(This is Part 1 or a 2-Part post)
Almost all organizations of any size produce a sales forecast and also a financial forecast. These are exceptionally critical documents for early stage companies since keeping a positive cash balance is often a goal of the exercise. And often, these two documents are prepared weekly…and by different people…separately.
So, the interesting part of this is that the sales forecast and the financial forecast are rarely linked. And this is a huge problem. Making sure that your sales forecast is directly tied to the financial plan is a “mission critical” exercise. There is really no reason to have a financial plan if the sales forecast does not drive the bookings and cash revenue on the financial plan. Yet, most entrepreneurs prepare these documents independently and therefore run into trouble.
Sometimes it can be fun to prepare the financial plan. You simply (optimistically) wish what contract sales are going to be and then assume instant collections on those sales and that drives your (cash-based) revenue on your financial forecast. Then you can alter expenses accordingly to make sure that you have a positive cash balance. Forecasting expenses, however, is never the problem. The problem is accurately forecasting contract bookings and cash-based revenue. The sales forecast often tells a dramatically different story than the wishful thinking financial forecast. Entrepreneurs, often, pretend that the sales forecast does not exist or is divorced from the revenue forecast in the financial plan.
Boards and investors HATE this. Boards are always trying to match these two documents up even if management does not. When boards discover discrepancies between the two, there is always trouble. And you should hate this too. It will eventually bite you and bite you hard.
Missing contract bookings and having cash flow issues is something that causes boards to lose confidence in their CEOs and their portfolio companies. This often leads to replacing the CEO, CFO or the VP Sales or all three (assuming you are big enough to have any or all three). In the best-case scenario, if the investors are so inclined to put more money into the company, this results in a down round. In the worst-case scenario, the investors leave the company for dead since the management has lost all credibility and there is no way to tell if the management team is not good, the product is no good or there is no market for the product. In any event the best and worst case scenarios are both unpleasant. Plus, you are the one who has to make payroll. It is never fun telling employees that they are not getting paid, particularly at the last minute. Employees lose confidence in you as well.
The way to deal with this is to prepare a proper sales forecast where:
- Probabilities of sales opportunities are entered strictly by the current sales cycle stage that the opportunity is in, as opposed to guessing
- These probabilities are based on historical rates (for instance, use the percentage for the demo stage as historically, how many deals that got a demo ended up closing
- Same goes for the time to close. Use average historical time frames for deals in any stage to close date, not what the customer simply tells you (buyers are liars…well, not liars but not accurate either.)
- Only list opportunities with a 50% probability or higher on the sales forecast
- The sales dollar value per deal is adjusted by the probability to create a probability-adjusted dollar forecast per deal (Forecasting a $50,000 contract at 50% probability yields a $25,000 forecast) You need to list both the raw number and the probability adjusted number but…
- The probability adjusted number total by month for the next 3-4 months is then what is then used in the cash collections portion of the financial forecast.
- Collections are assumed to be at least 30 days past invoicing (often 60 days is more realistic)
- Then, if you are really conservative, you drop these monthly totals down by an additional 25% more to be safe because bad things always happen
- Now you have a reasonable financial forecast
The same goes for renewals. You should forecast renewals at the renewal rate but probability adjusted for the attrition rate. In other words, if you have a 9% customer attrition rate, the renewal should be the renewal amount times 91%. If you are too new to have an attrition rate, then book the renewal at 90% probability regardless of how happy you think the customer is. Ultimately, you are going to get attrition and you will desperately miss that cash in a tight financial climate. Plan on it. BTW, normal attrition rates should be around 5% so you are being conservative with what was just suggested.
Now, when you look at your financial forecast it may not look very rosy, but it is real, not what you wish would happen.
This is simple, but effective and more accurate than the rose-colored glasses approach used by 95% of companies. This helps organizations better prepare for tougher financial times and, while not necessarily pretty, increases board confidence in forecasting (but maybe not performance). It is better to come in over your revenue and cash forecast than under it.
It is critical to be realistic about your sales forecast and realistic about your financial forecast and realistically tie the two together (the operative word being, of course: realistic). Almost all organizations struggle with revenue. It’s normal. But burying your head in the sand about missing revenue targets does not help. It hurts significantly. As a founder or CEO (or both), you have an obligation to yourself, your employees and your investors to tell the truth and be as accurate as you can. It comes with the territory. If you want to keep your job and keep your company, you will do the right thing.
For more information on how to better tie out your sales forecast with your financial forecast, please contact email@example.com. We are committed to helping entrepreneurs grow their great ideas into great companies.