That annoying crystal ball
By Jonathan Lim
Financial forecasting is a process that flows through the veins of effective organisations.
Unfortunately, these same forecasts can cause organisational blood clots if healthy practices aren’t followed. Two practices to avoid are:
- Trying to shorten the process or;
- Viewing the end result as a crystal ball which determines the fate of the business, and then hanging the poor fortune teller (business analyst) when fate falls short of expectations.
Shortening the Process
In our experience, it is easier to just prepare a cash flow forecast, or just prepare an income statement and cash flow.
However, including a balance sheet in your financial forecasts will help you to consider your organisation’s transactions carefully. It also lets you know if your forecast is arithmetically sound. For example, sales and debtor receipts can be matched, and error checks can be performed by ensuring the line on the cash flow statement agrees to the ‘bank’ line on the balance sheet.
A retail client of ours was planning a large advertising campaign. They engaged our services and we prepared a three-way financial model that enabled them to assess the impact of the advertising expenses and anticipate cash deficits in the coming months. With data we presented, the client was able to a make better business decision between tweaking their pricing strategy and obtaining additional financing.
Crystal Ball View
A spreadsheet is not a substitute for strategic analysis.
Unless your organisation has an economic moat with piranhas that will devour your competitors, forecasts should be driven by rigorous analyses of market conditions and the organisation’s competitive position within its industry.
Even if such economic moats do exist, extrapolating growth at the same rate for every period can be dangerous as all organisations are exposed to product life cycle risks.
We quote an example from Kenneth Gronbach’s book “The Age Curve”.
American Honda was selling motorcycles like hotcakes in the late 1970s and early 1980s.
“Their formula was simple: Honda sent the bikes from Japan to a New Jersey warehouse, where they were distributed to the Northeast regional dealers, who prepped them and displayed them on showroom floors. As soon as they were displayed at the dealerships, the marketing and advertising kicked in and the customers bought them—all of them. Life was good.”
In 1986, the sales volume for bikes plummeted without much warning. This continued for the next six years until the decline amounted to an 80 percent free fall. By 1992, most of the dealerships were ready to close.
In an attempt to explain this drop, the marketing and engineering departments attributed the drop to factors such as pricing and design.
Price and design were not the issue as sales still headed south even after being ‘corrected’. American Honda had failed to recognise changes to demographic winds. Honda’s target customers (Baby Boomers) had ‘moved on’ from the motorcycle phase of their lives and were replaced by Generation X, which was 11 percent smaller than the Boomers.
The sexiest of spreadsheets are unable to forecast such changes unless they are factored into the scenario analyses.
In a world where change is the only constant, forecasting has become an ongoing process that is integral for reliable and timely decision making.
Taking the easy way out when preparing your forecasts is perilous.
This is not a call for you to replace your analysts with demographers or statisticians. Instead, organisations must make an effort to stay cognisant of current and potential changes to their business environment when preparing their financial forecasts. By doing so, forecasts can become a reliable reflection of business reality, and will facilitate the process of recognising issues and opportunities, giving your organisation the opportunity to renew itself through a review of current strategy and/or a reorganisation of its financial structure.
Help is on the way!
Access Analytic can help you with this problem as we are experts in Excel financial modelling, counting some of Australia’s largest companies among our clients.
By reviewing both business and accounting logic, we can assist with building robust and powerful financial models that will improve your strategic planning process. This will allow you to focus on the big picture and optimise prioritisation of strategic initiatives.
To know if you are making decisions with confidence, call us on +61 8 6210 8500, or email us at email@example.com today.