Accurate financial forecasting is one of the most critical aspects to scaling a business successfully. After all, understanding where your business is headed and how your company is performing will inform leadership about critical decisions related to hiring, expansion, new business lines, and where to focus attention.
Many fast-growing companies have trouble producing reliable, accurate financial forecasts. This makes it difficult to reach strategic decisions, as well as manage the expectations of investors and other stakeholders.
The following five tips can be used to improve the accuracy and impact of your company’s forecasting today.
1. Understand your business and the big drivers
One of the basic ways to better understand your business is to look at the revenue and expense streams. Which elements are fixed, and which are variable?
Answering these questions will help you identify the main drivers of change. This process doesn’t have to be complicated, and in most cases, the answers come down to rates and volumes.
With revenue, for example, you should understand the relationship between pricing and future volumes. With costs, you should know the unit costs and the large step-functions that occur with scale.
Common drivers of financial results that you should know include recent history for your company and conventional rules of thumb for your industry. This includes metrics like sales productivity, revenue per unit, gross margin, marketing costs, and general and administrative cost. Do not limit yourself to these as there may be other elements that have more significant impact to your specific business. You need to develop awareness of what these big drivers are.
2. Accurate and timely data is critical.
It’s impossible to produce a reliable forecast if you have nothing to measure. Get as close as you can to the source of the actual operating data that has been clearly defined in your systems, so that you are sure it hasn’t been altered or modified. The fewer barriers between you and the data, the more accurate and useful it will be.
Make sure that you understand exactly what the data represents (i.e., what is the operating activity that the data captures?), and be aware of the wider context. While anecdotal information can be helpful, it is critical that you grasp how the data maps onto global activity.
Part of this context lies in when the data was captured and what time period it covers, which can change with different ways databases are constructed. Data should be accessible on a recurring basis and interpreted with consistent, logical definitions. For instance, you need to know if the data record for the field you are using is permanently time stamped or is the most recent version of the record.
3. Model your history before you try to model the future.
Generally, it’s best to work backwards to rates and volumes from revenue and cost drivers. The forecast method, for example, operates by reverse engineering historical rates and volumes.
To start, identify the drivers that have the most impact and those that are most likely to affect changes to the forecast. If you model historical revenue and costs accurately with these historical drivers, you can be reasonably confident that your forecasting method is sound.
If you are forecasting several periods out, ensure integrity by stopping to re-evaluate after each period. Use this re-evaluation to determine if the forecast needs to be adjusted up or down.
4. Communicate frequently with key business owners on future driver assumptions.
Use the historical context you develop to challenge existing assumptions about future drivers.
If these assumptions come from sales, for instance, evaluate how they compare to historical performance. Then, if significant changes to operating practices are still warranted, check the timing of those changes carefully to ensure that they are realistic.
The operating team needs to be able to provide a roadmap of anticipated changes in business drivers. As the finance leader in the process, it is up to you to ask questions that brings transparency to how change is going to take place.
Keep in mind that operating teams must be fully accountable for the driver predictions that they provide. The future driver should always have an owner or your finance department will own it by default.
Vetting your data and assumptions with senior leaders ensures that the people most responsible for delivering results are fully aware of the situation and further mitigates risk.
5. Document your level of confidence in the results and improve where necessary.
Always play it safe with your target goals, rates, volumes, ratios, and margins. Be realistic, and when in doubt, err on the side of caution.
Be especially wary of tying yourself to overly optimistic forecasts that render the goal unattainable and risk your credibility. A range of forecast scenarios, such as best case, likely case, and worst case, will force your organization to think through the full spectrum of possibilities and provides you with more insulation against errors.
If you are still not getting to where you need to be, don’t simply change your assumed numbers. Make sure that what you’re changing is something you can operationalize, and ensure that you are tying things to actual data in your business.
Make sure your accounting and financial planning and analysis personnel are working with the same terminology and definitions for financial measures so that actual results can be easily compared with the forecast. Having a common language for financial terms also prevents confusion throughout the organization.
Finally, carefully measure the success of your forecasts, particularly in terms of accuracy, and make improvements as needed.
The foundation of a successful enterprise is a clear understanding of what works, how it works, and what to do if a particular approach fails. This knowledge will equip you to build on past successes and make strategic decisions, comfortable in the knowledge that you have done all you can to ensure positive results.
