In this article, we explored the reasons why an SME owner should start performing financial forecasts that specifically target discretionary cash flow. However, a few questions remain. What time frame should a forecast encompass? How often should forecasts be updated? In this article, we will explore the benefit of performing rolling forecasts along with addressing best practices for time frames to use and frequency of updates.
Let’s first start off with defining the term rolling forecast. Traditionally, companies have created annual budgets, a process that usually started in the fourth quarter of the previous fiscal year. The annual budget would be prepared once and then as the fiscal year progressed, variances between actual results and the budget were calculated. The trouble with the annual budgeting cycle is that life often throws us curveballs and unforeseen issues may have significant impacts on a business during the course of a year. Thus, as the year progresses, the financial reality increasingly diverges from the budget which may have been set up in the last quarter of the previous fiscal year. This results in an increasingly useless (and potentially harmful) tool when it comes to steering the ship of your business. Not to mention, the significant amount of time and resources spent in putting together the budget has now been wasted.
The rolling forecast addresses this problem by decreasing the time between updates and by always looking forward a certain amount of time into the future. There are three main types of forecasts: short-term cash flow forecasts (measured in weeks or days), intermediate term (the next twelve months or so), and long-term (multiple years). For the intermediate term, businesses often choose a quarterly rolling forecast schedule that always looks a minimum of four quarters (or twelve months) ahead, although some may opt to forecast longer into the future if that is helpful to them. This replaces the old annual budget that never looks past the fiscal year in which it is modelling. By necessity, the cash flow forecast must be short term in nature and usually only looks at the next month or so since precise modelling of cash flows beyond a fiscal quarter would be riddled with imprecision. The longer-term forecast should be tied in with longer-term strategic goals. For example, if you have set a five-year goal to exit your business, it would be helpful to have a model of how you are going to get there financially by demonstrating an ability to generate cash flows that will support your desired valuation. This may only need to be updated annually but it will help you better understand how you are progressing and whether pivots in your strategy are required.
Budgets vs. Forecasts
Budgets and forecasts serve different purposes to organizations. A budget helps to allocate scarce resources amongst organizational members whereas the primary objective of a forecast is help guide management by identifying trends and highlight potential issues so that management can be proactive in addressing matters rather than reactive (and perhaps perpetually in crisis mode). A rolling forecast allows an owner-manager to better plan discretionary cash disbursements such as dividends, bonuses, or any type of expense that could potentially be deferred or, if cash in a surplus position, moved up in priority. If one is growing and exiting their business, investments will be required (whether they be in human capital, intellectual capital, physical capital, working capital or infrastructure). A good forecast can help an owner plan these investments with confidence while also pinpointing if financing is required to support such injections.
Management of Discretionary Cash Flows
Being able to manage discretionary and non-discretionary cash flows is increasingly important in cases where the organization is using bank debt facilities and has obligations to pay interest and covenants to monitor. For many family businesses, dividend distributions or salary to family members may be a way of life so through using a rolling forecast, a clearer vision of cash flows can help to smooth out this process through identifying potential cash shortfalls. Also, when a company is in growth mode (on their way towards an exit), sacrifices may have to be made with respect to foregoing bonuses or dividends by re-investing surplus cash into the business. The rolling forecast will help to identify time periods where that may be required.
Growing a business requires investments and prudent investing requires adequate returns on those cash outlays . Owners need to be able to understand their returns on investment and a rolling forecast can help address this issue. Investments of any type need to be able to generate future cash flows, otherwise they are just a drain on your bottom line. If your plan is to grow and exit, forecasts are even more imperative since the clock is ticking and you need a way to measure how far along you are towards your exit goals. If you were going on an important road trip, would you do it without a map or directions?
Frequency of Updates
How often should a rolling forecast be updated? As the name suggests, the forecast is continually updated during the year, not a once-a-year activity. You may have to experiment with what frequency works best but I would recommend the following schedule. For short term forecasts, a weekly update on cash should be performed. For intermediate term forecasts, these should be updated no less often than once a quarter. Finally, the long-term forecast spanning several years should be updated at least once a year minimum but can be updated quarterly or semi-annually as well. By instilling this process in your organization, the business is being driven by looking out the windshield, not the rear-view mirror. Value creation and de-risking take time and to efficiently move towards achieving your goals, you need to be able to constantly monitor progress, something a rolling forecasting schedule allows owners and managers to do.
Given the importance of cash flows on determining the value of a business, having a handle on current and expected repeatable and recurring cash flows only makes sense. If you are planning to grow and exit your business in the next decade, flying blind is not a good idea. Consider starting a rolling cash flow forecasting process today to start the journey towards a successful exit.