Global events like pandemics, wars, recessions, and supply chain disruptions play a huge role in shaping the business landscape. Yet most companies, especially in the middle market or below, are not forecasting on a regular basis — which means they are not nimble enough to react to these shockwaves.
Many companies wait a month or more for their actual financial results to come in, and their business decisions are based on this past data. This is not an ideal situation at the best of times, but when faced with a potential recession or other disruption, it is even more dangerous. It forces companies to rely on past information to determine how to respond, which may no longer represent what is likely to happen in the future. Planning and forecasting are critical because they allow you to be proactive rather than reactive. Building the discipline of continuously updating your forecasts will allow your management team to adjust as the business changes.
In this article, we will explore why you should be forecasting, how to do it, and what to keep in mind while planning for a potential recession.
Why forecasting is so critical
If you are not regularly forecasting, you are not recession ready. Without the right business planning, you will be behind your competitors who are adapting to changing market conditions faster. Planning also unlocks advantages when it comes to surviving a recession or even shifting patterns of supply and demand. Some of the ways planning and forecasting help you manage the business include:
1. Keep cash flowing
Cash is king — especially in a down market. While you might have a lot of accrued revenue on your balance sheet, that is just a number on a page. Until you can turn that revenue into cash, you will not be able to pay salaries or expenses. When markets are declining, a lot of pressure gets put on cash flow. Customers will try to pay their bills on extended terms; meanwhile, they are trying to speed up how quickly they can collect payment from their own customers. With a regular forecasting and reporting process, you can understand the impact of these pressures on your cash flow and can plan ahead whether that means delaying your accounts payable, accelerating your accounts receivable, or drawing on a lending facility to cover a gap. Knowing that you might face a cash shortfall ahead of time can even help you negotiate better credit terms or make more financing vehicles available.
2. Control your costs
A forecast not only allows you to understand your cost base but also where you can cut costs. Separating overhead and direct costs and segmenting them at the right level of detail will help management understand how to adjust gross margins, overhead expenses, or financing vehicles in the event the revenue picture changes.
Some critical questions to ask are:
- Is cash flow slowing down because working capital requirements are up?
- Are customers paying more slowly?
- Are direct labor costs increasing faster than pricing?
These trends may be hard to see in a given month, but when you look at forecast variances over a period of time and project the impact into the future, it is easier and faster to see what changes will be required.
3. Rev up your revenue engine
Forecasting also allows you to understand how to stimulate revenue generation. There might be issues you were ignoring when business was booming because you did not need them for growth. For instance, maybe you always had a lot of inbound interest, so you did not have to work as hard to generate demand. Now it is time to see what sales and marketing initiatives you can try and assess if they are meeting expectations.
Three steps to achieve effective forecasting
Most companies create an annual plan each year for the next year, including their goals and expectations, analysis of past performance, and budget estimations. These plans can take anywhere from three to five months to put together and generally apply to the following 12 months. During the planning process and over the course of the year, many of the original assumptions in your budget will change, so how do you capture the most value from the original budget, and what type of forecasting is most useful on an ongoing basis?
Ideally, you want to get to a place where you can produce an annual plan in less than two months and put out continuous, rolling forecasts every four weeks or more frequently. Your annual budget becomes your base plan while you forecast different levels of variability — allowing you to be nimble and make proactive adjustments as you go.
Here are the steps necessary to produce an effective, time efficient plan:
1. Identify your true KPIs (they might not be what you think)
Oftentimes, companies throw around key performance indicators (KPIs) pretty liberally. While metrics are important, having too many KPIs can become overwhelming and prevent you from making meaning out of the information you are gathering. If you have too many priorities, you have no priorities.
It is more useful for companies to think of their KPIs as instrument to affect change. For instance, maybe your day sales outstanding (DSO) is running at 120 days, meaning that it takes 120 days to turn accounts receivable into cash. A KPI you could introduce would be to regularly track DSO and compare it against a target of 60 days. Anytime you start to see the variance expanding, management must intervene.
When you are considering your KPIs, evaluate how you can reduce expenses, increase revenue, and increase cash flow. These are the metrics you should prioritize. Try to keep the list to no more than three to seven true KPIs so your entire management team can understand and focus on prioritizing the most important metrics.
2. Automate reporting to free up human capital
Once you get your KPIs situated, then it is time to set up your systems. You need a tool that is going to enable the automation of reporting, both for your KPIs and your financial systems. This will allow you to act faster and free up your team from manual reporting.
To do this, you need a performance management application, such as Vena or Power BI. Luckily, this kind of software is much more accessible and affordable to the mid-market today than it was a decade ago. Once set up, it will display your KPIs so you can understand how your finances are trending without needing your team to do tedious manual work consolidating and analyzing data. That frees up your staff to better understand what the data is presenting and how it can add value to the business
3. Make forecasting a regular, collaborative process
After you have automated your reporting and your KPIs, you have the ability to move into forecasting. At a minimum, you should be aiming to forecast quarterly, but monthly is ideal. You want to build your processes to make it easy to take your last forecast as a baseline and modify it with the new variables you receive. Best-in-class forecasters can even forecast at a moment’s notice because their systems and processes are nimble enough. That is a level to work towards over time, not something you can achieve overnight.
It is also important for your planning and forecasting process to be collaborative. Get input from the team members who are closest to different parts of the business and accountable for its results. Without the lens of the operator, finance teams may create unreasonable forecasts that are missing key information which will impair the credibility and usefulness of the forecast as a whole. Ensuring your key stakeholders are involved from the beginning is critical.
Face the future with confidence
Today’s middle-market companies have a lot to contend with, including global events and disruptions specific to their own industries. The key to surviving these kinds of disruptions, such as a recession, is to have a clear picture of the present state of your business and to proactively plan for the future.
The truth is, there is no perfect forecast. There is nothing that is going to predict every possible event, but by building planning and forecasting processes with clear KPIs, automated systems, and the collaboration of key stakeholders, you will be able to face the challenges of the future head-on, whatever those challenges may be.
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