In this two-part series of articles, the author shows you how to improve forecasting accuracy using...
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In the first part of this series, we discussed the importance of sales forecasting accuracy and how to improve it by employing proven quality methods. I showed how you can improve your sales forecasting accuracy and explained why it is important.
In the second part, we will discuss three components that rely heavily on an accurate Balance Sheet (BS): the Return on Capital Employed (ROCE), the Working Capital and Cash Flow.
Balance Sheet
The Balance Sheet comprises assets, liabilities and equity. However, there may not necessarily be a split in how you should handle things. Three important measures are calculated from the Balance Sheet, so these three abovementioned components are crucial.
ROCE can have greater strategic importance, while Working Capital and Cash Flow tend to be more volatile. ROCE depends on total assets, including Plant, Property and Equipment (PP&E). These are your long-term assets, and they depend on a long-term investment strategy.
Return on Capital Employed
When working with ROCE, PP&E is the main component that is not covered by other ratios. It is essential to collaborate closely with business leaders on this matter, as PP&E significantly influences a company's ability to enter new markets or expand within existing ones. Additionally, it plays an essential role in Cash Flow analysis, as understanding the timing of significant asset acquisitions ensures that Business Partners have the necessary funds to make strategic investments, fostering successful business growth.
Achieving accuracy in long-term planning requires direct collaboration with your plants. Each plant should maintain a continuously updated five-year outlook facilitated by asset tracking tools that provide valuable reports and forecasts for machinery replacement needs.
As an FP&A leader, you should consistently update this information. When a plant decides to improve or replace equipment, consolidating this data will be easy and you will be able to look at the overall picture. Having a capital strategy in place is a must.
Working Capital
Working capital is a great source of cash. When I was in college, I learned that “Cash is King.” Understanding when cash can be available is important to the leadership within your organisation.
Another component of your ROCE is Working Capital forecasts, inclusive of inventory, Accounts Receivable (AR) and Accounts Payable (AP). Monitoring your accuracy and then employing the PDCA cycle, as we discussed in part one, will help you improve your accuracy.
For long-term planning, it is important to take note of ratios such as Days Sales Outstanding for Accounts Receivable and Days Payable Outstanding for Accounts Payable. Review your ratios over the past couple of years and then consider if there are any strategic differences planned to possibly improve your standings in these two areas. Finally, layer them into your historical data. Only then use your sales to fill in the amounts.
Use the same approach for long-term inventory forecasts by analysing inventory turnover and incorporating strategies for improvement. Include any plans for expansion or reduction within the company. Being actively involved in these discussions is crucial, as understanding the company’s long-term strategy is key to accurate forecasting.
For short-term planning, you can get even more details as you should have a better understanding of where and when your spending may occur. Leverage modern ERP software to pull reports to feed your forecasting data.
You may use your seasonalised sales forecast along with your ratios beyond what is in your system to calculate month-end targets for both accounts and layer them with what has already been determined. Then, you can layer in any expected spending due to capital expenditures (CapEx).
For inventory management, it is crucial to understand factors such as excess and obsolete reserves and when the analysis may occur. Collaborate with the supply chain department to know if any large write-offs or returns are expected. Additionally, work with the sales team to account for special promotions and examine seasonal discrepancies or customer buying patterns, noting any inventory build-up in anticipation of seasonal sales. Reviewing historical data can provide valuable insights into these seasonal trends. It would be true if there were issues with your AR or AP, especially at year-end when companies prefer to hold cash, likely causing a spike in AR.
Cash Flow
All these components (PP&E and Working Capital) impact Cash Flow forecasting, especially today when the business needs more accurate forecasts because inflation is pushing interest rates higher.
Cash forecasting is imperative for keeping your company in business. Nobody wants to run short of cash and be unable to pay salaries and taxes. Short-term planning is crucial for the other Balance Sheet items that are large in cash. It can be payroll, prepaid assets, benefit plans, bonuses, taxes, and other items with a cash outflow.
That is why understanding your AR and AP is very important. Let me illustrate how seasonality may affect your cash standing. For instance, if you have an annual bonus payout to employees in April but experience a seasonal sales lag during the same period, you know how much you may need to borrow in the short term until your sales and AR can cover the borrowed amount.
Wrap Up
In summary, we examined forecasting accuracy, which is crucial because many company decisions rely on the forecasted data. Forecasting can allow business leaders to understand what calculated risks they can take, when they should enter or exit particular markets, and when they should make long-term strategic CapEx decisions.
When you work in forecasting, it is important not to get into political discussions within the company. Stick to objective facts. Having your forecasts as accurate as possible is very helpful when determining what risks can be taken to streamline the company’s growth. However, FP&A cannot eliminate all risks. Risks will always exist, but our job is to help leaders calculate them.
Your main focus should be on the level of detail relative to the forecast's time frame. The shorter the time frame, the more detailed and accurate the forecast should be. For example, if you are mid-month and preparing a sales forecast for the entire month, it should be highly accurate, and any discrepancies should be easily explainable. If you look at a five-year period, expect less accuracy depending on your industry. Nevertheless, you should track what and why has been missed, use the Plan-Do-Check-Act cycle, and learn from mistakes to keep improving your forecasting accuracy in the future.