Forecasting: What Happens Next?

by James Spencer

As we begin to move cautiously (and irreversibly?) out of lockdown, many of us are wondering what is coming next. With the dust beginning to settle, businesses are gazing into their crystal balls to try to make their predictions about the future so they can plan ahead effectively. In doing so, they should consider a financial forecast an essential tool.

In the last 12 months the number of times that we have heard the term “unprecedented” has been, frankly, unprecedented. However, the fact that every financial forecast for 2020 was wrong is certainly not without precedent. In fact, it is an old maxim in the world of financial forecasting that “the one thing that we know about every forecast is that it is wrong”.

A common question we hear is therefore: “If a forecast isn’t supposed to tell me what’s going to happen, why should I bother using one?

This question reveals a misunderstanding about what a forecast is meant to achieve. It doesn’t tell you what sales are going to be for each product or department for next year. It doesn’t tell you what gross profit margins are going to be, nor what the bank balance will be at the year end. It certainly doesn’t tell you the exact profit figure that you can expect to achieve.

While the structure and end goal of a forecast depends on the reason it is being prepared, fundamentally it is a way of predicting future outcomes based on a set of assumptions. Typically, those assumptions are painted with a broad brush (X% growth in sales, debtor days of Y, sales mix of A%:B%:C%).

The best forecasting tools are those that allow management to tweak the assumptions to provide outputs from a range of scenarios. A forecasting tool like this can help inform management what the breakeven case is, where pinch-points might be in the year, what the key drivers are that convert sales growth into higher profits, or what their best- and worst-case scenarios are based on certain assumptions.

Whilst all forecasts are “wrong” in the sense of being unable to perfectly predict the future, some are more wrong than others. How wrong they are depends on the assumptions used, how reasonable they are, and how robustly the forecast has been built.

When building a forecast it is essential that it covers the complete picture. That is, it must show the profit and loss statement and also the balance sheet at each interval (monthly / quarterly / annually). It is only when viewing the forecast results and the financial position as a whole that it is possible to determine whether the assumptions are reasonable.

A forecast is an essential part of management’s toolkit in every business. If you would like to speak to us about how we can help you build, improve or assess your forecast, please get in touch with the team.

Author

James Spencer

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