The Importance of Financial Forecasting During Your First 5 Years in Business
When you’re leading a startup or small business, you know just how tough it is out there: everything from economic fluctuations to the weather might impact your business. And the unfortunate reality is that 20% of businesses fail in the first year, and nearly 50% do not survive to see their five-year anniversary. While there are many reasons businesses can go belly-up, research tells us that the most common reason startups fail is because they run out of money.
But we have good news: there’s a trusty financial tool you can turn to, which can help you make the best data-informed financial decisions possible. No, it’s not a crystal ball. It’s financial forecasting.
The importance of financial forecasting shouldn’t be ignored, even when you’re focused on the financial state of your business today. Financial forecasting is the process of predicting the future of your business’ finances, based on past performance in areas such as revenue, costs, and cash flow.
Financial forecasting can help you make the best decisions possible for your business. When you know where your finances are heading, you can make choices that make sense.
To help you understand the importance of financial forecasting, we will deep-dive into exactly how it’s done.
How to Make Financial Forecasts
When you’re focused on the success of your business today, creating and utilizing financial forecasting models might seem like a heavy lift. But financial forecasting is important because it can help maximize your profitability. With financial forecasting, you might be able to anticipate slow months, gear up for busy periods, attract investors, or identify the ideal time to launch a new initiative.
A lack of planning can lead to unwanted surprises. For example, you want to avoid discovering you can’t cover payroll on payday. Financial forecasting can prevent those surprises by helping control cash flow. While there are different types of financial forecasting models, here’s a general step-by-step of how to tackle financial forecasting – even if you don’t have a ton of historical financial data.
1. Start with Expenses
For first-year business owners, forecasting expenses is easier than estimating revenue. Every business has fixed and variable expenses.
- Fixed expenses are those bills that must be paid regardless of sales volume.
- Variable expenses are services and products that vary depending on business activity.
Starting with fixed expenses, list the bills that must be paid at regular intervals for a set period.
An easy way to think of fixed costs is to list the bills that would still need to be paid if your business temporarily closed. They would include things such as rent, utilities, loan payments, insurance, phone, and internet. They might include website maintenance and hosting.
Variable costs change over time based on business growth and performance. They include what is termed “the cost of goods sold.” These expenses can be directly tied to the products or services you sell. The raw materials you purchase to make a product are part of the costs of goods sold (COGS). Variable expenses include direct labor, sales taxes, and operating expenses related to business activities.
Predicting variable expenditures can be challenging as they change from month to month. And don’t forget, if your business is seasonal, your variable costs can fluctuate significantly monthly. Monthly financial forecasts are necessary for cash flow purposes to ensure you have the cash when needed.
Sometimes an expense is both fixed and variable. For example, gas heat has a fixed cost. No matter what the business is doing, the gas bill runs close to $500.00 per month. When sales volumes increase, a second shift is needed for three months. The gas bill increases to $250.00 above the fixed amount for the three months, making the gas bill also variable.
Many business owners group their expenses by fixed, variable, and semi-variable. It makes it easier to spot gradual increases in fixed expenses and highlights added COGS. The more you know about where your money is going, the easier it is to control how it is spent.
2. Add Revenue
Determining revenue begins with pricing. Many entrepreneurs base their pricing on the competition. While that may be part of the equation, deciding on a pricing strategy means considering the following:
- Competition: How many companies offer the same or similar products? What are their price points?
- Need: Who urgently needs your product? Is there a demand for your services?
- Differentiators: What makes your product or services different from the rest of the market?
- Value: What is the perceived value of your solution?
- Cost: What does it cost to produce or acquire your product?
What business owners need to focus on is profit margin rather than sales. The first step is to do a break-even analysis (which tells you how much your business needs to make to cover all of the costs)
When a business can cover all its expenses through sales, it has reached its break-even point. The following formula can help determine the break-even point based on different pricing models.
Fixed costs / (price per unit – variable cost per unit) = number of units to reach break-even.
Business owners can adjust their pricing to determine the optimum price for their products and services.
For example, a company has $130,000 in fixed costs and plans to sell its table lamp for $64. The variable costs per unit for the table lamp are $40. Using the formula 130,000/(64-40), the company needs to sell about 5,417 lamps to break even. The results raise several questions:
- How long will it take to sell more than 5,000 lamps?
- Is there enough cash to cover expenses until the break-even point is reached
At this point, business owners need to look at their forecast assumptions. If they can’t sell that number of lamps before the money runs out, can they raise the price of the lamp? Can they reduce the variable costs per unit? Looking at a range of what-if scenarios can help companies refine forecasts for a more viable solution.
3. Look at Cash Flow
Understanding your business’ cash flow tells you how much money comes into your business, and how much leaves it. ,. Cash flow forecasts serve two purposes:
- They track monthly expenditures to ensure you can cover your expenses.
- They identify the burn rate to calculate when you’ll run out of money.
Sometimes, money doesn’t arrive as expected, leading to a shortfall for a specific month. Cash flow forecasts let you know in advance if that may occur so you can adjust spending, increase sales, or look for funding. Analyzing financial reports can also indicate when to look for larger investment dollars.
Burn rate is the amount of money your business consumes per month. It is an average of monthly expenditures for a given period. Suppose a company forecasts total expenditures in its first year at $250,000. That averages about $21,000 per month. The business has $465,000 from investors. Dividing the investment dollars by the per-month expenditures indicates the company has about 22 months before it runs out of cash. The number does not include any revenue from sales.
The 22 months are what investors call your runway. That is the length of time you have to make your business profitable. Alternatively, it’s the point where you look for additional funding. Whatever the decision, the financial forecasts tell you it’s time to act if you want your business to survive.
How Important Is Financial Forecasting to Business Survival?
So, what’s the importance of financial forecasting, really? One survey discovered that of the businesses started in 2017, 48.4% had failed by the end of 2022. That’s an average of 12.2% per year. The survey also found that many companies ultimately failed because they lacked a business plan and the money to keep their operations running..
Financial forecasting is a crucial component of any business plan. It’s critical for day-to-day operations, is a valuable aspect of decision-making, and helps you know what to expect (financially speaking). Not only that, but financial forecasting is often sought-after by investors and other financial institutions: it provides the data that investors and lenders need to decide whether to invest in, or loan money to, a business.
Financial Forecasting Isn’t a One-Time Thing
Initial financial forecasts are only the beginning. Business owners need to refine their first efforts until they arrive at a financial footing that ensures survival. Then, as the business grows, they need to update the forecasts to reflect changes. Many accounting software packages support financial forecasting.
Companies should revise their forecasts at least quarterly. They should compare the forecasts to actuals to assess where they stand. Startups may want to look at their burn rate more frequently, as expenditures can spiral out of control unless monitored.
Keeping investors informed through updated financial forecasts eliminates unpleasant surprises. They will be less likely to turn down added funding if they have been aware of the company’s finances from the start. Communication is the best way to maintain strong investor relationships.
Financial forecasting is the key to survival
Financial forecasting is crucial to the health and survival of your business, as is understanding the importance of financial forecasting. But we get it: you’d much rather focus on the day-to-day than spend valuable time crunching numbers.
That’s where we come into play. We’re hiline, and we provide businesses like yours with robust outsourced financial services. Our suite of services includes bookkeeping, finance, tax, and HR & payroll services, and we’ve got your back when it comes to financial forecasting.
If you’re ready to better predict the future of your business and make data-informed financial decisions, let’s talk.
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