k sales target didn’t arise from any realistic plan to reach, nurture and convert the customers required to get to this number. It says nothing about what you can actually achieve.
Bad forecasting will set arbitrary numbers without any sound reasoning. When your business is wildly off target later in the year, you’ll be scratching your head wondering why.
Good forecasting involves highlighting what you need to achieve. At the same time it will explain what supporting activities need to perform in order to get you there.
So, forecasting helps you to focus on the areas of the business important to reaching your goals.
This leads nicely into the third benefit: making better decisions.
3) Informed decision making through scenario testing
As I said earlier, forecasting is about asking questions.
These broadly fall into two categories:
- Questions about external factors
- Questions about internal factors
You need to answer these questions in the form of scenarios that cover a range of eventualities.
This range helps you plan ahead so your business is ready for whatever happens.
Questions about external factors
External factors are influences from outside of the business.
They might be due to changes to the local or global economy. It could be a new competitor entering the market or a problem with a supplier.
The commonality across all these factors is that they are hard to plan for. How can you plan for a new competitor turning up in 6 months time?
In most cases, you simply can’t.
What you can do, is stress test your finances.
You start asking ‘what-if’ questions like:
- What if my supplier prices rise by 10%?
- What if I make 20% less sales?
- What if corporation tax rate goes up?
Modelling the answers won’t help you predict what will happen but will ensure your business is prepared in case they do.
It affects your decision making right now. It might mean you delay the purchase of new equipment until you have a certain level of cash reserves. Cash reserves that will protect you against a worst case scenario.
Questions about internal factors
Now we are dealing with all the stuff you can control. What it boils down to is trying to work out two simple concepts:
- What is worth spending my money on?
- What is worth spending my time on?
Questions will look like:
- Which marketing channels are worth spending money on?
- When can I afford to buy new equipment?
- Do I need to employ more staff?
Many businesses assess decisions like this in isolation. They don’t look at the long term financial ramifications to judge whether it’s actually worthwhile.
Of course, it’s not practical to enforce making all judgements and decisions after they’ve been run through a financial forecast.
However, regularly forecasting will make you more aware of the long term financial health of your company and the factors that contribute to it.
It equips you with a more informed view that leads to better decision making.
So what does good financial planning look like?
So let’s pull out and summarise some of the lessons we’ve learnt so far:
- Forecasting is not about accuracy, it’s a decision making tool
- The process of forecasting is about asking good questions
- A forecast should be based on assumptions grounded in realism
- Realistic forecasts help you focus on activities important to reaching your goals
- Best and worst case scenarios help you stress test your business
- Planning ahead helps you set budgets so you don’t run out of cash
- The different flavours of financial statement show different sides of your business
Forecasting is not:
- A one time financial report you file away in a cabinet as soon as it’s out of the way with
- Setting arbitrary targets with no realistic method for achieving them
- A precise and accurate prediction of what will happen
We now know a bit more about what the forecasting process looks like.
You can see what should be included and why you need to be doing it. So it’s time to look at how you should practically go about approaching it.
How you should go about approaching it
So you can see why you need it, how can you approach this in a practical way that won’t eat up all your time?
I have to say, right now, this option has difficulties.
Creating a dynamic, flexible spreadsheet that shows the complete financial picture and allows you to test scenarios on the fly is neither easy or quick to do. Perhaps if you are both a financial expert and a spreadsheet wiz, you’d be able to do this.
For most of us, it’s a non-starter.
What’s the answer then?
Well, remember earlier I was describing how forecasting is not about creating a report.
As I’ve been hammering home, it’s about asking questions about the future that help you make decisions in the present.
If you want to understand the ramifications of those questions on your entire business, then you’ll need to look at the impact in the context of a financial report.
So your first job is simply to write down on a bit of paper the key sections of your business.
I’m talking about:
- Your primary sources of income – the stuff you sell
- Your costs of sale – costs directly related to the provision of your products or services
- Your team – the salaries of the people you need to make it all happen
- Your operating costs – other costs required to run your business
- Your marketing costs – the activities that generate new customers and drive new revenue
- Your sources of funding – any money injected into the business
You should break these sections down into groups that unpack the critical components of your business.
For example, you might sell a range of products. Breaking them down into important categories helps you look at their contribution to the whole picture.
This task helps you identify all the drivers. The important stuff, that you’re taking time away from now to do this forecast. Well the great thing is, although you might not be completely familiar with financial reports yet you do know this stuff like the back of your hand.
Being able to see the complete picture of your business on a piece of paper allows you to understand how the components relate to each other. If you intend to drive more customers, you need to lean on your marketing activities.
If you know your sales team are already at max capacity then this will mean recruiting a new team member in the future too. So there are some timing aspects around finding a new team member and ramping up marketing spend leading to more sales down the line. Is it all going to be worth it? When can you afford the additional costs?
This is our first question. We’ve phrased it using the known components of the business.
We haven’t started forecasting by looking at a Profit & Loss statement. We’ve started something better.
We’ve started creating a model of your business. This model isn’t a list of financial accounts, it’s simplified picture of all your business activities that drive changes in the financial reports.
What does this all mean? Well a spreadsheet would already struggle with quickly answering the question posed above.
A model, however, is far more capable…
I’m going to pitch something to you now
Since a spreadsheet is not going to be easy or quick I’m going to pitch a different software solution to the problem I’ve outlined so far.
In the spirit of being upfront – it starts from £15 per month (with a 14 day free trial). So if that is outside your budget then I understand if you feel you’re done here.
No hard feelings and I hope you got something out of my brief introduction to the world of financial forecasting.
If I have piqued your interest. Do read on!
Brixx is an online financial forecasting tool that allows you to enter your key business activities in the way you wrote them down on a piece of paper.
Add your team with their salaries. Add your products with their prices. Add your equipment with how much they are worth. Add all the important activities that contribute to the full picture.
The result is a model of your business.
This model facilitates quick, flexible changes without having to fight a battle across a complex range of financial reports. The software fights this battle for you by handling the accounting calculations behind the scenes.
At no point do you spend time working out what is meant to be contributing to the total liabilities line on the Balance Sheet. Brixx works this out for you based on the activities you enter.
In fact, the entire set of financial reports build naturally as you enter your normal business activities.
It helps you create a financial forecast in a more human way, focusing on the important stuff rather than any particular financial account.
It’s also why it’s so quick. You spend less time error checking the numbers and more time asking good questions.
Here at Brixx, we build software that helps you make better decisions by making financial forecasting easy and accessible.
We are bringing highly professional forecasting capabilities to small businesses and startups. The kind of capabilities previously only seen in big corporations with huge finance teams.
So, how do you get started? Well, you can have a poke around brixx.com for more information.
When you are ready:
- Sign up for a free trial (no credit card required)
- Start your financial plan with a provided template
- Modify the template to fit your business activities
- Begin forecasting the numbers!
If you find it valuable you can purchase one of our subscriptions later on. If not, your trial will end, you won’t be charged and you can continue your life as it was before.
If you continue with us, know that you’re backed by a friendly support team ready to help you. We’re also continuously working on free updates and improvements to the app.
We’re on a mission to improve the way businesses plan and explore the future.
Get started with Brixx financial forecasting software
- Create 5+ year forecasts
- Test ‘what if’ scenarios
- Detailed financial reports
- Model your business
- Easy to use