Various studies show that increasing financial forecast accuracy will lead to higher profits, lower inventory levels and a higher share price. By how much varies by industry, time period forecasted, forecast measure, business model and a myriad of other factors that all play into the financial forecast itself. With the speed of business constantly increasing, the ability to determine if financial forecast accuracy was due to better methods or external stimulant gets harder with every passing year.
Why does the financial impact of financial forecast accuracy matter? Because senior executives do not care how accurate a financial forecast is, they care about the impact that improved accuracy has on the bottom line. The ability of a Financial Planning and Analysis (FP&A) team to clearly demonstrate the financial impact of this accuracy will improve its chance to garner the capital it needs to improve business performance and increase its credibility and standing within the organization as a whole.
Benefits to Better Financial Forecasting
It all starts with sales forecasting (also called demand forecasting); the ability to forecast when a customer will buy, at what location and how much of a certain product or service given a certain price is by far and away the hardest job in financial forecasting. Intuitively, the more accurate a sales forecast:
- The higher a company’s revenue due to lower stock outs and/or fewer service delivery gaps
- Lower variable costs due to lower carrying cost of inventory, greater supplier discounts for product inputs and/or staffing levels, increased inventory turns, lower excess inventory and many other variable cost savings
- Enhanced product development timing – If you are able to forecast product obsolescence and/or a declining trend you can time new product introductions that will maximize sales.
Financial forecasting is not only about better sales forecasting. A financial forecast encompasses the impacts of management decisions on the profitability of the enterprise in general. Financial forecasts take the sales forecasts then models the related expenses including the intricacies that financing decisions and tax situations have on the enterprise. It then addresses any financing requirements and helps direct strategy. Better financial forecasting will lead to:
- Better cash flow optimization – If you offer your customers 60-day terms but your suppliers are giving you 30, you may have a cash crunch during high volume periods. More accurate financial forecasting will help mitigate or resolve any issues before they happen
- Stable cash position – In today’s volatile business climate many companies have chosen to hold more cash on their balance sheets as opposed to relying on financing from banks, maintain that safety net takes planning
- Strategic decisions – To optimize total corporate profitability a company will harvest its cash cows and invest in its rising stars. This can be done at multiple levels within the organization including individual product, product line, division or department.
- Capital budgeting – when will new fixed assets or real estate need to be acquired or acquisitions/divestures undertaken.
- Stakeholder credibility – This is one of the greatest advantages to more accurate financial forecasting and is the most overlooked in private industry. If company management can consistently do what they said they were going to do, stakeholder confidence will allow the company to better garner financial support during bad times and more easily capture better financing during good times.
- Increased management accountability – If a manager is unable to consistently meet his/her’s forecast, than a change in leadership may be needed.
Quantifying the Benefits of Better Financial Forecasting
There are multiple ways an FP&A professional may go about quantifying the impact of increased financial forecast accuracy on the business. Unfortunately, there are very few benchmarking studies or public research available on the topic. The reason may be due to the difficultly of attaining the data, its sensitivity and the lack of comparability as every business operates significantly differently even in the same industries.
In order to provide a rule of thumb to help guide those in the FP&A profession, I have examined several sales forecasting studies that can be used as a “rule of thumb” when working to calculate the potential ROI for any financial forecasting improvement projects that they may seek to undertake.
Due to the difficulty in comparing apples to apples, any study can only provide general guidance as to the profit improvement that a forecast accuracy initiative would provide. In addition, the need for an organization to maintain a degree of flexibility is critical to its long-term success, so even if forecast accuracy improved to the point that inventory and staffing levels could be readjusted to take advantage of the greater certainty the risk appetite of management may not allow for the change.
The greatest benefit in increased forecast accuracy may be in the increased credibility with investors and other stakeholders. For private equity firms that own a portfolio of companies, the use of accurate forecasting by its portfolio companies would allow the parent company to re-allocate cash upwards to the private equity umbrella for re-investment as opposed to being left in low interest accounts at the subsidiaries.
What is Your Forecast Accuracy ROI?
When modeling the effects of forecast accuracy it is important to look at both the balance sheet and the income statement for savings. Greater efficiency will lead to lower cash utilization that can then be reallocated to investments that produce a higher return.
A model posed by the operational forecasting expert Dr. John T Mentzer in the fall 1999 issue of The Journal of Business Forecasting puts forth a modified DuPont formula as a base in which to measure the impact of forecast accuracy has on a particular company’s performance. Although the model was meant to determine the financial impact of sales forecast accuracy, due to the inclusion of all expenses, it can also be used as a measure of overall financial forecasting as well.
The DuPont model is framework in which to view the impact of changes in sales, costs and capital have on the return on company assets and is expressed through the following formula:
This formula breaks down even further to: Return on Equity (ROE) = Net Profit / Shareholder’s Equity. Shareholder’s Equity is equal to invested capital + retained earnings – treasury shares (if applicable). This formula allows investors to calculate the return they are receiving for the capital they invested. Dr. Mentzer pulls out the retained earning – treasury shares component of shareholders equity as he believes that it is a financial decision of company owners.
This leaves the equation ROE = Net Profit/Invested Capital and is shown in further detail through the equation below:
By entering in the information from a company’s trailing twelve-month’s income statement with its most recent balance sheet, you then have a baseline ROE in which to pivot and run scenarios as to the effects that a more accurate financial forecast would have.
Is this the only way to measure financial forecast accuracy impact? No, but it provides a starting point in which to analyze any potential investment in financial forecast improvement. Financial forecasting is more art than science. FP&A teams should always strive for greater financial forecast accuracy while balancing enterprise risk and market uncertainty.