Forecasting as a Planning Tool — July 2016

This post involves budgeting and forecasting.

Virtually every well run business forecasts its Income Statement in one form or another and calls it a budget. However, savvy managements also forecast the Balance Sheet. This effort adds rigor to the forecasts of income and forces management to thoroughly evaluate its plans and question the underlying assumptions. While this is done under the explicit guidance of the CEO, the CFO and team members provide the heavy lifting.

A growing firm needs cash to finance its growth. The CFO must consider the impact of cash needs as part of the planning process. The process begins with a sales forecast. The basic assumptions underlying the sales forecast enables the preparation of a balance sheet to determine the cash the firm needs to fund the growth.

The mechanics of this effort are straightforward. Based on sales growth, the CFO determines the amount of cash necessary to cover operating expenses, fund receivable and inventory growth, expand capacity, provide a safety net for contingencies, pay debt obligations, and distribute cash to owners. Once these calculations are performed, we suggest multiple scenarios, so management better grasps what can go wrong. This will allow the CFO to anticipate challenges and develop proactive advice if a budget shortfall appears likely.

Once cash needs are determined, the CFO must forecast the basic balance sheet. This is accomplished by incorporating the profit forecast with the assets required to support sales growth and the appropriate amount of liabilities to fund the asset growth.

At this point, the CFO will examine whether or not performance ratios are acceptable based on industry standards or internal requirements. If the results of this exercise prove unsatisfactory, the CFO must determine what is imperative to make it occur. Along with others, the CFO determines if the alternative is acceptable and achievable.

While a one year forecast is very helpful for day to day management, a longer time frame is required for effective planning. We typically recommend a five year time frame. This exercise allows the assessment of long term funding needs based on annual sales growth. Quite often, trend lines (regression analysis) are used to forecast the forward looking information. This methodology also helps estimate the fixed and variable of each major expense.

Once management has good estimates of the fixed and variable components of company expenses, they can utilize breakeven analysis. This is a method for determining the amount of revenue necessary to cover both fixed and variable costs. Also, it allows the CFO to calculate incremental profitability once the breakeven point is achieved. Moreover, the methodology can be applied to the entire firm, key markets, or major business units. Likewise, it can be used to evaluate individual product lines.

The benefits of this endeavor are several-fold. It can determine the business’ leading profit centers. Management can use the results to derive an optimal product mix and focus the sales force accordingly. Finally, it can be used to plan expansion efforts in the premier profit centers.

While this forecasting process helps the CEO understand how anticipated sales must be funded, it also helps ensure that activities undertaken are consistent with the business owner’s vision. One method utilized by several large, successful companies starts with defining the desired outcome several years hence and what it looks like. The analysis then moves backwards towards the present through the steps necessary to achieve the vision, defining interim benchmarks at each step. The forecasting efforts we have reviewed quantify this process and act as a check on the individual programs utilized to complete each step.

Virtually every well run business forecasts its Income Statement in one form or another and calls it a budget. However, savvy managements also forecast the Balance Sheet. This effort adds rigor to the forecasts of income and forces management to thoroughly evaluate its plans and question the underlying assumptions. While this is done under the explicit guidance of the CEO, the CFO and team members provide the heavy lifting.

Capitol CFO Solutions serves clients in Washington D. C., Maryland, and Virginia. Please contact us for a free consultation.