This is a guest blog post from our partner Workday Adaptive Planning, outlining nine ways to plan in the changing world of finance.
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To thrive in a competitive and global marketplace, you need exceptional financial forecasting processes and a finance team capable of orchestrating them.
Financial forecasting is a key part of business planning, using past company performance and current conditions or trends to predict what is going to happen in the future.
It helps organizations adapt to uncertainty based on predicted demand for products or services.
When financial forecasting is executed well, organizations can withstand economic disruptions, adapt to revenue and expense fluctuations, and change course when challenges or opportunities arise. Poor forecasting, on the other hand, can sabotage your business.
Read on, and discover the nine steps that you can take to orchestrate financial forecasting processes that truly guide business strategy.
Step 1: Define Your Terms
What is financial forecasting and where does it fit in with traditional budgeting and planning processes? Financial planning and analysis (FP&A) practitioners use these terms in different ways, so here are a couple of definitions to get on the same page:
Forecast vs. plan. A plan refers to an annual forecast prepared for the upcoming fiscal or calendar year. The term “forecast” is usually reserved for periodic exercises to adjust your plan to reflect actual performance.
Forecast vs. budget. A budget is a plan for how you’re going to spend specific amounts of money. While this is a vital piece of any forecast, it is just one piece of the puzzle. A complete forecast should also include projected revenue, assets, liabilities, and cash flow. Truly strategic planners will even take operational key performance indicators (KPIs) into account.
Step 2: Model Your Revenue
Before you can build a comprehensive financial forecast, you need to build an accurate business model. One way to do that is by modeling revenue. An effective revenue model should be able to answer questions such as, “Which investments are necessary to grow revenue by 25% next year?” Or, “If revenue remains flat, which programs should we cut to maintain profitability?” With the right model in place, you’ll have the flexibility to run scenarios and examine assumptions so you can answer these questions with confidence.
Revenue models will vary widely based on your industry and business model. For example, a manufacturer might consider variables such as capacity and utilization, while a law firm might look at client lists and billing rates. Whatever the nature of your business, the right model will help you get a better handle on revenue so you can drive your business forward.
Here are a few common considerations:
- Get into the drivers. Challenge what you think you know. When modeling revenue, give yourself the flexibility to test and adjust your assumptions so you can gain fresh insights into untapped sources of revenue.
- Start with the relationship between price and volume. Terms and formulas may differ from one industry to the next, but most models boil down to the relationship between price and volume, so that’s a good place to start when modeling revenue.
- Consider tops down and bottoms up. Top-down financial forecasting and planning software models start with the big picture by focusing on high-level market trends, while bottom-up models are grounded in the operational details of your business. By taking both models into consideration, you can identify gaps in your current capabilities—and transform those gaps into opportunities.
Step 3: Model Your Expenses
In addition to the money coming in, your forecast will need to consider the money going out. Consider these key factors when modeling your expenses:
- Personnel. This is likely your largest expense. If your organization is primarily salaried employees, you might forecast personnel expenses on a per-employee basis. If, however, you are a national retailer or restaurant chain with a large number of hourly employees, you may prefer to build a forecast based on shifts or roles.
- Operating expenses (OPEX). Operating expenses are often tightly correlated with head count. Your expense model should reflect that.
- Cost of goods sold (COGS). You will need to forecast all costs associated with the delivery of revenue—including labor, materials, and overhead.
- Fixed vs. variable costs. Understanding what drives an expense is critical to getting the modeling right. A fixed cost (such as a data center) should be modeled on its own schedule, while a variable cost (such as raw materials and packaging) might be modeled according to a formula (e.g., as a percentage of total revenue).
- Allocations. In some cases, you’ll want to spread costs across segments or cost centers. Distributing IT expenses across multiple departments, for example, may help you understand the “fully loaded cost” of these services. Begin by identifying a key metric as the basis of your distribution. For instance, some costs might be allocated per employee, while others might be allocated per square foot.
Step 4: Set Your Cadence
Once you’ve built your model, it’s important to define a cadence and a calendar. Financial forecasting is not a one-off exercise, but rather a practice to develop and refine over time.
Plan. Begin with an annual plan or budgeting process that integrates input from stakeholders across the business to set targets and define requirements. The models you’ve developed will help you translate these objectives into a financial and operational plan for the year.
Quarterly and monthly forecasts. Inevitably, your organization will drift from your forecast. When that happens, you will need to revisit your plan, assess your performance, and revise your expectations. This periodic reckoning should never come as a surprise, but rather as part of a continuous and dynamic planning process.
Find a forecast cadence that works for you. Sometimes these constraints are set externally. For example, you may be obligated to make periodic reports to shareholders or trustees. While some reforecasts may occur on an ad hoc basis, you should establish a consistent cadence, whether semiannually, quarterly, or monthly. Each reforecast is an opportunity to assess performance and revise assumptions about the future. These shouldn’t replace the annual plan, which will remain relevant for compensation and other targets. Your reforecasts will live alongside your original plan and represent your latest and best predictions of business performance.
Daily and weekly forecasts. In some cases, you may need to generate forecasts on a much more frequent basis. Retail, hospitality, and other highly seasonal businesses may engage in daily or weekly monitoring to reflect customer shopping patterns. Other businesses may choose to do a flash weekly forecast around sales or other operational KPIs to ensure that they remain on track.
Step 5: Forecast What Matters
A useful financial forecast should encompass more than just the strict general ledger chart of accounts. It should also model your underlying operational assumptions. For example, manufacturers might focus on plant uptime, yield, and bar codes, while nonprofits might look closely at grants and membership.
For some organizations, the income statement offers sufficient insight into financial performance. Others, however, will generate a balance sheet and cash flow statement in addition to an income statement. For capital-intensive businesses (such as banks with assets under management or telecom companies building network infrastructure), forecasting capital expenditures (CAPEX) in the balance sheet is critical.
In some cases, building out a full balance sheet for the future may not be worth the trouble, but an abbreviated set of metrics will be sufficient to forecast how net cash will change over time.
“Getting to cash”—and having an understanding of how your operations will impact your future cash position—is essential for smaller organizations without significant reserves, as well as companies looking to raise funds.
Step 6: Define Your Reporting Process
Once you construct a comprehensive model of your business and incorporate your insights into the financial forecasting process, you need to define a set of reports you want to use (both internally and externally). Your reports should provide an easy-to-understand view of company health. They should include more than just a balance-sheet view of your company’s finances, incorporating performance of operational KPIs and “packs” of data you can easily share with your board of directors and management teams.
An efficient reporting process isn’t just about the reports you generate. It’s about how you get there.
If you manage reports using only spreadsheets, then you’re familiar with the process of bringing together all your data sources, manually importing them into various spreadsheets, and emailing them for approval. And that doesn’t even include the ad hoc requests you receive by email or from people you pass in the hallway.
The key to getting everyone the reports they need, faster and more accurately, is automation. An automated platform simplifies the gathering, reconciliation, and extraction of your data. That alone can transform your reporting processes from a monthly hassle to a dynamic, ongoing driver of organizational change.
Step 7: Drive Collaboration
You’ve automated your reporting. You’ve established a regular cadence. And you’ve amazed your stakeholders with the insights you’ve shared. But if you’re still the gatekeeper of information, you may be missing out on a tremendous opportunity. When stakeholders are not directly involved in the planning process, they don’t feel a sense of ownership.
When data is accessible through self-service financial forecasting tools, people will be more likely to adopt a proactive approach to gathering critical finance data, and they’ll come to embrace your plan as their own.
Step 8: Pick Your Financial Forecasting Tools
To help you take these steps, you’ll need the right financial forecasting tools. While Excel is where most finance teams get started, it’s not built for scale. As organizations grow and data sources multiply, organizations must turn to a cloud finance solution that can:
- Facilitate collaboration. Get everyone in your organization involved in the planning process by giving them access to real-time data so that business partners can take ownership of their numbers.
- Enable multiple-scenario planning. Combine high-level, top-down growth- and margin-based models with detailed, bottom-up personnel rosters and schedules in a single platform so you can quickly reconcile differences and address gaps.
- Provide a single source of truth. With a core set of operational and financial data that’s common across the company, you can align the organization and track your performance.
- Automate reporting. With centralized reporting and automated data integration, you can eliminate the need to hunt for and manually aggregate data. That frees you to focus on analysis while providing stakeholders with the information they need to make better, faster decisions
Step 9: Learn More
Financial forecasting comes down to answering a few key questions. How well can you understand your company’s position in the context of the economic environment? How much insight can you get into what’s driving opportunity and risk? And perhaps most important of all, how ably can you communicate these insights to decision-makers throughout your organization?
With the right financial forecasting software, you can have all those answers right at your fingertips—and you can help every team member feel that they’re part of the process.
This blog post was originally published on the Workday Adaptive Planning blog.