6 Ways to Make Financial Forecasts More Realistic
It's a rare entrepreneur who enjoys working on financial forecasts. Many feel like the time could be better spent on actually developing and running their business. Still, forecasts truly are a necessity. You need them to attract investors, but more importantly they help you develop long-term strategic plans.
Unless these forecasts are fairly accurate they aren't helpful at all. Inaccurate forecasts can lead to upset investors, mismanaged expenses and, potentially, running out of cash. Here are a few tips to help you make your forecasts as accurate as possible.
1. Use multiple scenarios.
There is a strong temptation to be optimistic when forecasting growth. To counter this, many entrepreneurs end up using extremely conservative estimates. In reality, neither is the only option you should forecast. You should devote your predictive energy to at least two scenarios, one optimistic and another cautious. This is especially true if there is uncertainty surrounding major factors that could impact your business, such as government regulations, new competition, or even overall economic growth.
It can be frustrating to use multiple forecasts. It clashes with the part of our brain that is hardwired to desire certainty and precision. Still, it helps you maintain flexibility in your strategic planning and create more realistic expectations for your investors.
2. Start with expenses.
In general, it’s much easier to predict your expenses than your revenues. Start building your forecast model by outlining your fixed expenses, things like rent, utilities and insurance. You can be almost certain these costs will occur in the coming quarter/year.
From there, think about the costs that could fluctuate directly with revenue. If revenues grow by 5 percent, you can probably expect your cost of sales to also grow by about 5 percent. There will be fluctuations in these expenses, but for the most part they should mirror revenue to a good degree.
Finally, project the expenses over which you have the most control. This is one place where multiple forecasts can come in handy. Identify which discretionary costs you might slash if business is rough, or where you will invest for future growth if you exceed expectations.
3. Identify your assumptions.
Any forecast requires you to make assumptions about things that are outside of your control. The best way to manage these assumptions and avoid subconscious bias is by explicitly identifying and writing them down.
The assumptions you should list include how much the market will grow or shrink, changes in the number of competitors and technological advancements that will impact your business.
4. Outline each step in your sales process.
Your revenue projections should go through the entire funnel of your sales channel rather than just guessing at a top-line number. You should create projections for each step of the sales funnel, and use that to arrive at the top line number.
As an example, the revenue projection for a pet supply store might involve the following steps:
1. Identify the total addressable market (i.e. number of pet owners) in the area.
2. Estimate what percentage of that market can be reached through marketing efforts.
3. Estimate what percentage of pet owners exposed to that marketing actually come into the store.
4. Estimate what percentage of people who come into the store will actually make a purchase.
5. Finally, estimate how much the people who do make a purchase will spend on average.
5. Find comparisons.
Assess the plausibility of your financial forecasts by comparing your projections to the results of comparable companies. For certain niche businesses, it can be hard to find data on comparable businesses, but at the very least you can compare your projections to your own operating history.
Look at certain key financial ratios such as gross margin, revenue per square foot (for retailers), and total headcount per customer. These ratios aren’t set in stone, but they can be very difficult to meaningfully change. If your projections include one of these ratios improving by over 10 percent, you might be getting too optimistic. The same goes for when your projections for these ratios are significantly superior to every single competitor in your industry.
6. Constantly reassess.
These forecasts should not be static. Don’t make one at the beginning of the year and then ignore it for the next 12 months. Regularly evaluate how close your operating results mirror those forecasts, and make changes to reflect any new information. The more up to date your forecasts are, the better prepared you will be to make informed strategic decisions. Also, you'll become more skilled in the process over time and will correct mistakes in your methods. As you become adept at forecasting costs and revenues, you'll be more confident about making future projections, even if not all business developments that occur are desirable.