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Forecasting Model: A Solution to Flying Blind

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You have probably heard the expression “Flying Blind” and maybe you have seen it used in the broad context of doing something by guesswork with no instructions. After some research, it turns out this phrase dates back to World War II when the visibility for pilots was so bad, they couldn’t see the horizon and therefore had to rely on instrumentation to guide them through. 

I am not a pilot, but I can imagine that flying an airplane in a storm would be very challenging. But what if you were “flying blind” without instruments? Well, that would be considered suicidal.

As a business owner, have you ever wondered where your cash was going? Have you stayed awake at night wondering how much new business you needed to get or if you should hire someone or lay people off?  How do you make such hard decisions? 

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.

As a CFO, I have spent over 20 years working with forecast models and have put together a list of some of the most important features that are needed.

Revenue / Sales Forecasting Model

Understanding the drivers as to what generates revenue and sales is the first step in building a good model. It is challenging to forecast much else at all without understanding the key service or product lines, revenue streams, or even contract terms. 

For example, in a marketing agency, the revenue streams could be an 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.

It is essential to keep track of estimated revenue and sales on a regular monthly basis to account for the effects of new business, fluctuating trends, and modifications in the business. A precise revenue forecast can be useful in verifying that all charges are consistent with a contract, particularly when dealing with service-oriented customers.

Expenses

There are so many types of expenses that should be forecasted with different drivers (the cause of the expense). See Managing Expenses for Growth. Understanding the drivers is essential in building a forecasting model that gets adjusted when variables change. For example, if revenue and sales change, then cost of goods sold or cost of service should change based on the historical margins for the business, product, or service. 

In most service businesses, the big expense is personnel costs, which is 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 scenario makes analysis easier because as revenue changes in the model, the personnel costs are automatically adjusted. So many costs can be attributed to personnel such as office supplies, travel, depreciation, training costs, and telecommunications. 

Some costs such as rent, software, or advertising costs might not have a direct correlation to personnel, at least in the short term, so they may need to forecasted based on another method.

So, you can see that the most effective forecasting model is not hard coded line by line. Instead, it is based on key drivers that affect all the numbers when those drivers change. This allows for versatile scenario analysis so that the executive team can make quick decisions.

A Note on EBITDA

Once sales, revenue, and expenses are forecasted, then we can put together a good Income Statement. But don’t just focus on EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). EBITDA is a good Key Performance Indicator (KPI) but it is missing some important components in forecasting the Balance Sheet and subsequently, Cash.

Balance Sheet

In this post, I'm not aiming to get too technical with business owners, but I do need to discuss the Balance Sheet. Working out where the money is going and predicting what it will be spent on necessitates an accurate Balance Sheet projection. Again, it's essential to pay attention to the major drivers:

  • Accounts Receivable is linked to sales and collection. 

  • Accounts Payable is related to cost of goods sold, operational costs, and other expenses to vendors.

  • Prepaid Expenses, Inventory, Accrued Liabilities, Fixed Assets, and Equity are all significant to predict based on trends and essential industry metrics.

Statement of Cash Flow

Once the Income Statement and Balance Sheet have been forecasted, then the Statement of Cash Flow can be created based mostly on formulas. A typical Statement of Cash Flow is separated by operating, investing, and financing activities: 

  • Operating activities are typically a component of the income, depreciation, and current assets and liabilities (those items less than a year old). 

  • Investing activities are typically purchases of fixed assets or long-term investments. 

  • Financing activities show cash flow related to debt and/or owner withdrawals/dividends.

 

Key Performance Indicators (KPIs) and Graphs

Most businesses typically have key measurements they like to see on a regular basis. Some KPIs could be:

  • Gross margin

  • Operating margin

  • Revenue per person

  • Revenue by service/product

  • Margin by service/product

  • Revenue growth over prior year, budget, and last forecast

  • Profit growth over prior year, budget, and last forecast

A good dashboard with the main KPIs is very helpful for management to review everything in one place.

Sometimes creating a graph can tell a story much faster than numbers. Showing trends of revenue compared to last year versus budget can be helpful to understand changes in the business. If graphs show many ups and downs, consider smoothing it by looking at a rolling three-month or twelve-month view. 

Be sure not to rely on just one graph because it could be misleading. Develop a set of multiple revenue, expense, and profit graphs that clarify the direction the company is going and what needs to be done to improve.

Benefits of Forecasting Model

A forecasting model is an essential tool that a business needs to navigate through the challenges of an unclear horizon. The forecasting model should be versatile with key drivers that can be easily adjusted to review different scenarios as the business changes. 

An outsourced CFO can help you navigate through the storm of uncertainty by providing guidance on creating and implementing a robust forecasting model. With their expertise in financial management, they can help you understand the drivers of your revenue and sales, forecast expenses, and make scenario analysis easier. Don't fly blind, let an outsourced CFO, like Bender CFO Services, guide you to financial success.

Contact us today to get started!