Why is a profit and loss forecast important for businesses?
Financial planning and forecasting play a crucial role in ensuring the success and sustainability of a company. Without a clear understanding of future revenues and expenses, companies may struggle to make informed decisions, allocate resources effectively, and ensure sustainable growth. A powerful tool to tackle these challenges is the profit and loss forecast.
This article aims to shed light on the significance of a profit and loss forecast and its calculation and provide examples to help you understand its practical application.
A profit and loss forecast is the projection of a company's anticipated financial performance over a specific period. By analysing historical data, market trends, and economic indicators, this forecasting tool empowers business owners to anticipate revenue, assess expenses, and determine the net profit or loss they may face.
This tool helps in forecasting profitability and plays a crucial role in cash flow management and liquidity planning. Providing insights into anticipated revenues and expenses, it enables businesses to proactively manage their cash flow, meet financial obligations, optimise resource allocation, and maintain a healthy financial position.
The profit and loss (P&L) statement, or income statement, summarises the following key elements or performance metrics of the company’s operations:
- Revenue/Sales: It is the total amount of money generated from the sale of goods, services, or other operating activities during a specific period.
- Cost of Goods Sold (COGS): These include the costs directly attributable to the production or acquisition of goods or services, such as raw material purchases, labour costs, and manufacturing overheads.
- Gross Profit: It is the difference between sales and COGS and represents the profit made before accounting for operating expenses.
- Operating Expenses: These encompass the non-production costs associated with running the daily operations, namely rent, utilities, and administrative costs.
- Operating Profit: It is the difference between gross profit and operating expenses and is representative of the profitability of the business’ core operations.
- Other Income and Expenses: These include gains and losses from the sale of assets, interest income/expense, taxes, etc. and aren’t pivotal to a company’s core.
- Net Income/ Loss: It represents the overall profit or loss earned by the company after accounting for all expenses.
See also: Balance Sheet Forecast: How-To
Let us consider an example to understand a profit and loss forecast.
Sarah's Bakery, a popular local bakery, wants to evaluate the financial viability of expanding its product line to include gluten-free and vegan options. They create a profit and loss forecast specifically for the new product line.
The forecast includes projected revenues from the sale of gluten-free and vegan products, costs associated with ingredients, packaging, marketing, and additional staff. By analysing the forecast, Sarah's Bakery can determine if the expansion will generate sufficient profit and help them meet customer demands.
In business terminology, a profit forecast and a profit and loss forecast are essentially the same thing. The terms "profit forecast" and "profit and loss forecast" are often used interchangeably to refer to a financial projection that estimates the expected profit or loss for a given period, typically a year.
The primary difference between a profit and loss forecast and a general forecast lies in their focus and scope.
A profit and loss forecast specifically centres around the financial performance of a business. This forecast is prepared using common accounting standards and is tailored to provide insights into the financial health and profitability of the company. It considers factors such as sales projections, production costs, operating expenses, and other revenue-generating or cost-incurring activities.
In comparison, a general forecast typically encompasses a broader range of predictions beyond financial aspects. It may include projections related to market trends, customer behaviour, industry growth, technological advancements, or any other relevant factors that impact the overall business environment.
A general forecast aims to provide a comprehensive outlook to guide decision-making, strategic planning, and resource allocation across various aspects of the business.
While both cash flow forecasts and profit and loss forecasts are important financial tools for projecting business performance, they vary greatly as they are concerned with different aspects of the company.
A cash flow forecast provides a precise view of the company’s net cash position by projecting cash inflows and outflows over a specific period, including cash sales, customer collections, loan repayments, and more. It helps assess the company's liquidity and working capital management from a short-term perspective, typically on a weekly or monthly basis. By proactively identifying any cash shortfalls, it enables firms to timely meet their obligations.
Conversely, a profit and loss forecast estimates the firm’s revenues and expenses, and how much profit it has earned over a certain period of time. It is concerned with the company’s operational performance and provides insights into the company’s cost management and profitability. Unlike a cash flow forecast, it has a relatively long-term perspective.
To calculate a profit and loss forecast, you need to consider several key elements. Here's a step-by-step guide on how to calculate it:
Gather historical data: Collect relevant financial information from past periods, such as sales revenue, cost of goods sold, operating expenses, and other income or expenses. This data will serve as a foundation for estimating future performance.
Define the forecast period: Determine the timeframe for the forecast, whether it's monthly, quarterly, or annually. The length of the period may vary depending on the business's needs and industry.
Project revenue: Estimate the expected sales revenue for each period based on market trends, historical sales data, anticipated changes in customer demand, pricing strategies, and any upcoming product launches or promotions.
Estimate cost of goods sold (COGS): Calculate the direct costs associated with producing goods or services, including raw materials, labour, manufacturing expenses, and any other variable costs. This estimation should align with the projected sales volume.
Factor in operating expenses: Consider all operating expenses, such as rent, utilities, salaries, marketing expenses, insurance, and other administrative costs. Ensure they are accurately accounted for in the forecast.
Calculate gross profit: Subtract the projected COGS from the estimated revenue to determine the gross profit for each period. This represents the profitability before accounting for operating expenses.
Deduct operating expenses: Subtract the operating expenses from the gross profit to calculate the operating profit (also known as earnings before interest and taxes, or EBIT). This figure reflects the profitability after accounting for all operating costs.
Include non-operating income and expenses: Factor in any non-operating income (e.g., interest income, investment gains) or expenses (e.g., interest expense, foreign exchange losses) that may impact the overall profit or loss.
Calculate net profit/loss: Subtract non-operating expenses from non-operating income and add the result to the operating profit. This will provide the net profit or loss for each period.
Review and adjust: Evaluate the forecasted figures, considering any external factors like market conditions, regulatory changes, or business-specific circumstances. Revise the forecast as needed to ensure its accuracy and relevance.
Various templates and software are available to simplify the process of creating a profit and loss forecast. These tools provide predefined categories and formulas that enable you to easily input your revenue and expense figures. An example of a template is given below.
|Particulars||Year 1||Year 2||Year 3|
|- Other Income|
|Cost of Goods Sold|
|- Direct Costs|
|- Indirect Costs|
|Total Cost of Goods Sold|
|- Other Expenses|
|Total Operating Expenses|
|- Interest Income|
|- Investment Gains|
|Total Other Income|
Microsoft Excel is a powerful tool that can be used to forecast profit and loss. Here's a step-by-step guide on how to forecast profit and loss using Excel:
Create a new Excel worksheet and set up a table with columns for Year, and rows for Revenue, Cost of Goods Sold, Operating Expenses, Other Income, and Net Profit. Alternatively, you can use the template given above.
Enter the forecasted revenue for each year in the Revenue row.
Calculate the cost of goods sold by entering the projected costs associated with production or delivery in the Cost of Goods Sold row.
Enter the forecasted operating expenses in the Operating Expenses row.
Include any other sources of income in the Other Income row.
Calculate the net profit by subtracting the total cost of goods sold and operating expenses from the revenue and adding any other income.
Format the table as desired and review the forecast for accuracy.
Refine the forecast by adjusting inputs and assumptions as needed.
Yes, a profit and loss (P&L) forecast is anessential component of a business plan and is included in its financial section. Serving as a financial roadmap, a P&L forecast demonstrates the new business’ profitability and viability to financial experts, which helps attract potential investors and lenders. It can also be used to benchmark the company’s actual performance after it becomes operational.
To gain actionable insights and make informed decisions based on your profit and loss forecast, take the following steps:
- Continuously monitor actual performance and compare it against the P&L forecast to identify variances.
- Analyse the causes of variation, including assumptions underlying revenue and expense projections, material changes in market and economic trends, and pricing effects.
- Conduct scenario planning and sensitivity analysis to understand the impact of differing circumstances on business performance and to better anticipate risks and opportunities.
- Follow it up by tweaking and realigning your financial targets with strategic goals for informed decision-making.
There are several factors that impact a business’ P&L forecast, such as sales volume, pricing strategies, and cost structure. External factors like market conditions, economic events, seasonality, and the regulatory environment also affect financial forecasts.
Businesses must establish key profitability metrics, such as gross profit ratio, EBITDA margin, and net profit margin, to effectively monitor their actual financial performance. These figures are then compared against P&L projections to identify variances. For instance, if the operating profit falls short of expectations, analyse whether it is related to lower sales or higher costs and accordingly take corrective action. Eventually, the underlying assumptions can be changed in the event of permanent changes in the circumstances facing the business.
Profit and loss forecasting involves certain limitations, such as data limitations, complexities in assumptions, and a lack of control over external factors, which may result in projections being less than accurate. Businesses must also be cautious of data integration challenges and the role of human biases when reviewing P&L forecasts. The ultimate aim should be to strike a balance between accuracy and adaptability to make more informed decisions.
Profit and loss forecasting is a resourceful tool to help you make informed decisions, allocate the limited resources effectively, and ensure your business's sustainable growth.