To rephrase a well-known bit of wisdom, “You can’t know where you’re going if you don’t know where you’re going.” Financial planning is essential to both running your business in the short term and growing your business over the long term.
You probably already do some financial forecasting now, no matter what type of business you’re in. A person who runs a small coffee shop, for example, has to calculate how much money came in today and how many paper cups and pounds of coffee beans she will need tomorrow. But that coffee shop owner could go on like that, doing short-term financial forecasting, virtually forever without fundamentally changing the business. If she wants to grow the business, she’s going to have to look beyond tomorrow, next week, or next year.
Let’s take a look at how the experts at Financial Optics can help you use good accounting practices to make a 5-year plan for your business to help you set achievable goals and be ready to overcome possible pitfalls.
Ready to ask our experts about financial forecasting? We’d love to talk.
First: Why do you need Financial Forecasting?
Understanding your finances is important to running your business for ensuring the basic necessities that enable you to operate day-to-day. But you need a deeper understanding in order to incorporate the added expenses of expanding your business, whether adding a new location or purchasing equipment and much more.
If your planned growth includes securing outside funding, such as a loan, you must be able to prove the health of your business. You do this through things such as sales trend and your disciplined financial management, such as smart budgeting of costs related to income. Any investor will want to see proof that your business makes money and has potential for at least continued or projected profitability, if not a clear plan for increasing future profitability. In other words, you need to be able to show that you will be able to repay the loan. Investors will also want to know potential challenges and how you plan to correct or overcome them.
If you’re not going after a new loan, you need to understand how much investment in growth you can afford to make out of pocket. Simply put, you need to know – for sure – how much money you can afford to spend.
Any business plan is anchored on financial forecasting and the many factors that inform and influence that forecast. Furthermore – and closer to your heart – financial forecasting gives you clear-eyed insight into your own business. You made the giant leap of faith to open your business because you had a goal – and financial forecasting is the tool you use to identify how close you’re getting to accomplishing that goal, any problems that stand in your way, and what you need to do to get across the goal line.
Current Health of Your Business
Begin with a thorough understanding of where your business is now. You likely wrote a business plan when you started out. Take another look at that plan, but this time not for the purpose of securing a loan but for your own insight. How has your business performed relevant to your projections in the business plan? This evaluation should be rooted in accurate accounting and reliable financial management: You already know (or should know) your numbers.
So, this understanding of your business performance should likely be reflected in a detailed spreadsheet that includes sales revenues, costs to generate those sales (i.e. cost of goods sold), operating costs, capital expenses, gross margin (by product, if applicable), sales increase/decrease (per product, if applicable), inventory turnover, debts and their interest rates, income taxes and your tax rate, depreciation schedule(s), plans for accounts receivable and payable, and depreciation schedules. Having reliable knowledge of these metrics is the very reason to have reliable, accurate accounting.
Historically, investors have primarily evaluated a company’s health based on its cash flow, income (net), and revenues. But more and more in recent years, there is a focus on earnings before interest, taxes, depreciation, and amortization (EBITDA). This metric is not necessarily required in many situations, but having it calculated can indicate your professionalism and help potential investors more easily understand your business’s ability to service debt, at least over the next year or two. It is particularly useful for comparing one company against another.
That said, there are drawbacks to using EBITDA for evaluation, especially of a rapidly growing company that heavily utilizes working capital to invest in assets, such as inventory, to grow sales.
We can help calculate your company’s EBITDA, explain further how it is useful, and how to incorporate it into your financial forecasting.
Ready to learn more about your company’s financial health? We’d love to talk.
Some business owners are clearly aware – even driven by – changes in their market or region or other industries that impact theirs. For example, a gas station owner may be closely watching the growing popularity of electric cars. But even if you are not aware of impending changes, take a moment to consider what possible factors could be different in the periods of your forecast. This may include trends in your area or industry, major shifts in the global economy, employment levels, etc. It’s always better to anticipate change is coming than to be surprised by it.
Different types of businesses have radically different levels of reliance on employees. List your key staff positions, expected staff needs, and what disruptions or improvements you think could be possible. Please be cautious of legal restrictions regarding asking about employees’ personal information, but, for example, do you have a newlywed who could be out for maternity leave? Do you have employees nearing retirement age? Does your business rely on a specific person with a unique skill set? What happens if she leaves the company?
What are your plans with the company? If all goes according to plan, will you still be in your current position a year from now? Ten years from now? What is your plan for transition when you are ready to leave?
When making projections, it’s important to stick to what you know rather than what you hope. So, in the interests of reducing conjecture as much as possible, we advise forecasting month-by-month for the next year, then quarterly for the following year or possibly two, then annual projections until year 5. In those forecasts, we suggest including projections for the following:
- Sales, with a description of what drives your sales or revenues. This should be based on history and known factors, such as a new residential development nearing completion that will increase the population of local residents who may be potential coffee shop customers.
- Expenses, including budgets for operating, generating sales, etc. Include known projections, such as if you know your rent will increase and when.
- Calculation of how known and projected expenses will change your income-to-costs ratio (margin).
- Cashflow, including a projection showing how the business is profitable – or when/how it will become profitable. Include monthly inflows/outflows for each of the forecast periods. Be sure to include a capital expenditures budget in cashflow forecasts, as capital expenditures for large ticket equipment for example do not impact the income statement and are only reflected as part of the balance sheet.
- Balance sheet, which should show the business’ worth or valuation. List assets, including cashflow as an asset. Also list liabilities, including debt and unpaid bills.
The Way Forward
With all this information parsed out yet gathered together in one place, you should be able to understand where you are now, where you want to go, what challenges could be ahead, and hopefully, how to get there – or at least identify what you need to tackle.
At Financial Optics we help our clients get clearly focused on cash flow, and the type of detail forecast discussed here will help you understand how much cash you are going to need as you grow, when you will need it, and where it is going to come from. That is the type of clarity that will help you sleep at night.
It should be clear that everything that goes into financial forecasting relies on good accounting. Financial Optics can make this entire process easier for you. We are experts in small business accounting, and we can help you decipher the numbers underlying your business, talk with you about your goals, and help you forecast your financial future.