Financial forecasting: what it can actually tell you about your business

A useful forecast shouldn't simply take last year's result and increase every number by the same percentage.

It should reflect how the business actually works.

That could include assumptions around:

• expected sales
• gross margin
• wages
• new employees and their start dates
• rent and other fixed overheads
• equipment purchases
• loan repayments
• tax
• BAS payments
• debtor collection
• owner drawings or distributions
• seasonal movements
• one-off projects or costs

Some assumptions will be fairly reliable. Others will be educated estimates. The important part is being able to see the difference.

If the forecast says the business will make $500,000 next year, the useful question isn't simply whether $500,000 is right. It is: what has to happen for the business to make $500,000?

That's where the conversation becomes useful.

There isn't much value in building a forecast simply because another financial year has started.

It becomes much more useful when the business has something to decide.

The cost of employing someone is more than their salary. There is superannuation, workers compensation, leave, equipment, software and potentially additional overhead.

There is also the timing. The new employee may start in October, while the additional revenue they're expected to help generate might not arrive until January.

A forecast can show what happens to cash during that gap.

It can also help answer a better question than “can we afford this salary?”.

The question becomes: what additional work or margin does this hire need to produce, and how long can the business carry the cost while that happens?

A business may be profitable enough to justify an equipment purchase but still put itself under unnecessary cash pressure by getting the timing or funding wrong.

A forecast can compare different assumptions around:

• purchase price
• deposit
• financing
• repayments
• expected additional revenue
• maintenance and running costs
• tax obligations falling due around the same time

The tax treatment matters, but it shouldn't be the only reason the purchase works. The underlying commercial decision still needs to make sense.

A profitable year does not necessarily mean the profit is sitting in the bank.

Cash may already be tied up in:

• debtors
• stock
• equipment
• loan repayments
• tax liabilities
• working capital

If the owners want to make a significant distribution, a forecast can show what the business looks like afterwards.

The question isn't simply how much profit have we made? It's what can the business reasonably afford to pay out while still funding what comes next?

Forecasts become particularly useful when you stop relying on one version of the future.

You might prepare the expected case, a stronger case and a weaker case.

That doesn't mean producing three enormous financial models. Sometimes changing two or three important assumptions is enough.

If a business expects $4 million of revenue next year, we might want to know what happens at $4.4 million, $4 million and $3.5 million.

The important part is then understanding what moves with revenue and what doesn't. Some costs will reduce if sales fall. Rent probably won't. Management salaries may not. Loan repayments won't.

That is why a drop in revenue can have a much larger impact on profit and cash than the revenue movement initially suggests.

A forecast does not make the future certain. It makes the assumptions visible.

Consider a business thinking about employing another senior person. The owners believe the hire will help the business grow.

Instead of debating whether that belief is right or wrong, we can put the assumptions on the table.

Current position:

• the business has a certain level of monthly revenue
• current wages are known
• existing overheads are known
• current cash and upcoming tax obligations are known

Proposed change:

• new employee starts in November
• employment cost begins immediately
• additional revenue is expected from February
• revenue builds gradually rather than arriving on day one

We can then model what happens if:

• Scenario A — the additional revenue arrives as expected.
• Scenario B — it arrives three months later.
• Scenario C — it arrives, but at only half the expected amount.

The model still cannot tell us which scenario will occur. But it can tell us whether the business can withstand B or C.

That can materially change the decision.

This is an important distinction.

A forecast can show a profitable business that still runs short of cash. That's because profit and cash measure different things.

For example, the business may record a sale today but not collect the money for 45 days. It may have a large tax payment due from profits earned in an earlier period. It may repay loan principal, which affects cash but is not treated as an expense in the same way as interest. It may purchase equipment or pay distributions to owners.

So when we're modelling an important decision, looking only at forecast profit can leave out a large part of the story.

We generally want to understand both: what happens to profit, and what happens to cash?

If cash timing is the pressure point in your business, getting paid sooner often changes the forecast more than another sale does.

Every forecast is wrong to some degree.

A customer leaves. A project starts late. An employee resigns. A sale expected in March happens in May. Interest rates change. The owners change their minds.

That doesn't make forecasting pointless.

The usefulness of a forecast comes from understanding the assumptions and updating them when circumstances change.

A forecast prepared in July and never looked at again is considerably less useful than one that is compared with actual results and adjusted as the business changes.

Looking forward doesn't mean ignoring what has already happened.

Historical accounts tell us:

• how the business has performed
• where margins have moved
• how costs behave
• when cash tends to become tight
• how quickly customers pay
• whether previous assumptions were realistic

That information gives us a better starting point for thinking about the future.

A forecast without reliable accounting information underneath it can create false confidence.

The actual numbers and the forecast should work together. A practical budget is often where that starts.

Forecasting can also be useful when several people own the business.

One owner may want to hire. Another may want to preserve cash. One may want a larger distribution. Another may want to invest more heavily in growth.

The forecast doesn't decide who is right. It gives everyone the same set of assumptions to discuss.

Instead of “I think we can afford it”, the conversation can become: if we do this, this is what needs to happen to revenue, margin and cash over the next 12 months.

That is a much better discussion.

There isn't one standard forecast that every business needs.

For a relatively straightforward business, a useful model might include:

• monthly profit and loss
• cash flow
• expected tax and BAS payments
• wages
• debt repayments
• planned capital expenditure
• owner distributions
• a few important operational assumptions

For another business, the critical drivers might be:

• employee utilisation
• project pipeline
• occupancy
• average transaction value
• gross margin
• labour percentage
• debtor days

The forecast should reflect the decisions the owners are trying to make.

Not every business needs a complicated model.

A good forecast doesn't tell you what is going to happen. It helps you understand what could happen.

More importantly, it shows what assumptions sit behind the plan.

If you're considering another employee, a large purchase, new finance, a distribution or another significant change in the business, putting the decision through a forecast before committing can expose issues that are much harder to deal with afterwards.

The starting point is usually simple:

What are we considering doing?

What do we expect to happen if we do it?

What happens if we're wrong?

Those are the questions the forecast should help answer.

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