Article written by:
Manager, Valuation & Business Advisory Services
Whether titled a “budget,” “forecast,” or “projection,” a forward-looking plan is a must-have for many valuations, but it can be a challenge to compile in the best of times. In “black swan” times such as the COVID-19 pandemic, budgeting can be downright daunting. In this article, we will discuss some guiding principles for preparing a forecast in the best and worst of times.
A budget is primarily a communication device, laying out both a company’s goals and how it plans to invest to achieve them. When performing a valuation, we use a budget to learn management’s priorities, growth plans, and any expected changes in the business. If events do not go to plan, management and valuators can use a budget to help determine where and why a variance occurred.
In order to be most effective, a good budget is:
A realistic, “middle of the road” budget should reflect how the business actually operates and is ideally built on some of the same metrics used to run the business. A realistic budget should also be based on historical data, as a valuator will ask questions to figure out any significant deviations from historical performance (e.g., a significant increase in gross margin or materially lower capital expenditures). Ideally, forecasts should include actual historical data so that forecasted data is presented in context and shown to correspond to reality. What constitutes “realistic” during COVID-19 is likely different than normal, and valuators will spend time learning how the business is impacted by the pandemic and plans for recovery in the coming years.
When preparing a budget, the Pareto Principle applies – the majority (~80%) of results will be driven by a smaller percentage (~20%) of variables. A good budget identifies and discusses business performance relative to these key variables. The benefit of a simple budget is that it is easy to explain, can be communicated to internal (e.g., employees) and external (e.g., valuators) constituents, and any variances from the projected performance are easier to identify. Simplicity also allows for adjustment and adaptation when unforeseen events, such as COVID-19, arise.
A logical budget starts with a business’s most consistent variables. For example, if a business has high levels of recurring revenue or a reliable backlog of work, it may make sense to begin with revenue and then add costs, investments and growth initiatives. If, on the other hand, the business has a sales force that needs to continually win new work, has lumpy sales, or is planning in a time of uncertainty (such as COVID-19), it may make sense to begin with known expenses, then build the path to the revenue needed to support them.
In an ideal scenario, a well-built, well-communicated, simple, logical budget guides organization-wide decisions around pricing, costs, investments, and more. This ensures that when confronted with a choice, decision-makers are more likely to choose the same option, driving the organization towards shared goals. When unforeseen complications such as COVID-19 arise, variables can be changed to drive the business in a “new normal”, and these changes are easier to communicate to the entire organization. Useful budgets are also likely to lead to easier valuations, as a consistent process and presentation mean fewer surprises when it comes time to read our report.
Please contact GBQ’s business valuation team for all of your valuation needs, including any questions on your budgeting process and how to make your budget realistic, simple, logical and useful.