Understand the Value of Financial Forecasting & Planning
One of the most significant (and often missed opportunities) as a business grows is understanding the value of and implementing the practice of forecasting and planning. Unless a business owner has been trained otherwise, most first time entrepreneurs resist the process of creating a forecast. They are in full action mode to produce and sell and don’t want to be tied down to making a plan. If they don’t recognize the value of a forecast and implement this process, most owners will not achieve or sustain significant levels of profitability.
What is a forecast and how does it serve toward achieving greater levels of profitability?
A forecast is a detailed financial model of how your business would perform if your strategies and plans are executed as your goals for profitability are met. A forecast provides a financial road map and is a powerful tool that assists you in achieving or even exceeding your goals for business growth and profitability. A financial forecast also informs you to make business decisions based on forecasted future financial outcomes.
The importance of goals as they relate to a forecast.
Setting goals (short term and long term) is integral to achieving success in any area of life. It’s no different in business and is a practice that business owners need to embrace. With goals set for both an increase in sales and bottom line profits for the year, a well designed forecast will provide the pathway to meeting those goals.
As the year progresses any number of factors (such as cost of goods sold, or operating expenses) that may contribute to having results that are either lower than or higher than the original goals set. It’s important to note that financial forecasts are an estimate, but well-informed, if produced by a reputable accountant.
What are the elements of a forecast?
A Profit & Loss forecast will have line items for:
Sales by Revenue Stream
(detail to include pricing, units of volume by product line, % increases by quarter)
Cost of Sales by Revenue Stream
(detail to include pricing, units of volume by product line, % increases by quarter)
Expenses by line item
(detail to include notes to the forecast that demonstrate an understanding of variable expenses increasing with volume and in some cases fixed expenses increasing at specific points in time)
Profit
(All of the detail “flows to the bottom line” to produce forecasted profits)
It is crucial to carefully construct a forecast to land at the profit level which you are aiming to achieve. If you don’t like the level of profits in the plan, you will need to go back and change your assumptions to get the desired level of profits.
Percentages to Monitor. The value of tracking the following relationships:
Gross Margin % (Gross Profit/Sales)
Margin % is defined as Gross Profit divided by Sales which is expressed as a percentage. (No one is good enough to track a few points in margin erosion by gut feel.) If your margin % is slipping, analysis of your pricing and costing structure and applying solutions will be necessary to get back on track. You need to have the appropriate accounting systems and metrics in place. A good small business accountant can help you track margins by product line so you can make appropriate adjustments to achieve the levels of profit you are seeking.
Expenses as a % of Margin (Expenses/Gross Profit)
This is one of the most valuable ratios that most business owners are not aware of. This ratio measures the total business expenses as a % of the gross profit $. The goal is to maintain as low a percentage as possible (the expenses in relation to gross profit). The lower the percentage of expenses to gross profit, the higher the resulting profits. The closer the percentage of expenses to gross profit moves toward 100% means profits are eroding. Most people find this concept confusing until a good accountant helps them understand it. It is a valuable tool once understood. For a more detailed explanation read our blog Margin Management.
Profit as a % of Sales (Profit/Sales)
When you effectively manage your margins (keeping your margins at the level you are forecasting) and control your expenses (making sure they are at the same level as forecasted), you will maintain your profits at the desired percent of sales. Eroding percentages of profits over time is your first and most obvious indicator of challenges that need to be addressed.
Tracking actual financial results against the forecast:
Once a forecast is in place and is being utilized for planning, the next integral step is in comparing your current financials against the forecast to be able to make timely and appropriate changes to increase profitability.
If you are looking to reach sustainable levels of profitability, it is a must to embrace the concept of implementing the process of forecasting and planning.
If your business would benefit from the services of a professional small business accountant Resolution Accounting can assist with your needs in forecasting and planning. Serving the entire Philadelphia region, including King of Prussia, Exton, the Main Line, Malvern, Chester County, Montgomery County, West Chester, Conshohocken, and more, Resolution Accounting offers small business accounting services and part-time CFO advisory services. Have more peace of mind and achieve increased profitability.
Ready to start? Contact Resolution Accounting – send us an email or call us now.
