6 ways financial forecasting isn’t what you think it is
The forecasting discipline is a tricky one.
To the outside world peering in, it looks like guesswork, pseudoscience, mysticism.
Yet it’s such a ubiquitous part of the business world.
Where do these predictions even come from? Are the numbers plucked from thin air? Are the figures just massaged to look the best they possibly can for investors?
Why spend time on such an unreliable activity anyway?
I’ve been part of the Brixx team for many years now and have seen the forecasting process from a range of angles.
From multi-million-pound turnover companies to bedroom startups – everyone has an eye to the future but people approach it in different ways and with different attitudes.
I’ve encountered plenty of ‘forecasting is just guesswork, it’s pointless’ and I’ve seen people incredibly concerned that their forecast isn’t accurate to 3 decimal places!
In this article, I’d like to go through some of the myths surrounding financial forecasting that might be holding you back from yielding the real benefits.
1) A forecast MUST be accurate
So let’s tackle this head on – your forecasts will never be accurate!
That is not their primary purpose.
You can only ever achieve 100% accuracy in historical reporting (and even they will likely have data entry errors!).
If you just look at the next week ahead, you’ll be able to get a moderately accurate picture, depending on the type of business you operate.
As soon as you start looking further, months or even years into the future – you don’t have a hope!
So how can you rely on a forecast that is inaccurate?
Well, here is where we encounter the idea that the forecasting discipline needs a very different attitude to diligently counting up the pennies from past operations.
The primary purpose of a forecast is to look at possibilities.
That’s ‘possibilities’ – plural.
You recognise right at the start of the process that you don’t know which possibility is 100% correct.
You are taking a more broad-brush approach. Less focused on the fine detail and more the strategic direction you are going in.
The bottom line of your forecast in 2 years time is going to be wrong by more than pennies, you know that for sure!
After you’ve explored multiple possible futures, you might then pick the projection you judge to be most likely. However, it’s not important that this comes true!
What is important is that you’ve used this exploration of possible futures to make informed decisions today that take into account the likely ways the future might unfold (and some unlikely ways too!).
2) You need a mountain of historical data to extrapolate from
This point flows neatly from the previous.
If you are completely focused on accuracy, then the only reliable source of truth is years of historical data to base your predictions from.
You’ve either got this data or you don’t.
So is every company less than 5 years old working to a handicap with their forecasting activities?
It’s certainly useful to have this data but there are few companies or markets that work to such a metronomic degree that you can quickly extrapolate a forecast from a previous year and be done.
Most will not and so every forecast needs to be handcrafted to a certain extent.
By that I mean it needs a closer inspection of the assumptions that drive any forecast and how they will be impacted by the approaching future.
A range of internal and external market factors will be in play in the coming months and years that will be different from prior periods.
The forecasting process is your chance to identify them in advance and consider carefully how they will impact your business.
Forecasting has a role to play no matter the age of your company and there are many techniques you can employ to mitigate the lack of historical data.
Read this article for a full breakdown of the techniques and process:
How to Create an Effective Financial Forecast With No Historical Data
3) It’s all guesswork – it’s impossible to predict the future
It’s certainly very difficult to predict the future but the game of forecasting is far from guesswork.
Since you can’t know for certain which future will become reality, you model a range of possibilities.
You might be very sceptical towards the value of forecasting, especially if you are a newly founded startup with little information to go on. However, what is the alternative? If you don’t make a forecast, then you truly will be guessing.
The value of a forecast is more than putting a stake in the ground for how much profit you’ll have made this time next year.
Creating a forecast forces you to focus on the factors that affect your growth.
It forces you to carefully think about what it would take to make these factors move in either direction.
This process gives you insights into your business and your strategy that is valuable in and of itself whether or not your profit predictions turn out to be true.
It helps you learn. And learning is one of the most valuable commodities in business.
Ultimately forecasting isn’t meant to be a prediction of the future. It’s a tool that informs your decisions in the now.
If its merit were purely on its prophetic capabilities we’d all have abandoned this process a long time ago!
4) Your projection HAS to be realistic
So if it can’t be accurate it must at least be realistic, right?
You may very well have read that forecasts should be grounded in realistic assumptions. We talk about it a lot on this blog.
That’s absolutely correct.
The range of realistic possibilities mentioned earlier in the article are established by your understanding of the assumptions that drive key metrics like revenue.
If website conversion rate is a key metric that drives your revenue, then how high or low this metric can go informs the range of realistic scenarios you look at.
However, forecasting isn’t just about looking at the most realistic path ahead.
When you are working with your forecasts, you have the opportunity to explore an infinite range of scenarios.
These scenarios sit on a gradient of realism.
From the tried and true path you’re familiar with to the bizarre and unlikely yellow brick road you might find yourself on.
Covid was an unlikely scenario. It would have been an unrealistic event to plan for in early 2019.
Should we all have been planning for this in our 2019 budgets? Should we be planning for a meteor strike or a supervolcano in 2021?
Clearly spending too much time in the realms of absurdness would be a waste of time. It’s time-consuming modelling a lot of scenarios and you need to exert your energies strategically.
People point at events like Covid and claim it makes a mockery of forecasting. It could never have been predicted!
However, anyone can run a neutral scenario around ‘what-if’ I don’t have any revenue for 1, 2, 3 or more months. What would I do in that situation?
Just because something is unlikely to happen, doesn’t mean it can’t. It certainly doesn’t mean you can’t plan for it either. Unlikely events happen every single year.
That’s where forecasting comes in as it can shine a light on all the possibilities and make you prepared in advance.
Even if it just means you’ve already given a certain outcome some thought in advance and you don’t get caught off guard completely when the unexpected does occur.
Both the realistic and the unrealistic will inform your decision making.
It doesn’t need to be an extreme event either. It’s a gradient, remember.
Understand the range of possibilities and their likelihoods through the medium of forecasting and you’ll be far more prepared for whatever comes at you.
5) Cash flow is the most important metric to forecast
When you are struggling to pay the bills, you scramble to make a cash flow forecast.
It helps ensure you’ve got enough money to cover you in the weeks ahead, and if not, it gives you time to act.
It’s a pretty important tool to keep your business operating smoothly.
It also gets a lot of focus due to this critical role.
This comes at the cost of a forecast based on your profitability.
Many small businesses miss out on the benefits of analysing your profit & loss report. This key financial report helps you discover how effectively your business is running. How efficiently are you operating? Are your profit margins sufficient and sustainable?
Ultimately, are the hours you and your team are working making you money or losing you money?
Only the Profit & Loss report can tell you this.
A cash flow report will let you down in this regard as the purity of your business performance get’s diluted by all the ways payment timing can be manipulated.
Of course, some businesses fall into the trap of focusing too much on the Profit & Loss report and miss upcoming cash flow dangers.
Both of these reports are important. They reveal different insights about your financial performance and can lead to different types of actions.
Spending time on both through historical reporting and future projections is highly worthwhile.
6) You create a forecast once a year
It’s a pretty common scene in many businesses, the year-end approaches and there is a flurry of stressful activity.
The company accounts go under the microscope to get the tax return in on time and without error. The year-end accounts are generated and maybe, if there is time, budgets are set for the year ahead.
These budgets, like last year’s budgets, should be based in your forecast for the years to come.
A forecast that should be informed by a variety of scenarios, ‘what-ifs’ and sensitivity analysis.
Actuals vs budget should be applied to the previous year to understand the variance between your predictions and reality.
Once completed, this rushed exercise is often forgotten. Documents filed away and not looked at until next year.
This approach can be slow and often ineffectual.
A more and more common approach in high growth companies is to conduct this analysis far more often on a quarterly or even monthly basis.
It allows you to analyse what you said you’d do in your budget vs what actually happened in reality. Then you can reforecast the remaining periods based on the inevitable variance that occurred and react accordingly.
This more regular analysis of your decisions allows you to react more quickly and implement changes if required.
It’s tricky to do this in a small business without dedicated financial resources but it’s becoming easier and easier with more and more tools aiding this process.
Forecasting is not about the future, it’s about NOW
Forecasting is not about creating a cast-iron, unerringly accurate prediction for the future. If that is your expectation, you’ll be disappointed.
You’ll also have missed out on the main benefits that forecasting can bring to your business.
The way you need to think about forecasting is that it’s not about the future.
It’s about driving actions in your business right now.
What you do in the next few weeks, months and years is informed by your expectations of the future. Not one possible path, but a landscape of possibilities that you map ahead making you prepared for whatever terrain you encounter.
If you’d like to begin modelling the future – start today with our free financial forecasting software!
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