Importance of financial forecasting

One of the main reasons for a small business failure is lack of planning of cash. A good forecasting mechanism increases business success chance and minimizes the failure risk. Small business owners must realize the importance of this tool to plan ahead in order to make their business successful.

A successful business owner relies on a forecast to develop a business strategy. In this global competitive environment, a business must adjust its strategy constantly. One way to address this competition is that owners/managers must predict what will happen tomorrow. Businesses who accurately forecast, advance ahead, while the ones that don’t, fall behind.

Budgeting is an essential part of a financial forecast; it is a mechanism to estimate future income and expense by utilizing and manipulating few variables. Different methods can be used to determine future income and expense. Predicting the future is not easy, which is why business owners sometimes seek professional help to prepare pro forma financial statements. These sets of statements are the financial plans for small business owners.

Why it is critical?

Financial forecasting is an important tool if you are applying for a business loan. It also plays a vital role if your business is cyclical, so you can overcome cash shortfalls and plan ahead accordingly to pay your vendors, rents, payroll and other business expenses.

If you are planning to introduce a new product, it allows you to construct a model of how your business might perform financially if certain strategies, events and plans are carried out.

How often should you prepare a financial forecast?

It depends on the circumstances of your business. Small businesses should prepare a financial plan quarterly or semi-annually. If you are having cash-flow issues, then preparing a financial forecast more often would be a better strategy. Likewise, if you are experiencing rapid growth, more frequent forecast strategy allows you to measure your performance more effectively and develop a plan to rectify any issues which could be critical in making your growth strategies successful.

Should you prepare a forecast yourself?

According to Morton J. Marcus, director of Indiana University’s Business Research Center, which provides forecasting services, “Most financial executives still rely on implicit forecasts they construct for themselves, using information they have gathered from a number of sources and working on an instinctive basis. But it is unlikely that they are looking at all of the variables. Using professional forecasts is really nothing more than prudent business behavior.” One of the reasons to hire an outsider is objectivity; there will be no emotions attached, whereas, an owner/executive might construct a forecast based on the assumptions with which he/she has some sentimental values.

For example, one of my clients had a dream to open up a restaurant so badly that he ignored all the warning signs. After discussing the idea with him and after introducing other cost factors which he disregarded, we found that the plan was not viable at that point and had to be revisited in future with a different location. As Marcus said, “models are based on past behavior. As conditions and behavior change, models must be revisited and modified”, with the help of a professional.

What is benchmarking and why is it important for my business?

In simple terms, benchmarking is a tool to compare business performance against the industry. It is one of the ways to judge what the best practices are and how you can improve your business process. For example, if the industry is earning 10% return on assets, while your business is earning only 6%, you can pin point the problem areas. However, it is important to know that when you use benchmarking data it should be relevant to your industry, business size and region. In other words, you should be comparing apples to apples. Achieving parity against the best in the industry may not always guarantee success.

Another factor you should consider when you use benchmarking data is how accurate the information is. This can be a difficult task given the data dynamics, sources of the data, sample size, timeliness and NAICS classification. A challenge business owners face is to which specific financial metrics should we compare and which ones are important to achieve the strategic goals. Another issue is how to measure non-financial metrics. Benchmarking techniques can be used both in service and product based businesses.

Benchmarking can result in frustration and failure if the business matter is not selected strategically. In order to appropriately select and prioritize benchmarking tasks, corporations need first to understand their critical success factors and business environment. This helps them identify their key business processes and drivers. The whole process of benchmarking should be aligned to the corporation’s mission, vision, values and strategy. All leading-edge corporations such as Xerox, DuPont, and HP use benchmarking as a valuable tool to improve their competitiveness and effectiveness. It is an integral part of their strategic planning.

In order to be a successful business you need to implement benchmarking effectively. It allows you to evaluate your business performance and ensure that your business is operating at an optimal level. Outside professionals can be engaged to streamline the whole process who will carefully select the relevant KPI’s for benchmarking critical to achieve your business objectives and strategic goals.

Salary or Dividend – Which One Is Better?

When tax planning for your next tax return, you may want to keep in mind whether to earn income through salary or dividends.

The owner or manager must determine the remuneration they wish to receive, and must therefore determine the optimal salary and dividend combination to maximize their cash flow. To avoid retroactive tax planning, it is best to connect with your accountant on this matter and they can advise which the best option is.

Salaries/bonuses and dividends are the most common methods of remunerating the owner/manager. Many owners provide themselves a payroll, just like their employees, and others may pay out dividends to themselves, or a mixture of the two. Below lists the differences of each:

Tax deductions

• Salary is subject to tax deductions and charges through the personal tax return. Dividends are paid out of the retained earnings of the company had have already been subject to corporate tax. A dividend tax credit is then given to the owner through their personal tax return which is equal to the taxes paid at corporate level.
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• Bonus should be paid out within 180 days of the fiscal year-end; otherwise it will be added back to the corporation income.

Income-splitting

• Advantage of dividend is to split income with family members who directly own the stocks in the corporation. Another advantage of dividend is that CRA does not do test the reasonability as in the case of salary.

Payroll deductions

• Earning a salary allows for providing pensionable earnings for CPP purposes and EI premiums, but both portions of CPP will need to be paid, both the employer and employee portions. On the other hand, dividends are not subject to these payroll deductions, as well as workers’ compensation and provincial payroll/health services.
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RRSPs

• A salary offers benefits in contribution to RRSP by gaining RRSP deduction room, and as a result, these investments come with creditor protection. Dividends do not exercise this benefit.
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When it comes to the time to filing taxes, working with your accountant will be your smartest decision. They will be able to calculate what would be the most beneficial combination of salary and dividends that results in the highest amount of cash left after taxes.