Understanding the strategic imperatives of financial forecasting in your organization

Today, in many organizations, management and financial analysts tend to focus and spend significant efforts on analysing historical sales, current income data and cashflow as a path to guidance for the assessment and interpretation of financials and growth in revenues.

But there is an increasing need for organizations to shift their focus and time towards a strategic indicator which can act as the key determinant of sales growth, financials, or valuation. That is financial forecasting.

Forecasting as a strategic tool is becoming increasingly crucial and indispensable for assessing and improving the business value. For instance, an organization’s enterprise value financially is based on its present discounted value of its free cash flow projections. Through forecasting of future cash flows, you can develop a game plan for achieving the earning objectives. Insights into the future say for 2 to 3 years ahead, can help evaluate the viability and effectiveness of your business strategy with a focus on meeting longer term goals.

Furthermore, forecasting can guide from an operational perspective such as for instance, to realize a 3X growth in the future, what sort of operational initiatives and core product or services business drivers should be augmented. This would let your business to change and tune its resources, process, and technology elements between making longer term strategic investments and tactical, short-term sales & marketing investments.

Financial forecasting as a strategic tool has the following attributes and correlation to your business aspects that you need to understand and leverage.

• The ability to make longer-term forecasts on company’s resource requirements and financials such as revenues and cashflows. Insights into a long-term horizon can help elucidate the effect of improvement in Organizations’ new plans and capability building measures which has less relevance on a shorter-term.

• Forecasting as a strategic tool can help reaffirm your organization’s industry and market position. Forecasting that is accurate and that can quantify uncertainty can provide deeper insights about how your industry and market is evolving and your addressable market share in a national or international market. The available strategic options for business growth based on forecasting can provide a conjecture about what sort of new resources and capabilities you require and how you can steer growth towards results.

• Your organization’s projected growth rates and profit margins especially given a longer-term should shed light on the industry competition and your differentiation. So, if you forecast higher growth rates, you must explain the core drivers, competitive edge, sustainable factors and how much further you would penetrate the markets. Furthermore, projecting into the future and an after-horizon, post-mortem assessment would seek actions for changes, remediation, and improvements from your other business departments.

• A great forecasting can drive stakeholders across your organization to think, plan and act effectively in ways to meet your business growth and financial targets in each industry context and mark dynamics. Therefore, your organization should consider assessment of outcomes of forecasting performance as an opportunity to learn and understand business gaps and challenges and hence be informed and prepared for fine-tuning its choices in business.

• Forecasting in your business is an ever-active process and an observable gauge, that should be periodically updated to observe changes in your operations and market. Rolling forecasts are particularly important if your organization is in an in evolving market or if you have ongoing transformational initiatives. Revised, rolling forecasts epitomize the perspective that business do not typically go according to plan and therefore there is a need to actively peek in to the future, track adjust and then continue to head in the most relevant and promising directions.

Probabilistic Forecasting – Technique for quantifying risks and managing your business goals.

The discussion up to this point has focused on the elements of forecasting and the variety of characteristics and implications in your business. To support forecast based business and financial goals due diligence, all of these elements must be combined and quantified for an understanding of the risks facing your business and for increased confidence that those risks have been properly defined and ultimately mitigated. This section describes probabilistic forecast method for managing your financial performance risks.

Many organizations emphasize its financial projections based on single, point forecasts which often provides a myopic view of the range of possible outcomes. Let us say if you were to consider Cash-flow assumptions, by adopting a process of probabilistic forecasting, you can have insights on a set of conservative and aggressive estimates. For instance, cashflows that may be reached or exceeded with a 90% probability; a baseline estimate, which is met with a 50% probability, and say aggressively estimated cashflow assumptions, which could be met with a 25% probability.

Leveraging a probabilistic forecasting process can help express a realistic picture of the opportunities and uncertainties your business faces and therefore can guide on what sort of business measures you would need to undertake to  achieve the baseline (best case) revenue probability.

Forecasts based on conservative, best case, and aggressive business plan assumptions.

Here we consider a case of forecasting cashflow which is a critical financial element in your organization. One of the big risks in your financial cashflow estimates could be the variability of the internal business factors such as market demand, availability of resources, payment backlogs, competitive dynamics etc. While forecasting improves all the time, no organization can guarantee that its established business with a history of strong market position will not underperform for a period.

Thus, to protect yourself against such under performance, probabilistic forecasting technique is a way that can help you to plan your investments, production and marketing initiatives and therefore de-risk from operational uncertainties and debts.

This involves the consideration of specific probabilistic forecasts of financial cash-flows which are expressed as P values. Typically, P50 and P90 and P25 probabilities can be used for assessment.

For instance for a forecast horizon of a year, A P50 figure is the level of cashflow that is forecasted to be exceeded 50% of the year – in other words the ‘average’ since half of the year’s fiscal outcome is expected to surpass this level, and the other half is predicted to fall below it. it is the most likely, best case outcome each year. The cashflow output using the P50 ranks your business initiatives higher and therefore you would want to promote your organizational projects using the P50 forecast numbers. The investment returns are likely to be better. But there is still a 50% uncertainty of lower cash-flow that can be below the P50 estimate.

A P90 figure is the level of cashflows that is forecasted to be exceeded 90% of the year. This is a more of a conservative estimate and as for your business goals, it comes with a lower level of risk – i.e. 90% of the time the cashflow will be exceeded and therefore your business would more likely meet the financial performance targets in the year.

Hence the strategy between assessing P50 and P90 estimates is that  while  P50 is a best cast average cashflow you can  expect to achieve, you could plan for a conservative assumptions in your product, marketing, sales and services strategy to deliver business outcomes that are met with cashflows based on P90 forecast estimates.

Then checking the case of your aggressive business assumptions that are met or exceeded with a 25% probability in cashflows i.e. P25 forecast overestimates the cashflow only 25% of the time in the horizon of 1 year.

Essentially, probabilistic forecasting helps solve the dilemma about how conservative your business assumptions can be such that your cashflows projections provide you a high liquidity with low risks and at the same time to check if with aggressive assumptions in your business plans , you can meet certain minimal level of cashflows or liquidity in your financials and therefore you have a better way to quantify risks and strategize your business for the years ahead.

Quality of Forecasting

Higher forecasting accuracy is a crucial factor and it enhances the reliability of decision making for your business without surprises.  For instance, Over forecasting of cash flow can lead to unrealistic liquidity scenario in your finance and can increase the risks financial obligations including debts. Whereas under forecasting cash flow can lead to lost opportunities to improve your innovation and business value. Furthermore, in your business if the best case p50 median forecast itself does not materialize; the forecasting process can help notify the possible gaps that your company must address and fix.

To summarize, Financial forecasting acts as a catalyst in your organization to deepen your understanding about the risks you face and accordingly forces your team to consider a path they need to pursue for risk remediation in addition to opportunities and revenue realization. In this way, the forecasting process helps your business to develop a playbook for dealing with uncertainties that may arise. If your financial reporting and assessments is geared up for long term outcomes and can leverage probabilistic and accurate forecasting, it can help your organization make better decisions, de-risk and achieve better outcomes.

Organizations that focus on forecasts and integrate the finance functions into their decision making stand the greatest chance of creating value for their customers, partners, and investors.

1CloudHub Financial forecasting services

1CloudHub as a partner of Amazon Web Services provides state of the art AI/ML based financial forecasting services that is 50% more accurate and with capabilities to forecast multiple probabilistic forecasts of your financials. This can help you leverage the promises of a new era of technology led business and financial growth and owning your future better.
1CloudHub works at the intersection of business and AI technology to help clients improve their business performance and create better value for their stakeholders. For more information about our financial forecasting service, click here