Even when managing your small business successfully, wrangling with financial reports can eat up time. What if you could speed up that process and use the extra time to be productive elsewhere? Try this seven-step approach for using sales data to create a revenue forecast for your growing business.
What Is a Revenue Forecast?
First let’s recap what a revenue forecast is and why it can be important for your company's success and cash flow. Revenue forecasting is the process of predicting your revenue over a period of time by using historical and current sales performance data. Businesses generally use a 12-month period since it aligns with the standard fiscal year, but forecasting can also be done at different intervals, such as quarterly or bi-annually.
Understanding likely future revenue can be useful to businesses in two ways:
- If you know revenue is likely to increase, you can plan for investment or other costs.
- If revenue is forecast to fall, the business can take steps to improve the forecast, such as finding new ways to drive revenue or reducing costs.
7 Steps to Forecast Revenue
The following steps provide an overview of how to forecast revenue, from selecting a timeline that works for your business needs and estimating expenses, to testing forecasts against key financial metrics and running “what-if” analyses.
1. Decide on a timeline.
Revenue is typically forecasted over 12 months. But there are several factors that can influence the best timeline for your needs. Seasonal businesses, for instance, might benefit from shorter forecasting periods, maybe quarterly or annually. Similarly, companies in rapidly changing markets, such as the tech industry, might also prefer to incorporate shorter timelines.
By preparing for various scenarios, you can better navigate future financial challenges and opportunities.
That said, it also can be helpful to provide a top-line annual prediction for the next two or three years. This outlook can help with strategic business planning and long-term goal achievement. However, the further out the forecast, the more uncertain it can be.
2. Consider what may drive or hinder growth.
Before you start predicting how your business will perform, you can consider the external factors that could drive or slow your sales over the next year.
Factors can include:
- Seasonal upticks
- Major public events
- Upcoming regulatory changes that might impact your sales
For example, a flower company's seasonal upticks may include February for Valentine’s Day and again in May for Mother’s Day. Similarly, hotels and restaurants located near venues hosting major sports and entertainment events can expect increased sales around games and concerts.
In addition, you can consider your planned business activity and predict how things like expansion, marketing campaigns, or new product launches might affect sales. You also might consider how the adoption of new technology might speed up order processing or manufacturing. All of these variables can affect business growth.
3. Estimate your expenses.
Future expenses are critical when creating a revenue forecast. Try to remember your business probably has predictable fixed costs as well as variable costs that increase or fall based on sales. Variable costs might include things like material expenses, packaging, and shipping.
To drive new revenue, it’s common for both fixed and variable costs to increase – these cost increases can support growth. For example, if you want to make more goods to keep up with demand, you may need to hire additional labor. The flower company may decide to hire seasonal workers to keep up with Valentine’s Day and Mother’s Day demands.
4. Forecast sales.
There are two primary methods to forecasting sales: the top-down and bottom-up analyses. The top-down method is used to assess the total value of a market and predict how much of that market you expect your business to capture.
Here’s how it works:
- Estimate your total market size to understand the number of potential customers.
- Define your company’s market penetration by calculating your share of the market based on current sales.
- Assess the maximum purchasing capacity of your customers annually and compare it to the average actual value of customer purchases in the same period.
- Assess competitor sales. Are they growing in comparison to your sales? You can adjust sales potential in response to their performance.
While this top-down approach can be a useful way of predicting possible sales, it usually provides a rough estimate. A bottom-up analysis can be more realistic. To use this more direct approach, first determine the average value of one sale and estimate the number of sales you expect to make in a given period. By multiplying these two figures, you can get a more grounded estimate of your total sales.
5. Combine expenses and sales into a forecast.
Once your sales forecast is ready, it’s time to merge that data with your estimated expenses to create a comprehensive revenue forecast. You can start by calculating your projected net revenue. This is done by subtracting your expenses from your projected sales. You can use past monthly expenses and sales as a baseline, and list them in a spreadsheet starting from your chosen date up to the present. Then, try to project your current sales and expenses into the future, considering both the sales forecast you’ve developed and the estimated expenses.
It can be helpful to factor in both planned business activities and anticipated external changes. These might include expansion efforts, marketing campaigns, new product launches, market trends, or economic shifts. Assessing their expected impact on your revenue and expenses can provide a more nuanced and accurate forecast, giving you a clearer picture of your financial trajectory.
6. Check your revenue forecast against key financial ratios.
Key financial ratios such as gross profit margin and operating profit margin can be used to help determine whether your forecast is realistic. You can compare forecasted margins with your historical margins to get a sense of whether your forecasts are on track.
Gross profit margin is the ratio of total direct costs to total revenue. For example, a manufacturing company’s margin would be calculated like this:
(Total Revenue – Cost of Goods Sold) / Total Revenue = Gross Profit Margin
Typically, the higher your gross margin, the better your cash flow. This can signal a stronger ability to meet financial obligations and even reinvest funds into the business. When you forecast gross margin, if there’s a significant deviation from historical trends or industry averages, it may indicate unrealistic revenue or cost estimations – meaning you may need to rework your predictions.
Operating profit margin is the profit your business makes after deducting the total operating expenses from your revenue. The operating profit formula is:
[Total Revenue – (Cost of Goods Sold + Operating Expenses) x 100] / Total Revenue = Operating Profit Margin
Increasing revenues should generally lead to a better operating profit margin. Generally, stable or increasing revenues lead to stable or improving operating profit margins. You can take note of your actual historical profit margins and compare them to future predictions. Again, a sharp, unexplained increase or decrease in this ratio could suggest an over- or underestimation in the forecast, warranting adjustments.
7. Test scenarios by adjusting variables.
With a revenue forecast complete, you can further test it by tweaking variables within your projected expenses and sales to reflect specific scenarios.
For example, what will happen to a company's revenue forecast if they make 100 more sales calls each week, generating an additional two sales per day? What impact would this have on costs (labor, technology) and revenues (additional sales)? You can explore a range of scenarios, from best-case to worst-case, to make sure you’re prepared for a variety of possibilities.
“What-if” analyses such as these can allow you to understand the factors likely to have the biggest positive (and negative) impact on your revenue, so you can both plan for and protect your business.
How to Perform a Profit Forecast
Once you've forecasted your predicted revenue, whether it’s three months, a year, or three years into the future, you can use these figures to forecast profit. First, you can determine the expected costs associated with generating your projected revenue, including direct costs such as materials, labor, and overhead, and indirect costs such as marketing, sales, and administrative expenses.
Then, you can subtract your expected costs from the projected revenue to calculate your expected profit. This figure can help you estimate the net income the business can expect to generate in the future.
It’s important to approach this process with a mix of optimism and caution. You can regularly review and update your profit forecast, especially if there are significant changes in market conditions, operational efficiency, or business goals. This iterative approach can help you maintain realistic expectations in the face of a changing business landscape.
Also, you might consider adopting a conservative stance in your estimates, particularly for longer-term forecasts. This approach can account for the inherent uncertainties and unforeseen changes that can impact your business. By preparing for various scenarios, you can better navigate future financial challenges and opportunities.
The Takeaway
To ensure accuracy in your profit forecast, you can regularly review and adjust your revenue and cost projections based on actual sales and revenue performance data. This can help you identify any discrepancies or inefficiencies and make informed decisions about how to optimize your business operations for maximum profitability.
A version of this article was originally published on May 24, 2023.
Photo: Getty Images
