Without a three way financial forecast, businesses can leave themselves open to planning errors and disastrous cash shortfalls. For instance:

• Forecasting only income and expenses commonly leads to a poor understanding of accounts receivable and accounts payable. Startups who fail to forecast the movement of cash from clients and to suppliers often find that they’re “making a lot of money on paper” but “don’t have enough cash in the bank”
• Forecasting only cash flow commonly leads to unwelcome surprises with respect to liabilities. For instance, small businesses might find that they haven’t planned enough cash reserves to cover an annual corporate income tax or payroll tax liability. It is therefore important to forecast the balance sheet

Proper financial planning requires a forecast that tracks the movement of income, expenses, cash, assets, liabilities and equity. If this sounds difficult to do, it is. Since this implies creating multi-dimensional forecasts that both predict future events. But also applies the logic of current accounting policies (for the treatment of expenses, revenue recognition, accruals, etc.) to future financials, and ensures the integrity of the numbers across three statements.

To construct a three way financial forecast, I recommend you work through the three forecasts individually first. Then you can iterate through the forecast multiple times to arrive at your final forecast.

Profit & Loss

Start with forecasting the income statement. Start at the top of the income statement and work your way down each line. Following, examine historical trends and think about what drives change in each one (don’t just apply a percentage growth). You might find that two lines are theoretically correlated – e.g. “sales commissions expense” may be directly driven by the previous month’s revenue, so you can use a formula. Furthermore, you may need to create additional forecast tables or spreadsheet tabs to support your analysis or assumptions. In some cases it’s easiest to just manually key in numbers – in some circumstances this can be more accurate and faster than fancy formulas.

Need a bit of help? View and explanation of Profit & Loss Statements here

Balance Sheet Forecast

Next turn your attention to the balance sheet. Many CEOs want to jump to forecasting Cash Flow but it’s easier to forecast cash flow once you have the balance sheet forecasted. 

Most businesses will have a mismatch in timing between when they receive cash and when they earn the revenue. If you receive pre-payments, you’ll need to add to your unearned revenue line on your balance sheet forecast. If you offer 30 day terms on your invoices, you’ll need to add to your accounts receivable balance for every sale. So create some rules here for the movements in and out of these accounts. 

You’ll need to consider payroll liabilities – often the income statement forecast considers payroll taxes expense, but sometimes it’s not paid exactly at the same time as the wages are paid. Similarly, business insurance is often accrued monthly, but paid annually – so you’ll have movements each month reducing the balance. Equipment may be depreciated over a number of years – this will show up on your income statement so you need to reflect these expenses on your accumulated depreciation account on your balance sheet forecast. 

Finally, think of any major purchases of equipment and any debt/investor activity you are planning. For instance, if you intend to take out a loan and use some of the proceeds to purchase equipment, you’ll record the loan as a liability and the cash and equipment as assets on your balance sheet forecast.

Need a bit of help? View and explanation of Balance Sheets here

Cash Flow

The cash flow forecast requires an understanding of how cash flow statements work. So read our Cash Flow Statements: Explanation and Examples article if you need a refresher. To forecast cash simply compile the above two forecasts. In each period:

1. Use the previous period’s closing cash balance
2. Add in net income from the income statement forecast for that period
3. Remove any non-cash movements – e.g. change in inventory or change in accounts receivable – from the balance sheet from that period
4. Consider any changes in investment, debt or equipment again from the balance sheet for that period
5. Your closing cash balance will be the result

A three way forecast shows a complete picture of one future scenario for a business. However, it’s important to remember that a forecast is just one of a nearly infinite number of possible scenarios. There are inherent flaws in forecasting. For instance, assumptions are always wrong to some degree, and  the past is not a predictor of the future. But we can at least ensure that our forecasts are internally consistent and as complete as possible. We can blame market forces for unpredictable business conditions, but if a business forgets to plan for a cash shortfall because the forecast failed to consider the timing of cash vs. revenue then the business owner or CEO can only blame herself.

Rolling a 3 Way forecast forward

Forecasts should be updated with live data on a regular basis. For this reason, ensure your model is created with solid formulas so that it’s easy to update.

Three way financial forecasting is a powerful approach to create a future state financial model for small business or large enterprise. It is inherently complicated by the need to ensure integrity between three forecasts at the same time. While applying the firm’s own accounting policies for the treatment of accruals, depreciation, prepaid expenses, unearned revenue, accounts receivables, etc.. So, while spreadsheet models may be up to the task, they should be compiled by professional FP&A analysts to increase the chances of success. Check out our CFO Services for help with 3 way forecasting for your business.