Why Forecast? – Part 2, The Operating Forecast

The operating forecast drives the financial forecast. In all other respects, it is a completely different animal. It looks out only one year. Its audience is you and your managers, not your banker.

The operating forecast is a one year detailed product-by-product, service-by-service prediction of revenues, operating costs and capital requirements. Unlike the financial forecast, it is a real prediction.

Who Does the Operating Forecast?

The employees responsible for these products and services do the forecasts. If you want to know what is likely to happen, they give you the best guess. They are the ones with greatest influence over whether the forecast come true.

The Operating Forecast – The Great Debate

You don’t just accept the managers’ first cuts. You make them explain the forecast. They may “sandbag” you with a “low-ball” forecast. The lower the forecast, the more likely they will receive their performance bonuses.

But you are the owner. You know the business and you push back. You test their assumptions. You ask abut specific clients to make sure they are close enough to them to know what the issues are in them buying more from you.

You go back and forth with your managers until you both walk out comfortable that the forecast is an achievable stretch.

In the process, you have renewed your comfort that your managers are on top of their operations. They walk out comfortable you understand their reality and still have the senior management skills they need for their success.

Give Forecasting the Attention It Needs

Schedule the operating plan process for quiet periods. The best business for which I ever worked was owned and operated by someone who had come up through the ranks. He knew the dead period and he scheduled his planning period within it. That way, his managers always had time to think about their business before they committed to a forecast and he had time to hear them out.

Conclusion: Operating Forecast = Accountability

Your operating forecast is a discipline. It forces you once a year to take stock. You think about your business. You assess your managers face to face.

You look at it every month to see whether you are ahead or behind. There is often good reason for patience in the face of underperformed forecasts. The important thing is that the forecast gives you a basis for having an intelligent discussion, which will tell you whether patience is warranted or not.

Why Forecast? – Part 1, Financial Forecasts

Why forecast? Forecasts are invariably wrong so why bother.

The answer is simple. Financial forecasts don’t predict the future. They test your ability to survive a bad future and take advantage of a good one. If your forecast covers reasonable pessimistic and optimistic outcomes, it is doing its job.

“Cases”

Your forecast should have three different cases:

• Base Case – what you think will happen based on your operating forecast (covered in “Why Forecast? – Part 2”).

• Conservative Case – what will happen if a recession hits, the competition strikes harder than you predict or your costs rise unexpectedly.

• Optimistic Case – what will happen if everything works out perfectly.

Financial Forecasts – How Long? How Often?

You do forecasts once a year.

The standard financial forecast covers five years for two reasons.

• Banks require most companies to repay their term loans in 2 – 5 years. You make the bank comfortable lending to you now by making it comfortable you can also borrow in the future when you need the money to repay the bank.

• Capital requirements must be assessed well ahead of need to allow for an intelligent capital-raising program.

Financial Forecasts Tell You What is Safe to Borrow ….

When you borrow money, you put your business at risk. If you can’t pay the interest, repay the principal and comply with the financial performance tests in the loan agreement, you may lose your business.

Recessions are inevitable. Bad things happen to good businesses. The conservative case tells you whether you can accomplish the three things you need to do in bad times.
• Survive
• Comply with the financial ratios in your bank agreement and
• Refinance your loan if it comes due.

Before you approach the bank for a loan, you want to have know how much you can borrow knowing that, even in a pessimistic case, you can make all the payments and observe all the performance tests likely to be in the loan agreement.

… and What to Negotiate For

The financial forecast also tells you what to negotiate for. It is smart to trade a higher interest rate for the lower default risk resulting from looser performance tests. A good forecast tells you what you need to negotiate for to know it will take a catastrophe for you to default.

Good News Can Be a Problem

Great performance can be a problem.
• You need more capital equipment and people to meet your production requirements.
• You need to finance more inventory, work in progress and receivables to keep up with your higher sales.

The optimistic case alerts you and your lender to your potential capital requirements so that you don’t run out of gas just as you are ready to pull ahead of the pack.

Conclusion: Financial Forecasting is Testing, Not Predicting

Financial forecasts do not try to predict the future. They test your ability to survive a bad future and take advantage of a good one. Their practical value is to tell you whether you have the capital you need, how much you can safely borrow and what terms to negotiate for in your loan agreement.