One of the most common goals for small business owners is generating enough cash flow to grow and scale. What it means to scale might vary from business to business, but it’s a universal truth that you need cash to do so. However, knowing how to increase profitability while keeping expenses in check can be difficult. That’s where financial forecasting comes in.
Keep reading to learn more about what a financial forecast is, how it can help your business reach desired financial outcomes, and how to develop an accurate forecasting model.
What is Financial Forecasting?
Financial forecasting (also known as cash flow forecasting) is the process of determining a business’s cash position in the present and future. There are two types of financial forecasting— short-term forecasting and long-term forecasting. The short-term forecast is a financial forecasting method designed to help business owners see their cash position currently and in the next 6-12 weeks. A short-term forecast is especially helpful to determine if your business is at risk of a cash shortage in the near future and allows you as a business owner to make a gameplan to overcome it. It’s recommended to review this financial forecast once a week.
A long-term forecast looks at how much cash you need in the long term (1-3 years out) which is influenced by the amount of risk you as a business owner feel comfortable taking. A long-term cash flow forecast is especially helpful to determine if your business will be generating enough cash to reach a desired business goal. If your future projections don’t show your business on track, you can make informed decisions and create business plans to change your future cash position (more on this later). Your long-term cash flow forecast should be reviewed on a monthly basis or when you are about to make a business decision that could drastically impact your business finances.
Now you might be wondering how you start on the journey towards financial forecasting. Below are the foundational metrics and information you will need to begin creating a cash forecast for your company.
Forecasting as Easy as 1…2…3…
Many business owners don’t have a clear understanding of their team’s capacity and what they can produce. For that reason, developing a forecast can feel impossible. However, a short-term and long-term forecast can help you truly understand your cash position inside and out in order to make strategic decisions.
Before we dive into how to create a forecast for your business, let’s start with a few important metrics that will impact future cash projections within your forecast. [The following metrics are for service-based businesses].
Total available hours = total working hours – total culture hours
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Total available hours: Count the working days for each month and multiply the number by eight hours per day. Subtract “culture hours” (hours spent for vacation time, holidays, R&D, internal projects, training or what have you).
Total billable hours = total available hours x weekly expectation %
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Total billable hours: Next, set the weekly billable expectation. Will each producer bill 30 hours, 38 hours? It’s up to you as a business owner and your leadership team to decide.
Average billable rate = standard rate – write-down rate
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Average billable rate: Take your standard rate (what you charge in estimates), then subtract your write-downs (the amount you typically lose off your standard rate; the amount you can’t bill). Any write-down greater than 10% should be looked at to determine why it is so large.
Individual revenue per producer = billable hours x average billable rate
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Individual revenue per producer: This is the billable hours for one producer x average billable rate. For instance, if a company has 1,200 billable hours and their average billable rate is $165, then the individual revenue per producer is $198,000 with the revenue varying month to month.
Forecasted revenue = Individual revenue x # of full-time producers
Now that we have these metrics in our back pocket, we can dive into how a financial forecast is actually created.
Proforma statements form the basis of financial forecasts. On a basic level, proforma statements are future projections of your cash flow statement, income statement, and balance sheet. You can use forecasting tools such as Reach to create these projections. Alternatively, you can plug in numbers (such as future revenue) to your financial statements manually to create a rudimentary forecast.
For example, if you want to grow revenue by 30% over the course of three years, you can plug this goal into the financial statements above to see what business changes are needed to reach your goal. You can also work backwards from your future forecasted revenue goal to determine what business metrics need to be changed, such as billable rate, number of individual producers, etc.
Manipulating forecast data to determine financial strategy changes is called scenario planning or financial modeling. You can also use scenario planning to come up with gameplans for business obstacles such as recessions and inflation.
Why Budgeting Isn’t Enough
Some of our clients have wondered why they need a forecast if they have a budget. The truth is that a budget is more a financial roadmap for how income and expenses will be used over a set period of time using historical data. However, it isn’t a great indicator of how a business might overcome obstacles or reach goals in the future.
That’s why I recommend using a forecast for future financial outcomes. It will help you prepare for financial changes and make informed decisions. This leads to our next point. You need to update your forecast frequently. So much changes in a business, even day-to-day. If a forecast isn’t updated with changes in expenses, incomes, etc., your forecast won’t truly reflect what cash position your business is in currently or will be in the future. I recommend reviewing your forecast and making updates on a monthly basis to ensure accurate, real-time data.
Our goal as financial advisors is to help our clients gain financial insights to make informed business decisions that change their company’s future and profitability. If you’d like to learn more about how our CFOs use financial data to impact our client’s business performance, schedule a free virtual CFO consultation.
