“If you don’t know where you’re going, any road will take you there.” – George Harrison
Large public companies and those in the middle market. Profitable and unprofitable. Rust-belt manufacturers to high-tech start-ups. Our business valuation group has worked with many companies at each end (and in the middle) of any spectrum, in countless industries. For most of them, we get the opportunity to spend time with key management, and learn a great deal about their companies. One of the main characteristics distinguishing many of the more successful companies we work with is sophistication surrounding and attention paid to the financial forecasting process.
As a business valuation professional, forecasting is central to our work – value is forward-looking (an investor is only entitled to future cash flows), so the key to current company value is expected future performance. So, we ask each business we work with for a budget/forecast/business plan. And we have heard all the excuses as to why one does not exist – “we don’t have a crystal ball”, “tell us what the economy will do next year and we’ll give you a forecast”, “we only can do a next year budget because it’s too tough to look past that”, “nobody does projections in our industry”, etc.
So what do we tell business owners and managers when we get resistance? First of all, we empathize – our line of work, business valuation consulting, is characterized by projects that are generally short-term in nature and for a specific purpose, rather than consistent, predictable engagements like an annual accounting audit. Despite being in an industry with minimal sources of recurring revenue and volume that is subject to large and unpredictable fluctuations… we still forecast! Secondly, is it likely that the business will sell someday? A prospective investor will probably want a forecast. And would a prudent investor buy into a company with a management team that has demonstrated it has no insights/predictions/plans for the future?
We often convince management to build a forecast when we tell them this – most of the successful businesses we work with have a well-thought-out forecast or business plan. Why? First of all, the act of having a forecast suggests an active/aggressive management team, one that sets targets which then require a plan and action items to get there. Rather than a passive management team content on waiting for opportunities, inspiring a culture that suggests its success is determined more by outside factors. In some respects, the process of building the forecast may be more important than the resulting forecast itself. For one, it helps align management and staff to specific goals, and often brings to the surface differing opinions or visions for the company. This communication between managers and departments is critical when making key business decisions – setting staffing levels, deciding whether to make investments in overhead, determining how to finance the business, etc. The process also encourages management to measure and study company trends/stats, and research those of the industry, which can be enlightening, and can certainly be helpful when it comes time to give performance reviews.
Now that we understand the importance of projections, what are some best practices or tips for those looking to improve their forecast? First off, there are a number of good ways to build a forecast (top-down, bottom-up) or forecasts (scenario analyses). Regardless, the best projections are diligently prepared by management with input from multiple contributors across various business functions (i.e., sales, finance, operations). The in-house person most responsible for putting together the financials (i.e., CFO/controller), perhaps with some assistance from an outside advisor, should be able to oversee the process. Here are some tips we give….
- Look at historical trends, and remove non-recurring or extraordinary items that distort results
- For mature companies, also look at economic/industry growth rates (3-5% growth is common)
- For cyclical companies, project in neutral economic climate, or through an entire economic cycle
- Make sure to consider sufficient investment (e.g., cap ex) to accommodate projected growth
- Use a format consistent with annual audited financial statements, for comparability
- Avoid “recency bias” – building off last year, which may have been the best/worst year ever, without considering other factors
Lastly, we tell management to remember even when the forecast is complete, the job is never done…. Periodically regroup as a team to compare actual results to projected, find out what went better than expected and what went worse, and try again!
The business valuation team at GBQ can help you build a forecast suitable for your business needs, and can also use this forecast to determine the value of your company.