Welcome back to The Profit Plot, a podcast where we help small business owners unlock the story behind their profitable business by unpacking one complex financial topic at a time. I am your host, Jeremy Millar.

In today's episode, we'll be discussing an essential tool for business owners that allows you to anticipate future financial outcomes, prepare for potential challenges, and make strategic decisions to keep your business on track for success. Today, we're talking about the importance of financial forecasting.

As always, it's important to define our terms so that we're all on the same page moving forward! Financial forecasting is the process of estimating future financial outcomes for your business. Typically budgets and forecasts go hand-in-hand! With a robust budget, you can understand what your business is spending or planning to spend and use financial modeling to make predictions about the future.

By looking ahead, you can better understand potential risks and opportunities that may come up for your business and take steps to ensure that you're on a sustainable path to growth. When done properly, financial forecasting allows you to combine your own unique insights into your business or industry as an owner with actual historical data to create attainable and realistic goals, accurate assumptions for the future, and a clear path forward.

Stay with us as we explore the importance of financial forecasting, discuss the critical elements of creating a good forecast, and share valuable tips to make your forecasting efforts more effective. Let's dive into financial forecasting and learn how to confidently plan for your business's future.

To really explore the concept of financial forecasting, I think it's vital to understand why it's such an important tool for all kinds of small businesses. Forecasting is more than just predicting the future; it's a vital part of managing your business effectively and preparing for challenges and opportunities.

One of the primary benefits of financial forecasting lies in establishing a better understanding of your business. Using historical data to understand what the future may hold forces you to get intimately familiar with what's currently happening in the business. This is a useful exercise for ensuring that your income and expenses are actually being leveraged productively.

Keeping a close eye on the financial information flowing in and out of your business during a certain period helps you identify potential cash flow issues before they become critical problems. By anticipating future cash inflows and outflows, you can preemptively make a plan for a period of reduced cash flow or slowed business, which ultimately helps you ensure that you have enough funds to cover expenses and keep your business running smoothly.

As I mentioned before, financial forecasting allows you to set goals and track your progress toward your objectives. But a key component of creating a financial forecast is using historical data to make predictions about what's going to happen in the future. Because you're using historical data, your goals are much more likely to be realistic and achievable than if you were simply conjuring up targets out of thin air. By creating a financial roadmap, you can measure your business's performance against your forecasts and adjust as needed to stay on track. This process helps you stay focused on your goals and ensures that your business is continually moving in the right direction.

Perhaps the most important aspect, financial forecasting enables clear decision-making by providing insights into the potential outcomes of various scenarios. For example, if you're considering taking on additional expenses like a new employee, reinvesting cash flow into larger marketing budgets, or trying to determine your level of profitability in the future, financial forecasting can help you estimate potential costs, revenues, and profit. As a business owner, you're able to make informed decisions that align with your business's financial goals and resources to create a level of clarity and understanding that you wouldn't have had otherwise.

Financial forecasting is a vital aspect of business planning that helps you anticipate future financial outcomes, manage potential risks, make informed decisions, and position your business for sustainable growth. But, what actually goes into creating a financial forecast, and how can you create one in your own business?

Let's talk briefly about the components that go into creating a foundational financial forecast.

Every financial forecast starts with the past. What's happened historically that you can draw from to inform your decisions about tomorrow? With every forecast that you make, you're making assumptions about how your business and the market itself will perform in the future. Your assumptions may or may not end up being true. That's why it's incredibly important to view any budget or forecast or projection that you put together as a moldable financial document - something that can and will change over time.

Personally, I like to start with forecasting expenses first. This may seem a bit confusing if we look at the structure of a P&L: revenue is on top, so naturally, we should start with it first, right?

Beginning any forecast by planning out the expenses you're going to incur over the next period of time allows you to understand something key: your breakeven number. This is the bare-minimum number that your small business needs to actually stay afloat; you need to pay for things like payroll, marketing, facilities, and a lot more.

Understanding our expenses first allows us to build a model for what the business needs to be sustained at a foundational level. From there, we can plan and adjust for growth and ultimately walk back into our revenue goals with a clear understanding of what we need to survive first.

Now, as we know, expenses are the costs your business is likely to incur in order to keep things running. These may include salaries, rent, utilities, marketing costs, and more.

For most small businesses, general expenses are relatively flat when graphed out visually. Most likely, your business spends a consistent average amount of money every month to keep things operational. You're spending a relatively flat amount on payroll, rent, utilities, and so on. There may be some slight seasonality, but general expenses tend to be pretty flat for most mature small businesses.

Of course, this is typically not the case for Cost of Goods Sold expenses, which can often fluctuate as a percentage of income that you're bringing in. It's often useful to focus on COGS after we've actually made predictions about our revenue.

So, let's say you've modeled out your expenses and have found that, based on the previous 12 months, your business is spending about $50,000 per month to keep the lights on, with a decent marketing budget, to pay your employees, and to provide benefits. At a base level, your business needs to continue to bring in income north of $50k in order to break even.

Now that we've spent time looking at our expenses from month-to-month, we can do the same for income. Here, we'll estimate the money the business has generated from selling products or services during the same period.

Based on history, we can identify trends in our income! To create accurate revenue projections, consider factors like historical sales data, industry trends, and any planned marketing or sales initiatives that may impact your future sales.

Does your business seem to speed up or slow down in certain months according to how much you're bringing in? This may be indicative of seasonality, market conditions, or something else. By looking back at history, we can see those trends and make a plan for a similar event in the future.

At this point, we can pair our knowledge of our breakeven figure and with the historical performance of our sales team. Most sales-oriented small business owners have an intuitive sense about how their market will be over the course of the next few months. Pairing that intuition with the knowledge of what your business needs to survive can help you create realistic projections for sales.

Are you planning to invest significantly in marketing in order to grow your sales channels? Maybe you're about to encounter a significant slow season. Whatever the case may be, it's much easier to create a realistic goal for how you'd like your business to perform when you understand the minimum that you need to bring in.

When making these revenue projections, it's important to understand the margin that your business makes based on the Cost of Goods Sold expenses you have. These costs are directly associated with the revenue that you're bringing in and the service that you're selling. For example, a candle company has to pay for the actual products they plan to sell in order to make any more. These costs are often best broken down as a percentage of your income, which you can identify based on history.

After subtracting your future Cost of Goods Sold from the future gross revenue your business is planning to generate, you'll find your gross profit. Then, subtract your total expenses from your gross profit in each period to find your projected net income.

Expenses and income aren't the only things to be keeping track of when it comes to creating a robust financial forecast, unfortunately. Our third and final key element has to do with financing and investing activities that affect your business's cash flow.

Cash flow forecasting involves estimating the inflows and outflows of cash within your business over a specific period. These are typically items that your business is responsible for paying, such as a debt premium.

Leveraging a cash flow forecast helps you understand your business's liquidity and its ability to meet short-term financial obligations.

By focusing on these key elements – revenue projections, expense projections, and cash flow projections – you'll be well on your way to creating an accurate and useful financial forecast for your business.

As I mentioned before, all projections are built on assumptions about what's going to happen in the future. Therefore, it's important to regularly update and adjust your forecasts to ensure they remain accurate and relevant.

As you gather new financial data and gain insights into your business's performance, refine your assumptions and projections to better align with your current circumstances. This ongoing process will help you stay agile and make informed decisions as your business evolves.

Real quick, there are four key things I want you to remember when building any kind of forecast:

First, set realistic expectations about how your business will perform. It's important to avoid overly optimistic or pessimistic forecasts. Leverage your intuitive insights from running your business to create realistic projections that consider the potential opportunities and challenges you're going to face in the future.

On a similar note, stay flexible and adaptable. Remember that forecasts are not set in stone. Be prepared to adjust your projections and plans as new information becomes available or circumstances change.

Seek input from team members and experts - do not do this alone. Work with an accountant, bookkeeper, financial coach, or any third party that can offer an unbiased opinion about the performance of your business and what's possible. Creating a plan for the future in a vacuum, devoid of feedback from anyone else, is a recipe for disaster.

Finally, utilize forecasting tools and software. There are incredible platforms and tools, even spreadsheet templates that can help make this seemingly insurmountable task easy. As long as you build the right financial foundation, you can leverage the financial data that your business is creating and interpret it using various tools and software available to help streamline the forecasting process and improve your accuracy.

Financial forecasting is an essential part of planning for the future of your business. By following these steps and tips, you can create accurate and useful forecasts that will help you make informed decisions and ensure the long-term success of your business.

And that brings us to the end of today's episode on financial forecasting.

I hope you found this discussion on the importance of forecasting helpful! Don't get discouraged if you're struggling to grasp how the process should work. It takes time and experience to unlock the full potential of these things!

Make sure that you're subscribed to the Profit Plot podcast on Spotify, Apple Podcasts, or wherever else you get your podcasts from. If you found today's episode particularly insightful, please share it with a small business owner in your life so that other entrepreneurs can benefit from this valuable information. The more knowledge we can share with one another, the better off we'll all be.

Join us again soon as we venture to unlock the financial story behind your profitable business. Looking forward to having you here with us next time, on the profit plot.