Forecasting is one of the cardinal rules of finance. Without it, even the strongest company can be ill-prepared for the future. Sure, it’s impossible to accurately predict what will happen in the next day, week, month or year. Look at what happened with COVID-19; its unprecedented impact wreaked unexpected havoc on economies globally.
Traditional forecasting is static. It relies on looking only at your past revenue and expenses, which are then used to predict the business’s financial performance over the next one, three, six, or twelve months. A dynamic forecast is updated regularly — think every day or week instead of each month or quarter — and it factors in a lot more detail than a traditional forecast.
A dynamic forecasting model offers much more value to your business because it includes a large number of financial and non-financial variables as part of the forecast. It paints a much clearer picture of what a company can expect and hope to achieve in both the short and long term with income statements, cash flow, cash reserves, balance sheets, and other measures of a business’s financial health.
The team at Summit CPA uses a three step process for any dynamic forecast. Here’s how it works:
Examine your current revenue stream to determine how it would be impacted in the best, break-even and worst case scenarios.
Look at your cash reserve to determine if you have sufficient cash to weather any possible storms of the worst case scenario.
Look at your existing costs and any other costs you’ll incur over the forecast period.
Each of our clients has been impacted differently by COVID-19. One of our clients was in a very stable financial situation when we began the forecasting process to prepare that company for COVID-19’s impact. The company in question usually has 30% of its annual revenue in the bank, but this past January, the client paid out bonuses through their profit-sharing plan. After the payments, they had approximately 20% of their revenue in cash on hand. Considering that we typically recommend a client have around 10-15% of revenue in their cash reserve, the client in question still had enough cash on hand to wait and see how the pandemic situation would play out before making any adjustments to their business operations.
In the meantime, the client turned to us to analyze the situation further and create a plan that would allow them to respond to any financial challenges that came their way during this period. We used dynamic forecasting to satisfy this request. These are the steps we took.
Review Existing Contracts
We looked at the existing contracts to see who was going to renew and who wasn’t. Our client spoke to each contract holder to see which ones would “definitely” be ending and which ones “might” be ending. We found that only two contracts would “definitely” be ending, so we removed them entirely from our consideration. We also found out that two additional contracts “might” be ending, so we had to decide whether or not to include them in the best-case scenario.
Placing these two contracts into a best-case scenario category meant that if both companies chose not to cancel their contracts with our client, our client would remain in a firm financial position.
Rank Potential Contracts In The Pipeline
We then took a look at the client's entire pipeline in order to determine which contracts they could land within the next three months. From there, we categorized the client's chance of winning these contracts by rating them as "high," "medium," and "low" possibilities. Each rating corresponded to a best-case, realistic, and worst-case scenario forecast. These three scenarios helped build out what the clients possible revenue and ultimate cash position might look like under specific circumstances.
Anything that was rated as a “high” possibility was kept in the best-case scenario. This action created a forecast that reflected how the business would look financially if the client closed every deal in the works and only lost the clients they knew they were going to lose. Potential deals labeled as a “medium” possibility were put in the realistic scenario and displayed a forecast composed of the client landing contracts they hoped they would win, but were uncertain about. Finally, the last forecast contained contracts that the client could close in the next three months, but didn't feel confident about landing. These contracts were ranked as a low possibility and made up the worst-case scenario.
Analyze Expenses, Predict Outcomes
After building out the scenarios mentioned above, we placed the client’s costs next to the predicted revenue generated through each of the three scenarios. This resulted in three very different financial outcomes for the client. The best-case scenario forecast resulted in a 30% profit and showed a growth in the client's cash. This scenario was ideal and in line with the client's usual expectations regarding the financial health of their business. The realistic case scenario forecast showed the client making a 10-15% profit, which was relatively low for a company accustomed to earning double that amount. However, this profit margin was still pretty good because the client had a healthy cash reserve and would be turning a profit. The last forecast depicted the worst-case scenario, which showed the client breaking even or taking a loss.
Cash was a key essential driver in the decision making process. Remember this client had 20% of their annualized revenue in the bank. The decision process would have looked completely different if they’d had no cash or tapped out their line of credit.
Loss is inherent to every business cycle. However, your company can withstand difficult periods of loss if you use a dynamic forecast to prepare appropriately. Think about it like a disaster preparedness plan. You don’t know if or when the natural disaster is coming, but you prepare for it anyways. If it’s hurricane season and you live in the Florida Keys, you know that you need to purchase hurricane shutters, batteries and other essential supplies that’ll help you weather the storm.
In summation, dynamic forecasting is essential for the success of your business. Whether your business is growing steadily, or you’re hit by a surprise loss one month, having a dynamic forecast that you review and adjust regularly will ensure that you are always looking ahead at what’s to come. As a business owner, you want to be sure you are making the right decisions for your business and the necessary course corrections as you go.
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