The importance of 3-Way Forecasting in the growth phase of your business
This article discusses the importance of 3-Way Forecasting in a growing business because:
- growing businesses face unique issues
- management need strategies for a range of outcomes
- a detailed understanding of the drivers of revenues and costs is critical to business success
- a detailed understanding of the impact of the balance sheet on cash reserves is critical to business success
- incorporating a 3-Way Forecasting system into the planning and operational activities of the business provides clarity on the impact of key drivers of business performance
Growth businesses – unique issues
Growth businesses face a range of issues that mature, low-growth businesses do not. This places additional demands on management decision-making. Issues that are either unique or more demanding in a growth business can often include:
- volatile sales outlook
- a higher proportion of low-profit customers or products/services
- an element of the workforce that are still building experience/skills in their role
- a higher level of recruits who are being trained and tying up other valuable resources
- capacity constraints and changing productivity levels
- changing system demands that require further development
- changing management structures in response to growing team sizes
- volatile cash movements in response to changing working capital and withholdings demands
- often a higher need for funding & equipment financing
These are only a few of the typical issues that the growth business may be dealing with. This situation is compounded by the fact that this type of business is typically under-resourced as well. This is due both to, the need to keep tight control over costs, and to the fact that the business is uncertain about its financial position in the near term, and so, errs on the side of caution. However, it is the lack of financial visibility that is the major constraint in this situation. This is a cost management paradox for the business. Under-resourcing the business is more likely to cause higher costs than to reduce costs. In an under-resourced business, costs will not be managed as well, and mistakes and oversights will be more prevalent. This, in turn, creates more work and further ties up scarce resources.
But for management to make good decisions on resourcing, it needs to have clear financial visibility of the near-term future of the business. It needs to understand the impact on its most critical resource, cash.
Strategies for a range of outcomes
The growing business needs to be able to plan for a range of situations. This can best be achieved by developing models that allow the team to understand the full impact of different growth levels. The questions it needs to be able to understand and have an answer for are:
- what is the impact of changes on our targeted sales levels?
- what is the impact of different mixes of sales (customer mix, product mix, channel mix, or territory mix)?
- how will scale (or lack of it) affect our cost of sales?
- are our planned sales, general and administrative cost structures appropriate under different outcomes?
- what levels of working capital do we need to fund under the various outcomes?
- what are our capacity constraints and, under various outcomes, will we have sufficient capacity to service our sales outcomes?
- if we need to raise capital, can we provide lenders/investors with valid projections that will support their lending/investing criteria?
Growing businesses need a dynamic strategic planning environment. They certainly cannot rely on an annual budget to meet their management needs. The business needs to be able to modify its plans in response to the changing environment it operates in, and to the changing relationship between its expectations and its achievements.
To do this, the growth business needs to use a dynamic planning process. The ideal process is to implement a “Rolling 3-Way Forecast” approach to planning. We recommend that a quarterly review be undertaken and that a 12m rolling period be used. Our view is that the “financial year” is a Tax Office construct that should have no influence on the planning process for a business (other than its impact on some costs and the timing of when the tax will be paid).
Rolling 3-way forecasting is a powerful management tool, however, business owners should be aware this is not a once off exercise. Nor is it something that they should seek from their tax accountant or other consultants that do not work closely with management. We see this process as a part of the critical management routines within the business. Whilst it will be overseen by your CFO (or contract/virtual CFO), it needs to be a “bottom-up” plan. This means that the assumptions and key drivers used in the forecasting model need to be provided by those members of the management team that best understand the achievable outcomes and the likely constraints.
3-way forecasting models need to be built around the drivers of business performance. There are many, many moving parts in a business, so the model needs to be modular. This allows different departments within the business to provide the input to that part of the model that they have control over. Additionally, this builds a critical sense of ownership within each of those departments.
And most business owners would have experienced the difficulty of getting key managers to take ownership of a budget that has been imposed on them.
Are there “off the shelf” 3-way forecasting models available? Well, yes there is, sort of. Every business is unique and therefore a 3-way forecasting model needs to be designed specifically for the business. There are of course principles and structural components that are common to all businesses, and these do need to be complied with.
We believe that there are some basics that the 3-way forecast model must meet. These include:
- it must be built around the drivers of revenue and cost for that business ($ should be an outcome of drivers, not just a direct input)
- the forecast must be compared to historical trends (for context)
- it must be modular to allow input from specific departments (bottom-up)
- it must have data integrity checks to ensure it is producing valid outputs
Where groups of companies are involved, a group model should be developed as well. The group model should include consolidated reporting applying intercompany eliminations. Forecast metrics, including bank covenants, can be included in the group model.
EBITDA – the only sustainable source of cash
Although funds are provided to the business by investors and debt lenders, the ultimate need of the business is for its operations to generate cash. The primary purpose of all businesses is for its operating activities to generate free cash flow to:
- meet the ongoing commitments of the business
- support the future growth of the business, and
- provide a return to the owners of the business
In the long run, this can only come from profits. In the short term, the business can fund its growth needs from other sources (debt & equity), but this is always based on the premise that the operations of the business will ultimately generate the free cash flows to meet the above stated needs.
Gross Profit
The key cash-generating metric of each business is its gross profit. Revenues and cost of sales (or cost of goods sold) will usually have a relationship with each other. The cost of sales will include a range of costs. The relationship between these costs and the revenues needs to be well understood. The drivers of revenue and cost of sales are the primary factors in the forecasting process.
Revenue is a combination of sales volumes and unit pricing. All students of economics understand that there is a relationship between sales volume and sales pricing. This is referred to as the elasticity of demand. However, for most growth businesses the relationship between sales volumes and pricing is a more obscure relationship. Market awareness of your products/services and the business’ value proposition can be a major constraint for many growth businesses.
The sales forecasting drivers will be different across different businesses. Ultimately the business will need to decide on a methodology for structuring its forecasting model. The categories that impact on sales and will also determine gross profit margins include:
- product/service types
- product/service groups
- projects/jobs
- territories
- channels
- key customers
- discount/rebate offerings
The drivers of cost can be determined in relation to the revenue types listed above. For example, margins in a wholesale channel would be lower than margins in a retail channel. Cost of sales will also be determined by other factors including:
- input purchase prices
- direct labour unit costs
- productivity levels
- waste levels
- foreign exchange rates and freight costs
The challenge for forecasting models is to find the relationships that are relatively direct but are not so complicated that the process becomes too difficult to maintain. Models can also use a standard cost approach to forecasting costs of sale.
Many businesses have a fixed cost element within their costs of sale (e.g., factory rental costs or production management in a manufacturing environment). Modelling will use a contribution margin measure as well as a gross profit measure to build consistency into the model. The two measures are best described as:
- Revenue – variable direct costs = Contribution Margin
- Contribution Margin – fixed direct costs = Gross Profit Margin
The classification of expense accounts as cost of sales or overhead expenditure is an important factor here. While there can be some grey areas, the following question needs to be addressed. Is this cost incurred due to activities involved in producing/delivering our products or services?
Overheads
Overhead expenditure is generally an easier area to forecast. For many businesses, overhead costs are often dominated by remuneration costs and sales & marketing costs. For the growth business, these can be more volatile, and the business needs to be more responsive to current performance.
The timing of additional staffing needs to be timed appropriately and sales & marketing plans would be under constant review. This need for ongoing review is best supported by a rolling forecast process and is not particularly suited by the annual budget process.
Balance sheet – a volatile driver of cash movements
Forecasting balance sheet changes can be somewhat more complex than forecasting profit and loss outcomes. It is fair to say that, in general, businesses focus heavily on their profit & loss reporting and have less focus on forecasting their balance sheet movements. 3-way forecasting gives the balance sheet movements a more prominent emphasis.
There are five broad areas of balance sheet movements that need to be forecast. These are:
- working capital
- withholdings
- fixed assets and investments
- loans and other long-term liabilities, and
- owner dividends and drawings
Cash is not actually forecasted in a 3-way model. It is the balancing figure. That is, the forecast EBITDA, plus forecast “other” income/expenses, plus the forecast movements to the five balance sheet areas results in a net cash inflow or outflow. The forecast cash position then becomes the starting cash balance plus the net cash inflow/outflow generated by the forecast.
Each of the five forecast areas has its own unique issues to deal with when forecasting for the upcoming period. There are usually factors that are business-specific as well. These are due to the type of business, existing trading and operational arrangements, and the business cultures, norms, and regular practices within each business.
Working capital
At its most basic, working capital forecasting can use basic metrics such as debtor days, stock turns, and creditor days. However, in practice, it can be more complicated. Receivables forecasting can be complicated by bad debts, intercompany sales, or special offers. Inventory levels can be influenced by the existence of slow-moving and redundant stock, by long lead times where stock is made to order or purchased from overseas, or from stock build-ups ahead of seasonal production. Payables are more complex to forecast because a proportion of expenses do not come through the accounts payable process. Examples of this include remuneration costs and on-costs, and a range of prepaid expenses.
Withholdings
These can have a substantial impact on cash movements at different times. Businesses collect and pay GST, they withhold PAYGW from payroll and they withhold superannuation and payroll tax. There are generally arrangements in place with the ATO to pay income tax based on a predetermined formula
(eg: % of sales levels). This can be considered a prepaid withholding. And each of these withholding types could be paid by the business at different times, usually monthly or quarterly.
Fixed assets and investments
Capex plans need to be factored into the forecast. Fixed assets are purchased to contribute to output or to support management and administrative performance. We have found the annual budget process to have weaknesses in this area. Capex plans will regularly change in relation to timing, and this is best suited to a rolling forecast process. Capex costs can exceed planned levels and the implementation process can often be more demanding than initially thought. All of these issues can be best addressed when management can be responsive and can modify near-term plans in this area.
Loans and other long-term liabilities
Planning new financing requirements can be a key to successfully acquiring the necessary funding. Nowadays, most lending bodies are requesting 3-way forecasts to support their financing decisions. The 3-way forecast will demonstrate; the need for funding (its purpose), the business’ capacity to meet repayments as they fall due, and the business’ covenant position in relation to the lender’s required covenants.
Planning to meet upcoming balloon payments and other major liabilities that are falling due in the next 12 months is also undertaken in the forecast. This could include the repayment of shareholder loans or other related party loans.
Owner dividends and drawings
Finally, owner dividends need to be included in the forecast model. This can provide owners with a greater level of assurance that the planned dividends will be paid at the appropriate time.
The role of the 3-Way Forecasting System
The 3-way forecasting process can be an annual process, (annual budget), however, we believe that the 12m rolling forecast is a more valuable process. For most businesses, we would recommend a quarterly renewal to become a part of their management calendar.
The quarterly focus enables this to be at the forefront of management’s mind. The regular focus on profit and cost drivers and the management of balance sheet parameters aligns the regular management functions with the forecasting strategies.
The business can respond to significant changes in its business environment. Whether this is the loss (or gain) of a major customer, the emergence of a new competitor, new technologies disrupting your industry, new legislative requirements, or even the emergence of a major pandemic, the business will respond by modifying its forecast to reflect these changes.
Too often we have seen annual budgets being ignored by Q3 or Q4 because the assumptions on which they were built are no longer appropriate. We see the financial year as something that is appropriate for tax reporting, but which is of little relevance to business performance (we note that bonus incentives and other hurdles can still be linked to the financial year forecast).
Using rolling 12m periods for reporting and forecasting removes the seasonality from performance measures and provides a consistent management focus throughout the year.
Instant improvements and ongoing continuous improvements
Once a business implements this process into its management routines, it will start to get immediate benefits. This has strong parallels to the ‘continuous improvement’ cycle. The 3-way forecast improvement cycle is depicted below:
The Virtual CFO Group Australia has well-developed 3-way forecasting models that it uses with a range of clients. These have been developed for a range of business types whose operations include manufacturing, service delivery, 3PL, and wholesale/retail both within Australia and internationally.
We have developed a clear understanding of how to generate real value from the process. The processes will work differently across different businesses. In each case, the growth outlook, business maturity, and resource capabilities of the business are critical factors that are taken into account when developing a rollout and maintenance program.
