The Dynamic Financial Planning Process
THE MAIN PURPOSE of the forecasting process is to let management always know in advance how much cash they will need and when they will need it. In addition, the forecast will set flexible goals that are very effective in controlling expenses. Furthermore, the by-product of the information produced will make the information in financial statements significantly more meaningful and be effectively used for managing the business. How can you assess financial data if you don't know what the numbers should be?
Shell Taper, owner of a small manufacturing company, is an excellent case in point. Recently, when I handed Shell his P&L, it showed a $50,000 profit for the year. Shell looked at it, and then asked me, "How do you think I did?"
"A $50,000 profit seems okay, Shell, but we can't really know how you did if we don't know how you wanted to do. If you anticipated a $250,000 profit, you did miserably. If you anticipated $10,000, you did quite well. You should be predetermining the results of operations, and then when the results are in, you'll know if you're on the right track."
THREE ITEMS NEEDED FOR AN EFFECTIVE FORECAST
I have noticed over the years that budgets or forecasts prepared by a company's internal staff tend to illustrate profit and loss without a cash flow or balance sheet forecast. They usually prepare a report that shows sales less costs and expenses profit, and that's all.
Not too long ago, I was asked to assist a company in the potential buyout of one of its competitors. My client was doing about $70 million in sales. It was a large and profitable company. I assumed the management of such a large company would be quite sophisticated on the financial side of the business. I set up a meeting with their CFO.
I started the discussion, "Let me make sure I understand the purpose of the merger. You believe that there will be substantial efficiencies in payroll and cost reductions. And the merged company will be in a good position financially to pay down the additional millions of dollars in new debt needed to complete the transaction?"
The CFO's response was quite positive.
"Have you prepared any P&L and/or cash flow forecasts as to what the anticipated cash flow requirements will be after the merger?" I asked.
"No", was his quick response.
Needless to say, I was quite surprised that no information was prepared to make certain they could sustain such a potentially large transaction.
My immediate advice to the president of the company was to have the forecasts prepared so as to reveal any potential cash flow problems they might encounter as a result of the merger. He agreed.
So why didn't the CFO prepare them? The answer is simple. It's too difficult and time consuming. And if they wanted to do any what if analysis, the time and energy was well beyond any effort the CFO wanted to deal with.
We were engaged to put together the forecasts. It took us about five hours. Two hours by my assistant and three for me. My three hours included a meeting with the CFO to get some additional assumptions. How were we able to complete them so fast? We used my secret weapon. The software I created.
The three items needed for effective forecasting are:
1. The twelve-month profit and loss. This report will let management know in advance if anticipated financial activities will produce a profit or not. It will also serve as a guide during the year as to whether expenses are under control or not. It is also great for looking at future tax requirements.
2. The twelve-month cash flow. This is the report that will let management know well in advance how much cash they will need and when they will need it.
3. Forecasted balance sheets for each month of the forecast. This report is the most neglected and is extremely important in the forecasting process. It tells you whether the other reports are realistic.
Several years ago, I was meeting with a client preparing a P&L and cash flow forecast. The company was profitable and had excellent cash flow. We sat in the client's conference room working on the forecast. When we completed the preparation, we were quite pleased as to the forecasted profit and amazing cash flow prospects. Everything was going to be terrific.
After reviewing the reports, we began to study the forecasted balance sheets. We both quickly realized there were major problems. The accounts receivable balances were forecasted lower than they had ever been. payables balances were larger than they should have been, and inventory was forecasted too low. Basically, the balance sheet made no sense at all.
Then it hit me like a ton of bricks. The balance sheet was telling us that the forecast was wrong. Obviously, the assumptions used to develop the cash flow were way off. Collection on accounts receivable balances was too rich, and the payment of the payables was not enough. The balance sheet was the barometer as to the efficacy of the other reports. If it made no sense, the other reports were wrong.
OH MY GOD, THREE FORECASTS
There are three types of financial forecasts I have seen over the years. Don't become anxious; you'll only deal with two. Make it easy on yourself. Get someone else to prepare them. If you take the approach of someone else doing the forecast, then you must be involved in the process. Only you can determine the assumptions to be used in the forecast development.
Delegate the task to a bookkeeper who searches for every penny in balancing the accounts, or some new hire who wants to impress the boss. Find someone you can trust and let that person assist you in this vital work. You will make all the decisions regarding the plan assumptions. The clerk handles the details. And best of all, I have developed a software program that will do it all for you. It's much easier than struggling with a complicated spread sheet program.
DON'T FORGET A PROFIT
You must not only prepare a dynamic financial forecast of future events, but you must make certain the plan will produce a profit. Treat profit as if it were any other expense of the business. Most entrepreneurial companies simply don't have the net worth, resources, or clout to sustain losses. It makes no sense to forecast a loss. If the forecast looks like you'll be operating at a loss over the next twelve months, change the way you will operate the business now before it's too late.
Profit and positive cash flow is the name of the game.
FORECAST NUMBER 1 THE PIE IN THE SKY FORECAST
This forecast, generally prepared for bankers and other financiers, usually promises high sales, low expenses, and large profits. It may be helpful in securing loans or investors, but forget about it as a management tool. It's not only a pie in the sky forecast, but also a Who do we think we are kidding forecast?
By the way; most good financial people will know the game you are playing; don't waste your time. Put it in your drawer and leave it there. Our management tool is forecast No. 2.
FORECAST NUMBER 2 THE I HOPE AND PRAY TO GOD I MAKE IT FORECAST
Achievable sales, honest operating expenses, and reasonable profits: This is reality. The forecast we are going to hang our hats on. The one we will make all efforts to achieve, so that we never have to use forecast No. 3.
FORECAST NUMBER THREE THE I HOPE AND PRAY TO GOD I NEVER USE IT FORECAST
This is the forecast for survival. If you cannot reach expected results, move into a survival mode.
I absolutely recommend a worse case scenario forecast. Most entrepreneurs operating small businesses generally do not react to changes in economic conditions on a timely basis. Prices increase, yet increasing sales prices lag well behind increases in the cost of doing business. I have seen it time and again. Large companies hire specialists, who attempt to predict economic future and may also employ large staffs to prepare forecasts based on predicted economic trends. This gives them a substantial edge in making it through hard times. We have no such advantage. Our edge is ourselves.
We make economic predictions based on gut feelings and seat-of-the-pants planning. It is absolutely necessary for us to react to changing conditions as quickly as possible. What do we do when our loan interest rates jump several points, expenses rise, sales are cut in half, and cash flow dries up? We must prepare for the worst well in advance.
The key triggering mechanism for going from a realistic forecast to the survival mode is a sudden or steady decline in sales. When things change, your best friend will be your forecast, assuming it can be revised for different levels of sales, expense and/or costs. If your sales are in decline, and you can quickly adjust your forecast this will give you an immediate view of the future and allow for a quick response to changing economic conditions.
THE MAIN PURPOSE of the forecasting process is to let management always know in advance how much cash they will need and when they will need it. In addition, the forecast will set flexible goals that are very effective in controlling expenses. Furthermore, the by-product of the information produced will make the information in financial statements significantly more meaningful and be effectively used for managing the business. How can you assess financial data if you don't know what the numbers should be?
Shell Taper, owner of a small manufacturing company, is an excellent case in point. Recently, when I handed Shell his P&L, it showed a $50,000 profit for the year. Shell looked at it, and then asked me, "How do you think I did?"
"A $50,000 profit seems okay, Shell, but we can't really know how you did if we don't know how you wanted to do. If you anticipated a $250,000 profit, you did miserably. If you anticipated $10,000, you did quite well. You should be predetermining the results of operations, and then when the results are in, you'll know if you're on the right track."
THREE ITEMS NEEDED FOR AN EFFECTIVE FORECAST
I have noticed over the years that budgets or forecasts prepared by a company's internal staff tend to illustrate profit and loss without a cash flow or balance sheet forecast. They usually prepare a report that shows sales less costs and expenses profit, and that's all.
Not too long ago, I was asked to assist a company in the potential buyout of one of its competitors. My client was doing about $70 million in sales. It was a large and profitable company. I assumed the management of such a large company would be quite sophisticated on the financial side of the business. I set up a meeting with their CFO.
I started the discussion, "Let me make sure I understand the purpose of the merger. You believe that there will be substantial efficiencies in payroll and cost reductions. And the merged company will be in a good position financially to pay down the additional millions of dollars in new debt needed to complete the transaction?"
The CFO's response was quite positive.
"Have you prepared any P&L and/or cash flow forecasts as to what the anticipated cash flow requirements will be after the merger?" I asked.
"No", was his quick response.
Needless to say, I was quite surprised that no information was prepared to make certain they could sustain such a potentially large transaction.
My immediate advice to the president of the company was to have the forecasts prepared so as to reveal any potential cash flow problems they might encounter as a result of the merger. He agreed.
So why didn't the CFO prepare them? The answer is simple. It's too difficult and time consuming. And if they wanted to do any what if analysis, the time and energy was well beyond any effort the CFO wanted to deal with.
We were engaged to put together the forecasts. It took us about five hours. Two hours by my assistant and three for me. My three hours included a meeting with the CFO to get some additional assumptions. How were we able to complete them so fast? We used my secret weapon. The software I created.
The three items needed for effective forecasting are:
1. The twelve-month profit and loss. This report will let management know in advance if anticipated financial activities will produce a profit or not. It will also serve as a guide during the year as to whether expenses are under control or not. It is also great for looking at future tax requirements.
2. The twelve-month cash flow. This is the report that will let management know well in advance how much cash they will need and when they will need it.
3. Forecasted balance sheets for each month of the forecast. This report is the most neglected and is extremely important in the forecasting process. It tells you whether the other reports are realistic.
Several years ago, I was meeting with a client preparing a P&L and cash flow forecast. The company was profitable and had excellent cash flow. We sat in the client's conference room working on the forecast. When we completed the preparation, we were quite pleased as to the forecasted profit and amazing cash flow prospects. Everything was going to be terrific.
After reviewing the reports, we began to study the forecasted balance sheets. We both quickly realized there were major problems. The accounts receivable balances were forecasted lower than they had ever been. payables balances were larger than they should have been, and inventory was forecasted too low. Basically, the balance sheet made no sense at all.
Then it hit me like a ton of bricks. The balance sheet was telling us that the forecast was wrong. Obviously, the assumptions used to develop the cash flow were way off. Collection on accounts receivable balances was too rich, and the payment of the payables was not enough. The balance sheet was the barometer as to the efficacy of the other reports. If it made no sense, the other reports were wrong.
OH MY GOD, THREE FORECASTS
There are three types of financial forecasts I have seen over the years. Don't become anxious; you'll only deal with two. Make it easy on yourself. Get someone else to prepare them. If you take the approach of someone else doing the forecast, then you must be involved in the process. Only you can determine the assumptions to be used in the forecast development.
Delegate the task to a bookkeeper who searches for every penny in balancing the accounts, or some new hire who wants to impress the boss. Find someone you can trust and let that person assist you in this vital work. You will make all the decisions regarding the plan assumptions. The clerk handles the details. And best of all, I have developed a software program that will do it all for you. It's much easier than struggling with a complicated spread sheet program.
DON'T FORGET A PROFIT
You must not only prepare a dynamic financial forecast of future events, but you must make certain the plan will produce a profit. Treat profit as if it were any other expense of the business. Most entrepreneurial companies simply don't have the net worth, resources, or clout to sustain losses. It makes no sense to forecast a loss. If the forecast looks like you'll be operating at a loss over the next twelve months, change the way you will operate the business now before it's too late.
Profit and positive cash flow is the name of the game.
FORECAST NUMBER 1 THE PIE IN THE SKY FORECAST
This forecast, generally prepared for bankers and other financiers, usually promises high sales, low expenses, and large profits. It may be helpful in securing loans or investors, but forget about it as a management tool. It's not only a pie in the sky forecast, but also a Who do we think we are kidding forecast?
By the way; most good financial people will know the game you are playing; don't waste your time. Put it in your drawer and leave it there. Our management tool is forecast No. 2.
FORECAST NUMBER 2 THE I HOPE AND PRAY TO GOD I MAKE IT FORECAST
Achievable sales, honest operating expenses, and reasonable profits: This is reality. The forecast we are going to hang our hats on. The one we will make all efforts to achieve, so that we never have to use forecast No. 3.
FORECAST NUMBER THREE THE I HOPE AND PRAY TO GOD I NEVER USE IT FORECAST
This is the forecast for survival. If you cannot reach expected results, move into a survival mode.
I absolutely recommend a worse case scenario forecast. Most entrepreneurs operating small businesses generally do not react to changes in economic conditions on a timely basis. Prices increase, yet increasing sales prices lag well behind increases in the cost of doing business. I have seen it time and again. Large companies hire specialists, who attempt to predict economic future and may also employ large staffs to prepare forecasts based on predicted economic trends. This gives them a substantial edge in making it through hard times. We have no such advantage. Our edge is ourselves.
We make economic predictions based on gut feelings and seat-of-the-pants planning. It is absolutely necessary for us to react to changing conditions as quickly as possible. What do we do when our loan interest rates jump several points, expenses rise, sales are cut in half, and cash flow dries up? We must prepare for the worst well in advance.
The key triggering mechanism for going from a realistic forecast to the survival mode is a sudden or steady decline in sales. When things change, your best friend will be your forecast, assuming it can be revised for different levels of sales, expense and/or costs. If your sales are in decline, and you can quickly adjust your forecast this will give you an immediate view of the future and allow for a quick response to changing economic conditions.