The Foundation for Forecasting and Calibration
Your utopia; that place where you love your business, love your lifestyle and make good money sits in the back of every entrepreneur’s mind. It unfortunately won’t fall in your lap. Putting dreams to paper (or spreadsheets) is the very real and tangible part of making those dreams a reality. That my friends, is what financial modelling is all about.
Now that the magic is out; what is financial modelling? At Measure, the financial model is an essential ingredient for the work we do with our Business Design clients and it is made up of the following:
– Financial Forecast
– Cash Flow Forecast
– Year-to-date (YTD) performance
Why do this, you might ask? A financial model’s use is wide ranging but in its simplest and most powerful form it comes down to: Forecasting and Calibration.
A Forecast is not a Budget:
A forecast and a budget might look similar; that is they are a group of assumptions about your business (revenue, variable and fixed costs, and profitability). However they are very different in use and function.
A budget is a static set of assumptions about your financial future, usually set out annually. You’re intended to stick to it. A middle manager in a large corporation might be heard saying “we’d love to do X, but we just don’t have the budget for it” or “it’s almost the end of the year, I better spend my budget or risk losing it next year”. This is static, inflexible and does little to inform you about the future or help make strategic decisions. In fact, research is showing that the budget mentality can do more damage than good. A business must be able to adapt to changing conditions over time.
Our view is that a forecast is fluid as a set of assumptions that are updated as new information is brought forward and its purpose is to help the entrepreneur make tactical decisions towards their strategic goals. It is simply a plan of action that needs to be tested in the real world. The ability to bring new information and knowledge into the forecast over time makes the business stronger. Assumptions become trends, and these trends can be impacted.
As an example, the year-to-date performance might show that the use of freelancers is 20% higher than we predicted. So what?
– A budget philosophy might result in the decision maker being scolded for coming in “over budget” and the financial model would not be adjusted.
– With a forecasting philosophy, the entrepreneur would evaluate if this increase in freelancer costs is linked to an increase in their target clients or an efficiency issue in project delivery. He/She would also evaluate whether these increased costs should be modelled into the future in her financial forecast.
Calibration is where true value is formed. It is a diligent process of evaluating your performance and adjusting your plan to achive your goals. Read more about calibration Here
Analyzing your business performance relative to its forecast and making course corrections throughout the year is critical for the calibration process and financial metrics. This is so important that we believe you are infinitely (pause for dramatic affect) more likely to reach your 1-year goals if you track and course correct (calibrate) throughout the year than if you wake up Dec 31st and see whether you’ve met your goals for the year or not. There should be no surprises as you work towards the goals to fuel your utopia, rather a series of strategic adjustments throughout the year to keep you and your business on track.
Above, we discussed that The Measure Business Design financial model is made up of four main categories. The financial forecast, the cash flow forecast, the year-to-date performance and a dashboard.
1. Financial Forecast
The financial forecast is essentially your income statement drawn out into the future. It is filled with assumptions, so how do we get more accurate in our forecasting? Our approach is to take a combination of reality (past history) and aspiration in the form of target setting. We believe that targets drive behaviour, so don’t set targets you know you can crush just so you can congratulate yourself later. Rather, set challenging but realistic targets. This combination is motivational and you’ll find that your business drives towards these targets almost subconsciously so don’t discount their importance. Here are some basics guidelines:
We use a target Client Mix Table to see where your projected revenue will come from. If your business has some distinct seasonality (high/low seasons), factor that in.
Variable Costs (Cost of Services)
These are costs that vary proportionately to your revenue. The use of freelancers is the most common here. Looking at historical use of freelancers and assessing whether that proportion is representative going forward is often helpful.
Those expenses that come at you every month regardless of how busy your business is. Wages (employees not freelancers), rent and general office expenses fall here.
Revenue less your variable and fixed expenses gives us your operating income before your take home pay. We advocate separating the owner’s pay from the rest of the team.
What you’d like draw out of the business each month. This often depends on the amount of operating income you have left at the end of the month and any plans to invest more into your business.
That amount left over after you pay yourself and any partners in your business.
2. Cash Flow Forecast
We know the bank account is the heartbeat of any business. In our article “How To Manage Cash Flows”, we discussed some strategies that we use with our Business Design clients to overcome the challenges of cash flow forecasting.
In our financial modelling, the cash flow forecast is an extension of the financial forecast that takes into account the timing of payments and any other inflows or outflows of cash that are not directly related to your business operations for the month.
For example, if we know that some large clients stretch out paying their invoices, we’ll factor this in. Other considerations are asset purchases like new computer equipment and paying back loans. These are elements that are not part of the monthly financial forecast but flow in and out of your bank account nevertheless, and have to be factored in.
Having a view on your cash flows looking 3-6 months out and their impact on your bank account will help you sleep better at night and make strategic decisions towards managing your cash.
3. Year-To-Date (YTD) Performance
With YTD performance we underscore the importance of trends vs. looking at a single slice of time. Using the financial models of our Business Design clients at Measure, we’ll look at YTD performance relative to the financial forecast we set out during our annual planning phase.
So, what does that look like?
The financial forecast (future looking income statement) sets out your targets for the operating year. In the YTD section of our financial model tool, you compare your targets to your actual results. For example, sometime in early April, you would compare your targets for Jan, Feb and March in all categories laid out in the financial model to your actual results for that same time period. The key here is to look for trends and outlying differences over our target. Are you under spending in Advertising and Marketing? You may have more cash because of this but are you effectively speaking to your target clients by limiting this spend?
Overwhelmed and can’t see the forest for the trees? As part of the Business Design process for our creative clients we often reiterate that it feels like there are hundreds of things you could do in a given year but 4-5 that you MUST do. They are “must dos” if you are serious about moving your business towards your utopia.
A dashboard helps you focus on those 4-5 strategic priorities and provides a unique snapshot of your business performance. It boils down all your financial, operations, and positioning info down to the most important information so the decision maker, you, can stay focused on those priorities that move the business forward in the direction of your utopia.
As entrepreneurs, we often have an intuitive sense of what’s going on in our business. It’s that gut feeling that has served us well. A financial model combining a financial forecast, cash flow forecast, YTD performance and a summary dashboard add the numbers and metrics to your gut instincts and equips you with the info you need to make those strategic decisions that moves your business towards the best version of itself.