When it comes to the financial health of your business, what is the most important number? Your CFO probably talks about more than one. Depending on the conversation, financial health might be discussed in terms of annual revenue growth, lifetime customer value, cash flow, forecasts, or EBITDA.
These are all important financial metrics, but according to Sequoia Capital–the most important number for your business is your forecast–and, more specifically, your ability to forecast accurately.
Why You Need to Focus on Your Financial Forecast
In June 2022, Sequoia, the leading VC firm, shared a presentation with their founders titled “Leading in Uncertain Times.” I think we can all agree that in the past year–if anything, the level of uncertainty has risen.
According to the National Bureau of Economic Research, which tracks the World Uncertainty Index, we’re on a trajectory for more uncertainty. NBEC compiles more than 25 years of global research to help businesses understand the full impact of all the factors generally labeled under ‘economic headwinds,’ and they have labeled the entire decade beginning in 2020 as a time of increasing global uncertainty.
Take a moment to look back over the past few years. While the aftermath of the global COVID-19 pandemic is likely the most significant shock to our global economic system, it has not been the only one.
Some of the most notable events in recent history include:
- COVID-19 Pandemic
- Global Supply Chain Disruptions
- Russia-Ukraine War
- High Inflation and Increasing Interest Rates
- U.S. Bank Failures
- Potential Debt Ceiling Standoff
While we have likely looked at these events as isolated, the research collected through WUI indicates that the effects of these events are feeding into a growing trend of increased uncertainty.
For businesses, this trend of increasing uncertainty means that it is increasingly difficult to predict future events or outcomes with confidence. This creates apprehension, making it difficult to plan for the future and ultimately leaving less room for error.
In business, uncertainty also means:
- Lower Sales Due to Cautious Consumer Spending
- Higher Expenses (Fuel, Transportation, Storage, Inventory, Etc.)
- Increased Operational Risk (e.g., Supply Chain Disruptions)
- Reduced Access to Capital (Bank Failures)
In short, a trend of increasing uncertainty means that businesses need to invest more in accurate forecasting now to prevent catastrophic losses when the next major economic event pops up.
What is the Right Way to Build a Forecast?
Building a financial forecast is an important exercise for any business; it allows you to anticipate and plan for future revenue and expenses. Unfortunately, it’s also a complex process often filled with bias and inaccurate assumptions, insufficient data, or gaps in expertise.
Here is a step-by-step process that can help take the guesswork out of building a forecast.
1. Start with a clear understanding of your business drivers: Before you can build a financial forecast, you need to have a good understanding of your business drivers, including what drives new sales, what are direct costs related to revenue, what additional overhead is required to support the organization and what working capital is required to keep the business flowing.
2. Define your assumptions: A financial forecast is only as good as the assumptions that underlie it. Be sure to clearly define your assumptions around revenue growth, expenses, margins, and other key drivers of your business. Remember, assumptions are usually interdependent.
3. Develop a revenue forecast: Start by forecasting your revenue based on your assumptions. The revenue forecast build should reflect “how you sell”. If it is an account executive-based B2B enterprise sales motion, the forecast should show hiring schedules, ramp-up timing, quota attainment ratios, etc.
If it is a direct-to-consumer product, the forecast should be based on marketing spend, return-on-ad-spend, CAC assumptions, etc. This may also involve breaking down your revenue by product or service line, customer segment, or geographic region, as the go-to-market motion may be different for each.
4. Estimate your expenses: Once you have a revenue forecast, estimate your expenses based on your assumptions. This may include variable expenses, such as the cost of goods sold (COGS) or sales commissions, as well as fixed expenses, like rent, salaries, and utilities.
For early-stage companies, COGS may have a fixed component that gets amortized as the business scales gradually approaching a “run-rate” gross margin. It’s important to consider the interdependency of the organization as you make growth assumptions.
For example, more sales mean you need more customer service staff or implementation staff. More hiring means you may need more recruiters, and so on.
5. Build a cash flow statement: With your revenue and expense forecasts in place, build a cash flow statement that shows how cash will flow in and out of your business over time. This is particularly relevant for businesses that have a mismatch in P&L-based earnings and cash flow.
For example, if you collect 12 months of revenue up front, have to purchase bulk inventory which will be sold over several months, or have large capital expenditures. Building out a detailed cash forecast is imperative to the survival and success of a business. Companies should, in general, have a separate 13-week cash flow forecast that can deliver high accuracy.
6. Review and refine: Finally, review your financial forecast regularly and refine it as needed based on changes in your business or the broader market. It’s important to note that building a financial forecast is an iterative process that requires ongoing refinement and adjustment. As you learn more about your business and the market, your assumptions and forecasts may need to be revised.
Additionally, it’s important to incorporate feedback from stakeholders, such as investors or lenders, to ensure that your forecast is aligned with their expectations and requirements.
How to Use Your Forecast
Building an accurate forecast is only part of the process. To make it useful–everyone needs to use the forecast as a tool that can provide a forward-looking perspective in key conversations that shape business decisions.
- Internal Management
- Investors & Shareholders
- Lenders & Creditors
- Business Partners, Collaborators, & Advisors
At a minimum, the financial forecast should be at the center of the conversation when reviewing financial numbers at the monthly close. Your internal management team should routinely compare monthly close to the forecast and dig into why there were discrepancies.
Carefully tracking actual performance against the forecast and drilling down into the underlying drivers provides insights into the go-forward action plan. A lower sales figure prompts a closer examination of the sale process, which leads to setting up better tracking of sales pipeline performance.
This helps the company understand the root cause of slower sales. Do we need to improve our win rate? Or do we need to focus on top-of-funnel lead generation? If it is lead generation, what is our highest ROI channel–is it organic leads from content marketing or cold outreach?
Asking tough questions–and getting to the root cause of problems that are draining financial resources is the first step in correcting the course–and improving the financial health of the company.
The effects of inaccurate forecasts ripple through the company:
- Production planning is disrupted when the company struggles to procure materials or allocate resources.
- Customers experience more frequent and longer delays as inventory management systems are slow to adapt.
- Pricing strategies fall behind.
- Higher-than-expected carrying costs impact working capital.
- Supplier and vendor relationships begin to break down as the company constantly looks for band-aids to their problem by asking for discounts or re-negotiating terms.
- Delayed hiring may deteriorate implementation times and customer satisfaction.
The Bottom Line–You Need to Improve the Accuracy of Your Financial Forecasts
We are all leading through uncertain times–and the data suggests that this turbulence is here to stay, at least for a while. One way that companies can stay on top in times of uncertainty is through diligent, precise financial forecasting. Remember – that is the most important number in your company.
At Embarc Advisors, we take pride in providing accessibility to top financial talent to help you improve the accuracy of your financial forecasts–and strengthen your business. Contact Embarc Advisors today!
Learn more about the value of finding the right financial talent with our blog: A New Approach to Corporate Development for SMBs.