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Financial Forecasting

Provided by SME Solutions Center - Kenya


What is Forecasting?

Financial forecasting helps you to determine several factors, including:

  • Your proposed (or existing) business’ cash requirements
  • The anticipated sales volumes
  • Your expected profits

Based on the ensuing forecasts, you figure out at what time your business will become profitable. If you have an already existing business, forecasting will help determine the cash you need to borrow or invest into your business. Essentially, these activities constitute budgeting. 

Key Principles

Financial forecasting is depended on factors such as:

  • The age of your business
  • The type of your business

The Business Age

You will easily make financial forecasts for a business that has been in existence for some time. In this case, you will have expense and revenue items covering considerable time duration. These items will form the basis of your forecasts. For a start-up, you have to base your analysis on predetermined, conceptual standards.

The Business Type

Your type of business will guide the forecasting you undertake. Various businesses have different production cycles. Consequently, your forecasts for a project-based business will differ from those for a continuous service business.   

Key Financial Projections

Some key forecasts include:

  • Break-even point
  • Profit and loss  
  • Cash flow

Break-Even Analysis

Through this analysis, you determine the monthly or weekly income you need so as to break even. The major figures you require include:

  • Overheads (fixed costs) like insurance and rent
  • Buying price
  • Selling price  
  • Gross profit
  • Selling price
  • Buying price
  • Gross profit percentage   

Break-Even Calculation

Step 1: Divide the period’s overheads (fixed expenses) by the gross profit percentage

= Overheads / Gross profit percentage   

Gross Profit = Selling Price - Buying Price

Gross profit percentage = Gross Profit / Selling Price

Determining the Break-Even Point

A hypothetical case of a lawnmower business would help you to get a grasp of the break-even concept. Suppose for a certain month, your business’ overheads amount to KES 5,000.

Fixed costs = KES 5,000

Assume you bought a lawnmower at KES 2,500 and sold it for KES 4,500

Your gross profit would be KES 4,500 (selling price) minus KES 2,500 (buying price).

Gross profit = KES 2,000

You arrive at your gross profit percentage figure by dividing your monthly overheads by the lawnmower selling price

Gross profit percentage = Gross profit/ Selling price

                                    = KES 2,000/KES 4,500

                                    = 0.44

To determine your break-even point, divide your monthly fixed costs by your profit percentage.

Break-Even Point = Overheads/Profit Percentage  

                                     = KES 5,000/O.44

                                    = KES 11,363.64

You need to sell lawnmowers worth approximately KES 11,364 so as to break even.

To arrive at the exact number of lawnmowers, divide the break-even point by the selling price

= KES 11,364/ KES 4,500

=2.5

= Approximately 3 lawnmowers

You need to sell 3 lawnmowers every month so as to break even.

In case your projected sales figures are below this break-even point, you risk running into losses.

To salvage the situation, you could take two options, namely:

  • Reducing expenses
  • Increasing sales

Profit and Loss Forecast

For this forecast, you polish the expense and sales projections used in the break-even analysis. You then use the fine-tuned expense and sales items to develop a formalised, systematic forecast of your business’ profit. Basically, the profit and loss forecast entails a month-by-month spread sheet of projected revenue and expense. Your spread sheet could cover up to 2 years.

Cash Flow Projection       

You need to develop a cash flow forecast for your business, especially if your business is new. The major steps include:

A.     Preparing a Spending Plan

This plan defines your anticipated purchases and bills

B.     Developing a Spread sheet

You will organise the spending plan items, together with the profit and loss items, into a spread sheet. Specify whether you will offer credit services and your proposed repayment period.

Merits of the Cash Flow Projection

It helps you to determine whether your new business will push through during the formative stage. Obviously, your new business will have a negative cash flow during this period. You need to determine the expected revenue and expense amounts so as to prepare accordingly.  You could borrow monies so as to prop a negative cash flow figure.     

Ratios

Ratios help you to evaluate your business’ performance in relation to similar businesses. With financial ratios, you compare different balance sheet elements. Ratios are usually presented in percentage form (normally as ‘a’ divided by ‘b’). Alternatively, you could express ratios as a:b. These financial statements facilitate financial reporting. Key ratios include:      

  • Current (acid-test) ratio
  • Quick ratio
  • Debt to equity ratio
  • Profit margin 

Current Ratio

You compute the current ratio by dividing current assets by current liabilities.

Current Ratio = Current Assets/ Current Liabilities   

With the current ratio, you assess your business’ ability to settle short-term debts. This capacity is your ‘cushion’ or ‘buffer’. Generally, a healthy current ratio should not be less than 1.

Quick Ratio

Computation

You calculate the quick ratio by deducting inventory from current assets. You then divide the difference by current liabilities.    

Quick Ratio = (Current Assets - Inventory)/ Current Liabilities

Purpose

Basically, you use the quick ratio to determine your business’ capacity to settle owing liabilities. In the process, you identify the money that could pay off the liabilities or the assets that can be easily transformed into cash. Generally, a quick ratio figure of at least 1 is good.     

Debt to Equity Ratio

You arrive at the debt to equity ratio by dividing your business’ overall liabilities (debt) by total owners’ equity.   

                        Debt to Equity Ratio = Owners’ Equity / Liabilities (Debt)

Rationale

In an ideal situation, your business’ debts should be less or equal to the money you invest into it. Otherwise, your business poses a risk to itself as well as to lenders. The debt to equity ratio determines the risk current or future creditors face when dealing with your business. The ratio also assesses your business’ risk. A high ratio indicates high risk; a low ratio shows less risk. 

Profit Margin  

You calculate the profit margin ratio by dividing your net income figure by the net sales for a particular trading period. The ratio is expressed as a percentage. 

Profit Marin = Net Income/ Net Sales

Principle

The profit margin determines how your sales figures translate into profit. In other words, it shows you the proportion of profit that is being ‘swallowed’ by your expenses.         

Financial forecasting enables you to predict your business’ money requirements, expected sales, and your likely profits. Whether operating an existing business or planning to set up one, you need to make forecasts. Forecasting will enable you to determine the money required for a start-up. This is basically a budgeting function. You also rely on forecasting to determine when a business will break even. Forecasting also facilitates financial reporting. Major forecast items include; break-even point, cash flow, and profit and loss. Forecasts do not however asses you business’ performance based on similar businesses. This shortfall is met by financial ratios which evaluate your business financial performance against some standard. Common ratios include; Debt to equity ratio, Current (acid-test) ratio, Quick ratio, and the Profit margin. Ratios enable you to compare different balance sheet items. The above financial statements are crucial to your business.

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