If you are the visionary sort of entrepreneur, gifted and guided by flashes of intuition, the idea of applying sophisticated financial forecasting to your small business may seem burdensome, humdrum, needlessly extravagant.
Vision is good. The best entrepreneurs have it. Intuition has value and shouldn’t be ignored. But visionary entrepreneurs who disdain analysis and fly by intuition alone are more likely to crash and burn.
The “how” of financial forecasting is pretty dry, but analysis has its charms. Think of it as solving a puzzle or unpacking a mystery.
Two brief definitions are in order:
• Short-range planning analyzes performance and recent trends to project income statements month by month at least 12 months ahead and to generate a cash budget for the same period.
• Long-range financial forecasts use sales targets to project financial statements — income statement, balance sheet, statement of cash flows — three to five years ahead, usually by showing the numbers on a monthly basis for the nearest 12 months and on a quarter-to-quarter basis thereafter.
What is the value of these exercises for business owners? What does long-range financial forecasting accomplish?
Some benefits of the forecasting process have psychological and practical values.
The exercise offers a change in altitude and perspective, like a drone with a camera gliding over a hidden landscape. This is helpful because when you are stuck in the trenches, grinding out progress incrementally, day by day, your vision is limited. When you take the time to project your financials forward, you see more and you see farther.
Forecasting improves your ability to see change coming. You are better positioned to anticipate problems and better prepared to deal with them.
For instance, we intuitively view sales growth as good. But growth that is too fast poses risks. Sales growth translates into asset growth. Asset growth has to be financed, either through higher levels of debt or investment.
Problems arise because risk becomes greater as debt increases relative to equity. Risk also is magnified when short-term borrowing is used to finance long-term needs.
Here is where forecasting yields its most important and most practical insights. When projections show debt increasing relative to equity or a mismatch between assets and their funding, the light flashes, telling you to tap the brakes. Forecasting presents you with the opportunity to modify growth objectives for safety’s sake, an opportunity you might miss if you were proceeding on intuition alone.
Finally, forecasting allows you to measure success. It replaces vague goals with specific objectives. Success is clear and unambiguous; the numbers make it so.
Bruce Ford is senior vice president and regional banking manager at City National Bank.