This is CFO Secrets. The weekly finance newsletter that likes hot butter on its breakfast toast

5 Minute Read Time

In Today’s Email:

• 👎 How NOT to use a forecast

• 👨‍🏫 An M&A Masterclass

• ⏳ How I spend my time

THE DEEP DIVE

Forecasting Culture: The Hidden Cost of Overforecasting

This is Week 3 of a 6 week series on FP&A.

“That’s the fourth consecutive month. Is this a joke?”

I’d had enough.

I was four months into a new Group CFO role.

This was the fourth monthly performance review I’d attended for this particular business unit.

And now this was the fourth time I’d sat through this management team call down their expected EBIT out-turn for the year.

Salami slicing expectations down four times in four months was a new record for me.

In my first meeting they announced, they were expecting a $4m miss against a budget of $25m. Here we go, I thought. Using a change in Exec to reset their base point.

But in the second meeting $21m EBIT became $20m.

In the third: $18m

Fourth: $15m

There were only two explanations for this:

1. They were out of control, and had no grip on the business.

2. They were drip feeding bad news in to ‘soften the blow’

I’m not sure which was worse.

Either way, I’d lost patience with Stuart, the CFO of the Business UNit.

Then he said the thing that made my mind up. I’m paraphrasing, but the gist was …

“We’ve been running the rolling forecast each month. And we are sharing the answer with you the forecast model is spitting out. What more do you want from finance.”

This pushed all my buttons:

• Lack of ownership over the output. Unacceptable from a Business Unit CFO. Especially one who took home over $500k the year before (and this is many years ago).

• Lack of impact over the outcome (reading the news vs making the news)

• Blinded by the process. Unwillingness to step back and see what matters behind the numbers

• Had no understanding of downstream implications. The gap created a cash hole. And it would blow out guidance with the market. He hadn’t even thought about those points.

Stuart was gone a couple of months later. Let’s call it ‘musical differences’.

But beyond the performance issue. Stuart’s legacy was a poor culture in the business. One that spent too much time forecasting, and not enough time executing.

On a constant treadmill of replanning bottom up assumptions and iterating.

Not just in finance, but across sales and operations too.

Unforgivable.

Meanwhile gross margins were being eaten by cost inflation and mix issues. Operational inefficiencies were destroying productivity.

It had prioritized forecast accuracy and process over execution and performance.

A disaster.

I’ve been vocal on my dislike for rolling forecasts in the past on Twitter.

Today I want to bring some nuance to that perspective. And help you work out the right way to use forecasts in your business.

A health warning before we start.

I’m not going to talk about financial modeling. I will assume that you are comfortable building a three statement model, driven by business KPIs. That's the foundation for what follows.

And beside … modeling is the easy part of forecasting.

First things first…

What is a forecast?

Here’s the first problem.

The term ‘forecast’ gets used broadly. It can mean so many different things.

But here we atalking about the process of projecting future financial outcomes for the rest of financial year. I.e. the year you are currently in.

To recap on where we are in the FP&A cycle:

• We started with the Long Term Plan

• Year 1 of the Long Term Plan evolved into the Annual Budget

• We are now into the reporting year, and have published monthly accounts reporting performance vs that budget

• Now we need to keep our projections for year 1 live (because the budget has started to become stale).

That final bullet is the focus of this post.

How are forecasts used?

This varies by business. It depends on the industry, system capability, team capability. Not to mention the whim of the CEO and CFO.

Good businesses are not blindly following a templated forecast process.

They are designing a bespoke process to drive performance in their business.

Let’s look at a few typical forecast approaches.

Quarterly Forecasts

This is the most common approach. A re-forecast at the end of each quarter.

Q1 forecast aka 3+9 = 3 months of actual + 9 months of projections

Q2 = 6+6

Q3 = 9+3

This tends to time well because 6+6 makes a timely base for Year 0 of the LTP.

And 9+3 can be the base for comparatives for next years budget.

Monthly Rolling Forecasts

Especially common in businesses using SAP, and other deeply integrated ERP systems.

From 1+11, 2+10, 3+9. Etc etc.

Many businesses like this approach, and so did Stuart. Because they have a frequent latest view of their performance out-turn. It financializes sales and operations planning decisions.

It sounds and feels neat and tidy.

I don’t like it.

It consumes a lot of resource and focus. The forecast process is high profile. But no single forecast version has any real gravitas in the business. It introduces more variables which makes it harder to keep people accountable.

The ground is constantly shifting, and it can bury many sins.

Bespoke Routine Forecast Cycle

Half way between a rigid quarterly process, and a rolling monthly process. Some businesses use this approach to ensure their forecast cycle fits their calender.

They are still running a formal reforecasting cycle, just at specific points that suit them.

I worked in a business early in my career that had two formal re-forecasts a year. One at Period 4 (a 4+8) and one at period 8 (8+4). The 8+4 was the base point for LTP and Budget.

I like this approach, because it suggests the business has thought about what works best for them. Rather than applying a textbook quarterly or monthly approach because it sounds tidy.

Dynamic Forecasting

There is an emerging trend towards real time dynamic forecasting. Called ‘Integrated Business Planning’.

Concept: you have perfect real time harmony between your operational and finance KPIs. And all the way through your supply chain.

With each replanning of the supply chain you see the impact on the forecast financials, in real time.

The major system implementers are out selling this as a utopian vision. I had a Big 4 partner pitch this to me this week.

I’m sure this will only get bigger.

And AI will speed up the move, especially if it can help clean up one of the biggest blockers to this working; data quality.

Business culture is another big barrier, AI won’t fix that.

Risk & Opportunity Forecasting

This is more of an offline process.

Using the budget (or a previous forecast version) as a static reference point.

Tracking the small number of big things that cause deviance from that reference point.

Risks being the negative drivers, and opportunities being the positive drivers.

This is tracked throughout the year. For full financial year revenue, EBIT and free cash flow as an example.

I like this approach because it’s simple, it is action oriented. And it maintains the integrity of targets and performance management.

There are a much smaller number of variables involved, and there is a clear reference point.

It’s very easy to put names, dates and actions against those risks and opportunities lines. It’s much harder to do that with an ever changing detailed 3 statement model.

But Which Approach is Best?

It depends, of course. (I’ll come back to what it depends upon later).

But before we do, there is a principle to establish.

And its important.

Let’s go back a few week’s to when we defined the purpose of FP&A…

Forecasting by definition means you are consuming business resource looking into the future. I.e. not looking at today.

The best performing businesses I’ve seen. The ones who squeeze every drop of shareholder value, all have one thing in common.

Great businesses spend a disproportionate amount of time executing.

90%+ of leadership energy and time was laser focused on execution. Sure there was half an eye on tomorrow. But they trusted their periphery vision for that.

The focus is on delivering today.

Drive the KPIs as hard as possible and the numbers will take care of themselves.

Behind the scenes, and especially in the back offices, things were a bit chaotic.

But relentless in delighting customers. Forecasting was only valuable if it helped them do that.

Jerry Seinfeld said it best:

In this analogy. Jerry and the writer’s room are the business, and McKinsey is the forecasting process. And “Are they funny?” is “will it improve my P&L or cash flow”?

Anyway, rant over. Here are a few things you can think about when designing your forecast process:

• Purpose; who is the forecast for? Is it to drive performance? Or is it for a corporate purpose?

• Frequency; monthly, quarterly, twice yearly, once yearly, adhoc

• Timing; where does it sit best in the cycle (timing of LTP and Budget will influence this)

• Static or Rolling; linked to frequency. Is there a meaningful break between forecast windows?

• Integrated vs finance only; An integrated forecast involves many stakeholders (more bottom up). A finance only forecast is a small team finance exercise (more top down). With an integrated forecast you get more accuracy (in theory), but have to manage the politics of the business trying to rewrite their targets.

• Scope; full 3 statements, income statement only? Key financial metrics only (revenue, EBIT, FCF)

• Routine approach; for a frequent process, a routine approach is essential. It can be a bit more improvised if less regular.

• Triggered by a specific business event; M&A, refinancing, equity raise.

• And now…Is it dynamic; real time or not

There are some situations where regular rolling forecasts are critical, not optional.

Particularly where there is an overwhelming constraining issue around funding. E.g.:

• Monitoring forecast debt covenant compliance

• Liquidity headroom / runway

• Startups raising equity regularly

But the above should be a corporate activity conducted by a small number of people who know the business well and can make good top down assumptions.

Finally, to bring this all to life. I have set out precisely how I use forecasts and projections in the annual planning cycle within my current business.

The Secret CFO Forecasting Cycle

1. Performance Management (involves business units)

   • Strong budget = reference for the year

   • Risk & Opportunities (+ supporting analysis behind each)

     • Full Financial Year

     • By Business Unit

     • EBIT & Cash Flow

   • Adhoc mid-year reforecast if things have changed significantly (normally 6+6)

2. Corporate Purposes. Involves small number of people in corporate team who know the business well

   • 13 week cash flow rolling weekly cash forecast (treasury)

   • Rolling 18 month covenant and liquidity forecast (FP&A)

   • Adhoc re-reforecast ahead of major corporate activity; M&A, refinance, new equity.

   • Guidance model for investor relations

The process is designed to cut distractions for the operators.

So they can focus on operating instead of forecasting.

Where the money actually gets made.

BOOK CLUB

M&A experience is a must have for a full stack CFO.

Problem: it’s a bit of a closed shop.

How do you get experience, when you don’t have any experience … And so on.

Whilst there’s no substitute for court side seats to a big transaction, the next best thing is to learn from the best. So you are ready when that big opportunity comes along.

Check out M&A Masterclass 2.0 by Eric Pacifici & Kevin Henderson. Cramming billions of dollars of M&A transaction experience into a neat package is quite something.

Episode 1 was a treat, and I can’t wait for the rest.

FEEDBACK CORNER

A review from last week:

I have no plans to ‘unmask’. I can assure you my face and name are as disappointing as each other.

THIS WEEK ON TWITTER

Silly season for half year cash management has started. It’s like Christmas. It seems to start earlier every year.

POACHED GREG

Greg has turned all ‘coke and sushi’ in Season 4, but this week we remember simpler times:

Anyway …

Some spicy takes on forecasts for you.

We are half way through this FP&A series now. We are going to take a one week break next week. I need to give my twitter a little more love, so you’ll see more there a bit more over the next few week.

Then straight back in on Saturday June 3rd with either KPIs or incentive structures. I haven’t decided yet. In fact … you tell me which you want first?

And yes I do write these about 24 hours before I send them).

You can find me here on CFO Secrets, Twitter, & LinkedIn.

Until next time…

Stay Crispy,

The Secret CFO

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director or friend. Well, maybe I’m your friend. But I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need to make the right decisions.