Forecast is a Centerpiece of Business Valuation

Business forecasting is a critical tool that can provide a roadmap that will aid company leaders in making strategic decisions for the coming year and maximize growth. At its core, forecasting involves predicting future trends and outcomes based on historical data, market analysis and relevant variables. 

How does this maximize growth potential? Companies that can anticipate market trends and consumer preferences gain a competitive edge. Forecasting enables businesses to stay ahead of the curve, innovate proactively and position themselves as industry leaders by responding swiftly to changing market dynamics. 

Building an annual forecast is a best practice for all businesses as a matter of strategic management.

But forecasting is also often undertaken as part of a specific project, such as satisfying lenders’ requirements for a large loan or undertaking a business valuation. 

A forecast is a centerpiece of a business valuation, illustrating for potential buyers and other stakeholders what a company’s potential is for future performance in the current economic environment and business marketplace. Even for a company that is not on the market, a forecast serves as a roadmap for meeting the owner’s goals for the coming year. If the goal is introduction of a new product line that will drive a 20% increase in revenues, what costs will be incurred along the way? How many new people will be needed, and what type of new technology? How will the growth be financed?  

The forecast will help answer those questions, enabling more informed business decision making throughout the journey. 

Cautionary Note 

A cautionary note should be acknowledged about doing a business forecast in 2024. Companies typically look at financial and operational performance going back three to five years in order to draw data from which to extrapolate their forecasts. However, in 2024 we are still only three or four years out from the dramatic effects that the COVID-19 pandemic had on many businesses.  

For many companies, COVID-19 was disastrous and resulted in one or two years of depressed sales. For others, such as online sellers and on-demand home delivery services, the pandemic was an economic boom. 

Either way, the historical revenue and cash flow data from those years cannot be used to create a reliable and realistic business forecast. The data must be normalized, if possible, or the business should rely on averages of non-pandemic years. 

Four Segments of a Forecast 

A forecast is a forward-looking document that is based on historical performance and an understanding of the current marketplace. A forecast consists of four key segments: 

1. Revenue  

In analyzing revenue for a forecast, a business needs to look at historical performance over the past three to five years and go beyond the numbers. What is the business selling? Who is buying it and how much? What are the sales trajectories? 

Looking to the future, what are the economic and marketplace factors that will impact the company’s revenues in the next year or two? The COVID-19 pandemic was a good example of an event that was disastrous for many businesses, but beneficial (in terms of business) for others. If you were in the event business, it was disastrous, but if you were a bicycle seller sales were stronger than ever. So, understanding how events – both anticipated and unanticipated – can impact your revenues is key to building a reliable forecast. 

It’s essential to look at internal factors, as well. If you have been growing 5% year over year, what is the likelihood of continuing to do so? Has the company gained a big customer, or lost one? Are you overly concentrated in one customer group or geographic area? Do you anticipate any down time or closures? 

Normalizing revenues and operations is also critical to reaching a realistic and reliable forecast. That means throwing out any revenue numbers that may be attributable to one-time events that are unlikely to be repeated. Remember the bicycle seller? Their business has probably settled back into a normal pattern since the pandemic ended. Likewise with the event planner. Relying on their 2021 revenues for forecasting data would require averaging revenue numbers from a couple of years prior to and subsequent to 2021 to reach a reasonable figure. 

Likewise, adjustments for seasonality must be made. A manufacturer of artificial Christmas trees is likely to see revenues concentrated in the fourth quarter of the year. 

2. Cost of Goods Sold 

If the cost of goods sold for a company has historically been 30% of revenues, they should be forecast at 30% of revenues going forward. There may be some minor variance due to unexpected price increases that could not be passed on to your customers, but generally the cost of goods sold is a stable percentage from one year to the next.  

It’s important to apply overhead and to understand the accounting methods that are used to account for the items that are attributable to the cost of goods sold.  

3. Operating Expenses  

Operating expenses reflect expenses incurred by a business that are not directly tied to the production of a good or service.  

Typically, the biggest factor is administration and overhead labor. This would include salaries for salespeople, office workers, legal, accounting and human resources, as well as the owner’s compensation. Most companies run lean on overhead, and these figures are generally stable from year to year. 

The second factor is related to facility costs, including repairs and maintenance, property tax, insurance, rent (if the building is not owned) and utilities. These costs are fairly fixed but include some discretionary variances. 

The third factor in operating expenses includes travel, meals, entertainment, legal and accounting fees, employee training and engagement and charitable activities, among other costs. This is typically the smallest bucket of expenses and the most variable from year to year. 

If a forecast is being built because the company is for sale, a best practice is to break out the compensation paid to owners, officers and senior leadership and show it separately.  

Pulling out depreciation and interest expense is another good practice that clarifies where expenses really are. Depreciation expense is a non-cash expenditure because you are using an asset and losing value on it while you use it. Interest expense is a discretionary cost. Take those two expenditures, plus non-recurring expenses and include those under “Other Income and expenses.” 

4. Cash Flow 

Central to an understanding of cash flow is understanding that profitability does not equal cash flow. 

Cash flow is determined as profit from net income plus depreciation and interest expense, minus debt service and any working capital.  

As a quick example, consider a manufacturing company that is showing a $1 million loss for the year. It may look like a lousy year to the owner. However, the company had $4 million in depreciation expense after a large purchase of new equipment – meaning it was actually a pretty good year. 

Timing is another factor that is critical to calculating cash flow. For this, look at your accounts receivable. The company may receive an order for which it must buy components, manufacture the item, deliver the item, invoice the customer and wait to be paid. If that’s a 90-day cycle, it must be built into the cash flow calculation. Understanding the timing around cash flow is key to the forecast and will be different for every company. 

Quarterly Review 

The best forecasts are detailed and based on an understanding of the evolving marketplace, but they needn’t be overly complex. It’s a forecast – a prediction of sorts – that should be reviewed quarterly to see if the company is on track to meet its goals or if unforeseen events have intervened. 

Contact an Adams Brown advisor for a discussion of how building an annual business forecast can help move your company forward.