Forecasting the Future

by: Smith and Howard

July 31, 2014

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Forecasting can help borrowers anticipate future financing needs and prove that they’ll be able to repay loans. But how do lenders know whether a forecast is achievable — or merely wishful thinking? Reliable budgets and business plans are based on forecasts that share several common denominators.

Reasonable assumptions ground the forecast 

The purpose of forecasting is to obtain the most realistic picture possible of a company’s future performance for as far out as management can look. Forecasts tell borrowers important information that can be used to make decisions, such as:

  • When are working capital shortages likely to take place — and is the line of credit sufficient to bridge cash flow gaps?
  • How much inventory, including raw materials, parts and finished goods, should the company purchase each month?
  • Does the company have the right mix of employees to meet its operational goals — and how should it remedy any deficiencies (or excess capacity)?
  • Are existing fixed assets currently being used to their fullest potential? If not, which assets should the company retire (or acquire)?

A forecast is typically organized using the same format as a borrower’s financial statements: an income statement, balance sheet and cash flow statement. Most also conclude with a statement of key assumptions that drive key numbers in the forecast. A detailed sales forecast drives many of these assumptions. 

Sound forecasts roll with the punches 

Borrowers use forecasts in their annual budgeting and strategic decision-making processes. But many budgets and business plans are out of date before the end of the first quarter. That’s because today’s complex, dynamic marketplace is almost impossible to forecast with certainty. So, many companies have replaced traditional annual budgets with rolling 12-month forecasts that are adaptable and look beyond year end.

Creating a meaningful rolling forecast necessitates ongoing comparisons between forecast and actual results. This enables management to unearth and respond to weaknesses in forecast assumptions and unexpected changes in the marketplace.

For example, a retailer that suffers a data breach could experience an unexpected drop in sales. If the company maintains a rolling forecast, it would be able to revise its plans for temporary decreases in inventory, as well as increases in technology and marketing costs related to remedying the breach. 

Forecasters recognize what they cannot change 

Almost all forecasts begin with historical financial results, but that’s only a starting point. Beware of borrowers who automatically assume current revenues and expenses will grow at a constant rate commensurate with inflation. That’s simply unrealistic for most companies today.

Management needs to evaluate the marketplace for emerging external threats and opportunities. For example, health care providers need to anticipate how emerging government regulations, including the ACA and HIPAA, will affect their future revenues and expenses.

Examples of other external obstacles that borrowers can’t change, but need to factor into forecasts, include rising energy costs, evolving weather patterns, and changes to tax and labor laws. On the other hand, changes in technology, including the growing popularity of social media and smart devices, may create marketing opportunities that proactive borrowers can use to their advantage.

Savvy borrowers watch how competitors are performing under the same market conditions. In an evolving market, the performance of competitors — especially market leaders — is often more meaningful than historical results. 

Everyone buys in 

Forecasts that employees perceive as dictatorial mandates are doomed to fail. Reliable ones are based on input from all functional areas, including the finance, sales and marketing, operations, and human resources departments. Cross-functional collaboration on forecasts helps borrowers balance predicting demand with planning for supplies, catching errors and omissions, and achieving companywide buy-in.

Getting input from an objective outside financial professional also helps. Smith & Howard professionals trained in financial reporting and have the added benefit of providing a fresh perspective that can breathe new life into a borrower’s budget or business plan. Contact us on our Commercial Lender Hotline at 404-874-6244.

How can we help?

If you have any questions and would like to connect with a team member please call 404-874-6244 or contact an advisor below.