Forecasting and budgeting are often used interchangeably, but the discussion below primarily applies to updating the budget with an improved forecast. I would consider the “Budget” a quarterly or annual plan approved by the board of directors or management team. The “Forecast” is an updated budget version that includes actual results and adjustments to future periods based on new information.

Financial Statements versus Drivers

Underlying business drivers should be the inputs to any forecast, with the financial statements as the end result. While revenue growth is essential, identifying what drives revenue enables the company to make changes when over or underachieving the goal. In a SAAS business, this means splitting new sales from renewals and measuring them individually. It involves understanding whether unit sales or a higher price point drives increased revenue for all businesses. Once a company forecasts at that granular level can adjust to drive improved results.

Complexity and Model Building

Even though the forecast is one of the most important documents the finance team produces, it should only be as complex as necessary to accomplish the task. An overly complicated model with many inputs across multiple tabs or files can be challenging to update and identify potential errors. The forecasting model should only be as complex as necessary to produce the desired results and with each cycle evaluated to remove any extraneous information.

Does the Model Work

Once a forecasting model has been built, the finance team should begin rigorously testing to determine accuracy. If sales increase in the model by 10%, does that drive an increase in revenue of a similar amount, or does revenue rise by 50%? If sales increase by 20%, but cash increases by 100%, the model has a different error to be resolved. Setting drivers to 0 and ensuring the ending financial account reverts to $0 tests the model and ensures it projects accurately. Testing extreme scenarios builds confidence that the model has integrity and no significant flaws.

Forecasting Process

Companies should begin forecasting as early in their lifecycle as possible to establish the habit. Thinking through the critical business drivers and expenses provides the management team with early insight into timing and priorities. If a business is chasing enterprise sales, forecasting the number of leads, conversion rate, and the time to close an opportunity highlights how far in advance the company needs to start activity to generate one sale. The forecast should be reviewed each month and discussed at a management level to determine what targets were met, which were not, and what changes may need to be made. The open discussion around drivers and assumptions creates a process of improvement that improves long-term results.

Forecast Timeframe

Most startups operate focusing on the next few months, but we recommend building a forecast model that covers multiple years in the future. Evaluating and understanding drivers will focus heavily on the near term. Still, management and the board need to understand key business inflection points 12 to 18 months in the future. At a venture-backed startup, we recommend building out the forecast until a cash zero date, even if that is multiple years in the future. Knowing when the company needs to raise more funds and how that timing changes based on updated business results dictates when the CEO needs to start fundraising. Even if the longer-term model is a much more simplified version, understanding key inflection points in the future will provide the team insight into when they need to make key decisions.

Forecasting Accuracy

No forecast is 100% accurate, regardless of the time or resources spent to create it. Large corporate finance teams with years of experience cannot 100% predict their company’s future with high certainty. Even knowing it will not be 100% accurate, a robust forecast highlights key issues earlier, creates time to adjust to challenges, and establishes a language to discuss the results with key stakeholders. When fundraising, sharing a metrics-driven forecast highlighting how funds will be spent and the impact of that investment provides all parties a clear starting point for discussions.

Spending Time Wisely

When building a forecast model, the focus should be on the model working correctly and without errors, driven by the underlying business drivers. The model should be simple to update as the underlying business changes, and the effort in building the model should reflect as much. If forecasting the hiring plan, does the model need to calculate a prorated monthly salary for a hire six months in the future? Or can the model assume all hires start on the first of the month, saving time and effort without losing accuracy? Nobody can predict exact start dates that far in advance, so don’t spend time creating a model that requires that level of granularity.

Right Model for Right Exercise

Most of the discussion above covers a standard model and process that forecasts the entire business over a longer period. But sometimes, the company may need a much more granular forecast for the next few weeks or months. For example, if nearing the end of a fundraising process, the company is also likely near cash zero. Rather than force the existing model to work in those confines, we recommend using the information from that forecast to create a new model for that situation. That will enable the company to double-check and ensure the company has all expenses forecast but be more precise about the timing of cash inflows and outflows.

In summary, differentiating between forecasting and budgeting is vital. At Bagchi Group, we grasp the intricacies and offer invaluable fractional CFO services for CEOs and founders. By understanding business drivers, streamlining models, and rigorous testing, we help optimize strategies. Trust us to guide your financial planning, ensuring accuracy and enabling insightful stakeholder discussions. Contact us now to unlock your company’s true potential while focusing on your vision’s advancement.