Building a Financial Forecast for Business Valuation | PCE

When it’s time to value your business, whether for succession planning, estate planning or gifting, resolving partnership issues, or a preparing for a potential sale, one of the most important documents you’ll need is a financial forecast. Business appraisers rely on management-prepared forecasts to estimate the future earnings and cash flows that are a core driver of the value of your business. Without a clear, credible forecast, you risk undervaluing your business, slowing the process, or even undermining negotiations. 

Many small business owners find themselves unsure of where to start. What should a financial forecast include? How detailed does it need to be? How do you determine a reasonable growth expectation? Can you rely on historical performance? Who can help you generate a forecast?

This guide answers those questions and walks you through the process of building a forecast that is clear, supportable, and valuable not only for your appraiser, but also for making smarter business decisions.

What is a Financial Forecast?

A financial forecast is a forward-looking projection of your business’s performance over a defined time horizon, typically three to five years. A forecast is a projection of the business’s future revenues, expenses, and cash flows based on assumptions about how your business will evolve over time. The length of the forecast period is usually dependent on how long it is estimated to take your company to realize steady growth and profit margins. For early-stage companies, this can be far in the future and for more mature companies, this can be several years out.

It is important to distinguish a forecast from a budget. A budget is often a short-term, operational plan for the upcoming year and is used to assess actual performance against expectations. A forecast, on the other hand, looks at long-term trends and assumptions about growth, profitability, and strategy and models out how the business can potentially perform in the future.

In the context of a business valuation, a forecast is critical when using income-based methods like the discounted cash flow (DCF) approach. The assumptions you make about the future become the foundation of the value estimate.

Key Components of a Financial Forecast

Revenue Forecast

1. • Revenue is often the first concept that management teams think about when developing a forecast. A concrete vision of how revenue can grow in the future often informs the expense projection since expenses are often tied to revenues.
   • You’ll want to project revenue based on identifiable drivers. Ask yourself: What products or services do we sell? How many units do we expect to sell? What price point have we achieved and what do we expect achieve? How many new customers will we acquire? Do we have any major leads in our pipeline?
   • Consider using a bottom-up approach (starting from individual sales reps or product lines) or a top-down approach (starting with market size and your market share), depending on your data.
   • If your business is seasonal or tied to economic cycles, that should be reflected in the timing and pacing of revenues.

Cost of Goods Sold (“COGS”)

1. • COGS includes all direct costs associated with producing your goods or services, such as materials, labor, and any variable overhead. Projecting COGS accurately is essential because it impacts your gross margin, which serves as a key benchmark for your appraiser and potential investors.
   • It is often helpful to identify the most recent trends in your gross margin [(Revenue less COGS) / Revenue] as this can inform just how much COGS can be expected based on future projected revenue.
   • If COGS has been volatile, it is important to understand why (are components to goods sold tied to volatile commodities?). If you rely on a volatile commodity, it could be helpful to review public data sources that professionally forecast future commodity prices to get a sense of what a reasonable expectation of your input costs could be.

Operating Expenses

1. • Your operating expenses, (i.e., payroll, rent, marketing, insurance, utilities, software, etc.) often times follow the direction of revenue, but are likely more fixed in nature. Separate fixed costs, such as rent, from variable costs like marketing. Modest growth rates are likely applicable for fixed costs, unless you expect to require a substantial fix cost investment/expansion to facilitate future growth plans. Variable costs are often more correlated to revenue growth and can be expected to grow quickly as the Company grows.
   • Discuss future variable cost expectations with your department leads to understand what they may require to help facilitate the growth of the Company.

Capital Expenditures and Depreciation

1. • Will your business need to invest in new equipment, vehicles, or technology in the coming years? These capital expenditures (capex) should be included, especially if they’re material to future growth.
   • Account for depreciation of those assets as well as existing assets.

Working Capital Needs

1. • Working capital is the cash you need to keep the business running day-to-day. As revenue grows, your working capital needs often increase.
   • Forecast key components such as accounts receivable, inventory, and accounts payable.

Developing Realistic Assumptions

The strength of your forecast lies in the credibility of its assumptions. Your appraiser will evaluate whether they are grounded in reality and supported by historical trends, industry data, or operational plans.

Tips for Making Realistic Assumptions

1. Use historical financial data as a baseline and attempt to identify any trends: Are sales growing steadily? Are margins improving? Are these trends likely to continue int the future?
2. Research industry benchmarks for your sector and compare them to your Company’s historical and projected performance. Common sources are: IBISWorld; Big 4 Accounting Firm industry reports; and AI LLMs such as ChatGPT, Claude, Perplexity, or Gemini (focus on questions about industry growth and making sure the LLM provides sources for you to confirm).
3. Consider macroeconomic factors such as inflation, labor shortages, regulatory changes, and your local economy. See the Federal Reserve Bank of St. Louis website for a trove of easily accessible national, state, and regional economic statistics.

Common Mistakes to Avoid When Building a Forecast

Many small business forecasts fall short of credibility because of a few common mistakes which you should do your best to avoid.

1. Unsupportable growth: Your growth forecast should be based in tangible realities about your business. Is your industry growing rapidly? Has the Company been experiencing substantial recent growth? Is a key customer generating a lot of sales and indicating this will continue? If there isn’t a well-grounded rationale for the growth, it may not reflect an achievable outcome and can reduce the credibility of the projections.
2. Ignoring past performance: If the Company has been struggling recently, it may be unreasonable to project a substantial improvement without a proper set of catalysts.
3. Rounding: Ensure you are not rounding significant numbers that drive the results in a material way.      
4. Granularity: It is important not to lump too many key line items together. Instead, provide as much granular data as possible. For example, it is best to provide many categories of expenses on an individual basis where each individual fact pattern can be assessed instead of providing a single lumped sum of the Company’s operating expenses where it is difficult to analyze the assumption.
5. Lack of detail or transparency: Each input should be labelled and include a description so a reviewer can properly interpret the full set of facts.

How the Forecast Fits Into the Valuation Process

Once completed, your forecast can be used to estimate the value of your business, typically by applying a DCF method. If the forecast is credible, the appraiser will utilize the forecast to develop the forecasted cash flows to the various equity and debt holders of the Company. The appraiser will then generate an appropriate discount rate to determine the present value of those cash flows. This discount rate will be determined by assessing the risk of the Company’s operations, market position, and the relative achievability of the forecasted results.

• Appraisers may adjust your forecast after consulting with you to better reflect a normalized financial position from the perspective of a potential buyer or lender. Adjustments might include: Normalizing management/owner compensation if it is projected to be above/below market compensation rates.
• Removing owner perks or benefits beyond typical executive benefits structures.
• Eliminating discretionary expenses that are not necessary or directly related to the operations of the business.

Conclusion

Creating a thoughtful financial forecast isn’t just about helping your appraiser, it’s a valuable exercise in understanding your business’s future potential and the value creation that it can produce over time. It clarifies your growth strategy, helps anticipate costs, and prepares you for future capital needs.

If you're planning a valuation engagement, don’t wait until the last minute to pull together a projection. Start now, refine as needed, and reach out to your appraiser or accountant with questions along the way.

A clear and well-supported forecast can make the difference between a rough estimate and a credible valuation.

Rolf Witt

Rolf Witt specializes in business valuations for estate planning, ESOPs, corporate transactions, and financial reporting. With over five years of experience, he brings deep expertise in valuing privately held businesses across a range of industries and asset classes.

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