Some business owners react to adversity like the impulsive person who buys a four-wheel drive vehicle after a late winter blizzard – when springtime is right around the corner. Rather than panic and needlessly overspend, the superior entrepreneur is guided by a plan. A financial forecast is the perfect tool for this plan.
A financial forecast presents prospective revenue, expenditures, and resulting cash flow. Most importantly, it conveys capital inflow needs and indicates when those needs are expected to arise. The forecast alerts you to make adjustments in areas you control when surrounding circumstances vary from your estimates. As actual events unfold, any deviation from the forecast is cause for corrective action.
Creation of a financial forecast is often an unfulfilled goal because the process is bounded by uncertainty. The forecast is based on estimations about a future that is always somewhat unpredictable. Therefore, a sound mechanism for maximizing the reliability of estimates is essential. Business owners can utilize one of two methods to construct their forecast: top-down or bottom-up.
Most small-business operators deploy top-down forecasting. This method starts with an estimation of the top line-item in a forecast-revenue. A common practice is reliance on past revenue. Added to this figure is an optimistic amount of growth. Sometimes future revenue is projected based on anecdotal evidence about the performance of similar companies in your industry or local competitors. Top-down forecasts frequently estimate the size of a customer market and the expected share of this market the business will capture.
A problem with this analysis is that industry trends constantly change. Failure to consider the direction of change is a major drawback. Moreover, top-down forecasting is especially difficult for businesses with limited histories on which to base estimations of market share.
Hence, a dependable top-line number is very elusive. When actual revenue strays from the predicted top line, the foundation of the entire forecast is skewed. You constantly adjust the financial forecast with new wild guesses.
A bottom-up approach to forecasting takes you out of the backseat and into the driver’s seat. This technique ignores guesswork about market size and market share. Rather, it considers the resources at your disposal and identifies projected revenue based on what you have to invest in the business.
Consider how many sales you can make utilizing your available time and money. With this information, you determine the number of customers you’re likely to capture and identify revenue by multiplying by the average price each customer pays.
Key to bottom-up financial forecasts is what drives your sales. This could be advertising expenditures, rent for an optimal physical location, investing in an efficient inventory tracking system, spending on tools needed for project completion, or reserving funds for necessary business travel. Comparing your eventual revenue and expenditures to forecasted figures reveals the true relationship of spending to revenue. This permits sensible modification to your financial forecast. You uncover what revenue to truly expect and how much additional investment is needed for robust growth.