Forecast

What is a forecast?

Forecast (German: Prognose, Hochrechnung or Vorschau) is the estimate of the likely result of a period that combines the values achieved so far (actuals) with the current expectation for the remaining months. Unlike the plan, the forecast is adjusted regularly. It shows where the company will stand at the end of the financial year or of a fixed time window, according to what is known today. Preparing and updating such forecasts is called forecasting.

A marathon runner proceeds in the same way: from her split time at kilometre 30 and how she feels, she re-estimates her likely finishing time. The target time she aimed for remains the yardstick against which she measures the race.

The forecast is a basic instrument of controlling and is usually updated monthly or quarterly. It appears in the monthly report to the management and the advisory board and in investor updates. In due diligence, the detailed review before a contract is signed, investors or buyers also look at it to assess the course of the current year.

Forecast and budget

The budget is adopted before the start of the financial year, remains unchanged afterwards and serves as a target and yardstick (budgeting). The forecast is the moving expectation: every month it takes in the new actuals and re-estimates the remaining months. The difference between forecast and budget shows what gap to the annual target is likely to remain and whether countermeasures are needed.

The status of a forecast is often given as a pair of numbers. "3+9" means three months of actuals and nine months of expectation, "9+3" accordingly nine months of actuals. With every month, the forecast moves closer to the actual annual result.

Forms of forecast

Projection and rolling forecast

The classic projection extends to the end of the financial year. Its horizon shrinks over the course of the year; in October it looks ahead only three months. The rolling forecast, by contrast, works with a fixed window, with twelve or 18 months being common. Every month, the month just ended drops out and a new one is added at the end. The look ahead stays the same length and is decoupled from the financial year, which suits growth companies with a tight liquidity runway.

Weekly liquidity forecast

For short-term solvency, planning is additionally done in weeks, commonly over 13 weeks. The basis is cash flows, not expenses and income: salaries, VAT, rents, loan repayments and expected customer payments with their specific dates (liquidity planning).

Driver-based forecast

Instead of extrapolating the accounts of the bookkeeping, a driver-based forecast derives the figures from a few influencing factors (drivers): sales pipeline and closing rate, new customers, cancellations, prices, planned hires and salaries. If a driver changes, revenue, costs and liquidity adjust consistently. Deviations can thus be traced to a specific driver.

Forecast accuracy: measuring how good forecasts are

The quality of a forecast shows afterwards: what was expected at a reporting date is later compared with the actual, item by item. The key figure for this is forecast accuracy.

Formula: Forecast error in percent = deviation between forecast and actual without sign divided by actual value × 100%; forecast accuracy = 100% - forecast error in percent

If EUR 1,500,000 of revenue was expected for a quarter and EUR 1,400,000 was achieved, the error is EUR 100,000 or around 7.1% of the actual, so the forecast accuracy is around 92.9%. More important than a single miss is a systematic distortion (forecast bias). If expected revenue is too high over many months or costs are regularly underestimated, the assumptions have to be corrected. Investors often reconcile earlier updates themselves.

Significance for financing, due diligence and insolvency law

The forecast yields the runway, that is, the number of months the available liquidity lasts at the expected cash outflow. Because a funding round takes several months from preparation to receipt of funds, the forecast determines the latest point at which the process has to begin.

During due diligence, investors and buyers follow the ongoing business development (current trading). They compare the actuals since the start of the year and the forecast with the plan that was presented at the start of the process. If the two diverge markedly during the process, valuation and terms are discussed afresh.

Insolvency law also requires a robust forecast. Over-indebtedness means that the assets no longer cover the debts. It is ruled out if the continuation of the company over the next twelve months is more likely than not (Section 19(2) of the German Insolvency Code, InsO). Whether payments that are foreseeably due can no longer be made (imminent illiquidity) is, as a rule, assessed over 24 months (Section 18(2) InsO). Both can only be assessed with documented planning based on comprehensible assumptions (early crisis detection).

Worked example: driver-based forecast 6+6

A software company whose financial year corresponds to the calendar year prepares a "6+6" forecast at the end of June. The budget provides for EUR 6,000,000 of revenue and EUR 6,700,000 of expenses, i.e. a result of minus EUR 700,000.

• Actuals January to June: revenue EUR 2,700,000, expenses EUR 3,300,000, result minus EUR 600,000.
• Revenue driver: monthly recurring revenue is EUR 480,000 at the end of June. A net increase of EUR 15,000 per month from new customers less cancellations is expected.
• Revenue July to December: 495,000 plus 510,000 plus 525,000 plus 540,000 plus 555,000 plus 570,000 = EUR 3,195,000.
• Cost driver: EUR 560,000 per month, from September an additional EUR 30,000 for three hires. July to December: 2 × 560,000 plus 4 × 590,000 = EUR 3,480,000.
• Forecast revenue: 2,700,000 plus 3,195,000 = EUR 5,895,000, which is EUR 105,000 or around 1.8% below budget.
• Forecast expenses: 3,300,000 plus 3,480,000 = EUR 6,780,000, which is EUR 80,000 above budget.
• Forecast result: 5,895,000 minus 6,780,000 = minus EUR 885,000, i.e. EUR 185,000 worse than budgeted.

A simple doubling of the half-year revenue would have given EUR 5,400,000 and overlooked the growth in the second half. The driver-based calculation shows that revenue falls only 1.8% short of budget. The result deviation of EUR 185,000 has two sources: EUR 105,000 is missing on revenue, and EUR 80,000 is added as extra costs. Countermeasures are therefore possible on both sides, for example through the timing of the hires. For liquidity, a result forecast is not enough, because payment terms, VAT and investments shift the payments. Only integrated financial planning maps this.

Distinction: forecast, budget-vs-actual comparison and cash flow projection

• Budget-vs-actual comparison: measures the actual against the plan and explains deviations. Its results are an essential input to the forecast.
• Liquidity planning: plans receipts and payments, often weekly. The liquidity forecast is its short-term, continuously updated part.
• Cash flow projection: the multi-year forecast of cash flows in the financial model, the basis for sizing a funding round and for valuation. The forecast concerns the current year or a short rolling window.

Common mistakes

• Budget replaced by the forecast. If the plan is overwritten with every projection, there is no yardstick against which target achievement is measured.
• Linear extrapolation. A projection from the average of the months so far overlooks growth, seasonal patterns and hires that have already been decided.
• Targets instead of expectation. A forecast that makes up arrears across the board in the fourth quarter reflects a wish and not the likely development.
• Assumptions not documented. Without drivers recorded in writing, neither the deviation can be explained later nor the forecast improved.

Frequently asked questions

How often is a forecast updated?

Usually monthly after the monthly closing, quarterly in business models with a calm course.

How long should a rolling forecast be?

As a rule of thumb, twelve to 18 months. In growth companies, the horizon should extend at least to the likely completion of the next financing and include a buffer for delays.

Does the advisory board have to approve a forecast?

As a rule, no. Approval reservations usually concern the budget. However, the forecast can give rise to a need for resolutions, for example for cost reductions or bridge financing by the shareholders.

Which forecast do investors see in due diligence?

The latest status for the current financial year, supplemented by the actual figures of the last months. In longer processes, it is updated during the review.

What is a forecast in sales?

A forecast of the closings and revenue of the coming weeks or months from the sales pipeline (sales forecast). Every open sales opportunity is weighted by the closing probability of its stage, so a quote of EUR 40,000 at 50% counts as EUR 20,000. The sales forecast supplies the most important driver for revenue in the financial forecast.

The Roemer Capital view

During a funding process, we keep our clients' forecast up to date until completion. Investors continuously compare the current year with the plan that was presented to them at the start of the process. A deviation that the company explains itself at an early stage burdens the negotiation much less than one that the investor discovers in due diligence.

We derive the start date of a round from the rolling forecast. A funding round typically takes 6 to 8 months; our guideline for the runway at the start of the process is therefore 12 to 18 months. If the forecast is not sufficient for this, we discuss cost measures or bridge financing by the existing shareholders before the start.