What is three-way forecasting and how is it performed? Colin Wright explains how understanding the future cash position of the business requires quality planning processes. This is achieved through the three-way forecast. As the name suggests, there are three components to this planning process.

  • The profit & loss forecast determines expected cash flows from operational activities
  • The balance sheet forecast determines expected cash flows based on the balance sheet movements of the business
  • The cashflow forecast is determined from the profit & loss and balance sheet forecasts

How well this process will forecast the cash position throughout the forecast period will depend on the quality of the forecast processes. These processes differ for the profit & loss and the balance sheet.

Profit & loss forecasting processes

The business will need to establish the level of detail that is considered in developing the profit & loss forecast. Simply using top level historical sales figures and a growth factor is not sufficient to produce an effective three-way forecast. The key drivers of revenues and costs need to be understood and used to generate the forecasts.

The sales forecast is the starting point. The key drivers of sales might be by key markets, key customers, major projects, or other factors. In many cases it is also necessary to forecast by key product/service groups. The right balance is achieved by having enough detail to generate meaningful and supported sales forecasts, but not so much detail that the processes gets bogged down.

The sales forecasting process enables the business to also forecast the costs of sales. It is likely that the gross profit margins will be determined by factors such as market mix, customer mix or product mix. The sales forecast, if constructed the right way, will enable the business to estimate the cost of sales with some degree of accuracy.

Forecasting overhead expenditure is the final key component. A combination of historical costs and strategic plans are used to determine these forecasts. The level of detail on which to base overhead forecasts will be influenced by the materiality of these costs. For example, remuneration related costs may be a very significant proportion of overhead costs. If this is the case, the business should develop a planning tool to assist with this process.

12 month rolling forecasts

The three-way forecasting process works best when treated as a 12-month rolling process. This enables the team to have a continuous focus and supports more accurate forecasting. It makes sense that the forecast for the next quarter will be more accurate than the forecast for the following quarter, and certainly more accurate than the period 7 to 12 months out.

Having said that, it is important to forecast 12 months out as that will enable the business to be planning for capital expenditure requirements, planning for capacity demands and planning for key operational resourcing needs (e.g. recruitment).

Balance sheet forecasting processes

The balance sheet forecasting can be broken down into 4 key categories. Firstly, working capital which is effectively the current assets and current liabilities. This includes receivables, payables, inventory, other payables (taxes, employee entitlements and other withholdings), prepayments and accrued expenses. Some work is involved in clarifying what the drivers are for each type of working capital account, but it is important because there can be significant cash movements in this area.

Secondly, the non-current assets need to be forecast. What additional assets will be purchased in the forecast period. This is referred to as the capex plans of the business. For some businesses they may have to pay bonds or establish term deposits to support bank guarantees, or they may simply have excess cash that they need to park somewhere until needed.

Thirdly, the non-current liabilities will be forecast. What are the plans around financing capital expenditure or financing working capital? In many businesses there are intercompany loans and related party loans that have a significant impact on cash reserves. Loan commitments need to be included and these could include balloon payments that increase loan commitments significantly at some point.
Finally, there is the forecast for capital movements. This could be the payment of dividends, or alternatively, a planned injection of capital from shareholders.

Once again, the 12m rolling approach to this enables the focus of management to be constantly brought on to the key management issues. Balance sheet accounts can often be neglected as the business focusses on operational demands. The rolling process involved in updating the three-way forecast constantly brings these issues back into focus.

The Virtual CFO Group Australia runs three-way forecasts for all its key clients. This process is an ongoing “review-plan-act-review” process that supports quality proactive management systems within the businesses.

These recommendations are from The Virtual CFO Group Australia. We’re currently undertaking these processes with our clients. Email info@virtualcfogroup.com.au or call 1300 854 524 to discuss how we can help your business to plan your way to be a more successful business in the post-coronavirus environment.