Small Business Series – Mistake 7A:
Continuing our series of common mistakes that small businesses may make, mistake 7A will consider businesses that are not adequately forecasting or projecting their income statements and balance sheets. A forecast takes a look at financial events that are expected to happen and in a forward-looking manner, approximates what the outcome will be. A projection takes a “what if” scenario and does the same thing. If these tools are not consistently and effectively implemented, businesses often miss the opportunity to identify areas of concern and have the appropriate proactive action and communication. Additionally, the best laid plans can potentially produce unintended short-term and/or long-term financial problems.
Mistake 7 will be broken up into two installments. In this installment, we will look at the value of preparing financial forecasts/projections and the dangers of not using them. The second installment will focus on how financial ratios and metrics can be utilized throughout that process.
For internal users, forecasts/projections can outline a path for the business to follow in order to meet their short and long-term goals. They can also identify the risks of straying from the path. When done to their fullest potential, both income statements and balance sheets can be completed.
Dangers await for those who choose not to take advantage of forecasts/projections. The best completed and executed income statement can be entirely invalidated by an out of control balance sheet. The strongest balance sheet can quickly deteriorate if it is not supporting a strong income statement.
When a small business enters into a relationship with a bank or other creditor, the bank or creditor will often times have financial expectations for that business. Let’s take a look at a few different scenarios of the impact that using financial forecasts/projections can have for external users. In each scenario, the following is true: “A small business has a standard line of credit and term loan with a bank. In this example, let’s say they have multiple covenants that the bank expects them to meet or they risk going into default. The small business meets the covenants for the first two years”. From that point, they all take different turns.
With no proactive warning to the bank, at the beginning of the third year the small business leases a new warehouse to prepare for anticipated growth. As a result, they experience heavy upfront costs and inventory growth before their anticipated revenue is realized and experience a down third year, resulting in failed covenants. The bank gives them a standard waiver. The revenue in the fourth year does not meet expectations and the covenants are failed again. No forecasts or projections are provided to the bank for the fifth year. Result: The bank has lost confidence in the client, due to a lack of communication from the client and a perceived lack of ability to meet their established covenants going forward. After the covenant is failed in the fourth year, the bank respectfully asks the small business to look for a new bank.
Part way through the second year, the client approaches the bank to let them know they have been running forecasts for the third year and anticipate that they may struggle meeting their third- and fourth-year covenants due to planned expansion. They present forecasts to the bank with different scenario models built in, explaining what they are planning to do, along with potential favorable and unfavorable variables. They expect to be in compliance with the bank’s existing covenants by the fifth year. Result: The bank proactively removes the covenants for the third and fourth year, and favorably makes changes to the existing covenants for the fifth year to give a cushion. The business meets the adjusted covenants in year five and is back to meeting the original covenants in year six. The bank and business continue to have a strong relationship built on reciprocal decision-making and a shared vision for the business’ long-term goals.
Part way through the second year, the client approaches the bank to let them know they have been running forecasts for the third year and expects that they may struggle meeting their covenants for the third and fourth year due to planned expansion. They present forecasts to the bank with different scenario models built in, explaining what they are planning to do, along with potential favorable and unfavorable variables. They expect to be in compliance with existing covenants by the fifth year. Result: The bank does not proactively adjust the covenants at the business’s request. The business adjusts their plans and restructures some of their debt, so that they can still pass their covenants in year three and four. At the end of year five, they are slightly behind where they want to be in their growth pattern, but they continue to have a strong relationship with their bank.
Discussion of Scenarios:
Each of these scenarios have played out countless times. The ability to effectively project/forecast has been and continues to be a valuable skill set of accounting professionals and a critical tool for small businesses. They can play a critical role in the long-term viability and success of a company. Forecasts can quickly be turned into projections as well.
Inherently, forecasts/projections are not perfect and do have risks. There are always unknown variables present that cannot be accounted for or anticipated. A solid practice is to prepare a forecast/projection, updating it as time progresses. If an unplanned for event takes place, update the forecast/projection to determine the impact and adjust plans as necessary. That is the beauty of the process! It can be fluid. Once the foundation has been made, they can be built upon and updated moving forward.
Creating forecasts/projections and keeping them updated does take time. With that said, countless successful businesses have found time and time again the value that they create. Give it a try and see what you think.
See previous installments in the Small Business Mistakes Series:
- Confusing Knowing Trade with Knowing a Business
- Forgetting ‘Achievable’ When Setting SMART Goals for a Small Business
- Failure to Implement Proper Capitalization Planning & Equity Retention in Your Business
- Failing to Price or Buy Appropriately
- Ignoring GAAP or Tax Effects of Business Decisions
- Avoiding Difficult Decisions in Your Business