What you know about the future can help you make better decisions for your business today. Developing forecasting and projections is a crucial aspect of strategic planning that can improve business management and help create a healthier, sustainable business.
A three-way forecast, also known as a three-statement model, is a financial model that combines vital financial statements – profit and loss, balance sheet, and cash flow – into a consolidated forecast. Thus, linking your projections for all three financial statements together. You can forecast your future cash position and financial health. To successfully build a three-way forecast, you need to understand the business entirely, the factors internally and externally affecting the company, as well as the essential components required for accurate projections.
What Makes Forecasting Beneficial?
Forecasting provides businesses with a roadmap for the future by predicting financial outcomes. It can be a great starting point for setting realistic and achievable financial goals to help you plan ahead. It also provides guidance in many areas of your business, and can help decision makers identify potential opportunities or issues in the future, such as:
- Planning for new hires
- Purchasing inventory and equipment
- Identifying potential cash shortages and when to raise cash
- How increasing your marketing budget can affect revenue
- Alerting you that the business needs to find alternative ways to make money
- Recognizing the best time for exiting the business and potentially selling it
This promotes reliable, forward-looking business management. Forecasting can reduce financial risk for a business. Without the input of economic future predictions, you operate the business with uncertainty for the future, and your financial decisions could be ill-informed.
The business will likely attract investors if you are forecasting your business’ financial results. Regular forecasting suggests to your investors that you are in control and have a solid business plan prepared for the future. Additionally, investors use a company’s financial forecast to predict its future performance and the potential future return on investment (ROI).
Building a Three-Way Forecast
A forecast can be constructed using various methods; it requires attention to detail and accurate data inputs. You can use one or a combination of these methods to create historical, bottom-up and top-down forecasts. Historical forecasts are based on your business’s past performance; this can provide valuable insights, but if the organization is a start-up, this option is impractical. Bottom-up forecasts begin with the minor components of the forecast and build from there, such as several units you expect to sell for each product/service multiplied by the sale or cost price of the product/service to arrive at your sales and cost of sales forecasted amounts. The advantage of this type of forecast is that if any variables change, the forecast is easy to adjust. This is useful for predicting sales and cost of sales, specifically for those in a pre-revenue stage. Top-down forecasts start with the market’s total size and estimate what percentage of the market the business can capture.
To create a 3-way forecast, you must choose a financial modeling software. Fathom, Reach Reporting and Excel can all be used to produce forecasts. The software will need to be able to project the income statement, balance sheet and cash flow statement, and they need to be interconnected, with cash flows linking to the balance sheet and income statements affecting the cash flow statement.
The most accurate forecasts are built using several components, including internal and external factors and qualitative and quantitative information. These include:
- Historic Financial Data – income statements, balance sheets and cash flow statements.
- Economic and Market Data – inflation rates, interest rates, tax rates, industry trends, seasonal trends.
- Assumptions – revenue growth rates, gross profit margins, operating expenses, working capital assumptions, potential capital expenditures.
- Business Strategic Plans – growth initiatives, cost reduction plans, investment plans.
- Other Internal Factors – sales pipelines, production capacity, staffing levels.
- Other External Factors – regulatory changes, technological advancements, geopolitical events.
Reviewing historical financial data to ensure accuracy for future predictions is essential. This data includes income statements, balance sheets and cash flow statements. Historical data helps analyze past performance to assist with future predictions, and by examining historical data, businesses can identify patterns, seasonality and areas for improvement. Depending on the type of business, historical data could be integral in building your forecast. Historical data is most helpful in predicting future operating expenses.
It is important to consider economic factors, such as interest and inflation rates, and incorporate realistic assumptions into the projections. To ensure accuracy, revenue and costs for future years should be increased in line with current inflation rates. Interest rates need to be up to date; therefore, if there are any loan repayments, you can ensure the cash payment, the interest expense in the profit and loss, and the loan movement in the balance sheet are all correct. Furthermore, market research and industry trends are crucial for developing a forecast. Understanding market conditions, customer preferences and competitor activities can help businesses anticipate changes and adjust their strategies accordingly.
You can create assumptions to apply to your forecast using information gathered from historical financial data, economic factors, marketing data and internal information about the business’ future. These could include revenue growth rates, gross profit margins, operating expenses, and working capital assumptions. Once these assumptions are set, you can implement them to update your forecast. For example, you could use your current gross profit margin to project into the future to determine the impact on the business. Alternatively, you could utilize scenario planning to apply a target gross profit margin to determine the effect this has on the company’s future.
The financial projections can be updated to embody the business’ strategic plans. This could be a new product or service launching, an acquisition of another company or reflecting a new investment, perhaps significant capital expenditure. A valuable way of demonstrating the effects of implementing strategic plans on future financials would be creating micro forecasts that individually represent the financial effects of a plan. Using forecasting software, micro forecasts can be switched on and off, and the timeline can be adjusted – demonstrating the impact on the financials and the business roadmap.
Incorporating internal factors, such as the sales pipeline, production capacity and staffing levels, is necessary for accurate forecasting. By aligning internal operations with financial projections, businesses can ensure their forecasts are realistic and achievable. Internal information can be helpful when building a forecast using the bottom-up approach. External factors, such as regulatory changes, technological advancements and geopolitical events, are vital for developing a comprehensive forecast. External factors can impact a business’s operations, financial performance, and strategic decisions. By staying informed about external influences, companies can adjust their forecasts and mitigate potential risks.
Takeaways
In summary, the combination of components you select to create your 3-way forecast will depend on what suits the business best to produce the most accurate predictions. Forecasting requires a combination of methods, historical data, economic factors, market research and internal and external factors. Businesses can create accurate projections that guide decision-making and strategic planning by collecting and analyzing relevant information. So, whether you are forecasting sales, expenses, or cash flow, remember to consider all the information required to build a reliable and insightful forecast for your business.
Author: Olga Doktorovich | [email protected]
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