As we are nearing the end of the fourth quarter, this is usually prime budgeting time for most companies. Many firms have already put together a forecast for next year, but perhaps there are reasons to review, update and modify closer to year end. Forecasts can be done for internal use (management, Board of Directors) as well as for external stakeholders, such as lenders or investors.
Here are some items to look out for to determine how thorough and reliable a forecast might be:
- A list of the key assumptions used in producing the forecast. This should be qualitative with only the highest level quantitative figures to help explain the major features. This is the forecast in layman’s terms.
- A bridge analysis from either a prior period of actual results or compared to a prior forecast. The bridge must show the variances and include explanations for any significant variance. This helps to evaluate the soundness of the logic and methodology used in putting together the new forecast
- Any forecast must also include a balance sheet and cash flow statement, not just an income statement (which is typically the only thing that comes to mind when a forecast is envisioned). The income statement only indicates profitability and does nothing to address cash. Cash is the most important thing, since a very profitable business will not remain profitable for long if it cannot make payroll and satisfy its creditors. The balance sheet requirements will help determine what financing might be needed to successfully achieve the forecast. The cash flow statement ties together the income statement and balance sheet to see where cash is being generated and / or what cash is required to run the business
- Any forecast that does not have the items listed above should be viewed with a higher level of suspicion. Regardless of how thorough a forecast seems to be on the surface, the following points should be assessed in your review process.
Income Statement Considerations:
- Round number, blanket assumptions on sales, such as a 10% or 15% growth rate, without any substance behind why that would be justified, are red flags. Substance should come in the form of identifying new products to customers, additional sales into an existing customer base, or entering new markets. Depending on the specifics, that will impact whether or not the company has the right resources included in the plan in order to realize success.
- If the forecast calls for no change in margins, that may be valid. But imagine if the growth is supposed to come from a certain customer segment, and that group has a different margin than the company average, then the forecasted margin should change from the baseline.
- An even better way to assess the forecast is by taking into account the company’s breakeven point. If you know the company’s contribution margin, you can look and see if that is changing over time. It is also helpful to evaluate if there are changes in the fixed costs.
Balance Sheet Considerations:
- For stable businesses, the balance sheet will probably not fluctuate much, but for growing organizations, there are many items that can change tremendously.
- Accounts Receivable – A new customer that requires longer terms means that the company will have to pay for supplies and wages before it ever collects the cash from a sale.
- Inventory – If the company has seasonal sales, it might be required to build inventory ahead of that season, such as the fourth quarter holiday shopping season. If product needs to be brought in starting in September or October, but the cash is not collected from the sale until November or December , these timing gaps are very crucial to make sure that liquidity is not impacted. The company could show great profits throughout this period, but until the cash is collected, profits don’t pay employee salaries.
- Investments into the business – If you are a manufacturer, you may need to buy more equipment to grow, or replace outdated machines. A good forecast should also include some contingency for unplanned events (i.e. unexpected replacement of equipment).
- Term Loans / Leases – Term loan payments are not deducted as an expense, so a company has to show profitability in order to generate enough cash flow to support any reduction in liabilities. These things are highlighted in a cash flow statement.
- Lumpy Payments – Other things to consider are timing on property taxes (typically 2 times per year), timing on insurance payments (usually front loaded), and things like vacation if employees are able to cash in, if unused.
- Another thing to keep in mind is how the business is forecasted relative to the way results are reported. If the forecast is based on changes in customer retention or average sales per customer, will these items be included in the reporting package at the same level? If not, perhaps some time should be spent to align these approaches so that the reporting can be more useful in comparing to the forecast, otherwise you risk causing confusion amongst the management team down the road.
- Where does the input for the assumptions come from? Are the sales goals a top-down mandate, or were the people that are responsible for generating sales getting to share their input? Does a plant manager have any say in the maintenance budget or staffing levels?
- In certain situations, it will make sense to have more than one forecast, such as having an internal forecast that contains stretch goals for management and employees, and another more conservative forecast that is presented to lenders. The rationale is that the company should strive for a high goal, but set covenants and expectations at a lower level for outside stakeholders.