Financial forecasting and price modeling
The fun part of any business operation….The devil is definitely in the detail when it comes to financial forecasting and price modeling and there is specific software out there to help you on your way. However at the inception of a business idea you probably don’t want to invest in software and consequently you will have to turn to more manual and rudimentary means of creating financial forecasts. I feel the best alternative to dedicated financial management software is Microsoft Excel (you could also use Google sheets if you are more familiar with it). Microsoft Excel is a pretty powerful tool when used correctly and can help you to create and maintain an up to date financial forecast relatively easily using its myriad of built in functions.
Financial forecasting – The 3 Key Statements
There are 3 key statements you will be looking to model when it comes to financial forecasting and this can either be very easy, or very complicated dependent on the nature and scale of your idea. These 3 key statements are:
The Income Statement (The Statement of Comprehensive Income)
The income statement is typically the headline statement of any company’s annual report and illustrates the position of the organisation from a revenue and profit perspective. When attempting to put together your income statement forecast, you are looking to recreate something similar to the below:
The above seems relatively straightforward and clear in terms of a format, however a careful level of thought needs to applied in the derivation of the numbers. For instance you will need to be aware of the following:
- Staff costs – If you are building staff costs into your financial forecasting model then you need to account for and accrue what is known as the “on-costs”. These are those costs over and above the simple salary cost that you will need to pay as an employer. For example depending on where your business is located you may need to pay into a pension plan, employee insurance plans and employee benefits. With all this accrued for you can then create a fully loaded cost for that particular employee and build such cost into your model.
- Capital expenditure and setup costs – Setup costs are concerned with the upfront costs of getting your idea off the ground, these could come in the form of consultancy costs, administration costs, travel etc. Such costs are incurred then and there and have no real tangible asset that can be recognised from it. Such setup costs will differ a little from capital expenditure which tends to focus on tangible assets such as machinery, hardware, equipment etc which can be incurred, but written up as an asset and then depreciated over the useful life of the asset under an accounting method such as straight line depreciation. This allows an organisation to incur a heavy expense upfront, but accrue for this expense under the income statement over a period of time that enables it to be spread against the revenue it is generating.
- Operating costs – Operating costs can be items that are incurred year over year. It relates to items such as rent, business insurance and facilities management which are incurred each year usually at a fixed/semi-fixed rate. Items such as direct materials, utilities and software licensing also fall under the operating cost umbrella, but can fluctuate in line with usage. With items such as software licensing there may also be a capital expenditure element (upfront cost) and an ongoing operating cost which will need to be accounted for separately.
The Balance Sheet
The balance sheet is used to provide a snapshot at a point in time of the organisations assets, liabilities and shareholder investment. It is called the balance sheet as your total assets should always balance with the total shareholders’ investment plus the total liabilities.
In a basic sense let’s say you take out a £10,000 long term loan plus retrieve £5000 in investment from shareholders, you use this to purchase £8000 machinery and spend a further £2000 on Inventory. This means your total assets are £8000 of machinery plus £2000 of Inventory plus £5,000 cash which would equal the total investment you garnered from your shareholder investment and long term loan (£10,000 plus £5000).
The below provides an illustration of what a company’s balance sheet could look like:
As you can see the balance sheet above has the Total Liabilities and Shareholders’ Equity balancing with the Total Assets of the company and there are a few things you need to be aware of:
- Current assets – Current assets are your company’s most liquid assets i.e. those assets that can easily become cash. This covers the obvious being how much free cash do you have in the company, but also things such as:
- Accounts Receivable – Money that is owed to you by customers e.g. you may extend credit terms and thus a customer will owe you x amount at a future point in time
- Inventory – Generally inventory can be (or at least should be) turned reasonably easily into cash
- Non-Current Assets – These are assets that have a longer term value to the organisation, that are not as liquid including things such as property and equipment and any long term investments held.
- Current liabilities – These are short term financial obligations for your business which are typically due within a year and can include things like:
- Accounts payable – Typically suppliers will extend credit terms to your business and the accounts payable line in the balance sheet is used to illustrate how much your business owes to these suppliers that has not yet been paid.
- Accrued expenses – These expenses are recognised under an accounting method known as accruals which basically translated to matching the expense to when it is incurred as oppose to when it is paid. For example this could be items such as a purchase from a supplier which is yet to be invoiced or interest payments on loans that are not yet payable, but payable in the near term.
- Short term debt – Typically any debt that is owed within the year
- Non-current Liabilities – These liabilities are financial obligations that are not due within the year and are therefore due in the longer term. Such liabilities could be things like deferred tax liabilities of portions of loans or other debt that does not fall due in the current year.
- Shareholders’ Equity – This represents the shareholders’ interest within the company and is usually made up of the capital (the amount that has been invested by the shareholders) and any retained earnings (profits that have been generated in the year, but have been reinvested in the business instead of being distributed to the shareholders.)
The Cash Flow Statement
The Cash Flow statement is a financial statement that summarises the flow of cash and cash equivalents through the business.
Putting together a forecast cash flow statement and understanding cash flow in business is absolutely paramount with many examples of profitable businesses with the ability to generate consistent revenue failing due to the inability to keep control over their cash.
The cash flow statement differs from the figures shown in the balance sheet and income statement as it takes into account cash items only, thus accounts receivable, accounts payable and non cash financial items (such as depreciation) need to be adjusted. The main components of the cash flow statement are:
Cash from operating activities
The cash from operating activities reflects any sources and uses of cash from business activities. For example this could include items such as cash receipts from the sales of goods and services and expenses such as rent payments or salary payments.
Some of the key things you need to account for are:
- Accounts receivable and Accounts payable – If you are looking to extend credit terms to your customers then you are going to need to keep track of the likely expected cash in at particular intervals and ensure it matches with your accounts payable. For example if I am extending 30 day terms to my customer, then I know a sale today would not translate into immediate cash, instead I would likely have to wait 30 days from now in order to receive payment. If my supplier wishes to be paid within 10 days then I have a cash flow issue as I now have a 20 day gap between when I have to pay my supplier versus when I receive the cash for the sale.
Cash from investing activities
Cash from investing activities covers a business’s investments for example a purchase or sale of an asset or a merger or acquisition or other miscellaneous cash investment. Generally investing activities result in cash out of the business, however in the example of an asset sale, it would result in a cash inflow.
Cash from financing activities
Financing activities include things such as investment from banks or shareholders, payment of earnings to shareholders (dividends) and any repayments of debt.
Financial Forecasting Overall
Financial forecasting is an imperative aspect in business and you should have at least a reasonable understanding of the 3 key statements and what they show. At the inception of a business these 3 statements will provide a snapshot of how your organisation is doing and therefore insight into areas you may need to change or successful areas that could be replicated. Keeping clear, accessible and regularly updated financial forecasts will ensure you remain on track and give you the ability to pivot quickly in the event something isn’t working as well as it should.
