Financial forecasting is a "top down" rather than a "bottom up" exercise. It's the opposite of how actual (historical) financial statements are created.
This is where many entrepreneurs and CFOs get tripped up. Creating historical financial statements is a process of gathering and recording thousands of transactions and reporting the results in the form of financial statements. The historical financial statements have to be right.
But forecasting is a very different process. A forecast is about hooking the vision and strategy of the company up to the likely financial implications of achieving that strategy. A forecast needs to be reliable.
You need to take yourself up to the 30,000 foot level and look down on the business financially as you forecast. It's about seeing the big picture more so than the nitty-gritty detail.
More Detail = More Error
One of the more counter-intuitive facts about forecasting is the more detail you bring into the forecasting process, the more error you will create.
I learned this very early in my CFO career when forecasting revenues.
We had 350 locations across the U.S. and Canada and we needed a reliable forecast of our combined revenues and cash flow. It was a franchise company and we did not have real-time access to sales at the location level. The sales information was sent to us at month-end. (This was in the early 1990's.)
We considered having each franchisee forecast their sales and submit it to us at corporate. But that was met with resistance. Plus, there is no way we would have anywhere near full compliance with that many people involved.
We tried forecasting each location ourselves and summing it up for our overall forecast. But it proved unreliable.
We tried having the Regional Managers provide their estimate by store since they were talking to franchisees frequently. But it proved unreliable and it put a lot of work on the Regional Managers.
Less Detail, Not More
I found the solution by estimating 1 number – comparable store sales increase/decrease. Not estimating 350 numbers. Just 1.
To get the forecast revenue number I would review comparable store sales % for the last twelve months. Then I would talk to a couple Regional Managers to get some anecdotal feedback on whether they are hearing good things about sales or bad things.
I would consider whether the revenues for the same month of the prior year were up or down. With that I could estimate the comparable store sales %. I multiplied that % times the revenue for the same month of the prior year and I had the revenue forecast.
It turned out to be amazingly reliable. Not perfect, but reliable.
Estimating 1 number was super-simple and it created a more reliable revenue forecast than estimating sales at 350 locations.
Remember, financial forecasting is a "top down" rather than a "bottom up" exercise.
The more detail you bring into the forecasting process, the more error you will create.
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