The Importance of Financial Forecasting

Forecasting and predicting the future. They’re the same thing, right? Not really.

We all make predictions at some point. Many of us thought the Philadelphia Eagles would win the Super Bowl. At other times we may try to figure out what stock is going to drive the best return in our portfolio next year, or what changes the next election cycle will bring. In all these cases, we’re a third-party bystander. We may have done some research to make educated predictions, but in general we’re not the ones behind the wheel driving the outcomes. That’s where forecasting differs.

The goal of forecasting is to understand the inputs that will lead to future outcomes and develop a roadmap of what the future may look like. That’s not to say there’s no uncertainty. The best-made forecasts often prove to be very different from future reality. But they also identify and understand the magnitude of that uncertainty and enable a well-developed forecast to help a company pivot its thinking and adjust to the actual outcomes as they occur.

Contributors: Dan Murphy and Alex George

• Dan Murphy, Managing Director, BMO Corporate Advisory

• Alex George, Assistant Vice President, BMO Corporate Advisory, BMO Commercial Bank

Components of a successful forecast

Whether you think of forecasting in terms of the next 13 weeks, next year or five years down the road, it’s key to identify and track the inputs that will help you achieve your projections. A few key buckets could include the following:

• Customer demand. You may have fixed price contracts on one end, both ends or neither. How do your customers buying trends change in different economic environments? What is the competitive landscape, and how difficult is it for customers to switch products? Are you able to pass costs (both supplies and labor) to your customers?

• Supplier relationships. Identifying how your ability to procure materials or products impacts your ability to generate revenue. How do fluctuating prices impact your profitability and cash generation? Supply chain challenges have been put increased pressure and focus on this in recent years. You may be unable to obtain what you need exactly when you need it, but understanding that uncertainty can impact how you respond to it.

• Capacity. Regardless of demand, how much can you produce, distribute or design within your current workspace and with your current employee base? If you were able to grow to a certain point, would you need to purchase a new building or new equipment? If so, make sure those costs of growth are incorporated in your forecast.

• Growth plans. A company growing beyond the standard cost of inflation is doing so by either taking market share from a competitor, buying that competitor or creating new products and services. For much of those options there is a cost to making acquisitions or R&D. Those incremental costs are vital factors to your forecast.

• Cyclicality. While this is out of your control, you can think about what happens when the market softens. A weakening market may mean a change in demand, costs or prices. Some companies thrive in a weak market, while others thrive in a strong market. You may not be able to predict what the economy will look like one year from now, and certainly not five years from now, but you can control how prepared you are to react to a changing economic landscape.

• Seasonality. It’s key to understand the timing of inflows and outflows. Seasonality is more key to some businesses and industries, but even nonseasonal businesses may have periods of higher expenses or higher revenue that aren’t perfectly aligned. It’s often essential to think more granular than annual when forecasting to account for this.

• Data quality. As with any well-intentioned analysis, quality of the inputs is vital—garbage in, garbage out. While you may engage a third-party resource, such as your bank or accounting firm, to assist with establishing a forecast, it’s also crucial to have the right internal involvement in identifying and evaluating the inputs. A well-structured forecast is not simply a finance department exercise, it requires C-level involvement to make actionable decisions and include valuable context to inform the model inputs.

• Debt. Leverage can be a great strategy to enhance returns and enable a business to pursue expansions beyond what cash balances can support. It’s also key to keep debt levels in mind to ensure you can meet future debt obligations and reporting requirements. Companies need to properly forecast the mandatory principal and interest payments due to any lenders based on their current and expected debt needs.

Once you’ve established the key inputs, it’s prudent to think about how those inputs may change in the future. The best forecasts will incorporate a base case, an upside case and a downside case. The financial and strategic actions you take in each of these situations is likely very different. Understanding how components of the forecast may change in these scenarios will arm you with the knowledge to adjust as you go. Strong companies may become distressed due to circumstances out of their control, but in many cases periods of strain on a business can often be avoided with an enhanced focus on where a company is going, not just where it is today.

Different forecasting models

Unfortunately, there’s no one size fits all forecasting process. Many companies focus on an annual budget, others project out five years, and some get even more granular and evaluate a 13-week cash flow forecast. This short-term forecast can be especially useful when near-term liquidity is constrained.

A 13-week cash flow forecast offers a granular view into a business’ cash position. When evaluating near-term cash drainage, the goal is not to bring about wholesale changes to operations (e.g., systemically raising prices or altering your operating model), but instead to focus on what you can control quickly (e.g., minor investments you can hold off on, or payables that can be comfortably stretched). Often utilized in distressed or turnaround scenarios, it can be a valuable arrow in your quiver to enhance your financial reporting.

Looking out further, via an annual budget or a multiyear forecast, enables companies to think about what the company looks like down the road. A long-term forecast enables a company to evaluate what level of capital expenditures it’ll need to achieve top-line growth, think about how customer or supplier contracts will affect margins as prices change in the future, and establish a roadmap to achieve strategic plans.

The best forecasts are not made and put on a shelf, but instead reviewed periodically with key stakeholders. As a forecast turns into reality, it’s best to not only update your model, but also evaluate what drove any delta between your forecast and actual performance. Were key contracts signed or altered? Did market factors positively or negatively impact your assumptions?

As you input actual performance into your model, you can also think through how that impacts the remaining periods in your forecast. If you projected 5% revenue growth and 0.2% margin expansion in year one of a five-year forecast, but the actual results were 15% growth and flat margins, it’s likely your later period assumptions may need to change. If you’re doing a five-year forecast, it’s not unlikely that year five will be notably different from your preliminary projection. By the end of year four, however, it’s also likely you’ll have a much more confident view of year five’s actual expectations.

The ongoing focus on adjusting a forecast will help keep surprises to a minimum and ensure the highest quality data possible, setting up your company for success.