Why prepare financial forecasts?
Various situations can necessitate a need for financial forecasts. Here are a few of the most common ones where a company’s management has to tackle the procedure.
- Assessment of the fair value of a company’s owners’ equity.
- Assessment of the profitability (net present value) of a project’s business plan.
- Valuation of a company’s assets and goodwill in the context of the impairment test.
- Setting and visualizing long-term goals for business activity.
- Input for management for making decisions using scenario analysis.
In practice, we see that preparing forecasts can often prove a complicated challenge for management. Much depends on the company’s phase in its life cycle. Forecasts are generally prepared for five to 10 years ahead; ordinarily, potential developments in such a long period cannot be predicted. This adds a greater or lesser amount of subjectivity to forecasting. Depending on what the purpose of forecasting is, the analyst has the possibility of significantly influencing the end result of the forecasts. At the same time, it is always worth thinking about what assumptions can be used to attain the most realistic result.
What to consider when preparing financial forecasts?
It is a wise idea to proceed from realistic baseline assumptions for revenue and expenses that follow general economic rationale. In addition, the specific nuances of the company and its area of activity must be considered.
Before diving into the spreadsheets for days on end trying to cobble together different figures, think about the following questions.
- What are the internal and external factors that create value for the company? What sort of key indicators should be used to track the effectiveness of the company’s operating activity?
- What is the specific nature of the business activity – is it seasonal or stable across all time periods?
- What growth phase is the company in? Does the risk scenario have to factor in various activity scenarios?
- Where is the company’s revenue generated? Does the company have long-term clients, one-off clients, fixed-term contracts? Does the company have key clients who might leave?
- What is the expense structure and what does the level of expenses depend on? Does it depend on internal management decisions, legislation that regulates the area of activity, or macroeconomic factors?
Consistency and comprehensiveness are important when preparing financial forecasts. It is wise to be guided by data-based approach, which lays the groundwork for well-reasoned forecasts. Inputs taken from thin air, so to speak, tend to raise questions for people reading the forecasts and thus may become a contentious issue later on.
Possible pitfalls in financial forecasting
As financial specialists, we deal with companies with different development trajectories. This has given us the opportunity to see the main weak points that a company‘s management may encounter when the need for preparing forecasts arises. The following are some of the areas of concern, accompanied by our recommendations of areas management should attend to.
Endless rapid growth of sales revenue
Overoptimism is a common theme when it comes to forecasting revenue. Often people make unreasonable assumptions about the steepness of the curves, especially for companies in the growth phase. To more realistically forecast growth, it is wise to correlate revenue forecasts with the principal business metrics. That will help to keep growth within realistically attainable range and give better input for management to plan activities to achieve the forecasted result. When preparing projected revenue figures, also note that a company cannot grow without end. Thus, be sure to think about when the growth might stabilize.
For companies in a more mature growth phase and longer history, look at the historical growth rates as these could be a good basis for preparing future forecasts, when the company’s activity has historically been stable and there are no plans to make significant changes in operating activity. It is also worth factoring in the general forecasted inflation rate.
Underestimation or overestimation of expenses
Inevitably, management may desire to put an unrealistic burnish on profitability in future periods. On one hand, management might be expected to be able to use rational decision making to reduce the expense base or change the expense structure. At the same time, it is important to also keep track of the general economic environment when forecasting expenses, i.e., inflation figures at the time the forecast was drawn up, regulatory aspects that impact the area of activity and changes in interest rates, as these may exert a significant influence on the expense base in future periods.
While underestimating expenses may be one area of concern, the opposite – and excessive conservatism - are not good either. When preparing forecasts for valuation purposes, there may be different reasons why a company’s value should be lower than in actuality it ought to be, objectively speaking.
An end result with low value-added
A good forecast’s level of detail and structure takes into account the purposes for which a forecast will be used and the end consumer’s interest. For example, if the purpose of preparing forecasts is to give management input for making informed decisions, it is likely not enough to have forecasts that go no deeper than simple growth rates and ratios. The forecast should be structured in a way that gives users the possibility to easily derive and put together an action plan to achieve the forecasted results. A high-quality forecast should also offer an overview of how the realization of various scenarios will impact the forecasted results.
What’s the difference between budgeting and financial forecasting?
Financial planning and budgeting are of key importance for shaping the bigger picture of the company’s processes and understanding shortcomings. Comparing the budget and actual results helps identify deficits in the organization’s processes and inefficiencies in activities. Most importantly, the goals set in the budget must be attainable. The management will not be able to understand actual problem areas in the company’s activity and processes if the budget is not aligned with the actual activity and general strategy of the firm.
A budget covers a shorter period, usually one year, and a budget has a strong connection to setting limits on spending for the given period. The keyword for a budget is constant comparison against the actual results and it is not a good idea to make adjustments to the budget during the period itself. Precise budget management helps simplify preparation of financial forecasts, as it gives an overview of the dynamics of the expenses. On the other hand, financial forecasting covers a longer period of business activity and constant updating of forecasts yields a better picture of the period ahead, taking into account different kinds of factors that have significantly affected expenses or revenues compared to the budgeted values.
How can Grant Thornton Baltic financial advisors help? On one hand, our role is to help you prepare financial forecasts but our job is also to validate inputs obtained from management. The goal is to give feedback about whether the forecasts are realistic and can be implemented. In addition, we draw attention to shortcomings in the forecasts and propose improvements.