What is Forecasting?
Provided by Visa, Content Partner for the SME Toolkit
Financial forecasting helps you predict the cost of your products or services, the amount of sales revenue, and profit you can anticipate. If your business is not already off the ground, financial forecasting will explain how much you'll have to invest or borrow.
Obviously, financial forecasting depends on your type of business—that is, whether you are a retail business, service business, manufacturing or wholesale business, or a project development business (that's a business like real estate rehabilitation in which you work on one house at a time.)
Financial History Helps
Forecasting is always easier if you've been in business for a little while, because you have months (or years) of actual revenue and expenses upon which to base your forecasts. If you haven't got any history this section can help you get started.
Don't be intimidated. Financial forecasting is not so bad. It's a matter of making educated guesses as to how much money you'll take in and how much you'll need to spend—and then using these estimates to calculate how and when your business will be profitable.
Here are the financial projections you should make:
THE BREAK-EVEN ANALYSIS
This analysis tells you how much revenue you'll need each week or month to break even. To calculate it, you need to make two estimates:
- Fixed costs. Also known as overhead, these costs usually include rent, insurance, and other regular, set expenses. (Loan repayments and the costs you pay for any goods you will resell are not fixed costs.)
- Gross profit percentage. Start with your gross profit—what's left after you deduct the direct costs for each sale. For example, if you paid QR150 for a bicycle and sold it for QR250, your gross profit is QR100. In order to determine your gross profit percentage, you divide your profit by the selling price—in this case 40% (QR100/250).
To calculate your break-even, divide your monthly overhead expenses by your profit percentage (as a decimal). For example, if your bicycle shop has fixed monthly costs of QR4,000, and your profit percentage is 40%, then you need sales of QR10,000 a month to break even (QR4,000 divided by .40). In terms of the bike store, if you were selling bicycles at QR250 a bicycle, you would need to sell 40 bikes a month to break even. If this amount is below your anticipated sales revenue, then you're facing a loss—and you'll need to lower expenses or increase sales to break even.
THE PROFIT AND LOSS FORECAST
In your profit and loss forecast (or P&L), you refine the sales and expense estimates that you used for your break-even analysis, into a formal, month-by-month projection of your business's profit for one or two years of operation. It's basically a spreadsheet that details your expected expenses and revenue on a month-by-month basis.
CASH FLOW PROJECTION
Your cash flow projection focuses on day-to-day operations and tries to help you predict whether you can survive those in-between times when you must pay bills but there is no revenue. For example, the cash flow for the first few months of a business is often negative. In order to survive, you may need to borrow money during that period. Cash flow projections are useful for every business, but they're particularly helpful if you have not yet opened.
To make your cash flow projection you'll have to prepare a spending plan, setting out items your business needs to buy, and expenses you will need to pay. You then feed these numbers, along with information from your profit and loss forecast, into a spreadsheet. You'll need to determine and add in details such as whether you will be making credit sales and how much time is granted—for example, you grant 90 days to pay a bill (Net 90) on your invoices. That helps determine when you can expect payments.
WHAT ARE RATIOS AND WHY DO THEY MATTER?
Reports and forecasts are great but they don't tell you how well you are doing in relation to other businesses within your industry. For example, is it healthy or unhealthy if your nail salon's total debt equals your total assets? Since companies come in different shapes and sizes, the best way to make comparisons is by using ratios—comparisons of different elements from your balance sheet.
Ratios: The Challenge
The challenge with ratios is that there's got to be some standard. If you discover your tap water is all brown and you have your well tested, and they report that you have magnesium at 47 parts per million, you don't know what you've got unless you can measure it against a standard. The same is true for ratios.
Ratios are commonly expressed as a percentage (usually x divided by y) or simply as “x:y.” At the end of each accounting period, you should review and calculate certain ratios. We recommend using four benchmark ratios:
CURRENT RATIO (ALSO KNOWN AS “ACID-TEST RATIO”)
This measures how well your business can pay off short-term debts (or as it is sometimes referred to, the size of your “buffer” or “cushion”). It's determined by dividing current assets by current liabilities. For example, if your current assets total QR100,000 and your current liabilities total QR50,000, the current ratio is expressed as a healthy 2 (or 2:1) ratio. (That is, you have QR2.00 in current assets for each QR1.00 in current debt.) If you paid off QR40,000 of the current liabilities so that it was QR60,000 in current assets and QR10,000 in current liabilities, your current ratio would improve to 6 (or 6:1). If on the other hand, if you had QR50,000 in assets and QR100,000 in debt, you would have a risky ratio of .5 (or 1:2).
Like your current ratio, the quick ratio measures your company's ability to pay outstanding liabilities. The difference is that the quick ratio analyzes the amount of cash (or assets that can be quickly converted to cash) that can be used to pay off liabilities. For that reason you determine the quick ratio by subtracting inventory from current assets, then dividing the result by current liabilities. (You subtract the inventory because that cannot be quickly converted to cash.) Therefore if you had current assets of QR100,000, current liabilities of QR50,000, and inventory of QR50,000, the quick ratio is expressed as a ‘good' 1 (or 1:1).
DEBT TO EQUITY RATIO (D/E)
This ratio is calculated by dividing the total debt (liabilities) by the total shareholder equity in the company. This ratio measures risk to current or future creditors—the higher the ratio, the greater the risk for the business (and for a lender). Ideally, your company's debts should not exceed the amount invested into it. For example, if your business's total debt is QR110,000 and your shareholder equity is QR95,000, your debt to worth ratio is 1.157. If that ratio were to rise dramatically—for example debt rose to QR250,000 making the ratio 2.63, it's a signal that your company could be having a problem (or is headed for one) and should hold off on incurring more debt.
In addition to the other four ratios, another ratio which you may find helpful is your profit margin. This is the calculation that matters the most to many business owners because it makes clear how much of each Qatari Riyal in sales ultimately becomes profit. It's a percentage calculated by dividing net income for any period by the net sales from that period. That is, it tells you how much of your profit is being eaten by your expenses. For example, if your appliance store netted QR100,000 on sales of QR1 million during the last twelve months, your profit margin is 10%.
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