With a new year just around the corner it's time to turn our attention to budgets and forecasts for the year ahead. For many the focus in recent years has been on survival and cash flow continues to be a challenge. But, while times are still difficult there are signs of a sustainable recovery.

Accurate budgeting and forecasting can alert a business to opportunities arising in a changing environment, this in turn gives a business the chance to take advantage at the earliest possible opportunity and gain a competitive advantage.

Sales rise and fall, markets fluctuate. This constant change makes it difficult to cater for all potential eventualities. However, the need for flexibility does not excuse a lack of forward planning. Businesses should do all they can to plan for the ups and downs of the economic cycle, thus avoiding the pitfalls associated with fluctuations in trading and cash flow difficulties. The primary driver of such planning is the budgeting and forecasting process.

As well as being an essential part of the business and scenario planning process, budgets and forecasts are a key risk management tool in your business. Budgets are typically fixed in advance and remain static for the duration of a selected period. They provide management with the ability to identify how and, more importantly, why actual results differ from those that were originally expected. By referencing the actual results against the assumptions used in the budgeting process the reason for the divergence can be analysed. It may be that margins varied from those predicted at the outset of the period; perhaps an unwelcome bad debt arose; there may have been unexpected currency fluctuations; overheads may be out of line with predictions. A business must be alive to changes in the business environment and to the accuracy of management's own assumptions if it is to thrive and to grow its business.

It is a reality that budgets and forecasts have both an internal and an external audience. A business's bankers are likely to demand access to both. While there may be a temptation on the part of a business to tend towards the optimistic end of possible scenarios in the hope of impressing the bank, such an approach runs the risk of being counter-productive over time. Over-optimistic budgeting and forecasts militate against good business husbandry. Furthermore, the bankers will quickly lose confidence in a business that constantly fails to live up to its own forecasts.

While budgets normally remain fixed for the selected period, forecasts are updated as and when actual financial results become known. A forecast therefore acts as a rolling estimate for a given period, providing an informed view of expected outcomes based on current trading, as opposed to budgeted activity.

Many businesses prepare their monthly management accounts (an essential management tool) and compare these to both their budgets and their forecasts. Variations from forecast may indicate that market conditions are changing more rapidly than anticipated. Such variations against budget may indicate that original expectations are unrealistic and may lead management to consider longer-term changes that may be required in the business.

Tips on the budgeting process

  • Look at your track record of meeting budgets and consider whether your new projections are achievable. If past performance demonstrates evidence of poor or over enthusiastic assumptions, take note of these and make suitable adjustments.
  • Challenge your assumptions, or get someone else to do it for you. Talk to your management team and your external advisers – they will all have views and these can be used to clarify and tighten your expectations.
  • Make sure your profit and loss, balance sheet and cash flows are fully integrated and reconciled.
  • Think about sensitivity and prepare different versions of your budget based on different scenarios. Ultimately you will have to choose which final version you use, but it will be good to know that if your sales are 30% less than you anticipate, you will still have enough cash to survive.
  • Ensure that you regularly review your budgets and forecasts against your actual financial results. If variations arise, analyse these and understand the likely impact on your business. Take action early to counter any emerging threats.

We have taken great care to ensure the accuracy of this newsletter. However, the newsletter is written in general terms and you are strongly recommended to seek specific advice before taking any action based on the information it contains. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. © Smith & Williamson Holdings Limited 2013. code 13/1077 exp: 31/03/2014