Are you Still Forecasting Only your Revenue and Expenses? Part 1

Can you tell if the budget you just put together is achievable?

If you are still budgeting and then re-forecasting only your revenue and expenses you may have run into a well known, yet often ignored phenomenon: Missing budget revenue targets due to cash shortages, inadequate credit lines, poorly timed financing arrangements, etc. This is very common during periods of growth, where a company must forecast its revenues and expenses required to achieve these growth objectives during the duration of the strategic and budget plan.

Companies that are in high growth industries and even established enterprises that cannot achieve very high gross margins soon find out that they have the potential to become very profitable but invariably run into one or more cash crunches along the way.  In fact, many organizations will not be able to deliver the results outlined in their budget for that reason alone. Of course, there are other reasons why companies miss their budget numbers but this discussion only focuses on poor and incomplete planning and budgeting.

Forecasting revenue and expenses is relatively easy if you have a solid strategic and operational plan. You can even do it using a set of spreadsheets, although I strongly recommend against it for many reasons, see my article Should Excel be Expelled?. The end result will be a forecasted income statement with columns of numbers for all periods in your budget. The trouble is that this is using accrual based accounting, which means that in reality a good portion of the forecasted sales in a certain period will bring in cash in a future period (in 30, 60 days or however many days each customer has to pay their invoices).

To make things worse, in order to make these forecasted sales you have to have inventory (if you are a product based business). This inventory must be readily available to ship in the period you say in your plan you will be shipping it. This means that you most likely have to either buy or make that product in a period earlier than the period the sale takes place. Now this implies that you had to spend cash either on the purchase of the finished product or on raw material, labor and outside services, with each one of these components occurring prior to the period in which the sale took place and with their unique payment terms.

Now consider forecasting new products or services that have not yet been developed and tested. Research and development expense that is often necessary prior to introducing new products will most likely show on the forecasted income statement; however, judging by the Income Statement alone you won’t know whether or not you will have the cash to perform these activities. If you are unable to complete R&D, testing, and any required certifications, etc., your new product availability may be delayed or the entire new product line may be cancelled, which in reality will result in not achieving the sales forecast for this new product line. The conclusion here, again, is that you need to have visibility into your cash balance during the budget period.

Will your forecasted income statement tell you whether or not you will have the cash to accomplish all that? Of course not. To do that you need a forecasted Balance Sheet and a forecasted Statement of Cash Flows which will further clarify where and when this cash is coming from (in what amount, from what source and in which period). Furthermore, these two statements must be tightly linked to the Income Statement and dynamically change as budget items affecting the Income Statement change, or as various versions and budget scenarios are evaluated. A budgeted profit and loss statement that most companies prepare annually will never accomplish that.

By now I hope I have you convinced that you must also forecast your Balance Sheet: Why you must Forecast your Balance Sheet Part 1 and Part 2. If you have a complete and accurate forecasted Balance Sheet and a forecasted Income Statement you can relatively easily compile a forecasted Statements of Cash Flows. Now you can have an insight into the future financial health of the company, and particularly into your cash needs along the budget timeline.

In the next installment we will see how a company can practically forecast its Balance Sheet using modern forecasting tools.

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