Having transplanted from Tennessee to Florida, I’ve just now gotten up to speed on the weather. In the summer, afternoon showers can pop up without warning, and the low 80s is “cool” for the locals. I am not there yet.
Hurricane Ian blew through southwest Florida in late September, which had my family and Floridians keener to forecast models, storm tracking, and cone watching. We were quite lucky in my neck of the woods, but the unpredictability of the storm’s ultimate landfall led to a lot of consternation.
After the dust settled, the forecast models got me thinking about the difficulty in “forecasting” business performance. How do you approach your family business budget? Do you ask your managers to “reach” or to create targets you expect to meet? Do you measure your forecasting accuracy? What is your process?
We’ve written previously on how to make your forecasts more useful with your P&L and cash flow statements, and below, we share three forecast reminders that may help you make better budgets: Measure yourself regularly, remember the law of averages, and adapt your roadmaps when needed.
“If you can’t measure it, you can’t improve it.” – Peter Drucker
Working with clients year after year has given us perspective on forecasting styles. Some family businesses leave ample cushion for their teams to beat, while the aspirational others point to where management is heading.
Some consistently hit their targets while others chronically “over-promise-and-under-deliver.” British statistician George Box famously said, “All models are wrong; some are useful.” To make your budget models useful, you should consistently evaluate your process relative to actual performance. Where are your blind spots? Where are we over/under-allocating expenses? What were the biggest surprises we had last year? Understanding where the forecast process went wrong, and right, will help you make better-informed budgets and forecasts in the future.
“You are not special.” – Tyler Durden
Well, perhaps that’s harsh. Likely your family business is indeed unique and has a special story, but not that special.
Remember the power of mean reversion and the law of averages when thinking about your family business forecast
Your family business operates in a competitive market, and any competitors are always looking to lay siege over the moat you have dug around market share and profits. Abnormally high-profit margins have a way of drifting towards industry averages, and super-charged growth generally tampers to a steady state.
A recent study of Wall Street analysts’ forecasts from 1997 to 2021 by Verdad, an asset management firm, found 3-year median forecast overestimation errors for revenue at 4.6%, EBITDA at 19.4%, and pre-tax earnings of 36.8% (!). From the piece:
“Across the board […] estimated growth rates systematically overshoot the actual outcomes. Importantly, analysts’ forecast errors seem to be bigger precisely in the areas that should matter most for stock prices: earnings further down the income statement that go to equity investors, and earnings further out in time.”
Remember the power of mean reversion and the law of averages when thinking about your family business forecast. Working with entrepreneurial families, we see success manifest in optimistic innovators and business owners. Remember to splash just a little bit of cold water on next year’s view to maintain a margin of safety.
“When the facts change, I change my mind. What do you do?” – Winston Churchill
Think about the last few years. The genesis of the COVID-19 pandemic, runaway inflation, and a war in Ukraine have all rattled financial markets and upturned how many companies operate. A forecast is a tool; to be a good tool, it must be adaptable to changing facts.
A good budget process does not lend to blind adherence to well-laid plans made six months hence. For example, a capital expenditure project you previously forecasted to complete with debt financing may make a lot less sense with borrowing rates up considerably in 2022. Supply chain issues and inflation may lead you to reassess your projected gross profit for the year, as well as your working capital needs.
Being able to pivot when needed keeps you dry in stormy weather and allows you to execute when opportunities arise.
Cloudy with a Chance of Recession?
As the public markets continue to reel and the chance of a recession “landfall” increases, now is the perfect time to review your budget process and prepare for what lies ahead.
Learning from past budgeting mistakes (and victories), remembering the law of averages, and maintaining an adaptive forecast process can help develop actionable plans that your directors can rely on. But when an outside perspective can be helpful in your forecast process, give one of our family business advisory professionals a call to confidentially discuss your challenges.