The most successful businesses create financial targets each year and incorporate them into their business plans.
Setting financial targets and forward planning allows you to clearly see the financial impact of your plans and gives you the confidence to make the right decisions to grow your business.
In this article we show you how to create a forecast for your business and track its key financial performance measures - profitability, assets, liabilities and equity as well as business cash flows.
For mature and stable businesses, they can use last year’s data to help them estimate their financial performance for the following year. This approach to forecasting is referred to as a “top down” approach.
For businesses that are in the start up phase or undergoing rapid change, they may not be able to rely on previous year’s data and have to forecast their financial performance by making certain assumptions about their plans for the coming year and knowledge of their industry. This approach is referred to as a “bottom up” approach to forecasting.
Forecasting profitability
When creating a forecast for your business, start with the Profit and Loss Statement. As the name suggests, The Profit and Loss Statement measures the profitability of your business, tracking its revenues, cost of sales, gross profit, overhead costs and net profits or losses.
Step 1: Estimate Overhead Costs
Overhead costs are those costs associated with operating your business. Examples include staff salaries, rent paid to your Landlord and the key operating and administration costs required to run your business. These costs don’t change in line with the revenues of your business and are often referred to as “fixed costs”.
For established businesses, use last year’s expenses as a starting point and take into account any expected changes for the coming year such as annual rent increases or increases in staff wage rates. Costs typically increase each year as a result of suppliers increasing their prices, so be sure to factor in a general price increase to accurately forecast your overhead costs for the coming year.
Step 2: Estimate Revenues
Once you have estimated your overhead costs, it’s now time to estimate your revenues. How you approach this will depend on the nature of your business and what sales records you have access to from your point of sales system. If you have a good point of sales system you will be able to see the number of customers that bought from you last year, what they bought and how much they paid, on average. This information will help you estimate your revenues more accurately for the coming year. If you don’t have access to this information then you typically estimate revenues based on a percentage change from the previous year based on your business plans and your views of the industry in which you operate.
The more data you have access to, the more reliable your revenue forecast will be. Make sure you spend the time required to accurately estimate your revenues because your revenues will impact the amount you plan to spend generating these revenues and your level of profitability. If you don’t have access to the information you need to accurately forecast your revenue, then update your systems and record this information in the coming year so you can more accurately forecast your revenues in the following year.
Step 3: Estimate Direct Costs
Direct cost are the costs required to generate your revenues. Examples include food and drink costs for a restaurant, product costs for a retailer or salaries paid to professional staff for an accounting, legal or engineering firm.
For retail and product based businesses, you will estimate your cost of sales based on the gross profit margin for each product line or an average across your products.
For service-based businesses that have a high salary and wage component, you will need to estimate your wage and on-costs for both existing staff and new staff. This will require you to estimate your staffing requirements to ensure you have enough capacity to generate your revenue targets.
Step 4: Calculate Profits
Calculate gross profit generated from your sales. Gross profit is calculated as the difference between your revenues and direct costs.
Calculate net profit. Net Profit is calculated by deducting your overhead costs from gross profit.
Forecasting Assets, Liabilities and Equity
Now that you have estimated your revenues, costs and net profit, you can turn your attention to your assets, liabilities and equity, recorded in your Balance Sheet.
Step 5: Review Opening Balances
To ensure your Balance Sheet accounts are accurate, start by reviewing your opening account balances, ensuring they are accurate.
Step 6: Estimate Working Capital Assets
Working capital assets include accounts receivable from customers, inventories on hand and cash in trading bank accounts.
Accounts receivable from customers is the amount of unpaid revenue at any point in time, determined by the credit terms provided to customers and assumptions made as to when the invoices will be paid.
Inventories on hand will be calculated by reference to the amount of stock required to generate customer orders, which will be calculated by the number of days sales required to be on hand at any point in time.
Cash in the bank will be the calculated by taking into account all of the operating, investing and financing cash flows of the business. This will be discussed further below regarding forecasting cash flow.
Step 7: Estimate Working Capital Liabilities
Working capital liabilities include business overdrafts, accounts payable owed to suppliers, employee entitlements such as superannuation and wages and taxes owed to the Australian Taxation Office.
These working capital liabilities at any point in time are determined by the number of days credit each supplier provides and when the amounts are paid.
Step 8: Estimate Capital Expenditures & Investments
Estimate the amount required to be spent on plant & equipment and other long-term capital assets required for the business. Capital expenditure will be determined by the need to replace business assets and any additional investments required to be made to implement the long-term growth plans of the business.
Step 9: Estimate Borrowings and Debt Repayments
Large capital expenditures may require the business to borrow money from its Bank to fund the purchase. Include any requirements for additional borrowings as well as repayment of these loans.
Step 10: Estimate Movements in Shareholder Equity
Equity includes the initial capital used to fund the business and retained profits from earlier years.
Estimate any additional capital injections and dividends or capital returns payable to shareholders.
Forecasting Cash Flows
Step 11: Estimate Operating Cash Flows
Operating cash flows include receipts from customers, payments to suppliers and employees and payments of tax obligations.
Your cash receipts from customers will be estimated based on your payment terms and when you expect your customer invoices will be paid. For example, if you provide credit terms of 30 days from the invoice date for your customers to pay you, you will include a 30 day term in your revenue projections to forecast when you are likely to receive this money.
Your cash payments to suppliers will be determined by any pre-agreed payment terms you have negotiated with them. For example, if you have 14 days to pay your key suppliers then you cash payments will be 14 days from your projected costs.
Payments to employees will be in line with your payroll cycle and payments of tax obligations will depend on when your GST, income tax and PAYGW liabilities are required to be paid each month or quarter.
Step 12: Estimate Investing Cash Flows
Investing cash flows include payments for plant & equipment and other items of capital expenditure required for your business. The timing of these cash flows will be based on your business plans and the terms provided by the supplier.
Step 13: Estimate Financing Cash Flows
Financing cash flows include borrowings from your Bank, repayments of debt obligations, dividend payments to your shareholders and capital injections from investors or business owners.
The timing of these cash flows will be based on your business plans and the terms provided by your Bank and Shareholders.
There’s a lot to consider when creating a forecast for your business but you don’t have to figure it out alone. Reach out to VBA today to help you create a financial plan for the coming year.