The ability to closely forecast your company’s future cash flows is a powerful tool for any management team. Forecasts can be used to support business decisions and capital allocation, plan for the future and anticipate changes in the marketplace. Additionally, a forecast is the main input in a discounted cash flow analysis, which is a valuation method used to determine how much your company is worth (the value of a company is equal to all of its future cash flow discounted at an appropriate rate). Below are a few of the most common pitfalls in building a forecast:
- Strictly Utilizing a Top-Down Approach. While it is easy to say “Our company grew 4% last year, so I anticipate we will do the same this upcoming year”, this approach does not supply significant insight on the expectations for the business. When developing a financial forecast for your company, it is helpful to recognize all of the readily available information that is at your fingertips. Utilizing data from your computer systems (e.g., revenue by customer, revenue by location, revenue by salesperson, etc.) can provide excellent data with which to build a company’s projections. While the greater detail may help improve the accuracy of the forecast, it is also helpful when looking back on a specific year and pinpointing data that resulted in the variation between actual and projected results.
- Taking a Short-Term Approach. Projecting cash flows into the future, especially after the first 12 months, can be a daunting task. However, understanding your company’s long term goals and the steps need to hit these goals is important for any management team. For example, if a company wishes to double profit by 2025, a long-term, detailed forecast can provide clarity in what that would look like. Will the company need to increase headcount? Does the company have the capacity to hit this goal or will it need to purchase more equipment? It all goes back to being able to make informed business decisions utilizing a forecast.
- Failure to Revisit Past Forecasts. As previously discussed, a detailed forecast can provide insight into the variance between actual and projected performance. Additionally, reviewing past forecasts can help the forecaster understand their own biases. Most commonly, a risk-averse forecaster may inherently build a “conservative” forecast. Conversely, a forecaster may have a tendency to be overambitious on a company’s ability to cut costs and improve margins. Understanding your inherent biases may help improve the forecasting process and result in informed business decisions.
Your company’s outlook is constantly changing and will continue to change. The ability to build a robust forecast and use it to make informed business decisions is an important tool for any business owner or management team to have. Should you have questions or wish to discuss this information in more detail, contact a member of GBQ’s Consulting team today.
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