You have probably heard the expression “Flying Blind,”. Maybe you have seen it used in the broad context of doing something by guesswork with no instructions. It turns out this phrase dates back to World War II. When the visibility for pilots gets so bad and they can't see the horizon, they have to rely on instrumentation to guide them through.
As a business owner, have you ever wondered where your cash was going?
Does wondering how much new business you need to get or if you should hire someone or lay people off keep you up at night?
If you are operating without a good forecasting model, then this is even worse than “flying blind.” You are flying blind with no instruments and with no guidance to help you maneuver the unknown.
I have spent over 20 years working with forecast models. Here are some components of what a good forecast model needs.
Understanding the drivers to what generates revenue and sales is the first step in building a good model. It is challenging to forecast much else without understanding the key service or product lines, revenue streams, or even contract terms. For example, in digital marketing, the revenue streams could be agency fee percentage of media, a monthly retainer, or even a markup based on the number of clicks or impressions (per 1,000 views) on a site.
Forecasting revenue needs to be updated monthly based on new business, trending, and business changes. A good revenue forecast can even help you understand if everything has been billed per a contract, specifically in service-oriented clients.
In most service businesses, the big expense is personnel costs, which are directly related to revenue. One method that I find effective is understanding the amount of revenue per person you expect per month for a particular service line and then adding a new employee to the model once revenue increases to a new level. This makes scenario analysis easier because, as revenue changes in the model, the personnel costs are automatically adjusted. Some costs fluctuate based on personnel such as office supplies, travel, training costs, and telecommunications. Some costs, such as rent, software, or advertising costs, might not directly correlate to personnel, at least in the short term, so they may need to forecast based on another method.
We can’t understand where the cash is going or forecast where it will go without a good Balance Sheet forecast. Once again, key drivers are important. Accounts Receivable is a component of sales and collections. Accounts Payable is a component of costs of goods sold, operating costs, and other vendor costs. Prepaid Expenses, Inventory, Accrued Liabilities, Fixed Assets, and Equity are all important to forecast based on trends and key industry metrics.
Forecasting cash is essential to the sustainability of the business. A typical Statement of Cash Flow is separated by operating, investing, and financing activities. The operating activities are typically a component of the income, depreciation, and current assets and liabilities (those items less than a year old). The investing activities are typically purchases of fixed assets or long term investments. Finally, financing activities show cash flow related to debt and/or owner withdrawals/dividends.
Most businesses typically have key measurements they like to see regularly.
Some KPIs could be the following:
- Gross margin %
- Operating margin %
- Revenue per person
- Revenue by service/product
- Margin by service/product
- Revenue growth over the prior year, budget, and last forecast
- Profit growth over the prior year, budget, and last forecast.
A good dashboard is beneficial for management to review everything in one place.
A forecasting model is an essential tool that a business needs to navigate through unclear challenges. The forecasting model should be versatile with key drivers that can be easily adjusted. When the path is uncertain, you might have to “fly blind” with just the instruments to lead you through the cloudy path ahead. Without a forecasting model, you are not only flying blind but with no direction or plan to what lies ahead. With a forecasting model, at least you have some reasonable guidance to direct you to a safe landing.