Two Tips on Financial Forecasting

Before I begin this posting, I would like to thank "professorola" for the comments on the last posting. Some valuable points were made. I suggest all readers take a look at them.


The last few postings have been discussing the importance of keeping score for your business. You can't make good decisions without knowing the score. A financial forecast or budget is part of that score.

So what is the best way of developing a cash flow or P&L Forecast? Well, I really can't say that there is one best way. I can say that I have two important rules that I have used for my own businesses and that I always recommend to my clients. The first rule is to start at zero (zero-based budgeting).

Most people want to take the easy way out when developing a budget, that is, they take last year's numbers and add or subtract a percentage. "Let's see now. Our insurance premium averaged about $500 per month last year so I'll add 10% and make it $550 every month this year." In my opinion, you might just as well throw darts at numbers. You need to start at zero. Why? There are two very important reasons.

First of all, if you don't start at zero, you are not questioning whether or not the revenue or expense item should exist next year. Instead, you are assuming that it is a valid revenue or expense item which will most likely increase or decrease. While that may be true for some items, it is not true for every item. If you take a hard look, you may find that you can eliminate some expense items. You also need to consider that new expenses may come into existence. You need to analyze whether or not you will have the same revenue generators next year. In addition, while it may be valid that the item will go up or down, simply adding to or subtracting from the previous year's actual expense or revenue assumes that you did a good job controlling that item last year. Maybe you did - but maybe you didn't. You need to start at zero if you want to have a solid forecast.

Secondly, when adding a percentage, most business owners add percentages that are typically too high because they "want to be conservative." That is a very dangerous practice. When they overspend, they feel good because "they are on or below budget." Wrong! They actually have overspent. Their "conservative" budget has given them a false sense of success. Here is a simple example. Although a business owner believes that he will spend $300 per month on office supplies, he puts $350 in the budget. He then spends $340 per month. What conclusion does he draw? He concludes that he was under budget by only $10 per month. "Not too bad," he says. Actually, he was over his realistic budget by $40 per month.

Is zero-based budgeting a lot of work? Absolutely. But it is necessary if you are going to develop a realistic financial forecast.

The second rule I have is always budget to the lowest level. What do I mean by that? Don't have a line that says "utilities." You need a line item for gas, one for electric, one for the telephone, fax, water, sewage, etc. Don't just forecast postage. Forecast postage for payables, postage for marketing mailings, etc. The lower the level, the more accurate you will be with your forecast. It is just like baking a cake. If you put in the right amount of each ingredient, the cake will turn out just fine.

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