Building a better AOP: How to use financial forecasting in your annual planning process

“Plans are only good intentions unless they immediately degenerate into hard work.”  — Peter Drucker

Your annual operating plan (AOP) can help you translate strategy into action when built with accurate financial forecasts. 

Accurate financial forecasts strengthen your AOP by ensuring you set realistic goals, devise effective strategies for implementation, and stay prepared for any unforeseen market conditions (given today’s dynamic global situation, no amount of planning can prepare you for exigencies). 

Financial forecasting predicts future business outcomes by considering existing data, current trends, and expert opinions. 

Unlike budgeting, which is typically short-term (e.g., monthly, quarterly, annual), financial forecasting covers both short and long periods (usually 12-24 months) and is more complex, involving various scenarios and outcomes to arrive at the most accurate prediction for their unique business conditions. 

This article will give you an in-depth understanding of how you can leverage financial forecasting to create a better AOP along with some tips on how to avoid common problems that occur in the annual planning process. Let’s dive in!

Understanding the importance of financial forecasting in annual planning and the AOP

Financial forecasting estimates future financial performance based on historical data, market trends, and business insights. In the context of annual planning, the financial forecast is central to the process and provides the foundation for the AOP, enabling companies to:

• Ground their future plans in the most current financial reality
• Identify trends and patterns that may impact future performance
• Set realistic and achievable goals
• Develop or adjust strategies in response to emerging challenges or opportunities
• Make more informed decisions about resource allocation
• Align departmental targets and KPIs with the overall financial and strategic objectives
• Be agile and stay ahead of competition

The process of financial forecasting for the AOP typically begins around the eighth month of the current fiscal year. At this point, companies have eight months of actual financial data and projected data for the remaining four months of the current year. 

This 12-month forecast then serves as the baseline for developing the upcoming year's AOP.

For example, let’s assume Company ABC’s fiscal year is from January 2024 to December 2024. 

The financial forecast for its current year (FY 2024) includes actuals for top line revenue for the first eight months of the fiscal year (January to August), which was 10% every month. The forecast also includes projections for the remaining four months (September to December) which estimate top line revenue at 11% every month. This forecast, which is  based on historical data, current trends, and business performance, now becomes the  baseline for FY 2025’s AOP. 

Note: For FY 2025’s AOP, Company ABC has to factor in considerations like the FY 2025 revenue plan vs. FY 2024 performance. What is the growth percentage and what is the expectation? What are the expenses? What will be the expenses? 

From the example, we can see that the FY 2024 full forecast of 124% revenue is the starting point for FY 2025’s AOP and that with an estimated revenue growth of 10%, the top line revenue forecast is 136.4% for FY 2025. 

The more accurate your financial forecast, the more effective your AOP will be in guiding your company's strategic direction, setting initiatives, and preparing for contingencies in the upcoming year. 

How does a rolling forecast inform the AOP?

Unlike a quarterly or annual budget which has a set timeframe, a rolling forecast projects your company’s budget, revenue, and expenses on a continuous basis. It usually has a forecast period 12-24 months out, over and above the calendar year, and is typically updated on a monthly or quarterly basis, taking into account YTD performance, the original budget, current market conditions, and any other factors that impact financial health and performance.

So, what exactly is the connection between rolling forecasts and your annual operating plan?

We know that once the AOP is finalized, usually at the end of the previous fiscal year, it cannot be changed. 

Let’s assume Company ABC (from the earlier example) has already created their FY 2025 AOP and it’s in the final stages of planning. 

Since the AOP is yet to be finalized and signed off (typically December 31), the CFO and finance team may choose to update the assumptions and numbers of the FY 2025 forecast—based on the rolling plan for the remaining four months (September to December 2024). This will help ensure that the company is better prepared to respond to any shifts in the market or course correct as needed (based on business performance). 

How does scenario planning affect the AOP?

When developing an AOP, it's crucial to consider various scenarios, especially as the fiscal year progresses. 

In the earlier example, at the eight-month mark of FY 2024, once Company ABC reviews the actuals vs. the forecast, it may not have enough time at that point to change course for the current year if the need arises. In such a situation, scenario analysis can help the company determine what it can realistically achieve for the remainder of the year.

For example, let’s assume Company ABC’s sales team wasn’t able to meet its growth targets until August 2024. 

This is when the sales manager has to consider various scenarios and explore different possibilities and outcomes. Consequently, the sales manager could come back with a more aggressive approach and set a higher run rate to make up for the lag every month in a bid to achieve the team’s overall target. However, this approach could be countered by the CXOs and other stakeholders who feel a more conservative approach would work better, in the light of available data sets and current trends.

Ultimately, the sales team and leadership may agree on a more achievable middle-ground approach and adjust the assumptions in FY 2024’s AOP accordingly to help ensure they have a realistic way forward for the remaining four months of FY 2024.

These different AOP scenarios also significantly impact cash flow projections. Higher revenue scenarios might predict more robust cash inflows. On the other hand, more conservative scenarios could indicate potential cash flow challenges. 

Pro tip: To mitigate risks and prepare for various outcomes, always try to include multiple scenarios in your AOP.

Two approaches for financial forecasting 

There are two main approaches in the financial forecasting process: top-down and bottom-up forecasting. These two approaches differ in how they define and adjust financial targets within an AOP. 

Top-down financial forecasting model

In the top-down approach, usually the CXOs and key stakeholders (board members and investors) direct the financial targets and overall objectives for the year. These targets then cascade down to various departments, forming the foundation for the company’s AOP.

This approach starts with a macro-level perspective, considering market trends, industry conditions, and other economic factors before narrowing down to specific company targets. 

• Pros of top-down forecasting:  Speedy and simple

• Cons of top-down forecasting:  Relies on assumptions and high-level estimates, resulting in ambitious targets for individual departments

Bottom-up financial forecasting model 

In the bottom-up approach, individual department heads share their insights on what is actually achievable, as compared to the leadership’s expectations, leading to a more balanced and actionable financial plan.

In this approach, each department creates its forecast based on actual figures, such as sales numbers, production capacity, or headcount. These departmental forecasts are then combined to form a company-wide financial forecast.

• Pros of bottom-up forecasting: Accurate and detailed

• Cons of bottom-up forecasting: Time-consuming and sometimes result in fragmented or siloed forecasts

While the leadership provides the overall targets in a top-down manner, the bottom-up data ensures that these targets are realistic and grounded in operational reality. This alignment between the two methods creates a comprehensive and actionable annual operating plan. 

In both approaches, however, CFOs and finance teams use different financial forecasting models to predict outcomes and manage resources as driven by their unique business requirements. These might include as the total addressable market (TAM) model, sales rep or quota-based model, or funnel-based or pipeline-based model.

Common mistakes to avoid in financial forecasting

Here’s a look at some of the common mistakes finance teams make during the process of financial forecasting and in AOP planning:

1. Using outdated data

One of the most frequent errors is relying on outdated data. For example, if you base your forecast on the first eight months of the previous year and leave out the final four months, you’re working with incomplete information. 

Let’s say you’re building a forecast for FY 2024 using the actuals from FY 2023 through August but without projections for the remaining months. This method falls short because it doesn’t capture recent trends that could significantly impact the next fiscal year.

2. Ignoring external factors

External factors play a huge role in financial forecasting. Market conditions, competitive trends, and macroeconomic downturns are crucial variables. Ignoring these factors can cause significant gaps in your forecast.

For example, you need to consider the placement and sale of your product against competitors. If a new competitor with a superior product enters the market, your expected sales may take a hit. Similarly, your forecast and outcomes would need to account for recessions or inflationary pressure. 

3. Overlooking seasonality

Seasonality often manifests in predictable patterns of customer behavior in SaaS. For instance, many businesses tend to evaluate and purchase new software solutions just before their annual planning cycles. Failing to account for these seasonal trends can result in misaligned revenue projections and challenges in resource allocation (both funds and personnel).

4. Being too optimistic or pessimistic

Overly optimistic projections can set unrealistic expectations, leading to lagging targets and potential loss of credibility. Conversely, being too pessimistic can result in underutilized resources and missed growth opportunities.

5. Failing to communicate or collaborate

Effective financial forecasting requires inputs and data from various departments and stakeholders across the organization. Therefore, it is all the more necessary to have open and transparent communication channels among the finance, sales, marketing, and operations teams. Each department brings unique insights that help create more accurate and comprehensive forecasts. Failing to collaborate can result in forecasts that don't reflect the business’ financial health in entirety, ultimately impacting your business performance.

6. Not learning from your mistakes

Another common pitfall is failing to learn from previous forecasting errors. If last year’s forecast didn’t hit the mark—perhaps your assumptions were flawed or market conditions shifted in a way you didn’t anticipate—it’s essential to revisit what went wrong and adjust your approach for the upcoming year accordingly.

Role of technology in AOP planning and financial forecasting 

As a CFO or senior finance leader, your goal is to not only create a comprehensive and accurate financial forecast that guides decision-making, but also ensure it covers all the scenarios and is adaptable to shifting market conditions and business needs. Striking the right balance between too complex or too simple financial models is key to the success of your financial forecasts and ultimately your annual operating plan. Technology in the form of strategic finance software plays an important role in making this balance easier to achieve. 

With the right financial forecasting tools, you can streamline the entire financial forecasting and AOP planning process, reduce manual errors, and ensure that your assumptions and forecasts remain relevant and adaptable.

Modern annual planning software like Drivetrain enables finance teams to leverage the power of automation and data more efficiently, and to create accurate financial forecasts and robust annual operating plans, by: 

1. Streamlining data consolidation: Drivetrain’s 200+ native integrations enable seamless data consolidation and validation from disparate systems into a single source of truth. 
2. Offering real-time visibility: With Drivetrain, your P&L updates in real-time as team members input data and you have access to the most recent figures around financial health and business performance.
3. Automating manual processes: Drivetrain automates key forecasting and planning processes, reducing the pressure on and manual workload of finance teams while minimizing human error in your financial models.
4. Enhancing financial reporting: Drivetrain's platform offers powerful dashboard and reporting capabilities, improving the effectiveness of AOP planning. Custom report templates help streamline the process of creating data-rich and consistent reports, while dynamic dashboards add clarity to the forecasts and assumptions by breaking down complex data into easily comprehensible charts and graphs.
5. Monitoring performance metrics: Drivetrain enables you to efficiently track and analyze your SaaS metrics, ensuring your forecasts are realistically aligned with your overall business objective and allied key performance indicators (KPIs).
6. Conducting scenario planning and what-if analysis: The platform's advanced scenario planning and “what-if” analysis capabilities enable SaaS CFOs and finance teams to model various outcomes and consider multiple scenarios to improve the accuracy and reliability of their financial forecasts, and remain agile in the face of shifting market economics.

Discover how Drivetrain can help you build more accurate financial forecasts and simplify your AOP planning.