This month we take a look at the power of forecasting and projecting and reminding ourselves that these tools are powerful and made a huge difference in the recent crisis… and will again in the next (current?) crisis. I open this month with a reminder of why forecasting is useful and not just an exercise and our guest writer, Advisor Patrick Hynes, takes us through the process.
“Complications arose, ensued, were overcome.” – Captain Jack Sparrow
Why Forecasting Isn’t Just an Exercise
For a long time in the run-up to the pandemic, things were generally good. We hit sales records every year, like you are supposed to, and while business is never without challenges, the discussion was generally around a minor deviation from expectations or last year’s performance. And then the pandemic hit. And for the first time in a long time, in a career for some, everyone was saying; “I don’t know what is coming.” At that moment, we thought things could grind to a halt or the demand for what we did could spike. And both things happened depending on whether you were a restaurant or a hospital. And so leaders generally said we’ll just have to work through it. And generally the result that was expected was what occurred. If the business was in the construction market, in general it did very well. If the business was a restaurant, in general it did poorly. So the impression was left that the result was the result from the beginning, and little we did would have an impact. This impression was enhanced by the government intervention which tended to make people feel that the outcome was not something they had a large impact on.
However, this is not really the case as you look closer. Within the broad swathes there were restaurants that survived and came out stronger. And this was due to the owners taking agency over what happened to them. Making course corrections in the moment and responding to the situation. A powerful tool in this process is forecasting and cash projection.
In a dynamic environment, forecasting and cash projection can keep you on the fairway. It may seem like a waste of time to predict when the market or external factors make prediction difficult or unlikely to be spot on. However, the process of creating a forecast, the best forecast you can, takes you through the details of operating the business and familiarizes you with the degrees of freedom you have and the sensitivity of the business to certain types of moves. Restauranteuers that looked, maybe in desperation, at how their businesses operated and what they could do came up with new an innovated changes to make in an effort to not lose this battle. In the same way, businesses that distribute building supplies looked closely at how they could put their hands on more inventory in order to satisfy their customers, many of whom were frustrated or even irate that they couldn’t get materials to keep their projects on schedule.
The point is not to predict the future as much as it is to look at the specifics of your operation in order to determine what changes to make to improve it. Either to mitigate negative impacts or to amplify positive ones.
Financial Forecast Process as a Decision-Making Tool
Very little in business is certain. When it comes to predicting the future, you can be 100% certain that any forecast will be...wrong.
So, why even bother? Does a financial forecast help me grow my business profitably? YES! If you focus on the financial forecast process.
A process is defined as "a natural phenomenon marked by gradual changes that lead toward a particular result." Think of better decisions, not just a number, as the desired result of a financial forecast process. Through this lens, the value of this process becomes evident well beyond the prediction of a single profit or loss number.
Let's be clear. I am not saying there is not value in projecting future profit or loss. I am saying there is greater value in creating the ability to make better decisions to change future outcomes.
When I discuss financial forecasting with startup entrepreneurs, I focus on representing the mechanics of the business within the financial model. Through this process, we produce various financial scenarios (some refer to these as "pro-formas"). These scenarios are designed to challenge assumptions within the business plan. This process of building scenarios using a financial model based on the mechanics of the business leads to a more robust business plan and improved decision-making.
Let's see how this work in practice with a hypothetical example. There is a growing electrical service company who provides two service lines: electric technician services (commonly thought of as their primary service line) and certified electrician training. Currently, most of their time and energy is spent supporting the electric technician service line. Through their financial modeling, they discover half of their profits are generated from the certified electrician training service line. The analysis suggest profits will grow faster, with less risk, by shifting focus to growing the training service line. As for the electric technician service line, their strategy shifts from growth to long-term health by focusing on better quality and efficiency. As they build out their three year plan, they see their expected profits are much greater than originally thought with a higher level of probability.
Let's expand this thinking to a larger and more complex business with established processes and structure. This structure brings complexity as well as a lack of flexibility to shift in response to economic or market changes. The complexity in this business needs to be represented in their financial model. Assumptions of growth in existing channels should be challenged, creating multiple financial scenarios. Each scenario should be assigned a probability. Opportunities and risks are identified with mitigating strategies proposed and debated. Proposed new products and channels are modeled as well, putting the spotlight on the most vital assumptions that will drive success or failure. These influence go / no-go decisions regarding these new products and channels. Collectively, this robust financial forecast process supports and influences decisions to drive better results.
The financial forecast on its own is a valuable tool. However, a robust financial forecast process is a game changer and a vital part of any business striving for healthy financial growth.
Call To Action
Take stock of your business.
1. Take stock of the business and determine its current trajectory.
2. Peel the onion and identify the key impactors of performance (do a little sensitivity analysis).
3. Develop three scenarios with forecasts for each: 1) the most likely scenario, 2) the disappointing scenario and 3) the wildest dreams scenario.
4. Do enough planning so that changes can be made quickly once you determine the scenario that actually plays out.
5. Make adjustments in the business that you find as result of examining the scenarios. (You don’t have to wait for a crisis to exit something that isn’t working out.)
I hope you found something to apply to your business in this MBR. Let me know either way.
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