Can you tell if the budget you just put together is achievable? If you are still budgeting and then re-forecasting only your revenue and expenses you may have already run into a well known, yet often ignored phenomenon: Missing budget revenue targets due to cash shortages, inadequate credit lines, or poorly timed financing arrangements.
This scenario is very common during periods of growth, where a company must forecast its revenues and expenses required to achieve growth objectives during the duration of the strategic plan and budget. For example, companies that are in high growth industries – and even established enterprises that cannot achieve very high gross margins – may quickly find they have the potential to become very profitable, but invariably run into one or more cash crunches along the way. In fact, many organizations will not be able to deliver the results outlined in their budget if they are only forecasting revenue and expenses. Of course, there are other reasons why companies miss their budget numbers, but this discussion only focuses on the impact of poor and incomplete planning and budgeting.
Forecasting revenue and expenses is relatively easy if you have a solid strategic and operational plan. The end result will be a forecasted income statement with columns of numbers for all periods in your budget. However, this is where the trouble begins, since most companies are using accrual based
Consider this scenario: If you are a product based business, achieving your forecasted sales means you also need to have inventory on hand. This inventory must be readily available to ship in the period in which you forecast this will be executed. It also means that you most likely have to either buy or make that product in a period earlier than the timing of the sale itself. This implies that you had to spend cash either on the purchase of the finished product or on raw material, labor and outside services, all of which has occurred prior to the period in which the sale took place and with different vendor payment terms.
Now consider how difficult this scenario becomes if you are forecasting new products or services that have not yet been developed or tested. Research and development expenses are often necessary prior to introducing new products and will most likely show on the forecasted income statement. However, judging by the Income Statement alone you won’t know whether or not you will have the cash to perform these activities. If you are unable to complete R&D, testing, certification, and so on, your new product availability may be delayed or the entire new product line may be cancelled, which will drastically alter the ability to achieve the sales forecast for the new product line. The conclusion here is that you need to have visibility into your cash balance during the budget period.
Will your forecasted Income Statement tell you whether or not you will have the cash to accomplish all that? Of course not! To do that you need a forecasted Balance Sheet and a forecasted Statement of Cash Flows which will further clarify when and where this cash is coming from (in what amount, from what source and in which period). These two statements must be tightly linked to the Income Statement and dynamically change as budget items affecting the Income Statement change, or as various versions and budget scenarios are evaluated. A budgeted profit and loss statement that most companies prepare annually will never accomplish that.
If you have a complete and accurate forecasted Balance Sheet and a forecasted Income Statement you can relatively easily compile a forecasted Statements of Cash Flows. From there you are empowered with the insight needed into the future financial health of the company, and particularly into your cash needs along the budget timeline.
But don’t rely on
For instance, when the forecasted Balance Sheet accounts are automatically updated by the software in each budget period with debits and credits, as derived from the forecasted revenue and expense lines and reflecting all activities dictated by the budget, the result is a consistent, complete and accurate Balance sheet for each period defined in the budget. The Statement of Cash Flows will be just as accurate and complete since it is generated from the forecasted Balance Sheet and Income Statement.
Finance professionals must forecast beyond just revenue and expenses in order to deliver better financial insight to their executive teams and line of business managers who depend on accurate data. Developing a forecasted Balance Sheet and Statement of Cash Flows will not only provide a clearer picture of what the organization can realistically achieve in the near term, but provide the direction needed to help the company succeed in the future.