Whether your company is a small startup or a large corporation, you need a clear view of your starting position (especially in the wake of the pandemic). Establishing solid forecasting models can help you avoid surprises and better project profits and losses.
Since forecasting is one of the most important steps in business planning and budgeting, it’s important to have a forecasting method that gets results. If your forecast method is unreliable or you haven’t found the right one for your company, it’s time to try something new.
COVID-19 is having far-reaching implications for the economy. Businesses are being stretched beyond what they considered their worst-case scenario. Focused, pragmatic crisis forecasting can help CFOs understand exactly how best to react and plan capital allocation during these uncertain times.
Take a look at these four forecasting model to determine the right blend for your business.
4 Forecasting Models for Data-Driven Businesses
1. Linear Forecasting and Driver-Based Planning
In normal times, financial planning teams generally use a range of driver-based models for budgeting, forecasting, and root-cause analysis. Over the years, they have likely cultivated their own standard reports and preferred views of information. Few have probably encountered the degrees of uncertainty they’re experiencing now or been asked to conjure up a crystal ball in a matter of days to make the most important decisions their companies have ever faced.
Relying on historical figures and trends to predict future performance is probably the simplest (and most widely used) forecasting model across all industries. This method of forecasting is built on an underlying assumption that the business will continue to grow at X% per annum, based on how it has performed in the past.
While many forecasters use prior year growth rates, or monthly performance, as a guide to future performance, the real world rarely follows the past with direct linearity. If there was one great learning from 2020, it is that the past is no longer a great predictor of the future.
2. Zero-Based Budgeting (ZBB)
Zero-based budgeting is making a comeback in 2021. First introduced to the public in 1970 by Peter A. Pyhrr in the Harvard Business Review, zero-based budgeting deviates from traditional budgeting concepts in that each budget is rebuilt from the ground up with stakeholders justifying each expense added to the new budget—irrespective of prior commitments and recurring expenses.
Some of the major drawbacks of the ZBB method are that it can be a resource-intensive process and may encourage stakeholders to focus on short-term goals at the expense of longer-term plans.
3. Rolling Forecasts
While incremental change is a distant speck in the rear-view mirror, a static view of the next twelve months feels like fortune-telling via a crystal ball. How can you predict the unpredictable? The reality is that change is happening at a faster pace than ever before and businesses need to be ready to adjust course to respond and adapt to changes as they detect headwinds.
Tracking the immediate needs of the business and forecasting the post-COVID-19 economic landscape requires timely data, sophisticated analysis, and methodologies that provide sufficient flexibility to adjust to highly unpredictable and complex near-term and long-term effects. Annual budgeting by itself simply does not provide the frequency or flexibility to meet the demands of the current planning environment.
Rolling forecasts provide efficient and timely updates that enable management to assess changes frequently and adjust quickly to a volatile environment. Technology is the foundation for a reliable, repetitive rolling forecast model. Forecasts must be linked to both financial and operational data sources. The technology needs to incorporate input from multiple individuals, teams, and departments, with an audit trail of inputs. Finally, the technology needs to ensure a workflow in which all inputs are systematically collected, incorporated, and approved by appropriate individuals.
This approach to forecasting and budgeting may represent both a cultural and a process shift for many organizations. In a rolling forecasting process, participants come together for short blocks of time throughout the fiscal year to both assess and update the organization’s financial performance. The entire process rests on answering the question, “How have the previous 30 days changed our view of the present and future?” In the COVID-19 pandemic, the answer to this question will frequently change, requiring managerial course corrections and adjustments to position the organization for success
4. Scenario Modeling
Developing a range of potential outcomes for how the pandemic might play out is no longer a luxury for resource-strapped Finance teams—it is a matter of survival planning. A best case, worst case, continue-as-is case, and most likely case range of scenarios represent the minimum number of financial models you should prepare and review.
The importance of exploring a breadth of potential outcomes is critical to preparing for an uncertain future. Each scenario should accommodate changes in core business drivers and economic indicators, such as the depth of a potential recession, the duration of any decline, along with the time, and resources, required to build back again. In each scenario, there should be identifiable triggers that alert Management to take a pre-agreed course of action. These actions could range from workforce rationalization, R&D investments, mergers and acquisitions, or funding requirements.
Regardless of the forecasting model(s) in use in your business, CFOs have a responsibility to ensure the four key aspects are incorporated into the forecasting process:
- Stress-test scenarios and assumptions to counter uncertainty and help you understand how sensitive the business is to the key drivers of performance.
- Reimagine the business from a zero base; even if this is a whiteboard exercise, there is value in questioning “How did we get here?” and “Where are we going next?”
- Hold back some spending centrally (as contingent resources) to build flexibility and optionality into budgets.
- Assign Finance talent to the highest-priority areas or topics to prevent burnout.
Financial Forecasting in Uncertain Times
Irrespective of what forecasting model you choose, a forecast is no longer an annual process that is then updated quarterly for any significant changes.
In times of great uncertainty, forecasting needs to be a living document that can accommodate rapidly changing markets and circumstances.
The degree of disruption created in 2020 means that we need to prepare to face challenges that are deeper and more disruptive than we could have ever imagined. What got us here, may not get us there.
Take this time to reflect and rethink what is needed from Finance. With the benefit of hindsight, we’ve put together some foundational building blocks to ensure you are future-ready for whatever is to come:
- Apply new lenses to the forecasting process. Slice and dice the information by geography and by industry. Look at spending in different buckets—discretionary, non-discretionary, etc.
- Adjust the granularity and regularity of the forecasting process to reflect the current scenario. Many companies that have previously relied on 13-week forecasts are now actively making 52-week projections that they update every month or quarter, depending on factors like the economic outlook.
- Revise and justify base case assumptions—do they reflect the new realities?
- Have you considered your customer’s financial health and the potential risk to your sales or cash flow position? For example, will your churn rate increase next year?
- Have you adjusted the sales forecast for changes in customer buying patterns or demand? For example, leasing/coworking spaces may be negatively impacted, or your business may be anticipating a release of pent-up demand.
- Are there additional legislative or compliance obligations that need to be considered, like the closure of non-essential stores, return to work practices, etc.?
- To what degree will you invest or gather an ROI on investments in digital capabilities?
- Establish a single source of truth—think of this as your “war room” of data. When time is of the essence, we cannot afford to debate the starting position or the validity of the facts and assumptions being used to drive the financial model.
- Agree on the metrics to report on that resonate with all internal stakeholders. Create tolerance levels that trigger alerts.
- Understand the business levers available to you and when they should be used.
Finally, consider using a tool like Kloudio. Kloudio removes the data wrangling in all financial forecasting models, giving your Finance team back the time to focus on protecting and growing your business. Download our free guide to learn how to streamline your financial planning with a continuous month-end close process.