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Small business forecasting...like an investment banker

Posted on November 27, 2017 at 11:41am

Over 95% of small businesses and startups fail after 5 years. The majority of these have attributed lack of financial planning as the reason for their failure. As a former investment banker and current private equity fund manager, this statistic was very surprising to me, particularly because it is something that is preventable. When talking to small business owners across various industries, what continues to surprise and puzzle me is the lack of forward planning and in particular financial forecasting that is done before making the leap - taking out a business loan, quitting a job, entering into a lease. In mergers and acquisition transactions, as well as when institutional investors invest into businesses, there is generally a LOT of financial analysis that will be required, often run by teams of analysts, before an investor is comfortable to go ahead. Now I'm not saying you need to spend months running financial analysis, but some of that focus of big business, should certainly be brought into small business, and which should in the very least improve the probability of your success. So let's get into it:


Why do financial forecasting?

Despite what I've just said, financial forecasting is NEVER correct, things will never go exactly as you planned. So why do it? This is a question that often came up throughout my finance career. Financial forecasting is not meant to pin-point the outcome, it is meant to help you understand the your direction, but also where to go after that first step, and the second, third, fourth and so on. Financial forecasting is about understanding your business better. In a fast moving environment with a thousand possibilities, it helps you narrow down the key indicators to look for and how to react to each. In this sense it helps you become better prepared, more knowledgeable and more likely to succeed.


Practically, financial forecasting will help you answer questions like:

  • Will my business idea be profitable or am I wasting my time?
  • How much starting cash do I need?
  • How much more cash do I need to tip into my business over time?
  • When will I start making a profit?
  • What is my biggest risk financially that may sink my business and how do I reduce this risk?
  • What is the most profitable part of my business and how do I enhance that profit?
  • It's one year on, what should I look for to adjust my business plan?


 Small business owners are often too busy setting up or running their business to do adequate forecasting, often they do the minimum required for bank financing, which is more a check-the-box exercise rather than deeply thinking about and understanding the business. And while people seem to understand the importance of a business plan or strategy, without a financial forecasting to back it up, a business plan is just a bunch of words, with no way of knowing whether it stacks up.


What is financial forecasting?

Architects will build a miniaturised model of a building they are designing to better study the interaction of different aspects, viewpoints as well as communicate their ideas. A financial forecast can be thought of in the same way, it is a representation of the financial architecture of a business. One key difference is while an architectural model is generally static (does not move), a financial forecast should be flexible and dynamic, in that you can throw in changes to circumstances (economic downturn, a new competitor setting up shop) and look at how the financial forecast responds. This more advanced form of dynamic financial forecasting is often referred to as financial modelling, allows you to see how your forecast respond to changes and help you develop a plan for each circumstance. More on financial models later.


Financial forecasting is often confused with accounting, because both deals with cashflows, profit and sometimes balance sheets. The difference between the two is while accounting is recording what has happened in the past, financial forecasting is forward looking. "You don't do financials in a business plan the same way you calculate the details in your accounting reports," says Tim Berry, president and founder of Palo Alto Software, who wrote the book, The Plan-As-You-Go Business Plan. "It's not tax reporting. It's an elaborate educated guess."


To get to how much cash you expect your business to make (or you need to contribute in the early years) you will need to forecast each of the following things:

  • Revenue - money coming in
  • Expenses - both direct expense (e.g. cost of goods sold) and indirect expense (e.g. rent)
  • Capital expenditure - one off asset purchases (e.g. company car, equipment)
  • Financing costs - payments on any business loans or creditors


Before you start, you should do some research to see what is relevant for your industry. You should aim to start simple, adding more information or refinements over time as you have a better understanding of your business. You should try to come up with a monthly forecast to illustrate any potential month-to-month cashflow issues your business may have.


How to financial forecast?

Two words: Microsoft Excel. A common reaction to these two words is some form of dread. But as someone who has spent my entire working life around Excel (not uncommon amongst financial professionals), it is an extremely powerful tool that can be moulded into almost anything you can think of in the hands of an experienced  user. It is relatively easy to pick up and use, and widely accessible. If you are not familiar with excel I recommend you look at a few introductory YouTube videos on it. Excel can be useful not just in business but also in creating simple budgets or itineraries for your personal life.


I would also suggest following an established framework to ensure you have not missed anything in your forecasts. You can download simple spreadsheets online or request this from your bank manager.


Since a key benefit of financial forecasting is not just coming up with a single scenario, but understanding the outcomes for a range of scenarios, and how you should respond to each, your forecasting should be as flexible as possible. By this I mean, where possible, try to link items you're forecasting to each other or to the underlying drivers. Are certain costs linked to your sales? Is your financing costs linked to you asset acquisition? The linkages not only saves you time and avoid errors when you decide to change your assumptions, but formulating these linkages helps you think about and understand the key drivers of costs and profitability of your business. It also helps you think about how you would respond to these changes. If sales half, will you move to a smaller office or sell the company car?  If sales double, do you need to hire more staff or buy more equipment? What do either of these scenarios mean for your profitability?


Advanced forecasting: financial models

Big businesses typically employ teams of professionals to construct financial models to help with their forecasting. The difference between a financial model and a spreadsheet is the flexibility financial models provide over spreadsheets. Where a spreadsheet is basically a series of tables where your inputs are your final results, a financial model is a network of rules and calculations that will respond automatically to any changes to your inputs. Financial models can also generate more complex things like depreciation schedules and tax liabilities. Having a systems of rule-based calculations allows you to perform a deeper level of analysis and allow you to answer questions like:

  • Which line of products is the most profitable or add the most to my bottom line (and I should focus on growing)?
  • What should the ongoing cash reserve in the business be?
  • Can I use more debt in my business to boost shareholder returns?
  • Which expense item should I focus my attention on to manage / mitigate?

If you want the next level of analysis of your business, unfortunately there are limited products available online. Spark Financial Model is one that provides big-business-style financial models with an easy-to-use interface to help with your forecasting.


More tips:

  • Forecast at least three scenarios: a "most realistic" or base case; a negative or conservative case; and an positive or aggressive case. This will help you understand the range of possibilities your business face
  • Add contingencies if you are uncertain about something. The more uncertain you are the bigger the contingency
  • Break a monthly number into a daily number to help sense check your forecast. Having 3,000 sales per month may be meaningless to you, but you might be more comfortable when thinking of this as 100 sales a day
  • Think about underlying drivers and linkages. When you drill down to it, a lot of decisions a business case will be based on how much customers they expect. This drives how much goods to order or staff to employ or equipment to purchase. You should try to reflect this in your forecasts to make it as flexible as possible.
  • Don't obsess about the details. As mentioned before, you'll never get your forecasts right so don't sweat about whether its 3,010 or 3,050 sales a month. What is more important is what your cashflows look like at 3,000 versus 5,000 versus 1,000 sales a month, and how you might adjust your business plan for these scenarios.
  • Check out my Youtube channel on https://www.youtube.com/watch?v=soZWvDEsBPI&list=PL_l0rbmP9OPzMruXYMOW-BhVpSTzSR9tR for more tips

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