From the course: Financial Modeling and Forecasting Financial Statements

Analyze potential business with a financial forecast

From the course: Financial Modeling and Forecasting Financial Statements

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Analyze potential business with a financial forecast

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Running an organization without the benefit of any financial forecast is a very exciting exercise. From one day to the next, you have no idea what's coming. Every morning you wake up to a whole new collection of surprises. That's one way to run an organization. A different way is to spend some time carefully constructing a numerical plan, a financial model, a forecast. Now there will still be surprises, but you'll have a model, a plan, a forecast within which to adapt to those surprises. Now think about a company that's been around for a long time. Let's use General Electric as an example. They've been around since 1878 when Thomas Edison started the Edison Electric Light Company. Now let's compare this old company, General Electric, to a brand new company, a startup a company that involves just two partners, 10 employees, and lots of exciting ideas. Which one of these two companies, the old one or the new one, is likely to have a more comprehensive, sophisticated internal financial modeling and forecasting process to aid in both short-term and long-term planning? Well, the old company, of course. General Electric, for example, has a very elaborate internal financial modeling and forecasting process. In contrast, the startup company they probably haven't taken any time to make any kind of financial plan at all. Now think about which of these two companies really needs a financial plan. The old company, General Electric, or the new startup company. Now of course they both can benefit from financial planning and forecasting, but which one can benefit more? Well, let me put it this way. If General Electric decided not to do any detailed financial forecasting this year, would the General Electric employees still know what to do? Well, sure they would. The company's been around for so long that everyone knows what to do. You pretty much do what you did last year, plus a little more. At least for a year or two, General Electric could probably continue forward in good shape without a formal financial plan, just by operating on organizational inertia. Now, how about that startup company? In a startup company, no one knows what they are doing because it has never happened before. This is their first year. They are creating the business as they go. So it would be extremely useful for the partners in this startup company to spend a little time planning out on paper how things are going to go before launching into the unknown. For example, our startup company has 10 employees now, but is that enough to handle the necessary workload next month, or is it too many? Well, if you haven't even tried to forecast your level of activity next month, along with the output capacity of your employees, then you have no idea whether 10 employees is too many, too few, or just right. Consider another example. Let's say that your startup company is developing green technology and needs the rare earth element terbium in its production process. The company's terbium supplier is located in China, and the average time between an order being placed and when the terbium arrives is about two months. But sometimes it's one month, and sometimes it can be as long as four months. And without terbium, the entire production process shuts down. With this uncertainty about Terbium delivery delays, operating startup company without a detailed financial and production forecast of Terbium needs is terrifying. A careful financial model is simply a numerical plan of a business's activities made in advance that helps a business identify and solve problems before those problems ever actually arise in the real world. Yes, that startup company needs a financial plan. They need it badly. Trying to operate your new business without some advanced financial modeling is like driving a car without looking ahead out of the front windshield. Exciting? Sure, but not a good idea.

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