Within the work of the MHA Corporate Finance team, we are often asked why we consider financial forecasting to be such an important component of most of the transactional M&A, fund raising and strategic growth projects we are involved in, and how we go about preparing a robust financial model. Therefore, we thought devoting a BlogSpot to the topic may be useful.
What are financial forecasts and why do they matter?
The financial forecast is a key tool that a business deploys to predict its future performance. In the absence of a crystal ball, the forecast is relied upon to estimate the direction of travel for financial metrics like revenue or costs.
Business owners and management teams who adopt and maintain financial forecasting best practices are better positioned to grow through focusing on key value drivers and resource allocation, and to weather unexpected setbacks. Whilst it’s impossible to accurately predict the future – as the COVID-19 pandemic has demonstrated, creating and maintaining a robust financial modelling methodology based on a solid understanding of the key metrics of your particular business’ operating model is more than likely going to provide you with a valuable tool to financially assess alternate business opportunities and so direct short, medium and long term business strategy.
The fact is, companies don’t end up with strong balance sheets, healthy cash flows and robust funding structures which underpin strong growth and shareholder value, by chance. Financial health and the ability to clearly articulate the potential future prospects of a business to debt funders, equity investors and potential acquirers is a function of appropriate data analysis, a clear understanding of the business and up-to-date customer and market insights.
The process of building a robust forecast model often requires key management to amend their historic approach to strategic business planning and forces them to consider in more detail the causal links between changes in operational activity and the resulting financial outcomes, so that more meaningful scenario planning can be undertaken and often-competing strategic options ranked in order of priority by reference to a range of key criteria…commercial, financial, operational, logistical etc.
What does a financial forecast comprise?
As a minimum, a forecast needs to include fully integrated income statements (P&L account), cashflow and balance sheets, with “integrated” meaning that a change to an underlying data input (e.g. a monthly sales value), or a working capital driver (e.g. Debtor days), automatically updates all the key financial statements to appropriately reflect the amended data, without the need for further analysis or modelling. Hence, an integrated model will always be in balance and the dreaded need for “balancing figures” becomes a thing of the past.
Typically, a forecasting model will cover a 3 to 5 year period, built on a monthly basis.
How do I create a robust financial forecast model?
Whilst there are a number of forecasting packages available to the SME market, sometimes linked directly to accounting software packages, our experience is that these packages are necessarily limited in their functionality and do not include sufficient flexibility in how they allow a particular business to model its specific operations and way of doing business.
Different management teams, often in the same sector, “see” their businesses differently and so require a bespoke forecasting methodology or set of KPI’s as key outputs from the forecasting process – e.g, do they manage sales by reference to SKU’s, product groups, customer types, geographic regions, sales territories, or sales channels? – each will potentially impute a different way of designing the most appropriate sales forecasting approach within the model.
Therefore, we have adopted an Excel spreadsheet approach, based essentially on the principles enshrined within the ICAEW’s “Twenty principles for good spreadsheet practice” and the increasingly adopted FAST approach to modelling;
- Flexible: to enable easy updating – flexibility being a product of simplicity
- Appropriate: the model must be a reasonable representation of reality
- Structured: a rigorous and consistent approach to structuring a spreadsheet is essential
- Transparent: the model must be based on simple, clear formulas and logic which enable a model to be picked up by anyone and quickly understand its approach – complex strings of formulae and embedded macros which require advanced modelling skills might be clever, but make the understanding of a model difficult and the ability for anyone other than the original creator of the model to pick it up, potentially impossible.
In reality, the dark art of financial forecasting is the process of blending together many types of data, or assumptions, to build a credible plan for the future. Therefore the key is to design a model which can adequately reflect the fundamental underlying transaction streams and inter-relationships within a particular business, in a way which strikes an appropriate balance between simplicity and complexity – simple enough to be easily updated and understood, complex enough so as not to “dumb-down” the outputs from the model to a state where they add no meaningful improvement in management’s understanding of the business or predictions of likely financial outcomes of alternate business strategies.
Each source of data can either be historic data or based on predictions. Some elements of this information will be more certain than others. For instance, the business will probably know the costs of its insurance or rent and be able to predict these with confidence. By contrast, the price of raw materials is volatile – and when it comes to future demand or churn rates, the whole exercise can be little more than an informed guess, especially in an early-stage or fast-growth business. However, the accuracy of predictions usually increases each year a forecast is updated as the surrounding processes develop year by year.
The more variables a forecast attempts to incorporate (e.g. competitor analysis) the more realistic it is likely to become, but always be aware of tipping over into undue complexity and lack of transparency …we’d strongly recommend you adopt FAST and stick to those principles.
Can MHA Moore & Smalley help?
SME business owners and management teams shouldn’t let the lack of a finance team or skilled Excel modeller in their team dissuade them from financial forecasting or modelling.
If you see a need for this kind of tool to assist in the development of your business model, assessment of alternate business growth or shareholder value realisation strategies, or as advance preparation for a share sale and external Due Diligence review process on the business’ future prospects, please contact a member of our Corporate Finance team by filling in the form here who would be delighted to assist.