Business Plans--The Rules of Forecasting, Part 1 of 2

We have developed a set of rules regarding forecasting that we apply in writing business plans. We share them with you in this article in the hope that you will find these rules worthy of adopting in your efforts to write business plans as well.

Investors expect the forecasts in a business plan to present realistic, achievable goals. One of the best ways to have your plan rejected is to demonstrate that projections were not prepared thoughtfully and, therefore, the numbers are not defendable. This is most often demonstrated by not showing the details (if any) that went into the projections.

It is important to remember that investors typically review the projections first, at least in a cursory manner. This makes sense when you realize two things: 1) they are most interested in the money they might be able to make, and 2) they can easily spot common mistakes made by sloppy entrepreneurs (in order to quickly reject poor plans).

Rule 1: For a forecast to be valid, it must portray realistic expectations.

An unrealistic forecast is useless to anybody. The entrepreneur is unlikely to achieve the goals and the investor is unlikely to recover their investment, let alone make a profit.

Corollary 1A: A pessimistic forecast is equally as invalid as an optimistic one.
Conservative estimates are good as long as they still demonstrate a high likelihood of achievability. However, if the projections are perceived as too conservative, or even pessimistic, it looks like the entrepreneur is trying to build too much of a "fudge" factor into the numbers.
On the other hand, an overly optimistic project demonstrates the entrepreneur is trying to make the project look better than it should.
The best approach is to make the projections as realistic, achievable, and defendable as possible. In other words, show that you have done your "homework."

Corollary 1B: The first year of a realistic forecast should become the operating budget.
The investor will expect at least this level of confidence in the projections. If you can´t make a realistic projection for the first year that can be used as a budget, more homework should be done.

Corollary 1C: Budgets must be prepared within the context of the long-range forecast.
If you were to plan an automobile trip from Denver to New York, it would not make sense to start by driving to Los Angeles. Likewise, make sure that the short-term activities and expenditures are in keeping with, and support, the long-term goals of the company.

Rule 2: Don´t blindly rely on a "rule of thumb" to forecast the future.

Rules of thumb are techniques many people use to help them prepare forecasts. These rules can be useful when used as clues to guide the forecasting process, such as by comparing your past or future performance against that of similar companies. The problems come in when these techniques are used without regard to making sure they apply to your specific situation.

Corollary 2A: Don´t use percentages as a "crutch" in forecasting growth or trends.
You must be able to defend your projections. If your numbers are determined by "blindly" applying a percentage, the results become less defendable. For example, I had a client who initially projected a sales growth that, within five years, would require every person on Earth--now and in the past--to be a daily customer. Obviously, this was an unbelievable and un-defendable result.

Rule 3: Make sure each and every assumption in the forecast is supported.

You should expect an interested investor to place your projections "under a microscope." Therefore, never underestimate the degree to which you may need to defend an assumption.

Rule 4: Validate and verify every calculation.

I had a client whose business used equipment manufactured in Europe. Therefore, he had to convert the machine´s input and output from kilograms to pounds. The projections showed a relatively conservative, but realistic, profit margin for his particular industry. When I reviewed the plan, I checked his conversion factor (from kilograms to pounds) and found he used the wrong factor. When the correct factor was used, his net income changed from a profit to a loss--a very significant result that would have been a disaster had it been discovered by an investor.

Corollary 4A: Don´t trust published calculations.
Published numbers have been found to be wrong. There may be a misprint. It doesn´t hurt to verify the numbers and you become more of an expert in the process.