- Forecasting may conjure up feelings of dread for business owners, but it's a necessary part of running a successful business.
- Forecasting has become a necessity during the pandemic, with businesses forced to show their expected payroll to get government-backed forgivable loans.
- Most small businesses should focus on their cash flow, sales and expenses when starting to forecast.
- This article is for small business owners who want to learn how to properly conduct financial forecasting.
Planning for the future in uncertain times may seem futile, but now more than ever, forecasting should be top of mind for small business owners. That's true whether you have five employees or 50. Without looking into the future, you won't be able to prepare for the worst – or be ready for the best.
"Many business owners avoid forecasting because it's tedious or intimidating," Clare Levison, a CPA and member of the American Institute of Certified Public Accountants Financial Literacy Commission, told Business News Daily. "Small business owners are passionate about what they are doing and don't love the financial aspect of running a business, but it's a crucial piece of being successful."
Forecasting doesn't have to be a source of dread. There are easy ways to plan for your business's future, even amid the severe uncertainty brought on by the global coronavirus pandemic.
What is forecasting?
For small business owners, forecasting is the process of looking at past and present data, as well as marketplace trends, to predict the company's future financial performance. It enables you to gauge how much revenue you'll potentially earn in a particular period and plan for big expenses.
Furthermore, this process is necessary for a business to be approved for a government loan through the CARES Act.
"In North America, the ability to get government relief is based on your ability to accurately present your cash flow in and out in the form of payroll and to understand if that loan will turn into a grant," said David Axler, vice president of books, banking and tax at Wave. "For small businesses … to keep your business open and going, you literally have to know what's going on."
Forecasting is different from budgeting for small businesses, but they go hand in hand. The forecast predicts the results for the company, while the budget lays out how the business will get there. In other words, a forecast gives you the foundation to build on.
Key takeaway: Forecasting is an important element of a successful business. It means looking at your past and present sales data and weighing that against marketplace trends to plan for a specific period.
What is the importance of forecasting?
Forecasting may seem like yet another item to add to the to-do list, but there are clear benefits to this type of business planning. Here are three big reasons to conduct forecasting.
1. It helps you plan for the future.
Running a business can be uncertain in normal times; add a global pandemic to the mix, and it may be impossible to tell how your business will fare in a week, let alone a year. A forecast brings some clarity to your business, even if it's bad.
"You can anticipate what could be coming down the pike, not just what's going on one day," said Mike Slack, manager of the H&R Block Tax Institute. "It's crucial that a forecast is created to plan for what's coming."
Slack said to create forecasts for different scenarios – for instance, a forecast for a nationwide pandemic recovery and one that plans for more shutdowns and restrictions.
2. It can inform business decisions.
Without an accurate representation of what's going on in your business, you won't know if there are challenges brewing or if you can chase a new growth opportunity. A forecast can inform business decisions, streamline operations and improve profitability.
"It really helps with some of the decisions that you'll ultimately need to make for your business," Axler said. "That goes for businesses of any size." [Looking for a small business loan? Check out our financial recommendations and guide first.]
3. It prevents tax bill surprises.
Death and taxes are two of life's certainties, yet many small business owners are caught off guard when they are hit with a big tax bill. Forecasting can prevent that shock, since it involves laying out all your expenses for the year.
"Without forecasting, you [might still] wind up solving the month-to-month cash flow issues, paying your bills, negotiating new terms every now and then, and staying in the black," said Jon Fasoli, vice president for Intuit QuickBooks. "But come the end of the year, you have a massive tax bill you don't have the cash for. Avoiding those moments of surprise are done through cash flow forecasting."
Key takeaway: Forecasting has a lot of benefits, mainly in planning for both the good and the bad. It can inform business decisions and prevent big surprises such as a huge tax bill.
What are the methods used in forecasting?
There are two common methods of forecasting: qualitative and quantitative. The more viable method for your company depends largely on how long you've been in business.
- Qualitative forecasting: With this method, you're making business predictions without the benefit of measuring them against past data. It's the common method for new businesses that lack historical sales or expense data. It largely relies on the judgment of the person creating the forecast. It's also a popular method for forecasting far into the future.
- Quantitative forecasting: You can use this method when you have measurable data to inform the forecast. By measuring sales against past performance, you can gauge if business is growing or slowing. It's a common method for short-term forecasting.
Key takeaway: The two common forecasting methods are qualitative and quantitative forecasting. With qualitative forecasting, there is no data to rely on or measure against; with the quantitative method, there is.
What are the various types of forecasting in business?
Business owners can measure several items to conduct their forecasts.
- Cash flow: Cash flow forecasting means predicting how much money will come in and go out of your business for a set period. The more accurate your cash flow forecast is, the smoother your business will run during that time, because you'll be able to plan your operations according to the money you will and won't have.
- Sales forecast: To properly manage inventory or demand, you would forecast future sales. This means looking at your business's past performance to predict your future sales.
- Startup cost forecasting: Used by new businesses, this forecast determines how much startup costs the company will face in the coming months or year.
- Expense forecasting: Unexpected expenses can eat away at your profits. With expense forecasting, you remove much of the surprise by laying out all the expenses your business will incur over a future period.
- Demand forecasting: To gauge your future sales, you can try to forecast demand. To do this, you'd look at your historical data, including your sales and seasonal trends, to pinpoint future periods of high and low demand.
Key takeaway: You can measure and project your cash flow, sales, startup costs, expenses, and/or demand for your financial forecast.
How do you develop a forecast?
When you're developing a forecasting method, the level of detail you need depends on your type of business and its complexity. For most small business owners, cash flow is a good place to start, according to Fasoli. After all, cash flow is really what makes or breaks a business.
"The variables baked into the cash flow forecasting should include seasonality, how to anticipate ebbs and flows, the terms of your payments, how much time you anticipate passing between finishing works and getting paid, and what structure you have in place to incentivize people to pay on time," Fasoli said.
In addition to the money flowing into your business, look at your expenses, including inventory, rent or mortgage, payroll, tax obligations, supplies, and all the other monthly costs of operating a business. Combine these data points for a view of what to expect in the next six months, the next year, or even further in the future.
"For businesses that have historical data, look back at where cash was positive and negative, and drill into those moments," Fasoli said. "What drove cash flow, and what was a surprise? And bake that into the forecast."
The timing of your financial forecast is also important, but how far out you should look depends on your business and temperament. You don't want to gear up to forecast your business for the next five years only to get overwhelmed quickly. Levison recommends breaking it down into a one-year, three-year and five-year forecast that you update regularly to get a complete picture of your enterprise.
"I encourage people to, on a weekly basis, keep track of revenue and expenses; on a monthly basis, update the annual forecast for the current year; and, on a yearly basis, update the three- and five-year outlooks," she said.
Levison said to forecast your revenue, which is how much sales are coming in; your expenses, which include your contractual obligations such as rent and credit cards; and your future obligations, which are the items you know you'll spend money on in the coming year.
At the end of the day, you want to choose a forecasting method that works for you and your small business. Forecasting shouldn't be a dreaded exercise, but an embraced tool to help you run your business effectively.
"Think of it the same way you would think of a household budget," Levison said. "Every single person needs a household budget, and every single business owner needs a forecast."
Key takeaway: Small business owners should focus on cash flow, sales and expenses in their forecasts. You should have short-term and long-term forecasts that you update regularly. It may seem scary at first, but it's an essential part of running a successful business.