Wouldn't it be great if we could tell the future? If we could predict things like how much money our business will make in the future, how quickly we'll run out of cash, or even just what you can spend on lunch tomorrow!
While it is impossible to know exactly what's going to happen in the future (at least for now), we do know that history is constantly repeating itself.
So, when we keep excellent records with enough data, we can start identifying trends that occur over time. Using financial data, we can see weeks and months where spending is historically high and infer that similar things might happen in the future using some basic math. Still, one of the most difficult aspects of any financial forecast is revenue; it's just incredibly hard to predict how much money we'll make in the future, especially early on!
The Revenue Problem
Revenue, or sales, is just a fancy word to denote money that's coming into a business in exchange for goods or services.
In many businesses, like e-commerce, tax planning, and Christmas light installations, sales increase and decrease depending on the season of the year. For example, e-commerce companies often see massive spikes in sales during the winter due to the holidays.
Businesses often start off being built on one-off sales or one-off service engagements. With this structure, it's easy enough to see that the best customers are the ones that return again and again to make additional purchases. They had an excellent interaction with your business or enjoyed your product so much that they decide to come back.
These sales are incredibly difficult to predict. With the seasonality of many businesses, one-off customers, and repeat customers, there's not always a clear pattern!
What is Monthly Recurring Revenue?
MRR, or Monthly Recurring Revenue, is a common metric used by businesses of all sizes to denote money that's received for products and services billed every month. Think of Netflix, for example, who gives the option for subscribers to be billed monthly. For $20 per month, you're able to stream thousands of shows from their platform. In exchange, they reliably receive $20 from you (and the rest of their 200 million subscribers) every month like clockwork.
This MRR subscription model is extremely common in technology-based businesses because it's an easily digestible, scalable, and predictable pricing model.
Now, not every business is quickly built using subscription-style billing. Restaurants, physical products, and some services are better suited for one-off services! However, subscription-style billing enables business owners to better predict what their sales will be in the future.
How to Predict Sales Using MRR (Monthly Recurring Revenue)
How do you project growth using MRR? The process is relatively simple.
First, we'll need to understand our revenue growth rate. Put simply, this is the rate at which the amount of money coming into the business increases (or in some cases, decreases) each month. Calculating the growth rate of your business is easy, we use the following formula:
Present Month - Past Month / Past Month
For example, to understand growth between January (01) and February (02), we would simply calculate February minus January divided by January to get a decimal rate.
Let's say our business did $10,000 of sales in January and $15,000 of sales in February.
$15,000 (01) minus $10,000 (02) equals $5,000.
$5,000 divided $10,000 (01) equals 05.
Multiplying this rate allows us to get a percentage of 50%. That means our business grew by 50% from January to February! By calculating this rate of month-to-month growth over the span of several periods, we can get an average rate of growth.
Identify the rate of growth from January to February, February to March, March to April, and so on. Then, add up each percentage and divide them by the total number of months to understand your average growth rate. The more data that you have, the more accurate your average becomes.
Once we have an average growth rate from looking at several periods in time, we can use that percentage to predict the future. For example, if your average MRR growth rate over the past 12 months has been 30%, you can assume that your next month's MRR will be 30% more than the previous. If the business has $10,000 of MRR in January, assuming a 20% growth rate, we can predict that February MRR will increase to $12,000 (10,000 x 1.20).
What if you don't use MRR?
As I mentioned before, not every business is ripe for an MRR-based billing model, and that's okay. There are two excellent ways of analyzing sales for businesses without recurring billing.
First, we can understand trends of revenue by analyzing historical data. By comparing current data to previous periods, you can begin to see trends of growth. Looking at a previous year broken out into months, it's much easier to pick out periods in which revenue was higher or lower (seasonality). You can compare trends from prior years to show how revenue will ebb and flow in your current year.
Another option for understanding sales is to use a rolling period average. For example, if you measure your business in months, taking an average per quarter allows you to get an idea of what the following month may hold. For example, taking the average number of sales between January, February, and March can help to predict sales for April. Larger sample sizes can affect how the seasonality of your revenue shows up in your predictions.
What's the catch?
While predicting your sales revenue may be incredibly helpful, it's a slippery slope.
Projections are useful guiding tools, but they're never going to be fully accurate. It's almost impossible to exactly project what's going to happen in a business simply because there are so many factors that go into making money! The world is constantly changing and evolving; political, economic, social, and technological factors will affect every small business differently.
Using projected sales figures can help you to get a rough understanding of what you can achieve within your business, but it's certainly possible to be under or over those numbers by a huge margin! Take every projection that you make with a grain of salt and always be sure to consult with an independent third party to check your math.