Business Forecasting

Financial forecasts for businesses are statements that are based on estimates and drawn up before the events they describe take place. They are included in the Business Plan. In the business plan the written sections and financial information should support each other. The information should be sufficient for a decision to be made about finance for the business. Financial forecasts can help with:

Planning – by showing the financial implications of business ideas, to ensure the right amount of finance will be sought.
Control – by forming the basis of a budget that is later compared with the actual results. This will highlight any need to adjust income or related costs.

The Reasons for Forecasting

In order to see how the business is likely to perform a profit and loss forecast is needed. This should show the position on a month-by month basis for the first year (to assist with future monitoring), and may be produced on a quarterly or even annual basis for subsequent years. The profit forecast (sometimes called a budget) aims to match the income and expenditure of a business to the period in which goods or services were provided. It is needed to show what profit the proprietor(s) of the firm expect it to make, so they can make a decision as to whether it is worth starting the business or carrying it on. From the viewpoint of an outside investor, it will show whether he or she is likely to make a reasonable return on the investment.

The cash flow forecast aims to record the anticipated flow of receipts and payments related to those goods and services. These receipts and payments will not always occur in the same month as the figures appearing in the profit forecast. The cash flow forecast is necessary to demonstrate how much cash will be needed to start or continue the business. Its completion enables sufficient funds to be raised before they are needed, and if it is not possible to do this, allows the person or people running the business to take a reasoned decision as to what they should do. This may mean not starting the business at all (or winding it up if it is already trading), or reducing sales and therefore cash need. This may mean being selective when offered work, and paying due regard to the payment terms offered.

For the business start-up, a Statement of Pre-start Expenses is often useful. The total of this can be included as expenditure in the main forecasts (in month 1), and should also be included as part of the “Capital Introduced” in the cash flow forecast (again in month 1).

All the above forecasts should have explanatory notes appended where appropriate. By prudent forecasting and regular monitoring, sensible decisions can be made before a crisis point is reached, and corrective action taken where necessary.

How Far Ahead to Plan

How far ahead to try and forecast depends on a number of factors:

When the business will break even
When any loan requested/granted will be repaid
The degree of accuracy possible
The degree of change likely once the business is established

A profit forecast and a cash flow forecast showing the position on a monthly basis for the first year is a minimum requirement.

The Differences between the Forecasts

Certain items (for example capital expenditure) will be treated differently in the profit forecast than in the cash flow forecast.

The first question to ask when deciding which items to put where is “Does this item have an effect on the profitability of the business?” If the answer is yes, then the item in question should be included in the profit forecast. The second question is “Is this item something for which cash will be received or for which cash must be paid?” If the answer is yes, then the item should be included in the cash flow forecast.

What goes in which Forecast

Some items which often cause confusion in this context are:

Capital Introduced. If the proprietor, partner or directors of a business introduce their own money into it that money will be shown in the cash flow forecast as “Capital Introduced”. The transaction will have no direct impact on the profitability of the business, so it will not be shown in the profit forecast.
Drawings/Salaries. In the case of a limited company any money drawn by those running the business must be treated as a salary, and tax and National Insurance paid on it under the PAYE system. In such a case the gross salary paid, plus Employer’s National Insurance, must be shown in the profit forecast. The net amount of the salary (i.e. after deductions) will be shown in the cash flow forecast in the month paid, and the subsequent payment to the Inland Revenue (for the deductions and Employer’s National Insurance) shown in the month that payment is made (usually the month following payment of salary).
When financial projections are being prepared for sole traders or partnerships it is strongly recommended that an amount for monthly drawings is included in both the Profit and Cash Flow Forecasts. This amount should be set at the minimum that the proprietor or partners need to draw, based on survival budgets drawn up by them. Of course, the proprietors/partners will not be restricted to drawing the minimum amounts shown in their projections, and can draw as much cash as is available, although they should take account the impact that drawings have on a business.
Loans Received. If a loan is received from a bank or other commercial source the amount of this will be included in the cash flow forecast, when it is received, and repayments will also be shown.
The increase in the overheads of the business will not usually be the whole value of loan repayments, as in most cases these will both reduce the loan (although probably not by much in its early stages) and pay the interest. Only the cost of the interest (and any other associated charges) should be included in the profit forecast.
Purchase of Capital Assets. Here the whole cost of the asset purchased (including VAT) will be included in the cash flow forecast in the month when payment has to be made. In the profit forecast the net cost of the asset to the business (excluding VAT if the business is VAT registered, including VAT if not) will be written off over its useful life. This “writing off” is called depreciation.
Example: A new van is purchased for £6,000 net of VAT in May. The anticipated life of the van is four years. Assuming that immediate payment has to be made for this item, an amount of £6,000 plus VAT at the prevailing rate will be included in the cash flow forecast in May. An amount of £125 will be entered in the profit forecast in May, and in every month afterwards for four years.
Overhead Expenses. Where overhead expenses are constant, one-twelfth of the annual cost should be entered into the profit forecast, but they should be put into the cash flow forecast when it is estimated payment will be made.
Example: Premises are leased for £12,000 per annum from January, with rent payable quarterly in advance, a total of £3,000 will be entered in the cash flow forecast in January, April, July and October. A constant figure of £1,000 per month will be entered in the profit forecast, as this is the charge against profits.
Purchase of Stock for Re-Sale. Where goods are purchased for stock, the cost will be entered in the cash flow forecast in the month when payment has to be made (Not necessarily the month of delivery). No entry will be made in the profit forecast until the stock is actually sold.
Example: Goods costing £20,000 (exclusive of VAT) are purchased for stock in October on 30 days credit. The business making the purchase is VAT registered and can therefore recover the tax paid. The goods are subsequently sold in December, again on 30 days credit.

In the cash flow forecast a figure of £20,000 plus VAT at the prevailing rate will be entered in November (the month payment will have to be made). It would be incorrect to include the purchase in the profit forecast for that month, for the goods are still an asset of the business and will be included in the balance sheet of the business. (The balance sheet is a statement of what is “owned and owed” at a set point in time).

The sale will show in the profit forecast in December (the month in which it is made) as £40,000 in sales income, and at that time the cost of stock goods (£20,000) will be shown as purchases. The sale will be shown in the cash flow forecast as £40,000 plus VAT at the prevailing rate in the month when it is expected payment will be received. This may be in January (when payment is indeed due), but if it is thought customers are likely to abuse credit terms it will be prudent to enter the receipt in February or even March.