5 Pitfalls That Can Kill Your Financial Forecast
Most large organization spend a considerable amount of resources performing some type of financial forecasting. Conversely, small and medium-sized businesses spend less time on planning for the future. Larger organizations have more to lose, therefore, the need to actively assess changes in the market to take advantage of opportunities or avoid risks becomes a more urgent priority. All companies, regardless of size, can garner economic rewards through financial forecasting.
So why don’t more companies do it? Because it is HARD to do well that’s why and let’s face it, no one likes hard work. By keeping the below common pitfalls in my mind, any financial forecaster, regardless of company size, will have a clearer picture of their future financial prospects.
Forecasting Sales NOT Products or Service
Most financial forecasts pivot off a sales forecast, which makes how the sales forecast is created critical to the success of the overall financial forecast. If you have 3-5 years of historical financial data, it is easy to assume an ongoing trend with a constant growth rate. This type of sales forecasting can produce a very accurate looking projection over the short term but it is an accident waiting to happen.
The idea of driver-based financial forecasting has been around for years and the premise is simple, don’t forecast the P&L line item, forecast the drivers of the P&L line item. For example, if you sell widgets, don’t forecast the total sales of widgets, forecast the number of widgets you intend to sell and the expected prices you anticipate to sell them for.
Why does this nuance matter? Because customers do not buy sales from a company, they buy widgets and if you forecast only sales; changes in price and quantity may be hidden and offsetting robbing you of valuable insight, preventing you from taking action when a trend changes. This also allows you to adjust pricing assumptions quickly to take into account competition.
Most large organization spend a considerable amount of resources performing some type of financial forecasting. Conversely, small and medium-sized businesses spend less time on planning for the future. Larger organizations have more to lose, therefore, the need to actively assess changes in the market to take advantage of opportunities or avoid risks becomes a more urgent priority. All companies, regardless of size, can garner economic rewards through financial forecasting.
So why don’t more companies do it? Because it is HARD to do well that’s why and let’s face it, no one likes hard work. By keeping the below common pitfalls in my mind, any financial forecaster, regardless of company size, will have a clearer picture of their future financial prospects.
Forgetting Price Times Quantity
Every line item of a financial forecast is effected by the basic economic equation of price times quantity. The correlation that sales has with cost of goods sold or other variable inputs to derive a gross margin is due not only to the correlation of input drivers but also the correlation, or lack thereof, of the price of those inputs.
For example, when I worked at a large commercial printer, paper and ink were large inputs into our manufacturing process. Both paper and ink prices had very little correlation to our sales volume. To a certain extent, we could hedge price changes by purchasing and warehousing paper, but that was not always feasible given customer requirements. Therefore, when forecasting cost of goods sold we also made assumptions on paper and ink prices as separate input schedules in the financial forecast.
This truth holds for non-variable costs as well just because sales decrease by 10% does not mean a company can cut SG&A by 10%. The correlation will not be one to one and with costs being sticky when revenues decline, forecasting a decrease in SG&A in lock step with sales is counter intuitive.
Most large organization spend a considerable amount of resources performing some type of financial forecasting. Conversely, small and medium-sized businesses spend less time on planning for the future. Larger organizations have more to lose, therefore, the need to actively assess changes in the market to take advantage of opportunities or avoid risks becomes a more urgent priority. All companies, regardless of size, can garner economic rewards through financial forecasting.
So why don’t more companies do it? Because it is HARD to do well that’s why and let’s face it, no one likes hard work. By keeping the below common pitfalls in my mind, any financial forecaster, regardless of company size, will have a clearer picture of their future financial prospects.
The Use of More Than One Plug
The only plug in a financial forecast should be for additional funds needed. This is the cash shortfall or surplus derived from the cash flow statement. Frequently this is represented in the forecasted balance sheet as either an increase/decrease of debt or an increase/decrease in cash reserves. That is the only “plug” that a financial forecaster should have in the model. Plugs in other components lead to mistakes in forecasting because they make everything work. Financial forecasting without plugs is much harder but produces a much better model.
In my research, I have found one scholar who has put forth a process that would eliminate plugs completely. I have yet to see this in practice but encourage others to review his work and see if it works for them. (Please e-mail me with your results). The paper, “Forecasting Financial Statements with No plugs and No Circularity” can be downloaded for free: here.
Most large organization spend a considerable amount of resources performing some type of financial forecasting. Conversely, small and medium-sized businesses spend less time on planning for the future. Larger organizations have more to lose, therefore, the need to actively assess changes in the market to take advantage of opportunities or avoid risks becomes a more urgent priority. All companies, regardless of size, can garner economic rewards through financial forecasting.
So why don’t more companies do it? Because it is HARD to do well that’s why and let’s face it, no one likes hard work. By keeping the below common pitfalls in my mind, any financial forecaster, regardless of company size, will have a clearer picture of their future financial prospects.
Using Percentage of Sales for All Financial Statement Line Items
Some line items, such as property plant and equipment, may have a long-run relationship to sales, but not necessarily from year to year. For example, when producing a financial forecast, depreciation is added back into operating cash flow, but when new investments in fixed assets will be added is more difficult to ascertain. A detailed supporting schedule with a list of assumptions should be a key input into any financial forecast.
A good rule of thumb is that every line item that does not have a supporting schedule should be forecasted with one or more of the following three methods:
As a percentage of sales
Using a ratio or metric – for example using days-sales-outstanding to calculate accounts receivable balance for the balance sheet
Utilizing regression techniques
Most large organization spend a considerable amount of resources performing some type of financial forecasting. Conversely, small and medium-sized businesses spend less time on planning for the future. Larger organizations have more to lose, therefore, the need to actively assess changes in the market to take advantage of opportunities or avoid risks becomes a more urgent priority. All companies, regardless of size, can garner economic rewards through financial forecasting.
So why don’t more companies do it? Because it is HARD to do well that’s why and let’s face it, no one likes hard work. By keeping the below common pitfalls in my mind, any financial forecaster, regardless of company size, will have a clearer picture of their future financial prospects.
Lack of Financial Constraints as a Check
Regardless of the industry, a debt to equity level that is 5x the industry average is probably not financially workable. Neither is a negative gross margin or unreasonably low payroll expenses. Financial forecasting requires the use of many linked schedules, no matter what software was used to create it.
Asking the question, “Does this make sense?” Is a logical step when any changes are made to the financial forecast. Another good idea is to generate a schedule of similar publicly traded company ratios and/or use the Risk Management Association’s Annual Statement Studies as a basis for reasonableness in which to compare your financial forecast to.
Financial Forecasting : For The Love of The Climb
Finance professionals are hard-wired to be analytical, to rely solely on facts and to base decision on evidence, but that is not the way the world works. Sales do not come in even every month, equipment does not break on time and sometimes the Hail Mary pass does work. Financial forecasters need to understand that their financial model is a piece of art, worked on diligently and with the greatest of care, but it is still only an interpretation of the world as it stands at one point in time.
Financial forecasts must be constantly tended to through updating with actuals, changing assumptions and adapting it to the changing field of business. At the end of the day, a financial forecast is not about achieving the goal that was initially set out, but the climb to that goal. A financial forecast is a road map to the top of an uncharted mountain which you know will requires on-the-fly detours caused by blocked roads, down trees, rough terrain, steep cliff and bad weather. The climb will also have days filled with unforeseen beauty and ease. The trick is to never get complaisant during the good times and remember that the bad times will not last forever.
Keep climbing…
